How Much Does the Boss Make?, Wall Street Journal, January
Beyond Disclosure, Forbes, January 19, 2006
How Much Does the Boss Make?
Wall Street Journal, January 18, 2006
By Lucian Bebchuk
Investors should applaud the SEC's vote yesterday to propose an expansion
in disclosure requirements for executive pay. While there is room for
reasonable disagreement on the merits of prevailing pay arrangements,
there can be little disagreement on the quality of disclosure practices.
These are highly inadequate.
Companies have commonly taken a "lawyerly" approach, not disclosing
to investors much more than SEC regulations explicitly require. As a result,
some information necessary to form a good picture of pay packages isn't
disclosed. Other information is disclosed in ways that obfuscate, not
inform. Investors shouldn't have to devote significant time and effort
to put together a company jigsaw puzzle.
A recent study
on Executive Pensions by Robert Jackson and myself highlights
the problem with inadequate disclosures. Because firms generally don't
report a dollar value for executives' pension plans, their value is omitted
from pay figures relied on by investors, the media and compensation researchers.
Companies do, however, disclose information that enables researchers willing
to do some work to estimate the plans' value. After deriving estimates
for CEOs of S&P 500 companies, our study found that their pension
plans had a median value of $15 million; that the ratio of a CEO's pension
value to the total compensation during service (including equity and non-equity
pay) had a median value of 34%; and that including pension values would
have increased from 15% to 39% the median percentage that salary-like
annual payments comprise of a CEO's total compensation over time.
Investors have been even more in the dark about the benefits executives
derive from deferred compensation plans. These enable executives to enjoy
tax-free accumulation of investment gains by shifting tax liability to
the company. With firms not reporting the amounts their executives have
deferred -- as current disclosure requirements permit them to do -- it
is difficult for outsiders to obtain even a rough estimate of executives'
gains from such plans.
The good news is that firms could, at a small cost, provide investors
with a much-improved picture by making certain additional disclosures
that Jesse Fried and I put forward in our book on executive pay. Some
of those improvements are in the proposals put forward by the SEC yesterday,
and I hope that others will be included as the SEC proceeds with disclosure
Companies should disclose each year, as the SEC would like them to do,
the dollar value of every material benefit that executives derive from
their employment, including the annual increase in the value of pension
plans as well as annual gains from a deferred benefit plan. Such disclosures
would eliminate distortions caused when pay-designers use some forms of
compensation for camouflage value rather than economic efficiency. The
massive use of defined benefit plans has been partly motivated by a desire
to provide chunks of performance-insensitive pay under the radar screen.
Investors care not only about total pay but also the relationship between
pay and performance. They should get information that enables them to
assess the incentive effects of pay packages. When executives unload options,
companies should report not only the resulting gains but also the amount
by which these exceed, or fall short of, the gains the executive would
have made had the company's stock return equaled the industry's return.
Such disclosure will tell investors how much of an executive's equity-based
compensation is due to market movements rather than firm-specific performance.
Investors should also be told the extent to which executives unload shares
given to them as incentive compensation. Such unloading can dilute incentives
or create perverse incentives to manipulate short-term stock prices. Companies
should report what fraction of equity-based instruments awarded to each
executive as compensation is still retained by the executive.
As to bonuses, companies should disclose not just the amounts paid but
also the metrics that produced them. Investors should be able to judge
whether generous bonuses result from good performance or from poor setting
of targets. Empirical evidence suggests that bonus compensation has been
relatively little correlated with performance -- a major concern.
Finally, because executives' incentives are influenced by their departure
packages, companies should annually disclose, as the SEC is now considering,
the dollar value of the package that each executive will receive upon
departure in the scenarios of a takeover, termination and retirement.
Investors should not learn the dollar value of departure packages only
when an executive is out of the door, or on the way out.
Warren Buffet observed last year that "executive compensation is
the acid test of corporate governance." Expanded disclosures will
enable investors to better evaluate how companies score on this critical
test. These disclosures, I expect, will highlight that much work remains
to be done to fix our executive compensation system.
Mr. Bebchuk, director of the Program on Corporate Governance at Harvard
Law School, is the co-author, with Jesse Fried, of "Pay Without Performance:
The Unfulfilled Promise of Executive Compensation" (Harvard, 2004).
Forbes, January 19,
By Lucian Bebchuk
Tuesdays Securities and Exchange Commission vote in favor of expanded
disclosure of executive pay arrangements is a necessary and very useful
step. But we should harbor no illusion that it would be sufficient by
itself to fix the problems of U.S. executive compensation.
Reforming the disclosure of executive compensation is necessary because
companies have for too long taken advantage of "holes" in existing
disclosure regulations to "camouflage" large amounts of performance-insensitive
compensation. Firms should not be permitted to fail to provide investors
with a complete, accurate and transparent picture of pay packages.
But while improved disclosure is necessary, it is also insufficient. In
explaining the rationale for improving disclosure of pay arrangements,
SEC Chairman Christopher Cox stressed that "the market for executive
talent is no different" from other markets and, like other markets,
will perform better with more information. The problem, however, is that
the market for executive talent has been operating quite differently from
Executives' pay is not set by companies' owners, but rather by companies'
boards. Insulated from shareholders by existing legal arrangements, boards
have not been setting pay arrangements solely with shareholder interests
in mind. Indeed, notwithstanding the limitations of current disclosure
requirements, some significant flaws of existing pay arrangements have
been evident for some time. Given investors' limited power, however, these
flaws have persisted.
In a recent study
on the growth of pay, Yaniv Grinstein and myself found
that the aggregate compensation paid by public companies to their top-five
executives added up to about $350 billion during the period 1993 to 2003,
and made up 10% of the aggregate profits of these companies during the
periods last three years. (These figures do not include the substantial
amounts that executives get through executive
pensions and other forms of stealth compensation not included
in standard datasets.) Although this growth in pay has been presented
as essential for providing managers with powerful incentives, pay is less
sensitive to performance than is feasible and desirable. Investors have
been hardly getting as much incentive bang for their buck as possible.
The evidence indicates that bonus payments and salary increases are little
correlated with managers' own performance. The substantial compensation
delivered to executives through stealth compensation via retirement benefits
is again poorly linked to performance. And most of the payoffs executives
get from equity-based pay result from marketwide and industrywide movements,
as well as from short-term fluctuations in stock prices rather than from
managers' own long-term performance. Arrangements guaranteeing executives
a soft landing in the event of failure further contribute to weakening
the pay-performance link.
Indeed, not only does most executive compensation fail to produce incentives
to enhance shareholder value, but much compensation is paid in ways that
provide perverse incentives. Executives continue to enjoy broad freedom
to unload options, which enables executives to benefit from increases
in short-term stock prices that come at the expense of long-term value.
And the standard design of bonus plans rewards executives for increases
in short-term financial measures that do not reflect long-term increases
in value. Furthermore, as is empirically documented in a recent study
expansion and CEO pay by Yaniv Grinstein and myself, existing
pay practices reward rather than discourage empire building.
In Tuesdays meeting, an SEC commissioner remarked that, once improved
disclosure requirements are in place, the continuation of compensation
practices would imply that investors are content with them. Such inference
would be warranted, however, only when boards could be relied on to change
practices opposed by shareholders. Under existing arrangements, the existence
of practices merely implies that directors are content with them, not
necessarily shareholders. After all, despite investors pressure on companies
to improve their disclosures of pay, an SEC intervention is necessary
to get companies to do so.
What is necessary, then, is not only better disclosure but also a fundamental
reform in the allocation of power between boards and shareholders. Shareholders
have been told that recent reforms, which strengthened director independence,
will secure adequate board performance. But even though independence rules
out some bad motives that directors might otherwise have, it does not
provide the affirmative incentive to serve shareholders that are necessary
to counter directors' natural tendency to side with executives.
To provide directors with such incentives, directors must be made not
only independent of insiders but also dependent on shareholders. Shareholders'
power to remove directors should be turned from a fiction into a reality.
Shareholders should be permitted to place candidates on the corporate
ballot. Directors should not serve if a majority of the shareholders withhold
votes from them. Staggered boards and other impediments to director removal
by shareholders should be dismantled. And shareholders should have the
power to initiate and adopt changes in the governance arrangements set
in corporate charters; their existing power to pass nonbinding resolutions,
which boards commonly ignore, is insufficient. (A fuller account of these
desirable reforms can be found in my articles on the
myth of the shareholder franchise and the
case for increasing shareholder power.)
The problems of executive compensation reflect the deeper problems of
board unaccountability produced by exiting arrangements. Better disclosure
is, therefore, not a substitute for addressing these problems. Shareholders
should be given not only more information but also the power they need
to use such information effectively.
Lucian Bebchuk, a professor of law, economics and finance and director
of the program on corporate governance at Harvard law school, is co-author,
with Jesse Fried, of Pay
Without Performance: The Unfulfilled Promise of Executive Compensation.