Friday, August 13, 2004

SSRN-Remuneration: Where We've Been, How We Got to Here, What are the Problems, and How to Fix Them by Michael Jensen, Kevin Murphy, Eric Wruck

SSRN-Remuneration: Where We've Been, How We Got to Here, What are the Problems, and How to Fix Them by Michael Jensen, Kevin Murphy, Eric Wruck

In many ways, Murphy and Jensen's 1990 paper on CEO pay may have been one of the most influential finance papers written in the past 15 years. It showed not only how CEOs were being paid, but also stressed the importance of incentive based (pay for performance) pay. As I wrote in the summary of that paper for my classes: This is a classic work in the field. It laid the groundwork for much of the executive compensation research that followed.

Regular readers will realize that in the 15 years that have followed Murphy and Jensen have kept more than busy with each rising still higher into the upper-Echelon of academic finance. While Jensen has been busy in many areas within finance, Murphy has specialized in Executive compensation.

Now the two stars have again gotten together (with the assistance of Eric Wruck) to produce what may well be considered the definitive look at executive compensation in the post corporate governance crisis era. They now only show how things have changed since 1990 (the pay level has gone way up and options dominate more than anyone would have dreamt in 1990), but also show how things are changing as a result of both accounting scandals (Enron, Etc) as well as the public outcry from Grasso's compensation from the NYSE and Jack Welch's pay from GE.

In a move that is often outside of academic writings, the authors also make 38 recommendations that can be used by company Boards of Directors as well as financial market regulators to improve the way executives are rewarded. (As an aside, these recommendations are near the top of the paper and will likely serve as a good executive summary for in-class usage.)

While I am not going to attempt to completely review the entire 116 pages here (that was not a misprint! the paper is over 100 pages long!), I will point out some of the more important points.
  • "Companies should embrace enlightened value which 'creating firm value' is not one of many objectives, but the firm's sole or governing objective" (R1) This must then be integrated with the pay system.
  • Try not to use employment contracts (R2)
  • Do not reward "incompetence" or when the executive is replaced "for cause"
  • Recognize (i.e. expense) the cost of stock options
  • Be as transparent as possible with pay packages
  • Do not allow overvalued equity to exist. Communicate to the market that it is overvalued, even though it will lead to a lower stock price. This is not a contradiction. Too many problems result from poor incentives and from basing decisions based on overvalued equity. In the long run, communcating the truth to the markets will be better for shareholders. (Note this is identical to the Jensen 2004 paper we reviewed in June.)
  • Short Sellers may know something. Audit committees should "cummuncate" with them to know what to look out for.
  • FinanceProfessors should teach of the dangers of overvaluation (consider it done). I love their quote, one we have used in class before: "Maximizing firm value does not mean maximizing the price of the stock." To which iI would add: know the difference between short-term maximazation based on information assymentries and true long term maximization.
  • Make sure boards know they work for shareholders and not for the CEO.
  • Independent chairman persons are prefered.
  • Stock options should be adjusted for dividend payments
  • Stock options should be indexed so that the stock price must rise at a rate above teh company's cost of equity.
  • "Do not measure performance anywhere in an organiztion with ratios. Simply put: if it is a performance measure and a ratio, its wrong"

Wow. What a paper! I can imagine teaching out of nothing else but this paper for several class periods! I HIGHLY RECOMMEND READING IT!!!!


Jensen, Michael C., Murphy, Kevin J. and Wruck, Eric G., "Remuneration: Where We've Been, How We Got to Here, What are the Problems, and How to Fix Them" (July 12, 2004). Harvard NOM Working Paper No. 04-28; ECGI - Finance Working Paper No. 44/2004.

This paper is copyrighted by the authors.

BTW In the interest of full disclosure I must say that I took a class from Murphy at the University of Rochester and it was one of my favorite 4 or 5 classes I ever took. So my writing on his work may be slightly biased. But I doubt it ;)

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