Archives For executive compensation

This coming Friday (Oct. 12), the Center for Business Law and Regulation at Case Western Law School will host what promises to be a terrific symposium on executive compensation.  Presenters include TOTM alumnus Todd Henderson (Chicago Law), Jill Fisch (Penn Law), Jesse Fried (Harvard Law), David Walker (Boston U Law), David Larcker (Stanford Business), Stephen L. Brown (TIAA-CREF), Paul Hodgson (GMI Ratings), William Mulligan (Primus Venture Partners).

Here’s a description of the symposium:

Executive compensation has become the most contentious issue in corporate governance. Many claim that poorly designed executive compensation helped cause the recent financial collapse, but critics disagree widely about what was wrong with those designs. Management and investors are wrestling over their roles in structuring executive compensation through say-on-pay and over the role of proxy advisory services. The symposium brings together prominent practicing attorneys, institutional investors, proxy advisors, and academics to discuss the current issues and where we are, or should be, headed.

If you’re in Cleveland and able to make it to the symposium (for which 4.5 hours of CLE is available), do it.  Otherwise, check out the webcast.

Say on say on pay?

Larry Ribstein —  6 November 2011

“Say on pay” seems like one of those “chicken soup” ideas — at best salutary and at worst unobjectionable.  Who could object to letting the shareholders vote on executive pay?

Minor Myers, for one, in The Perils of Shareholder Voting on Executive Compensation. He suggests that “the more involved shareholders are in a firm’s managerial decisions, the more difficult it is for directors to be held accountable for the outcome of those decisions.” The shareholder vote, he argues, will insulate directors’ compensation decisions from shareholder outrage, which might otherwise have served as an important discipline.  He “proposes amending the [say on pay] legislation to allow firms to opt-out of the say on pay regime by shareholder vote. This preserves the benefits of say on pay for those firms where shareholders wish to retain it and allows other firms to exit the regime at little cost.”

This proposal makes some sense. Myers cites evidence indicating that some firms gain and others lose from say on pay.  In other words, some firms find that they benefit more from holding directors solely responsible for managerial pay than by having the (mostly disengaged) shareholders take responsibility. Indeed, Myers’ theory suggests say on pay may be a boon to greedy managers.

Although Myers would amend say on pay to make it optional, one wonders why the rule would be necessary at all.  State corporation law already provides for something like an opt-in regime by authorizing charter amendments on this issue. Myers argues that opt-out is better than opt-in because the equilibrium under the opt-in alternative would be driven by managerial opportunism.  But given shareholder inertia, I’m not persuaded the equilibrium under opt out would be any better.

In any event, the rationale for federal interference in state corporate law is the need for federal minimum standards.  If say on pay is no longer a minimum standard — if, like other corporate governance provisions it is just another default rule, with costs and benefits that vary from firm to firm — then why should it be a federal rule?

Myers’ analysis suggests that say on pay is, at best, one possible decent default rule, suitable for some firms.  If that’s the best rationale we can come up with, then it’s hard to see why we shouldn’t have federal say on all other corporate governance — in other words, a full-fledged optional federal corporate law.  Such a law could include a say on pay opt-in.  Or we could have an opt-in federal corporate law with opt out say on pay.  We could call such a statute say on say on say on pay.

Or we could just forget the whole thing.

As I discussed last May, corporations are hoarding cash.  According to today’s WSJ, they’re still hoarding cash.

Mira Ganor writes, in Agency Costs in the Era of Economic Crisis, that it could be about CEO compensation. Here’s the abstract:

This Article reports results of an empirical study that suggests that the current economic crisis has changed managerial behavior in the US in a way that may impede economic recovery. The study finds a strong, statistically significant and economically meaningful, positive correlation between the CEO total annual compensation and corporate cash holdings during the economic crisis, in the years 2008-2010. This correlation did not exist in comparable magnitudes in prior years. The finding supports the criticism against current managerial compensation practices and suggests that high CEO compensation increases managerial risk aversion in times of crisis and contributes to the growing money hoarding practices that worsen an economic slowdown. One possible explanation for the empirical findings is that during the last economic crisis, managerial risk seeking transformed into risk aversion that stalls economic recovery. The study has implications for the discussion on managerial pay arrangements and the implementation of the Dodd-Frank Act concerning say-on-pay

Whatever the cause, as I wrote last May there is a possible solution for cash hoarding (and possibly a better way to deal with agency costs generally), at least for some types of firms:

As I’ve pointed out in numerous articles (e.g.) and in my Rise of the Uncorporation, the uncorporation replaces often-ineffective corporate-type disciplines like fiduciary duties and shareholder voting with financial discipline centered on debt and distributions, which restricts the amount of cash managers have to play with.

And the underuse of the uncorporate form itself comes down to another problem:  the corporate tax.

Yesterday at the Illinois Corporate Colloquium Steve Choi presented his paper (with Pritchard and Weichman), Scandal Enforcement at the SEC: Salience and the Arc of the Option Backdating Investigations.  Here’s the abstract:

We study the impact of scandal-driven media scrutiny on the SEC’s allocation of enforcement resources. We focus on the SEC’s investigations of option backdating in the wake of numerous media articles on the practice of backdating. We find that as the level of media scrutiny of option backdating increased, the SEC shifted its mix of investigations significantly toward backdating investigations and away from investigations involving other accounting issues. We test the hypothesis that SEC pursued more marginal investigations into backdating as the media frenzy surrounding the practice persisted at the expense of pursuing more egregious accounting issues that did not involve backdating. Our event study of stock market reactions to the initial disclosure of backdating investigations shows that those reactions declined over our sample period. We also find that later backdating investigations are less likely to target individuals and less likely to accompanied by a parallel criminal investigation. Looking at the consequences of the SEC’s backdating investigations, later investigations were more likely to be terminated or produce no monetary penalties. We find that the magnitude of the option backdating accounting errors diminished over time relative to other accounting errors that attracted SEC investigations.

As readers of this blog, and Ideoblog before it, will appreciate, this paper particularly resonated with me.  As I wrote in a large number of posts (e.g.) backdating was a molehill the media blew up into a mountain.  Now come Choi et al with evidence that while the SEC was spending its scarce resources on this overblown molehill it was ignoring real mountains (e.g., Madoff).

I found the paper overall quite persuasive.  I wasn’t entirely convinced by the evidence that the backdating cases were getting weaker.  In particular, stock price reactions may just indicate the market was learning about the which companies were involved before the investigations were brought, and was gradually figuring out that backdating was not such a big deal.  But I was convinced of the evidence of the opportunity costs of the SEC’s backdating obsession — the otherwise inexplicable decline in investigations of serious non-backdating accounting problems.

As we discussed in the Colloquium, the paper reveals that there are agency costs not just in the backdating companies that were investigated but also in the agency that was doing the investigating.  Although it’s not clear exactly what moved the SEC to follow the media, there is at least some doubt about whether the SEC’s resource allocation decisions were in the public interest.

This calls attention to another set of agents — the ones in the media.  Why did the media love backdating so much?  As discussed in my Public Face of Scholarship, there are “demand” and “supply” explanations:  the public demands stories about cheating executives and/or journalists like to supply these stories.  David Baron, Persistent Media Bias, presents a supply theory emphasizing journalists’ anti-market bias.

Whatever the cause of media bias, when the media is influential its bias can result in bad public policy. SEC enforcement isn’t the only example. As I discuss in my article (at 1210-11, footnotes omitted):

Where interest groups are closely divided, the outcome of political battles may depend on how much voter support each side can enlist. This may depend on how journalists have portrayed the issue to the public. For example, the press is an important influence on corporate governance. One factor in the rapid passage of the Sarbanes-Oxley Act, the strongest federal financial regulation in seventy years, may have been the overwhelmingly negative coverage of business in the first half of 2002: seventy-seven percent of the 613 major network evening news stories on business concerned corporate scandals.

It’s not clear what can be done to better align SEC enforcement policy with the public interest.  Incentive compensation for SEC investigators?  Perhaps the only thing we can do (as with corporate crime) is to try to keep in mind when creating regulation that even if corporate agents may sometimes do the wrong thing, people don’t stop being people when they go to work for the government.

Now that regulating banker pay has been studied exhaustively, here’s something else worth studying:  bank regulator pay.  Fred Tung and Todd Henderson are on the case, in Pay for Regulator Performance.  Here’s the abstract:

Few doubt that executive compensation arrangements encouraged the excessive risk taking by banks that led to the recent Financial Crisis. Accordingly, academics and lawmakers have called for the reform of banker pay practices. In this Article, we argue that regulator pay is to blame as well, and that fixing it may be easier and more effective than reforming banker pay. Regulatory failures during the Financial Crisis resulted at least in part from a lack of sufficient incentives for examiners to act aggressively to prevent excessive risk. Bank regulators are rarely paid for performance, and in atypical cases involving performance bonus programs, the bonuses have been allocated in highly inefficient ways. We propose that regulators, specifically bank examiners, be compensated with a debt-heavy mix of phantom bank equity and debt, as well as a separate bonus linked to the timing of the decision to shut down a bank. Our pay-for-performance approach for regulators would help reduce the incidence of future regulatory failures

This is an interesting and well-executed idea which inspired a few thoughts.

First, if private-sector-type compensation for regulators is worthwhile, why not just rely on private sector rather than government regulators?  It would seem that the difference between government and private industry is really all about incentives.  Indeed, if we only semi-privatize by injecting market incentives into government actors, this could create tension in incentives analogous to imposing “corporate social responsibility” on corporate agents.

Second, might this proposal work for other types of gatekeepers, such as auditors?  Of course accounting regulation has moved in the opposite direction, toward making them more “independent.”  The Tung-Henderson analysis suggests that carefully structured performance pay may be a better way to go.

Third, if bank regulators, what about other public servants, including prosecutors? As I’ve written in my recently published Agents Prosecuting Agents (SSRN draft), they are agents too. Would incentive compensation better align their interests with those of the public?  My article discusses some problems with this (footnotes omitted):

Designing incentive compensation for prosecutors presents significant challenges.  Even in private law firms in which lawyers produce a clear financial output in the form of fees, there is controversy over whether billable hours or lockstep seniority-based compensation provides the best overall incentives.  The compensation design challenge is greater for prosecutors because there is no measure of the value of prosecutorial efforts.  Obviously a simple metric such as number of prosecutions would skew incentives, in that it may induce prosecutors to ignore the social costs of misguided prosecutions.  One author has proposed compensation based on convictions of charged crimes with deductions for findings of prosecutorial misconduct.  However, this could skew incentives toward, for example, undercharging defendants and over-caution.  On the other hand, tests that try to take more factors into account would be very costly to apply.

Tung and Henderson show how to overcome these metrics problems with bank regulators.  I’m skeptical analogous devices would work for prosecutors, even regarding purely corporate crime.  You’d have to, among other things, measure the deterrence effects of particular prosecutions. Not sure event studies could manage this.

There’s a lot more in this thought-provoking piece. Read the whole thing.

I have blogged extensively about the waste and injustice of the overblown backdating scandal.  (The posts are collected in Ideoblog’s executive compensation archive).  Now we have an accounting of the opportunity costs of the SEC’s pursuit of this so-called scandal.  Here’s the abstract of Choi, Pritchard and Wiechman, Scandal Enforcement at the SEC: Salience and the Arc of the Option Backdating Investigations:

We study the impact of scandal-driven media scrutiny on the SEC’s allocation of enforcement resources. We focus on the SEC’s investigations of option backdating in the wake of numerous media articles on the practice of backdating. We find that as the level of media scrutiny of option backdating increased, the SEC shifted its mix of investigations significantly toward backdating investigations and away from investigations involving other accounting issues. We test the hypothesis that SEC pursued more marginal investigations into backdating as the media frenzy surrounding the practice persisted at the expense of pursuing more egregious accounting issues that did not involve backdating. Our event study of stock market reactions to the initial disclosure of backdating investigations shows that those reactions declined over our sample period. We also find that later backdating investigations are less likely to target individuals and less likely to accompanied by a parallel criminal investigation. Looking at the consequences of the SEC’s backdating investigations, later investigations were more likely to be terminated or produce no monetary penalties. We find that the magnitude of the option backdating accounting errors diminished over time relative to other accounting errors that attracted SEC investigations.

And the conclusion:

Our study shows that the backdating investigations crowded out alternative investigative possibilities. Moreover, it is reasonable to conclude that the investigations foregone were likely to have more substantial impact than the backdating investigations that were pursued. We find that the stock market reaction to backdating investigations declined over time as the scandal progressed. The SEC was less likely to include individuals in its investigations, and federal prosecutors were less inclined to pursue criminal investigations. We also find that the consequences of the SEC’s backdating investigations declined as the scandal wore on. The SEC was more likely to terminate later investigations, and the SEC was more likely to come away with no monetary penalty.

The most plausible explanation for this decline in the consequences of the SEC’s backdating investigations is case selection. We find that the SEC‘s backdating investigations focused on smaller accounting errors later in the cycle of investigations. Smaller cases produced smaller consequences. Our conclusions hold whether we focus on just accounting investigations as our baseline of comparison, which we argue is the most similar comparator, or the expanded set of all SEC investigations of public companies. The SEC is an independent agency, but its independence from the executive branch does not mean that it is independent from political currents. The SEC’s response to the option backdating shows that it is not immune to the political imperative to “do something” in response to newspaper headlines. We cannot know which accounting investigations were not pursued because the SEC was occupied with backdating, but our analysis makes clear that the opportunity cost of the backdating scandal investigations.

And the SEC’s opportunity costs are only part of the opportunity-cost story. Consider what the WSJ missed as it pursued its Pulitzer for backdating.

Looks like a new scandal is brewing. 

A WSJ article co-written by one of the backdating reporters (Mark Maremont) looks through FAA flight records to find that

dozens of jets operated by publicly traded corporations made 30% or more of their trips to or from resort destinations, sometimes more than 50%. Often, these were places where their top executives own homes. The review covered nearly every jet flight in the U.S. over the four-year period from 2007 to 2010.* * *

Now, before we get too panicked, there are explanations.  As one lawyer said, “Even if they go to a resort, they’re still reviewing papers, looking at their BlackBerrys and talking on the phone. You just can’t compartmentalize these guys’ lives.” And there could be business reasons for the trips (e.g., if with clients), or the leisure stop could be a low-cost add-on to a business trip, or there may be security reasons for having the private jet to go everywhere.  And the Journal found some firms fully disclosed actual costs of the personal flights.

Assuming the jet use is a pure perk, how worried should we be? 

David Yermack, Flights of Fancy: Corporate Jets, CEO Perquisites, and Inferior Shareholder Returns (SSRN), 80 J. FIN. ECON. 211 (2006), found that firms that disclosed executive use of company plans underperformed the market by more than 4% annual, far exceeding the cost of the plane use, and on disclosure their stocks dropped an average 1.1%.

But Henderson & Spindler, Corporate Heroin: A Defense Of Perks, Executive Loans, And Conspicuous Consumption 93 Geo. L.J. 1835 (2005) (SSRN) show how corporate perks such as jet use can reduce final period problems that arise when executives have saved enough to retire. However, Henderson & Spindler note that that perks “can lead to undesirable employee behavior when inappropriately or excessively implemented.” 

So firms should disclose the costs of personal jet use.  And the SEC should clarify the disclosure rules (e.g., does an executive home office in a vacation home count as a company office?).  No doubt Gretchen Morgenson and her ilk will villify the executives who use the jets whether or not the use is efficient.  At some point we’ll get a story about how some firms are going private so they can use jets.

So now you have all the stories and you’re free to worry about other things.

Did you know that shareholders in US corporations are like oppressed citizens of corrupt governments?  Or that “say on pay” is their Arab Spring?

If not, you haven’t been reading Gretchen Morgenson.  Better that you read Christine Hurt’s excellent critique of Morgenson’s latest screed.

Reuters reports on Henry Hu’s somewhat controversial tenure heading the SEC’s new Division of Risk, Strategy and Financial Innovation.

The SEC brought in Hu, a widely recognized expert on financial regulation, in response to its embarrassing Madoff failure.  The Reuters article discusses some reservations about how much Hu accomplished, but I want to focus on another issue it covers:  the price of Hu’s services.

The SEC let Hu call Austin home, then paid him to travel between DC and Austin and to stay in temporary housing in Chevy Chase.  According to Reuters, here’s what all this amounted to:

Travel vouchers obtained by Reuters through a Freedom of Information Act request show that Hu sought reimbursement from the SEC ranging from about $4,000 a month to as high as $8,000 per month.

From December 2009 through December 2010, the vouchers, stamped as “processed,” added up to roughly $80,000, according to the records. The division’s total travel budget was about $345,000 in fiscal 2010 that ended Sept. 30.

Meanwhile, the SEC still paid a portion of his salary and benefits while the University of Texas paid the rest.

In the 2nd-year renewal of his agreement with the SEC, which was never fully exercised, the agency agreed to pay $198,333 of Hu’s $307,611 university salary plus $47,800 toward his insurance and retirement benefits, according to reviewed documents.

The maximum annual salary for SEC division heads who are full-fledged federal employees was capped at $230,700 in 2010.

Hu says he accepted “what top SEC staff informed me as to the chief approach and its terms.” The SEC’s inspector general is investigating the propriety of the arrangements.  Larry Harris, a former SEC economist, is quoted as saying: “The allocation of so much travel expense to a single person, where the travel did not directly promote the mission of the agency is extremely troubling.”

This is interesting in light of the SEC’s obsession with executive pay, and its responsibility for administering new say on pay rules.  Of course the SEC can argue that it was surely important to get the right person.  But companies always make similar noises about the complex demands of executive recruitment. 

I suppose it’s too much to expect a national referendum on SEC pay.  But shouldn’t we at least give Congress a say on SEC pay?  If anything it’s more justified here, since investors can simply sell or decide not to invest in companies that pay too much, but what’s the taxpayers’ remedy for excesses by the SEC?

Acharya, Gabarro and Volpin’s Competition for Managers, Corporate Governance and Incentive Compensation has interesting insights and data on both corporate governance and executive compensation debates.  In the final analysis, I think it’s most interesting for what it says about the uncorporation.  Here’s the abstract: 

We propose a model in which firms use corporate governance as part of an optimal compensation scheme: better governance incentivizes managers to perform better and thus saves on the cost of providing pay for performance. However, when managerial talent is scarce, firms compete to attract better managers. This reduces an individual firm’s incentives to invest in corporate governance because managerial rents are determined by the manager’s reservation value when employed elsewhere and thus by other firms’ governance. In equilibrium, better managers end up at firms with weaker governance, and conversely, better-governed firms have lower-quality managers. Consistent with these implications, we show empirically that a firm’s executive compensation is not chosen in isolation but also depends on other firms’ governance and that better managers are matched to firms with weaker corporate governance.

Some particularly interesting points in the paper:

  • Pay-for-performance compensation is greater in firms with weaker governance, thus indicating that these are substitutes.  Another reminder of the dangers of putting on blinders when evaluating and regulating corporate governance.
  • Executive compensation depends not just on a firm’s own governance, but on the governance of the firm’s competitors of comparable size.
  • Managerial quality also depends on firm governance. When a firm gets a better CEO, the quality of its governance decreases, and vice versa,

This paper shows that corporate governance and executive compensation are much more complicated not only than regulators’ simplistic assumptions, but even than some leading theories, such as Gabaix & Landier on the effect of firm capitalization (Why Has CEO Pay Increased So Much?, 123 QJE 49 (2008)) and Hermalin & Weisbach on CEO power (Endogenously Chosen Boards of Directors and Their Monitoring of the CEO, 88 American Economic Review 96 (1998)).  The authors note that the offsetting effects of governance and managerial quality “may explain why it has proven so hard so far to find direct evidence that corporate governance increases firm performance.”

Of particular interest for my work is this final observation in the paper:

A notable exception is the link between governance and performance found in firms owned by private equity: Private equity ownership features strong corporate governance, high pay-for-performance but also significant CEO co-investment, and superior operating performance. Since private equity funds hold concentrated stakes in firms they own and manage, they internalize better (compared, for example, to dispersed shareholders) the benefits of investing in costly governance. Our model and empirical results can be viewed as providing an explanation for why there exist governance inefficiencies in firms with dispersed shareholders that concentrated private equity investors can “arbitrage” through their investments in active governance.

This is another testament to the governance implications of the uncorporation.  For explanations of these implications, see my Rise of the Uncorporation, Chapter 8, and Partnership Governance of Large Firms.