Archives For executive compensation

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.

DSK and media bias

Larry Ribstein —  5 July 2011

Bret Stephens wonders why he and fellow journalists ignored the fact that “[a]lmost from the beginning, there was something amiss in the case of People v. Dominique Strauss-Kahn.” He speculates:

I did enjoy the thought of this mandarin of the tax-exemptocracy being pulled from the comfort of his first-class Air France seat and dispatched to Riker’s Island without regard to status or dignity. And I admired the humble immigrant who would risk so much for the sake of justice. And I smiled at the spectacle of France’s Socialists finding their would-be savior exposed by American prosecutors when they had been hypocritically observing a code of silence about his habits. And I liked seeing the IMF red-faced for whitewashing DSK’s previous escapades.

* * *

He adds that

this is as good an opportunity as any to ask where else we might be committing similar blunders. The climate change obsession, with its Manichean concept of polluting corporations versus noble eco-warriors? The Wall Street obsession, with its belief the boardroom boys were criminally guilty of the financial crisis? The China obsession, with its view that the Middle Kingdom is destined to overtake the U.S. in global economic and political clout? The Israel obsession, with its notion that if only Jewish settlements were removed from the West Bank peace would break out throughout the Middle East?

In each of these cases, the media (broadly speaking) has too often been guilty of looking only for the evidence that fits a pre-existing story line. * * *

But anecdotes are not data—which happens to be the world’s most easily neglected truism. Also true is that sloppy moral categories like the powerful and the powerless, or the selfish and the altruistic, are often misleading and susceptible to manipulation. And the journalists who most deserve to earn their keep are those who understand that the line of any story is likely to be crooked.

I discussed these issues five years ago in my Public Face of Scholarship. I found a rich economics literature analyzing media bias:

  • Michael Jensen observed that people “want sensationalist stories that present choices between good and evil and simple solutions rather than complex explanations.”
  • Core, Guay and Larcker studied the journalist coverage of executive compensation, noting that the press emphasizes sensationalism rather than realistic analysis of the extent of excessive compensation.
  • Gregory S. Miller, The Press as a Watchdog for Accounting Fraud, 44 J. ACCT. RES. 1001 (2006) found that the press emphasized sensationalist elements in stories about accounting fraud.
  • Gentzkow & Shapiro, Media Bias and Reputation, 114 J. POL. ECON. 280 (2006) argue that the news media seek to confirm what the audience thinks it already knows rather than risk being rejected. 
  • Mullainathan & Shleifer conclude that journalists feed audience biases.
  • David Baron reverses causation, arguing that media bias originates with left-leaning anti-market journalists rather than with an effort to serve the audience.

I discussed these theories by way of arguing that bloggers can help correct these tendencies.  That may have happened in this case, but being biased in favor of the accepted wisdom here I didn’t follow any bloggers who might have caught on. 

All of this shows that media and audience bias can be very sticky, and we need a lot of different information sources to combat it.  In other words, free speech is important.  This includes not only bloggers, but for-profit corporate speech, which can cut against some of the biases Stephens referred to.

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.

So you thought unconscionability was for furniture stores?  Larry Cunningham has news for you:

This Article explains why and how traditional contract law’s theory of unconscionability should be used to create a modicum of judicial scrutiny to strike obnoxious pay contracts and preserve legitimate ones. Under this proposal, pay contracts that are the product of managerial domination of the process and formed on terms massively favoring the executive will be stricken. This will follow direct shareholder lawsuits in state courts where the contract is made or performed and applying that state’s contract law. This new legal theory circumvents today’s dead-end route, where pay contracts are always upheld in derivative shareholder lawsuits applying corporate law that sets no meaningful limits on executive pay. This proposal creates new but modest pressure from sister states on Delaware to take greater responsibility for the effects its production of corporate law has nationally.

For those outraged by lopsided corporate executive compensation, this Article offers an appealing new legal theory of contractual unconscionability to police them. Those who see no or few problems with contemporary pay arrangements, or who are outraged by federal regulatory schemes like the Dodd-Frank Act, will welcome how this proposal is narrowly tailored using common law to address the most obnoxious cases.

The article, among other things, would take the executive pay issue out of the internal affairs doctrine and put it into the morass of general choice of law rules for contracts (footnotes omitted):

[B]ecause they are not matters of internal affairs, they would be governed by the law of the state having the greatest interest.  Managers could name Delaware as the choice of law by contract and maintain Delaware’s quasi-monopoly that insulates the devices from judicial scrutiny. Yet contractual choice-of-law clauses are but one factor relevant to determining what law governs a contract.

To be sure, says Cunningham,

investors may recoil at the prospect of gadfly fellow shareholders challenging corporate pay contracts.

But he sees this as

a way to restore a modicum of external pressure on the State of Delaware, the leading promulgator of corporate law for national use. * * * [T]he practical reality is that the competition has ended, and Delaware faces no such pressure today.

There is, of course, a substantial literature questioning the Bebchuk-Fried-Walker conclusion on which this proposal is based that executive pay is out of whack.  And another substantial literature on whether or not the market for corporate law is out of whack.  But let’s put those questions aside and play along with the premises of the proposal.  Consider the consequences: 

  • Under this proposal, an executive, having negotiated her pay with a corporate board, would have no way of knowing whether, at some point, the pay might be challenged under standards to be named later in some state (her residence state, the corporation’s main place of doing business, somewhere else?) at the instigation of a lawyer seeking to extort a payment from the company. 
  • Executives would retain whatever power they supposedly had over the corporation in negotiating their contract to negotiate protection from or payment for this litigation risk.  Shareholders, of course, would pay.
  • Firms would surely find some way to deal with this new rule.  Would the result be better than the system we have now of entrusting the decision to directors?

I guess you could say I’m not convinced. I prefer to take this article as an interesting thought-experiment on why regulation of corporate pay is misguided.

I appeared on CNBC’s Street Sense today to talk about Morgan Stanley’s new policy on bonuses and what it means for the future of Wall Street executive compensation.  See here.

Larry E. Ribstein is the Mildred Van Voorhis Jones Chair in Law and the associate dean for Research, University of Illinois College of Law

I thought I’d aim my opening post at the question that motivated my interest in this symposium:  is behavioral economics leading us to the end of free markets and the takeover of the regulatory state?

Consider how far we’ve come since the days of “caveat emptor,” when sellers had a legal right to fool and cheat buyers, and consumers were free to be fooled and cheated.

At some point we entered the age of disclosure.  Disclosure regulation could be rationalized in the name of consumer sovereignty.  Freedom is arguably not much good when it’s just another word for losing money to sellers.  Of course disclosure laws can be misguided or excessive.  At their worst they are just another way to regulate conduct — e.g., mandatory proxy disclosures about executive compensation.

Behavioral economics tells us, however, that just giving consumers some information is not enough.  Indeed, disclosure becomes part of the problem.  New information can’t help people who are “anchored” in old information, or simply use it to “confirm” their initial judgments.  Consumers might over-rely on the parts of the disclosures that are most “available” or erroneously “frame” the information presented.  Some of these errors might be corrected by getting the disclosures just right, but others might be unaffected or exacerbated.  A decade ago an article listed almost 40 research topics relating to behavioral finance, which is just one branch of behavioral economics, many identifying distinct theories concerning behavioral biases.

Behaviorism-based regulation has no clear stopping point because everybody makes mistakes that can be attributed to some heuristic flaw.  Consider a leading experimental study of mutual fund investing by Harvard staff members, Wharton MBA students and Harvard college students. The Harvard staffers were mostly college educated and the students reported average SAT scores in the 98th and 99th percentiles. The study showed that the participants failed to choose among basically identical index funds so as to minimize fees.  If we can’t trust these consumers to make simple financial decisions, whom can we trust? Continue Reading…

Say on Pay

J.W. Verret —  19 October 2010

A late Monday press release from the Securities and Exchange Commission announces a rule proposal to implement the say on pay requirements of the Dodd-Frank Act.  I testified before both houses of Congress against the legislative authorizing language in Dodd-Frank that the SEC uses to promulgate the rule.  My testimony before the House Financial Services Committee is available here.  My testimony before the Senate Banking Committee is available here.

The SEC release includes the three central provisions described below:

Shareholder Approval of Executive Compensation

Under the proposed rules implementing the Dodd-Frank Act, companies subject to the federal proxy rules would be required to provide shareholders with an advisory vote on executive compensation….

The SEC’s proposal requires companies to provide disclosure about the say-on-pay vote in the annual meeting proxy statement, including whether the vote is non-binding. The proposal also would require the company to disclose in the Compensation Discussion and Analysis, or CD&A, whether, and if so, how companies have considered the results of previous say-on-pay votes.

Shareholder Approval of the Frequency of Shareholder Votes on Executive Compensation

Under the proposal, companies subject to the federal proxy rules also would be required to allow shareholders to vote on how often they would like to cast a say-on-pay vote, namely: every year, every other year, or once every three years.

Shareholders would be allowed to cast this non-binding “frequency” vote at least once every six years beginning with the first annual shareholders’ meeting taking place on or after Jan. 21, 2011.

The proposals would require companies to provide disclosure about the frequency vote in the annual meeting proxy statement, including whether the vote is non-binding.

Shareholder Approval and Disclosure of Golden Parachute Arrangements

Under the proposal, companies also would be required to provide additional information about the compensation arrangements with executive officers in connection with merger transactions. Disclosures of these “golden parachute” arrangements would be required of all agreements and understandings that the acquiring and target companies have with the named executive officers of both companies.

This “golden parachute” disclosure also would be required in connection with going-private transactions and third-party tender offers, so that the information is available for shareholders no matter the structure of the transaction.

Further, the proposed rules would require companies to provide a shareholder advisory vote to approve certain “golden parachute” compensation arrangements in merger proxy statements.

I am at least partially relieved that Boards seem to be permitted to bifurcate decisions over pay from decisions over golden parachutes based on this brief description of the SEC’s proposal.  Let me take this opportunity to plug my testimony before the Senate Banking Committee hearing that considered the Dodd-Frank provisions that gave the SEC authority to promulgate this rule, in which I urged that if the Committee ultimately decided to support say-on-pay over my objection they at least treat golden parachutes as a distinctly different animal.

I argued for a full exemption for golden parachutes from say-on-pay.  I think golden parachutes are an easy transaction response to the quandry of reconciling Delaware’s position on the poison pill with an appreciation of the benefits of the market for corporate control.  In my view, golden parachutes are delightfully Coasian.

Let’s say you accept the argument that the Delaware cases of the 1980s re-apportioned negotiating authority, outside of the current terms of the corporate contract between shareholders and boards, by permitting poison pills that you think inefficiently inhibited the market for corporate control.  Then you would love the fact that side transactions immediately are invented to encourage executives to rescind the pill for motives beyond pure entrenchment in the form of a negotiated side payment.

Golden parachutes are, indeed, a transaction of which the benefit and the cost should itself be capitalized into share price ex ante because the terms of the payout are clear in advance.  It is also a contractual term that creditors, suppliers, and customers will also more easily take into account in considering how the incentive effects of the contractual provision on the executives will affect their own contractual relationship with the firm and its executives.

Now, for some video.  I appeared on The News Hour with Jim Lehrer to argue against the Dodd-Frank implementing amendment for say-on-pay, and a number of other related executive compensation provisions, just after they passed the House, see here.

DeLong on Henderson III

Larry Ribstein —  7 October 2010

On October 3 I wrote

The DeLong point I want to focus on is his last:  “I genuinely do not understand why Henderson has his job.” By which he means Todd’s law professor job.

DeLong’s sole reported basis for this is a post, not by Todd, but by my co-blogger Jay Verret, who refers to a recent Henderson paper, Insider Trading and CEO Pay.  Jay says Todd’s findings in the paper “are in line with Henry Manne’s original thesis from nearly 40 years ago that insider trading didn’t diminish firm market value on net and may serve a useful purpose as an executive compensation device to motivate managers to maximize the value of the firm.”

DeLong responds that “[g]iving firm managers the freedom to use information they privately have as a result of their jobs to decide when to buy and sell shares of stock does not motivate managers to manage the firm in the interest of shareholders.”  That’s because, according to DeLong, “the ability to engage in insider trading. . . gives managers an incentive to make the price of the stock vary–they don’t care which way.. . . Insider trading makes executives’ portfolios’ long not the company but long the volatility of the company. . . . This claim that freedom to engage in insider trading aligns executives’ interests with those of shareholders is so basically wrong, so obviously erroneous, so simply stupid that–well, words fail me.”

As Jay notes, there’s at least significant intelligent debate on these issues.  Opponents of insider trading regulation don’t argue that insider trading is always good, but that firms should be allowed to contract for it.  But the most remarkable thing about DeLong’s post is that it accuses Todd of being “stupid” and unfit for law teaching because of an argument Todd didn’t make! 

If DeLong had bothered to look even at the abstract of Todd’s article, perhaps he would have noticed that the article’s not about alignment of incentives, but about whether boards bargain with insiders over their gains.  Todd finds evidence consistent with the hypothesis that “boards pay executives in a way that reflects the profits they are expected to earn from informed trades.” 

Todd doesn’t even argue based on this evidence that insider trading liability should be abolished.  Rather, he says only that “the case for classic insider trading is made much weaker by this data.”  He also notes in the abstract that “there still may be good reasons to prohibit some individuals from trading on material, non-public information.” One of these reasons might be DeLong’s point that firms would be better off if insiders weren’t paid with insider trading profits.  Maybe that holds even if the insiders are willing to pay for the opportunity to trade.  I don’t necessarily subscribe to DeLong’s arguments, but I’m not willing to call somebody “stupid” and unfit for teaching for making them.  My only point here is that Todd doesn’t discuss this issue at all. 

I will leave it to the reader to decide what we should make of a Professor of Economics at U.C Berkeley, Chair of Berkeley’s Political Economy major and former Deputy Assistant Secretary of the Treasury who is willing, in print, to accuse somebody of being “simply stupid” for a position he does not take expressed in a blog post he didn’t write

DeLong responds:

Ribstein, Adler, Volokh, etc.:

[T]he abstract of Todd [Henderson]’s article… [shows] that the article’s not about alignment of incentives, but about whether boards bargain with insiders over their gains. Todd finds evidence consistent with the hypothesis that “boards pay executives in a way that reflects the profits they are expected to earn from informed trades”…

J.W. Verret:

In “Insider Trading and CEO Pay,” Prof. Henderson examines the effectiveness of insider trading as a compensation device…. His findings are… that insider trading… may serve a useful purpose as an executive compensation device to motivate managers to maximize the value of the firm…

Todd Henderson, in said abstract:

Insider Trading and CEO Pay: This Paper presents evidence boards of directors “bargain” with executives about the profits they expect to make from trades in firm stock. The evidence suggests executives whose trading freedom is increased using Rule 10b5-1 trading plans experienced reductions in other forms of pay to offset the potential gains from trading. There are two benefits from trading—portfolio optimization and informed trading profits—and this Paper allows us to isolate them. The data show boards pay executives in a way that reflects the profits they are expected to earn from informed trades…. As a matter of policy, the data seriously undercut criticisms of the laissez-faire view of insider trading…. At least with respect to classic insider trading (that is, a manager of a firm trading on the basis of information about the firm where she works), if boards are taking potential trading profits into consideration when setting pay, it is difficult to locate potential victims of this trading. Current shareholders should be happy with a deal that pays managers in part out of the hide of future shareholders…

I call this one for Verret 6-0, 6-0, 6-0.

The reader will note two things.  First, Verret did not say what DeLong attributes to him in his edited version of Verret’s initial post, as Verret himself noted later.  Second, Todd’s abstract does not say what DeLong’s edited version of Verret says.  Henderson says that the data shows that insider pay adjusts to reflect expected insider trading profits, not that “insider trading. . . may serve a useful purpose as an executive compensation device to motivate managers to maximize the value of the firm.” 

I wonder whether (1) DeLong does not understand the difference between these two statements; or (2) by clever manipulation DeLong wants the reader to believe that Henderson said something he didn’t say, so that DeLong can then call it stupid (which, as I said earlier, it isn’t).

Whichever is the case, I also wonder why a person in DeLong’s position decided to embark on this character assassination in the first place.

Update:  Jonathan Adler also responds, with more detail on the stuff DeLong cut out.  That is all I plan to say about DeLong on Henderson (and probably about DeLong on anything).  There is much more that can be said about whether insider trading should be regulated, and I will likely discuss it when the issue is raised by a new case, SEC rule or cogent commentary.  In particular, I expect to have more to say later about Henderson’s very interesting paper which DeLong carelessly trashes.  But I can now see that a discussion with the likes of Brad DeLong is not productive.

We recently welcomed Harwell Wells to the Illinois Corporate Colloquium to discuss his and Randall Thomas’s Executive Compensation in the Courts: Board Capture, Optimal Contracting and Officer Fiduciary Duties.  

The paper suggests a new approach to controlling executive compensation:  the courts.  The paper is partly historical, noting that courts have, in fact, been “surprisingly willing to second-guess decisions on executive compensation,” although after doing so they ultimately withdraw from the field to avoid becoming “entangled in setting pay.”  The article says Delaware’s recent Gantler v. Stephens, which recognizes fiduciary duties of corporate officers, “opens the door for courts to monitor executive compensation by scrutinizing rigorously officers’ actions in negotiating their own compensation agreements.” Thomas & Wells also draw on Delaware holdings “that corporate officers are bound by their duty of loyalty to negotiate employment contracts in an arm’s-length, adversarial manner.”

Thomas & Wells suggest their “approach should be welcomed by the courts, which will not be required to determine whether compensation packages are fair or merited, but will instead be asked to engage in a familiar task, examining whether proper procedures were followed in setting compensation.”  The abstract concludes:

This approach . . . promises to break an impasse between the two major academic approaches to executive compensation. Advocates of “Board Capture” theory have long argued that senior executives so dominate their boards that they can effectively set their own pay. “Optimal contracting” theorists doubt this, contending that, given legal and economic constraints, executive compensation agreements are likely to be pretty good and benefit shareholders. The approach advocated here should, surprisingly, please both camps. To Board Capture theorists, it offers to cast light on pay negotiations they believe are largely a sham; to Optimal Contracting theorists, it offers a way to improve the already adequate negotiating environment.

Given the ongoing focus on executive compensation, which shows no sign of abating, this is a timely suggestion.  It’s also an intriguing idea which sparked a lot of discussion in class.  I agree that focus on board procedure offers some benefits over attempting to set pay.  But I also have some skepticism and questions about the proposal.

First, are courts any better suited to determining how pay should be negotiated than what it is? The Delaware Supreme Court thought it knew in Smith v. Van Gorkom when it threw out a seemingly fairly priced transaction solely because it didn’t like the negotiation process.  The post-Van Gorkom fallout in Delaware, including 102(b)(7), and the cases insisting that price be considered with procedure, indicated the problems with the court’s assumption.

Second, I question characterizing the officers’ duty in this situation as fiduciary. As I’ve written, the fiduciary duty is properly conceived of as a duty of unselfishness.  This doesn’t fit with an officer negotiating for what is essentially an exception to the duty – that is, the officer’s compensation.  The officer should have some disclosure duty in this situation, but that’s not the same thing as the hard-core duty of unselfishness. 

Third, what would a fiduciary duty of fair negotiation entail beyond disclosure? There would certainly be a substantial period of unpredictability while courts figure this out, and firms likely would have to tack a premium onto pay packages to reflect the risk of judicial second-guessing. 

Fourth, it’s worth observing that the duty Thomas & Wells describe is similar to the one Judge Easterbrook tried to set in the mutual fund investment adviser context – disclosure and no “tricks.”  See my paper, Federal Misgovernance of Mutual Funds.  The Supreme Court shot the Easterbrook test down in Jones v. Harris. The Court reasoned more or less that the statute says “fiduciary duty” and disclosure-no-tricks isn’t a fiduciary duty.  This is a cost of trying to apply a fiduciary duty where it doesn’t really belong.  The same issues of containing a “fiduciary duty” of fair negotiations would apply here.

I suspect that if courts recognized this duty firms would comply by having their compensation consultants concoct a rigid set of procedures that would protect pay from second-guessing.  On the bright side, this could protect firms from judicial second-guessing of the size of pay packages, which Thomas & Wells show does happen periodically.  Since it’s probably not enough anymore in this regulatory environment just to say markets work, maybe Thomas & Wells is the best we can do.