The Impact of Compensation on Effective Corporate Governance

By Blake                                                                                        August 7, 2013

Professor: XXXXX

 

Final Exam: Wed August 7, 2013 3:15-6:15

 

Material Covered: June 25, 2013- August 7, 2013 M,W 3:15-6:15 and beyond

Lorsch; Mallin; Articles on Corportate Governance, Schleifer and Vishny, et al.

 

Questions: Choose 3 of 6.

 

 

§     I.        Question  1:  The Impact of Compensation on Effective Corporate Governance

 

References:    Brickly, Bhagat, and Lease:  “The Impact of Long- Range Managerial Compensation Plans on Shareholder Wealth,” 1985

                   Lorsch, “The Future of Boards,” HBS 2010

                    Mallin, “Corporate Governance” 2010

                    Vishny and Schleifer, “A Survey of Corporate Governance,” 1997

                   Moran and Beggs, Various Articles and In Class Discussions on Corporate Governance, Harvard, 2013.

 

(Introduction to part a, b, c)

The escalating compensation packages paid to a CEO (or other top senior manager), dysfunctional behavior associated with taking inordinate risk and being paid bonuses in spite (or perhaps because) of it, and the all too often lump-sum payments made to a CEO that are often not tied to performance (i.e. golden parachutes) have been under the spotlight. Since 2007 at the start of the Financial Crisis, the aforementioned highlight some of the worst features of American corporate governance structure. There needs to be a rethinking of the manner in which CEOs and other senior executives are compensated, because the way compensation is allocated can be a powerful signal not just to shareholders but to corporate culture in America and wider society (Lorsch, et. al., 2010).  In the following paragraphs, we will address the current structure of the corporate executive compensation plan (and how it got that way), whether or not corporate executives and corporate boards are paid appropriately, and recommendations for reform based on what was learned in this course.

(Part a and b). First, there is no right answer as to whether or not corporate executives and corporate boards are “paid appropriately,” indeed, some shareholders and stakeholders would argue that they need to be paid more. In attempting to answer this question we must explore what they are paid, how we got here, and concerns of the current compensation structure. In most countries with Common Law (U.K, U.S) and some with Civil Law (rest of Europe) CEOs are paid in the millions of dollars and in the many multiples compared to the average worker: in the U.S. the CEO was paid 44 times the average worker in 1980, and 344 times the average worker by 2007 (Lorsch, et.al as shown in a long survey on compensation, 2010). What is clear is that compensation for the CEO (and other senior management) has spiraled higher and higher, and for board members, though normally not nearly as high as the CEO, more stock options and other pay bonuses has also lead to an all-time compensation high. One concern that this spiral for executive’s and board’s compensation is not appropriate is the following: there exists a market fallacy that there is senior level competitive talent flow. However, the evidence is clear that there is not a sufficiently established correlation between executive compensation plans and the company’s economic performance. With regards to the board: the board is often composed of individuals who do not properly hold the CEO accountable, who may be staggered, who may be spread too thin in their committee assignments and outside obligations, and who do not meet enough or ask the necessary questions to warrant a high salary and high stock + option bonuses. Often, the compensation committee just pays management, and perhaps even directors, more and more just to be in the “top-quartile” in their 10-K CD&A report so they can look good in front of other companies and in front of their shareholders. What’s concerning is that board compensation is arguably inappropriate because committees do not properly do their job since they do not meet enough nor ask searching questions and since boards all too often do not do their job of holding executives or directors who take inordinate risk accountable (Mallin and Moran 2010). All in all, the argument is clear: widely accepted compensation plans for directors and for executives are not appropriately justified because they do not properly link the management’s and the Board’s bonuses to the company’s long term economic performance, are inherently dependent on the “market fallacy” of talent flows, compensation committees and boards as a whole do a poor job in holding others (and themselves) accountable, and executives and boards often have little to no control on macro economic outputs of a company as individuals but have better control as a group.

(Part c) According to Lorsch, Mallin, et al., compensation for boards and executives can be changed to better align their interest with the interest of shareholders by being more inclusive in their accountability to stakeholders as well as more effectively addressing the agency theory (as well as agency costs) to maximize shareholder value. The key driving forces of the economic theory surrounding reforms of the management compensation system is to first ensure institutional arrangements that designate independent directors or committees to communicate with shareholders. Additionally, the directors should be paid in stock (holdings should equal 5-25% of net worth) and the nominating committee should elicit suggestions from large shareholders and consider suggestions from all shareholders. Second, there should be management compensation reforms by: having accounting and compensation systems based on creating shareholder value and long term corporate health via the actions of qualified individuals on the boards. (Mallin, 2010). Compensation should be tied to marginal changes in performance and long-term objectives (i.e. 35% expected bonus, 25% long term objectives- with downside risk, etc.). Additionally, director compensation should mostly come in stock based on company’s short term and long term performance (Vishny and Schleifer, 1997). Lastly, to address the problem in the agency theory of misaligned interest, directors and executives should have significant stakes in the company, or “skin in the game” (Miller and Modigliani, 1978-1985).

(Conclusion to parts a, b, and c)

In summary, we need to recognize that the term “appropriately paid,” when referring to the compensation of executives and boards alike, could be tricky to define, since the assumptions underlining it must first be better understood. First, there is a need to recognize that incentives only have motivational power if they reward outcomes over which executives have control (Lorsch, Brickly, Bhagat, and Lease, 1995, 2010). Corporate leaders and boards (because they receive the bulk of their compensation in stock and options) should be provided with company economic outcomes (which they may affect), not for gyrations in the stock market, (which they can’t truly affect). For both boards and executives, incentive plans in their compensation package should have “lines of sight” between the effort of the executives, the accountability level (especially of the compensation committee) of the board, the results they achieve, and the rewards they are paid. (“Lines of sight” is a term attributed to Lorsch, 2010). The executives, and in particular the board as a whole, not just the compensation committee, positively affect  their corporate governances if they send a message to all connected to the company that the ultimate purpose of its board and management is to focus on achieving corporate health. The compensation package should be a means for that, not an end. According to Moran, however, some companies may very well outlast their function and stakeholders are better served if resource are not spent in keeping a dying elephant alive (Moran, Harvard, 2013). All in all, compensation improves corporate governance within the company if the board recognizes and acts on the fact that: long term health depends on a collaborative effort of a group of senior executives, rewarding group behavior as well as individual behavior (when appropriate) is beneficial; compensation packages should include not only monetary awards for board members and executives, but also non-monetary awards such as promotions to more responsible positions; tie compensation to long term performance, a minimum bench mark of several years, not one year or less, and eliminate lump-sum payments not tied to performance (golden parachutes, make whole payments). The compensation committee must recognize that its job in creating compensation plans for “outside” executives is a matter of negotiation, not just acquiescence so the board and company looks good. Therefore, when talking about compensation, all parties should be prepared for processes of negotiations.