Reforming Corporate Governance: The Key to Improving Executive Pay Jesse Fried Harvard Law School

1. Reforming Corporate Governance: The Key to Improving Executive Pay Jesse Fried Harvard Law School Washington D.C. May 4, 2010

2. My work with Lucian Bebchuk offers a critical account of the CEO pay- setting process and its outcomes. • Today’s remarks: • (1) the basic problem with the CEO pay-setting process • (2) why giving shareholders more power should reduce this problem.

3. Executive Pay: The Stakes • Excess pay costs shareholders • Poorly structured pay arrangements: • Dilute incentives to serve shareholders • Distort incentives – • E.g.: ability to unwind stock early causes execs to focus on short-term earnings, at expense of long-term value

4. “Official View” of Executive Compensation • Arm’s-length bargaining with execs • Executives are human – seek higher pay, regardless of performance • But directors, loyal to shareholders, bargain hard with execs • design pay to properly compensate, incentivize execs • CEO pay is a market like any other • The official view • underlies most financial economists’ work on subject • usedto justify boards’ compensation decisions to • shareholders • policymakers • courts

5. Problem with Official View • The official arm’s length story • is neat, tractable, and reassuring – • but fails to account for realities of pay-setting process • It’s not only executives whose incentives matter. • Must look at incentives of directors • Cannot assume directors automatically serve shareholders in setting executive pay.

6. Do Boards Bargain at Arm’s Length? • Many reasons directors favor executives: • Incentives • Going along w/CEO facilitates re-nomination by board • 99+% board elections not contested • CEO’s power to reward directors • Social factors • Collegiality • Loyalty and friendship • Cognitive dissonance • directors who are/were CEOs like current system • Personal costs of favoring executives are small • Paying with other people’s money

7. Warren Buffett (2009) • “In the [last] forty years, …the CEO has had an important role determining their [own] compensation. These people pick their own compensation committees…. [they] aren't looking for Dobermans; they're looking for cocker spaniels. It's been a system that the CEO has dominated. In my experience,boards have done little in the way of thinking through as an owner what they ought to pay these people.”

8. The Managerial Power Approach: Power, Outrage & Camouflage • The same factors preventing arm’s-length bargaining give executives power over boards • Executives use power to influence own pay • Pay higher, more performance-decoupled than it should be • Power not unlimited, of course; constrained by fear of shareholder outrage • More outrageous an arrangement is perceived to be, greater market and social costs to executives and directors • Fear of outrage creates desire to camouflage (obscure or justify) both amount, performance-insensitivity of exec pay

9. Evidence for Managerial Power Approach • Relationship between power and pay • More power, higher pay • More power, pay more decoupled from performance • Gratuitous payments made to outgoing executives • Equity and non-equity pay that is decoupled from executive’s own performance • Camouflage-driven pay practices

10. Camouflage pre-1992: • An SEC official describes pre-1992 state of affairs as follows: “The information [in the executive compensation section] was wholly unintelligible . . . . Depending on the company’s attitude toward disclosure, you might get reference to a $3,500,081 pay package spelled out rather than in numbers. ………. Someone once gave a series of institutional investor analysts a proxy statement and asked them to compute the compensation received by the executives covered in the proxy statement. No two analysts came up with the same number. The numbers that were calculated varied widely.” Linda C. Quinn, Executive Compensation under the New SEC Disclosure Requirements, 63 U. Cin. L. Rev. 769, 770-71 (1995).

11. Camouflage post-1992 (1) • 1992: Summary Comp Table • Firms required to report most forms of compensation in standardized tables with dollar amounts • Salary • Bonus • Long-term incentive compensation • But post-1992 pay designers began relying heavily on • forms of compensation not reportable in table (eg SERPS) • performance-insensitive compensation that can be reported as something other than “salary” • Made to look performance-related. • E.g.: “guaranteed bonus” • 2007: SEC “fixes” table to capture SERPs, etc.

12. Camouflage post-1992 (2) • Backdating, Etc. • option grant backdating to lower exercise price • Inflated value of stock options “under the radar screen” • $ billions, thousands of firms • United Health: $500M paid back by CEO (2007) • option exercise backdating, grant springloading • All of this secret compensation • hard to reconcile with official arm’s-length story • but consistent with managerial power approach

13. Going Forward: What Should be Done? • Root problem: directors don’t care enough about shareholders • “Independence requirements” don’t make directors loyal to shareholders • We should make it easier to replace directors • Majority-voting • Give shareholders access to corporate ballot • Reimburse proxy challengers attracting considerable support • Directors would be more likely to consider shareholders’ interests if greater fear of removal

14. Making Directors More Accountable By making boards accountable to shareholders and attentive to their interests, such reforms would: • make reality closer to the “official story” of arm’s length negotiations • improve executive compensation arrangements; & • improve corporate governance more generally

15. End

16. Introduction • Widespread agreement: many U.S. boards have approved executive pay deals that do not serve shareholders • Pay too high • Pay too decoupled from performance • But still insufficient recognition about • scope and source of problems; and • need for fundamental reforms