_________________________________________________________________
E M P L O Y E E B E N E F I T S , C O M P E N S A T I O N
& P E N S I O N L A W
Vol. 6, No. 15: August 11, 2005
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Publisher: Employment, Labor, Compensation & Pension Law Journals
a division of
Social Science Electronic Publishing, Inc. (SSEP)
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Editor: PAMELA PERUN
Urban Institute
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Copyright: SSEP, Inc. 2005. All rights reserved.
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Topic of This Issue:
Executive Compensation
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T A B L E of C O N T E N T S
_________________________________________________________________
NEW and FORTHCOMING ARTICLES
"CEO Compensation and the Seasoned Equity Offering Decision"
Managerial and Decision Economics, Forthcoming
JOSEPH F. BRAZEL
North Carolina State University
Department of Accounting
ELIZABETH WEBB
Federal Reserve Bank of Philadelphia
"Anatomy of a Paradigm Shift: An Overview of the Deferred
Compensation Provisions of the American Jobs Creation Act of
2004"
Tax Management Compensation Planning Journal, Vol. 33, p.
31, February 4, 2005
ALDEN J. BIANCHI
Mintz Levin
"Executive Compensation, Corporate Governance, and the
Partner-Manager"
University of Illinois Law Review, Forthcoming
RICHARD A. BOOTH
University of Maryland School of Law
WORKING PAPERS
"Pay Me Later: Inside Debt and its Role in Managerial
Compensation"
DAVID YERMACK
New York University
Department of Finance
RANGARAJAN K. SUNDARAM
New York University
Department of Finance
"Board Independence and the Design of Executive Compensation"
RAVI SINGH
Harvard University
Negotiations, Organizations and Markets Unit
"Managerial Incentives in Highly Levered Firms"
ALEX EDMANS
Massachusetts Institute of Technology (MIT)
Sloan School of Management
"Pay without Performance: Overview of the Issues"
LUCIAN ARYE BEBCHUK
Harvard Law School
National Bureau of Economic Research (NBER)
JESSE M. FRIED
University of California, Berkeley - School of Law
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N E W and F O R T H C O M I N G Articles
_________________________________________________________________
"CEO Compensation and the Seasoned Equity Offering Decision"
Managerial and Decision Economics, Forthcoming
BY: JOSEPH F. BRAZEL
North Carolina State University
Department of Accounting
ELIZABETH WEBB
Federal Reserve Bank of Philadelphia
Contact: JOSEPH F. BRAZEL
Email: Mailto:joe_brazel@ncsu.edu
Postal: North Carolina State University
Department of Accounting
Raleigh, NC 27695-8113 UNITED STATES
Phone: 919-513-1772
Co-Auth: ELIZABETH WEBB
Email: Mailto:elizabeth.webb@phil.frb.org
Postal: Federal Reserve Bank of Philadelphia
Ten Independence Mall
Philadelphia, PA 19106-1574 UNITED STATES
ABSTRACT:
Empirical research on seasoned equity offerings indicates that
the decision to make an SEO typically engenders a decline in
firm value, as investors interpret this decision as a signal of
poor financial health or that the stock is overpriced. Here, we
add to the literature by analyzing the short-term market
reaction to SEO announcements and the chief executive officer's
link to firm performance (i.e., the proportion of CEO
equity-based compensation). Results support the hypothesis that
investors are more likely to view the announcement of an SEO as
a last resort source of capital when the proportion of CEO
equity-based compensation is high. In such cases of high
equity-based compensation, our findings indicate that the SEO
announcement provides an incremental signal of financial
distress above that provided by financial statements. We also
find this relationship (last resort signal) to be stronger when
large information asymmetries exist between management and
investors. Thus, managers should consider the ramifications of
executive compensation structure when considering whether to
make an SEO.
JEL Classification: D82, G30
______________________________
"Anatomy of a Paradigm Shift: An Overview of the Deferred
Compensation Provisions of the American Jobs Creation Act of
2004"
Tax Management Compensation Planning Journal, Vol. 33, p.
31, February 4, 2005
BY: ALDEN J. BIANCHI
Mintz Levin
Contact: ALDEN J. BIANCHI
Email: Mailto:ajbianchi@mintz.com
Postal: Mintz Levin
One Financial Center
Boston, MA 02111 UNITED STATES
Note: This is a description of the paper and not the actual
abstract.
ABSTRACT:
Congress has for some time been concerned with abuses involving
deferred compensation arrangements - i.e., arrangements under
which compensation, thought earned currently, is deferred to
some future time or event, with a corresponding postponement of
taxation. The matter came to a head, however, with the collapse
of Enron Corporation. While rank-and-file employees saw much of
the value of their retirement accounts evaporate, balances in
certain executive deferred compensation plans remained
relatively secure. But it was the need to comply with export-tax
subsidy reforms demanded by the World Trade Organization that
moved Congress to enact the American Jobs Creation Act of 2004
(the Act).
Prior to the Act, there arose a gulf between the government's
view of how deferred compensation ought to be taxed and the way
that courts saw things. For the most part, the courts were far
more permissive. In 1978, the Internal Revenue Service sought to
intervene by issuing a regulation that would have effectively
taxed currently virtually all deferred compensation. Congress
intervened, however, to put a stop to the new rule. From this
point on, the law governing deferred compensation was for the
most part judge-made.
Among (many) other things, the Act substantially rewrote the
rules governing all sorts of deferred and executive compensation
arrangements. The Act added new Section 409A to the Internal
Revenue Code, establishing strict new rules concerning the
timing of elections, acceleration and deferral of distributions,
limits on off-shore funding arrangements and financial health
triggers, among others. The new rules supplement rather than
displace prior law. Congress also directed the Internal Revenue
Service and the U.S. Department of the Treasury to issue
guidance implementing the new rules.
This article begins with an overview of pre-Act law and
describes the origins and evolution of such important tax
concepts as constructive receipt and economic benefit. It then
provides an overview of Code Section 409A and its legislative
history, and explains the first major item of regulatory
guidance, IRS Notice 205-1. The article concludes with
recommendations to employers and plan sponsors regarding
compliance.
______________________________
"Executive Compensation, Corporate Governance, and the
Partner-Manager"
University of Illinois Law Review, Forthcoming
BY: RICHARD A. BOOTH
University of Maryland School of Law
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=719983
Paper ID: U of Maryland Legal Studies Research Paper No. 2005-39
Contact: RICHARD A. BOOTH
Email: Mailto:rbooth@law.umaryland.edu
Postal: University of Maryland School of Law
500 West Baltimore Street
Baltimore, MD 21201-1786 UNITED STATES
Phone: 410-706-4269
Fax: 410-706-2184
ABSTRACT:
In the debate over executive compensation, the assumption seems
to be that the CEO of a publicly traded corporation is
ultimately an employee of the corporation. According to the
conventional view, the business belongs to the stockholders.
Executive compensation is an expense like any other business
expense that must be subtracted from income in reckoning
stockholder return. The central problem has been that the CEO
has too much power. The board of directors has not acted as an
effective monitor. Thus, the problem of executive compensation
appears to be a thinly disguised problem of self-dealing.
As I argue here, partnership law offers an alternative model
that may explain some of the more puzzling aspects of executive
compensation. Simply stated, if one sees a publicly traded
corporation as a partnership between management and
stockholders, the fact that a substantial share of gains goes to
management does not seem problematic.
In this article, I briefly recount the evolution of corporate
theory and practice over the last forty or so years and offer an
explanation as to why executive compensation came to rely so
heavily on stock options. In short, stockholders became
increasingly diversified as a result of investing through
institutions, increasingly immune to company-specific risk, and
increasingly insistent that individual companies maximize
return. Managers are by nature precluded from fully diversifying
because much if not most of their wealth must remain tied to the
fortunes of a single company. Thus, market forces have required
CEOs to bear increasing levels of risk.
As is well recognized, using stock options as the primary form
of executive compensation serves the purpose of focusing a CEO
on stock price rather than second best metrics such as earnings
or assets. What is less well recognized is that options also
force managers to assume additional risk. As a result, CEOs
naturally insist on the prospect of greater returns. It should
thus come as no surprise that success will be more richly
rewarded. In effect, CEOs have bargained for a substantial piece
of the action. They have come to insist on returns more
consistent with those of a partner rather than an employee.
Finally, I address several misconceptions about executive
compensation. First, I show that in the aggregate, executive
compensation (including option-based compensation) has been
remarkably stable over the last twenty years, suggesting that
the perception of excess may be the result of redistribution and
undue focus on those who have gained from the evolution to
options. Second, I argue that unlike other forms of compensation
stock options are self-regulating and thus inherently less
worrisome than other more fixed forms of compensation. The use
of options requires careful attention to the potential for
dilution and encourages payout to stockholders in the form of
repurchases. Again, these features of option based compensation
result in a more partnership-like relationship than has been
recognized by most commentators. Finally, I argue that the
partnership model of the corporation sheds new light on the
debate over how to account for stock options. To be specific, if
stock options are seen as a way for CEOs and other high level
managers to participate as equity partners in company returns,
it makes little sense to treat the grant of stock options as an
expense.
JEL Classification: G32, G34, J33, K22, L22, M52
______________________________
W O R K I N G P A P E R Abstracts
_________________________________________________________________
"Pay Me Later: Inside Debt and its Role in Managerial
Compensation"
BY: DAVID YERMACK
New York University
Department of Finance
RANGARAJAN K. SUNDARAM
New York University
Department of Finance
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=717102
Paper ID: NYU, Law and Economics Research Paper No. 05-08
Date: May 16, 2005
Contact: DAVID YERMACK
Email: Mailto:dyermack@stern.nyu.edu
Postal: New York University
Department of Finance
MEC 9-56
44 West 4th Street
New York, NY 10012-1126 UNITED STATES
Phone: 212-998-0357
Fax: 212-995-4220
Co-Auth: RANGARAJAN K. SUNDARAM
Email: Mailto:rsundara@stern.nyu.edu
Postal: New York University
Department of Finance
Stern School of Business
44 West 4th Street
New York, NY 10012-1126 UNITED STATES
ABSTRACT:
Inside debt, such as pensions and deferred compensation,
constitutes a widely used form of executive compensation, yet
the valuation and incentive effects of these instruments have
been almost entirely overlooked by prior work. Our paper
initiates this line of research. Among our findings are that
pensions constitute a significant component of overall
compensation; that CEO compensation in most firms exhibits a
balance between debt- and equity-based incentives, with the
balance shifting systematically away from equity and toward debt
as CEOs grow older; that CEOs with high debt-based incentives
manage their firms conservatively to reduce default risk; and
that pension plan compensation strongly influences patterns of
CEO turnover and CEO cash compensation.
JEL Classification: G34, J33
______________________________
"Board Independence and the Design of Executive Compensation"
BY: RAVI SINGH
Harvard University
Negotiations, Organizations and Markets Unit
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=673741
Paper ID: EFA 2005 Moscow Meetings Paper
Date: February 2005
Contact: RAVI SINGH
Email: Mailto:rsingh@hbs.edu
Postal: Harvard University
Negotiations, Organizations and Markets Unit
Soldiers Field
Boston, MA 02163 UNITED STATES
ABSTRACT:
In this paper, I analyze how the influence of executives affects
the compensation decisions of boards of directors. Boards vary
in their degree of independence, and compensation decisions not
only serve to motivate executives and allocate rents, but also
affect a board's reputation for independence. Although greater
managerial influence over the board has the obvious effect of
increasing the level of pay, there is a more subtle relationship
between the extent of this influence and the composition of pay.
The theory predicts that it is not necessarily the most captured
boards that are prone to choose inefficient pay-for-performance
sensitivities and transfer rents in opaque ways as commonly
argued. Reputational concerns may cause comparatively
independent boards to place excessive weight on investor
perception at the expense of efficiency, resulting in pay
packages that, for example, provide excessive incentives. By
making the decisions of boards extremely visible, mandatory
disclosure of executive compensation lowers the level of pay at
the expense of distortions in the structure. Finally, I show
that boards exploit investor uncertainty about the outside
opportunities of executives and the appropriate strength of
incentives to justify higher levels of compensation.
JEL Classification: G34, J33, M52, D82
______________________________
"Managerial Incentives in Highly Levered Firms"
BY: ALEX EDMANS
Massachusetts Institute of Technology (MIT)
Sloan School of Management
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=758508
Date: August 2005
Contact: ALEX EDMANS
Email: Mailto:aedmans@mit.edu
Postal: Massachusetts Institute of Technology (MIT)
Sloan School of Management
Cambridge, MA 02142 UNITED STATES
Phone: 617-253-3919
ABSTRACT:
Compensating managers with debt as well as equity stakes in
their firm is a seemingly natural solution to the agency costs
of debt. However, it is absent from both current practice and
the academic literature. I consider several possible
rationalizations, none of which are wholly satisfactory.
Covenants are incomplete and managers may risk-shift to avoid
breaching covenant triggers. Private benefits and bonuses give
the manager incentives to achieve solvency; however, he remains
insensitive to liquidation value given bankruptcy and may gamble
for resurrection. Risk aversion may mean that a fall in the
manager's equity stake must accompany the assumption of debt.
However, effort incentives are not reduced if effort is
productive in improving liquidation value, or if bankruptcy is
likely. Managerial debt stakes may thus be particularly
effective in LBOs and CDOs, and to "insure" large, liquid firms
against a collapse.
JEL Classification: G32, G34, J33
______________________________
"Pay without Performance: Overview of the Issues"
BY: LUCIAN ARYE BEBCHUK
Harvard Law School
National Bureau of Economic Research (NBER)
JESSE M. FRIED
University of California, Berkeley - School of Law
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=761970
Date: July 2005
Contact: LUCIAN ARYE BEBCHUK
Email: Mailto:bebchuk@law.harvard.edu
Postal: Harvard Law School
1563 Massachusetts Avenue
Cambridge, MA 02138 UNITED STATES
Phone: 617-495-3138
Fax: 617-496-3119
Co-Auth: JESSE M. FRIED
Email: Mailto:FRIEDJ@MAIL.LAW.BERKELEY.EDU
Postal: University of California, Berkeley - School of Law
Boalt Hall
Berkeley, CA 94720-7200 UNITED STATES
ABSTRACT:
In a recent book, and accompanying articles we critique existing
executive pay arrangements and the corporate governance
processes producing them, and put forward proposals for
improving both executive pay and corporate governance. This
paper provides an overview of the main elements of our critique
and proposals. We show that, under current legal arrangements,
boards cannot be expected to contract at arm's length with the
executives whose pay they set. We discuss how managers'
influence can explain many features of the executive
compensation landscape, including ones that researchers
subscribing to the arm's length contracting view have long
viewed as puzzling. We also explain how managerial influence can
lead to inefficient arrangements that generate weak or even
perverse incentives, as well as to arrangements that make the
amount and performance-insensitivity of pay less transparent.
Finally, we outline our proposals for improving the transparency
of executive pay, the connection between pay and performance,
and the accountability of corporate boards.