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.     

Private Equity,Corporate Governance,and the Reinvention of the Market for Corporate Control

In the early 1980s, during the first U.S. wave of debt‐financed hostile takeovers and leveraged buyouts, finance professors Michael Jensen and Richard Ruback introduced the concept of the “market for corporate control” and defined it as “the market in which alternative management teams compete for the right to manage corporate resources.” Since then, the dramatic expansion of the private equity market, and the resulting competition between corporate (or “strategic”) and “financial” buyers for deals, have both reinforced and revealed the limitations of this old definition. This article explains how, over the past 25 years, the private equity market has helped reinvent the market for corporate control, particularly in the U.S. What's more, the author argues that the effects of private equity on the behavior of companies both public and private have been important enough to warrant a new definition of the market for corporate control—one that, as presented in this article, emphasizes corporate governance and the benefits of the competition for deals between private equity firms and public acquirers. Along with their more effective governance systems, top private equity firms have developed a distinctive approach to reorganizing companies for efficiency and value. The author's research on private equity, comprising over 20 years of interviews and case studies as well as large‐sample analysis, has led her to identify four principles of reorganization that help explain the success of these buyout firms. Besides providing a source of competitive advantage to private equity firms, the management practices that derive from these four principles are now being adopted by many public companies. And, in the author's words, “private equity's most important and lasting contribution to the global economy may well be its effect on the world's public corporations—those companies that will continue to carry out the lion's share of the world's growth opportunities.”     

Baylor University Roundtable on The Corporate Mission, CEO Pay, and Improving the Dialogue with Investors

A small group of academics and practitioners discusses four major controversies in the theory and practice of corporate finance:

• • What is the social purpose of the public corporation? Should corporate managements aim to maximize the profitability and value of their companies, or should they instead try to balance the interests of their shareholders against those of “stakeholder” groups, such as employees, customers, and local communities?
• • Should corporate executives consider ending the common practice of earnings guidance? Are there other ways of shifting the focus of the public dialogue between management and investors away from near-term earnings and toward longer-run corporate strategies, policies, and goals? And can companies influence the kinds of investors who buy their shares?
• • Are U.S. CEOs overpaid? What role have equity ownership and financial incentives played in the past performance of U.S. companies? And are there ways of improving the design of U.S. executive pay?
• • Can the principles of corporate governance and financial management at the core of the private equity model—notably, equity incentives, high leverage, and active participation by large investors—be used to increase the values of U.S. public companies?

     

Session III: Securities Law in Twenty‐First Century America: A Conversation with SEC Commissioner Robert Jackson

SEC Commissioner Robert Jackson comments on three major issues the Commission has been investigating: (1) the concentration of ownership among American stock exchanges; (2) the extent of common ownership of, and potential for undue influence over, U.S. corporations by large institutional shareholders; and (3) the role of corporate boards in promoting and protecting stakeholder interests as well as shareholder interests. In the first of the three areas, Jackson argues that the ownership of 12 of the 13 U.S. stock exchanges by just three financial conglomerates suggests a competitiveness problem— one that, despite the significant reductions in trading costs during the last 15 years, should receive further investigation. To the concerns raised by the common and increasingly concentrated ownership of U.S. public companies by institutional shareholders, the Commissioner's main response is to note that whatever culpability corporate America is forced to assume for our large and growing environmental and social problems must be shared with the largest U.S. institutional shareholders, whose collective resources and influence confer a responsibility to help guide companies when responding to such problems. Finally, on the issue of stakeholder theory and ESG, Jackson insists that asking corporate boards to put the interests of all stakeholders on a par with their shareholders’ when making strategic business decisions would be a mistake. Besides creating a major accountability problem, the adoption of stakeholder theory in place of “the clear, single‐minded objective function of increasing long‐run shareholder value” would deprive boards of their principal guide “when making the difficult tradeoffs among stakeholders that effective oversight and management of public companies require.”     

Statement of the Financial Economists Roundtable: Corporate Tax Reform

Corporate tax reform has been a controversial issue in the U.S. for several years, particularly as U.S. companies have accumulated cash in lower‐tax overseas subsidiaries, while some have used “inversions” to establish overseas corporate domiciles. Two features of U.S. corporate taxation stand out: 1. U.S. corporate income tax rates are the highest in the industrialized world. The federal rate is 35%; and, when combined with state taxes, it averages 39%, as compared to an OECD average of 24%. 2. U.S. corporations pay U.S. tax on their worldwide income, but can choose to avoid indefinitely corporate tax on foreign profits by not repatriating them. Neither feature is present in most other Western countries, where the norm is a “territorial” system that taxes companies only on their domestic profits. The Trump administration has proposed to cut U.S. corporate tax rates to 20%, thereby bringing them down to the OECD average, and to adopt a territorial tax regime like those found in most other Western nations. In this statement signed by 31 senior financial economists, the authors recommend cutting U.S. corporate tax rates, but retaining the current system of taxing the worldwide profits of U.S. companies (while giving them credit for taxes paid in overseas jurisdictions). Once U.S. rates drop to the international average, the economists point out, U.S. companies would have much less incentive under the worldwide system to use transfer pricing schemes to shift their profits to low‐tax jurisdictions than under the proposed territorial alternative. Indeed, under the current system, if the lower rates under consideration are enacted, the location of a company's business activity (including the firm's underlying intellectual property) would not affect its taxation. Along with lower corporate tax rates, the economists also recommend that Congress limit or remove the corporate option to defer the taxation of offshore profits and provide a schedule for repatriating off‐shore funds, using the inducement of the now lower rates as well as the possibility of a “tax holiday.”     

Energy Infrastructure Investment and the Rise of the Uncorporation1

While most large U.S. businesses have long been organized as corporations, a significant portion of our economy, including major parts of our energy infrastructure, are organized as other types of legal entities. These “uncorporations” include such business forms as Master Limited Partnerships (MLPs) and Limited Liability Companies (LLCs). Many practitioners have dismissed these alternative entities as merely tax devices and only peripherally important to mainstream business. But this view misses important features of the uncorporation that make it an important alternative in dealing with the “agency” costs that arise in public companies from separating managerial control from equity ownership. Corporate governance relies heavily on agents such as auditors, class action lawyers, judges, and independent directors to protect shareholders from managerial self‐interest. The obvious costs and defects of relying on these governance mechanisms have generally been seen as a reasonable price to pay for the benefits of the corporate form. But this conclusion depends on the availability and effectiveness of the alternative mechanisms for addressing agency costs. Uncorporations provide such an alternative by tying managers' economic well‐being so closely to that of their firms that corporate monitoring devices become less necessary. Uncorporate governance mechanisms include managerial compensation that is based largely (if not entirely) on the firm's profits or cash distributions, and restrictions on managers' control of corporate cash through liquidation rights and requirements for cash distributions. Business people and policy makers should evaluate the potential benefits of uncorporations before concluding that the costs of corporate governance are an inevitable price of separating ownership and control in modern firms.     

Eclipse of the Public Corporation or Eclipse of the Public Markets?

The authors look back at Michael Jensen's 1989 article “The Eclipse of the Public Corporation.” They find some of his predictions have been borne out but other important ones, not. Jensen concluded that the publicly held corporation was in decline and had outlived its usefulness in many sectors. He argued that agency costs made public corporations an inefficient form of organization and that new private organizational forms promoted by private equity firms would likely replace the public firm. The number of public firms in the U.S. has declined significantly but there are still many hugely profitable and successful public companies. U.S. public markets are still well‐suited for firms with mostly tangible assets. So, what we are really witnessing is an eclipse not of public corporations, but of the public markets as the place where young firms with mostly intangible capital seek their funding. This is especially true when the usefulness of the intangible assets has yet to be proven. Sometimes the market is extremely optimistic about some intangible assets, but otherwise firms with unproven intangible assets may be better off funding themselves privately. This evolution has a downside: investors limited to public markets are cut off from investing in high intangible‐asset firms. Additionally, as fewer firms remain publicly listed, fewer firms will be transparent to society.     

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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Delaware Public Benefit Corporations: Widening the Fiduciary Aperture to Broaden the Corporate Mission

As a past practitioner of corporate law in Delaware for 26 years who remains convinced that the for‐profit corporation remains the best vehicle for raising and allocating private capital, the author nevertheless also believes that the stockholder primacy model that currently animates corporate fiduciary principles is too narrow. In the excerpts from his new book that make up this article, the author describes the “benefit corporation,” which introduces a corporate governance model based on stakeholder principles. This model encompasses a more complete recognition of the complex interdependencies between all aspects of a global society, and of the responsibility of corporations to reflect those interdependencies in their decision‐making. Although initially a skeptic, the author now believes that benefit corporation law offers an important opportunity for companies to align the interests of their investors with those of their stakeholders in a potentially value‐increasing way that is discouraged by traditional corporate law. State legislatures began authorizing benefit corporations in 2010, and they are now available in 32 U.S. jurisdictions. Over 3,000 benefit corporations have been formed. What's more, they are raising capital from traditional funders, including venture capitalists, and at least one benefit corporation has already gone public. As the author says in closing, “the stakeholder governance model facilitated by benefit corporations provides a clear path to a future of shared value creation, and some investors and corporations have started down that path.”     

Law and Executive Compensation: A Cross‐Country Study

Companies outside the U.S. use substantially less equity in their compensation mix than U.S. firms. But despite this consistent “cross‐sectional” difference, the pattern of changes in equity‐based pay of non‐U.S. companies over time appears to mirror changes in the pay of U.S. companies. The authors provide persuasive evidence that features of a nation's legal environment help explain major differences in compensation structure across countries. As a general rule, companies in countries that provide greater protection of shareholder rights use larger amounts of equity‐based compensation. And the equity mix also tends to be higher when a country's legal system ensures strict enforcement of the laws that are on the books. At the same time, since the equity mix varies considerably over time within the same legal environment, it is clear that factors other than the legal environment affect compensation structure. The authors report that, after controlling for legal factors, company‐specific variables that proxy for “agency” conflicts—not only between managers and shareholders, but between controlling and minority shareholders as well—also affect the compensation mix in fairly predictable ways. The bottom line of this study is that, although we may have a global market for talent, compensation structures across countries are not likely to converge unless and until the underlying legal protections afforded shareholders converge. At the same time, the effect of agency costs in compensation design for non‐U.S. firms appears to be partly conditioned by the nation's legal system and the entire set of regulatory and other institutions that are affected by it.     

The Rise of Agency Capitalism and the Role of Shareholder Activists in Making It Work

The past 50 years have seen a fundamental change in the ownership of U.S. public companies, one in which the relatively small holdings of many individual shareholders have been supplanted by the large holdings of institutional investors, such as pension funds, mutual funds, and bank trust departments. Such large institutional investors are now said to own over 70% of the stock of the largest 1,000 U.S. public corporations; and in many of these companies, as the authors go on to note, “as few as two dozen institutional investors” own enough shares “to exert substantial influence, if not effective control.” But this reconcentration of ownership does not represent a complete solution to the “agency” problems arising from the “separation of ownership and control” that troubled Berle and Means, the relative powerlessness of shareholders in the face of a class of “professional” corporate managers who owned little if any stock. As the authors note, this shift from an era of “managerial capitalism” to one they identify as “agency capitalism” has come with a somewhat new and different set of “agency conflicts” and associated costs. The fact that most institutional investors hold highly diversified portfolios and compete (and are compensated) on the basis of “relative performance” provides them with little incentive to engage in the vigorous monitoring of corporate performance and investor activism that could address shortfalls in such performance. As a consequence, such large institutional investors—not to mention the large and growing body of indexers like Vanguard and BlackRock—are likely to appear “rationally apathetic” about corporate governance. But, as the authors also point out, there is a solution to this agency conflict—and to the corporate governance “vacuum” that has been said to result from the alleged apathy of well‐diversified (and indexed) institutional investors: the emergence of shareholder activists. The activist hedge funds and other specialized activists who have come on the scene during the last 15 or 20 years are now playing an important role in supporting this relatively new ownership structure. Instead of taking control positions, the activists “tee‐up” strategic business and financing choices that are then decided upon by the vote of institutional shareholders that are best characterized not as apathetic, but as rationally “reticent”; that is, they allow the activists, if not to do their talking for them, then to serve as a catalyst for the expression of institutional shareholder voice. The institutions are by no means rubber stamps for activists' proposals; in some cases voting for the activists' proposals, in many cases against them, the institutions function as the long‐term arbiters of whether such proposals should and will go forward. In the closing section of the article, the authors discuss a number of recent legal decisions that appear to recognize this relatively new role played by activists and the institutions that choose to support them (or not)—legal decisions that appear to confirm investors' competence and right to be entrusted with such authority over corporate decision‐making.     

FMA Roundtable on New Developments in European Corporate Governance

In this discussion that took place in Helsinki last June, three European financial economists and a leading authority on U.S. corporate governance consider the relative strengths and weaknesses of the world's two main corporate financing and governance systems: the Anglo‐American market‐based system, with its dispersed share ownership, lots of takeovers, and an otherwise vigorous market for corporate control; and the relationship‐based, or “main bank,” system associated with Japan, Germany, and continental Europe generally. The distinguishing features of the relationship‐based system are large controlling shareholders, including the main banks themselves, and few takeovers or other signs of a well‐functioning corporate control market. Given the steady increase in the globalization of business and international diversification by large institutional investors, the panelists were asked to address the question: can we expect one of these two systems to prevail over time, or will both systems continue to coexist, while seeking to adopt some of the most valuable aspects of the other? The consensus was that, in Germany as well as continental Europe, corporate financing and governance practices have already begun to look much like those in the U.S. and U.K., with much less reliance on bank loans and greater use of bonds and public equity. And these financing changes have resulted in major changes in ownership structures that have seen local main banks largely supplanted by foreign institutional investors—some of whom have demanded a greater voice in how companies are run. Moreover, Finnish economist Tom Berglund may well have provided a blueprint for the dominant European governance system of the future in describing the “Nordic model” as

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Shareholders’ tax incentives and changes in the organizational form of foreign operations

This study examines whether the tax incentives of home-country shareholders influence the organizational form changes of foreign operations. While a corporation and a limited company (LC) in South Korea are treated the same for Korean tax purposes, an LC can be treated as a pass-through entity for U.S. tax purposes. This tax treatment of LCs can create incentives for U.S. owners to convert their Korean corporations to LCs. We find that private corporations owned by U.S. shareholders are more likely to convert to LCs than those owned by non-U.S. shareholders. We also find that the tax costs and benefits of conversion affect the likelihood of LC conversion for U.S.-owned firms. Overall, our results suggest that multinational corporations use organizational form changes as a tool for international tax strategies.     

VALUE MAXIMIZATION AND STAKEHOLDER THEORY: COMPATIBLE OR NOT?

Complicating the current corporate governance controversy is a major disagreement about the fundamental purpose of the corporation. There are two main views on what should constitute the principal goal of the firm. Most economists tend to endorse value maximization—that is, maximization of the value of the firm's debt plus equity—or a version of value maximization known as “value‐based management” (VBM) that aims to maximize shareholder value. The main challenger is “stakeholder theory,” which argues that the corporation exists to benefit not just investors but all its major constituencies—employees, customers, suppliers, the local community, and the federal government, as well as shareholders. Thus, whereas the success of a corporation under VBM could be assessed simply by its long‐run return to shareholders, under stakeholder theory a company's success would be judged by taking account of its contributions to all its stakeholders. Using statistical analysis of various measures of corporate success in satisfying non‐investor stakeholders, the author investigates whether a broader focus on multiple stakeholders is necessarily inconsistent with the pursuit of long‐term shareholder value. His main findings in fact suggest just the opposite—namely, that long‐term value creation appears to be a necessary condition for maintaining corporate investment in stakeholder relationships. More specifically, the author's study shows that companies with higher levels of value creation tend to have stronger reputations for treating stakeholders well while companies that create little value end up shortchanging not just their shareholders but all their constituencies. For profitable companies that have previously failed to devote the optimal level of resources to their non‐investor stakeholders, the message of this article is that investing in stakeholders can add value—and, in fact, it pays for companies to spend an additional dollar on stakeholder relationships as long as the present value of the expected (long‐run) return is at least a dollar.     

Leveraged Buyouts in the U.K. and Continental Europe: Retrospect and Prospect

The markets for management buyouts in the U.K. and continental Europe have experienced dramatic growth in the past ten years. In the U.K., buyouts accounted for half of the total M&A activity (measured by value) in 2005. And as in the U.S. during the‘80s, the greatest number of U.K. buyouts in recent years have been management‐ and investor‐led acquisitions of divisions of large corporations. In continental Europe, by contrast, the largest fraction of deals has involved the purchase of family‐owned private businesses. But in recent years, increased pressure for shareholder value in countries like France, Netherlands, and even Germany has led to a growing number of buyouts of divisions of listed companies. Like the U.K., continental Europe has also seen a small but growing number of purchases of entire public companies (known as private‐to‐public transactions, or PTPs), including the largest ever buyout in Europe, the €13 billion purchase this year of the Danish corporation TDC. In view of the record levels of capital raised by European private equity funds in recent years‐which, until 2005, exceeded the amounts invested in any given year‐we can expect more growth in private equity investment in the near future. In continental Europe, the prospects for buyouts remain especially strong, given both the pressure from investors to restructure larger corporations and the possibilities for adding value in family‐owned firms. But, as the authors note, today's private equity firms face a number of challenges in earning adequate returns for their investors. One is increased competition. In addition to the increased activity of U.S. private equity firms, local private equity investors are also facing competition from hedge funds and new entrants such as government‐sponsored operators, family offices, and wealthy entrepreneurs. Another major challenge is finding value‐preserving exit vehicles. Although an IPO is an option for the largest buyouts with growth prospects, most buyout investments are harvested either through sales to other companies or, increasingly, other private equity firms. The latter transactions, known as “secondary” buyouts, now account for a significant share of new funds invested by private equity firms across Europe.     

New Corporate Forms: One Viable Solution to Advancing Environmental Sustainability

There is a clear trend in corporate governance toward increased attention to the environmental and social impacts of business operations. Major consulting firms are advising Fortune 500 companies on how to become more environmentally sustainable, private equity and “impact” investors are measuring environmental, social, and governance (ESG) factors, and voluntary reporting and shareholder resolutions on issues of environmental sustainability are on the rise. While traditional corporate forms allow companies to embrace social and environmental responsibility with some measure of success, various real and perceived risks encourage directors to focus on short‐term profitability. Even if a company has a strong social mission at inception, founders often have difficulty “anchoring their mission” over time. And the lack of required disclosure of social and environmental performance makes it more difficult for investors to evaluate and compare companies. Many believe that the institutionalized mispricing of natural resources and the continued failure to price externalities, combined with the progressive nature of climate change, require the transformation of both business and law. This article discusses social and environmental sustainability within the traditional corporate form and then explores three emerging alternatives that are now being used by businesses in California: limited liability corporations (LLCs); benefit corporations (B corps); and flexible purpose corporations (FPCs). Of these three alternatives, FPCs—a corporate form that requires shareholders to agree on one or more social missions with management and the board—may be best suited to meet the needs of the many small private firms (as well as some large public companies) that, whether for purely economic or altruistic reasons, plan to integrate ESG into their operations.     

Canadian Business Trusts: A New Organizational Structure

The focus of this paper is a subset of income trusts called business trusts, a Canadian financial innovation that has experienced remarkable success in the Canadian market, but not in the U.S. At theendof2005, there were more than 170 business trusts (most of them in Canada, but a handful in the U.S.) with an aggregate market value of over $90 billion. Like income trusts generally, which include REITs and oil & gas trusts, business trusts are designed in large part to avoid taxation at the corporate level by distributing a substantial proportion of a business's operating cash flow. The business trust structure provides investors (called “unit holders”) with what amounts to a combination of subordinated, high‐yield debt and high‐yielding equity. But unlike the subordinated debt in most highly leveraged transactions (HLTs), the “internal” debt in a business trust unit is effectively “stapled” to the equity part of the security. And this kind of “strip financing” (which was a common practice in U.S. LBOs during the‘80s) means that, besides providing stable cash‐generating companies with a tax‐minimizing way of paying out excess cash, the business unit structure also limits the “financial distress costs” associated with HLTs. In the event of financial trouble, the unit holders are likely to be much more cooperative than ordinary subordinated debt holders in restructuring interest payments since the benefits of so doing accrue to the equity portion of their units. The original income trust structure has also been used by a number of U.S.‐based companies that listed their shares on the TSX. But, in the attempt to make the securities suitable for listing on the AM EX, and in response to auditor demands intended to address potential IRS concerns, the instruments were modified in ways that sacrificed one of the important benefits of the original structure. The changes were designed to make the subordinated debt issued as part of a package with equity look more like external, third‐party debt. And in so doing, the low‐cost restructuring feature built into the Canadian version was lost, and the U.S. trusts failed to gain acceptance.     

The Icahn Manifesto

The title of this opening chapter in the author's new book on activist investors refers to Carl Icahn's solution to the “agency” problem faced by the shareholders of public companies in motivating corporate managers and boards to maximize firm value. During the 1960s and '70s, U.S. public companies tended to be run in ways designed to increase their size while minimizing their financial risk, with heavy emphasis on corporate diversification. Icahn successfully challenged corporate managers throughout the 1970s and 1980s by buying blocks of shares in companies he believed were undervalued and then demanding board seats and other changes in corporate governance and management. This article describes the evolution of Icahn as an investor. Starting by investing in undervalued, closed‐end mutual funds and then shorting shares of the stocks in the underlying portfolio, Icahn was able to get fund managers either to liquidate their funds (giving Icahn an arbitrage profit on his long mutual fund/short underlying stocks position) or take other steps to eliminate the “value gap.” After closing the value gaps within the limited universe of closed‐end mutual funds, Icahn turned his attention to the shares of companies trading for less than his perception of the value of their assets. As the author goes on to point out, the strategy that Icahn used with such powerful effect can be traced to the influence of the great value investor Benjamin Graham. Graham was a forceful advocate for the use of shareholder activism to bring about change in underperforming—and in that sense undervalued—companies. The first edition of Graham's investing classic, Security Analysis, published in 1934, devoted an entire chapter to the relationship between shareholders and management, which Graham described as “one of the strangest phenomena of American finance.”     

SIX CHALLENGES IN DESIGNING EQUITY-BASED PAY

The past two decades have seen a dramatic increase in the equitybased pay of U.S. corporate executives, an increase that has been driven almost entirely by the explosion of stock option grants. When properly designed, equity‐based pay can raise corporate productivity and shareholder value by helping companies attract, motivate, and retain talented managers. But there are good reasons to question whether the current forms of U.S. equity pay are optimal. In many cases, substantial stock and option payoffs to top executives–particularly those who cashed out much of their holdings near the top of the market–appear to have come at the expense of their shareholders, generating considerable skepticism about not just executive pay practices, but the overall quality of U.S. corporate governance. At the same time, many companies that have experienced sharp stock price declines are now struggling with the problem of retaining employees holding lots of deep‐underwater options. This article discusses the design of equity‐based pay plans that aim to motivate sustainable, or long‐run, value creation. As a first step, the author recommends the use of longer vesting periods and other requirements on executive stock and option holdings, both to limit managers' ability to “time” the market and to reduce their incentives to take shortsighted actions that increase near‐term earnings at the expense of longer‐term cash flow. Besides requiring “more permanent” holdings, the author also proposes a change in how stock options are issued. In place of popular “fixed value” plans that adjust the number of options awarded each year to reflect changes in the share price (and that effectively reward management for poor performance by granting more options when the price falls, and fewer when it rises), the author recommends the use of “fixed number” plans that avoid this unintended distortion of incentives. As the author also notes, there is considerable confusion about the real economic cost of options relative to stock. Part of the confusion stems, of course, from current GAAP accounting, which allows companies to report the issuance of at‐the‐money options as costless and so creates a bias against stock and other forms of compensation. But, coming on top of the “opportunity cost” of executive stock options to the company's shareholders, there is another, potentially significant cost of options (and, to a lesser extent, stock) that arises from the propensity of executives and employees to place a lower value on company stock and options than well‐diversified outside investors. The author's conclusion is that grants of (slow‐vesting) stock are likely to have at least three significant advantages over employee stock options:

• ? they are more highly valued by executives and employees (per dollar of cost to shareholders);
• ? they continue to provide reasonably strong ownership incentives and retention power, regardless of whether the stock price rises or falls, because they don't go underwater; and
• ? the value of such grants is much more transparent to stockholders, employees, and the press.