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Executive Compensation How Does Pay Influence Decisions and Governance?

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Executive Compensation How Does Pay Influence Decisions and Governance? Executive Compensation How does pay influence decisions and governance? A white paper by the Sanford C. Bernstein & Co. EMBA Student Leadership and Ethics Board Daniel Jurow ‘09 Sophie Romana ‘08 James Deasy ‘09 Walter Haddick ‘09 Natalie Napierala ‘08 Tiffany Cale Contents EXECUTIVE SUMMARY ..........................................................................................................................1 EXECUTIVE CoMpEnsation And dECISIon-MAkIng ....................................................................2 Executive Compensation and Risk Management—Learning from Prospect Theory ........................ 2 Compensation Levels, Bankruptcy and M&A ......................................................................................3 Executive Compensation and Product Quality ....................................................................................3 Executive Compensation and Processes versus Outcomes...............................................................3 SUppLY And dEMAnd oF EXECUTIVE TALEnT ................................................................................4 Increased Competition Fuels Demand for CEO Talent .......................................................................4 Globalization and Manager Discretion Theory ....................................................................................5 Lone Ranger Theory—“Superstar CEOs” .............................................................................................5 Lone Ranger Theory Unmasked............................................................................................................6 REgULAToRY RESPONSES And UnInTEndEd ConSEQUEnCES ................................................ 7 Tax Code Changes ................................................................................................................................8 Disclosure Rules ....................................................................................................................................8 Say On Pay .............................................................................................................................................9 Clawbacks............................................................................................................................................10 gLoBAL InnoVATIonS In EXECUTIVE CoMpEnSATIon POLICY .................................................11 France: the End of the reign of “Chairman & CEO” ...........................................................................11 Netherlands: Assessing the Potential Exposure and Risks of Remuneration ..................................12 Japan: The End of the Bureaucrat CEO? ...........................................................................................13 Germany: The Birth of the Environmental CEO..................................................................................13 ConCLUSIon .........................................................................................................................................15 Is There More to Compensation Than Just Money?...........................................................................16 AppEndIX: Executive compensation limits under Treasury Guideline 15 and the Stimulus Bill .......17 Executive Compensation Executive Summary biases. For example, when excessive executive compensation occurs in economically significant amounts for a firm, it can In the wake of the extraordinary collapse of the housing result in suboptimal managerial decision making related to market bubble and the ensuing global recession, numerous mergers and acquisitions, lower product quality, and too great traditional assumptions—such as lax la issez-fa ire banking an emphasis on outcomes rather than managerial processes. oversight and the primacy of shareholder value maximization— are under attack as root causes of the financial system Because senior executive compensation packages are settled meltdown. Another such assumption under fresh attack is the in a negotiation between the executives and board members infallibility of our carefully designed remuneration systems for acting on behalf of the company’s internal and external senior executives in publicly owned corporations, particularly shareholders, we also examine in this White Paper whether in the banking sector, where performance rewards reached these agreements are negotiated fairly—at arms’ length—such historical highs, resulting not in great performance but that the clearing price for executive talent is economically outsized risk-taking. efficient. Though there are aggregate data that directionally support the argument that executive pay merely reflects the In the face of aggregate data showing a dramatic increase in going rate for scarce talent, this topic is perhaps the most the ratio of CEO pay to average-worker pay (from 24 times hotly contested in the study of executive compensation, as in 1965 to 262 times in 2005), particularly since the rise of a litany of potential distortions to the process are raised. stock option and restricted stock awards in the early 1990s, Economic theory has not, thus far, fully captured the inner arguments in defense of rising executive compensation dynamics of director-manager power relationships and packages often rely on the following to justify the trend: information asymmetries and the Student Leadership and efficient-market theory—a global shortage of superior Ethics Board therefore cannot conclude that current pay executive talent causes their pay to rise, and agency theory— practices, in total, represent the optimal price shareholders the best way to ensure shareholder-manager alignment is to should be willing to pay for senior talent. make the managers into equity-holders. But when stunning management failures and unprecedented destruction of Because the US government has already intervened since shareholder value are brought into the light, it becomes October 2008 to legislate changes to executive compensation increasingly difficult to defend current executive remunerative schemes for publicly owned firms, we next examine the policies with these economic underpinnings. efficacy of the government’s toolset in capping executive pay, including taxation, disclosure rules, and the restrictions At the same time, the public debate, particularly in the embedded in TARP including “say on pay” and clawbacks. The media, frequently boils down to a single, difficult question of Board concludes that US government regulation of executive whether a firm’s pay packages are “fair”—fair to the company’s pay has historically been incomplete, ill conceived, and shareholders, fair to its other employees, or otherwise fair to ineffective—and thus rife with unintended consequences. the community at large and society in general. Should any one We then look globally at important developments regarding person be able to earn hundreds of millions of dollars over the compensation regulation, particularly in Europe, and a robust course of a few years in a bull market, or at their retirement, cataloguing of the current and proposed US regulatory or when fired, particularly when it seems like they are writing changes follows as an appendix. their own check? The aim of this White Paper is not to vilify corporate boards The EMBA Student Leadership and Ethics Board members or the executives whose compensation is in question; nor is recognize that fairness is a limited tool for understanding it to prescribe regulatory barriers to excessive remuneration. and responding to the debate on executive compensation. It In our investigation, we have learned that, by and large, key is, of course, a relative concept that changes depending on stakeholders have tried to make the best decisions possible whose vantage point one takes when analyzing the fairness with a limited amount of information; nonetheless, in an of a particular pay policy. In this, the Board’s inaugural White increasingly complex process, misunderstanding the economic Paper, we have deliberately chosen not to study the topic and managerial underpinnings of compensation design is from the perspective of a single audience, and therefore we the most frequent cause of egregious error. We conclude do not attempt to conclude whether trends in pay policies and our White Paper, then, with a summary of findings and key regulatory responses in the United States have been fair. questions for boards, compensation consultants, investors, analysts, executives, employees, and researchers to ask as Instead, we examine the issue of excessive executive they grapple with the difficulties of modern compensation compensation by first asking if it matters at all whether CEOs design. and senior executives of publicly owned firms are overpaid. In our analysis of the current literature, interviews with academics, executives, and compensation consultants, the Board does not attempt to determine a direct inflection point where a given level of compensation correlated directly to a diminished return to shareholders, though such research would add great value to this debate. Rather, we learn that certain human decision-making biases are exacerbated as a person reaches increasingly large absolute and relative (compared to peers) amounts of wealth. The agency model, in theory and practice, does not mitigate these decision-making Executive Compensation 1 Executive Compensation and more to an outside investor with balanced portfolio than they Decision-Making are to a manager
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