Example Of Essay On The Ethical Shortcomings Of Modern Corporate Executive Compensation And Short-Term Incentivization
Type of paper: Essay
Topic: Ethics, Company, Management, Corporation, Business, Finance, System, Incentive
In 2009, the world watched as the American economy teetered on the precipice of another major collapse. Why? Because a few corporate officials took advantage of a skewed and ultimately flawed corporate executive compensation plan. The collapse of Enron, and the financial corruption in the major institutes of Wall Street led America into the worst recession experienced since the Great Depression. Obama took the time out of his busy schedule to comment on the erupting scandal, condemning the corporate industry as a whole for its lack of integrity, saying the “culture of excess greed, excess compensation and excess risk has to change.” What President Obama was really pointing out was that the lack of ethics with which the current corporate executive pay structure was built has led to risky business practices and ultimately an unstable national economy.
While many point to the fact that most corporate executive make 500 to 600% of the wages paid to their company’s lowest employee salaries as the primary cause of the economic downturn, the real issue is not that simple. It is not the size of the CEO payments, but rather the failure to apply business ethics to the development of the payment structure that has led a number of businesses to ruin. Analyzing the most common corporate executive compensation packages through the lens of ethical principles and theories quickly reveals why the current system is so prone to abuse.
First and foremost it is important to understand that every CEO’s total pay structure is made up of five significant parts: base salary, short term incentives, bonuses, stock options and
benefits packages. Some of these areas are more susceptible to unethical behavior than others. Typically, the benefits package, which includes health insurance, a retirement plan, vacation and sick leave and other basic benefits, is not a source of corruption. However, the bonus system and short-term incentives programs are seldom closely monitored and easily abused, leading to unethical payment and ultimately, in some cases, corporate failure.
The ethics scandal was not limited to a few corporation on Walstreet. In fact, a report published just before the collapse in the New York Times reported that “this year, 20 percent said they expected more than 10 major ethics scandals among the Fortune 500 companies in the next 12 months, down from 32 percent a year ago. An additional 41 percent said they expected 6 to 10 major scandals the next year (2003).” In this study a major scandal was one that would ultimately cost shareholders more than $200 million, and many of which were fueled by CEOs proving that they could meet the performance targets set for them.
Short term incentives often lead to extreme risk taking in order to reach the specific goals or measures of success set forth in the formula is that is driving the incentive. The CEO can manipulate numbers across the short-term for great financial gain, and while that level of risk taken can, in the short term, greatly profit a company, it can also lead to major holes in the organization’s management structure, and major flaws in their long term financial strategy.
Before the recent failure of Wall Street, Harvard School of Business released a study that went so far as to say that short-term incentivization programs for company CEOs can “never work (Kohn, 1996).” Kohns’s article warned against the very incentivizing metrics that ultimately led to a downturn economy, looking forward to the long-term effects of short term thinking, in the absence of ethical guidance. An ethical analysis will quickly reveal that this is because incentives and bonuses force the CEO into a position where multiple major ethical theories are compromised, and it is easy to lose sight of what is “right and wrong.”
Short term incentives work against Utilitarianism. Utilitarianism, in terms of ethical theory, insists that what is “right” does the greatest good for the greatest number of people. More specifically, the founder of utilitarianism, Jeremy Bentham (1789), considered an action as morally justified if there is no alternative action that would generate greater happiness for those involved. Those basing their financial decisions for a company on Utilitarian Ethics would
choose actions that created trickle-down wealth and raised the morale of the company as a whole. Their actions would benefit not only the corporate bottom line and their own incentive-earnings, but also increase the payout-to those in lower positions in the company. Treasury Secretary Tim Geithner sums it up this way: “Some of the decisions that contributed to this crisis occurred when people were able to earn immediate gains without their compensation reflecting the long term risks they were taking for their companies and their shareholders.” (Ethics Resource Center, 2010, p.4) Similarly, while salary should reflect performance, and should not be increased when job related success is lacking, it is seldom effected by the CEO’s ethics. It is static, or established at the time of the contract’s signature, and is not effected by a CEO’s choices or an abstract set of conditions.
On the other hand, short term incentives increase the likelihood that a CEO will act in direct opposition to Utilitarian principles. A CEO who is trying to earn a short-term incentive is looking to financially gain, personally, from his actions, and so is not invested in what is best for the company as a whole. Often, a CEO offered a high-stakes short term incentive is more likely to take risks with company funds. Afie Krohn, of Harvard, argues that this is because “Rewards do not create a lasting commitment. They merely, and temporarily, change what we do (1996).”
This means that a corporate executive that is investing in the idea of a “reward” or incentive is not thinking about the long-term best interests of his company, but rather in the earning of a short term personal pay off. Similarly, the Ethics Resource Center argues that “The drive to reach shorterm goals can translate into business strategies that can ruin a business, cost employees their jobs, and even spill over into the general economy (2010, p. 3). A look at companies that failed, like Enron, quickly reveals that this type of short term thinking for personal gain led a major company to destruction.
The truth is that Enron’s failure might have been as simple as their inability to find growth in new markets, if bonuses had not been based on short-term growth and the ability to meet specific quarterly financial goals. To ensure that short-term incentives were earned, Enron CEO’s hid the company’s struggling financial state, burying the short-comings in paperwork and ensuring that on paper the quarterly goals were met. The company’s financial health was undermined by the desires of a few, and their ability to mask a larger problem in order to continue reaching short-term incentive goals (Gracia, 2012, p. 3)
This issue could have been entirely avoided if Utilitarian ethics had been in play in the Enron culture. Then, rather than burying the company’s financial failings, the corporate CEOs might have brought them rapidly to light, hoping that exposing the company’s failure to meet quarterly growth milestones would encourage someone in the team to find a long-term solution to the market issues contributing to the company’s slipping profits. Unfortunately the payment system actually rewarded the CEOs’ unethical and dishonest behaviors by allowing them to doctor the numbers in order to pad financial payouts.
Similarly, the use of bonuses and incentives ultimately damage relationships and work against the ethical concept of care. Care ethics insist that what makes a decision good or bad is whether or not it helps develop and support relationships with other people. A CEO who is making decisions based on the ethical perspective of care are driven by their desire to provide support to the most vulnerable members of their team.
Short-term incentives, and bonus programs run counter to this need. “Leaders of the Total Quality Management movement have emphasized, incentive programs, and the performance appraisal systems that accompany them, reduce the possibilities for cooperation (Kohn, 1996).” While systems can be built to financially remunerate collaboration, most reward systems create clear “winners” and “losers,” which is bad for relationships at every level of the corporation.
In some extreme cases, a lack of care went so far as to create a culture where CEOs could “always win, and never lose” (Ethics Resource Center, 2010, P.4) For example, in 2008, AIG faced heavy public censure when it paid out $165 million in excess pay, or bonuses, to corporate executives after taking bail out money to keep the business afloat. This was a clear case of “winners” and “losers.” The CEOs were made winners, and paid bonuses for their apparent excellence, despite the fact that the company’s stock was failing, and the government supporting their day to day operations. And, perhaps more concerning, these bonuses were paid out to a class of winners while the company “losers,” or those at the bottom of AIG’s ranks, were taking pay cuts, facing lay-offs and struggling to provide for their families.
This type of ethical breech breeds distrust and opens a company up to a host of larger concerns. Employees who have a poor relationship with their boss because they are perceived as “uncaring” or “unfair” are less likely to come to their superiors with real concerns. They are less likely to report unsafe working conditions, less likely to seek out ways to improve productivity, and generally suffer a lower morale than those who work in an environment that is free of unbalanced incentives.
Payments which were built to engender care are paid equally to all employees. They, for example, might reward everyone in a company for safety if the company as a whole goes a set
Finally, incentives have seldom been structured to hold CEO’s accountable to a sense of duty. The Ethics Resource Center found that incentives are typically based only on financial metrics without regard to ethics or leadership (2010, p.5). Deontology, or the ethics of duty demands that decisions be judged by their ability to serve a person’s duty. Therefore, the corporate incentive system should work to incentivize the CEO’s consistent performance in that area.
While it could be said that a CEO has many duties, Forbes argues that the one thing that sets the CEO role apart from any other leadership position is the company, is their responsibility to provide “high level strategy” to determine the “long-term direction of the company.” This means that the incentive program used by most corporations, which only looks at short term financial metrics as a measure of success, run directly counter to the ethics of duty. A company that was interested in fostering the ethics of duty would insist on a bonus program that looked at the company’s long-term strategy and movement toward long-term goals, rather than rewarding short-term financial successes.
The breach in ethics, generally, is not on the part of the CEO. The CEO’s payment package encourages them to default to self-serving ethics, which allow them to make decisions based on what is good for their self. What is “good” or “bad” is what benefits their own earnings, which ultimately may lead to moral shortcomings, and corporate negligence.
Rather, it is a lack of foresight on the part of the contract writers, who do not encourage ethical behavior by structuring a bonus system that rewards virtuous leadership. Instead of creating a system with arbitrary bonuses and short-term financial goals, those deciding the terms of employment should establish a system that would reward long term strategy, utilitarian ethics and a growing trust between the CEO and lower level employees in the business.
Unfortunately, if those changes are not made voluntarily by the corporations, they may be mandated by the government. The Ethics Resource Center has publicly admonished the current system and insisted that if “It doesn’t happen, somebody is going to do it [reform compensation] for them” There is a cry from the public for that change to include improved business ethics, and a clear virtue system.
In 2008 and 2009 it became clear what would happen to society if the current corporate culture was allowed to thrive, and short-term advancement was valued over long-term strategy. Chaos and collapse. While attention has been drawn to the high salaries of those at the top, it is not the contractual pay that runs contrary to business ethics, but rather the bonus and short-term incentives system that values financial gains alone, and not leadership, ethical behavior, long-term planning, or collaboration as a means of measuring success. A simple analysis reveals that the most common corporate executive compensation packages, when carefully views through the lens of ethical principles and theories are easily corruptible and focused on self-serving ethics rather than the good of the whole.
A quality corporate executive compensation system cannot be divorced from the application of ethical principles. “Absent an ethical culture, even the best designed compensation plan can only do so much. A variety of researchers suggest that they the best way to accomplish an improved payment structure is to encourage virtuous behaviors, transparency, and a team atmosphere. It is also recommended that companies create compensation committees that can think and act like an owner without the bias of self-serving ethics to determine how a company’s leadership will be paid.
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Gracia, E. Corporate Short-Term Thinking And The Winner Take All Market. (n.d.). Retrieved January 13, 2015, from http://www.westga.edu/~bquest/2004/thinking.htm
Kohn, A. (1993, September 1). Why Incentive Plans Cannot Work. Retrieved January 14, 2015, from https://hbr.org/1993/09/why-incentive-plans-cannot-work
Mcgeehan, P. (2003, June 16). Most Corporate Ethics Officials Are Critical of Top Officers' Pay. Retrieved January 13, 2015, from http://www.nytimes.com/2003/06/17/business/most-corporate-ethics-officials-are-critical-of-top-officers-pay.html