Agency Cost Problems in Executive Compensation: An Evaluation of Dividend Equivalent Rights on Restricted Stocks

Abstract

Some authors argue that the integration of stock options as well as restricted stocks into executive compensation may reduce the conflicts between shareholders and management but may at the same time give rise to other agency problems connected to debt. While this line of argument may hold some merit, the structure of executive compensation packages, has over the years, focused less on stock options and more on restricted stocks. A classic example of this trend is Microsoft, who in 2003, switched from using stock options to restricted stock.Compensating executives through restricted stocks has recently come under scrutiny due to the fact that some of these executives receive dividend equivalents on restricted stocks even before the vesting period. One recent example of a company that has received such criticism is CA. Inc. CA’s executives received as much as $19,530 apiece on dividend equivalents from stock that they do not own. The relevant question that follows is whether executives are extracting additional compensation from shareholders using dividend equivalents or are dividend equivalents appropriate incentives to executives.This paper will examine the concept of restricted stocks as part of executive compensation and the motivation of companies in using this compensation policy to address the agency costs problem. I will also examine practical examples of CEO’s who have received dividend equivalent payments on restricted stocks, variations of corporate treatment of dividend equivalent rights and the motivation of some companies who chose to defer payment on dividend equivalents until an executive earns the shares.This paper will further examine, whether there are agency cost benefits of dividend equivalent rights, which merit a strong case for its use. I conclude that there are a quite a number of significant agency cost benefits of dividend equivalent rights, one of which includes the fact that it helps executives focus on, and rewards them for managing the business to produce cash that is capable of being distributed to shareholders in the form of a dividend.I will also look at some of the criticisms that have been asserted by shareholder activist groups as to how dividend equivalent rights reduce firm value, increase agency costs, and fails to achieve the objectives of adopting restricted stocks as a performance enhancing compensation package. I will describe the criticisms with a view to determining the basis of the criticisms and I conclude that while the criticisms are well founded, calling for complete elimination of dividend equivalent rights is not an appropriate solution to the agency cost problem. Finally, I will put forward my recommendations for policy reforms.