Executive Pay and its Disclosure

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 reform.

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).

Beyond Disclosure
Forbes, January 19, 2006

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 other markets.

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 on firm 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.