Pay without Performance : The Unfulfilled Promise of Executive Compensation

Rating:
Summary: Thoughtful Analysis But Remedies Need More Work
Review:


In his letter to Berkshire Hathaway investors in 2004, Warren Buffett wrote:

"In judging whether Corporate America is serious about reforming itself, CEO pay remains the acid test. To date, the results aren't encouraging."


PAY WITHOUT PERFORMANCE expands on Buffett's comments and provides a research base to support it. The authors also suggests what needs to be done to effectively deal with this "acid test" of corporate reform.

Lucian Bebchuck is the William J. Friedman and Alicia Townsend Friedman Professor of Law, Economics, and Finance at the Harvard University School of Law. He is also a Research Associate of the National Bureau of Economic Research. Bebchuck has a doctorate in economics from Harvard and a law degree from Harvard. Jesse Fried is Professor of Law at the Boalt School of Law at the University of California at Berkeley. Prior to his academic career, he practiced tax law in Boston. Fried holds degrees in economics and law from Harvard University.

The authors argue that Sarbanes Oxley reforms may have marginally improved the independence of Boards from CEOs. But Board members are still not dependent enough upon the shareholders they are supposed to represent. This dysfunctionality in the system makes it impossible for Compensation Committees to conduct true "arms length" compensation discussions with CEOs.

The result is a CEO compensation system that tends to verbalize pay for performance without actually achieving it for CEOs.

When CEO pay is uncoupled from performance, Board members seek to avoid having to pay "outrage costs" from the shareholders. One of the ways of avoiding paying "outrage costs" is to make it difficult for the average shareholder to truly understand the level of CEO compensation and how that level is unrelated to corporate performance. The authors call these techniques compensation "camouflage."

The authors are quite clear in describing examples and providing research to support their ideas.

They propose remedies that focus on two themes: tying CEO compensation to real corporate performance and tying Boards to shareholders.

With respect to tying CEO compensation to real corporate performance, they would seek to remove "windfall" and "rising tide" factors from CEO bonus/option payments. Windfall factors involve one-time rises in shareholder value. An example might include a sharp rise in stock value because the CEO makes a decision to downsize or receives a large payment from the successful settlement of a law-suit. Another windfall factor might be allowing accounting for revenue to move from one quarter to the next so that the stock will look like it is rising at a steeper angle. "Rising tide" factors would factor out increases in CEO compensation because an average company is benefiting from average industry growth that impacts all average players. These issues merit serious consideration from Compensation Committees. And Warren Buffet is correct in his assessment that most Boards have thus far failed the "acid test."

With respect to tying Boards to shareholders, the authors would terminate staggered Board elections. They would have the entire Board be up for election at the same time. I am reasonably sure that the authors' remedy here would be worse than the disease they are seeking to cure.

A Board of Directors is a work group that is supposed to be thoughtful and deliberative in nature. Their proposal would make the Board a far more responsive body at the expense of thoughtfulness. To make an analogy, the U.S. Senate is a more effective deliberative body because it is less subject to the passions of the moment. And it is less subject to the passions of the moment because only 33% of its members are up for election every two years. The U.S. House of Representative is far less effective as a deliberative body. And one of the reasons is that all members are accountable to the voters every two years.

Regardless of whether you agree or disagree with their analysis, their key theme deserves consideration: if Boards allow CEO pay to be unrelated to corporate performance, it is important to define the problem correctly. The problem is not about greedy or lazy individuals. The problem is about a system that is not rewarding leaders for doing the right things.

As Warren Buffet has said, fixing that system will be the "acid test" of the free enterprise system in the 21St Century.

Larry Stybel
www.boardoptions.com
[e-mail]








Rating:
Summary: Great analysis; flawed reform proposals
Review: I have been reading Pay Without Performance: The Unfulfilled Promise of Executive Compensation by (Harvard law professor) Lucian Bebchuk and (Boalt law prof) Jesse Fried. Bebchuk and Fried take issue with the standard academic account of executive compensation, which goes something like this: Executive compensation is a classic agency cost problem. Although CEOs and other executives are agents of the corporation and its shareholders, they have incentives to shirk. Indeed, they have incentives to behave opportunistically - i.e., to maximize their own wealth and perks at the expense of their shareholder principals. Accordingly, executive compensation schemes must be designed in ways that constrain shirking and opportunism; in other words, executive compensation schemes should strive to align executives' interests with those of the shareholders. In the literature, this usually leads to a recommendation of some sort of performance-based pay scheme, typically entailing the use of stock options.

Bebchuk and Fried do a good job of explaining why executive compensation schemes fail adequately to align managerial and shareholder interests. In brief, they make the very sensible point that managerial influence over the board of directors taints the process by which executive compensation is set. In other words, the system by which agency costs are to be checked is itself tainted by an agency cost problem.

I get off the boat, however, when it comes to the solution. Bebchuk and Fried want to displace the time-tested corporate governance system of director primacy with an untested new system based on shareholder primacy. As regular readers of my academic work know, this is anathema in my book. (I'm writing a review of their book for the Texas Law Review, which will focus on this point, and which should be available on www.ssrn.com in a month or two.)

Having said that, however, Bebchuk and Fried are to be praised for having written a book that makes highly technical doctrinal and economic analysis accessible to the educated lay reader, while not dumbing down some very sophisticated analysis. As a result, the book remains useful to the specialist as well. It is definitely a book that anyone interested in corporate governance and executive compensation ought to own.

Rating:
Summary: Shareholder Power!
Review: In Pay Without Performance, Lucian Bebchuk and Jesse Fried argue that incentive structures provided by crony directors encourage CEOs to focus on short-term earnings at the expense of long-term success.

Fewer than 1% of 1,000 executives studied from 1993 to 1999 resigned or left under pressure because of poor performance. Obviously, boards have not been doing their job. "We present evidence that compensation arrangements have often been designed with an eye to camouflaging rent and minimizing outrage," the authors state. "Firms have systematically taken steps that make less transparent both the total amount of compensation and the extent to which it is decoupled from managers' own performance."

They call the existing system's bluff. The myth is that shareholders already have the power to remove directors but everyone knows the deck is stacked against them. Bebchuk and Fried look to truly empower shareholders, especially through access to the proxy, as a major part of the solution. Access to the corporate ballot will allow shareholders to replace directors and demand greater transparency. Directors who are directly accountable to shareholders will be more aligned with their interests in setting compensation schemes and in all of their other duties.