Revisionist corporate governance

Geoffrey Manne —  29 May 2009

If you haven’t been living under a rock recently, you’ve seen an incredible amount of hand wringing–and proposed regulation–around “excessive compensation.”  I’m a little too lazy to amass all the relevant links here, but both the administration and the congress are introducing regulations/bills and talking about the issue extensively.

Commentators, too, have gotten in on the act, and one of the most respected, Alan Blinder, has recently penned a much-lauded WSJ op-ed on the topic, titled, “Crazy Compensation and the Crisis.”  The op-ed is well-written, and even makes some good points.  Here’s an excerpt I can get behind:

What to do? It is tempting to conclude that the U.S. (and other) governments should regulate compensation practices to eliminate, or at least greatly reduce, go-for-broke incentives. But the prospects for success in this domain are slim. (I was in the Clinton administration in 1993 when we tried — and failed miserably.) The executives, lawyers and accountants who design compensation systems are imaginative, skilled and definitely not disinterested. Congress and government bureaucrats won’t beat them at this game.

I might disagree with the emphasis–I would say that even if government could be successful at regulating pay practices it shouldn’t do it, but the point is certainly a good one.  Blinder is also right on when he notes the benefits in this regard of partnerships over public corporations, a persuasive point Larry Ribstein has been making for a long while.

But the premise of the op-ed–and a lot of corporate governance talk these days–strikes me as problematic, incomplete and revisionist.  Here’s a key bit:

Take a typical trader at a bank, investment bank, hedge fund or whatever. Darwinian selection ensures us that these folks are generally smart young people with more than the usual appetite for both money and risk-taking. Unfortunately, their compensation schemes exacerbate these natural tendencies by offering them the following sort of go-for-broke incentives when they place financial bets: Heads, you become richer than Croesus; tails, you get no bonus, receive instead about four times the national average salary, and may (or may not) have to look for a new job. These bright young people are no dummies. Faced with such skewed incentives, they place lots of big bets. If tails come up, OPM will absorb almost all of the losses anyway.

The op-ed has been cited favorably by commentators ranging from the predictably-tiresome-and-unlikely-to-know-better (Frank Pasquale) to the informative-but-reflexively-pro-regulation (James Kwak) to the always-interesting-and-not-normally-in the-company-of-the-likes-of-Frank-Pasquale (Marc Hodak).

But it strikes me as shocking that Blinder (and his supporters)–who expresses surprise as well as dismay at the extent to which compensation schemes reward the upside so heavily and induce risk-taking–doesn’t even mention Agency Theory.

While Blinder may be surprised that corporate boards have been making such silly mistakes for so long, I would think that every professor or finance, corporate governance, corporate law, securities, and a few other disciplines besides would know that one of the fundamental problems of the corporate form is aligning risk-averse managerial interests with risk-preferring, diversified, shareholder interests.  Remove insider trading and short-selling from the equation and you’re left with potentially-large stock options and other forms of performance-based, deferred compensation.  Which have been lauded and paraded around for years as the salvation of entire industries.  So before we stare in amazement that firms are engaging in these sorts of compensation schemes (schemes that may lead to huge upside paydays, and even some large downside paydays, as well) perhaps we should understand the basic theory behind such behavior–as well as the raft of empirical studies supporting the theory.

Look–this isn’t to say that there might not be problems.  Efforts to align incentives may be out of whack, of course–only a fool would presume perfection on the part of market actors.  But only a greater fool would grant the government the power to control compensation schemes, and do so without acknowledging that there are incentive alignment problems; that there are agency costs; and that firms–to say nothing of broader markets–are complex entities not amenable to easy political solutions.  Alan Blinder should know this, and while his restraint is admirable (at least now–I guess he was more ambitious when he was in the Clinton administration) this is just fodder for the corporate governance revisionists who act like agency theory doesn’t exist and only criminals and greedy bloodsuckers design (and receive) executive compensation schemes.  (Actually, come to think of it, once the government starts setting corporate pay, this will almost be true!  I kid, I’m kidding.  Mostly).

Addendum: I should note two more things.  First, I was being a bit flip.  Blinder is clearly (and appropriately) sensitive to the agency problem of the separation of ownership and control inherent in compensation committees’ paying executives with shareholders’ money.  The problem I have is in the failure to acknowledge that there is another agency problem to deal with:  It is too facile to solve the one without concern for the other.

The second point I should make is that Marc Hodak, at least, among the op-ed’s fans, understands the agency problem, and shouldn’t be tarred with my criticism.  His citation to Jensen & Murphy’s “It’s not How Much You Pay, But How” article reflects exactly this concern–the focus should be structuring compensation to account for various agency problems, not blithely limiting its size.  The irony (to answer, I think, Marc’s riddle) is that Jensen and Murphy noted that, at least in 1990, all else equal, the size of executive compensation seemed low.  Again–the real concern was/is with appropriate structure, but at the end of the day, appropriate structure would, I think, for Jensen and Murphy in 1990, have resulted in higher payouts.  Blinder and, to name a few others, Barney Frank and Chuck Schumer, don’t seem to see it this way at all.

Geoffrey Manne


4 responses to Revisionist corporate governance


    There were two things about the Blinder article that appealed to me. First, I found his nominal concern about pay structure, as opposed to a myopic focus on pay level, to be refreshing in this “eat the rich” environment. Second, I appreciated Blinder’s belated humility about the efficacy of government intervention in compensation matters, which has been a serial comedy of unintended consequences. Blinder rightly points out that this is an issue only the board can address.

    Like you, I think he didn’t go far enough in appreciating the underlying agency issues. I also think he grossly understated the incentives at top management levels to get it right. Dick Fuld may have lacked the proper foresight or wisdom or intelligence to avoid what befell Lehman, but someone please explain to me how, after losing 90% of his net worth and 100% of his legacy, he lacked the proper incentive?

    The irony of assigning a common title to Jensen & Murphy’s paper and Blinder’s column is that J&M’s compelling vision of adding significant executive incentive leverage was combined with the Clinton/Blinder constraints on salary to create the explosion of stock options that eventually resulted in the asymmetrical risk/reward issues Blinder now bemoans. Which goes to support your point that these issues are hard to solve, even for people with the greatest interest and knowledge in doing so.


    What do you think of this proposal promoted by Surowiecki (at the URL above):

    “There are ways to make boards proactive and more than nominally independent. Investors need to be able to play a much bigger role in determining who ends up on boards, nominating candidates themselves, instead of choosing among the C.E.O.’s picks. (The S.E.C. is currently considering a proposal to make it easier for big shareholders to do this, which would be a good start.) On top of that, it’s time to revive an idea that was first floated by the corporate-law scholars Ronald Gilson and Reinier Kraakman, who proposed that big institutional investors create a cadre of full-time directors, people whose only job would be to sit on corporate boards and look after shareholder value. Most board members, accomplished as they may be in their real jobs, are amateurs when it comes to being directors. So it shouldn’t surprise us when they get buffaloed or pushed around by C.E.O.s, who are professionals. Right now, boards are made up of moonlighters. And, if the last few years have shown anything, it’s that protecting shareholder interests is a full-time job.”

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