ProfessorBainbridge.com

The Sins of the Fathers

My friend and colleague E ugene Volokh has blogged an objection to holding Yale law students accountable for the actions of the Yale law school:

I have in the past criticized law schools' attempts to exclude military recruiters from campus. But I have to also criticize this reaction by a federal district judge (thanks to How Appealing for the pointer):

An Alabama federal judge has told Yale Law School he won't accept its graduates for clerkships because the school blocks military recruiters from campus. . . .

Is it really fair to take the school's actions out on innocent Yale law students? Yes, I realize that the school's actions might themselves be seen as hurting innocent Yale law students to send a message -- but that doesn't make it right, nor does it make Yale students responsible for what the law school does.

Here?s at least one reason it might be fair to do so: If Yale law students knew about Yale's policy when they decided to attend Yale, they assumed the risk that some employers who disagree with that policy would decline to hire them. If the policy is of new vintage, such that some current students chose Yale before the policy went into affect, there may be some transitional unfairness. Other than that exception, however, they made their bed when they chose Yale and now they have to lie in it. Law students are grownups, after all. Indeed, Judge Frank's famous remark about preferred stockholders - "preferred stockholders are not-like sailors or idiots or infants- wards of the judiciary" - strikes me as being equally relevant to law students.

On the other hand, Eugene's post raises the broader and perhaps more interesting question of the extent to which it is fair to hold the constituents of an organization responsible for the acts of the organization, especially when those constituents are not themselves responsible for the acts or policies in question.

When the question is framed in this manner, I am more inclined to agree with Eugene. Consider the perhaps somewhat analogous case of shareholders of corporations which are being sued by those seeking slavery reparations. In a TCS column on that subject, I observed:

In sum, both deterrence and retributive justice require that punishment be directed solely at those who actually commit wrongdoing. In this context, it would be the directors, officers, or controlling shareholders who actually enslaved people. Since they're long dead, there is nobody left who properly can be punished.

Our view of the fairness of the judge's decision thus might depend on whether we think he is punishing Yale law students for having made a poor decision to attend Yale or using them as a vehicle for punishing Yale. Only in the latter case, it seems to me, is the judge violating the Kantian requirement to treat others as you would yourself, i.e, as ends, but never as means.

Update: OTB takes a pragmatic view, concluding:

While I agree with < span style="color: #990000;">Eugene Volokh that making students suffer for the actions of the school's administration is problematic, Acker's options are somewhat limited. Presumably, he's already withholding whatever donations he would otherwise have been making. Further, one could argue that the students are somewhat complicit in the policy since, one suspects, it would be overturned if enough students raised a fuss.

 

Donaldson on Executive Compensation

SEC Chairman William Donaldson is at it again:

On executive compensation, Mr. Donaldson -- noting that companies continue to reward executives with lucrative pay packages and perquisites -- said he will push for better disclosure so investors know exactly how much chief executives and other corporate officials are getting.

He said the SEC's current executive-compensation disclosure requirement "obfuscates the total package" of executive pay and needs to be changed. ...

Mr. Donaldson said he plans to work with staff to find a way to make compensation disclosure more transparent and understandable. But beyond better disclosure, Mr. Donaldson said he also is concerned about the performance measures some companies use to reward executives.

In some cases, he said, officials may be getting paid to simply hit Wall Street estimates rather than actually improve a company's long-term performance. "I believe that performance should be paid and good performance should receive good pay, but there has to be a better definition of what real performance is," he said. Mr. Donaldson said he wants companies and boards to start paying closer attention to what metrics they use to determine compensation. (Link to WSJ; sub. req'd)

I took a swipe at Donaldson the last time he went off on executive compensation. My friends and fellow law professors Gordon Smith and Larry Ribstein take him to task this time around.

Let's be clear about two things. First, as I explain at pages 106- 111 of my Corporation Law and Economics text, the SEC has no power - none, nada, zilch - to regulate the substance of corporate governance, including but not limited to the merits of executive compensation. These issues are left to state corporate law:

Consistent with this clear congressional intent, the Supreme Court has routinely rejected efforts to preempt state law and create a de facto federal law of corporations. Because ?state regulation of corporate governance is regulation of entities whose very existence and attributes are a product of state law,? the court has consistently reaffirmed that: ?It . . . is an accepted part of the business landscape in this country for states to create corporations, to prescribe their powers, and to define the rights that are acquired by purchasing their shares.? Indeed, the Supreme Court opines that ?[n]o principle of corporation law and practice is more firmly established than a State?s authority to regulate domestic corporations.?[1]

...

Does the Supreme Court?s defense of what might be called ?corporate federalism? make policy sense? Those who believe in the so- called ?race to the bottom? hypothesis will argue that it does not, but the empirical evidence on that purported race, while mixed, tends to favor the competing race to the top hypothesis. In the absence of compelling evidence on the competing race hypotheses, we do well to consider the Supreme Court?s argument that states have a number of legitimate interests in regulating such matters. The corporation is a creature of the state, ?whose very existence and attributes are a product of state law.?[3] States therefore were said to have an interest in overseeing the firms they create. States also have an interest in protecting the shareholders of their corporations. Finally, states have a legitimate ?interest in promoting stable relationships among parties involved in the corporations it charters, as well as in ensuring that investors in such corporations have an effective voice in corporate affairs.? If so, state regulation not only protects shareholders, but also protects investor and entrepreneurial confidence in the fairness and effectiveness of the state corporation law.[4]

The Supreme Court has suggested that the country as a whole benefits from state regulation in this area, as well. The markets that facilitate national and international participation in ownership of corporations are essential for providing capital not only for new enterprises but also for established companies that need to expand their businesses. This beneficial free market system depends at its core upon the fact that corporations generally are organized under, and governed by, the law of the state of their incorporation.[5]

This is so in large part because ousting the states from their traditional role as the primary regulators of corporate governance would eliminate a valuable opportunity for experimentation with alternative solutions to the many difficult regulatory problems that arise in corporate law. As Justice Brandeis pointed out many years ago, ?It is one of the happy incidents of the federal system that a single courageous State may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of country.?[6] So long as state legislation is limited to regulation of firms incorporated within the state, as it generally is, there is no risk of conflicting rules applying to the same corporation. Experimentation thus does not result in confusion, but may well lead to more efficient corporate law rules.

Where then do we draw the line between the state and federal regulatory regimes? As a general rule of thumb, federal law appropriately is concerned mainly with disclosure obligations, as well as procedural and antifraud rules designed to make disclosure more effective. In contrast, regulating the substance of corporate governance standards is appropriately left to the states.

As the last paragraph suggests, the SEC admittedly has authority to regulate disclosure, including disclosure relating to executive compensation. As I explain at pages 481-482 of Corporation Law and Economics, however, this is an unwise use of the SEC's powers:

The SEC argues that its rules provide shareholders with a clear and concise presentation of compensation paid officers, which supposedly gives shareholders greater opportunity to make their views known. Presumably, greater disclosure enables shareholders to complain to the board about excessively high compensation, challenge excessive compensation in derivative litigation, reject excessive compensation plans put to a shareholder vote, and vote out of office directors who approve excessive compensation. The theory of rational shareholder apathy, however, predicts that most shareholders prefer to be passive investors.[1] A rational shareholder will expend the effort to make an informed decision only if the expected benefits of doing so outweigh its costs. Given the length and complexity of SEC disclosure documents, the opportunity cost entailed in becoming informed before voting is quite high and very apparent. Moreover, most shareholders? holdings are too small to have any significant effect on the vote?s outcome. Accordingly, shareholders assign a relatively low value to the expected benefits of careful consideration.

If shareholders are rationally apathetic, more comprehensible information will not lead to better decisions. Indeed, greater volumes of information will only make the situation worse. If the SEC?s executive compensation disclosure rules thus increase the cost to companies of complying with their disclosure obligations, but do not lead to more informed shareholder decisionmaking, what then is their purpose? One can but infer that, in adopting these rules, the SEC got back into the therapeutic disclosure business. In other words, the Commission is using disclosure requirements not to inform shareholders, but to affect substantive corporate behavior. In this case, to put the brakes on executive compensation.

Therapeutic disclosure requirements undoubtedly affect corporate behavior. Therapeutic disclosure, however, is troubling on at least two levels. First, seeking to effect substantive goals through disclosure requirements violates the Congressional intent behind the federal securities laws. When the New Deal era Congresses adopted the Securities Act and the Securities Exchange Act, there were three possible statutory approaches under consideration: (1) the fraud model, which would simply prohibit fraud in the sale of secu?rities; (2) the disclosure model, which would allow issuers to sell very risky or even unsound securities, provided they gave buyers enough information to make an informed investment decision; and (3) the blue sky model, pursuant to which the SEC would engage in merit review of a security and its issuer. The federal securities laws adopted a mixture of the first two approaches, but explicitly rejected federal merit review. As such, the substantive behavior of corporate issuers is not within the SEC?s purview.

Second, and even more disturbing, in this case the SEC?s rules overstep the boundaries between the federal and state regulatory spheres. The Commission contended that its rules bring shareholders into the compensation committee or board meeting room and thereby enable them to see specific decisions through the eyes of the directors. This goal, however, flies in the face of the separation of ownership and control created by state corporate law. Under state law, shareholders have no right to approve most board decisions, let alone to initiate corporate action. Of particular relevance in this context, shareholders have no right to participate in compensation decisions. In other words, they have no right to be brought within the meeting room. 

In other words, Donaldson ought to go about his business. the SEC has plenty to do without getting into these areas in which it has no power or authority.

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[1] CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69, 89 (1987).

[2] Burks v. Lasker, 441 U.S. 471, 478 (1979) (citations omitted).

[3] CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69, 89 (1987).

[4] Some argue that the state also has an interest in corporations that make a substantial contribution to the state. Corporations provide employment and a crucial tax base, sell and purchase goods and services, and supply support for community activities. This interest in any corporation will vary from case to case, but it is a real interest, deriving from the corporation?s existence as a tangible economic entity created by state law. See Mark A. Sargent, Do the Second Generation State Takeover Statutes Violate the Commerce Clause?, 8 Corp. L. Rev. 3, 23 (1985).

[5] CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69, 90 (1987).

[6] New State Ice Co v. Liebmann, 285 U.S. 262, 311 (1932) (Brandeis, J., dissenting).

[1] The SEC may believe that this shareholder passivity model no longer holds true in light of the growing importance of institutional investors. To be sure, institutional investors are an increasingly important force in the stock markets and, moreover, some institutions are playing a more active role in corporate governance. At the same time, however, the passivity model undoubtedly will remain applicable even to most institutional investors. See Stephen M. Bainbridge, The Politics of Corporate Governance, 18 Harv. J. L. & Pub. Pol?y 671 (1995).

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The Ongoing Demise of the Imperial CEO: Bye, Bye Carly

In theory, corporations are run by their board of directors. As the Delaware corporation statute puts it, for example:

The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors ....

While DGCL section 141(a) thus allows the board to delegate powers to managers, it leaves no doubt that it is the board that is ultimately to be the primary authority.

According to conventional wisdom, however, the board-management relationship is reversed in the real world. According to this view, a corporation?s CEO dominates the company?s board of directors by using his de facto power to select and compensate directors and by exploiting his personal ties with the board members. For a good recent statement of this view, see Lucian Bebchuk and Jesse Fried?s provocative book on executive compensation (which I reviewed at great length for the Texas Law Review and at much shorter length for TCS).

CST and Marxism: Plus Ruminations on Catholic Legal Scholarship

At a conference over the weekend, I had what one observer referred to as a "full and frank" discussion of the intellectual roots of Catholic social thought with esteemed Catholic legal scholar Tom Shaffer. As I understood Tom's claim, he argued that CST is basically Marxist in origin because it accepts virtually all of Marx's core principals excepting only such things as the claim that religion is the opiate of the masses and so on.

I will concede that elements of CST were infused with a Marxist sensibility during the heyday of liberation theology, of course, but I rather forcefully rejected Tom's apparent view that the key documents - especially the foundation stone laid by Rerum Novarum should be understood as even quasi-Marxist documents.

In doing some subsequent research on the subject, I found a very interesting essay on the historical roots of CST by Father Robert Sirico. Fr. Sirico concludes that:

Taken as a whole, and read in the context of its historical setting, Rerum Novarum provides one of the most finely honed defenses of the free market and private property order in the annals of Catholic, indeed Christian, social thought up until the appearance of Centesimus Annus, which expands Leo's notion of property beyond land ownership, to include "the possession of know-how, technology and skill." (#32)

I suspect my friend Mark Sargent would add Sirico to his list of CST outliers, which includes myself and Michael Novak (at least I'm in very good company!). Yet, I thought Sirico's essay makes a very strong case that the key documents of CST in fact can be squared with a classical liberal understanding of the roles of the state and the economy. More precisely, Sirico claims:

Articulating a classically liberal view of the social crisis is obviously not what Leo had in mind when he wrote his encyclical. Yet, I would contend that classical liberal thought is at least as much in the tradition of Rerum Novarum as is the collectivist interpretation it has historically received.

Indeed, the standard interpretation given Rerum Novarum in many circles has obfuscated much of what is authentically liberal in Catholic social thought. Unfortunately, the interpretations of certain theorists have so dominated discussions on what is the proper Christian response to social, political, and economic calamities or injustices, that any classical liberal interpretation of contemporary injustices is greeted as naive, insensitive, or even heretical.

Perhaps it is precisely because CST is capable of both such an interpretation and that given it by Tom Shaffer that we end up, as Mark Sargent put it at the conference, back where we started from. In other words, it perhaps is not surprising that putting ideas through what Mark calls the "Catholic wringer" leads us back to the same place we would arrive using wholly secular precepts.

This line of analysis may call into question the enterprise to which the Mirror of Justice blog is devoted; namely, is it worth trying to figure out what a distinctively Catholic legal thought looks lie? Is CST and Catholicism generally such a big tent that there inevitably will be multiple legitimate Catholic perspectives on legal questions? If so, what do we add to the debate by invoking CST other than perhaps very useful end of insisting that faith-based discourse has a legitimate role in the public square. I'm genuinely curious and so plan to pose these questions to my fellow Mirror of Justice bloggers.

Liberal media bias and shareholder rights

Hugh Hewitt invites me to comment on an interesting aspect of the Jordan Eason flap:

Even if Jordan does not want the remarks made public, the Time Warner corporate leadership owes it to their shareholders to force disclosure. I would be interested in Professor Bainbridge's take on the various duties, if any, flowing around a situation where a senior, senior executive is caught not in criminal wrongdoing but rather the sort of controversy that drags the brand value down.  The Professor of the Vines has been skeptical in the past of corporate pressure as a means to communication company change, but perhaps there is some sort of obligation for the company to investigate whether a senior exec is lying through his teeth in order to head off major damage should he be revealed to have done so?

Oddly enough, I am teaching a case in today's Business Associations class that speaks directly to this issue; namely, Kamin v. American Express, 383 N.Y.S.2d 807, in which the court explained:

A complaint which alleges merely that some course of action other than that pursued by the Board of Directors would have been more advantageous gives rise to no cognizable cause of action. Courts have more than enough to do in adjudicating legal rights and devising remedies for wrongs. The directors’ room rather than the courtroom is the appropriate forum for thrashing out purely business questions which will have an impact on profits, market prices, competitive situations, or tax advantages.

It is true that directors have a duty to keep themselves informed. Directors who are grossly negligent in failing to inform themselves of material developments with the firm in theory can be held liable for that failure. (See the discussion of the duty of oversight at pages 291-96 of my Corporation Law and Economics text.) Hence, Time Warner's board may have a duty to investigate the impact of the Eason Jordan flap on the CNN brand (I'm more than a little skeptical as to whether the flap really is material to a company of Time Warner's size and diversification, however). If the board were to do so and decide to take no action, however, Kamin makes clear that there will be no cause of action for the shareholders.

Update: My friend and fellow law professor Gordon Smith agrees:

I understand that Hugh is intense on the subject of liberal media bias, and I am sympathetic to a point. I even posted some information on media bias yesterday at Times & Seasons, though I will admit that the studies did not blow my socks off, and I think claims of media bias are wildly overblown by Hugh and like-minded folks. Nevertheless, despite my sympathy for Hugh's outrage at Jordan, the notion that Time Warner's board has a duty to stockholders to "force disclosure" is fanciful in the extreme. Like Steve, I cannot imagine that this flap is material to Time Warner, and even if it were, the board would have broad discretion to pursue its own notion of the proper course of action. While such action could conceivably include forcing disclosure, no law would compel that result. Simple as that.

Which just goes to show that life in the frozen tundra of Wisconsin has not deprived him of his keen insight.

Hewitt Invites

Hugh Hewitt invites me to comment on an interesting aspect of the Jordan Eason flap:

Even if Jordan does not want the remarks made public, the Time Warner corporate leadership owes it to their shareholders to force disclosure. I would be interested in Professor Bainbridge's take on the various duties, if any, flowing around a situation where a senior, senior executive is caught not in criminal wrongdoing but rather the sort of controversy that drags the brand value down.  The Professor of the Vines has been skeptical in the past of corporate pressure as a means to communication company change, but perhaps there is some sort of obligation for the company to investigate whether a senior exec is lying through his teeth in order to head off major damage should he be revealed to have done so?

Oddly enough, I am teaching a case in today's Business Associations class that speaks directly to this issue; namely, Kamin v. American Express, 383 N.Y.S.2d 807, in which the court explained:

A complaint which alleges merely that some course of action other than that pursued by the Board of Directors would have been more advantageous gives rise to no cognizable cause of action. Courts have more than enough to do in adjudicating legal rights and devising remedies for wrongs. The directors’ room rather than the courtroom is the appropriate forum for thrashing out purely business questions which will have an impact on profits, market prices, competitive situations, or tax advantages.

It is true that directors have a duty to keep themselves informed. Directors who are grossly negligent in failing to inform themselves of material developments with the firm in theory can be held liable for that failure. (See the discussion of the duty of oversight at pages 291-96 of my Corporation Law and Economics text.) Hence, Time Warner's board may have a duty to investigate the impact of the Eason Jordan flap on the CNN brand (I'm more than a little skeptical as to whether the flap really is material to a company of Time Warner's size and diversification, however). If the board were to do so and decide to take no action, however, Kamin makes clear that there will be no cause of action for the shareholders.

Update: My friend and fellow law professor Gordon Smith agrees:

I understand that Hugh is intense on the subject of liberal media bias, and I am sympathetic to a point. I even posted some information on media bias yesterday at Times & Seasons, though I will admit that the studies did not blow my socks off, and I think claims of media bias are wildly overblown by Hugh and like-minded folks. Nevertheless, despite my sympathy for Hugh's outrage at Jordan, the notion that Time Warner's board has a duty to stockholders to "force disclosure" is fanciful in the extreme. Like Steve, I cannot imagine that this flap is material to Time Warner, and even if it were, the board would have broad discretion to pursue its own notion of the proper course of action. While such action could conceivably include forcing disclosure, no law would compel that result. Simple as that.

Which just goes to show that life in the frozen tundra of Wisconsin has not deprived him of his keen insight.

The Right's Attack on Public Pension Funds

The LA Times op-ed page gave California Treasurer Phil Angelides a platform to launch a vicious attack on Governor Arnold Schwarzenegger's plans to shift new public employee pension funds from large defined benefit plans like CalPERS into 401(k)-like personal accounts:

Gov. Arnold Schwarzenegger says getting rid of public pension plans for California's state and local government workers is about helping to balance the budget. Peel back the budget wrapping on his plan, though, and you will find the governor's real agenda: the California prong of a national attack on the pension funds that have stood up for corporate reform and the interests of ordinary families and investors hurt by the recent wave of corporate scandal.

It is true that Schwarzenegger's plan would have the added side benefit of pulling the teeth of CalPERS and, if done on a national basis, other state public pension funds that have been corporate governance activists. Yet, the reason is not to protect business, but to protect investors and taxpayers. From what. you ask? I answered that question in a TCS column several months ago:

[Corporate governance] activism is principally the province of a very limited group of institutions. Almost exclusively, the activists are union and state employee pension funds. They are the ones using shareholder proposals to pressure management. They are the ones most likely to seek board representation. As AFSCME chairman Gerald McEntee recently told LA Times columnist James Flanigan: "We're not looking to take over the corporation, but to have a voice through one or two or three seats on the board."

One might reasonably wonder what a public employee union knows about running business corporations. Might they have another agenda for board representation?

The interests of large and small investors often differ. As management becomes more beholden to the interests of large shareholders, it may become less concerned with the welfare of smaller investors. If the large shareholders with the most influence are unions or state pensions, however, the problem is exacerbated.

The interests of unions as investors differ radically from those of ordinary investors. The pension fund of the union representing Safeway workers, for example, is trying to oust directors who stood up to the union in collective bargaining negotiations. Union pension funds have used shareholder proposals to obtain employee benefits they couldn't get through bargaining (although the SEC usually doesn't allow these proposals onto the proxy statement). AFSCME's involvement especially worries me; the public sector employee union is highly politicized and seems especially likely to use its pension funds as a vehicle for advancing political/social goals unrelated to shareholder interests generally.

Public pension funds are even more likely to do so. Indeed, the LA Times recently reported that CalPers' renewed activism is being "fueled partly by the political ambitions of Phil Angelides, California's state treasurer and a Calpers board member, who is considering running for governor of California in 2006." In other words, Angelides is using the retirement savings of California's public employees to further his own political ends.

Such abuse of public pension funds by incumbent politicians is unfair to their political opponents, other investors, and especially the retirees who depend on those funds. Studies have consistently shown that the greater the extent to which a public pension fund is subject to direct political control, the worse its investment returns.

Schwarzenegger's proposal thus would be an important step towards ensuring that state employee retirement plans are devoted solely to the interests of workers and retirees rather than the personal political interests of hacks like Angelides and his union buddies.

The drag on investment returns from CalPERS political shenanigans is clear. Workers and retirees who were free to invest in, say, a S&P 500 index mutual fund would have done much better that CalPERS beneficiaries:

At the end of the 2003 calendar year, the pension fund's investments had gained 23.3 percent--close to but still lagging the Dow Jones Industrial Average (up 25.3 percent) and well behind the wider S&P 500 Index (28.7 percent). (Link)

Granted, CalPERS did okay in some down years. Over time, however, it has significantly underperformed a well-diversified passively managed portfolio.

The problem is endemic to activist public pension funds. As Roberta Romano's detailed empirical analysis observed, "the empirical studies suggest that it has an insignificant effect on targeted firms' performance. Very few find evidence of a positive impact, and some even find a significant negative stock price effect from activism." Given the lack of evidence for positive effects, why do CalPERS and other public pension funds waste resources pursuing it? Romano suggests:

It is quite probable that private benefits accrue to some investors from sponsoring at least some shareholder proposals. The disparity in identity of sponsors--the predominance of public and union funds, which, in contrast to private sector funds, are not in competition for investor dollars--is strongly suggestive of their presence. Examples of potential benefits which would be disproportionately of interest to proposal sponsors are enhanced political reputations for public pension fund managers or progress on labor rights desired by union fund managers. A further potential private benefit concerns personal employment, the "revolving door" issue common to government employees.

In other words, as my TCS column suggested, the activism Angelides praised likely benefits politicos like Angelides, but not investors or plan beneficiaries.

The Compensation Conundrum

My latest TCS Daily column

Executive compensation has grown by leaps and bounds over the last two decades. By 2003, the average large firm CEO made 500 times what the average worker made. In the aggregate, during the five-year period 1998-2002, compensation paid to the top five executives at 1500 large public corporations totaled roughly $100 billion.

Yet, we live in an era in which many occupations carry such vast rewards. Lead actors routinely earn $20 million per film. The NBA's average salary is over $4 million per year. Top investment bankers can earn annual bonuses of $5 to $15 million. Unless one's objection is solely based on the size of executive compensation, perhaps for redistributionist reasons, critics of executive compensation must be able to distinguish corporate managers from these other highly paid occupations.

In their new book Pay Without Performance (Cambridge, MA: Harvard University Press, 2004. Pp. xii, 278. $24.95), law professors Lucian Bebchuk and Jesse Fried contend that actors and sports stars bargain at arms'-length with their employers, while managers essentially set their own compensation. As a result, they claim, even though managers are under a fiduciary duty to maximize shareholder wealth, executive compensation arrangements often fail to provide executives with proper incentives to do so and may even cause executive and shareholder interests to diverge. In other words, the executive compensation scandal is not the rapid growth of management pay in recent years, as too many glibly opine, but rather the failure of compensation schemes to award high pay only for top performance.

Bebchuk and Fried's analysis is premised on what they call "managerial power." They claim that "directors have been influenced by management, sympathetic to executives, insufficiently motivated to bargain over compensation, or simply ineffectual in overseeing compensation." As a result, executive pay has greatly exceeded the levels that would prevail if directors loyal to shareholder interests actually bargained with managers at arms'-length.

In a true tour de force, Bebchuk and Fried march relentlessly through one form of executive compensation after another, advancing a consistent story of how management influence taints and distorts the compensation process. Although they frequently reference theoretical models and empirical studies supporting their argument, this section was clearly written with a lay reader in mind. Bebchuk and Fried's efforts in this regard are quite successful; they have produced a highly accessible indictment of executive compensation practices.

Bebchuk and Fried's Managerial Power Model

Conventional wisdom says that the principal-agent problem is the central issue of corporate governance. Agents who shirk do not internalize all of the costs thereby created; the principal reaps part of the value of hard work by the agent, but the agent receives all of the value of shirking. Wherever a principal-agent problem is found, we thus expect to see a mixture of carrots and sticks designed to constrain shirking. The sticks include ex post sanctions, up to and including dismissal. The carrots include incentives that align the agent's interests with those of the principal.

In theory, the principal-agent problem could be ameliorated by executive compensation schemes that realign the interests of corporate managers with those of the shareholders. In practice, however, as Bebchuk and Fried show, the most common forms of executive compensation fail to remedy the principal-agent problem. Indeed, some forms exacerbate the problem.

According to Bebchuk and Fried, boards of directors -- even those nominally independent of management -- have strong incentives to acquiesce in executive compensation that pays managers rents (i.e., amounts in excess of the compensation management would receive if the board had bargained with them at arms'-length). Among these are: Directors often are chosen de facto by the CEO. Once a director is on the board, pay and other incentives give the director a strong interest in being reelected; in turn, due to the CEO's considerable influence over selection of the board slate, this gives directors an incentive to stay on the CEO's good side. Directors who work closely with top management develop feelings of loyalty and affection for those managers, as well as becoming inculcated with norms of collegiality and team spirit, which induce directors to "go along" with bloated pay packages. Finally, Bebchuk and Fried argue that those few directors who resist these incentives and seek to put shareholder interests first face a number of obstacles in both the law and practice of corporate governance.

The net effect of managerial power is that CEO pay packets are higher than would obtain under arms'-length bargaining and less sensitive to performance. As a result, compensation of CEOs and other top managers has become a not insignificant chunk of corporate earnings. Yet, Bebchuk and Fried claim, much of that pay has been insensitive to the performance of those companies.

A Cautionary Note on the Evidence

Whether one is persuaded by Pay Without Performance depends in large measure on whether one buys Bebchuk and Fried's interpretation of the evidence, which is often plausible but contestable. In fact, a forthcoming review of Bebchuk and Fried's book by John Core, Wayne Guay, and Randall Thomas argues "that in many settings where 'managerial power' exists, observed contracts anticipate and try to minimize the costs of this power, and therefore may in fact be written optimally." Accordingly, they contend, the managerial power and optimal contracting models are "complementary, and not competing, explanations."

Indeed, while Bebchuk and Fried marshal considerable evidence in support of their managerial power model, there is much competing evidence suggesting that executive compensation packages are designed to align managerial and shareholder interests. Consider, for example, the much maligned practice of management perquisites. If managerial power has widespread traction as an explanation of compensation practices, one would assume that the evidence would show no correlation between the provision of perks and shareholder interests. In fact, however, The Economist recently reported on an interesting study of executive perks finding just the opposite:

"Raghuram Rajan, the IMF's chief economist, and Julie Wulf, of the Wharton School, looked at how more than 300 big companies dished out perks to their executives in 1986-99. It turns out that neither cash-rich, low-growth firms nor firms with weak governance shower their executives with unusually generous perks. The authors did, however, find evidence to support two competing explanations.

"First, firms in the sample with more hierarchical organizations lavished more perks on their executives than firms with flatter structures. Why? Perks are a cheap way to demonstrate status. Just as the armed forces ration medals, firms ration the distribution of conspicuous symbols of corporate status.

"Second, perks are a cheap way to boost executive productivity. Firms based in places where it takes a long time to commute are more likely to give the boss a chauffeured limousine. Firms located far from large airports are likelier to lay on a corporate jet.

"In other words, executive perks seem to be set with shareholder interests in mind, which is inconsistent with the possibility that managerial power offers a unified field theory of executive compensation.

This example is not intended as a comprehensive rebuttal of the managerial power model, but rather to highlight the possibility that many executive compensation practices are at least as consistent with an arms'-length bargaining model as the managerial power model. Indeed, in an important analysis, Bengt Holmstrom and Steven Kaplan noted that while many observers complain that executive compensation packages "represent unmerited transfers of shareholder wealth to top executives with limited if any beneficial incentive effects," the evidence offers "several reasons to be skeptical of these conclusions."

Does the Managerial Power Model Still Hold True?

Pay Without Performance is based in very large part on a law review article Bebchuk and Fried published (with then coauthor David Walker) in 2002. Several versions of that paper were posted to the Social Science Research Network Electronic Library, including one as early as December 2001. In the interim, the world has changed.

In June 2002, the New York Stock Exchange's board approved new listing standards that, inter alia, significantly enlarged the role and power of independent members of listed companies' boards of directors. NASDAQ and AMEX adopted similar changes. A number of the new listing standards speak directly to the problems identified by Bebchuk and Fried.

In July 2002, President Bush signed into law the "Public Company Accounting Reform and Investor Protection Act" of 2002 (the Sarbanes-Oxley Act), which he praised for making "the most far-reaching reforms of American business practices since the time of Franklin Delano Roosevelt." Again, a number of those reforms speak directly to the sources of managerial power identified by Bebchuk and Fried.

Unfortunately for Bebchuk and Fried, they were thus caught in a time bind. Many incremental reforms that they might have proposed are now law, but we do not yet know how well those reforms will work. In response, Bebchuk and Fried adopted a uniform tactic of dismissing those reforms as inadequate.

Under the NYSE's new listing standards, for example, listed companies must create a compensation committee, comprised solely of independent directors, whose minimal duties include setting the CEO's compensation. The committee must adopt written charters specifying their roles, duties, and powers, which must at a minimum conform to the listing standard's detailed requirements. The committee is now charged with hiring compensation consultants, a task previously left to management. To address the longstanding problem of director interlocks, in which the CEO of two companies would sit on each other's board of directors' compensation committee, and presumably scratch each other's back, the new listing standards provide that a director may not be deemed independent if he is employed (or has been employed in the last five years) by a company in which an executive officer of the listed company serves as a member of the board of directors' compensation committee.

Bebchuk and Fried dismiss these developments on grounds that the new standards "merely make mandatory a practice that most public companies already have been following for some time." Surely this is too glib. In the first place, all public corporations -- not just "most" -- must now comply with these requirements. In the second, transforming what were once mere matters of good practice into affirmative legal requirements may have a salutary effect. To be sure, I am speculating here, but the larger point is that we simply don't know yet. As a practical matter, the process of implementing the new listing standards has just begun. Inevitably, it will take time to determine whether they are as toothless as Bebchuk and Fried claim.

Instructively, however, a recent study of compensation committees in IPO firms found "little support for the managerial power model." They found no evidence that including insiders or executives from other firms on the compensation committee was correlated with either higher CEO pay levels or lower incentives. Instead, noting that higher director compensation was coupled with higher CEO compensation and that the presence of large blockholders was correlated with lower CEO compensation, the study concludes that "CEO pay and incentives are set taking into account the supervisor (compensation committee)'s self-interest rather than simply assuming the supervisor will act on the owner's behalf or co-opt with CEO."

The NYSE's new standards also require that all listed corporations create a nominating and corporate governance committee comprised solely of independent directors. Again, Bebchuk and Fried dismiss this change as inadequate to limit the power of the CEO. Here, however, there is research to the contrary. Westphal and Zajac have demonstrated that as board power increases relative to the CEO -- measured by such factors as the percentage of insiders and whether the CEO also served as chairman -- newly appointed directors become more demographically similar to the board. Accordingly, enhanced powers of independent directors to control the nomination process should prove an effective constraint on CEO influence.

The new listing standards also substantially limit the CEO's ability to financially reward compliant directors. The new rules, for example, limit the amount of additional compensation directors may receive over and above their director fees. They also limit the amount of business that may be conducted between the corporation and a business associated with one of its independent directors.

Finally, the NYSE's new stock exchange listing standards significantly tighten the definition of director independence. To be sure, the evidence as to the corporate governance value of director independence is, at best, mixed. (For a summary of the evidence and the NYSE rules, see my article A Critique of the NYSE's Director Independence Listing Standards.) Yet, the new rules are only now taking effect. In addition, as Bebchuk and Fried concede, the amount of time independent directors are devoting to board work, including compensation decisions, has been increasing significantly in recent years. Once again, it may be too early to tell whether the new rules will make significant changes.

In sum, Bebchuk and Fried acknowledge that the changes just described will move the executive compensation process towards the arms'-length ideal, but contend that those changes do not eliminate the various factors that they claim give directors incentives to favor executives at the expense of shareholders. Accordingly, they claim, sweeping reforms are required. But how do we know? Indeed these changes are only now taking affect. Surely it is too soon to tell, especially since there is evidence that the changes already in place can be expected to have salubrious effects.

Conclusion

Should we change the law to more closely regulate executive compensation. If you believe executive compensation is just plain too high, none of the foregoing will matter. You'll want the law to drive down compensation levels. If the absolute level of executive compensation isn't what concerns you, however, the policy question depends on whether you think compensation is set at arms'-length between managers and directors acting on behalf of the shareholders or is essentially set by the managers themselves without regard to shareholder interests.

Bebchuk and Fried clearly fall into the latter category. Accordingly, Pay Without Performance closes with a slew of recommended reforms to change the law.

In this essay, by contrast, I have argued that the managerial power model was never a complete explanation of what is going on with executive compensation. In addition, I note that we've already seen important reforms that promise to significantly constrain both managers and directors. The bottom line thus is that we should wait and see what happens next before rushing forward with more changes in the law.

John Randolph famously opined that "Providence moves slowly, but the devil always hurries." Let's stay on the side of the angels.

The Grasso Pay Flap

The release of the NYSE report on former CEO Richard Grasso's pay package prompted this observation from the WSJ($):

Carl McCall, the former New York state comptroller who headed the NYSE board's compensation committee in 2003 when it approved Mr. Grasso's most-lucrative contract, signed the document without fully understanding or reading all of it. Like Mr. Spitzer, Mr. McCall is a prominent Democrat, and Mr. Grasso has questioned why Mr. Spitzer didn't sue Mr. McCall, too. Wall Street financier Kenneth Langone, a Republican donor who was Mr. McCall's predecessor as compensation chairman, is named in Mr. Spitzer's suit. ...

One legal expert who has followed the case said some of the report's most-damaging revelations involve Mr. McCall, now a private-equity investor. In addition to not fully reading the 2003 contract, the report said, Mr. McCall asked an NYSE staffer to give him a written description of the document to use in briefing the full NYSE board, but then didn't review it. When he made his presentation to the board, "by most accounts [he] struggled in explaining" the contract, the report said.

"I am scratching my head as to why ... Mr. Spitzer went after Mr. Langone but not Mr. McCall," said Henry Hu, a law professor at the University of Texas at Austin.

One possible explanaton, of course, is that Eliot Spitzer plans to run as a Democrat for Governor of New York in 2006. he's even got a campaign website up and running. And there's precedent in Spitzer's past to believe that prosecutorial decisions are made for political reasons.

So how does Spitzer explain the decision not to go after McCall?

Asked why Mr. McCall wasn't sued, a Spitzer spokesman said, "You have to draw a distinction between who misled the board and people who were misled."

At first blush, that sort of makes sense. And it would make sense if Spitzer was going after Grasso and Langone in a criminal prosecution in which the distinction between malfeasance and misfesance presumably would loom large. In a civil suit for excess compensation, however, that distinction is far less significant. Directors who are grossly negligent in failing to inform themselves before approving an excessive compensation package can be held liable for that failure. Based on the facts in the report, one could certainly make a plausible case for liability on that ground against McCall. Hence, in fact, it does seem reasonable to infer that Spitzer's political aspirations once again intruded on the decisionmaking process.

BTW, Houston attorney Tom Kirkendall makes a very nice point in his post on the NYSE report:

Of course, the MSM is self-righteously indignant with the corpulent details of Mr. Grasso's perks, including $193 million in annual pay, early pension payouts and estimated interest earned on those payouts from 1995 through 2003, as well as the $240,000-a-year secretary, two $130,000-a-year drivers, access to a private plane, and club memberships. ... Alas, what is completely lost in the MSM treatment of Mr. Grasso's pay and Mr. Spitzer's Robin Hood lawsuit is the real issue, which is the failed corporate governance model of the NYSE.

Exactly. What the MSM (and, I think, Spitzer) persistently ignore is that the central legal issue is not the amount of the compensation but the process by which it was set. Yes, the compensation must be excessive in order for there to be a recovery. But you never reach the question of whether the compensation was in fact excessive until you first determine that the business judgment rule does not protect the board's decision. And in order to rebut the business judgment rule so as to reach the merits of the claim you must show that the decisionmaking process was flawed by a grossly negligent failure on the part of the board to be informed about the decision. (See generally my law review article The Business Judgment Rule as Abstention Doctrine.)