Introduction
Shareholders do not directly participate in management, transferring this function to the hired CEO. It may result in a conflict of interest of owners and managers as the leading participants in corporate relations. Shareholders are concerned about a highly profitable company strengthening its long-term business position and a low level of risk for their investments. The case analyzed by Harford and Li (2007) aims to explore the problem of decoupling CEO wealth and firm performance. CEOs create strategies and often make the final decisions about mergers and acquisitions (M&A). Therefore, executives tend to perform various types of M&A at the expense of debt rather than optimize business processes.
Case
The level of dependence of CEOs and board members’ earnings to company earnings are different. According to Harford and Li (2007), a few decades ago, the stock portfolio’s modifications affected CEOs and shareholders in the same way. However, there is another tendency when CEOs’ compensation only grows after acquisition (Harford & Li, 2007). According to Harford and Li (2007), this trend explains the reasons for value-destroying mergers in the 1990s. Harford and Li (2007) observe that the average CEO’s salary rises by 41% from the fiscal year before acquisition to the year after its completion. This results in the insensitivity of CEOs’ pay to a company’s performance, whereas the latter can show negative figures.
Corporate Governance Area
Corporate governance is a management system designed to maintain effective interaction between shareholders and the company’s management. It helps shareholders to have at their disposal a mechanism to control the company’s CEO, as well as to defend their interests in terms of problems with other influence groups (Larcker& Tayan, 2016). Corporate governance aims to resolve conflicts of interest between owners and managers of the organization (Larcker& Tayan, 2016). One of the areas of concern in corporate governance is executive compensation (Larcker& Tayan, 2016). At present, the CEO’s remuneration issues have been among the most controversial topics from the perspective of its fairness.
Discussion
Referring to CEOs, their interests may not coincide with shareholders’ intentions as hired managers are prone to building business empires and enhancing their prestige and compensation. The study, conducted by Harford and Li (2007), reveals the evidence of acquisition impact on CEO’s wage in a favorable way for the latter. Furthermore, according to Harford and Li (2007), after acquisitions, the CEO compensation is less dependent on the company’s economic performance. Another research conducted by Choi et al. (2020) suggests that CEOs practice acquisitions to increase the company’s size to raise their compensation.
Moreover, Choi et al. (2020) note that the firm size matters for the CEO compensation, mainly when these factors are interconnected. Harford and Li (2007) observed that the pay for bidding organizations’ CEOs is stable despite their shareholders being worse off. Thus, acquisition can be driven by CEOs proceeding from personal financial interests.
The agency theory assumes that different participants are dependent on each other in commercial relations. Shareholders give instructions for the correct execution by the CEO. The critical point is information asymmetry; referring to executive compensation, it is much stronger due to acquisitions, which can be considered the only way to achieve such asymmetry (Harford & Li, 2007). Chen et al. (2017) report a positive correlation between CEO’s compensation and asset growth through bank mergers. Since CEOs have more information, they can use its advantage for their purposes. According to Choi et al. (2020), it results in CEOs’ opportunistic behavior as acquisitions may create opportunities for self-serving executives. Chen et al. (2017) claim that merger growth raises equity compensation levels without impacting cash compensation. Thus, post-acquisition CEO compensation is higher than pre-acquisition CEO salary.
The reasons for such an issue are the company’s weak governance, ineffective monitoring by the board and powerful, entrenched CEOs. According to Harford and Li (2007), large internal investment does not contribute to compensation growth to the same extent as acquisition. Harford and Li (2007) note that internal and external investment affect CEOs and boards differently. CEO’s pay always requires negotiation after the acquisition, while capital expenditures do not require such actions.
However, there is another evidence that acquisition does not benefit the CEO’s compensation. These days, the information is available publicly, preventing opportunistic behavior (Choi et al., 2020). Reputation theory implies that CEOs try to maintain lasting careers; consequently, particular actions may affect their labor market status (Choi et al., 2020). The study conducted by Bick and Crook (2018) explores that CEOs are more expected to be discharged for unlucrative acquisitions. Hence, this outcome does not contribute to the CEO’s intention to make acquisitions (Bick & Crook, 2018).
Furthermore, Bick and Crook (2018) concluded, researching M&A activities after 2003, that increasing CEOs’ pay has stopped after that year. Harford and Li (2007) investigated mainly acquisitions at the end of the 20th century. However, the findings by Bick and Crook (2018) concluded that compensation after M&A completion remains sensitive to negative firm performance. The results of different periods vary in terms of sensitivity of CEOs’ pay and companies’ performance.
Practices
Several practices can resolve the issue of increasing the CEO’s pay after acquisition. Choi et al. (2020) claim that active monitoring and diminishing CEO power manage decreased post-acquisition bonuses. This also contributes to the enhanced CEO compensation sensitivity to acquisition results (Choi et al., 2020). Bick and Crook (2018) argue that mutual funds can balance compensation-level inefficiencies. Even though executives receive higher compensation, CEOs, on average, are not getting more excess earnings (Bick & Crook, 2018).
The common interests of executives and owners could be improved by the increasing stock use in CEO compensation (Choi et al., 2020). According to Choi et al. (2020), if it were connected to the organization’s performance, CEOs would not be engaged in unprofitable acquisitions. According to Bick and Crook (2018), voting against management by monitoring funds increases sensitivity to negative performance (p. 87). Thus, active shareholder participation contributes to decreasing potential compensation growth.
Personal conclusion
In my opinion, the objective of the corporate governance system is to reduce the overall amount of agency costs and increase the value of the company for investors. CEOs generating significant free cash flows do not intend to pay dividends to shareholders but offer to finance ineffective mergers and acquisitions. To resolve this conflict, shareholders should consider effective control mechanisms and assess the ways of CEOs’ encouragement, particularly the cost of paying remuneration and motivating managers.
General Conclusion
To sum up, unprofitable acquisition decisions do not cause the CEO’s compensation to decrease; on the contrary, it leads to its growth (Harford & Li, 2007). Several studies conducted after that show mixed results and points of view; for instance, Bick and Crook (2018) elaborate on their position that at present unprofitable acquisitions may lead to reputational damage, dismissal of CEOs. However, the tendency to perform M&A instead of optimizing business processes still exists and depends on the firm’s size (Chen et al., 2017). Moreover, to reduce this issue, active monitoring and diminishing CEO power should be implemented to decrease post-acquisition bonuses (Choi et al., 2020). Overall, executives’ interests such as increasing the size of the company, career growth, personal enrichment come into conflict with the interests of shareholders.
References
Bick, P., & Crook, M. D. (2018). The effects of mutual funds on M&A compensation. Journal of Financial Research, 41(1), 67-89. Web.
Chen, Z., Hung, W., Li, D., & Xing, L. (2017) The impact of bank merger growth on CEO compensation. Journal of Business Finance & Accounting, 44(9–10), 1398–1442. Web.
Choi, J. J., Genc, O. F., & Ju, M. (2020). Is an M&A self‐dealing? Evidence on international and domestic acquisitions and CEO compensation. Journal of Business Finance & Accounting, 47(9-10), 1290-1315. Web.
Harford, J., & Li, K. (2007). Decoupling CEO wealth and firm performance: The case of acquiring CEOs. The Journal of Finance, 62(2), 917-949. Web.
WebLarcker, D., & Tayan, B. (2016). Corporate governance matters: A closer look at organizational choices and their consequences. Pearson Education.