Chapter 12 executive compensation
Introduction
Because the executive compensation is a potential solution to the principal-agent problem
by aligning CEO and shareholder interests it is a central feature of the corporate governance
system.
Factors what make CEO pay interesting
- Large amount of money which grows very fast. This isn’t always tied to the firm’s
performance
- CEOs total pay is 100 times as much as the average US household
- Scandals and financial crisis have shaken the public’s trust in the CEOs of many firms.
There are 2 competing perspectives on executive compensation:
1. Optimal contracting theory -> markets ultimately determine executive compensation
2. Managerial power theory -> executive pay arrangements are not the outcome of
arm’s length contracting. CEO lay arrangements are fundamentally flawed and
managerial excess is widespread. Executive compensation is part of the corporate
governance problem, rather than the solution.
Theories of executive compensation
The shareholders (principal) elect a board to act on their behalf. The board decides the pay
of the CEO (agent). The economic objective it to align the interests.
Optimal contracting view
- Generally motivated by the principal-agent considerations. There is a big information
asymmetry. The principal isn’t aware of the amount of effort the manager puts in.
- In order to avoid moral hazard management should be rewarded contingent to the
firms performance
- Agency theory predicts that second best contracts reduce opportunistic behaviour on
the part of executives -> These are second best because individual effort cannot be
directly contracted upon.
- Agency costs are not completely eliminated.
Managerial power view
- CEO set pay in their own interests, rather dan shareholder interest.
- The managerial power view argues that bargaining between corporate boards and
CEOs is not determined by arms-length bargaining and that executives’ pay is
excessive. The resulting pay contracts are not in shareholders’’ interests. How can
executives get that much money
o One theory is that CEOs exercise their power and influence over their boards
and use this to lobby for high pay levels.
What constitutes a weak board?
- Too large and to many members
- CEO has appointed outside directors who are beholden to the CEO for their jobs
- Directors may serve on too many boards -> too busy to effectively monitor
- CEO is also chair of the board -> potential conflict of interest
, - The board is too friendly with the CEO
When boardroom governance is weak, managerial power theories predict that excess pay
will result.
There are limits on how high CEO pay can be. It has been argued that too much
compensation can severely damage an executive’s reputation or cause embarrassment. ->
outrage costs
Empirical evidence on executive compensation
Data
Disclosure rules require publicly traded firs to disclose compensation information for the five
highest paid officers and the CEO separately. In addition to the annual measure of
compensation the Securities and Exchange Commission requires companies to reveal the
beneficial ownership of the CEO and the board of directors.
The level of CEO compensation
- That the average exceeds the median pay reflects the fact that there are some highly
paid CEOs that drag the average upwards -> CEO pay is skewed
- CEO pay both increase and decrease
- CEO pay is correlated to economic wealth creation
- Non-CEO executive compensation displays a similar time-series behaviour to CEO
pay
, The structure of executive compensation
- The salary part is pretty consistent (probably because if you earn more than 1 million
you have unfavourable tax)
- The amount of pay delivered in the form of stock options ballooned during the 1990.
- Shift towards performance based compensation
- Restricted stock has become relatively more important mechanism to deliver equity
compensation (probably because of their accounting and tax treatment)
Stock options (aka share options)
stock option is a contract that gives the holder the right to purchase the underlying stock at
some pre-determined price in the future. This can be a potentially effective way to align the
interests of managers with firms and resolve agency problems.
The link between CEO pay and firm performance
There is a positive relation between the pay and the performance, but the correlation is
much weaker than the pay-for-performance link.
Executive compensation in Europe
Europe is catching up with the US regarding executive pay.
- US CEOs earn more than European CEOs
- US CEOs have more pay-at-risk in the form of bonuses and share options
The governance of executive pay
The board of directors and the compensation committee set the pay. Shareholders do have a
say in the annual ‘say-on-pay’ vote.
Compensation committees
A compensation committee makes the process of pay setting much more transparent, and
hopefully more independent, by removing the CEO from deliberations about compensation.
Compensation consultants
Introduction
Because the executive compensation is a potential solution to the principal-agent problem
by aligning CEO and shareholder interests it is a central feature of the corporate governance
system.
Factors what make CEO pay interesting
- Large amount of money which grows very fast. This isn’t always tied to the firm’s
performance
- CEOs total pay is 100 times as much as the average US household
- Scandals and financial crisis have shaken the public’s trust in the CEOs of many firms.
There are 2 competing perspectives on executive compensation:
1. Optimal contracting theory -> markets ultimately determine executive compensation
2. Managerial power theory -> executive pay arrangements are not the outcome of
arm’s length contracting. CEO lay arrangements are fundamentally flawed and
managerial excess is widespread. Executive compensation is part of the corporate
governance problem, rather than the solution.
Theories of executive compensation
The shareholders (principal) elect a board to act on their behalf. The board decides the pay
of the CEO (agent). The economic objective it to align the interests.
Optimal contracting view
- Generally motivated by the principal-agent considerations. There is a big information
asymmetry. The principal isn’t aware of the amount of effort the manager puts in.
- In order to avoid moral hazard management should be rewarded contingent to the
firms performance
- Agency theory predicts that second best contracts reduce opportunistic behaviour on
the part of executives -> These are second best because individual effort cannot be
directly contracted upon.
- Agency costs are not completely eliminated.
Managerial power view
- CEO set pay in their own interests, rather dan shareholder interest.
- The managerial power view argues that bargaining between corporate boards and
CEOs is not determined by arms-length bargaining and that executives’ pay is
excessive. The resulting pay contracts are not in shareholders’’ interests. How can
executives get that much money
o One theory is that CEOs exercise their power and influence over their boards
and use this to lobby for high pay levels.
What constitutes a weak board?
- Too large and to many members
- CEO has appointed outside directors who are beholden to the CEO for their jobs
- Directors may serve on too many boards -> too busy to effectively monitor
- CEO is also chair of the board -> potential conflict of interest
, - The board is too friendly with the CEO
When boardroom governance is weak, managerial power theories predict that excess pay
will result.
There are limits on how high CEO pay can be. It has been argued that too much
compensation can severely damage an executive’s reputation or cause embarrassment. ->
outrage costs
Empirical evidence on executive compensation
Data
Disclosure rules require publicly traded firs to disclose compensation information for the five
highest paid officers and the CEO separately. In addition to the annual measure of
compensation the Securities and Exchange Commission requires companies to reveal the
beneficial ownership of the CEO and the board of directors.
The level of CEO compensation
- That the average exceeds the median pay reflects the fact that there are some highly
paid CEOs that drag the average upwards -> CEO pay is skewed
- CEO pay both increase and decrease
- CEO pay is correlated to economic wealth creation
- Non-CEO executive compensation displays a similar time-series behaviour to CEO
pay
, The structure of executive compensation
- The salary part is pretty consistent (probably because if you earn more than 1 million
you have unfavourable tax)
- The amount of pay delivered in the form of stock options ballooned during the 1990.
- Shift towards performance based compensation
- Restricted stock has become relatively more important mechanism to deliver equity
compensation (probably because of their accounting and tax treatment)
Stock options (aka share options)
stock option is a contract that gives the holder the right to purchase the underlying stock at
some pre-determined price in the future. This can be a potentially effective way to align the
interests of managers with firms and resolve agency problems.
The link between CEO pay and firm performance
There is a positive relation between the pay and the performance, but the correlation is
much weaker than the pay-for-performance link.
Executive compensation in Europe
Europe is catching up with the US regarding executive pay.
- US CEOs earn more than European CEOs
- US CEOs have more pay-at-risk in the form of bonuses and share options
The governance of executive pay
The board of directors and the compensation committee set the pay. Shareholders do have a
say in the annual ‘say-on-pay’ vote.
Compensation committees
A compensation committee makes the process of pay setting much more transparent, and
hopefully more independent, by removing the CEO from deliberations about compensation.
Compensation consultants
