PersPeCtIves on exeCutIve CoMPensatIon
By Lemma W. Senbet
“A well designed equitybased compensation
can serve as a key
mechanism for
corporate governance.“
The Rise of Equity-Based
Compensation: The Bright and
The Dark
I
nthinkingaboutthemostsignificantdevelopmentinthefieldofcorporategovernanceover
thelastquarterofacentury,Ihavebeeninfluencedbythetwolandmarkeventsofthelastdecade,
whichhaveprofoundlysharpenedtheroleoffinance
inthepublicdomain�Inthewakeofthelastdecade,
theburstoftheinformationtechnologyboomand
theensuingmassivecorporatescandalstriggereda
collapseofwell-knowncompanies,suchasEnron,
WorldCom,andAdelphia�Moreover,bytheendof
thelastdecade,theburstofthehousingbubbleand
thesubprimecrisisledtoashutdownofthecredit
marketandacollapseofvenerablefinancialinstitutionswhichgotrescuedbypublicfunds�
Thereisanongoingdebatebothinacademicand
policycirclesontheextenttowhichcorporategovernancefailuresmighthavecontributedtothese
landmarkepisodes�Thereisnearconsensuson
thelinkbetweenthescandalssurroundingthedot�
combubbleandfailuresincorporategovernance�
However,thelinkbetweentheill-designedincentivefeaturesofcompensationandfinancialcrisisis
stillbeingdebated�Itisclear,though,thatexecutivecompensationandgovernanceingeneralhave
receivedwidepublicattention�
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Thelast25yearsalsosawarobustpay-for-performancemovement�Thelong-standingquestionhas
beenwhetherexecutivecompensationstructures
providesufficientincentivesforexecutivestoalign
themwithshareholders�Agencytheorysuggests
thattheprimarymeansbywhichshareholders
ensureincentivealignmentistotieexecutivepay
tocompanyperformance�Infact,consistentwith
this,duringthelate1980sandearly1990sthere
wasanincreasedpressurefrominstitutionalinvestors,suchastheUnitedShareholdersAssociation,
theCouncilofInstitutionalInvestors,andlarge
statepensionfunds,forcompaniestotieexecutivepaycloselytocompanyperformance�The
pay-for-performancemovementhadanimpacton
thestructureofcompensation,withdramaticshift
towardequity-basedcompensation,inclusiveof
bothequityparticipationandoption-basedpay�
Theaccumulatedacademicevidenceovertheyears
suggeststhatasubstantialportionofCEOwealth
is,infact,tiedtocompanyperformance,andbetter
incentivealignmenthasbeenasourceofincrease
inshareholderwealthovertheyears�
However,therewasadarksidetothepay-performancemovement�Therewereseveralcasesin
whichexecutivepayrosedramaticallyeventhough
thecompaniesweredoingpoorlyandtheirstock
priceswereplummeting,suggesting,onthesurface,
insufficientlinkagebetweenpayandlong-term
corporateperformanceandthepossibilitythat
executiveswerepaidexcessively�Infact,thepublic
concernaboutexcessivepayleadtotheadoptionof
theSection162(m)oftheInternalRevenueCode,
whichendedupcreatingunintendedconsequences
bydistortingthestructureofcompositiontobe
heavilybiasedtowardincentivepay,withadramaticriseinoption-basedcompensation�
Theglobalfinancialcrisishasnowgenerated
extensivedebateontheroleofexecutivepayinthe
propagationofthecrisis�Thisinturnhasweighed
inprominentlyinthedebateaboutfinancialpolicy
reformpertainingtoourlargestfinancialservice
companies�Theissuehereismoreaboutexcessive
risk-takingstemmingfromaggressiveincentivefeaturesofcompensation,ratherthanexcessivepay�
Thus,overthelast25yearswehavewitnessed:(a)
extensivedebateonexcessivepay;(b)theadvent
of162(m),(c)financialexcesses;and(d)acrisis
ofepicproportions�Equity-basedcompensation,
particularlystockoptioncompensation,hasbeen
centraltotheseissues�Thisleadsmetoconclude
thereisoneaspectofcorporategovernancethat
hasbecometheunifyinglinkfortheseissues,
namelytheriseofequity-basedcompensation,and
Iconsiderthisasthemostsignificantdevelopment
overthelast25years�
The positive and the dark: Welldesignedequitybasedcompensationcanserveasakeymechanism
forcorporategovernance�Shareholder-manager
incentivealignmentleadstovaluecreationand
contributestotheoveralleconomicgrowthand
employmentcreation�Thisispositivenews�
However,thereisalsoadarksidetoequity-based
compensation�Flawedcompensationschemes
candestroyvalueanddetractfromtheoverall
economicperformance�Asanexample,compensationschemesthatmotivateexcessivefocuson
© 2011 Institutional Shareholder Services Inc.
PersPeCtIves on exeCutIve CoMPensatIon
short-termprofitstomeetshort-runanalysts’expectationscan
destroylong-runshareholdervalue�Moreover,ifthestockisovervalued,equity-basedcompensationmayincentivizethemanager
toover-investormanipulateearningstojustifythefirm’scurrent
stockprice�Somehaveconvincinglyarguedthatsuchmanipulations
havecontributedtothecorporatescandalssurroundingthedot�com
bubble(Jensen2005)�
Excessive pay debate: ThereisalsoawidelyheldviewthatexecutivecompensationintheU�S�isexcessiveinthesenseitishigher
thanthatrequiredtoretainandmotivateexecutives�Inthe1990s
averageCEOcompensationincreasedsignificantly,bothinabsolute
andinrelativeterms�Theinflation-adjustedlevelofaverageCEO
payforS&P500companiesstoodat$14�7millionin2000,five
timestheaverage10yearsbefore�Onanothermetric,the2000level
wasabout400timesthatofaverageemployeecompensation,up
fromonly42timesin1980(seeBusiness Week,Sept�11,2000)�
Butwhatisexcessive?Presumablyitishigher
paythantheexecutivecouldcommandina
competitivemarketforexecutives�Itissafe
tosaytherehavebeeninstancesofmega
stockoptiongrantsbeingmadetoundeservingtop-levelexecutives�Forinstance,Dennis
Kozlowski,formerCEOofTyco,wasgranted
nearlysixmillionoptionsvaluedat$81millionattheverytimethathewasallegedly
lootingthecompany�However,itisdifficult
togeneralizefromthesecasesaboutwhether
theaveragelevelofexecutivecompensation
wasexcessive�
Thereisevidencesuggestingthattheincentivestructureofpay
isdifferentbetweenfinancialandnon-financialfirms(DeYoung,
Peng,andYang(2009)�Inparticular,thesensitivityofexecutivepay
tovolatility(vega)divergedbetweenbanksandnon-banksafter
1999�Asaconsequence,anargumentcanbemadethattherewere
incentivesforexcessiverisk-taking,asreflectedinmorecreditrisk
andmoreprivatemortgagesecuritizations�Oneconsequenceof
thisformofrisk-takingisanelevatedlevelofsystemicriskinwhich
banksbecomeespeciallystressedduringeconomicdownturns�
However,thisissuggestiveandacausationisyettobeestablished�
Overall,whetherflawedincentivesincompensationarethecritical
driverofthefinancialcrisisremainsanempiricallyinteresting
questionforfutureresearch�
“Overly generous compensation
packages with large-sized stock
option grants may have created
incentives for managers to
manipulate company financial
statements in order to drive up
stock prices, contributing to the
corporate scandals of the postdot-com era.”
Section 162 (m) and the rise of option-based compensation:
Section162(m)wasenactedin1993asameansofmitigating
excessivepay�Thestatuedisallowstaxdeductibilityforallcompensationpaidto“proxy-namedexecutives”inexcessof$1million,
unlesssuchcompensationis“performance-based�”However,it
endedupcreatingunintendedconsequences�Onanaftertaxbasis,
performance-basedcompensation,particularlystockoptions,
becamelessexpensivethanbasesalariesandstockgrants�Stock
optionsdidsatisfythe“performance-based”test,sincetheyare
directlylinkedtotheunderlyingstock�Thismusthaveleadtoa
dramaticriseinoption-basedcompensation�Infact,theaverage
grant-datevalueofoptionssoaredfromnearzeroin1970toover
$7millionin2000(HallandMurphy,2003)�
Overlygenerouscompensationpackageswithlarge-sizedstock
optiongrantsmayhavecreatedincentivesformanagerstomanipulatecompanyfinancialstatementsinordertodriveupstockprices,
contributingtothecorporatescandalsofthepost-dot-comera�
Executive pay and financial crisis: Executivecompensationhas
beenaprominentandvisibletargetofregulatorsandpolicymakers
inresponsetothecrisis�Akeyquestioninthesepolicyresponses
iswhether,andtowhatextent,flawedcompensationstructuresat
financialfirmscontributedtothecrisis�Giventhatshareholdersof
leveredinstitutionsbenefitfromexcessiverisk,payingexecutives
© 2011 Institutional Shareholder Services Inc.
withstockoroptionsandaligningthemwithshareholderscanhave
theperverseeffectofpushingexecutivestotakeonextrarisk.
lookIng ahead: the next
25 years
Imakethefollowingpredictionsbasedona
simpleguidingprinciplethatIbelievewill
prevailoverthenext25years�Theprinciple
isthatthelevelofexecutivepayshouldnot
belegislatedorregulated,directlyorindirectly�Inparticular,thechoiceofcompensationstructuresshouldbelefttothefirm,and
regulatoryandtaxreformsshouldnotfavor
oneformofcompensationoveranother�
1. Section 162 (m) will be repealed. Thisruleisamisguidedeffort
toregulatethelevelandstructureofexecutivecompensation,and
shouldberepealed�Companies,throughtheirboardsandshareholders,willbefreetodeterminetheoptimalformandlevelof
executivecompensation�Inthosecaseswherecorporateboards
arenotexercisingthisfunctioninaresponsibleway,therewillbe
changesincorporategovernanceinstitutionsorothermechanisms
(e�g�,“sayonpay”)toenhancethepowerofshareholderstomonitor
executivecompensationdirectly�
2. Longer vesting periods will prevail: Duetolongervestingperiods,therewillbeimprovedlinkageofpaytolong-termperformance
andlesstocashoutbasedonshort-termfavorableresults�Even
bonuseswillbebasedonmulti-yearmetricstobetteralignexecutiveswithlong-termshareholderwealthmaximization�
3. Shareholders will directly influence executive pay:
Shareholderswillhaveamoredirectmechanismforinfluencingthe
levelandstructureofexecutivecompensation�Alltop-management
compensationplans,includingsalary,equity-basedcompensation,
andseverancepackageswillbesubjecttoashareholderproxyvote�
Duetolimitedexperienceandinformationpossessedbyindividual
shareholders,anadvisoryvotewillprevailinwell-governedcompanies�Thus,goodgovernancewillberewarded�
4. Compensation committees will be independent and finance
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PersPeCtIves on exeCutIve CoMPensatIon
“This crisis has inspired
more, and even
invasive, regulation
both in the financial
and non-financial
sectors, and the role
of the government in
corporate governance
and financial
regulation has actually
expanded.”
literate: Compensationcommitteeswillbecomposedentirelyofindependentdirectorstoensure
thatcompensationissetinanarms-lengthbargainingprocess�Thecommitteeswillbeaidedbycompensationcommitteessupportedbyindependent
compensationconsultants�
Equallyimportant,compensationcommitteeswill
havesufficientexpertiseinfinancetosufficiently
understandthecompensationcontractsandthe
methodsusedtovalueproperlytheincentivefeaturesinthesecontracts�
5. There will be more expanded disclosure involving all elements of pay: Disclosurewillbemore
explicitandexpandedtocoverallelementsofexecutivecompensation,includingretirementbenefits,
severancepackages,perquisites,andotherdirect
orindirectschemesofcompensation�Moreover,
financialtransactionsbyexecutives,particularly
hedgingtransactions,thataffectpay-performance
sensitivity,willbedisclosedtoboardsandcompensationcommittees�
6. There will be increasing state dominance of
governance around the world: Wehavealready
witnessedtheadventofpayczarasaconsequence
ofTARPbailouts�Forthefirsttimeinhistory,the
financialcrisisledtheU�S�governmenttoacquire
exorbitantownershipstakesinourlargestcompanies�Ithasalsoemergedasadominantcreditor�
Thiscrisishasinspiredmore,andeveninvasive,
regulationbothinthefinancialandnon-financial
sectors,andtheroleofthegovernmentincorporategovernanceandfinancialregulationhasactuallyexpanded�Thus,theroleofthegovernment
incorporategovernance,includingexecutivepay,
throughdirectownershipandimplicitguarantees
islikelytoincreaseunlessthependulumshiftsasa
resultofsomebacklashfromindustry�
However,theincreasingroleofthegovernment
isconsistentwithwhatishappeningaroundthe
world,sincestate-ownedcorporationsinfastgrowingBRICs(Brazil,Russia,India,andChina)have
emergedasseriouscompetitorstothetraditional
corporations,withtheresultantstatecapitalism
emergingasanalternativeformofthetraditional
corporategovernance�Atthistimeitisdifficultto
predicttheeconomicconsequencesoftheglobal
trendintheincreasedstateroleingovernanceof
corporations�
About the Author
❙ Lemma W. Senbet is the William E. Mayer chair professor of finance and director of the Center
for Financial Policy at the Smith School of Business at the University of Maryland. His colleagues,
Michael Faulkender, Dalida Kadyrzhanova, and N. Prabhala, contributed to this article.
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