Eliminating the Agency Problem in Publicly Traded Companies

Eliminating the Agency Problem in Publicly Traded Companies

An agency problem in publicly traded companies is the phenomenon that occurs when agents (the management of a company) who are entrusted with the responsibility of wealth maximization by principals (stakeholders) take advantage of their positions for personal enrichment. Managers can leverage loopholes that exist in companies to siphon company resources for their own benefit. Principals can leverage negative and positive incentives to arrest the agency problem. A wide body of research reveals that executive compensation schemes can help alleviate the agency problem in publicly traded companies.

According to Bebchuk and Fried (2003), boards can use the optimal contracting approach to design executive compensation in a way that offers CEOs incentives to maximize shareholder value. Based on this strategy, a CEO’s salary will increase if the company’s stocks perform well in the market. This incentive will motivate the CEO to implement strategies that will help the company perform well, and that includes improving the day-to-day operations. However, this approach comes with some flaws. For instance, there are political limitations that affect the extent to which generosity can be extended to company executives. To that end, tying the CEO’s compensation to stock performance may not be a high-powered approach to alleviate the agency problem.

Another approach that will go a long way to mitigate the agency problem in publicly traded companies is the managerial power approach. This approach is based on the fact that CEO compensation arrangements design is a product of the agency problem. A key building block of this strategy is the outrage costs and constraints. Although this approach gives a CEO the power to determine their earnings, their acceptance or rejection of salary increases will depend on the expected reactions of relevant outside parties (Bebchuk & Fried, 2003). Outrage is particularly limiting for CEOs because it can embarrass them, leading to reputational harm. To that end, the more outrage a compensation arrangement is likely to cause, the less likely that managers will accept the offer. In the long run, compensation arrangements that benefit executives but are suboptimal to shareholders will be accepted or rejected based on how outsiders perceive them.

Bebchuk and Fried (2003) propose transparency and disclosure as a way of limiting CEO rent-seeking. As stated above, rent-seeking tendencies can attract negative reactions from outside parties, harming an executive’s reputation in the process. Disclosure will prevent camouflage, a phenomenon where managers try to hide or legitimize rent-seeking arrangements. A strong desire to camouflage can lead to adopting compensation arrangements that hurt company interests. Therefore, compulsory disclosures will act as a limiting factor to safeguard shareholder interests.

In summary, the optimal contracting and managerial power approaches are executive compensation schemes that can go a long way to mitigate the agency problem. On the one hand, the optimal contracting approach offers executives incentives to improve shareholder value instead of pursuing their interests. A good example of the optimal contracting compensation arrangement is linking the CEO’s compensation to company performance, including performance in the stock market; hence, the incentive to maximize shareholder value. On the other hand, the managerial power approach, which emanates from the fact that CEO compensation design is a product of the agency problem, can be used to prevent rent-seeking. The managerial power approach will prevent executives from designing and/or legitimizing offers that benefit them but offer suboptimal value to shareholders.

References

Bebchuk, L. A., & Fried, J. M. (2003). Executive compensation as an agency problem. The Journal of Economic Perspectives, 17(3), 71–92. https://doi.org/10.1257/089533003769204362

ORDER A PLAGIARISM-FREE PAPER HERE

We’ll write everything from scratch

Eliminating the Agency Problem in Publicly Traded Companies

Lesson Objectives:

Explain how executive compensation schemes can alleviate the agency problem in publicly traded companies
Recognize that the design of compensation arrangements is also partly a product of the same agency problem.
Assignment III details:
Read the attached article by Bebchuk and Fried:

Eliminating the Agency Problem in Publicly Traded Companies

Bebchuk, Lucian and Fried, Jesse (2003). “Executive Compensation as an Agency Problem,” Journal of Economic Perspectives volume 17, Number 3, Summer 2003, pp. 71-92

Assignment – From the article, briefly discuss how executive compensation can be designed to help alleviate agency problems in publicly traded companies.

Submit Assignment:

Create your document using MS Word. Limit your answer/write-up to two pages. When you have completed the assignment, save the file and submit (upload). Check your spelling and grammar.