“Firms that pay their CEOs in the top ten percent of pay earn negative abnormal returns over the next five years of approximately -13%. The effect is stronger for CEOs who receive higher incentive pay relative to their peers. Our results are consistent with high-pay induced CEO overconfidence and investor overreaction towards firms with high paid CEOs.” That was the conclusion of Performance for pay? The relationship between CEO incentive compensation and future stock price performance by Cooper, Gulen, and Rau… one of two studies highlighted in Does Golden Pay for the CEOs Sink Stocks? (Jason Zweig, WSJ, 12/26/09).
According to Rau, CEOs in his study averaged $23 million—but leave their shareholders poorer (relative to other companies in the same industry) by an average of $2.4 billion per year. Each dollar that goes into the CEO’s pocket appears to take $100 out of shareholders’ pockets. If that is true, there is obviously something very very wrong with the typical incentive structure.
The CEO Pay Slice by Bebchuk, Cremers, and Peyer investigated the fraction of the aggregate compensation of the top-five executive team captured by the CEO – and the value, performance, and behavior of public firms. They found “CPS is negatively associated with firm value as measured by industry- adjusted Tobin’s Q.” CPS is found to be correlated with
- lower (industry-adjusted) accounting profitability,
- lower stock returns accompanying acquisitions announced by the firm and higher likelihood of a negative stock return accompanying such announcements,
- higher odds of the CEO’s receiving a “lucky” option grant at the lowest price of the month,
- greater tendency to reward the CEO for luck due to positive industry-wide shocks,
- lower performance sensitivity of CEO turnover,
- lower firm-specific variability of stock returns over time, and
- lower stock market returns accompanying the filing of proxy statements for periods where CPS increases.
Zweig’s article goes on to cite Benjamin Graham’s 1951 recommendation that directors “must have an arm’s-length relationship with management; they also should combine “good character and general business ability” with “substantial stock ownership.” (They should have purchased most of their shares outright rather than getting them through option grants.)” He also notes that Graham called to independent directors to publish a separate annual report analyzing whether the business is “showing the results for the outside stockholder which could be expected of it under proper management.”
Each month I take readers on a time trip in CorpGov.net’s “WayBack Machine,” to see what we were discussing 5 and 10 years ago. It is interesting to see how often we are grappling with the same issues. If we had only listened to Graham 58 years ago, how different would corporate governance be today? While we can’t change the past, we can at least work to ensure CEO pay is better aligned long-term shareowner value in the future.
Service Employees International Union (SEIU) Master Trust launched a campaign recently, mostly aimed at banks, proposing the following reforms:
- Requiring that at least 80 percent of an executive’s annual compensation be subject to multi-year vesting and/or holding periods;
- Requiring executives and directors to hold a significant equity stake in the company and basing that stake on the value of the executive’s annual compensation package;
- Making the timing of the equity awards predictable so shareowners know by the annual meeting date the total compensation level awarded to the executive team in the previous year;
- Enacting effective clawback provisions that call for the automatic return of any bonus or incentive compensation awarded on the basis of financial results that subsequently required restatement;
- Requiring a substantial portion of annual cash and/or equity bonuses to be held until performance criteria are achieved;
- Making retention grants conditional upon executives remaining with the company;
- Prohibiting executives and directors from engaging in any hedging, derivative or other transactions with respect to equity-based awards granted as incentive compensation;
- Placing restrictions on severance payments, death/disability payments, compensation related to changes in control and perquisites;
- Forming a shareowner advisory committee to advise the board and the compensation committee on executive and director compensation;
- Allowing shareowners to cast an annual advisory vote on executive compensation;
- Including in proxy statements information about the steps being taken to align compensation with long- term incentives, to avoid incentives that promote undue risk taking and to prevent windfalls where there is no long-term shareowner gain;
- Requiring that at least three independent directors serve on the compensation committee;
- Prohibiting compensation committee directors from serving on the audit committee; and
- Adopting bylaws that allow shareowners to place director candidates on corporate ballots subject to certain conditions.
These seem like a good start. However, the devil is in the details. For example, requiring 80% of an exec’s annual compensation be subject to multi-year vesting and/or holding periods… getting 80% two years later meets that vague definition but certainly doesn’t meet criteria that would dissuade CEOs from gaming the system. Certainly, much more needs to be done in this area. RiskMetrics made an important change to their policy for 2010 by assessing the alignment of CEO’s total direct compensation and total shareholder return over a period of at least five years.
More discussion at How to Tie Equity Pay to Long-Term Performance, HBR, 6/24/09; Executive Compensation, Ethicsworld.org; Are senior executives worth what they are paid? Steven N. Kaplan vs Nell Minow, The Economist, 10/28/09.