Reforming Corporate Governance:
The Key to Improving Executive Pay
Jesse Fried
Harvard Law School
Washington D.C.
May 4, 2010
My work with Lucian
Bebchuk offers a critical
account of the CEO paysetting process and its
outcomes.
Today’s remarks:
(1) the basic
problem with the
CEO pay-setting
process
(2) why giving
shareholders more
power should reduce
this problem.

Executive Pay: The Stakes


Excess pay costs shareholders
Poorly structured pay arrangements:


Dilute incentives to serve shareholders
Distort incentives –

E.g.: ability to unwind stock early causes
execs to focus on short-term earnings, at
expense of long-term value
“Official View” of Executive Compensation

Arm’s-length bargaining with execs


Executives are human – seek higher pay, regardless of
performance
But directors, loyal to shareholders, bargain hard with execs



design pay to properly compensate, incentivize execs
CEO pay is a market like any other
The official view


underlies most financial economists’ work on subject
used to justify boards’ compensation decisions to
 shareholders
 policymakers
 courts
Problem with Official View

The official arm’s length story



is neat, tractable, and reassuring –
but fails to account for realities of pay-setting
process
It’s not only executives whose incentives
matter.


Must look at incentives of directors
Cannot assume directors automatically serve
shareholders in setting executive pay.
Do Boards Bargain at Arm’s Length?

Many reasons directors favor executives:
 Incentives
 Going along w/CEO facilitates re-nomination by board

99+% board elections not contested
CEO’s power to reward directors
Social factors
 Collegiality
 Loyalty and friendship
 Cognitive dissonance




directors who are/were CEOs like current system
Personal costs of favoring executives are small

Paying with other people’s money
Warren Buffett (2009)

“In the [last] forty years, …the CEO has had an
important role determining their [own]
compensation. These people pick their own
compensation committees…. [they] aren't looking
for Dobermans; they're looking for cocker
spaniels. It's been a system that the CEO has
dominated. In my experience, boards have done
little in the way of thinking through as an owner
what they ought to pay these people.”
The Managerial Power Approach:
Power, Outrage & Camouflage

The same factors preventing arm’s-length bargaining
give executives power over boards

Executives use power to influence own pay


Power not unlimited, of course; constrained by fear
of shareholder outrage


Pay higher, more performance-decoupled than it should be
More outrageous an arrangement is perceived to be, greater
market and social costs to executives and directors
Fear of outrage creates desire to camouflage
(obscure or justify) both amount, performanceinsensitivity of exec pay
Evidence for
Managerial Power Approach

Relationship between power and pay


More power, higher pay
More power, pay more decoupled from performance

Gratuitous payments made to outgoing executives

Equity and non-equity pay that is decoupled from executive’s own
performance

Camouflage-driven pay practices
Camouflage pre-1992:

An SEC official describes pre-1992 state of affairs as follows:
“The information [in the executive compensation section] was
wholly unintelligible . . . .
Depending on the company’s attitude toward disclosure, you
might get reference to a $3,500,081 pay package spelled out
rather than in numbers. ……….
Someone once gave a series of institutional investor analysts a
proxy statement and asked them to compute the
compensation received by the executives covered in the proxy
statement. No two analysts came up with the same number.
The numbers that were calculated varied widely.”
Linda C. Quinn, Executive Compensation under the New SEC
Disclosure Requirements, 63 U. Cin. L. Rev. 769, 770-71 (1995).
Camouflage post-1992 (1)

1992: Summary Comp Table

Firms required to report most forms of compensation in
standardized tables with dollar amounts




But post-1992 pay designers began relying heavily on


forms of compensation not reportable in table (eg SERPS)
performance-insensitive compensation that can be reported
as something other than “salary”



Salary
Bonus
Long-term incentive compensation
Made to look performance-related.
E.g.: “guaranteed bonus”
2007: SEC “fixes” table to capture SERPs, etc.
Camouflage post-1992 (2)

Backdating, Etc.

option grant backdating to lower exercise price


Inflated value of stock options “under the radar screen”
$ billions, thousands of firms



United Health: $500M paid back by CEO (2007)
option exercise backdating, grant springloading
All of this secret compensation


hard to reconcile with official arm’s-length story
but consistent with managerial power approach
Going Forward: What Should be Done?

Root problem: directors don’t care enough about
shareholders


We should make it easier to replace directors




“Independence requirements” don’t make directors
loyal to shareholders
Majority-voting
Give shareholders access to corporate ballot
Reimburse proxy challengers attracting considerable
support
Directors would be more likely to consider
shareholders’ interests if greater fear of removal
Making Directors More Accountable
By making boards accountable to shareholders and
attentive to their interests, such reforms would:



make reality closer to the “official story” of arm’s
length negotiations
improve executive compensation arrangements; &
improve corporate governance more generally
End
Introduction

Widespread agreement: many U.S. boards
have approved executive pay deals that do
not serve shareholders



Pay too high
Pay too decoupled from performance
But still insufficient recognition about
 scope and source of problems; and
 need for fundamental reforms