Overview of Pay without Performance Presentation by Jesse Fried Columbia University October 15, 2004

Presentation Outline Why we wrote the book The stakes Part I: Official view and its shortcomings Part II: Power and pay Part III: Decoupling pay from performance Part IV: Going forward Concluding remarks

Why we wrote the book Widespread recognition: many boards approved executive pay deals that did not serve shareholders But we believe still insufficient recognition about Scope and source of problems; and Need for fundamental reforms to address them

Why the book? To question systematically several widely-held views about executive compensation: “Rotten apples” view “Paying for performance” view “Transient lapses” view “Independence is enough” view

Why the book? “Rotten apples” view: Concerns about executive compensation have been exaggerated: Flawed arrangements have been limited to small number of firms Our conclusion: It’s the barrel, not a few apples: Problems have been widespread, persistent, and systemic.

Why the book? “Paying for performance” view: Current pay levels might seem high -- but are necessary to provide executives w/ powerful incentives. Our conclusion: Current pay arrangements not designed to tightly link pay and managers’ own performance.

Why the book? “Transient lapses” view: Even if flaws widespread, they resulted from boards’ mistakes and misperceptions Boards can be expected to self-correct with time and better understanding. Our conclusion: It’s bad incentives, not lapses. Problems stem from defects in underlying governance structure – governance reforms needed.

Why the book? “Independence is enough” v iew: OK, reforms might have been necessary – but recent moves to increase director independence will adequately address past problems. Our conclusion: Strengthening independence is beneficial, but falls far short of solving problems. Additional reforms that make boards more dependent on shareholders are necessary.

Why the book? To deliver a broader message about corporate governance in general: Executive compensation provides a window for examining our corporate governance system The corporate governance system: Depends on boards to serve as guardians of shareholder interests. Largely insulates boards from intervention and removal by shareholders

Why the book? Our study of executive pay: Casts doubt on wisdom of relying on boards to perform their critical function well under current arrangements Provides basis for our proposals to make boards more accountable

The Stakes Executive pay not merely symbolic. Has substantial practical importance for shareholders/policymakers. Amounts at stake substantial: Bebchuk-Grinstein (2004): Aggregate top-5 pay during about $250 billion 7.5% of aggregate corporate earnings (10% during )

The stakes (2) Excess pay is not only or principal cost. We show that managers’ influence over compensation arrangements: Dilutes incentives to serve shareholders Distorts incentives – e.g., ability to unwind equity gives incentive to improve short term earnings reports at expense of long-term value

Part I: Official View and its Shortcomings The “official view”: Corporate boards operate at arm’s-length from executives – it’s a market like any other. The “official view” -- Serves as practical basis for legal rules and public policy. Used to justify boards’ compensation decisions to shareholders, policymakers, courts. Underlies most economists’ research on executive compensation Used as basis for explaining common compensation arrangements Practices that do not seem to fit considered “anomalies” or “puzzles”

Problem with the Official View The official arm’s length story is neat, tractable, and reassuring – but it fails to account for realities of executive compensation. Executives not only ones whose incentives matter. Must look at incentives of directors Cannot assume they will automatically serve shareholders in setting executives’ pay.

Have Boards Bargained at Arm’s Length? We show many reasons directors favor executives: Incentives Going along helps chance of re-nomination to board CEO’s power to reward directors Social factors Collegiality and team spirit Deference to company’s leader Loyalty and friendship Cognitive dissonance (directors who are current/former executives) Personal costs of favoring executives are small Show outside market forces not tight enough to prevent deviations from arm’s length bargaining Such deviations can occur without subjecting managers and directors to large costs

Part II: Power and Pay The same factors undermining arm’s-length bargaining indicate managers have power over boards Executives use power to influence own pay Managers extract “rents:” the difference between what they get and what that they would get under true arm’s length bargaining

Power and Pay: “Camouflage” and its Costs Rents not unlimited. Limits on how far directors will go, how far managers want them to go Importance of outside perceptions and appearance: “outrage” More outrageous an arrangement is perceived, greater market and social costs to executives and directors “Camouflage:” Outrage gives compensation designers incentive to obscure and legitimize both level and performance- insensitivity of executive compensation Costs of camouflage: Attempts to camouflage can lead to adoption of inefficient compensation structures – structures that are less efficient but good at obscuring, legitimizing amount of pay and insensitivity to performance

Evidence of Managerial Influence (1) We predict managerial power vis-à-vis board/shareholders to be correlated with pay arrangements that are more favorable to insiders Indeed, there is empirical evidence that pay is greater/less sensitive to performance in firms with More antitakeover provisions Weaker shareholder rights CEO who is also chair of board Directors appointed under current CEO Compensation committee has little company stock More interlocking directors Without large outside block-holders

Evidence of Managerial Influence (2) We present evidence compensation arrangements often designed to camouflage rents and minimize outrage. firms have systematically made less transparent both total amount of compensation and extent pay decoupled from managers’ own performance. We show widespread use of various types of compensation – such as postretirement perks and consulting arrangements, deferred compensation, and pension plans – unlikely to reflect efficiency considerations.

Evidence of Managerial Influence (3) Golden Goodbyes We document how boards provide managers with more than they were contractually entitled to -- grant “golden goodbyes” to executives when they retire, resign, or their firm is acquired, even when the performance of the manager is sub-par Given managers’ influence over board, such golden goodbyes might be necessary to get a majority of the board to agree to fire CEO or sell the company But their presence indicates the influence managers have over the board.

Part III: Decoupling Pay from Performance Rise in executive compensation has been justified as necessary to strengthen incentives Financial economists have applauded: Shareholders should care more about incentives than about the amount paid executives. “It’s not how much you pay, but how” (Jensen & Murphy) Institutional investors have accepted higher pay as price of improving managers’ incentives

Decoupling Pay and performance (2) Managers’ influence has enabled them to get arrangements that tie compensation too loosely to own performance The result: Much of additional value provided to execs has not been tied to own performance: shareholders have not received as much bang for the buck as possible Firms could have generated the same increase in incentives at much lower cost, or used the same amount to generate stronger incentives Indeed, seeming legitimacy of equity-based compensation has enabled execs to obtain amounts that would have been impossible to get as cash compensation

Decoupling Non-Equity Pay There is only a weak link between managers’ own performance and Bonus, salary, and other forms of cash compensation The large amounts of “stealth compensation” given through retirement plans

Decoupling of Equity-Based Compensation But what about equity-based compensation? Devil is in the details: Equity-based pay delivers much less pay for performance than believed Windfalls: Rewards for general market and industry-wide movements. Most of value in conventional options and restricted stock rewards managers for “luck” Re-pricing, “backdoor repricing”, reload options – all further weaken link b/w pay and performance Broad freedom to unload vested options/restricted stock Rewards for short-term price increases that may not last while Producing perverse incentives

Part IV: Going Forward Improving executive compensation Transparency: not enough for information to be in public domain – must be easy to access, understand. For example, companies should be required to report annual increase in present value of retirement benefits Institutional investors should press for tightened link between pay and performance in ways we identify But no good substitutes for board negotiating at arm’s length: how can we get directors to better serve as shareholders’ guardians?

Going Forward: Limits of Independence Recent reforms, including new stock exchange listing requirements, emphasize strengthening director independence from executives. These reforms will reduce but not eliminate directors’ pro-executive tilt: Going along still generally remain safest strategy for being re-nominated Executives’ ability to reward cooperative directors is reduced but not eliminated Social and psychological factors – collegiality, deference to leader, loyalty, cognitive dissonance – all remain As long as directors do not have meaningful incentives to enhance shareholder value, even a significantly reduced tilt in favor of executives can have a major impact Even if complete independence from executives could be achieved, still concern: directors might pursue own objectives at expense of shareholders

Going Forward: Beyond Independence For each company, vast number of individuals could be considered “independent directors” Two key questions (1) Who is selected from this vast pool? (2) What will their incentives be once appointed? Strengthened independence eliminates some people from pool, reduces bad incentives for those appointed. But does not fully answer (1) and (2) To improve director selection and incentives, we must not only make directors more independent of executives, but also make them more dependent on shareholders

Going Forward: Making Directors More Accountable Current insulation of boards from shareholders not inevitable product of dispersed ownership; rather, largely results from legal arrangements in place. We should: Make it easier for shareholders to replace directors Election reform (including shareholder access to the ballot) is needed Shareholder power to replace the board is currently a myth – it should be turned into reality Give shareholders power to initiate and adopt charter amendments. Abolish management’s control over changes in corporate governance arrangements.

Making Directors More Accountable By making boards accountable to shareholders and attentive to their interests, such reforms would: Make reality more closely resemble official story of arm’s length negotiations Improve executive compensation arrangements Improve corporate governance more generally

Alternative Critiques Our critique of executive compensation differs from two other types: The ethical/fairness critique. The critique: People should not be paid as much Our view: instrumental and shareholder-oriented. Would accept higher compensation if were beneficial for performance. Incentives don’t matter critique: That view: Monetary incentives unnecessary to motivate executives Like defenders of current pay arrangements, we believe that incentives do matter This is why we worry that directors lack sufficient incentives to guard shareholder interests. We believe: executive compensation can provide useful incentives – but managers’ influence over incentive machinery has resulted in compensation being not only instrument for reducing agency costs but also part of the agency problem itself.

Recognition and Reality This is area where perceptions matter a great deal. The very recognition of problems may help alleviate them: Executive compensation practices: Widespread recognition of how managerial influence distorts pay arrangements serves as a useful check Makes it more difficult to camouflage rents and pay-performance insensitivity. Corporate reforms: Given management’s clout as an interest group, reforms possible only if shareholders, public officials have fuller understanding of pervasiveness and cost of current flaws in governance Helping to bring about such an understanding is a main aim of our book.

Conclusion The problems of executive pay are not behind us – no reason for complacency The promise of executive compensation yet to be fulfilled