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

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AGENCY CONFLICTS AND CORPORATE GOVERNANCE

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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

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.

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…

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.”

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."

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.

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.

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.

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.

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?

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.

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

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.

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.