BF Notes Session 8 - Ch. 8 Notes. Agency Conflicts and...

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Ch. 8 Notes. Agency Conflicts and Corporate Governance (Ch. 8) Overview Chapter 8 describes how behavioral phenomena impede good corporate governance. In practice, compensation systems that are intended to align the interests of managers with those of shareholders feature insufficient variability in respect to pay for performance , insufficient dismissal , and overpayment of executives . Overconfidence on the part of both directors and managers interferes with the institution of appropriate compensation systems. Managers who are excessively optimistic , or whose behavior conforms to prospect theory , find stock options particularly attractive as a form of compensation. Firms appear to exploit these biases . However, options can exacerbate the alignment of interests between managers and shareholders. Aversion to a sure loss can be an important factor influencing the behavior of auditors and managers in respect to agency conflicts, especially when unethical and fraudulent behavior is involved. Traditional Approach to Agency Conflicts The traditional approach to agency conflicts involves principals designing contracts that satisfy three constraints known respectively as the participation constraint, the incentive compatibility constraint, and the nonoverpayment constraint. Paying for Performance in Practice Survey evidence indicates that in practice, most compensation systems do not satisfy the compatibility constraint and the nonoverpayment constraint. Instead executive compensation does not exhibit sufficient variability in respect to performance, does not involve dismissal as frequently as is warranted, and is unduly generous to executives. The use of stock options has increased over time. Although options appear to have been beneficial in respect to retention (the participation constraint), there is little evidence that their use has served to align the interests of managers with shareholders (incentive compatibility constraint). Corporate governance is positively associated with provisions that increase shareholder rights. Overconfidence Among Directors and Executives Overconfident directors delude themselves into believing they are doing a good job of overseeing managers. Overconfident managers render it difficult for directors to put effective compensation systems into place. This section provides a series of quotations by directors, which appeared in Fortune magazine, that identify many key issues. The quotations illustrate self-attribution error and the better-than-average effect. Stock Option-Based Compensation
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According to prospect theory, people are prone to overweight the small probabilities associated with large gains. This phenomenon has been called a casino effect. Along with excessive optimism, it explains why executives are prone to overvalue the stock options they receive as part of their compensation. Firms appear to exploit managers’ biases when they grant stock options.
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This note was uploaded on 10/30/2009 for the course FIN 645 taught by Professor Arshapalli during the Fall '09 term at University of Maryland Baltimore.

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BF Notes Session 8 - Ch. 8 Notes. Agency Conflicts and...

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