Gouvernance au quotidien - Everyday Governance

Monitoring board and management, a new way or an old concept?

Monitors include the board of directors, the general counsel, and an internal and external auditor.

The primary purpose of a corporate governance system is to reduce agency costs within an organization. Agency costs occur when the individuals managing or working in an organization take self-interested actions to make themselves better off, with the cost of these actions borne by shareholders.

Agency costs can manifest themselves in countless ways.

-        inappropriate use of corporate assets for personal purposes

-        the bribery of a purchasing agent to facilitate a product sale

-        the manipulation of financial results to boost the size of a bonus

-        trading on the basis of material non-public information

-        the acquisition of a non-strategic asset to increase managerial domain

-        the failure to train a successor to increase the perception of one’s value to the organization.

Time has shown individuals to be extremely creative in devising new ways to profit from the abuse of their organizational position.

To reduce agency costs, companies hire monitors to oversee various activities. These monitors are paid by the organization, but their responsibilities are (largely) non-managerial. They are not expected to develop or implement the corporate strategy, they do not have direct responsibility for profit generation, nor do they control or allocate company assets.

Rather, their job is to safeguard assets, monitor for illicit activity, and discourage management

from excessive risk taking. Though difficult to measure, the success of these efforts will manifest itself through an improvement in operating. Performance, corporate value, and risk levels when agency costs are reduced in the system.

What is the appropriate compensation structure for these individuals?

Compensation design for corporate monitors is complicated.

On the one hand, the objectives of a corporate monitor are to detect and mitigate agency problems. Success is defined as the prevention of errors, while failure is defined as the allowance of errors. This suggests that monitors should be paid largely on a fixed-salary basis, with failure to detect malfeasance punishable by a substantial decrease in salary or outright termination from the firm. A fixed salary discourages variations in outcomes and encourages risk minimization. From this viewpoint, corporate monitors should receive little to no incentive compensation.

On the other hand, an entirely fixed compensation system might not provide sufficient incentive for vigilant monitoring. With little incentive to “perform,” monitors might grow lax in their oversight. A corporation might also not be able to attract the best monitors. From this viewpoint, the corporation should include variable compensation elements to encourage effective oversight, or to attract highly qualified individuals. (…)

The potential downside from imposing compensation risk on monitors is that they might be co-opted by the very executives and employees they are expected to oversee. With their compensation tied to corporate performance, they have an incentive to turn a blind eye when management operates in grey areas (such as questionable sales practices, earnings management, insider stock sales, etc.), the detection of which would threaten their own bonus.

Furthermore, the question arises as to what form the variable compensation should take (cash or equity) and what performance targets should be used (stock price, operating, or other financial and nonfinancial metrics). (…)

Sources: Fixed or Contingent: How Should “Governance Monitors” Be Paid?