Managerial Incentives and Corporate Ethics: examining the structure of executive compensation contracts that can maximise social and environmental benefits

Since the seminal work of Jensen and Meckling (1976) on the separation of ownership and control and the associated agency costs, a significant volume of research has focused on corporate governance practices that can potentially align the interests of managers (agents) with those of shareholders (principals) (Shleifer and Vishny, 1997). One of the most important, and often controversial, corporate governance mechanisms used to mitigate agency costs is the structure of executive compensation contracts. Indeed, there is empirical evidence that linking the wealth of managers with that of shareholders via the provision of incentive compensation can reduce information asymmetry (Bernardo et al., 2009), prevent value-destroying managerial actions (Edmans et al., 2009), motivate innovation (Manso 2011), exert managerial effort (Dodonova and Khoroshilov, 2014) and improve the quality of investment decisions (Datta et al., 2011; Minnick et al., 2011; Croci and Petmezas, 2015) increasing firm value and benefiting shareholders.

Balafas and Florackis, 2014) and under certain circumstances it can also result in higher risk aversion (Lambert et al., 1991, Brisley, 2006). In addition, it has been documented that executive compensation rises following investment decisions that increase firm size irrespectively of whether these investments create value or not (Schmidt and Fowler, 1990; Kroll et al.,1990; Bliss and Rosen, 2001, Harford and Li, 2007). Therefore, powerful managers are likely to pursue size-increasing investments (Grinstein and Hribar, 2004) and rig their compensation contracts for their own benefit (Duffhues and Kabir, 2008; Morse et al., 2011).

However, the above discussion focuses on the interests of shareholders only ignoring those of other groups of stakeholders (e.g. employees, customers, suppliers, local communities, environmental groups, government). In the modern societies profit maximisation may not be the only corporate objective. Quite a few companies often recognise the need to act in a socially responsible and ethical way following more altruistic strategies (Watson and Head, 2016). In addition, an increasing number of studies highlight the importance of Corporate Social Responsibility (CSR) in corporate governance and the necessity to take stakeholders’ interests into account in strategic corporate decisions (Porter and Kramar, 2006; Arora and Dharwadkar, 2011; Young and Thyil, 2014). Given the trade-off between financial performance and social-environmental strategies (Walley and Whitehead, 1994; Jaffe et al., 1995) managers may need to be provided with appropriate compensation incentives in order to pursue non-financial goals (Gabel and Sinclair-Desgagné, 1992). Nevertheless, very little research has been conducted in this area so far. Mahoney and Thorne (2005, 2006) argue that long-term compensation incentives can align the interests of executives with those of the society strengthening CSR. Similarly, it is found that the provision of CSR-related incentives can lead to greater levels of social performance (Hong et al.,2016) while higher proportions of cash-based compensation is negatively associated with CSR (Karim et al., 2017).Regarding the impact of socially and environmentally responsible behaviour on managerial compensation, the evidence is mixed: some studies document a positive relation between environmental factors and CEO wealth (Campbell et al., 2007, Berrone and Gomez-Mejia, 2009) while others advocate an adverse impact of CSR on CEO compensation (Cai et al., 2011).

The main problem with these studies though is the way managerial compensation and the associated incentives are measured. Simplified measures of incentive compensation such as the value and volume of new options and stock grants, scaled and unscaled numbers of options and stock held and the sum of these are only noisy proxies and cannot properly capture incentives provided to managers via their compensation contracts (Core and Guay 2002, Coles et al., 2006). Therefore, this project aims to examine the structure of executive compensation contracts that can maximise social and environmental benefits using appropriate measures of managerial incentives. In doing so, the diverse interests of the different groups of stakeholders should be taken into account as “one size fits all” approach is unlikely to be a suitable solution to such a complicated issue.