In a WSJ op-ed today, Martin Lipton, Jay Lorsch, and Theodore Mirvis opine that:
This week New York Sen. Chuck Schumer is expected to introduce the Shareholder Bill of Rights Act of 2009. The stated goal of the legislation -- "to prioritize the long-term health of firms and their shareholders" -- is commendable.
The trouble is that its provisions actually encourage the opposite. In its current form, the bill would require annual votes by stockholders on executive compensation. It would grant stockholders a new right to include their own director nominees in the corporation's proxy statement. The bill would put an end to staggered boards at all companies (the traditional option of electing one-third of the board each year). And it would require that all directors receive a majority of votes cast to be elected. Public companies would be forced to split the CEO and board chair positions.
Excessive stockholder power is precisely what caused the short-term fixation that led to the current financial crisis. As stockholder power increased over the last 20 years, our stock markets also became increasingly institutionalized. The real investors are mostly professional money managers who are focused on the short term.
Let's break this collection of really bad ideas down into its component parts, starting with
Say on Pay
Proponents of federal legislation entitling shareholders to vote on executive compensation must carry a burden of proving three distinct claims: First, that there is an executive compensation problem justifying legislative intervention. Second, that any such legislative intervention should be imposed at the federal level. Third, say on pay is an effective solution to the problem.
If any of these claims fail, the case for a federal say on pay law collapses. In this post, I focus on the first and third claims.
Is there an executive compensation problem?
There is no question but that executive compensation has grown significantly over the last two decades. House Report 110-088, which accompanies H.R.1257, notes that in FY 2005 the median CEO among 1400 large companies “received $13.51 million in total compensation, up 16 percent over FY 2004.” The Report also notes that “in 1991, the average large-company CEO received approximately 140 times the pay of an average worker; in 2003, the ratio was about 500 to 1.”
But so what? Many occupations today carry 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. Indeed, according to an April 2007 NY Times report, “The highest paid” investment banker on Wall Street in 2006 was Lloyd Blankfein of Goldman Sachs, who “earned $54.3 million in salary, cash, restricted stock and stock options.” Yet, that sum is dwarfed by the pay of private hedge fund managers. The same Time story reports that hedge fund manager James Simons earned $1.7 billion in 2006 and that two other hedge fund managers also cracked the billion dollar level.
Accordingly, unless one’s objection to the amounts received by corporate executives is based solely on the size of those amounts, one must be able to distinguish corporate managers from these other highly paid occupations.
In their book, Pay Without Performance,[1]upon which House Report 110-088 heavily relies, 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, but rather the failure of compensation schemes to award high pay only for top performance.
Corporate management is viewed conventionally as a classic principal-agent problem. The literature widely credits Adolf Berle and Gardiner Means with tracing the problem to the separation of ownership and control in public corporations.[2]They observed that shareholders, who conventionally are assumed to own the firm, exercise virtually no control over either day to day operations or long-term policy. Instead, control is exercised by a cadre of professional managers. This “separation of ownership from control produces a condition where the interests of owner and of ultimate manager may, and often do, diverge ....”[3]
The literature identifies three particular ways in which the interests of shareholders and managers may diverge. First, and most obviously, managers may shirk—in the colloquial sense of the word—by substituting leisure for effort.[4]Second, managers who make significant non-diversifiable investments in firm specific human capital and hold undiversified investment portfolios in which equity of their employer is substantially over-represented, will seek to minimize firm-specific risks that shareholders eliminate through diversification. As a result, managers generally are more risk averse than shareholders would prefer. Third, managers’ claims on the corporation are limited to their tenure with the firm, while the shareholders’ claim have an indefinite life. As a result, managers and shareholders will value cash flows using different time horizons; in particular, managers will place a low value on cash flows likely to be received after their tenure ends.
In theory, these divergences in interest can be ameliorated by executive compensation schemes that realign the interests of corporate managers with those of the shareholders.
According to Bebchuk and Fried, however, 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). As a result, as their title implies, executives are getting high pay that is largely decoupled from performance incentives.
It is certainly true that directors all too 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. Finally, Bebchuk and Fried argue that 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.
Since Bebchuk and Fried provide much of the intellectual framework for federal proposals of the sort advanced by Schumer, it is worth noting that their claims have faced strong criticism. One review, for example, 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.”[5]Another argues that “most of the results that [Bebchuk and Fried] see as requiring us to postulate managerial dominance turn out to be consistent with a less sinister explanation.”[6]Finally, and perhaps most importantly, Gabaix and Landier find that “the six-fold increase of CEO pay between 1980 and 2003 can be fully attributed to the six-fold increase in market capitalization of large US companies.”[7]In other words, CEOs got richer because their shareholders got richer.
An important piece of evidence in support of this claim is that there are relatively modest differences in pay practices between firms that have a controlling shareholder and those with dispersed share ownership. Why would a controlling shareholder permit managers to extract rents at its expense? Does it not seem more plausible that large blockholders tolerate the challenged compensation practices because they are consistent with shareholder interests rather than representing management’s ability to extract rents inconsistent with shareholder wealth maximization? Support for this explanation is provided by a recent study finding that “highly paid CEOs are more skilled when firms are small or when there are fewer environmental constraints on managerial discretion. This link between pay and skill is especially strong if there is a blockholder to monitor management ….”[8]As such, the observation that the allegedly questionable compensation practices occur both in companies with dispersed and those with concentrated ownership may suggest that those practices are attributable to phenomena other than managerial control.
As another example, consider 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, an interesting study of executive perks found 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.[9]
In other words, executive perks seem to be set with shareholder interests in mind.
In sum, the evidence simply does not support the managerial power model on which HR 1257 rests. To the contrary, executive pay turns out to be closely linked to performance. Put simply, HR 1257 is attacking a problem that does not exist.
Or, perhaps, a problem that has gone away:
Steven Kaplan … calculates that … for firms in the S&P 500 index, average chief-executive compensation peaked in 2000, and has since fallen by about a third. …
Indeed, Fortune magazine's Dominic Basulto thinks CEOs now need to be paid more:
… there’s strong evidence that, far from being paid too much, many CEOs are paid too little. Not only do the top managers of multibillion-dollar corporations earn less than basketball players…, they are also outpaced in compensation by financial impresarios at hedge funds, private equity firms, and investment banks. Should we care? Yes. If other positions pay far more, then the best and the brightest minds will be drawn away from running major businesses to pursuits that may not be as socially useful—if not to the basketball court, then to money management.
Say on Pay and Director Primacy
There is no more basic question in corporate governance than “who decides”? Is a particular decision or oversight task to be assigned to the board of directors, management, or shareholders?
Corporate law generally adopts what I have called “director primacy.” It assigns decision making to the board of directors or the managers to whom the board has properly delegated authority.
Executive compensation is no exception.
The proponents of say on pay often emphasize that HR 1257 proposes only an advisory vote. Yet, the logic of an advisory vote on pay seems to be the same as that underlying precatory shareholder proposals made pursuant to Rule 14a-8. Even though neither is binding, they are nevertheless expected to affect director decisions.
Moreover, say on pay is just one of an array of proposals for empowering shareholders. In that context, it is part of an ongoing effort by a handful of activists to shift substantially the locus of decision making authority.
The trouble is that shareholder involvement in corporate decision making seems likely to disrupt the very mechanism that makes the public corporation practicable; namely, the vesting of “authoritative control” in the board of directors.
The director primacy model is grounded in Kenneth Arrow’s work on organizational decision making, which identified two basic decision-making mechanisms: “consensus” and “authority.”[1]Organizations use some form of consensus-based decision making when each voting stakeholder in the organization has identical information and interests. In the absence of information asymmetries and conflicting interests, collective decision making can take place at relatively low cost. In contrast, organizations resort to authority-based decision-making structures where stakeholders have conflicting interests and asymmetrical access to information. In such organizations, information is funneled to a central agency empowered to make decisions binding on the whole organization.
Small business firms typically use some form of consensus decision making. As firms grow in size, however, consensus-based decision-making systems become less practical. By the time we reach the publicly held corporation, their use becomes essentially impractical.[2]Hence, it is hardly surprising that the modern public corporation has the key characteristics of an authority-based decision-making structure. Shareholders have neither the information nor the incentives necessary to make sound decisions on either operational or policy questions.[3]Overcoming the collective action problems that prevent meaningful shareholder involvement would be difficult and costly.[4]Rather, shareholders should prefer to irrevocably delegate decisionmaking authority to some smaller group.[5]
The board of directors as an institution of corporate governance, of course, does not follow inexorably from the necessity for authoritative control. After all, an individual chief executive could serve as the requisite central decision maker. Yet, corporate law vests ultimate control in a board acting collectively rather than in an individual executive. I have elsewhere suggested two reasons for doing so: (1) under certain conditions, groups make better decisions than individuals and (2) group decision making is an important constraint on agency costs.[6]In any event, the key point is that effective corporate governance requires that decision-making authority be vested in a small, discrete central agency rather than in a large, diffuse electorate.
The case for vesting authority in the board becomes even stronger once one admits to the analysis the relative merits of directors and shareholders. Whatever flaws board governance may have, they pale in comparison to the information asymmetries and collective action problems that lead most shareholders to be rationally apathetic. A rational shareholder will expend the effort to make an informed decision only if the expected benefits of doing so outweigh its costs.[7]Given the length and complexity of corporate disclosure documents, especially in a proxy contest where the shareholder is receiving multiple communications from the contending parties, the opportunity cost entailed in becoming informed before voting is quite high and very apparent. In addition, most shareholders’ holdings are too small to have any significant effect on the vote’s outcome. Accordingly, shareholders can be expected to assign a relatively low value to the expected benefits of careful consideration. Shareholders are thus rationally apathetic. For the average shareholder, the necessary investment of time and effort in making informed voting decisions simply is not worthwhile.[8]
Most shareholders recognize that they are better off pursuing a policy of rational apathy rather than an activist agenda. They know that directors have better information and better incentives than do the shareholders.
Instead, activist shareholders—the type likely to make use of the powers say on pay and its ilk would empower—have tended to come from a distinct sub-set of institutional investors; namely, union and public employee pension funds.[9]As I have observed elsewhere:
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.[10]
The deficiencies of shareholders as decision makers thus compounds the inherent undesirability of reposing ultimate control of an authority-based organization in the hands of a diffuse electorate rather than a central agency.
Conclusion
Legislation that “fixes” a nonexistent problem by upsetting basic principles of federalism ought to be a nonstarter. Unfortunately, the executive compensation debate has become so thoroughly bollixed up with issues of class warfare and financial populism that rational arguments seem to fall on deaf ears.
--------------------------------------------------------------------------------
[1]Lucian Bebchuk & Jesse Fried, Pay Without Performance (Cambridge, MA: Harvard University Press, 2004).
[2]Adolf A. Berle & Gardiner C. Means, The Modern Corporation and Private Property (1932).
[3] Id. at 6.
[4]Michael C. Jensen, A Theory of the Firm: Governance, Residual Claims, and Organizational Forms 144 (2000).
[5]John E. Core, Wayne R. Guay, & Randall S. Thomas, Is U.S. CEO Compensation Inefficient Pay without Performance?28 (December 1, 2004).
[6]Franklin G. Snyder, More Pieces of the CEO Compensation Puzzle, 28 Del. J. Corp. L. 129, 132 (2003).
[7]Xavier Gabaix & Augustin Landier, Why Has CEO Pay Increased so Much?(May 8, 2006).
[8]Robert Daines et al., The Good, the Bad and the Lucky: CEO Pay and Skill5 (Nov. 2004).
[9]In Defence of the Indefensible, Is Showering the Boss With Perks Good For Shareholders?, The Economist, Dec. 2, 2004.
--------------------------------------------------------------------------------
[1]Kenneth J. Arrow, The Limits of Organization 68-70 (1974).
[2]See generally Stephen M. Bainbridge, Privately Ordered Participatory Management: An Organizational Failures Analysis, 23 Del. J. Corp. L. 979, 1055-75 (1998) (explaining the necessity of authority-based governance in public corporations).
[3]See Bainbridge, supra note 2, at 1057-60 (identifying the conflicting interests and access to information of corporate constituents).
[4] Id. at 1056.
[5]As Arrow explains, under condition of disparate access to information and conflicting interests, it is “cheaper and more efficient to transmit all the pieces of information to a central place” and to have the central office “make the collective choice and transmit it rather than retransmit all the information on which the decision is based.” Arrow, supra note 1, at 68-69. In the dominant M-form corporation, the board of directors and the senior management team function as that central office. See Bainbridge, supra note 2, at 1009 (discussing M-form corporation).
[6]Stephen M. Bainbridge, Why a Board? Group Decisionmaking in Corporate Governance, 55 Vand. L. Rev. 1 (2002).
[7]Robert C. Clark, Corporate Law 391 (1986).
[8]See id. at 390-92.
[9]As I have noted elsewhere, “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.” Stephen M. Bainbridge, Pension Funds Play Politics, Tech Central Station, April 21, 2004.
[10] Id.
