CEO Pay and Corporate Governance in the U.S.: Perceptions,Facts, and Challenges

This article brings a broad range of statistical studies and evidence to bear on three common perceptions about the CEO compensation and governance of U.S. public companies: (1) CEOs are overpaid and their pay keeps increasing; (2) CEOs are not paid for their performance; and (3) boards do not penalize CEOs for poor performance. While average CEO pay increased substantially during the 1990s, it has declined since then— by more than 30%—from peak levels that were reached around 2000. Moreover, when viewed relative to corporate net income or profits, CEO pay levels at S&P 500 companies are the lowest they've been in the last 20 years. And the ratio of large‐company CEO pay to firm market value is roughly similar to its level in the late 1970s, and lower than the levels that prevailed before the 1960s. What's more, in studies that begin with the late '70s, private company executives have seen their pay increase by at least as much as public companies. And when set against the compensation of other highly paid groups, today's levels of CEO pay, although somewhat above their long‐term historical average, are about the same as their average levels in the early 1990s. At the same time, the pay of U.S. CEOs appears to be reasonably highly correlated with corporate performance. As evidence, the author cites a 2010 study reporting that, over the period 1992 to 2005, companies with CEOs in the top quintile (top 20%) of realized pay in any given year had generated stock returns that were 60% higher than the average companies in their industries over the previous three years. Conversely, companies with CEOs in the bottom quintile of realized pay underperformed their industries by almost 20% in the previous three years. And along with lower pay, the CEOs of poorly performing companies in the 2000s faced a significant increase in the likelihood of dismissal by their own boards. When viewed together, these findings suggest that corporate boards have done a reasonably good job of overseeing CEO pay, and that factors such as technological advances and increased scale have played meaningful roles in driving the pay of both CEOs and others with top incomes—people who are assumed to have comparable skills, experience, and opportunities. If one wants to use increases in CEO pay as evidence of managerial power or “board capture,” one also has to explain why the other professional groups have experienced similar, or even higher, growth in pay. A more straightforward interpretation of the evidence reviewed in this article is that the market for talent has driven a meaningful portion of the increase in pay at the top. Consistent with this conclusion, top executive pay policies at roughly 97% of S&P 500 and Russell 3000 companies received majority shareholder support in the Dodd‐Frank mandated “Say‐on‐Pay” votes in 2011 and 2012, the first two years the measure was in force.     

U.S. Corporate Governance: Accomplishments and Failings A Discussion with Michael Jensen and Robert Monks

Two of America's most prominent shareholder activists discuss three major issues surrounding the U.S. corporate governance system: (1) the case for increasing shareholder “democracy” by expanding investor access to the corporate proxy; (2) lessons for public companies in the success of private equity; and (3) the current level and design of CEO pay. On the first of the three subjects, Robert Monks suggests that the U.S. should adopt the British convention of the “extraordinary general meeting,” or “EGM,” which gives a majority of shareholders who attend the meeting the right to remove any or all of a company's directors “with or without cause.” Such shareholder meetings are permitted in virtually all developed economies outside the U.S. because, as Monks goes on to say, they represent “a far more efficient and effective solution than the idea of having shareholders nominate people for the simple reason that even very involved, financially sophisticated fiduciaries are not the best people to nominate directors.” Moreover, according to both Jensen and Monks, corporate boards in the U.K. do a better job than their U.S. counterparts of monitoring top management on behalf of shareholders. In contrast to the U.S., where the majority of companies continue to be run by CEO/Chairmen, over 90% of English companies are now chaired by outside directors, contributing to “a culture of independent‐minded chairmen capable of providing a high level of oversight.” In the U.S., by contrast, most corporate directors continue to view themselves as “employees of the CEO.” And, as a result, U.S. boards generally fail to exercise effective oversight and control until outside forces—often in the form of activist investors such as hedge funds and private equity—bring about a “crisis.” In companies owned and run by private equity firms, by contrast, top management is vigorously monitored and controlled by a board made up of the firm's largest investors. And the fact that the rewards to the operating heads of successful private equity‐controlled firms are typically multiples of those received by comparably effective public company CEOs suggests that the problem with U.S. CEO pay is not its level, but its lack of correlation with performance.     

What Public Companies Can Learn from Private Equity Pay Plans

Studies of private equity pay, including one by current SEC commissioner Robert Jackson, have pointed to restrictions on equity sales as a key difference between private equity and public company pay. In this article, the author argues that there is another very important difference: equity compensation in PE pay plans is typically front loaded, with top executives of portfolio companies often required to buy shares, and receiving upfront option grants on three times the number of shares they purchase. Such front‐loaded equity compensation allows PE pay plans to avoid the unintended effects of the “competitive pay policy” that have been embraced by public companies for the past 50 years. Competitive pay—targeted, for example, to provide 50th percentile total compensation regardless of past performance—has the effect of creating a systematic “performance penalty,” rewarding poor performance with more shares and penalizing superior performance with fewer shares. The author's research shows that, for public companies during the past decade or so, the number of shares granted has fallen by 7% for each 10% increase in share prices—and that, primarily for this reason, the front loaded option grants used by PE firms have provided five times more incentive (“pay leverage”) than the average public company's annual series of equity grants. What's more, to the extent that PE pay has been guided by partnership and fixed‐sharing concepts rather than competitive pay, it is the spiritual heir to the value‐sharing concepts that guided public company pay in the first half of the 20th century. For 60 years, General Motors used value sharing in “economic profit”—10% of GM's profit above a 7% return on capital was the formula for the bonus pool for many years—as the basis for all incentive compensation. The author uses the GM history to highlight four ways to improve public company incentives and corporate governance.     

University of Delaware

During the early '90s, sharehold‐ers and other observers were call‐ing for a stronger link between CEO pay and performance–more spe‐cifically, a link between CEO pay and shareholder value. One result was a dramatic increase in the use of stock options for incentive pur‐poses. But, in the face of a booming stock market during the '90s, the “excesses” in CEO pay became a controversial issue in the business press. And when a number of CEOs cashed out their option holdings just prior to the collapse of their own companies' stock prices, the topic generated even more controversy. This roundtable brings together a small group of people from academia, business, institutional investing, and the courts to discuss problems with executive pay and corporate governance. There was general agreement among the pan‐elists that the board of directors and the compensation committee have a fiduciary responsibility to share‐holders to ensure that executive compensation is appropriate, and that an active, informed, and inde‐pendent board is critical to achiev‐ing that end. Nevertheless, in many cases, shareholders have voted on stock option plans and have almost always approved them–and in this sense they too bear some responsi‐bility for incentive plans that fail to serve their own interest. As one remedy for the problem, both the New York Stock Exchange and the Conference Board have called for boards to hire the compensation consultants who design the compen‐sation plans. But this is not likely to be a complete solution since, as several panelists pointed out, the consultants do not negotiate executive pay con‐tracts. There have also been new regulations on board independence to prevent “friendly” boards from overpaying their CEOs–although, here again, some panelists expressed reservations about the loss of “institu‐tional memory” if these regulations mean giving up board members from a company's major suppliers or lead banks. The loss of such outside ex‐pertise and knowledge of the com‐pany may be even more critical now that board members with any pos‐sible relationship to the firm are pro‐hibited from sitting on various board committees. In general, there was a clear pref‐erence among the panelists for market‐based solutions–with greater reliance on investors' ef‐forts to protect their own inter‐ests–as a meaningful alternative to new regulations designed to ensure the sort of responsible be‐havior that monitoring by inves‐tors is intended to accomplish. Survey data indicate that institu‐tional investors have finally real‐ized that pay packages matter, espe‐cially when they are outrageously high and completely disconnected from financial performance. In such cases, investors are likely to “weigh in” on compensation prac‐tices, and through repeated use, the shareholder voting process could become an effective force for disciplining management. The primary role of the judiciary in all this is twofold: first, to hold corpo‐rate board members accountable for their actions; and second, to protect the integrity of the share‐holder voting process.     

Does Say‐on‐Pay Matter? Evidence from Say‐on‐Pay Proposals in the United States

We investigate the effect of say‐on‐pay (SOP) proposals on changes in executive and director compensation. Relative to non‐SOP firms, SOP firms’ total compensation to CEOs does not significantly change after the proposal. However, the mix of compensation does change—companies move away from using cash compensation toward more incentive compensation, offsetting the reduction in bonus. Further, the mix of compensation of non‐CEO executives changes similarly to that of CEOs. Compensation to directors of SOP firms increases less than non‐SOP firms. Firms whose CEOs are well compensated, especially with cash‐based compensation, are most likely to receive a proposal.     

A CEO's Playbook for Creating Long‐Term Value: Ten Essential Resource Allocation Practices

A former CEO of a large and successful public company teams up with a former chief investment strategist and a well‐known academic to suggest ten practices for public companies intent on creating long‐run value:

1. Establish long‐term value creation as the company's governing objective.
2. Ensure that annual plans are consistent with the company's long‐term strategic plan.
3. Understand the expectations embedded in today's stock price.
4. Conduct a “premortem”—and so gain a solid understanding of what can go wrong—before making any large capital allocation decisions.
5. Incorporate the “outside view” in the strategic planning process.
6. Reallocate capital to its highest‐valued use, selling corporate assets that are worth more to or in the hands of others.
7. Prioritize strategies rather than individual projects.
8. Avoid public commitments, such as earnings guidance, that can compromise a company's capital allocation flexibility.
9. Apply best private equity practices to public companies.
10. CEOs should work closely with their boards of directors to set clear expectations for creating long‐term value.

These practices, as the authors note in closing, “are meant to provide a starting point for public companies in carrying out their mission of creating long‐run value—and in a way that earns the respect, if not the admiration and support, of all its important stakeholders.”     

Do corporate governance mechanisms influence CEO compensation? An empirical investigation of UK companies

The aim of this paper is to empirically examine the influence of corporate governance mechanisms, that is, ownership and board structure of companies, on the level of CEO compensation for a sample of 414 large UK companies for the fiscal year 2003/2004. The results show that measures of board and ownership structures explain a significant amount of cross-sectional variation in the total CEO compensation, which is the sum of cash and equity-based compensation, after controlling other firm characteristics. We find that firms with larger board size and a higher proportion of non-executive directors on their boards pay their CEOs higher compensation, suggesting that non-executive directors are not more efficient in monitoring than executive directors. We also find that institutional ownership and block-holder ownership have a significant and negative impact on CEO compensation. Our results are consistent with the existence of active monitoring by block-holders and institutional shareholders. Finally, the results show that CEO compensation is lower when the directors’ ownership is higher.     

What Drives CEOs to Take on More Risk? Some Evidence from the Laboratory of REITs

Many have pointed to excessive risk‐taking by the CEOs of financial firms as a contributor to the recent worldwide economic crisis. The same observers often blame questionable corporate governance structures and compensation practices for that risk‐taking. But is this perception correct? And what is the relationship between CEO incentives and risk‐taking outside of the financial industry, where the government guarantees provided by deposit insurance could have distorted incentives? In an attempt to answer these questions, the authors analyze the relationship between CEO incentives and corporate risk‐taking by 101 U.S. REITs during the period 2003 to 2007. Their main finding is that corporate risk‐taking, as measured by the growth rate in corporate debt (the only measure of risk that is completely under the control of the CEO), is inversely related to CEO stock ownership—that is, the larger the CEO's equity ownership stake, the slower the growth in debt financing and financial risk‐taking. At the same time, the authors find that financial risk‐taking is positively related to large cash bonuses for the CEOs and to situations in which the CEO is also chairman of the board of directors. Finally, the authors also report that CEOs who are relatively new to the job grow more slowly and borrow less, suggesting that boards of directors can temporarily contain risky expansion plans by the CEO. These results provide support for those corporate governance reformers who wish to cut cash bonus payments for CEOs in favor of long‐term stock ownership.     

CEO Compensation and Firm Performance: an Empirical Investigation of UK Panel Data

This paper examines the link between CEO pay and performance employing a unique, hand‐collected panel data set of 390 UK non‐financial firms from the FTSE All Share Index for the period 1999–2005. We include both cash (salary and bonus) and equity‐based (stock options and long‐term incentive plans) components of CEO compensation, and CEO wealth based on share holdings, stock option and stock awards holdings in our analysis. In addition, we control for a comprehensive set of corporate governance variables. The empirical results show that in comparison to the previous findings for US CEOs, pay‐performance elasticity for UK CEOs seems to be lower; pay‐performance elasticity for UK CEOs is 0.075 (0.095) for cash compensation (total direct compensation), indicating that a ten percentage increase in shareholder return corresponds to an increase of 0.75% (0.95%) in cash (total direct) compensation. We also find that both the median share holdings and stock‐based pay‐performance sensitivity are lower for UK CEOs when we compare our findings with the previous findings for US CEOs. Thus, our results suggest that corporate governance reports in the UK, such as the Greenbury Report (1995) that proposed CEO compensation be more closely linked to performance, have not been totally effective. Our findings also indicate that institutional ownership has a positive and significant influence on CEO pay‐performance sensitivity of option grants. Finally, we find that longer CEO tenure is associated with lower pay‐performance sensitivity of option grants suggesting the entrenchment effect of CEO tenure.     

Columbia Law School Roundtable on A Governance Research Agenda for the Academy

Since Jensen and Meckling's formulation of the theory of “agency costs” in 1976, corporate finance and governance scholars have produced a large body of research that attempts to identify the most important features and practices of effective corporate governance systems. But for all the research that has been done in the past 40 years, many practitioners continue to see a disconnect between theory and practice, between the questions researched and the questions that need to be answered. In this roundtable, Martijn Cremers begins by challenging the conventional view that limiting “agency costs” is the main challenge confronted by boards of directors in representing shareholder interests and, hence, the proper focus of most governance scholarship. Especially in today's economy, with the high values assigned to growth companies, the most important function of corporate governance may instead be to overcome the problem of American “short termism” that he attributes to “inadequate shareholder commitment to long‐term cooperation.” And he buttresses his argument with the findings of his own recent research suggesting that obstacles to the workings of the corporate control market like staggered boards and supermajority voting requirements may actually improve long‐run corporate performance by lengthening the decision‐making horizon of boards and the managements they supervise. Vik Khanna discusses Indian Corporate Social Responsibility (CSR) spending and its effects in light of a recent law requiring Indian companies of a certain size to devote at least 2% of their after‐tax profit to CSR initiatives. One unintended effect of this mandate, which took effect in 2010, was that all Indian companies that were spending more than the prescribed 2% of profits cut their expenditure back to that minimum, suggesting that CSR and advertising are substitutes to some extent, and that such legal mandates can discourage CSR spending by early adapters or “leaders.” Nevertheless, Khanna also found evidence of social norms developing in support of CSR, including a spreading perception that such spending can help some companies achieve strategic goals. Jeff Gordon closes by arguing that, to the extent investors are short‐sighted, their short‐sightedness is likely to be justified by their recognition that public company directors have neither the information nor the incentives to do an effective job of monitoring corporate managements. The best solution to the problems with U.S. corporate governance is to replace today's “thinly informed” directors with “activist” directors who more closely resemble the directors of private‐equity owned firms. Such directors would spend far more time with, and be much more knowledgeable about, corporate management and operations—and they would have much more of their personal wealth at stake in the form of company stock.     

Board 3.0: What the Private‐Equity Governance Model Can Offer Public Companies∗

The authors view board structures as an adaptive institution that responds to the key challenges faced by public companies: helping management solve the problems of production and organization of large‐scale enterprise; limiting managerial agency costs; serving as a delegated monitor of the firm's compliance obligations; and responding to the governance environment of changing shareholder ownership patterns. U.S. company board structures are shown to have evolved over time, often through discontinuous lurches, as particular functions have waxed and waned in importance. This article is part of a larger project that traces two iterations of the public company board, what the authors call Board 1.0 (the “advisory board”) and Board 2.0 (the “monitoring board”). The authors argue in particular that Board 2.0, as embedded in both current practice and regulation, now fails the functional fit test for many companies. First, it does not scale to match the dramatic increase in the size and complexity of many modern public corporations. Second, at a time of reconcentrated ownership achieved through institutional investors and increased activism, it does not have the expertise and commitment needed to resolve the tension between managerial or market myopia, or “short‐termism,” and managerial “hyperopia.” This article holds out an optional alternative, Board 3.0, which would bring to the public company board some strategies used by private equity firms for their portfolio company boards. Such “Portco” boards consist of directors who are “thickly informed,” “heavily resourced,” and “intensely interested.” Bringing such “empowered directors” to public company boards could facilitate evolution of the public company board model in response to dramatic changes in the corporate business environment. The authors also suggest possible routes for implementing Board 3.0, including the enlisting of PE firms as “relational investors” that would have both capacity and incentives to engineer changes in board structure.     

EXECUTIVE COMPENSATION STRUCTURE AND CORPORATE GOVERNANCE CHOICES

Using data that reflect the significant growth in incentive compensation during the last decade, we extend research in this area by specifying a more complete model that addresses both corporate governance and risk‐sharing factors that theory suggests should influence compensation policy. We find that the extent of incentive compensation is systematically related to other features of corporate governance, as well as to factors affecting managerial risk aversion. The results support the following conclusions: (a) the presence of outside directors and blockholders facilitates the use of incentive compensation, (b) incentive compensation is inversely related to use of leverage, and (c) the incentive pay component of compensation is lower for CEOs near or at retirement age and is decreasing in the percentage of firm stock already owned by the CEO. JEL classification: G34     

The efficiency of compensation contracting in China: Do better CEOs get better paid?

Over recent years, China adopted a number of ‘western-style’ reforms of corporate governance and executive compensation. We investigate whether boards of Chinese firms evaluate CEO ability and remunerate their CEOs accordingly, an essential tenet of efficient compensation contracting. Using Data Envelopment Analysis to measure CEO ability, we do not find any evidence that CEO ability matters in compensation contracting decisions—it does not lead to either higher pay, stronger pay-for-performance sensitivity, or a higher likelihood of equity grants. This is surprising, since we find evidence that higher ability CEOs achieve superior firm performance. In contrast, we find that powerful CEOs do not overperform, while they enjoy large abnormal pay. Overall, our results suggest that Chinese firms fail to embrace new corporate governance reforms and are unable to fully utilize the reforms’ benefits.

     

CEO incentives-its not how much you pay, but how

The arrival of spring means yet another round in the national debate over executive compensation. But the critics have it wrong. The relentless attention on how much CEOs are paid diverts public attention from the real problem-how CEOs are paid. The authors present an in-depth statistical analysis of executive compensation. The study incorporates data on thousands of CEOs spanning five decades. Their surprising conclusions are at odds with the prevailing wisdom on CEO pay: Despite the headlines, top executives are not receiving record salaries and bonuses. Cash compensation has increased over the past 15 years, but CEO pay levels are just now catching up to where they were 50 years ago. Annual changes in executive compensation do not reflect changes in corporate performance. For the median CEO in the 250 largest public companies, a $1,000 change in shareholder value corresponds to a change of just 6.7 cents in salary and bonus over a two-year period. With respect to pay for performance, CEO compensation is getting worse rather than better. CEO stock ownership-the best link between shareholder wealth and executive well-being-was ten times greater in the 1930s than in the 1980s. Compensation policy is one of the most important factors in an organization's success. Not only does it shape how top executives behave but it also helps determine what kind of executives an organization attracts. That's why it's so urgent that boards of directors reform their compensation practices and adopt systems that reward outstanding performance and penalize poor performance.     

Lucky CEOs and Lucky Directors

We study the relation between opportunistic timing of option grants and corporate governance failures, focusing on “lucky” grants awarded at the lowest price of the grant month. Option grant practices were designed to provide lucky grants not only to executives but also to independent directors. Lucky grants to both CEOs and directors were the product of deliberate choices, not of firms’ routines, and were timed to make them more profitable. Lucky grants are associated with higher CEO compensation from other sources, no majority of independent directors, no outside blockholder on the compensation committee, and a long‐serving CEO.     

A Fireside Chat with Raj Gupta: What It Takes to Create Long‐Term Value

The chairman of two public companies (and former chair and CEO of Rohm and Haas) draws on his experience as a director of five private and 15 public companies in discussing the challenges and opportunities facing today's corporate boards. Perhaps the most formidable challenge is the pace of technological change, which is making business models ‘in all industries and countries’ obsolete and forcing companies to adapt much more quickly than in the past. Along with the risk of obsolescence is the increase in ‘reputational risk’ associated with an ‘information age’ in which companies are forced to monitor the nearly continuous flow of fact, hearsay, and outright fabrication. The author recommends that public company boards adopt a new ‘partnership’ model. Besides ensuring an ‘ethical tone at the top,’ corporate directors should aim to become partners with the senior management team by playing more active roles in strategic planning, risk management, and the design of performance evaluation and incentive pay systems. In the most striking departure from current practice, the author urges directors to seize the opportunity created by the ‘reconcentration’ of ownership of U.S. public companies by actively engaging large institutional investors in a strategic dialogue about the companies' strengths and vulnerabilities. In so doing, proactive directors can help their management teams preempt shareholder activists and create long‐run value by creating a more effective two‐way channel of communication, one with the potential to give management more confidence when undertaking large strategic investments with longer‐run payoffs.     

The Role of Corporate Boards: A Roundtable Discussion of Where We're Going and Where We've Been

In this roundtable that took place at the 2016 Millstein Governance Forum at Columbia Law School, four directors of public companies discuss the changing role and responsibilities of corporate boards. In response to increasingly active investors who are looking to management and boards for more information and greater accountability, the four panelists describe the growing demands on boards for both competence and commitment to the job. Despite considerable improvements since the year 2000, and especially since the 2008 financial crisis, the clear consensus is that U.S. corporate directors must become more like owners of the corporation who “truly represent the long‐term interests of all of the shareholders.” But if activist investors appear to pose the most formidable new challenge for corporate directors—one that has the potential to lead to shortsighted managerial decision‐making—there has been another, less visible development that should be welcomed by wellrun companies that are investing in their future growth as well as meeting investors’ expectations for current performance. According to Raj Gupta, who serves on the boards of HewlettPackard, Delphi Automotive, Arconic, and the Vanguard Group,

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Monitoring Managers: Does It Matter?

We study how well‐incentivized boards monitor CEOs and whether monitoring improves performance. Using unique, detailed data on boards' information sets and decisions for a large sample of private equity–backed firms, we find that gathering information helps boards learn about CEO ability. “Soft” information plays a much larger role than hard data, such as the performance metrics that prior literature focuses on, and helps avoid firing a CEO for bad luck or in response to adverse external shocks. We show that governance reforms increase the effectiveness of board monitoring and establish a causal link between forced CEO turnover and performance improvements.     

Say on Pay: Is It Needed? Does It Work?

A leading compensation practitioner reviews “Say on Pay” rules, those corporate practices giving shareholders the right to vote on executive compensation. The assumption behind “Say on Pay” is that managers may be overpaid because directors fail to provide adequate oversight. O'Byrne questions this underlying assumption. He provides substantial evidence that directors do a poor job overseeing executive pay and that directors have weak incentives to pursue shareholder interests in executive pay. He also finds that “Say on Pay voting is sensitive to differences in pay for performance, but so forgiving that extraordinary pay premiums are required to elicit a majority ‘no’ vote”; and “that three quarters of institutional investors have lower SOP voting quality… than the average investor and almost all have a short‐term focus, with much greater vote sensitivity to current year grant date pay premiums than to long‐term pay alignment and cost.” The common corporate practice of providing competitive target compensation regardless of past performance leads to low alignment of pay and performance. Unfortunately, directors have little incentive to protect shareholder interests “because they are paid labor providers, just like management, not stewards of substantial personal capital.”