A look at Executive Compensation

This semester we really had to rush through executive compensation (market conditions took up quite a bit of class time), so I want to make my classes (and by extension others) aware of some of the debate on CEO pay. So a special post on CEO pay.

First yes CEO pay is high and getting higher over time. But I really do not want to address that to much bust to say that the level of pay appears to be closely tied to firm size and I will ignore level of pay since I am not sure it matters as much as the popular press claims. For a nice review try Jensen, Murphy, and Wruck 2004 or this by BusinessKnowhow 2007.

An important paper that I do want to point out is from Jared Harris that suggests that despite of good intentions (I will give boards the benefit of the doubt), that stock options might actually make agency costs worst:

"At best, incentive compensation has an ambiguous relationship with firm performance that can reward executives for luck (Bertrand & Mullainathan, 2001), or encourage CEOs to manage their personal reputations rather than their organizations (March, 1984). Research indicates that current forms of managerial incentive pay do not effectively align the incentives of managers and shareholders; indeed, a number of studies have had difficulty showing any positive link between executive incentive pay and improved performance of the firm (e.g., Mishra, McConaughy, & Gobeli, 2000; Murphy, 1999), and some work suggests that high CEO incentive pay or perquisites may in fact decrease firm performance (Blasi & Kruse, 2003; Core, Holthausen, & Larcker, 1999; Yermack, 2006).

As a corollary to these troubling results about the disconnect between incentive pay and firm performance, it also appears that incentive alignment does little to alleviate concerns about malfeasance and self-dealing. While incentive pay is traditionally seen as an alternative to monitoring as a way to prevent managerial misconduct (Tosi, Katz, & Gomez-Mejia, 1997; Zajac & Westphal, 1994), empirical results do little to confirm the claim that malfeasance is reduced. Indeed, recent research (Harris & Bromiley, 2007) investigates whether large potential payoffs for managers – contrary to classically formulated incentive theory – do not supply an adequate incentive for the good management practices that scholars typically suppose, but rather provide an enticement to cheat, commit fraud, or otherwise cook the books in an attempt to fabricate the levels of corporate performance that will trigger the payoff."

Supposing for a moment that CEO pay is a problem for more than just jealousy reasons, what can be done? It appears that regulation and increased transparency may not work as well as more active shareholders. Two papers to back this claim.

First that active institutional shareholders do keep pay LEVELS lower. From 2003.

"Hartzell and Starks find that as institutional ownership goes up, the
firm is more likely to use pay for performance plans. Additionally, the
level of CEO pay tends to go down. These findings suggest that
institutional investors make better monitors than ordinary investors do.
Possibly more convincing however, (since it solves the endogenity
problem which is that is the institutional investors may select which
stocks that pay for performance and pay managers less) is their analysis
that finds as managerial ownership goes up, pay goes down relative to
control groups in the periods that follow."

and then the article suggesting regulation and transparency do not lower pay levels

SSRN-How Much Sunlight Does it Take to Disinfect a Boardroom? A Short History of Executive Compensation Regulation by Ian Dew-Becker:

"This paper reviews the history of executive compensation disclosure and other government policies affecting CEO pay, and as well surveys the literature on the effects of these policies. Disclosure has increased nearly uniformly since 1933. A number of other regulations, including special taxes on CEO pay and rules regarding votes on some pay packages have also been introduced, particularly in the last 20 years. However, there is little solid evidence that any of these policies have had any substantial impact on pay. Policy changes have likely helped drive the move towards more use of stock options, but there is no conclusive evidence on how policy has otherwise affected the level or composition of pay"

Spotlight on Bonuses

It seems like everyone's attention has turned to pay and bonuses at Financial Institutions, so I will at least temporarily join the crowd.

To set the stage, this is just a sampling of the 3,745 news items (according to Google) today alone that dealt with Wall Street bonuses

From What Red Ink? Wall Street Paid Fat Bonuses-NY Times.

"Despite crippling losses, multibillion-dollar bailouts and the passing of some of the most prominent names in the business, employees at financial companies in New York, the now-diminished world capital of capital, collected an estimated $18.4 billion in bonuses for the year.

That was the sixth-largest haul on record, according to a report released Wednesday by the New York State comptroller."

From CBS News:



Obama Pressures Wall Street Over Bonuses - NYTimes.com:

"President Obama branded Wall Street bankers “shameful” on Thursday for giving themselves nearly $20 billion in bonuses as the economy was deteriorating and the government was spending billions to bail out some of the nation’s most prominent financial institutions...."there will be time for them to get bonuses....Now’s not that time.”

I agree with most of the articles and the President but not for the fairness reasons (although as a signal to customers and employees accepting any bonus seems a horrible move) but rather because what a bonus is intended to do.

Bonuses are meant as rewards used to create the proper incentives. Bonuses that are paid regardless of performance do not do that. And yes I realize that bonuses are way down, but given their performance, they still seem too high.

If you take a second and examine compensation, there are two key things to consider: the level of pay (how much you pay people) and the form of pay (Salary, Bonus, market-based pay etc.). Each is important, but the form much more so.

Level of pay is what attracts and keeps employees (and yes even managers). In the words of Keven Murphy when I took his class, it is what "gets them in the door and what keeps them. Form of pay (and re-evaluations of the level of pay) is what creates incentives and helps to motivate people to do what we want them to do.

Don't think so? Consider this example directly from my class. Suppose you are hired as CEO of a firm and paid a straight salary of $2 million a year. You are told that the pay will never change so long as your firm does not go out of business and you can not be fired. How would you behave? Consider the many agency costs that may arise. Risk taking would likely be scaled way back, debts reduced, dividends and capital expenditures lowered since your main goal is to keep the firm in business so you get your $2 million annuity.

Bonuses and market-based pay are, at least in theory, designed to motivate the employee to do what is in the firm's (and more specifically the shareholders') best interest. For instance, stock options that increase in value with increasing volatility, are a means of making managers less risk averse. Bonuses are similar but more often based on non market factors (either accounting-based or performance based).

Which gets us back to the question of paying Wall Street executives bonuses. If the form of pay is to serve as a proper motivator (that is to motivate them to do what we want), something has to be at risk (Again go back to the example, if I say you get a $2 million bonus no matter how well you do, does it motivate you or is it just another word for salary?).

By any standard, most financial institutions have had a horrible year. To reward managers (which is essentially saying "Good job") is wrong. Indeed, a strong case may be made that the reason why bonuses have been so high over the past few years is not that the firms were doing so well, but that they appeared to be doing so well and the outcome of many of the investments had not yet been determined. Thus some ex-post settlement (IF I remember correctly it was Jensen and Meckling in 1976 who suggested this) whereby the executives give back past bonuses (and not just this year's) is really what should happen.

Now of course it is not going to. There is a movement afoot to get some of this year's bonuses back at firms who got government bailouts but even this faces very long odds.

While it may be a disappointment (in the spirit of no matter how many times Charlie Brown goes to kick the football, I always hope that Lucy will come around this time and do the right thing and let him kick and I am disappointed when Lucy pulls it away), it really should not be a surprise to anyone that managers will largely get their bonuses even if the bonuses are smaller than in the past (remember they probably should not have gotten the past ones at all if the true value of their investments were known then).

As Garvey and Mibourn (2003) showed managers tend to get rewarded when things go right (good luck?) and yet are not penalized when things go wrong (bad luck?). I somehow doubt that this time around will be any different Charlie Brown will still end up on his back and managers will still look out for themselves and not shareholders.

The Incentive to 'Bet the Farm': CEO Compensation and Major Investments by Gavin Smith, Peter Swan

In prepping for my MBA 610 (Corporate Finance) class where we examine executive pay and how it impacts agency costs, I found this article by Gavin Smith and Peter Swan.

SSRN-The Incentive to 'Bet the Farm': CEO Compensation and Major Investments:

Swim and Swan look at firms that do major investments and those that do not. They find that the way the CEO is paid does influence the investment behavior of the firms.

From the abstract:

"CEO incentives with option-based asymmetric payoffs greatly increase the likelihood that a firm will increase risk by undertaking both major real investments and acquisitions. In contrast, equity-based incentives that induce upside and downside symmetric payoffs are associated with fewer major acquisitions and neither encourages nor discourages real investments. Fixed pay is associated with low likelihood of major investments and a poorer prognosis.

When option-incentivized CEOs use equity for funding real investment decisions they have the best combination of incentives and funding source"

Which is really cool. It may not be the most ground breaking paper I have ever seen, but it definitely is worth the read! (If nothing else, read the 8 page introduction! In fact, if you are in my class, you should definitely do so :) )

Cite: Smith, Gavin and Swan, Peter L., "The Incentive to 'Bet the Farm': CEO Compensation and Major Investments" (23 February, 2008). Available at SSRN: http://ssrn.com/abstract=1009323

The sleuth who exposed backdating scandal

I always like to see finance professors in the news!

Philadelphia Inquirer | 09/21/2006 | Sleuth who exposed backdating scandal:

A few "look-ins":

"From his second-floor office at Iowa's Tippie College of Business, [Erik] Lie spent months analyzing data to demonstrate how companies were illegally and retroactively timing, or backdating, stock option grants to fatten bonuses paid to top executives.

"He's uncovered a scandal that has just mushroomed," said Adam C. Pritchard, a former attorney at the Securities and Exchange Commission and now a law professor at the University of Michigan.

and later in the article:

"'The Enron stuff is very sexy, but that type of fraud was not pervasive,' said Andrew Metrick, a professor of finance and corporate governance at the Wharton School in Philadelphia. 'This is widespread, pervasive. I think when this is all said and done, the total amount of dollars that we'll find have been stolen from the corporate till is larger here than any other case we've seen.'"

Read the entire article here.

CFO.com on one impact of back dating

Gee, I ad not thought of this impact:

From CFO.com:

"Lost amid the swirl of media attention, however, is what backdating, or other practices, such as re-pricing, might mean if you happen to be one of the people who holds those options.

In much the same way that backdating is now prompting some companies to restate, corporate tinkering with options can damage the personal equivalent of a financial statement: your tax return."

Why is this a problem?

"The board's action makes the option a non-qualified stock option because the exercise price does not equal the fair market value of the stock at the date of the grant.

Non-qualified stock options require tax payment at the ordinary income rate for the difference between the grant price and the price at which the option is exercised (the gain). Non-qualified stock options do not meet the criteria to be treated as an incentive stock option, which has a tax benefit of having the options taxed at the lower capital gains tax rate."

Do managers backdate options?

Do managers backdate options? It sure seems that way.

From Reuters:

"A U.S. government probe into stock option grants for executives widened on Tuesday with more technology companies being called on to explain the way these grants are awarded.

The investigation focuses on whether companies are giving executives backdated options after a run-up in the stock. Backdated securities are priced at a value before a rally, which boosts their returns."

From NPR:

" The Securities and Exchange Commission (SEC) is reportedly examining the timing of stock option awards by corporations." (BTW this is included to you can listen to it--has several professors speaking on it.)

From the LA Times:

""The stock-option game is supposed to confer the potential for profit, but also some risk," said John Freeman, a professor of business ethics at the University of South Carolina Law School who was a special counsel to the SEC during the 1970s. "When in essence the executives are betting on yesterday's horse races, knowing the outcome, there's no risk whatever.""

What does past academic research have to say on this? Most of the evidence suggests that backdating probably does occur.

For years there have been papers showing that managers tend to announce bad news prior to option grants and even time the grants prior to price run ups (see Yermack 1997) it has only been more recently that researchers have noticed that the price appreciation was not merely due to firm specific factors (which managers may be able to control and time) but also market wide factors (i.e. the stock market goes up after option grants).

Last year a paper by Narayanan and Seyhun suggested that this may be the result of backdating the option grants. More recently two papers by Collins, Gong, and Li (a) and (b) find further evidence that backdating is (or at least was) happening and that unscheduled grant dates (where this can occur) tend to be found more commonly at firms whose management has relatively more control over their board of directors.

Stay tuned!!

* A quick comment to any manager who may have done this: Why bother? Why risk it all cheating for a few extra dollars? (Indeed it reminds me of the Adelphia case where the firm outsourced snow plowing to a Rigas owned firm. It just doesn't seem worth it.)

*As an aside, once again this shows that finance and accounting go hand in hand as Collins, Gong, and Li are accounting professors!