Jensen and Murphy (2004) provide a list of practices that should enable financial markets and corporations to efficiently address corporate governance problems. Discuss the ones you consider to be most influential. Do you think they will lead to optimal contracts?IntroductionIn a report by Jensen and Murphy (2004), they compiled a list of 38 recommendations on how to improve the effectiveness of compensation schemes in particular and corporate governance practices in general. Throughout the report are recommendations and guidelines for improving both the governance and design of executive remuneration policies, processes, and practices. Some of the recommendations are specific prescriptions for designing efficient remuneration plans. Others are better thought of as guiding principles that can be applied broadly across and within organizations. In their report, it should be noted that they have not attempted to design an optimal remuneration policy since such a policy must be specific to each organization taking into account its idiosyncrasies and the specific competitive and organizational strategies, culture and the laws and regulatory conditions it must deal with.

In this session, we focus on a few of the recommendations not because the others are not important but simply these will allow us to understand and consider some of the most influential recommendations which might lead to optimal contracts. Compensation SchemesSince incentives are greater in the presence of high equity-based compensation (both to increase value and to avoid destruction of value), boards must understand that additional monitoring is likely to be required (R-6). Because of the increased benefits of manipulating financial reports and/or operating decisions to pump up the stock and therefore generate larger payoffs in the short term, remuneration and audit committees must increase their monitoring. In addition, they should pay careful attention to ensuring that their managers cannot benefit from short-term increases in stock prices that are achieved at the expense of long-term value destruction.R-4. The cost to the corporation of granting an option to an employee is the opportunity cost the firm gives up by not selling the option in the market, and that cost should be recognized in the firms accounting statements as an expense.When a company grants an option to an employee, it bears an economic cost equal to what an outside investor would pay for the option. With appropriate downward adjustments for early exercise and forfeiture (and ignoring potentially valuable inside information held by executives), the Black and Scholes (1973) formula yields a reasonable estimate of the companys cost of granting an option to an employee.Since most employees are assumed to be risk averse and undiversified, and because they are prohibited from trading the options or taking actions to hedge their risk (such as short-selling company stock), employees will naturally value options less than what the company assumed it to be. Since the companys cost exceeds the employees value, options are an expensive way to convey compensation to risk-averse employees. It is therefore important for the remuneration committee and board to ensure that the productivity benefits the company as awarding costly options are more than enough to make up for the pay premium they have to offer to employees receiving the options.For example, Jensen & Murphy (2004) noted that many US companies granting options generally do not make a careful comparison of the cost and value of options, but rather treat options as being essentially free to grant. When a US company grants an option to an employee, it bears no accounting charge and incurs no outlay of cash. Moreover, when the option is exercised, the company (usually) issues a new share to the executive, incurs no cash outlay, and receives a cash benefit in the form of a tax deduction for the spread between the stock price and the exercise price. These factors make the perceived cost of an option to the company much lower than the economic cost, and often even lower than the value of the option to the employee. As a result, too many options are granted to too many people, and options with favorable accounting treatment will be preferred to other better incentive plans with less favorable accounting treatment.R-26. Design bonus plans with linear pay-performance relations.The efficiency of alternative performance standards depends on the extent to which managers can influence the standard-setting process: managers can increase bonuses either by taking actions that increase the performance measure or by taking actions that decrease the performance standard. For example, when standards are based on prior-year performance, managers will tend to avoid unusually positive performance outcomes, since good current performance is penalized in the next period through an increased standard. Similarly, when standards are based on meeting the predetermined company budget, managers have incentives to negotiate easy budgets and to avoid actions this year that might have an undesirable effect on next years budget. Standards based on the performance of co-workers create incentives to sabotage co-worker performance or collude and collectively shirk, while standards based on the performance of an industry peer group provide incentives to select weak industries and peers.In spite of the obvious problems, most companies use standards that are readily influenced by managers. For example, Murphy (2000) finds that 89% of a sample of 177 large US companies base standards on budgets or prior-year performance. These issues are so important that the board and remuneration committee should be involved in setting clear general policy that limits the counterproductive effects of these systems since the integrity of the company depends on it.Corporate GovernanceSimilarly, well-designed corporate governance policies (including director remuneration) can mitigate agency problems by defining rules, processes, checks, and balances that help ensure boards of directors faithfully fulfill their fiduciary duties to shareholders. Moreover, since well-designed pay policies cannot resolve all conflicts of interest and agency problems between executives and the firm, well-designed corporate governance systems implemented by directors of high integrity must be in place to resolve those conflicts that cannot be handled by remuneration policies alone.R-14. The board should be chaired by a person who is not the CEO, was not the CEO, and will not be the CEOThe critical job of the Chair is to run the process that evaluates, compensates, hires and fires the CEO and top management team. The CEO cannot perform that job adequately.R-15. Limit the number of outside CEOs sitting on the boardOutside CEOs offer advantages as board members for many obvious reasons. What generally have gone unaddressed are the disadvantages they bring to the board. It is natural for them to subconsciously (if not consciously) view the board through CEO eyes a lens where the power of the CEO is not seriously challenged, except perhaps in the event of serious problems such as obvious incompetence or malfeasance.R-16. The CEO should be the only member of the management team with board membership.While members of the management team can add value by participating in board discussions there is little reason to have them be formal voting members. When other members of the management team are voting members of the board we increase the likelihood that the board will consider its job to be that of supporting, not monitoring, the CEO. Members of management that can add value to board discussions can and should do so by being at the meetings regularly as ex-officio members.R-17. Remuneration committees should seldom, if ever, use compensation consultants for executive remuneration purposes who are also used by the firm for actuarial or lower-level employee remuneration assignments.Conflicts between these dual roles of compensation consultants dramatically disadvantage the remuneration committee and the firm and facilitate more generous executive pay packages. Consider the situation of a consultant who hopes to close a multi-million dollar actuarial or lower-level employee engagement. The same consultant engaged as an advisor on CEO and top manager remuneration policies (that might amount to only a high five-figure or low six-figure fee) would be put at a significant disadvantage in recommending value-creating remuneration policies inconsistent with what the CEO desires. The reasons for avoiding these conflicting roles are essentially the same as the rules that are emerging that limit the use of a firms auditor as a consultant.Companies retain compensation consultants in large part to get access to survey information used for competitive benchmarking. The use of such information coupled with the increase in power, visibility and other non-pecuniary benefits play a role in reducing managerial willingness to shrink a firm when that is the value-creating action and similarly increase the motivation to grow a firm even when it destroys value. In addition, Jensen & Murphy (2004) believe that misuse of survey information provided by compensation consultants has led to systematic increases in executive pay levels. ConclusionConsistent with agency theory, the primary intent of these recommendations is to promote more independence of the board and to increase transparency of board decision making. Further it aims to ensure greater accountability from market participants and to provide clearer and more linear pay-performance schemes. As some have argued that corporation needs to reduce or prohibit managers from holding equity (Martain, 2003a). Jensen and Murphy (2010) believe it unwise to return to the old days in which managers were paid like bureaucrats and all the problems associated with that situation (Frey and Osterloh, 2004). As mentioned, all compensation schemes have the potential to both reduce and to increase agency problems. But these compensation schemes should also be coupled with effective corporate governance as they are the only solution to the agency problems.All in all, these recommendations highlight how compensation schemes together with corporate governance can truly help reduce agency costs instead of becoming part of the agency problem as optimal contracts are draw out to employees.