Customer Reviews

Pay without Performance: The Unfulfilled Promise of Executive Compensation

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In his letter to Berkshire Hathaway investors in 2004, Warren Buffett wrote:

"In judging whether Corporate America is serious about reforming itself, CEO pay remains the acid test. To date, the results aren't encouraging."


PAY WITHOUT PERFORMANCE expands on Buffett's comments and provides a research base to support it. The authors also suggests what needs to be done to effectively deal with this "acid test" of corporate reform.

Lucian Bebchuck is the William J. Friedman and Alicia Townsend Friedman Professor of Law, Economics, and Finance at the Harvard University School of Law. He is also a Research Associate of the National Bureau of Economic Research. Bebchuck has a doctorate in economics from Harvard and a law degree from Harvard. Jesse Fried is Professor of Law at the Boalt School of Law at the University of California at Berkeley. Prior to his academic career, he practiced tax law in Boston. Fried holds degrees in economics and law from Harvard University.

The authors argue that Sarbanes Oxley reforms may have marginally improved the independence of Boards from CEOs. But Board members are still not dependent enough upon the shareholders they are supposed to represent. This dysfunctionality in the system makes it impossible for Compensation Committees to conduct true "arms length" compensation discussions with CEOs.

The result is a CEO compensation system that tends to verbalize pay for performance without actually achieving it for CEOs.

When CEO pay is uncoupled from performance, Board members seek to avoid having to pay "outrage costs" from the shareholders. One of the ways of avoiding paying "outrage costs" is to make it difficult for the average shareholder to truly understand the level of CEO compensation and how that level is unrelated to corporate performance. The authors call these techniques compensation "camouflage."

The authors are quite clear in describing examples and providing research to support their ideas.

They propose remedies that focus on two themes: tying CEO compensation to real corporate performance and tying Boards to shareholders.

With respect to tying CEO compensation to real corporate performance, they would seek to remove "windfall" and "rising tide" factors from CEO bonus/option payments. Windfall factors involve one-time rises in shareholder value. An example might include a sharp rise in stock value because the CEO makes a decision to downsize or receives a large payment from the successful settlement of a law-suit. Another windfall factor might be allowing accounting for revenue to move from one quarter to the next so that the stock will look like it is rising at a steeper angle. "Rising tide" factors would factor out increases in CEO compensation because an average company is benefiting from average industry growth that impacts all average players. These issues merit serious consideration from Compensation Committees. And Warren Buffet is correct in his assessment that most Boards have thus far failed the "acid test."

With respect to tying Boards to shareholders, the authors would terminate staggered Board elections. They would have the entire Board be up for election at the same time. I am reasonably sure that the authors' remedy here would be worse than the disease they are seeking to cure.

A Board of Directors is a work group that is supposed to be thoughtful and deliberative in nature. Their proposal would make the Board a far more responsive body at the expense of thoughtfulness. To make an analogy, the U.S. Senate is a more effective deliberative body because it is less subject to the passions of the moment. And it is less subject to the passions of the moment because only 33% of its members are up for election every two years. The U.S. House of Representative is far less effective as a deliberative body. And one of the reasons is that all members are accountable to the voters every two years.

Regardless of whether you agree or disagree with their analysis, their key theme deserves consideration: if Boards allow CEO pay to be unrelated to corporate performance, it is important to define the problem correctly. The problem is not about greedy or lazy individuals. The problem is about a system that is not rewarding leaders for doing the right things.

As Warren Buffet has said, fixing that system will be the "acid test" of the free enterprise system in the 21St Century.

Larry Stybel
www.boardoptions.com
lstybel@boardoptions.com

I have been reading Pay Without Performance: The Unfulfilled Promise of Executive Compensation by (Harvard law professor) Lucian Bebchuk and (Boalt law prof) Jesse Fried. Bebchuk and Fried take issue with the standard academic account of executive compensation, which goes something like this: Executive compensation is a classic agency cost problem. Although CEOs and other executives are agents of the corporation and its shareholders, they have incentives to shirk. Indeed, they have incentives to behave opportunistically - i.e., to maximize their own wealth and perks at the expense of their shareholder principals. Accordingly, executive compensation schemes must be designed in ways that constrain shirking and opportunism; in other words, executive compensation schemes should strive to align executives' interests with those of the shareholders. In the literature, this usually leads to a recommendation of some sort of performance-based pay scheme, typically entailing the use of stock options.

Bebchuk and Fried do a good job of explaining why executive compensation schemes fail adequately to align managerial and shareholder interests. In brief, they make the very sensible point that managerial influence over the board of directors taints the process by which executive compensation is set. In other words, the system by which agency costs are to be checked is itself tainted by an agency cost problem.

I get off the boat, however, when it comes to the solution. Bebchuk and Fried want to displace the time-tested corporate governance system of director primacy with an untested new system based on shareholder primacy. As regular readers of my academic work know, this is anathema in my book. (I'm writing a review of their book for the Texas Law Review, which will focus on this point, and which should be available on www.ssrn.com in a month or two.)

Having said that, however, Bebchuk and Fried are to be praised for having written a book that makes highly technical doctrinal and economic analysis accessible to the educated lay reader, while not dumbing down some very sophisticated analysis. As a result, the book remains useful to the specialist as well. It is definitely a book that anyone interested in corporate governance and executive compensation ought to own.

Other reviewers have made many excellent points. I'll try to avoid duplicating their comments here...

- This book is written by two law school professors. They carefully and precisely make their case. Even as they make their points, they consider possible counter-arguments, and then cite further evidence to answer these objections. They clearly and methodically make their case.

- They start from a somewhat unique set of premises.
--> Whereas many critiques of executive compensation approach the large amounts as an egregious breach of egalitarian values, the authors are indifferent about the size of exec compensation.
--> On the flip side, while many would excuse large compensation packages as necessary to obtain top talent in a tight market, the authors come from a perspective of "if shareholders, as the *owners* of the company, can pay a lot for exec talent, but not get good returns, what's wrong with the market for executive talent?" This book challenges long held assumptions price always equals quality when shopping for top management talent.

- For a book that cites hard economic facts as often as they do, it also does a great job of analyzing the human element of this market to provide insights that seem missing in public debate about executive pay.

- Even as someone who is an outsider both to corporate governance and executive compenation, I found this book accessible and an enjoyable read. As a shareholder of a number of companies, I intend to take opportunities to reform this clearly corrupt system.

Highly recommend this book for everyone who owns shares in a publicly traded company, or works for one.

This is an excellent book. The authors have done extensive research from both a legal and economic standpoint to support their hypothesis that companies with better Board governance, more accountable CEOs, better structured CEO compensation packages perform much better than the others. They show better operating performance resulting in superior shareholder value creation over the long term.

Their diagnostic of what ales executive compensations are so well grounded they have become common knowledge for any readers of the financial press over the past couple of decades. Compensation of CEOs and other top officers has become insane. The structure of equity compensation has become so tilted in the CEOs favor that as the authors indicate they really don't have to perform. If they perform poorly they make a boatload of money. If their performance is about average they make an astronomical amount of money. What kind of pay-for-performance is this?

Other reviewers have had surprisingly strong reactions to the authors' proposals to redress the effectiveness of executive compensation. I found that surprising given that the authors' proposals are not that radical to begin with. They boil down to restructuring equity compensation so they reflect targets and vesting periods that make economic sense and align the economic interest of the executive with the long-term interest of shareholders. Their proposals also entails a massive shift of power from entrenched Board members plagued with serious conflict of interest to the shareholders of the companies who are the ones bearing the full brunt of the equity risk. In the days of the Enron, Tyco International, Arthur Andersen recent scandals, I find the authors recommendations rather sound. I do think a shift from Board to shareholder power would do a good deal to restore the integrity of certain executives, the transparency and the quality of accounting and financial disclosure.

Thus, I really think you will enjoy and learn a lot from this book. In a similar fashion, if you want to educate yourself regarding how movie stars are paid, and why just like CEOs they may be grossly overpaid I strongly recommend the recently released book "The Big Picture" by Edward Jay Epstein. This is another fascinating point that touches on the sensitive topic of a privilege group that earns a staggering amount of money hardly justifiable on any grounds.

Superb exposé on the appalling lack of ethical fortitude amongst our country's business elite--namely the chief executives, their officers, and sadly those given the responsibility for representing the shareholders' interests, the directors. The adage "no one looks after your money like you do" is well-remembered by the reader of "Pay without Performance."

Primarily due to a phenomenon know as "interlocking" executives cross-pollinate their respective boards with a surprisingly shallow gene pool leaving the ordinary shareholder hardly independently represented at all.

Bebchuk and Fried do well by illustrating the mockery known as "independent compensation committees" when these committees are typically hired under the corporation's own HR department usually by CEO referral. Tough to place credence in any recommendation so biased from the outset!

Now only two years after the publication of this book, and several studies cited therein, the SEC has launched a sweeping probe into options timing--in particular boards who allowed their executives to cherry-pick the grant dates of options to take advantage of inside information to profit at the expense of shareholders at large. Criminal, yet condoned by far too many corporate "leaders."

Ultimately the question arises--Is the solution for shareholders to vote via increased legislation or with their wallet by only investing in corporations fully aligned with their interests? The authors make an excellent case for instituting a performance-based compensation system as well as supporting the role of making directors truly independent and not pawns of the CEO. Fantastic resource on corporate culture run amok--the elusive 5 Stars!

Small business owners know exactly how much their employees are making to a penny. But when it comes to owning stocks, these same individuals do not have the slightest clue how much the managers of the companies that they own make. Executive compensation is not as simple as the compensation for lower level employees because executive compensation includes salary, bonuses, stock options, and so on. This book makes executive compensation clearer. I highly recommend it to all investors.

- Mariusz Skonieczny, author of Why Are We So Clueless about the Stock Market? Learn how to invest your money, how to pick stocks, and how to make money in the stock market

So sang Leonard Cohen in 1988's "Everybody Knows".

The game of executive compensation, this fascinating study of CEO pay demonstrates, is definitely fixed. In theory, executives are hired by a company's impartial board of directors, who negotiate with them at "arm's lengths". If the CEO of large public owned companies receive huge compensation - and they do - that's because they are worth it. Much of the compensation is tied to the firm and the CEO's performance. Thus the CEO has an incentive to ably serve shareholder's interests. As Gordon Gekko put it (Wall Street (20th Anniversary Edition)): "Greed is Good".

Or so goes the theory.

But everybody knows that the theory is nonsense; Lucian Bebchuk and Jesse Fried's study confirms that common sense perception: That CEO compensation is a game of insiders enriching themselves (and each other) at the outsiders' expense.

Far from being "arm's lengths" negotiators, the directors of a company are more or less stooges of the Firm's CEO. They don't quite serve at his pleasure, but he has ample control. Until the 2003 reforms, while the directors in the "compensation committee" had to be "independent" (that is, not part of the company), the directors on the "nominating committee" that picked the directors were not. Thus the CEO might have sat on, and maybe chaired, the nominating committee. After the Enron scandal and the 2003 reforms, the members of the "nominating committee" have to be independent. But that begs the question - who is an independent director? Well, Independent directors are people who may receive compensation from the CEO controlled company - but no more than 100,000 US dollars a year. And that does not include perks given to family members, donated to charities you favor (or work in), or, with some limitations, to companies you are involved in (p. 28). Director Independence is more of less a sham. And even if it weren't, Directors have little incentive to curb CEO compensation - many of them are or were CEOs themselves. Sometimes it's an "I'll rub your back and you'll rub mine" deal where the CEO of one company is a director of another company who's CEO is a director of his company. At any case, the atmosphere among the directors is friendly, collegial and non-confrontational - as one board member puts it, it's somewhat like a club (p. 32).

There are few effective checks on the powers of CEOs to feast on the shareholder's money. The CEO's compensation is not a large enough issue for the market to respond to, and the Courts generally refuse to intervene in decisions by professional executives and directors.

The best defense against CEO abuse is what Bebchuk and Fried call "outrage" - the bad publicity caused by the discovery of the executives' scandalous self dealing. Outrage does check some of the worst abuses. Fortunately for the CEOs, though, there is a way to give themselves large compensation that is not sensitive to their performance: camouflage. Executives and directors have found ingenious ways of devising gigantic rewards that are hard to recognize as rewards. Whether in the form of perks (such as unlimited use of the corporate jet long after retirement), fat consultancy fees (for which little actual consulting is done), or so-called "split dollar life insurance policies" (don't ask). But the worst offenders are probably the stock options. Until recently, chief executives would get options that were not indexed to the market or the sector -meaning that the executive would benefit from any increase in the company's stock price, even one that he had nothing to do with. And if the share's price went down - no worry, the option's target price would go down as well. "Heads, I win, Tails - I also win".

Fried and Bebchuk paint a gloomy picture of the current state of affairs. They acknowledge that their work is primarily descriptive rather than normative, but they still offer two chapters of solutions.

The first chapter focuses on various reforms, outlawing the most outrageous current schemes. That sounds to me like a good but essentially hopeless idea: No matter how many loopholes regulators would close, CEOs and their directors would always find new loopholes to exploit.

More promising is the final chapter, which focuses on ways to improve corporate democracy. Currently, the firm's directors are more or less immune from challenges by shareholders. Bebchuk and Fried offer reforms that could make them more accountable.

But to what end? The problem of collective action (one shareholder's actions serve the interests of non-active shareholders; this everyone has an incentive to do little) plagues corporations. Could better corporate governance really overcome it? I doubt it.

I wish Fried and Bebchuk would expand their watch to look at executive compensation outside the US, or even in different eras of US history. In The Conscience of a Liberal,Paul Krugman argues that the massive pay to US executives is not inevitable - it is the results of specific political and economic forces in US society. Maybe the US can learn from the experience of others.

Bebchuk and Fried's book is well written and very interesting, even if it is somewhat too detailed and technical for the casual reader. I recommend it if you want to know the nuts and Bolts of what "everybody knows".

Pay without Performance: The Unfulfilled Promise of Executive Compensation was the best book published in 2004 in the field of corporate governance. Lucian Bebchuk and Jesse Fried focus on one aspect of corporate governance, executive pay, and clearly demonstrate that many features of executive pay are better explained as a result of shear managerial power, rather than arm's-length bargaining by boards of directors.

After thoughtful analysis, they find "systematic use of compensation practices that obscure the amount and performance insensitivity of pay, and the showering of gratuitous benefits on departing executives." The cost of current corporate governance systems is weak incentives to reduce managerial slack or increase shareholder value and "perverse incentives" for managers to "misreport results, suppress bad news, and choose projects and strategies that are less transparent."

Their recommendations on improving executive compensation are clearly aimed at eliminating or reducing some of the most egregious of the practices of those they document. Interestingly, the recommendations are written to shareholders, apparently because there is little likelihood such reforms will be raised by even "independent" directors without further corporate governance reforms. A few examples are as follows:

* To reduce windfalls in equity-based plans, shareholder should encourage that at least some of the gains in stock price due to general market or industry movements be filtered out. "At a minimum, option exercise prices should be adjusted so that managers are rewarded for stock price gains only to the extent that they exceed those gains (if any) enjoyed by the most poorly performing firms."

* Executives should be prohibited from hedging or derivative transactions to reduce their exposure to fluctuations in the company's stock and should be required to disclose proposed sale of shares in advance to reduce perverse incentives to benefit from short-term gains that don't reflect long-term prospects.

* Do not provide large payments to executives who depart because of poor performance.

* The compensation table should include and should place a dollar value on all forms of "stealth" compensation, such as pensions, deferred compensation, postretirement perks and consulting requirements.

* Allow shareholders to propose and vote on binding rules for executive compensation arrangements.

Although many directors now own shares, their related financial incentives are still too weak to induce them to take on the unpleasant task of firmly negotiating with their CEOs. Recent reforms requiring a majority of independent directors, and their exclusive use on compensation and nominating committees, may be beneficial but "cannot be relied on" to produce the kind of arm's length relationship between directors and executives needed. CEOs retain influence over director compensation and rewards, as well as social and psychological rewards. "The key to reelection is remaining on the company's slate." Remaining on good terms with the CEO and their director allies continues to be the best strategy for renominatation.

Executive compensation "requires case-specific knowledge and thus is best designed by informed decision makers." They conclude, "While we should lessen directors' dependence on shareholder, we should also seek to increase directors' dependence on shareholders." After discussing the now failed "open access" SEC proposal to grant shareholders the right to place a token number of candidates on the ballot after specified "triggering events," the authors propose the following significant corporate governance reforms:

* Access to the ballot should be granted to any group of shareholders that satisfies certain ownership thresholds. Their example is 5%, held for at least a year.

* Such slates should be able to replace all or most incumbent directors in any given year.

* Companies should be required to distribute the proxy statements of shareholder nominated candidates and should be required to reimburse reasonable costs if they garner "sufficient support."

* Legal reforms should require or encourage firms to have all directors stand for election together.

* Shareholders should be given the power to initiate and approved proposals to reincorporate and/or adopt charter amendments.

In their conclusion, the authors recognize the "political obstacles to the necessary legal reforms are substantial" and that "corporate management has long been a powerful interest group." The demand for reforms must be greater than management's power to block them. "This can happen only if investors and policy makers recognize the substantial costs that current arrangement impose." Pay without Performance will certainly contribute to such recognition. It should be required reading for every fund fiduciary, SEC board and staff, as well as all members of Congress. Shareholders should read will sitting down.

Jesse Fried is a corporate compensation grandstander who seems to show up at every scandal (recently the backdating scandal). Unfortunately it is obvious he has no "real world" management experience!

On Mr. Frieds allegation that stock option expenses are "hidden" by CEOs, corporate types in order to increase their bonus targets:
- CEO compensation (bonus targets etc) are almost NEVER based on non cash expenses, such as stock options expenses. Bonus targets are typically cash flow based only (meaning it doesn't matter to CEO bonus targets if stock options expenses are high or not) and anyone writing a book on executive compensation should KNOW THIS!

On Mr. Frieds allegation that the only possible reason for stock option backdating (without expensing) is to HIDE expenses to the company, presumably to increase the mysterious "bonus targets" above:
- Stock option backdating is used to give a hiring bonus that is only redeemable in 4 years and only if the company continues to perform (reflected in the stock price). The "locked in" and vesting aspects of stock options backdating are the reason they are used, resulting in significant value to company that cash hiring bonuses do not provide. These are not used to hide expenses and anyone who had ever seen these used in a real world setting would know this.

In my opinion, Mr. Fried needs to hire a management consultant who has actually PERFORMED AS A MANAGER before he writes anymore assessments on the state of executive pay.