1. McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8 AGENCY CONFLICTS AND CORPORATE GOVERNANCE Behavioral Corporate Finance by Hersh Shefrin

2. 1 Paying For Performance In Practice  Executive compensation displays too little variability in respect to pay for performance insufficient dismissal excessive payment  Directors are overconfident in their ability to structure incentives appropriately without overpaying executives.  Directors' tasks are made more difficult by the overconfidence of executives.

3. 2 Quotes from Fortune Magazine  I've seen situations that are messed up, and yet the directors think they’re doing a hell of a job.  They delude themselves.  They think things are being done right and fairly--they don’t think they’re being had--when actually the excesses they’re approving are just mind-boggling…

4. 3 Insufficient Variability in Pay for Performance  The pendulum has to swing both ways--and usually it doesn’t.  A comp committee also hears a lot about external factors, things that couldn’t have been anticipated when the budget was being made.  People say, “We worked our butts off”--da-da- da-da. And you have to answer, “Look, that was the deal. You agreed to work here for a year under that deal, and if the shareholders get dung, then you get dung.”

5. 4 Better Than Average Effect  How in the world do you stop that when every self-respecting compensation committee— I just read this once again today in a proxy— says:  "We want our CEO’s compensation to be between the 50th and 75th percentile in our peer group.  If everybody does that, it’s Lake Wobegon, where every kid is above average."

6. 5 Stock Options  Excessively optimistic employees overvalue stock options.  Managers who behave in accordance with prospect theory might find the risk characteristics of stock options attractive because of the casino effect. Risk seeking behavior resulting from overweighting low probabilities.

7. 6 Auditing Agency Conflicts  Auditors are vulnerable to being “bribed” by unscrupulous firms in order to issue clean options.  Audit firms are partnerships, not corporations.  Traditional view holds that auditing firms have reputations for integrity to protect.

8. 7 Arthur Andersen  Consulting division became much more profitable than the auditing division.  In 1989, the consultants managed to alter the profit-sharing rule, in their favor.  The change in sharing rule left the auditors lagging behind those of attorneys, investment bankers, and especially consultants.

9. 8 2X  In 1997, the partners at Andersen Consulting voted to split off completely from Arthur Andersen to become Accenture.  In the wake of their departure Arthur Andersen instituted a policy known as “2X.”  Under 2X, for every dollar of auditing work, partners were required to bring in twice the revenue in non-auditing work.

10. 9 Reference Point Issues?  Did 2X shift Andersen’s auditors from perceiving themselves to be in the domain of gains to perceiving themselves to be in the domain of losses?  Does attitude towards risk depend upon whether a person perceives him- or herself to be in the domain of losses as opposed to the domain of gains?

11. 10 Scandals  Among the list of Arthur Andersen’s audit clients were: Boston Chicken Sunbeam Waste Management WorldCom Enron.  At each of these firms, a major scandal ensued.  Andersen employees charged with shredding Enron documents, and firm was dissolved.

12. 11 Sarbanes-Oxley  In the wake of these financial scandals, Congress passed the Sarbanes-Oxley Act of 2002.  SEC requires that the CEO and CFO of every publicly traded firm certify, under oath, the veracity of their firm’s financial statements.

13. 12 HealthSouth  First firm charged under Sarbanes-Oxley.  The SEC accused HealthSouth executives of having engaged in insider trading.  Executives sold substantial amounts of HealthSouth stock while they knew that the firm’s financial statements grossly misstated its earnings and assets.

14. 13 HealthSouth Executives  Five former HealthSouth CFOs pled guilty to charges.  HealthSouth CEO claimed he was victim of deception by his CFOs and was acquitted.  Government attorneys dismayed at failure of first prosecution under Sarbanes-Oxley.