Reform of CEO Salaries

Efforts

The U.S. Securities and Exchange Commission (SEC) has -

*        asked publicly traded companies to disclose more information explaining how their executives' compensation amounts are determined.

*        posted compensation amounts on its website[1] to make it easier for investors to compare compensation amounts paid by different companies.

It is interesting to juxtapose SEC regulations related to executive compensation with Congressional efforts to address such compensation.[2]

One attempt to give executives more "skin in the game" of increasing stockholder value has been to set up Target Ownership Plans, whereby the executives are given a "target" of a number of shares of company stock to own.

These plans have not impressed critics, in part because of the low targets set—often less than the value of one year of the executive's compensation—and in part because firms seldom impose a penalty for not meeting the target.[3] According to David F. Larcker, some studies have found higher likelihood of restatement of earnings, (i.e. discovery of accounting manipulation) in companies where executives hold large equity positions, some have found a lower likelihood, and some have found no association.[4]

Shareholders, often members of the Council of Institutional Investors or the Interfaith Center on Corporate Responsibility have often filed shareholder resolutions.[5] 21 such resolutions were filed in 2003.[6] About a dozen were voted on in 2007, with two coming very close to passing.[7] As of 2007 the U.S. Congress was debating mandating shareholder approval of executive pay packages at publicly traded US companies.[8]

Unions have been very vocal in their opposition to high executive compensation. The AFL-CIO sponsors a website called Executive Paywatch[9] which allows users to compare their salaries to the CEOs of the companies where they work.

Questions

A 2009 study found incentive compensation did not lead to better "stock performance". The study by Michael J. Cooper, Huseyin Gulen, and P. Raghavendra Rau found "... managerial compensation components such as restricted stock, options and long-term incentive payouts, that are meant to align managerial interests with shareholder value, do not necessarily translate into higher future returns for shareholders." The authors did "not take a stance on whether this means that the incentives are inadequate or whether they do not work. Further research is necessary to answer this question."[10]

According to researchers at the Federal Reserve Board, the "evidence since the 1980s suggests" that the level and structure of executive compensation in US public corporations are "largely unresponsive to tax incentives".[11]

Proposals

A number of strategies that have been proposed to reform and/or limit executive compensation, particularly in the wake of the post-2008 financial collapse and Troubled Asset Relief Program.

These include government regulations such as -

  1. say-on-pay vote requirements,

  2. restrictions on tax "gross-ups" (paying not just compensation but also the tax bill for the compensation),

  3. golden parachute compensation and other severance payments,

  4. stricter standards for independence of compensation committees and their advisers,

  5. and clawbacks (recovery of compensation for unearned performance-based pay).[12]

Some advocates propose that the government intervene only in standards—requiring complete disclosure of compensation and making "say on pay votes" compulsory rather than advisory—leaving limits and/or changes in compensation to stockholders and boards.[13] Others believe government tax and regulation of pay is essential to cut excessive pay.[14]

Some specific suggestions are:

  • Boards of Directors should rise to the occasion, "to do their jobs", provide true oversight, better leadership, greater effectiveness, and so on.[15][16]

Require more disclosure

  • Require that board put a monetary value on all forms of compensation and compensation from all sources, and include this information in the compensation tables the SEC requires companies provide, to put an end to stealth compensation"[17]
  • Require that shareholders be provided with information on how much of the gain on the executive stock options comes from general market performance and industry sector performance[17]
  • Require that shareholders be provided with information on a regular basis of the unloading by the top five executives of any equity instruments received as part of their compensation.[17]
  • Require that shareholders be provided with information on the "performance formulas" used by compensation committees. Business journalist Clive Crook emphasizes this would highlight the awarding of bonuses when a company's performance is "well below the median of the chosen measure of success", i.e. "doing worse than most of the firms in its segment".[18]
  • Take advantage of the provision requiring corporations to disclose the gap between their CEO and most typical workers, found in the Dodd–Frank law.[19][20]

Changes in compensation

  • Encourage long term thinking and discourage pursuit of short-term profits.
    • Extend the vesting period of executives' stock and options.[21] Current vesting periods can be as short as three years, which encourages managers to inflate short-term stock price at the expense of long-run value, since they can sell their holdings before a decline occurs.[22]
    • Take away compensation ("malus" or "clawback") for poor performance as well as rewarding executives ("bonus") for good performance (known as the Bonus-malus system). Bonuses would be held in escrow and not immediately vested and in the event of losses in future years reduced retroactively (aka clawed back).[23] Research on similar clawback provisions that were voluntarily adopted by US firms between 2007–2009 finds that clawback provisions improve the accuracy of firms' financial statements and increase external users reliance on firms' accounting information. However, the same research also notes that executives demand an increase in base salary to offset the additional risk of having to repay incentive compensation in the event of a restatement.[24]
    • Prevent insider trading by executives (which currently is extremely difficult to monitor or prosecute) by taking away control over the exact time of unloading options and other equity compensation.[25]
  • Prevent executives from hedging their stock or stock options in the company, since hedging can weaken or eliminate the incentive effects that these instruments are intended to have on the manager.[26]
  • Factor out windfalls unrelated to the managers' own efforts in calculating bonuses or granting stock options. One way is Indexing Operating Performance to exclude market and sector-wide share price movements. With stock options the exercise price would follow the index. Instead of issuing options to the executive with an exercise price equal to the current market price of (for example) $100, the options strike price would be $100 multiplied by the market index.[27] Performance conditioned vesting would not adjust the strike price but simply not vest the options unless certain performance targets were met. The adjustments could be designed to be gentle, moderate or aggressive depending on the firm's situation. A more gentle benchmark to be exceeded for example might be the appreciation of the shares of the bottom 20 percent of firm in the company's sector.[28] Another windfall to be adjusted for would be falling interest rates.
  • Including Debt or Debt-Like compensation along with cash and equity based compensation. Equity based compensation encourages risk taking by executives. Making part of an executive compensation in the form of a debt-like instrument should reduce this tendency since debt value does not benefit from successful gambling of company income and more closely align managers with all investors, both shareholders and bondholders.[29][30] Therefore, as of 2011, there are several proposals to enforce financial institutions to use debt like compensation.[31]

Changes in corporate governance

  • Abolish the practice of having a joint chief executive and chairman of board of directors. Install independent bosses to oversee boards instead. Former Walt Disney Co. chief financial officer and director Gary Wilson states he saw "boards transformed overnight from supplicants to independents" when the two roles were separated at companies where he was a director.[32] As of 2010 only 21 percent of boards were chaired by bona fide independent directors (as opposed to the CEO, an ex-CEO or someone otherwise defined as a company "insider") according to RiskMetrics Group.[32][33]
  • Take advantage of "say on pay" requirements to cast shareholder votes against excessive or otherwise ill-advised pay packages.[19][34]
  • Make mandatory the audit of executive pay by an independent firm. These would play a role similar to public accounting firms reporting on corporate financial results. Since executive pay is an extremely technical and complex issue, without an audit to guide shareholders, the power to approve executive pay by vote won't be much help.[35]
  • Empower shareholders to have more control over board of directors by
    • getting rid of "staggered" boards (where only a fraction of directors are elected each time directors are elected, making it more time consuming and expensive to challenge directors) which offers directors insulation from disgruntled shareholders and resulting proxy contests and hostile acquisition[36]
    • give any shareholder or group of shareholders who have owned more than 5 percent (or similar significant number) of shares for at least one year, and want to field a slate of directors in board elections, an even playing field with incumbent directors. Distribute proxy statements for them just as the incumbents statements are, and reimburse reasonable "campaign" costs incurred by them.[37]
    • remove the board's veto power over changes to the company's basic governance arrangements and give shareholders the power to initiate and approve by vote proposals to reincorporate or to adopt a charter amendment to corporate charters.[38]

  • Take away some of the CEO's power to reward directors and put them under his/her sway and give the directors "substantial" positive incentives "to enhance shareholder value"[39]

More direct government intervention

  • Have congress pass a law that sets a ratio of pay between a firm's CEO and its most typical workers (25X for example) and encourages corporations not to exceed it by
    • denying them government contracts if they do[19] or
    • denying corporate income tax deductions on executive compensation in excess of the ratio. The Institute for Policy Studies estimates that capping "tax deductibility at no more than 25 times the pay of the lowest-paid worker could generate more than $5 billion in extra federal revenues per year."[40] In 2009, California Representative Barbara Lee was pushing legislation that would cap deductibility at that ratio.[41]
  • Raise the tax paid by private equity managers by eliminating the "carried interest" loophole which taxes the profit share portion of their compensation at only 15 percent (the long term capital gains rate). Although private equity managers make up only a fraction of all executives, this costs the US Treasury an estimated $2.7 billion, according to Congress's Joint Committee on Taxation.[42]
  • Set a maximum wage or maximum compensation for executives. This was enacted in early 2009—$500,000 per year being the maximum—for companies receiving extraordinary financial assistance from US taxpayers.[43]

The authors recommend lengthening the vesting period of equity and options.

 

V. CONCLUSION

There are at least two quite different goals underlying the current focus on high executive compensation:

*        concern about poor corporate governance; and

*        concern about growing inequality.

Concern about poor corporate governance:

Part III presents the leading argument among law and economics scholars for concentrating only on economic efficiency when applying legal rules. This argument states that we should set most laws at their efficient level, then achieve the redistribution of income and wealth that we desire through tax and transfer policies. I argue that this strategy does not take into account political constraints that may block that implementation of policy. Aiming to reduce executive compensation may be a more politically feasible way of reducing inequality and is worth pursuing for that reason

Part IV presents a different argument for focusing only on the corporate governance concern. According to this argument, executive compensation only accounts for a very small part of the growth in general inequality. Even if it is appropriate to use legal rules to try to reduce inequality, using executive compensation rules for that purpose is ineffective because executive compensation is just too small a part of the problem. I am more agnostic about this argument, but I am inclined to believe that this reasoning should not block positing reduced inequality as a goal of executive compensation regulation. There is certainly some evidence in support of this argument against targeting inequality through executive compensation, but I also consider some counter evidence and argue that we need more thorough and varied empirical inquiries into what role executive compensation has played in the growth of inequality in the United States. Overall, reforming executive compensation seems likely to be a moderately important part of a broader strategy of reducing inequality in the United States. Thus, I condude that neither of the two positions analyzed in this article should dissuade us from pursuing reduced inequality as one of the guiding goals of executive compensation regulation.

Although advocates who are motivated by differing concerns may still be able to agree on many measures for regulating executive compensation, sometimes they are likely to disagree. Thus, it is helpful to think about whether both concerns provide potentially valid reasons for regulation.

In this essay, I have attempted to make one small step in thinking about that question. Most corporate law scholars seem to care only about corporate governance, not inequality. This position seems to put them at odds with most politicians on the issue of executive pay. My inquiry has been whether the scholars are justified in ignoring the effect of corporate pay on inequality. In addressing that question, I have considered two different arguments in favor of ignoring the inequality concern.  Neither of these arguments are frequently articulated in the corporate law literature.

Indeed, the lack of concern with general inequality is not itself often explicitly articulated; however, it appears to underlie most scholarship in the area. Thus, even if one believed that neither of the arguments that I have considered here was correct, one could still choose to ignore the inequality concern for some other reason. I do think, however, that these two arguments are among the very best available to defend the prevailing scholarly implicit consensus. Hence, I hope to have removed some intellectual roadblocks to using the reduction of inequality as a goal in regulating executive compensation.

Of the two arguments, I think the first-the broader, more theoretical argument-is the weaker. The Kaplow and Shavell argument for using tax policy alone to correct for excessive inequality is built on shaky assumptions and ignores much political reality. There is not much reason to accept it as a general proposition, and in the particular case of executive compensation, it is not very persuasive. The second argument, though, should be of much greater concern for those tempted to use executive pay regulation to address economic inequality.  We still need better evidence as to how much of a role executive pay has played in growing inequality, but the answer seems to be that its role is fairly modest at most. Those who really want to tackle growing inequality will have to advance many other policy reforms as well. Still, regulating executive pay is likely to be a sensible and decently important part of an overall package of reforms.

Of course, in this brief essay, I have done nothing to show why we should care about inequality as a problem in the first place.  I have not even produced Kaplan and Rauh raise several methodological objections to the Dew-Becker and Gordon article.  See Kaplan & Rauh, supra note 26, at 6. NEW YORK LAW SCHOOL LAW REVIEW evidence to show that inequality has grown significantly in the last few decades; I have simply assumed this disputed point, although there is plenty of evidence for it. 43 Even assuming inequality exists and that we should want to reduce it, I have not showed that the benefits of doing so exceed the costs of any particular reform proposal. Nor have I laid out what different policy proposals might follow for executive compensation were we to take reducing inequality seriously as an important goal in this area. Others have addressed those points elsewhere. My limited task here has been to consider whether either of the two arguments presented in this essay can justify ignoring inequality as a concern in regulating executive compensation. My provisional answer is no. If corporate law scholars want to continue ignoring reduced inequality as a goal, they should devote more effort to defending that choice. Better still, they should accept reducing inequality as a legitimate and important goal in our efforts to regulate executive compensation.

43. See generally Autor, supra no