Overview of Pay without Performance

1
Overview of Pay without Performance

• Presentation by Jesse Fried
• Columbia University
• October 15, 2004

2
Presentation Outline

• Why we wrote the book
• The stakes
• Part I Official view and its shortcomings
• Part II Power and pay
• Part III Decoupling pay from performance
• Part IV Going forward
• Concluding remarks

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Why we wrote the book

• Widespread recognition many boards approved
  executive pay deals that did not serve
  shareholders
• But we believe still insufficient recognition
  about
• Scope and source of problems and
• Need for fundamental reforms to address them

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Why the book?

• To question systematically several widely-held
  views about executive compensation
• Rotten apples view
• Paying for performance view
• Transient lapses view
• Independence is enough view

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Why the book?

• Rotten apples view
• Concerns about executive compensation have been
  exaggerated Flawed arrangements have been
  limited to small number of firms
• Our conclusion
• Its the barrel, not a few apples Problems have
  been widespread, persistent, and systemic.

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Why the book?

• Paying for performance view
• Current pay levels might seem high --
• but are necessary to provide executives w/
  powerful incentives.
• Our conclusion
• Current pay arrangements not designed to tightly
  link pay and managers own performance.

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Why the book?

• Transient lapses view
• Even if flaws widespread, they resulted from
  boards mistakes and misperceptions
• Boards can be expected to self-correct with time
  and better understanding.
• Our conclusion
• Its bad incentives, not lapses.
• Problems stem from defects in underlying
  governance structure governance reforms needed.
  

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Why the book?

• Independence is enough view
• OK, reforms might have been necessary but
  recent moves to increase director independence
  will adequately address past problems.
• Our conclusion
• Strengthening independence is beneficial, but
  falls far short of solving problems.
• Additional reforms that make boards more
  dependent on shareholders are necessary.

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Why the book?

• To deliver a broader message about corporate
  governance in general
• Executive compensation provides a window for
  examining our corporate governance system
• The corporate governance system
• Depends on boards to serve as guardians of
  shareholder interests.
• Largely insulates boards from intervention and
  removal by shareholders

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Why the book?

• Our study of executive pay
• Casts doubt on wisdom of relying on boards to
  perform their critical function well under
  current arrangements
• Provides basis for our proposals to make boards
  more accountable

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The Stakes

• Executive pay not merely symbolic. Has
  substantial practical importance for
  shareholders/policymakers.
• Amounts at stake substantial
• Bebchuk-Grinstein (2004)
• Aggregate top-5 pay during 1993-2002 about 250
  billion
• 7.5 of aggregate corporate earnings (10 during
  1998-2002)

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The stakes (2)

• Excess pay is not only or principal cost. We show
  that managers influence over compensation
  arrangements
• Dilutes incentives to serve shareholders
• Distorts incentives e.g., ability to unwind
  equity gives incentive to improve short term
  earnings reports at expense of long-term value

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Part I Official View and its Shortcomings

• The official view
• Corporate boards operate at arms-length from
  executives its a market like any other.
• The official view --
• Serves as practical basis for legal rules and
  public policy. Used to justify boards
  compensation decisions to shareholders,
  policymakers, courts.
• Underlies most economists research on executive
  compensation
• Used as basis for explaining common compensation
  arrangements
• Practices that do not seem to fit considered
  anomalies or puzzles

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Problem with the Official View

• The official arms length story is neat,
  tractable, and reassuring but it fails to
  account for realities of executive compensation.
  
• Executives not only ones whose incentives
  matter.
• Must look at incentives of directors
• Cannot assume they will automatically serve
  shareholders in setting executives pay.

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Have Boards Bargained at Arms Length?

• We show many reasons directors favor executives
• Incentives
• Going along helps chance of re-nomination to
  board
• CEOs power to reward directors
• Social factors
• Collegiality and team spirit
• Deference to companys leader
• Loyalty and friendship
• Cognitive dissonance (directors who are
  current/former executives)
• Personal costs of favoring executives are small
• Show outside market forces not tight enough to
  prevent deviations from arms length bargaining
• Such deviations can occur without subjecting
  managers and directors to large costs

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Part II Power and Pay

• The same factors undermining arms-length
  bargaining indicate managers have power over
  boards
• Executives use power to influence own pay
• Managers extract rents the difference between
  what they get and what that they would get under
  true arms length bargaining

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Power and Pay Camouflage and its Costs

• Rents not unlimited. Limits on how far
  directors will go, how far managers want them to
  go
• Importance of outside perceptions and appearance
  outrage
• More outrageous an arrangement is perceived,
  greater market and social costs to executives and
  directors
• Camouflage Outrage gives compensation
  designers incentive to obscure and legitimize
  both level and performance-insensitivity of
  executive compensation
• Costs of camouflage Attempts to camouflage can
  lead to adoption of inefficient compensation
  structures structures that are less efficient
  but good at obscuring, legitimizing amount of pay
  and insensitivity to performance

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Evidence of Managerial Influence (1)

• We predict managerial power vis-à-vis
  board/shareholders to be correlated with pay
  arrangements that are more favorable to insiders
• Indeed, there is empirical evidence that pay is
  greater/less sensitive to performance in firms
  with
• More antitakeover provisions
• Weaker shareholder rights
• CEO who is also chair of board
• Directors appointed under current CEO
• Compensation committee has little company stock
• More interlocking directors
• Without large outside block-holders

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Evidence of Managerial Influence (2)

• We present evidence compensation arrangements
  often designed to camouflage rents and minimize
  outrage.
• firms have systematically made less transparent
  both total amount of compensation and extent pay
  decoupled from managers own performance.
• We show widespread use of various types of
  compensation such as postretirement perks and
  consulting arrangements, deferred compensation,
  and pension plans unlikely to reflect
  efficiency considerations.

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Evidence of Managerial Influence (3)

• Golden Goodbyes
• We document how boards provide managers with more
  than they were contractually entitled to --
  grant golden goodbyes to executives when they
  retire, resign, or their firm is acquired, even
  when the performance of the manager is sub-par
• Given managers influence over board, such golden
  goodbyes might be necessary to get a majority of
  the board to agree to fire CEO or sell the
  company
• But their presence indicates the influence
  managers have over the board.

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Part III Decoupling Pay from Performance

• Rise in executive compensation has been justified
  as necessary to strengthen incentives
• Financial economists have applauded Shareholders
  should care more about incentives than about the
  amount paid executives.
• Its not how much you pay, but how (Jensen
  Murphy)
• Institutional investors have accepted higher pay
  as price of improving managers incentives

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Decoupling Pay and performance (2)

• Managers influence has enabled them to get
  arrangements that tie compensation too loosely to
  own performance
• The result
• Much of additional value provided to execs has
  not been tied to own performance shareholders
  have not received as much bang for the buck as
  possible
• Firms could have generated the same increase in
  incentives at much lower cost, or used the same
  amount to generate stronger incentives
• Indeed, seeming legitimacy of equity-based
  compensation has enabled execs to obtain amounts
  that would have been impossible to get as cash
  compensation

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Decoupling Non-Equity Pay

• There is only a weak link between managers own
  performance and
• Bonus, salary, and other forms of cash
  compensation
• The large amounts of stealth compensation
  given through retirement plans

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Decoupling of Equity-Based Compensation

• But what about equity-based compensation?
• Devil is in the details Equity-based pay
  delivers much less pay for performance than
  believed
• Windfalls Rewards for general market and
  industry-wide movements. Most of value in
  conventional options and restricted stock rewards
  managers for luck
• Re-pricing, backdoor repricing, reload options
  all further weaken link b/w pay and performance
• Broad freedom to unload vested
  options/restricted stock
• Rewards for short-term price increases that may
  not last while
• Producing perverse incentives

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Part IV Going Forward

• Improving executive compensation
• Transparency not enough for information to be in
  public domain must be easy to access,
  understand.
• For example, companies should be required to
  report annual increase in present value of
  retirement benefits
• Institutional investors should press for
  tightened link between pay and performance in
  ways we identify
• But no good substitutes for board negotiating at
  arms length how can we get directors to better
  serve as shareholders guardians?

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Going Forward Limits of Independence

• Recent reforms, including new stock exchange
  listing requirements, emphasize strengthening
  director independence from executives. These
  reforms will reduce but not eliminate directors
  pro-executive tilt
• Going along still generally remain safest
  strategy for being re-nominated
• Executives ability to reward cooperative
  directors is reduced but not eliminated
• Social and psychological factors collegiality,
  deference to leader, loyalty, cognitive
  dissonance all remain
• As long as directors do not have meaningful
  incentives to enhance shareholder value, even a
  significantly reduced tilt in favor of executives
  can have a major impact
• Even if complete independence from executives
  could be achieved, still concern directors might
  pursue own objectives at expense of shareholders

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Going Forward Beyond Independence

• For each company, vast number of individuals
  could be considered independent directors
• Two key questions
• (1) Who is selected from this vast pool?
• (2) What will their incentives be once appointed?
• Strengthened independence eliminates some people
  from pool, reduces bad incentives for those
  appointed. But does not fully answer (1) and (2)
• To improve director selection and incentives, we
  must not only make directors more independent of
  executives, but also make them more dependent on
  shareholders

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Going Forward Making Directors More Accountable

• Current insulation of boards from shareholders
  not inevitable product of dispersed ownership
  rather, largely results from legal arrangements
  in place. We should
• Make it easier for shareholders to replace
  directors
• Election reform (including shareholder access to
  the ballot) is needed
• Shareholder power to replace the board is
  currently a myth it should be turned into
  reality
• Give shareholders power to initiate and adopt
  charter amendments.
• Abolish managements control over changes in
  corporate governance arrangements.

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Making Directors More Accountable

• By making boards accountable to shareholders and
  attentive to their interests, such reforms would
• Make reality more closely resemble official story
  of arms length negotiations
• Improve executive compensation arrangements
• Improve corporate governance more generally

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Alternative Critiques

• Our critique of executive compensation differs
  from two other types
• The ethical/fairness critique.
• The critique People should not be paid as much
• Our view instrumental and shareholder-oriented.
  Would accept higher compensation if were
  beneficial for performance.
• Incentives dont matter critique
• That view Monetary incentives unnecessary to
  motivate executives
• Like defenders of current pay arrangements, we
  believe that incentives do matter
• This is why we worry that directors lack
  sufficient incentives to guard shareholder
  interests.
• We believe executive compensation can provide
  useful incentives but managers influence over
  incentive machinery has resulted in compensation
  being not only instrument for reducing agency
  costs but also part of the agency problem itself.

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Recognition and Reality

• This is area where perceptions matter a great
  deal. The very recognition of problems may help
  alleviate them
• Executive compensation practices Widespread
  recognition of how managerial influence distorts
  pay arrangements serves as a useful check
• Makes it more difficult to camouflage rents and
  pay-performance insensitivity.
• Corporate reforms Given managements clout as an
  interest group, reforms possible only if
  shareholders, public officials have fuller
  understanding of pervasiveness and cost of
  current flaws in governance
• Helping to bring about such an understanding is a
  main aim of our book.

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Conclusion

• The problems of executive pay are not behind us
  no reason for complacency
• The promise of executive compensation yet to be
  fulfilled