6 th session: pay without performance

6th session:Pay without Performance

Performance EvaluationIMSc in Business AdministrationSeptember October 2009*Performance Evaluation [email protected]

Performance Evaluation [email protected]

In judging whether corporate America is serious about reforming itself, CEO pay remains the acid test. To date, the results arent encouraging.Warren Buffet, letter to shareholders of Berkshire Hathaway, Inc., Feb.2004

Session 06 - *Performance Evaluation [email protected]


Session 06 - *Performance Evaluation [email protected] without PerformanceThe Official StoryProblemsRecommendationsAdapted from Bebchuk, Lucian, and Jesse Fried, Pay without Performance The Unfullfilled Promise of Executive Compensation, Harvard University Press, 2004 (and also the short version in The Journal of Applied Corporate Finance, Vol.17 Number 4 (Fall2005), pp. 9-23)

Other key references in the Executive Compensation LiteratureJohn Core, Robert Holthausen, and David Larcker, Corporate Governance, Chief Executive Compensation, and Firm Performance, Journal of Financial Economics, Vol. 51 (1999), pp. 371-406. (CHL)Richard Cyert, Sok-Hyon Kang, and Praveen Kumar, Corporate Governance, Takeovers, and Top-Management Compensation: Theory and Evidence, Management Science, Vol. 48 (2002), pp. 453-469. (CKK)Marianne Bertrand and Sendhil Mullainathan, Agents With and Without Principals, American Economic Review, Vol. 90 (2000), pp. 203-208. (BeMu)Kenneth A. Borokhovich, Kelly R. Brunarski, and Robert Parrino, CEO Contracting and Anti-Takeover Amendments, Journal of Finance, Vol. 52 (1997), pp. 1503-1513.


Session 06 - *Performance Evaluation [email protected] it is supposed to workSeparation of ownership and control creates agency relationship between shareholders and managersHow much effort to exert?What compensation to reward the agents? How many perks to consume?Which strategy and business choices to make for the company (Empire building)Are these still the best managers for the firm?Board as the Guardian for Shareholders Interests Power to run the company is vested on the board (not on the CEO)Many board member are there only to keep the managers in line (in line with the shareholders interests)Failure to proctect shareholders interests leads shareholders to either:Fire the out of line BoardSell the share to hostile acquirer


[One or Two-tiered Governance Models]CEOBoard of Directors (including non-executive supervising directors and other executive managing directors)*Performance Evaluation [email protected]


Arms Length Bargaining over CompensationBoards role in negotiating on the shareholders behalf the compensation of the managersEfficient contracting:Must provide enough value to induce the executive to accept and remain in the position (sounds familiar? IRC?)Must align incentives and induce performance based compensation A well designed compensation scheme can make up for the fact that supervising directors cannot monitor or evaluate executives decisions.*Performance Evaluation [email protected]


Its the Market for Talent!The CEO labor market meets all the criteria of any market Ira Kay, compensation consultant testifying before the US Senate.Star athletes or rock stars?CEO pay problem is similar to arguing that Michael Schumacher cannot be paid more than other great driving legends of the 50s or 60s, like Fangio or Fitipaldi

*Performance Evaluation [email protected]


Why do board members side with the CEO?Board members reelection is often contingent on CEO approvalCEO effectively bought off BMs by offering them special perks and economic benefitsBMs own compensation packagesInterlocksOther existing of potential business dependences*Performance Evaluation [email protected]


Why do board members side with the CEO?Social and psychological factorsFriendship and loyaltyCollegiality and team spiritAuthority and deferrence towards seniorityCognitive dissonanceSmall cost of favoring CEOReduction in the value of BMs holdingsReputational costsInsufficient Time and InformationInfrequent firing of CEOsLake Wobegon Effect and ratcheting*Performance Evaluation [email protected]


What can the shareholders do?Sue the board! Litigation is extremely hard:Courts are ill equipped to judge compensation packagesWas the package approved by some nominally independent board member?Is there any rationality in the package or is it a complete waste?



What can the shareholders do?Legal technicalitiesCompensation packages are legally only hurting shareholders indirectly. derivative suit suit brought on behalf of the corporation, but who has the power to represent the corporation and its interests? demand requirement shareholders ask the board to inquire on facts, and board dismisses the inquiredemand futility plaintiff (shareholders) must present particularized facts that create reasonable doubt that the directors are disinterested and independent. How can do this without the inquire? Catch22...Even if they get this far:Special litigation committee board can appoint independent committee to establish if the suit is in the best interest of the firm...



What can the shareholders do?Vote against employee stock option plansAfter SOX voting on these plans is mandatory!Plans being voted are not specific enough (shareholders do not vote on particular executive packages)Voting against such a plan leads to a management crisis...Other compensation packages (or forms thereof) may still pass against the shareholders vote, but they loose tax deduction rightsVoting processYou are voting against them - the management (and all their proxies, usually including other employees who happen to hold shares and also benefit from the same package, but also typical management buddies such as institutional investors)*Performance Evaluation [email protected]


What can the shareholders do?Vote on precatory (wishful and non binding) resolutionsLow ceilings on executive compensationElimination of options*Performance Evaluation [email protected]


*Performance Evaluation [email protected] else can the shareholders do?RUN!


*Performance Evaluation [email protected] ForcesManagerial Labor MarketsUnrewarded good performers will leave (IRC)Underperformers can be fired and better ones hiredBut CEO dismissal is extremely rare and involves large adaptation costs for the firing company


*Performance Evaluation [email protected] ForcesMarket for Corporate ControlUnderperforming managers lead to sagging stock prices and vulnerability to takeoverThis should keep CEOs in lineBulletproof boards (staggered poison pills high premiums on takeovers)


*Performance Evaluation [email protected] ForcesMarket for Additional CapitalSimilar to previous argument: Underperforming managers lead to need for additional fundingAdditional capital means new shareholdersProduct MarketAgain, underperforming managers will become obvious in comparison with competitors


*Performance Evaluation [email protected] ForcesIt is true that market forces do introduce natural correcting mechanisms into the bargaining process (at least, I still believe in that)However, it is also true that such correcting mechanisms are not always immediate, and they are fully anticipated by the managers


What it amounts to is that theres no one representing shareholders. Its like having labor negotiations where one side doesnt care.A Fortune 500 CEO quoted in the book (pg.61).



Executive Compensation The Power GameFirst, there is evidence that executive compensation is higher when the board is relatively weak or ineffectual vis- vis the CEO. In particular, compensation is higher: when the board is large, which makes it more difficult for directors to organize in opposition to the CEO; when more of the outside directors have been appointed by the CEO, which could cause them to feel gratitude or obligation to the CEO; and when outside directors serve on three or more boards, and thus are more likely to be distracted. (CHL)Also, CEO pay is 20% to 40% higher if the CEO is the chairman of the board, and it is negatively correlated with the stock ownership of compensation committee members. (CHL and CKK)



Executive Compensation The Power GameSecond, studies find that compensation is lower in the presence of a large outside shareholder. A large outside shareholder might engage in closer monitoring and thereby reduce managers influence over their compensation. One study finds a negative correlation between the equity ownership of the largest shareholder and the amount of CEO compensation. (CKK) Another study finds that CEOs in companies without a 5% (or larger) outside shareholder tend to receive more luckbased paythat is, pay associated with profit increases that are generated entirely by external factors (such as changes in oil prices and exchange rates) rather than by managers own efforts. (BeMu)



Executive Compensation The Power GameThird, there is evidence linking executive pay to the concentration of institutional shareholders, which are more likely to monitor the CEO and the board.One study finds that more concentrated institutional ownership leads to lower and more performance-sensitive compensation. Another study finds that the effect of institutional shareholders on CEO pay depends on the nature of their relationships with the firm. *Performance Evaluation [email protected]


Executive Compensation The Power GameFinally, studies find a connection between pay and antitakeover provisions, arrangements that make CEOs and their boards less vulnerable to a hostile takeover. One study finds that CEOs of companies adopting anti-takeover provisions enjoy above-market compensation before adoption of the provisions and that adoption is followed by further significant increases in pay.



The Walk of ShameThere is evidence that the design of compensation arrangements is indeed influenced by how outsiders perceive them.



Camouflage and Stealth CompensationTry to legitimize, justify, or obscureor, more generally, to camouflagethe amount and performance- insensitivity of executive compensation. The desire to camouflage has an important effect on pay structures. Compensation designers attempts to obscure the amount and performance-insensitivity of compensation have led to arrangements that undermine and distort managerial incentives, thereby weakening firm performance. *Performance Evaluation [email protected]


Camouflage and Stealth CompensationOverall, the camouflage motive turns out to be quite useful in explaining many otherwise puzzling features of the executive compensation landscape. Among the arrangements that disguise or downplay the amount and performance-insensitivity of compensation are executive pension plans, deferred compensation arrangements, and post-retirement perks.



Camouflage and Stealth CompensationOmission of retirement benefits from standard compensation datasets has distorted investors picture of pay arrangements. In particular, this omission has led to: significant underestimations of the total amount of pay; considerable distortions in comparisons among executive pay packages; and substantial overestimations of the extent to which executive pay is linked to performance.



Gratuitous goodbye paymentsIn many cases, boards give departing CEOs payments and benefits that are not required under the terms of a CEOs compensation contract. Such gratuitous goodbye payments are common even when CEOs perform so poorly that their boards feel compelled to replace them.



The Decoupling of Pay from PerformanceNon-Equity CompensationEquity-based fraction of managers compensation has increased considerably during the past decade and has therefore received more attention, non-equity compensation continues to be substantial.base salary and sign-up golden hello and bonus payments (which end up not being performance based)



Non-Equity CompensationCompanies use subjective criteria for at least some of their bonus payments. When companies do use objective criteria, these criteria and their implementation are usually not designed to reward managers for their own contribution to the firms performance. Bonuses are typically based not on how the firms operating performance or earnings increased relative to its peers but rather on other metrics. Finally, many boards award bonuses to managers simply for buying other companies. *Performance Evaluation [email protected]


Windfalls in Equity-Based CompensationIn principle equity-based compensation can provide managers with desirable incentives. In practice, however, the design of executives stock options has enabled executives to reap substantial rewards even when their own performance was merely passable or even poor.*Performance Evaluation [email protected]


Rewards for Market-Wide and Industry-Wide MovementsConventional stock options enable executives to gain from any increase in the nominal stock price above the grant-date market value. This in turn means that executives can profit even when their companies performance significantly lags that of their peers, as long as market-wide and industry-wide movements provide sufficient lift for the stock price. *Performance Evaluation [email protected]


Rewards for Short-Term SpikesOption plans have been designed, and largely continue to be designed, in ways that enable executives to make considerable gains from temporary spikes in the companys stock price, even when long-term stock performance is poor. In addition to being granted the freedom to exercise their options as soon as they vest and sell the underlying stock, executives often have considerable control over the timing of sales, enabling them to benefit from their inside information. The features of option plans that reward managers for short-term spikes not only decouple pay from managers own performance, but also provide incentives to manipulate earnings. *Performance Evaluation [email protected]


Compensation At and After DepartureThis stealth compensation includes executive pensions, deferred compensation arrangements, and post-retirement consulting contracts and perks. Take, for example, Franklin Raines, who was forced to retire as Fannie Maes CEO in late 2004. Upon departure, Fannie owed him (and his surviving spouse after his death) an annual pension of approximately $1.4 million, an amount specified without any connection to the firms stock performance under Raines. Further decoupling pay from performance are severance payments given to departing executives. Executives pushed out by their boards are typically paid a severance amounting to two or three years worth of annual compensation. These payments are not reduced even when the executives performance has been clearly and objectively dismal. Furthermore, standard severance provisions do not reduce the severance payment even if the executive quickly finds other employment.*Performance Evaluation [email protected]


Excessive executive compensation creates two problems. First, public outrage undermines support for the free market, the system that makes possible corporate profits. Second, overcompensated executives are more likely to acquiesce to demands from anti-business activists, in order to insulate themselves from criticism for their high pay.



Improving TransparencyTransparency would provide shareholders with a more accurate picture of total pay and its relationship to performance and thereby provide some check on departures from arrangements that serve shareholder interests. Furthermore, transparency would eliminate the distortions that currently arise when pay designers choose particular forms of compensation for their camouflage value rather than for their efficiency. Finally, transparency would impose little cost on companies because it would simply require them to disclose clearly information they have or can obtain at negligible cost.



Recommendation 1: Place a Dollar Valueon All Forms of CompensationExecutives routinely receive substantial stealth compensation in the form of pensions, deferred compensation, and post-retirement perks and consulting contracts.Although certain details of these benefits appear in various SEC filings, companies have not been required to place a dollar value on any of these forms of benefits and to include this value in the summary tables that receive the most attention from investors and the media.Placing a monetary value on each benefit provided or promised to an executive, and to include this value in the summary compensation table in the year the executive becomes entitled to it.E.g., compensation tables should include the amount by which the expected value of an executives promised pension payments increases during the year.



Recommendation 2: Disclose All Non-Deductible CompensationThe tax code permits companies to deduct certain payments to executives but not others. Companies routinely include in their disclosure boilerplate language notifying shareholders that some of the arrangements may result in the firm being unable to deduct a portion of an executives compensation.But they do not provide details about what particular amounts end up not being deductible. Companies should provide full details about the components of pay that are not deductible, place a monetary value on the costs of this non-deductibility to the firm, and disclose this dollar cost to investors.*Performance Evaluation [email protected]


Recommendation 3: Expense OptionsOptions should be expensed. From an accountants perspective, expensing is desirable because it leads to a more accurate reflection of the companys financial situation. Expensing is beneficial because it makes the costs imposed by option-based compensation more visible to investors on an ongoing basis.*Performance Evaluation [email protected]


Recommendation 4: Report the Relationship between Pay and PerformanceCompanies should report to their shareholders how much of their executives profits from equity and non-equity compensation is attributable to general market and industry movements. This could be done by requiring firms to calculate and report the gains made by managers from the exercise of options and to report what fraction, if any, reflects the companys success in outperforming its industry peers. Such disclosure would help clarify the extent to which the companys equity-based plans reward the managers for good relative performance.*Performance Evaluation [email protected]


Recommendation 5: Disclose Option and Share UnloadingCompanies should be required to make transparent to shareholders on a regular basis the extent to which their top five executives have unloaded any equity instruments received as part of their compensation. Although a diligent and dedicated researcher can obtain this information by sifting through stacks of executive trading reports filed with the SEC, requiring the firm to compile and report such information would highlight for all investors the extent to which managers have used their freedom to unwind incentives.*Performance Evaluation [email protected]


Improving Pay ArrangementsWell-designed executive compensation can provide executives with cost-effective incentives to generate shareholder value. We have argued, however, that the promise of such arrangements has not yet been realized. Below we note various changes that companies should consider, and investors should urge companies to adopt, in order to strengthen the link between pay and performance and thereby improve executives incentives.



Recommendation 1: Reduce Windfalls in Equity-Based CompensationInvestors should encourage firms to adopt equity compensation plans that filter out at least some of the gains in the stock price that are due to general market or industry movements. This can be done not only by indexing the exercise price of stock options, but in other ways as well.*Performance Evaluation [email protected]


Recommendation 2: Reduce Windfalls in Bonus PlansFor similar reasons, companies should design bonus plans that filter out improvements in financial performance due to economy- or industry-wide movements. Even assuming that it is desirable to focus on accounting rather than stock price performance, as most bonus plans seek to do, rewarding executives for improvements in accounting measures enjoyed by all companies in the industry is not a cost-effective way to provide incentives. Thus, bonus plans should not be based on absolute increases in earnings, sales, revenues, and so forth, but rather on such increases relative to peer companies.



Recommendation 3: Limit the Unwinding of Equity IncentivesInvestors should also seek to curtail executives broad freedom to unwind the equity-based incentives provided by their compensation plans. It may be desirable to separate the vesting of options and managers ability to unwind them. By requiring that executives hold vested options (or the shares resulting from the exercise of such options) for a given period after vesting, boards would ensure that options already belonging to executives will remain in their hands for some time, continuing to provide incentives to increase shareholder value. Furthermore, such restrictions would eliminate the significant distortions that can result from rewarding executives for short-term spikes in the stock price that do not subsequently hold. To prevent circumvention, such restrictions should be backed by contractual prohibitions on executives hedging or using any other scheme that effectively eliminates some of their exposure to declines in the firms stock price. *Performance Evaluation [email protected]


Recommendation 4: Tie Bonuses to Long-Term PerformanceEven assuming it were desirable to reward managers for improvements in accounting results, such rewards should not be given for short-term results but only for improvements that are sustained over a considerable period of time. Rewarding executives for short-term improvements is not an effective way to provide beneficial incentives and indeed might create incentives to manipulate short-term accounting results. Compensation contracts should also generally include clawback provisions that require managers to return payments based on accounting numbers that are subsequently restated.



Recommendation 5: Be Wary of Paying for ExpansionBecause running a larger company increases managers power, prestige, and perquisites, executives might have an incentive to expand the company at the expense of shareholder value. Executive compensation arrangements should seek to counter rather than reinforce this incentive. While a larger firm size might lead the board to raise executive pay, boards should keep in mind that an expectation that expansion will result in higher pay can provide executives with incentives to expand even when doing so would not be value-maximizing.



Recommendation 6: Restore Dividend-NeutralityUnder current option plans, terms are not updated to reflect the payment of dividends and, as a result, executives payoffs are reduced when they decide to pay a dividend. There is evidence that companies run by executives whose pay has a large option component tend to pay lower dividends and instead distribute cash through share repurchases, which have a less adverse effect on the value of managers options but may not be the most efficient form of payout. To reduce distortions in managers payout decisions, all equity-based compensation should be designed in such a way that it neither encourages nor discourages the payment of dividends.*Performance Evaluation [email protected]


Recommendation 7: Rethink Executive PensionsGiven that companies have been moving away from defined benefit plans to defined contribution plans for non-executive employees, it is far from clear that providing executives with defined benefit plans is required by riskbearing considerations. Unlike defined contribution plans, which force the employee to bear the risk of poor investment performance, defined benefit plans shift the risk of investment performance to the firm. However, executives do not seem less able to bear such risk than other employees. *Performance Evaluation [email protected]


Recommendation 8: Avoid Soft-Landing ArrangementsSoft-landing arrangements, which provide managers with a generous exit package when they are pushed out due to failure, dilute executives incentives. While companies spend large amounts on producing a payoff gap between good and poor performance, the money spent on soft-landing arrangements works in the opposite direction, narrowing the payoff gap between good and poor performance. At present, executives are commonly promised generous severance arrangements in the event of termination, unless the termination is triggered by an extremely narrow set of circumstances (such as criminal indictment or malfeasance). Boards should consider provisions that make the termination payoff depend on the reasons for the executives termination and the terminated executives record. Even if companies stick to the existing, broad definition of termination without cause, the payoff in such a termination should depend in part on the firms performance relative to its peers during the executives service. An executive who is terminated against a background of extremely poor stock performance should get less than an executive who is terminated when the companys performance is reasonable.



*****(CKK) More specifically, doubling the percentage ownership of a large outside shareholder is associated with a 12% to 14% reduction in a CEOs non-salary compensation*Jay C. Hartzell and Laura T. Starks, Institutional Investors and Executive Compensation, Journal of Finance, Vol. 58 (2003), pp. 2351-2374.David Parthiban, Rahul Kochar, and Edward Levitas, The Effect of Institutional Investors on the Level and Mix of CEO Compensation, Academy of Management Journal, Vol. 41 (1998), pp. 200-208.

This study reports that CEO pay is negatively correlated with the presence of pressure resistant institutionsinstitutions that have no other business relationship with the firm and thus presumably are concerned only with the firms share value. But CEO pay is positively correlated with the presence of pressure sensitive institutionsthose having business relationships with the firm (such as managing its pension funds) and thus more vulnerable to management pressure.**

6 th session: pay without performance

Documents

performance based compensation

firm performance

chief executive compensation

management compensation

shareholders interestsfailure

shareholders behalf

executive managing directors

corporate governance