"How to Tie Equity Compensation to Long-Term Results" 

Journal of Applied Corporate Finance, Vol. 22, Issue 1, pp. 99-106, Winter 2010

LUCIAN A. BEBCHUK, Harvard University - Harvard Law School, National Bureau of Economic Research (NBER), European Corporate Governance Institute (ECGI)
Email: bebchuk@law.harvard.edu
JESSE M. FRIED, Harvard Law School
Email: jfried@law.harvard.edu

Companies, investors, and regulators around the world are now seeking to tie executives’ payoffs to long-term results and avoid rewarding executives for short-term gains. Focusing on equity-based compensation, the primary component of top executives’ pay, the authors analyze how such compensation should best be structured to provide executives with incentives to focus on long-term value creation.

To improve the link between equity compensation and long-term results, the authors recommend that executives be prevented from unwinding their equity incentives for a significant time period after vesting. At the same time, however, the authors suggest that it would be counterproductive to require that executives hold their equity incentives until retirement, as some have proposed. Instead, the authors recommend that companies adopt a combination of “grant-based” and “aggregate” limitations on the unwinding of equity incentives.

Grant-based limitations would allow executives to unwind the equity incentives associated with a particular grant only gradually after vesting, according to a fixed, pre-specified schedule put in place at the time of the grant. Aggregate limitations on unwinding would prevent an executive from unloading more than a specified fraction of the executive’s freely disposable equity incentives in any given year.

Finally, the authors emphasize the need for effective limitations on executives’ use of hedging and derivative transactions that would weaken the connection between executive payoffs and long-term stock values that a well-designed equity arrangement should produce.

"Executive Compensation: An Overview of Research on Corporate Practices and Proposed Reforms" 

Journal of Applied Corporate Finance, Vol. 22, Issue 1, pp. 107-118, Winter 2010

MICHAEL W. FAULKENDER, University of Maryland - Robert H. Smith School of Business
Email: mfaulken@rhsmith.umd.edu
DALIDA KADYRZHANOVA, University of Maryland
Email: dkadyrz@rhsmith.umd.edu
N. PRABHALA, affiliation not provided to SSRN
LEMMA W. SENBET, University of Maryland - Robert H. Smith School of Business
Email: lsenbet@rhsmith.umd.edu

Two landmark episodes of the last decade, the 2001 dot-com crisis and the 2008 bursting of the housing bubble, have drawn attention to the size and structure of executive pay plans and their possible role in propagating or worsening the crises. In this policy-oriented piece, the authors discuss the key issues in the debate on executive pay and express their support for a number of reform proposals that have been advanced in academic and policy circles.

The article begins by dividing the compensation debate into four key issues:

First, while public outrage has focused on the size of the pay packages at failed financial institutions, it is perhaps more important to focus on the structure of compensation and the process of setting compensation to prevent future crises. An effective pay package is not necessarily the one most laden with equity incentives. Too much equity exposure can cause excessive risk-taking, manipulation, and shift executive attention away from true value creation.

Second, incentive structures should incorporate indexing and clawbacks to guard against the possibility that performance benchmarks are rewarding luck more than sustainable, long-run performance.

Third, the compensation-setting process should be placed in the hands of shareholders, boards, and advisors who are not only independent but also possess ample expertise in the financial instruments used to incentivize pay.

Fourth and finally, any proposals for changes in compensation design or the taxation of compensation should anticipate how executives will alter their behavior in response to the changes, and evaluate the effect of the changes net of such offsetting responses.
 

"CEO Compensation" 

Rock Center for Corporate Governance at Stanford University Working Paper No. 77

CAROLA FRYDMAN, MIT Sloan School of Management
Email: Frydman@mit.edu
DIRK JENTER, Stanford Graduate School of Business, National Bureau of Economic Research (NBER)
Email: djenter@mit.edu

This paper surveys the recent literature on CEO compensation. The rapid rise in CEO pay over the last 30 years has sparked an intense debate about the nature of the pay-setting process. Many view the high level of CEO compensation as the result of powerful managers setting their own pay. Others interpret high pay as the result of optimal contracting in a competitive market for managerial talent. We describe and discuss the empirical evidence on the evolution of CEO pay and on the relationship between pay and firm performance since the 1930s. Our review suggests that both managerial power and competitive market forces are important determinants of CEO pay, but that neither approach is fully consistent with the available evidence. We briefly discuss promising directions for future research.

"Promotion Incentives and Corporate Performance: Is There a Bright Side to 'Overpaying' the CEO?" 

Journal of Applied Corporate Finance, Vol. 22, Issue 1, pp. 119-128, Winter 2010

JAYANT R. KALE, Georgia State University
Email: jkale@gsu.edu
EBRU REIS, Bentley University
Email: ereis@bentley.edu
ANAND VENKATESWARAN, Northeastern University - Finance and Insurance Area
Email: anand@gsu.edu

Earlier studies have shown that stronger equity-based incentives for CEOs are generally associated with better corporate performance and higher values. In this article, the authors report the findings of their recent study of the effects of promotion-based “tournament” incentives for non-CEO executives (or “VPs”) on corporate performance for a large sample of companies during the 12-year period from 1993–2004.

The study’s main finding is that such tournament incentives, as measured by the pay differential between the CEO and VPs, were associated with better corporate operating performance and higher corporate stock returns. Moreover, tournament incentives, as one would expect, appeared to be more effective when CEOs were nearing retirement - but less effective when the firm had a new CEO (and even weaker when the new CEO was an outsider).

"Executive Pay Inefficiencies in the Financial Sector" 

Colorado College Working Paper No. 2010-02

HALEY BARTON, affiliation not provided to SSRN
Email: haley.barton@coloradocollege.edu
JUDITH A. LAUX, Colorado College - Department of Economics and Business
Email: jlaux@ColoradoCollege.edu

This study considers the implications of excessive non-salary-based executive pay on capital structure during the years 2005 through 2007, directly preceding the 2008 stock market crash. The hypothesis proposes that for firms in the financial sector, executives awarded generous compensation packages compared to salary implemented a higher use of debt in their firm’s capital structure. The study examines data on 40 firms in the financial sector and 40 firms in the manufacturing sector to empirically test for a relationship between executive pay and leverage. Cross-sectional analysis of nine models reveals that compensation is a significant determinant of a firm’s total debt-to-total assets ratio for the financial sector, especially with the existence of a one- to two- year lag between the variables, while the manufacturing sector yielded no significant relationship. These findings reveal sources of agency conflicts and behavioral biases within the financial sector during the three years preceding the financial collapse.

"The Billion Dollar Gaps Revisiting Section 162(M)" 

KNUT PEDER HEEN, University of Mannheim - Finance Area
Email: heen@corporate-finance-mannheim.de

The paper studies executive compensation anomalies which may be tied to the million dollar cap on executive compensation. The paper explains the regulation, show how firms may react to preserve tax deductibility of the compensation, and document that firms have been adapting their compensation arrangements to preserve tax deductibility of the executive compensation. In particular, I find that compensation has been shifted away from salary towards stock options for the affected executives, and that executives who earn annual salaries above $1 million often defer payment of parts of the salary until retirement. Both schemes preserve tax deductibility of the compensation. The paper also illustrate how the million dollar cap’s preferential tax treatment of at-the-money options may explain its total dominance as equity-based compensation, and how the preferential tax treatment may have played a part in the option backdating scandal which unfolded during the mid 2000s. It may even have been socially optimal to backdate options.