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Executive Compensation in Widely-Held US Firms
ESNIE 2007
Jesse FriedBoalt Hall School of Law
U.C. Berkeley
Overview of Presentation
Why study U.S. CEO pay? 2 conflicting views
classical “optimal contracting” “managerial power” approach
Managerial power approach: in depth Sources of power “Outrage Constraint” & “Camouflage” Costs to shareholders Policy implications
A picture is worth 1000 words
Why study U.S. CEO pay? Economic importance
Amounts Incentive effects
Managerial effort Decision-making
Window into functioning of U.S. corporate governance system generally
Theoretical interest Setting for testing agency/governance/labor market
theories Good data (public firms)
Interaction among economics/social norms /political & legal institutions
Public fascination
Two views of CEO pay Optimal contracting approach
E.g., Murphy (1999); Core, Guay & Larcker (2001); Gabaix & Landier (2007); Kaplan (2007)
Managerial power approach E.g. Bebchuk & Fried (2002,03,04,05);
Yermack (1997); Bertrand & Mullainathan (2001); Blanchard & Lopez-de-Silanes & Shleifer (1994)
Shared premise of both views Managerial agency problem
Managers of widely-held public firms have significant power
Berle & Means (1932) Jensen & Meckling (1976): “agency problem”
Managers use power to benefit selves Empire building (Jensen, 1974; Williamson, 1964) Failure to distribute excess cash (Jensen, 1986) Entrenchment (Shleifer & Vishny, 1989)
Optimal K Approach Classical financial economic view Executive pay is remedy to agency
problem Boards design pay scheme to
Compensate and retain executives Incentivize managers to increase
shareholder value Main flaw: due to political limitations on
pay amounts, CEOs pay may be insufficiently high powered Jensen & Murphy, 1990; Kaplan 2006
Managerial Power Approach
Executive compensation is potential remedy to managerial agency problem
But it is also part of the agency problem itself Managers use their positional power to get
pay excessive too decoupled from own performance
weakens incentives to generate shareholder value perverts incentives
Arrangements deviate from optimal K
Managerial power approach
Sources of Managerial Power “Outrage constraint” “Camouflage” Pay Distortions Going forward: what should be
done
Sources of Managerial Power (1)
Optimal K assumes arm’s length bargaining b/w board & CEO
But why? if they assume executives not “hard-
wired” to serve shareholders, why should they presume directors will automatically seek to do so?
Sources of Managerial Power (2)
CEOs have power over directors Economic Incentives
directorship: $200K, perks, prestige, connections Until now, CEOs control renomination to board
Social factors Collegiality Loyalty Cognitive dissonance (directors are current/former
executives) Personal costs of favoring executives are
small
Result of Managerial Power
Managers want pay that is Higher More decoupled from performance (easier to
get)
Boards routinely approve executive pay deals that do not serve shareholders Pay likely too high Pay decoupled from performance
Dilutes incentives Distort incentives
Only a slight exaggeration…
Evidence of power-pay effects CEO pay higher, less performance-
based when board weaker
Larger board, more “independent” directors appt’d by CEO, directors serving on multiple boards, CEO is board chair (Core, Holthausen & Larcker, 1999)
no large outside shareholder eg Lambert, Leicker, Weigelt 1993
fewer “pressure-resistant” institutional shareholders
David, Kochar, Levitas 1998 more anti-takeover provisions
Borokhovich, Brunarski, Parrino 1997
Constraints on Managerial Power? (1)
Corporate law? State corporate law defers to board
compensation decisions under “business judgment rule” (e.g. Disney)
Takeover market discipline?
Staggered boards Courts allow “poison pills”
Hostile takeovers expensive, rare
Constraints on Power? (2) Election of new directors?
Corporation sends out proxy materials with names of board nominees
Check “yes” or “withhold” Send proxy back to company to be voted “yes” or
“withhold” Unless competing proxy, 1 “yes” vote gets director
elected under “plurality voting rule” Don’t need approval of majority of votes, just plurality
No competing proxies Costs of mailing competing proxy high
Managers won’t release shareholder list Collective action problem
Result: 99% elections uncontested
“Outrage Constraint”
Outrage Constraint
Boards’ main constraint: adverse publicity and “outrage”
Outrage imposes social and economic costs embarrassment shareholders more likely to support (rare)
challenge to management Evidence of publicity’s effect
Thomas & Martin (1999) Dyck & Zingales (2004) Wu (2004)
“Camouflage”
Fear of outrage leads firms to “camouflage” pay
Pay designers try to obscure and legitimize
amount of pay performance-insensitivity
Camouflage pre-1992: An SEC official describes the pre-1992 state of affairs
as follows:
“The information [in the executive compensation section] was wholly unintelligible . . . .
Depending on the company’s attitude toward disclosure, you might get reference to a $3,500,081 pay package spelled out rather than in numbers. ……….
Someone once gave a series of institutional investor analysts a proxy statement and asked them to compute the compensation received by the executives covered in the proxy statement. No two analysts came up with the same number. The numbers that were calculated varied widely.”[1]
[1].Linda C. Quinn, Executive Compensation under the New SEC Disclosure Requirements, 63 U. Cin. L. Rev. 769, 770-71 (1995).
1992: Summary Pay Table (SEC)
Firms required to clearly report most forms of compensation in tables with dollar amounts Salary Bonus Stock options (number) Long-term incentive compensation
Comp table became focus of Media, economists, shareholders
Post 1992 Camouflage
Pay designers began relying heavily on
forms of compensation not reportable in any column in comp table
post-exit payments (e.g. pensions, golden parachutes) low-interest loans (Worldcom: $400 million)
performance-insensitive compensation that
can be reported as something other than “salary”
E.g.: “guaranteed bonus”
Other CEO pay distortions (1)
Non-equity pay weakly linked to performance
often driven by luck (e.g. oil company earnings)
bonuses have low “goalposts” often tied to manipulable metrics (accounting
earnings)
Other CEO pay distortions (2) Equity pay
Option plans fail to filter out windfalls Most stock price increases do not reflect
Firm-specific factor CEO’s contribution
Firms could use market/sector-based indexing but don’t
Backdating accentuates windfalls Few restrictions on unwinding
Managers not required to hold shares (diluting incentives)
Can sell on inside information (perverting incentives)
Costs to shareholders Direct
Top-5 pay = 10% of aggregate corporate earnings during 2001-2003
Bebchuk & Grinstein (2005) up from 5% during 1993-1995
Indirect Perverted incentives, e.g
Size justifies pay: incentive to acquire Manipulate earnings to sell at high price
Fannie Mae spent $1 billion cleaning up accounting
Going Forward: What Should Be Done ? (1)
Transparency Outrage constraint currently main check
on managerial power Constraint depends on transparency SEC must track efforts by pay designers
to get around new disclosure rules
2006 Disclosure Rules (SEC)
Improved summary table reporting Annual change in actuarial value of pension Total amount More detail
More transparent reporting of
Outstanding equity Post retirement payouts
More detailed rationale for pay package
Result: harder to camouflage compensation
What should be done (2) Increase shareholder power
Problem: managerial power Must counterbalance with more
shareholder power Should make it easier to replace
directors SEC could make companies turn proxy
material into corporate ballot with both management and shareholder candidates (like political election)
Dramatically lower cost so shareholders can cheaply replace bad directors
Some setbacks 2003: SEC chair supports
“shareholder access” to proxy statement Business execs pressure White House,
SEC chair resigns But fight is not over
Pressure many companies to adopt “majority vote” for individual directors
So shareholders can “punish” individual directors by withholding votes
Hedge funds becoming active
The future Further empowering shareholders
best hope for improving Executive compensation US corporate governance generally
THE END
Boards behaving better
CEO pay increases moderating Kaplan, 2007
CEO turnover increasing Kaplan & Minton, 2007
Congress
1993: Tax: Section 162(m)
2002: Sarbox Prohibition on loans Clawback
1993: IRC Section 162(m) Outcry in early 1990s that pay decoupled
from performance
Congress: “Non-performance” pay over $1m not deductible by company At-the-money options qualify as performance pay
Problem: does not address managerial
power Some managers continue to get more than $1m
salary Who is hurt?
Unintended effect of 162(m) Signals acceptability of
Salary up to $1 million Large option grants (Congress deems it
“performance comp”)
Used to justify total pay increase Below $1 million salaries rise to $1 million Option grants skyrocket
Bull market turns options into windfalls
Huge increase in actual non-performance pay
Congress: SarbOx 2002 Prohibition on loans
Outrage over huge, hidden low-cost loans 1920s proposal to ban loans resurrected Effect: disrupts efficient contracting
Clawback provision Return bonuses, stock proceeds
Following earnings misstatement caused by “misconduct”
Shareholder-serving boards should have done this on their own
Not yet applied
End
Pay without Performance
Jesse FriedMarch 7, 2006
Berkeley
For fuller exposition of views on the
subject: Pay without
Performance (Harvard University Press,
2004)
Going Forward: Making Directors More Accountable to Shareholders
We should make it easier for shareholders to replace directors E.g., giving shareholders access to
corporate ballot would reduce costs of challenging current board
Not a panacea – still collective action problem
but increasing probability of shareholder revolt will improve incentives
Making Directors More Accountable
By making boards accountable to shareholders and attentive to their interests, such reform would:
Make reality more like official story of arm’s length negotiations
Improve executive compensation arrangements Improve corporate governance more generally
Decoupling Pay from Performance (1)
Rise in executive compensation has been justified as necessary to strengthen incentives
Financial economists have applauded: Shareholders should care more about incentives than about the amount paid executives.“It’s not how much you pay, but how” (Jensen
& Murphy, 1990) Institutional investors have accepted higher
pay as price of improving managers’ incentives
Decoupling Pay and performance (2)
But the devil is in the details: managers’
compensation is less linked to performance than is commonly appreciated.
Managers’ own performance does not explain much of the cross-sectional variation in managers’ compensation.
Firms could have generated the same increase in incentives at much lower cost, or used the same amount to generate stronger incentives
Decoupling Pay from performance (3)
Factors contributing to the weak link between
pay and managers’ own performance:(1) The historically weak link between bonus
payments and long-term stock returns. (2) The large amounts given through
performance-insensitive retirement benefits.
(3) The large fraction of gains from equity-based compensation resulting from market-wide and industry-wide movements.
Decoupling Pay from Performance (4)
(4) Practices of “back-door re-pricing” and
reload options that enable gains even when long-term stock returns are flat.
(5) Executives’ broad freedom to unload vested options/restricted stock.
(6) “Soft landing” arrangements for pushed out executives that reduce the payoff differences between good performance and failure.
And more …
Paying for performance (1)
Reduce windfalls from equity-based compensation:
Filter out some or all of the gains resulting from market-wide or sector-wide movements.
Can be done in various ways; indexing is only one option.
Move to restricted stock increases windfalls – restricted stock is an option with an exercise price of zero.
Paying for performance (2)
Reduce windfalls from bonus compensation:
Filter out some or all of the improvements in accounting performance resulting from market-wide or sector-wide movements.
[E.g., look at increase in earnings relative to peers.]
Paying for performance (3)
Tie equity-based compensation to long-term values:
Separate vesting and freedom to unload: require holding for several years after vesting (even until/after retirement).
Prohibit contractually any hedging or other scheme that effectively unloads some of the exposure to firm returns.
Limit the ability of serving executives to time sales.
Paying for performance (4)Tie the performance-based component of non-
equity compensation to long-term values: Assuming it is desirable to link pay to
improvement in some accounting measures, don’t link to short-term (e.g., annual) changes – can lead to gaming and distortions or at least to decoupling of pay from long-term changes in value.
Claw-back provisions that reverse payments made on the basis of restated financial figures: “if it wasn’t earned it must be returned.”
Paying for Performance (5)
Rethink termination arrangements:
Current arrangements provide “soft landing” in any termination that is not for fault, defined extremely narrowly. This is costly – reduces the payoff difference between good and poor performance.
Consider:-- Broadening the definition of “for cause” termination-- Making the severance payment depend on the
performance during the executive’s service.
Easy for companies to fix: Company should include in annual
proxy statement: increase in value of retirement entitlement
from last year and its current value
Improving Transparency
Improving transparency (2)
Another important instance of opaqueness: deferred compensation arrangements.
Benefit executives by providing tax-free buildup of investment gains.
Outsiders cannot make even a rough approximation of value
Firms can easily make these benefits transparent.
Board Accountability
Recent reforms emphasize strengthening director independence from executives.
Strengthened independence is beneficial but it is an insufficient foundation for board accountability.
For each company, vast number of individuals could be considered “independent directors.” Two key questions
(1) Who is selected from this vast pool? (2) What will their incentives be once appointed?
Strengthened independence eliminates some people from pool, reduces bad incentives for those appointed. But does not fully answer (1) and (2)
Board Accountability (2)
We should make directors not only more independent of executives, but also make them more accountable to shareholders
What we need is reduced insulation from shareholders.
Can be done in a way that does not provide distraction and short-terms focus
Improving Board Accountability
Make shareholder power to remove directors real (even if weak).
Election reform: (1) Adopt procedure for shareholder nomination of directors(2) Provide company reimbursement for shareholders whose nominees receive sufficient shareholder support.
Improving board accountability (2)
Remove charter-based staggered boards, which prevent shareholders from ever replacing a majority of the directors in one vote.
• Evidence staggered boards are associated with 4-5% lower firm value • [ Bebchuk and Cohen, The Costs of
Entrenched Boards, JFE, 2005]
Conclusion
There is much that can be done – and should be done – to link pay more closely to performance.