In the new book Pay Without Performance: The Unfulfilled Promise of Executive Compensation, Lucian Bebchuk and Jesse Fried make the case that the executive compensation system in the U.S. is fundamentally broken. We like to think that executive pay is the product of arm's-length negotiation, that the executive bargains in his or her own best interest, while the board of directors bargains for the best interests of the shareholders. Bebchuk and Fried argue that, in fact, soaring executive pay is the result of management power.
"Compensation arrangements have often deviated from arm's-length contracting because directors have been influenced by management, sympathetic to executives, insufficiently motivated to bargain over compensation, or simply ineffectual in overseeing compensation," the authors write. "Executives' influence over directors has enabled them to obtain "rents"—benefits greater than those obtainable under true arm's-length bargaining."
The book opens with a quote from Harvard Business School Dean Kim Clark asking the fundamental question about executive scandals: "Is it a problem of bad apples, or is it the barrel?" For Bebchuk and Fried, the problem is in the barrel, and to an extent, well underplayed.
In this interview, Bebchuk and Fried discuss their book and their ideas for how executive pay and corporate governance could improve.
Bebchuk is Friedman Professor of Law, Economics, and Finance and Director of the Program on Corporate Governance at Harvard Law School. Fried is professor of law at the University of California at Berkeley.
Mallory Stark: Why did you write Pay Without Performance?Lucian Bebchuk: Although there is now widespread recognition that many boards approved executive pay packages that did not serve shareholder interests, there is still insufficient understanding of the scope, source, and severity of the problems. We wanted to provide a full account of the widespread flaws in compensation arrangements and the resulting costs to shareholders. Studying pay arrangements also enabled us to identify some more basic problems with our system of corporate governance. Finally, we wanted not only to improve recognition of existing problems, but also to contribute to solving them. The book puts forward proposals for improving both executive compensation and corporate governance more generally.
Q: How important are executive pay problems in the grand scheme of things?
Bebchuk: The problems of executive pay are of real practical significance for investors and the economy. The amounts paid to executives are significant even relative to the large market capitalization of public firms. In a recent study with Yaniv Grinstein, we find that the aggregate compensation paid by public firms to their top-five executives during 1993-2002 was about $250 billion. Aggregate top-five compensation was equal to 10 percent of aggregate corporate earnings in 1998-2002, up from 6 percent of aggregate corporate earnings during 1993-1997. Thus, if compensation could be cut without weakening managerial incentives, which we show it could, the direct gains to investors would have real practical significance.
Moreover, the excess pay obtained by executives is not the only, and probably not even the primary, cost of flawed pay arrangements. Executives' influence has produced pay arrangements that provide diluted and sometimes perverse incentives. These distortions might well have been the biggest costs arising from executives' influence on their own pay; eliminating them could produce substantial benefits.
Q: In what ways have the problems of executive pay been under-appreciated?
Jesse Fried: There are many who believe that concerns about executive pay have been exaggerated. Some hold the "rotten apples" view that flawed compensation arrangements have been limited to a small number of firms. In contrast, we conclude that problems have been widespread, persistent, and systemic.
|We conclude that problems have been widespread, persistent, and systemic.|
|— Jesse Fried|
There are also those who accept that flaws in compensation arrangements have been common but maintain that these flaws have resulted from honest mistakes and misperceptions on the part of loyal boards that can be expected to fix the problems on their own. But the problems we identify have stemmed not from transient lapses that boards can be expected to self-correct; rather, they have stemmed from basic defects in the underlying governance structures that enable executives to exert considerable influence over their own pay.
Finally, there are some who maintain that recent reforms, which strengthen director independence, would fully address past problems. We show, however, that the problems are ones that cannot be expected to go away merely by strengthening the independence of directors. Directors, we argue, must be made not only independent of insiders, but also more dependent on shareholders.
Q: What are the problems you identify in the pay-setting process?
Fried: We show that directors have persistently failed to negotiate at arm's length with the executives whose pay they set. We identify a myriad of factors that lead directors to go along with pay arrangements favorable to executives. Executives' influence on pay setting can explain a wide range of compensation practices and patterns, including ones that have long been viewed as puzzles by economists assuming arm's-length contracting. The role of managerial influence also explains why pay is higher and less sensitive to performance in firms in which executives are more entrenched or have more power vis-Ã -vis the board.
The flaws in the pay-setting process have resulted in substantively flawed outcomes. Pay has been insufficiently linked to performance. And pay schemes have been designed in ways that camouflage both the amount of compensation and its insensitivity to performance.
Q: Do you agree with the view that increasing pay levels is necessary to provide managers with powerful incentives to enhance shareholder value?
Bebchuk: No, we don't. Pay schemes fail to provide incentives in a cost-effective way, and shareholders have been receiving much less bang for their buck than possible. Indeed, pay is far less sensitive to performance than is commonly recognized. To begin, there is evidence that cash compensation, including the large amounts paid in bonuses, is little correlated with managers' own performance. In addition, much value is delivered to executives through what we call "stealth compensation"—forms of pay whose dollar amount is not included in publicly filed compensation tables—and this stealth compensation also isn't tightly linked to performance.
Even with respect to equity-based pay, the link between pay and performance is much weaker than possible. Most of the payoffs from executives' equity-based compensation come from market-wide and industry-wide movements, as well as from short-term fluctuations in stock prices, rather than from managers' own long-term performance.
Furthermore, compensation contracts and provisions provide executives with substantial downside protection that further decouples pay from performance. Compared with other employees, executives receive an unusually large fraction of their full-term compensation in the event they leave due to under-performance.
Finally, current compensation arrangements not only fail to provide incentives to enhance shareholder value in a cost-effective way, but also provide perverse incentives. For example, broad freedom to unload options and shares has provided executives with incentives to produce short-term stock price increases that come at the expense of long-term value.
Q: You talked about the camouflaging of pay. Can you give an example of how pay has been camouflaged?
Fried: Firms have used retirement benefits, for example, to provide executives with substantial amounts of stealth compensation. Given the lack of tax subsidy, firms' substantial use of nonqualified pension and deferred compensation arrangements is difficult to explain on efficiency grounds. But such arrangements can serve an effective camouflage role, providing executives with large amounts of performance-insensitive pay below investors' radar screen. Under current disclosure requirements, firms do not have to place a monetary value on retirement benefits and include it in the compensation tables that companies file and outsiders follow. Indeed, the executive compensation figures used by the media and researchers, as well as the figures of aggregate compensation Lucian noted earlier, do not include these retirement benefits.
Q: How can pay arrangements be improved?
Bebchuk: We would like to see pay arrangements designed to serve shareholders' interests, not managers' interests. Institutional investors could use our findings to pressure boards more effectively on executive compensation. Our analysis identifies the types of pay arrangements that institutions should resist as well as those that they should encourage. Investors should, for example, urge firms to use equity-based schemes that filter out windfalls, to tie pay tightly to managers' own performance, to substantially limit managers' freedom to unload equity incentives, and to avoid contractual provisions that provide executives with soft landings in the event of failure.
To constrain boards' ability to camouflage executive pay, the SEC should ensure that firms make the total amount of an executive's pay and its sensitivity to performance transparent to a wide range of outsiders. It is not enough for information about compensation to be public; it must be accessible to investors. We propose various changes in disclosure requirements that would increase transparency. For example, firms must be required to place a monetary value on all benefits given or promised to executives and to include them in the compensation tables.
|We would like to see pay arrangements designed to serve shareholders' interests, not managers' interests.|
|— Lucian Bebchuk|
Finally, the most promising remedy, but also the one most difficult to obtain politically, would be to adopt reforms that make boards more attentive to shareholder interests. If directors can be relied on to focus on shareholder interests, the pay-setting process, and board oversight of executives more generally, will be greatly improved.
Q: Why aren't recent reforms sufficient to address problems of board unaccountability?
Fried: Recent reforms, primarily the new stock exchange listing requirements, seek to improve board oversight by strengthening the independence of directors. Even though these reforms are beneficial, they fall far short of what's necessary. We show that the new listing requirements weaken executives' influence over directors, but do not eliminate it. Moreover, there are limits to what independence can do by itself. Independence does not ensure that directors will have incentives to focus on shareholder interests or that directors will be well selected. In addition to becoming more independent of insiders, directors also must become more dependent on shareholders. To this end, we should eliminate the arrangements that currently entrench directors and insulate them from shareholders.
Q: Do you support the SEC proposal to permit shareholders to place director candidates on the corporate ballot?
Bebchuk: We support it as a step in the right direction. Shareholder power to replace directors is now largely a myth. In a recent study, I provide evidence that, outside the hostile takeover context, the incidence of electoral challenges to directors has been practically negligible in the past decade. To make directors more accountable, this power must be turned from a myth into a reality. Although the SEC proposal is thus a step in the right direction, it is a very mild step that should be supplemented with other changes.
Q: What else should be done to make boards more accountable to shareholders?
Bebchuk: It would be desirable to get rid of staggered boards, which most public companies now have, and have all directors stand for annual election. Staggered boards provide a powerful protection from removal in either a proxy fight or a hostile takeover. In a recent empirical study, [my colleague] Alma Cohen and I found that staggered boards bring about an economically significant reduction in firm value.
In addition to being able to remove directors, shareholders should have the power, which they lack under current rules, to initiate and adopt changes in governance arrangements. Under current rules, shareholders can pass only nonbinding resolutions, and boards often ignore these resolutions. Allowing shareholders to set governance arrangements would contribute to making boards more accountable to shareholders.
Q: What do you hope to accomplish with this book?
Fried: We believe that it is important to bring about recognition of the flaws in current compensation arrangements and in the governance processes that produce them. With better understanding of these flaws, institutional investors will be able to pressure companies to make desirable changes. Furthermore, the regulatory reforms we advocate would not be possible unless investors and public officials come to fully understand how pervasive and costly existing flaws are. Pay Without Performance, we hope, will help bring about a better understanding of both the existing problems and how they could be solved.
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Those applauding the rise in executive compensation have stressed the benefits to shareholders from strengthening managers' incentives to increase shareholder value. Indeed, in the beginning of the 1990s, prominent financial economists such as Michael Jensen and Kevin Murphy urged shareholders to be more accepting of large pay packages that would provide high-powered incentives. Shareholders, it was argued, should care much more about providing managers with sufficiently strong incentives than about the amounts spent on executive pay.
Indeed, throughout the past decade, shareholders have often accepted the increase in executive pay as the price of improving managers' incentives. Higher compensation has been presented as essential for improving managers' incentives and therefore worth the additional cost. Unfortunately, however, much of the additional value provided to executives has not actually been tied to their own performance. Shareholders have not received as much bang for their buck as possible.
Managers have used their influence to obtain higher compensation through arrangements that have substantially decoupled pay from performance. Firms could have generated the same increase in incentives at a much lower cost, or they could have used the amount spent to obtain more powerful incentives. Executive pay is much less sensitive to performance than has commonly been recognized.
Although equity-based compensation has recently drawn the most attention, much executive pay comes in forms other than equity, such as salary and bonus. The evidence indicates that cash compensation—including bonuses—has been at best weakly correlated with firms' industry-adjusted performance. Such compensation has been generously awarded even to managers whose performance was mediocre relative to other executives in their industry. Furthermore, financial economists have paid little attention to the other forms of non-equity compensation that managers frequently receive, such as favorable loans, pensions and deferred compensation, and various perks. These less-noticed forms of compensation, which can be substantial, have tended to be insensitive to managerial performance.
In light of the historically weak link between non-equity compensation and managerial performance, shareholders and regulators wishing to make pay more sensitive to performance have increasingly looked to, and encouraged, equity-based compensation—that is, compensation based on the value of the company's stock. Most equity-based compensation has taken the form of stock options—options to buy a certain number of company shares for a specified price (the "exercise" or "strike" price). We strongly support equity-based compensation, which in principle can provide managers with desirable incentives. Unfortunately, however, managers have been able to use their influence to obtain option arrangements that have deviated substantially from arm's-length contracting in ways that favor the managers. Our analysis indicates that equity-based plans have enabled executives to reap substantial rewards even when their performance was merely passable or even poor.
For instance, firms have failed to filter out stock price rises that are due largely to industry and general market trends and thus are unrelated to managers' own contribution to shareholder value. Although there is a whole range of ways in which such windfalls could be filtered out, a large majority of firms have continued to cling to conventional option plans under which most of the equity-based compensation paid to managers is not tied to their own performance. In addition, firms have given executives broad freedom to unload options and shares, a practice that has been beneficial to executives but costly to shareholders. Unfortunately, most of the boards now changing their equity-based compensation plans in response to outside pressure are still choosing to avoid plans that would effectively eliminate such windfalls. Rather, they are moving to plans, such as those based on restricted stock, that fail to eliminate, and sometimes even increase, these windfalls.
How important is the subject of executive pay? Why should one read a whole book on the subject? Some might wonder whether executive compensation has a significant economic impact on the corporate sector. The problems existing in the area of executive compensation, it might be argued, do not substantially affect shareholders' bottom line and are thus mainly symbolic.
Even if symbolism were unimportant, however, the subject of executive compensation is of substantial practical importance for shareholders and policymakers. Flaws in compensation arrangements impose substantial costs on shareholders. To begin with, there is the excess pay that managers receive as a result of their power, that is, the difference between what managers' influence enables them to obtain and what they would get under arm's-length contracting. As a current study by Yaniv Grinstein and one of us seeks to document in detail, the amounts involved are hardly pocket change for shareholders.
During the five-year period 1998-2002, the compensation paid to the top five executives at each company in the widely-used ExecuComp database, aggregated over the 1500 companies in the database, totaled about $100 billion (in 2002 dollars). And the capitalized present value of aggregate top-5 compensation in publicly traded U.S. companies is rather substantial. During the past ten years, the growth rate of aggregate executive compensation has kept pace with that of total stock market capitalization. Assuming that aggregate executive compensation continues to grow in tandem with market capitalization or that managers' share of aggregate corporate profits remains at current levels, the capitalized present value of aggregate top-5 compensation in publicly held U.S. firms could be on the order of half a trillion dollars. Thus, if compensation could be cut without weakening managerial incentives, the gain to investors would not be merely symbolic. It would have real practical significance.
Furthermore, and perhaps even more important, managers' influence on compensation arrangements dilutes and distorts the incentives that they produce. In our view, the reduction in shareholder value caused by these inefficiencies—rather than that caused by excessive managerial pay—could well be the biggest cost arising from managerial influence over compensation.
We discuss two incentive problems that current pay arrangements have been producing. First, compensation arrangements have been providing weaker incentives to reduce managerial slack and to increase shareholder value than would be the case under arm's-length contracting. Both the non-equity and equity components of managerial compensation have been more severely decoupled from managers' contribution to company performance than superficial appearances might suggest. Making pay more sensitive to performance may well benefit shareholders substantially.
Second, prevailing compensation practices have also created perverse incentives. For example, managers' ability to unload options and shares has provided them with incentives to misreport results, suppress bad news, and choose projects and strategies that are less transparent to the market. Improving compensation schemes could thus considerably benefit shareholders by reducing the costs resulting from such distorted behavior.