Executive compensation is potential remedy to manageria

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Executive Compensation in Widely-Held US Firms

• ESNIE 2007
• Jesse Fried
• Boalt Hall School of Law
• U.C. Berkeley

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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

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A picture is worth 1000 words
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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

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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)

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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)

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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

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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

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Managerial power approach

• Sources of Managerial Power
• Outrage constraint
• Camouflage
• Pay Distortions
• Going forward what should be done

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Sources of Managerial Power (1)

• Optimal K assumes arms 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?

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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

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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

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Only a slight exaggeration
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Evidence of power-pay effects

• CEO pay higher, less performance-based when
• board weaker
• Larger board, more independent directors apptd
  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

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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

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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
• Dont need approval of majority of votes, just
  plurality
• No competing proxies
• Costs of mailing competing proxy high
• Managers wont release shareholder list
• Collective action problem
• Result 99 elections uncontested

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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 publicitys effect
• Thomas Martin (1999)
• Dyck Zingales (2004)
• Wu (2004)

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Camouflage

• Fear of outrage leads firms to camouflage pay
• Pay designers try to obscure and legitimize
• amount of pay
• performance-insensitivity

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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 companys 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).

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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

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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

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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)

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Other CEO pay distortions (2)

• Equity pay
• Option plans fail to filter out windfalls
• Most stock price increases do not reflect
• Firm-specific factor
• CEOs contribution
• Firms could use market/sector-based indexing but
  dont
• Backdating accentuates windfalls
• Few restrictions on unwinding
• Managers not required to hold shares (diluting
  incentives)
• Can sell on inside information (perverting
  incentives)

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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

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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

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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

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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

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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

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The future

• Further empowering shareholders best hope for
  improving
• Executive compensation
• US corporate governance generally
• THE END

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Boards behaving better

• CEO pay increases moderating
• Kaplan, 2007
• CEO turnover increasing
• Kaplan Minton, 2007

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Congress

• 1993 Tax Section 162(m)
• 2002 Sarbox
• Prohibition on loans
• Clawback

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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?

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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

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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

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End
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Pay without Performance

• Jesse Fried
• March 7, 2006
• Berkeley
• For fuller exposition of views on the subject
• Pay without Performance (Harvard University
  Press, 2004)

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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

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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 arms
  length negotiations
• Improve executive compensation arrangements
• Improve corporate governance more generally

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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.
• Its not how much you pay, but how (Jensen
  Murphy, 1990)
• Institutional investors have accepted higher pay
  as price of improving managers incentives

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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

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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.

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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

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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.

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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.

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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.

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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, dont
  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 wasnt earned it must be returned.

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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 executives service.

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• Improving Transparency

• 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

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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.

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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)

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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

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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.

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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

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Conclusion

• There is much that can be done and should be
  done to link pay more closely to performance.