Aligning Directors' Remuneration with Corporate Governance Principles

This report delves into the critical aspects of corporate governance, focusing on executive remuneration and its alignment with agency theory. It examines the rationale and limitations of using directors' remuneration packages to align the interests of shareholders and directors, exploring both the p...Read More

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Corporate Governance

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Table of Contents
Introduction...............................................................................................................................2
Executive Remuneration and Agency Theory............................................................................3
Positive implication of aligning directors’ remuneration package............................................4
Limitations of aligning directors’ remuneration package..........................................................5
Corporate Governance Strategies..............................................................................................7
Conclusion................................................................................................................................10
References................................................................................................................................11

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Introduction
In the ever-changing business world, the importance of ethical leadership of directors has
increased substantially since they play a major role in directing the company to achieve its
corporate objectives. Directors are advised that they must comply with corporate
governance principles to make sure that they maintain a balance between the interests of
stakeholders while avoiding prioritising their personal interest (Fassin, 2012). In this regards,
a highly controversial subject is executive compensation which has attracted the attention
of media, academics, and regulators in the past few decades. There are various forms in
which the executive compensation is criticised for the level of pay itself or its relationship
with the profitability of the company and the failure of the managerial pay settings (Melis,
Gaia, and Carta, 2015). It is a key area of corporate governance which has become a part of
the research of academics due to a wide range of factors. There are both benefits and
challenges of using the directors’ remuneration to benefit the shareholders and directors
themselves by aligning a link between the pay and the performance of the company (Melis,
Carta, and Gaia, 2012). The objective of this report is to explore both the rationale and
limitation of using the directors’ remuneration package in order to align it with the interest
of shareholders and directors of the company. This report will also evaluate various
corporate governance strategies that can assist in addressing the deficiencies relating to the
remuneration packages of directors.

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Executive Remuneration and Agency Theory
In the case of companies, especially large enterprises, there is a separation when it comes to
actual ownership of the company from its control which is divided between three parties:
the shareholders/owners of the company, the board of directors of the company and the
managers/executives of the company that handles its daily operations (Mallin, Melis and
Gaia, 2015). The company is owned by its shareholders, and the board of directors is
responsible for making decisions on behalf of the shareholders to make sure that the
company achieves its corporate objectives. The executives are responsible for carrying out
the decisions made by the directors by managing their daily actions. However, there is a
possibility that the directors and executives of the company use its assets in order to
improve their lifestyle (Melis, Carta, and Gaia, 2012). They can take unfair advantage of their
position to satisfy their personal needs by living a luxurious lifestyle while charging the
expenses such as holiday trips and luxury cars to the account of shareholders which
contradicts with the interest of shareholders (Boivie, Bednar and Barker, 2015). Therefore,
the executive compensation and corporate governance principles are the cornerstones of
the principle-agent relationship that protects the interest of shareholders and other
stakeholders of the company.
This agency relationship shows a link between the executive remuneration and the interest
of shareholders of the company. Executive remuneration includes various options such as
base salary, pension, stock grants, car, healthcare, stock options, bonus, and other benefits.
The base salary which is given to the executives or directors in the company is not related
with their performance in the organisation; however, the bonuses, stock options and other
facilities which are received by the directors or executives are linked with accounting-based
performance measures (Qin, 2012). In the case of stock options, the directors have the right
to purchase shares of the company which is available for them at an exercise price and time
period. After the share price increases above the exercise price, the executives and directors
achieve profits. The performance shares are given by the company only if specific
performance criteria are met by directors relating to the performance of the company such
as per earning per share targets. If the performance of the company improves, its share
price increases as well and shareholders benefits; however, the performance shares of

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executives are more valuable than compared to other shares (Fassin, 2012). They also
receive additional remunerations along with benefits such as paid vacations which resulted
in increasing their earnings substantially.
Positive implication of aligning directors’ remuneration package
One of the key corporate governance issues is the alignment of the interest of shareholder
along with directors’ remuneration package. The rationale of this theory provides that
parties can benefit from this alignment which ultimately resulted in benefiting the whole
organisation (Grasse, Davis and Ihrke, 2014). An agency relationship is created between the
directors and shareholders of the company, especially in large enterprises, because the
shareholders delegate their powers of making business decisions and managing day-to-day
operations of the company to the directors and managers because it is not practical for
them to manage the everyday operations of the company. Since the directors and
executives form policies and manage day-to-day operations of the company, they might not
always prioritise the interest of the company, and they might not act in their best interest
(Grasse, Davis and Ihrke, 2014). Due to these factors, an ‘agency problem’ is created
because the directors and executives pursue their personal financial interest rather than
striving to achieve the financial interest of shareholders of the company (Mallin, Melis and
Gaia, 2015). They might also misuse their positions to take unfair advantage of the assets of
the company to live a lavish lifestyle while spending the capital of the company.
Directors of a company are susceptible to human nature due to which they might pursue
their own economic agendas rather than focusing on maximising the wealth of the
shareholders (Melis, Carta, and Gaia, 2012). This issue of agency problem is more acute in
the determination of executive and director compensation. Although the independent
directors of a company are appointed in order to make sure that they can set their personal
interest aside and act for the interest of shareholders; however, the agency problem arises
with them as well due to directors’ remuneration package (Melis, Gaia, and Carta, 2015).
Even though the role of directors and executives are different; however, they work together
to achieve a common goal. For example, the chairman of the board might defer to the CEO’s
recommendations while setting the remuneration for the executive management team.

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These factors show that the directors might focus on their compensation while
implementation of business policies rather than the interest of the shareholders.
In order to address this issue, the directors’ remuneration package can be aligned with the
interest of directors and shareholders to make sure that they achieve the common
objectives. The rationale for giving remuneration to the directors based on their
performance to act in the best interest of the shareholders resulted in increasing the
profitability of the company along with its market valuation (Andreas, Rapp and Wolff,
2012). If directors receive compensation based on their ability to maximise the value of
shareholders of the company, then they are more likely to take actions which are beneficial
for the shareholders since it will also benefit them as well. Options for director
remunerations such as paid holidays, car, private jet, bonuses, and others might not
motivate the directors to prioritise the interest of the shareholders (Yayla and Hu, 2014).
However, receiving stock options which align with the market value of the company resulted
in motivating directors to ensure that they take actions which are focused on benefiting the
shareholders of the company since it benefits them as well. In the case of independent
directors, the strategy of stock options cannot be applied; however, their remuneration
package can also be decided based on the performance of the company. Independent
directors can receive bonuses or other facilities based on their ability to maximise the
market value of the organisation which encourage them to ensure that they take
appropriate steps to benefit the shareholders (Jaafar, Wahab and James, 2012). These
factors support the argument that the directors’ remuneration package should be aligned
with the interest of directors and shareholders which ensure that they act in the best
interest of the shareowners which resulted in expanding the profitability and market
valuation of the organisation.
Limitations of aligning directors’ remuneration package
Although there are various benefits which encourage the alignment of directors and
shareholders benefits with the directors’ remuneration package; however, there are various
corporate governance issues which are raised due to these actions which hinder the interest
of other stakeholders of the company. Corporate governance is referred to a set of rules
and practices through which the actions of a company is directed and controlled. The

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objective of these policies is to ensure that the management focuses on maintaining a
balance between the interest of stakeholders of the company which includes shareholders,
employees, customers, government, local communities, suppliers, environment, and others
(Tricker, 2015). Traditionally, it was considered that the directors owe a duty towards the
shareholders of the company since they act as their agent based on which they have to
prioritise the best interest of shareholders above their personal interest. However, this
concept has proven wrong since the directors are not obligated towards the shareholders of
the company. Instead, they are responsible for promoting the interest of a wide range of
stakeholders to ensure that they maintain a balance between their interests while taking
business decision (Ahmed and Henry, 2012).
The key limitation of aligning the directors’ remuneration package with directors and
shareholders interest is that it encourages directors to solely focus on maximising the value
of shareholders of the company since it benefits them as well (Lee and Isa, 2015). They did
not take the interest of other stakeholders of the company into consideration because it
might hinder their interest as well. For example, the employees of the company might face
physical or mental health issues due to working in an unsafe or hostile working
environment; however, the directors might ignore their sufferings since implementing
effective health facilities and giving healthcare benefits of employees will resulted in
reducing the revenue of the company which ultimately hinders their personal interest as
well (Van den Berghe, 2012). In case the directors solely focus on the interest of
shareholders, then it could have disastrous impacts on other stakeholders of the company
since it resulted in a violation of corporate governance principles which are highlighted by a
large number of real-world examples. A recent example is Volkswagen emissions scandal in
which the management of the company deliberately promotes practices to develop engines
in the company that cheats the emissions tests which resulted in increasing the sales of the
company (Rhodes, 2016).
The management took this decision to expand the value of shareholders of the company by
increasing the profitability of the organisation; however, they did not take into
consideration the interest of other stakeholders such as the environment and society
(Rhodes, 2016). The directors of the company also failed to take appropriate actions to stop
these actions since they were also benefiting from them because their interest was aligned

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with the interest of shareholders of the company. It shows the negative implications which
parties might face due to the alignment of directors’ remuneration package with
shareholders and directors’ interest. In case effective corporate governance practices are
not adopted by the company, then it also resulted in negatively affecting the interest of
shareholders of the company even if their interest is aligned with the interest of directors of
the company. Enron scandal is a good example in which the directors included wrong details
regarding the revenue and asset valuation of the company because they wanted to
maximise shareholders values since it was in their interest as well. However, it resulted
leading up to one of the biggest scandals in the history which negatively affect a large
number of people which include shareholders of Enron as well (Bhasin, 2013).
Corporate Governance Strategies
The aim of corporate governance strategies is to address the inherent risks which are
associated between directors, shareholders and managers of the company to make sure
that they take balanced decisions while maintaining a balance between the interest of
stakeholders of the company rather than solely focusing on increasing the interest of
shareholders of the company (Jo and Harjoto, 2012). Following are various corporate
governance strategies that can assist in addressing the deficiencies of the use of directors’
remuneration package that is aligned with the best interest of directors and shareholders.
 Implementation of Corporate Social Responsibility Structure
Corporate social responsibility (CSR) is referred to a self-regulatory business approach which
is adopted by companies to contribute to sustainable development by delivering social
environment and economic benefits for all stakeholders of the company. An effective CSR
structure resulted in increasing the accountability of directors and shareholders of the
company by increasing transparency and reporting practices in the company (Rekker,
Benson and Faff, 2014). In this framework, the directors have to publish a report in which
they include details regarding the actions taken by them to promote the interest of different
stakeholders of the company. In case the directors take any actions that could hinder the
interest of stakeholders, then they can be held accountable by the public, and they can be
enforced to take corrective actions (Knudsen, Geisler and Ege, 2013). By adopting this

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approach in the business, companies will be able to align the directors’ remuneration
package with the interest of shareholders and directors of the company.
In this framework, an obligation will be imposed on the directors of the company to make
sure that they did not take illegal or unethical actions in order to maximise the interest of
shareholders of the company while avoiding the interest of other stakeholders such as
suppliers, employees, customers or the environment (Hong, Li, and Minor, 2016). This
structure also promotes transparency in the day-to-day operations of a company which also
resulted in enforcing the directors to ensure that they take corrective measures to maintain
a balance between the interests of stakeholders rather than solely focusing on personal
interest. However, without effective reporting, the CSR structure remains effective due to
which the company should ensure that there is a system for periodic reporting in the
organisation which will lead to positive outcomes in the organisation (Knudsen, Geisler and
Ege, 2013).
 Transparent Engagement
There should be transparency when the remuneration package of directors and executives
are decided in companies to make sure that they did not receive any unfair advantage
above others which allow them to bypass their responsibilities to achieve personal interests.
Directors should disclose the remuneration which they are getting along with other benefits
which they receive in the organisation (Gregory-Smith, 2012). In case the directors’
remuneration package is not aligned with the performance of the company, it makes it
easier for them to avoid their responsibilities in the organisation. However, linking the
package with performance also encourage them to avoid their responsibilities towards
other stakeholders. Therefore, transparency is important in the operations of the company
to ensure that the decision of remuneration package take into consideration the interest of
other stakeholders rather than the sole interest of the shareholders to ensure that the
directors did not misuse their position for personal benefits (Tura, 2012). The audit
committee of the company should work along with sustainable board committee and
remuneration committee to monitor the process of deciding the remuneration of the
company to make sure that the directors did not misuse their powers to increase their
remunerations.

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 External Assistance
Although internal policies can be implemented by an organisation to ensure that it did not
violate corporate governance principles; however, external assistance enables the company
to ensure that its policies are monitors from an independent perspective to avoid the
changes of fraud. For example, auditors or an external remuneration committee can assist
the company ensuring that its directors and executives receive equitable remuneration
based on the performance of the company while ensuring that they did not violate
corporate governance principles to achieve personal interest (Cybinski and Windsor, 2013).
Through external assistance, the chances of fraud in the decision making also reduce in the
company, and it makes it easier for the directors to avoid their responsibilities.

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Conclusion
Based on the above observations, it can be concluded that the decision of aligning the
directors’ remuneration package with the interest of shareholders and directors of the
company has various benefits and challenges. The rationale which supports this argument is
that it encourages directors to focus on maximising the value of shareholders of the
company rather than solely focusing on personal interest since their personal benefits are
aligned with the interest of shareholders. However, the key limitation of this strategy is that
it encourages directors to avoid the responsibility of making sure that the rights of other
stakeholders in the company are not breached. Examples of Enron and Volkswagen is
evaluated in this report to understand how the shareholders might also suffer if they align
the directors’ remuneration package with their and directors interest. Various corporate
governance strategies are recommended in this report that can assist in effective alignment
of directors’ remuneration package with the interest of shareholders while ensuring that the
interest of other stakeholders it not breaches such as adoption of an effective CSR structure
to increase accountability of directors. Companies can also rely on transparent engagement
and external assistance to avoid misuse of directors’ powers and imposing accountability on
them to make sure that they prioritised the interest of a diverse range of stakeholders
which will assist in sustaining the growth of the company.

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