executive_compensation.pdf

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Journal of Applied Corporate Finance Volume 22 Number 1 A Morgan Stanley Publication Winter 2010 107

Executive Compensation: An Overview of Research

on Corporate Practices and Proposed Reforms

1. All four authors are members of the Corporate Governance Track Team chaired by

Lemma Senbet, Director of the Center for Financial Policy at the University of Marylands

Robert H. Smith School of Business. The Center for Financial Policy (CFP) has the pri-

mary mission of promoting research and education that informs policy. It is organized

around ve tracks, one of which is corporate governance. We wish to acknowledge our

colleague, Jerry Hoberg, who gave us comments on his reading of the earlier version of

the paper. The views and opinions expressed in this white paper are those of the authors

and should not be interpreted as representing those of the Center for Financial Policy and

Robert H Smith School of Business.

2. For instance, the 2003 statement of the Financial Economists Roundtable makes

several recommendations, of which stock option expensing has now been adopted.

vr h s dcd, w hv wissd wo d-m ts tt tt t t m. T st t tm

2000 and the ensuing corporate scandals triggered a collapse w-w ms s s E, WCm,

A, st mss stt swealth as well as damage to other stakeholders. More recently,the end o a housing bubble and the subprime debacle led to ashudow o h crdi mrks d h iurs o vr sttts s s Lm Bts L. T 2008 ss s tword. Ts dmrk pisods hv drw io o hhigh vs o xcuiv compsio, d o h possiiiytt t stt xt s m t-uted to the post-1990s bubbles, corporate scandals, and recentci crisis.

Many observers believe that top-level executive compen-

st s t st t -tm tprormc. Tr r svr css i which xcuiv pyt ms s mt t t msw t st s w mmt.St ts w s t ts . O s mst s wt-s st t ts m t tsor managers to manipulate company nancial statements inordr o driv up sock prics, coriuig o h corporss t st-tm t t crisis. Besides the insucient link between compensation andstock prices, the level o executive compensation is also widely

ivd o much highr h h rquird o ri dmoiv civ op mgrs.I ts -t , w sss t sss

t t t t xt xss support or a number o reorm proposals aimed at improvingt mt st stt t sstm. ss m s, t t t w t.2

Our attempt here is to provide a rationale or these proposalsw t sts t ss t t. t sss st wt t ss or rorm, w sr y rviwig h ky issus o xcuivcompensation and its possible role in the major nancial criseso h s dcd.

What Caused the Global Financial Crisis?T 2008 ss ws tt t s s . S s w t q-uid mortgage securities worth cents on the dollar. With ewsts t t t sttts m ts, t s t t t t stdried up. Matters came to a head in September 2008 ollow- t st qst L Bank o America and the ailure o Lehman Brothers. Creditmts , sm s, stmts , tt mmt s

m tt. tt s, t wslarge-scale government intervention across the globe. In theU.S., t mss stt t sector through government takeovers o ail ing institutions,t s t t ARP, mt stmst ss st tx ssts, , mrcy, sc simuus.

I t w t ss, t mmt qst poicy mkrs hs how s o rspod o h cimdow. A h sm im, h prvio o criss i huur rquirs udrsdig o why h crisis occurrdin the rst place. Te crisis can be understood as an interplay

tw mm ts, stts st mfawed government policies, and fawed incentives or severalplayers in the nancial markets. A confuence o these actors t xss s-t t mts-kig h ws ciid i sigic pr y h crio mx, q mt sts. A ts stt taking a look at the incentives o the dierent parties to theserscios.

O

by Michael Faulkender, Dalida Kadyrzhanova, N. Prabhala,

and Lemma Senbet, University of Maryland1


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108 Journal of Applied Corporate Finance Volume 22 Number 1 A Morgan Stanley Publication Winter 2010

3. See, for example, John, Saunders, and Senbet (2000); and Bebchuk and Spamann

(2009). Full citations of all studies cited in the text or footnotes are provided in the

References section at the end.

4. Evidence of this implicit insurance in bond market pricing is provided by Penas and

Unal (2004).

or the high ratings had their own incentive problems. In manyinstances, the complex securities were designed with the adviceo the ratings agencies, which collected a ee or this service (insomhig rsmig py-o-py mod).

T ttm , t, s tt stt-tions had incentives to take too much risk, but such risk-takingwas made easible or compounded by loose money and severalohr rguory disorios i h mrkpc.

Whr dos compsio i his mg? O rgo public outrage has been the size o the pay packages o manyms t sttts. st, m tt-t s t t t ss Lmpoys roud h im o h Bk o Amric kovr.

Bu i h siz o compsio is criy imporissue, especially in a market or talent that is becoming global,ss ttt s t t stt ms-

io, d o h procss o sig compsio i cisttts. I tms mst stt, sxts t m qt ts. t xtt t ss sttts tm xss s-t, xts wt st opios d igig hm wih shrhodrs coud hv huwd c o pushig xcuivs o k o xr risk.A ss ttt s t t the pay-setting process at banks. Nevertheless several reormst t m t t ss tt s s s t msms -stt ts s. I t m ts t, w s

each o these three acets o the issue: pay level, pay structure,d h py-sig procss.

Executive Compensation:The Good Side and the Dark SideAn important theoretical perspective on the design o manage-mt ts s t t sts,w ss fts tst ts mt t sts, t tw m-mt ts ss. I t tt, ts w t t Js William Meckling (1976), which demonstrated the incentives

s-t t ms wt ss t 100% ws t ms t t ts tt m . stt wt sm xm, m wt 3% sti puicy rdd compy gs 100% o h s romsm s t s 3% t sts.Moreover, the sensitivity o the managers wealth to that o thess ts sm xm, t s 100 s wts t s s x h dgr o igm chivd y h compsio sruc-ur. Tis prspciv hs d o h widsprd corpor us

T 2008 ss s t t t xss t s s s, w m t ms. As st, m ws s t st 70%. T m ms ws mt

m t t m s, w x tsts m s s, sm s,ow- or o-documio A-A os, d os wih srrates. With repayment o these loans predicated on house pricet t t w m, s tmd risky s o hous prics.

Why did banks take on such risks? One contributing actorws h pro-housig iiiivs o h U.. Cogrss, wih isss t Cmmt Rstmt At xtsst mt-ss tts . At ws t s m s t U.S. Rs t t tm s, w t

t m m s t w tts. T xt t s t t smortgages. And thus at a micro level, excessive risk-taking can udrsood s produc o fwd icivs.

A s mj stt ts m m thigh vrg o ks. Fic schors hv og rcogizdthe incentives o the shareholders o levered institutions to take xt s s t smmt tw t m-t s ws ft ws. Ext mtdeposit insurance adds to this moral hazard problem.3 Withxpici FDIC dposi isurc, dposiors who joy FDICtt ts t w t s-

t. Imt s s t ttt t t t t (B) s w sttts w t t t stss.4 T tt -, xt st s, mt B sts ms ts s t t xss s.Te expansion o risky real estate loan portolios can be vieweds misio o hs icivs.

Other regulatory distortions also contributed to the crisis.As already noted, GSEs like FreddicMac and Fannie Mae wereenabled and encouraged to buy vast pools o mortgage debt. Intheory, these were private but in practice their debt was viewedas carrying a government guarantee, giving them access to cheap

tt s s m ws s w w tt t tuyig homs. Rguios so iroducd disorios i hdemand or debt by pushing investors to buy instruments withhigh credit ratings. Te demand or high-rated debt was met by s t mt- sts. Atthe MBS received high credit ratings, they were complex illiq- ms ws ts st t qst s tst sttst ms s ssmts ttt t t st. T t s ss


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109Journal of Applied Corporate Finance Volume 22 Number 1 A Morgan Stanley Publication Winter 2010

Figure 1 Mean Sensitivity of CEO Wealth to Firm Performance for S&P 500 Firms ($Thousands)

5. See, for example, Haugen and Senbet (1981).

6. The relation between pay and performance is not uniform across rms and across

industries. In particular, pay was relatively less aligned with performance among large

rms and at regulated utilities.

o pricip-g hory suggss h h primry ms ywhich shrhodrs sur h mgri cios r igdwt t tsts s t t xt t m -mc.

I ft (tt s ts ss),Js (1990) t stmt

empirical measure o pay-perormance sensitivitya measuredesigned to answer the question: to what extent does executivecompensation vary with shareholder wealth? Teir methodol- ss ss (O Lst Sqs) stmts m tt ts tt CEO t i rm prormc. T rgrssio coci is k s estimate o the pay-perormance sensitivity. Measuring peror-m tms s , Js simd h, durig h priod o hir sudy (1974-1986),t xt s t $3.25 $1000icrs i shrhodr wh. O h sis, hy cocuddtt xt ws ss sst t s

wh.6

Bu i h irur dos o provid cr-cu swrs othe question o whether the Jensen-Murphy pay-perormancesstt s t w, m t sts stsst tt s m m wt m tm. , sts sw tt t stmts -m sstts t 1992-2006 (shown in Figure 1) were driven mostly by changesin the value oexisting or accumulatedstock and option grants, t ss w ts. xm, s

o mpoy sock d opio ps.5

O t st s, t, w-s xtmst s s msm t . It s t tt t m-rial incentives with those o shareholders in making importantstmt ss. I t t s

mt, mmt mst t sous, socks, opios, svrc pckgs, d prormc-sd rmiio.

Bu i iciv igm c d o vu crio dcontribute to overall economic growth and employment, theres s s t mst. w mstschms c d o vu dsrucio. For isc, xcssivs st-tm tms ttt t st t ticivs c d xcuivs o pss up promisig og-rminvestments. In addition, i the rm is overvalued, stock-basedcompensation may lead managers to overinvest or manipulaterigs o jusiy h rms curr sock pric.

S t sss xt mst mx. W w st sm sss tt t xt mst. W ttmt trepresent both sides o the debate, and then evaluate a numbero rorm proposs dvcd i cdmic d poicy circs.

Pay-Performance Sensitivity: Too Low?T st qst s wt xt ms-t stts t st ts ms tk opim cios o h o shrhodrs. T irur

200

300

400

500

600

700

800

900

1000

1100

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Year


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Pay Levels: Excessive?Te level o CEO pay in large U.S. companies has surged overt st t s, m xs st t ts. T s ts t

m ms, ms, tts tt ss s . A w s tt xss t-mmt mst s s fw mchisms i h py-sig procss.

The Dramatic Rise in Pay.T s upward trend in both the absolute pay levels o executives andt s t t -xt ms. As s 2, t tt CEO S&P 500rms icrsd rom ou $850,000 i 1970 o $14 miioin 2000, ell briefy to $9.4 million in 2002, and went back upto about $13.5 million between 2005 and 2007 beore declin-ig o ou $10.5 miio i 2008 mid h go ci

crisis.T ss tt mst w t

t mt sssts, w CEOs st -mst. Cmst s t sm large corporations, but remained substantially higher in largerms.9 I t, CEOs t sttm t s xt s; ws CEOs 34% m, , t -CEOs 1975, 2007CEO py ws wic h o o-CEO xcuivs.

Finally, inequality between executives and workers over thest t s s s st. A t

xts ws t 40 tms t tt t w 1970. Tt t t 400 2000, dciig o pproximy 320 i 2008.10

W w st t ss xss ? W agnostic at best. Examples o egregious pay packages are clearlyo hrd o d. For xmp, Ror Nrdi rcivd $210m xt m HmDt R Gss NYSE $187.5 m w tNYE ws si o-pro. I som css, h pckgs wrgrd o gd hivs. Dis Kozowski, ormr CEO oyco, ws grd ry six miio w opios (5.1 miioshrs i yco pus 800,000 opios i susidiry) vud

$81 miio h vry im h ws chrgd wih ooig hcompy o miios o dors.Bt ts xms sts xs-

s xt , t t s tt t t average xcuiv compsio, d whhr i is oo high o rc,moiv, d ri h righ pop. T sim o moscdmics is cosis wih his gosic viw.

rpord y H d Lim (1998), 95% o h simd1996 pay-perormance sensitivity or CEOs in manuacturingms ft s t existingts sock opios (64%) d sock (31%), wih oy 5% comig

rom h grig o w sock d sock opios i 1996.Another actor contributing to the rise in pay-perormance

sensitivities has been the dramatic increase in the use o execu-t st ts s t 1980s.7 st, t t-t ts s m 1970 tover $7 million in 2000. Although this value ell to $4.4 millioni 2002, y 2005 i hd com ck o ou $6 miio. Ads ts w t t ts ws t m-id y qu icrs i s sry, his icrs i opios st st t structure x-iv py. T chg c s jus y oig h, whrss ss t 38% tt CEO

1992, t t 17% 2000. T s t-s ws t m compis i h mucurig d ci scors, whroptions grants more than doubled in dollar terms over the lastwo dcds.

Finally, option grants became an important component opy o oy or CEOs, u so or xcuivs ow h opir. I c, h vs mjoriy o opios hv grd oemployees below the top executive level. And that majority hascoiud o icrs ovr im. Bw h mid-1990s dt 2004, t t t ts t ms xts w t t s m ss

h 85% o ovr 90%.T w t t-s st st

ss t sstt tt CEO t m -mc ui 2008, wh h ssiiviy oghr wih h m t ss. A tsconsistent with the basic prescription o agency theory that payprcics shoud im o i xcuiv py o rm prormc,t m ssts tt sstt t CEO wt s w t t t m t m-s. xm, t st St(2009) sm CEOs ts tt s ssconstitute only about 10% o total compensation, and that the

wealth o these CEOs increases by an average o about $24 orevery $1,000 o shareholder value created. And this, o course,sts mt mmt t stmtsrpord y Js d urphy.

, t tt s ssts tt t ssttvriio i iciv py mog dir idusris d sizgroups is cosis wih opim corcig.8

7. See Murphy (1999); Core, Guay, and Larcker (2002); and Hall and Murphy

(2003).

8. In a model of dynamic industry equilibrium, Falato and Kadyrzhanova (2008)

show that incentives are optimally lower among industry leaders, since they have fewer

growth opportunities than laggards and so the benets of managerial effort are smaller.

Edmans, Gabaix, and Landier (2008) embed the principal-agent problem in a competi-

tive talent assignment model and show that the Jensen-Murphy pay-performance sensi-

tivity and its negative relationship with rm size can be quantitatively reconciled with

optimal contracting.

9. For documentation, see Gabaix and Landier (2008).

10. Jennifer Reingold, Executive Pay: The Numbers are Staggering, but So is the

Performance of American Business. So How Closely are they Linked? BusinessWeek,

April 19, 1999, p. 72.


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Figure 2 Dramatic Rise in Pay

ss w t m t through changes in corporate law or other governance institu-ts, t t mwmt ss tmoior xcuiv py mor dircy. W com o hs issusr i his ppr.

Te recent uproar over retention bonuses at ailed institu-

ts s t s t. Rtt ss t ms t st wt t m t w t ts w t wss, ss t t m tsportolios. Paying individuals to complete a task is more like asalary than a bonus, but calling it a bonus makes it less likelyt t St 162 (m). R ts s wreduce the incentive o companies to misclassiy compensation t t. , t, tx, ssrequirements should apply symmetrically to all pieces o thecompsio pckgs.

Pay and governance. T cdmic irur suggss h

w t msms w, msd o hv grr ifuc o h procss h drmistheir own compensation. Consequently, they extract rents andprotect themselves rom the consequences o bad perormance.Accordig o his viw, h scio i xcuiv py rfcsici rsrs o wh rom shrhodrs o xcuivsw j t m st t w .11 Tsviw hs rcivd cosidr io i h popur prss,especially ater the outrage over high bonuses at nancial insti-uios h cr o h ci crisis i 2007-2008.

Policy response:While the debate on excessive compensa-io rmis op d widy corovrsi, w rgu gisthe temptation to legislate or regulate the levels or the structureo executive compensation. In particular, the choice o compen-st stts s t t t ms tmss,d ccouig rus d x rms shoud o vor o

m mst t (s, st ts csh or sock).

A s t s t It R S CSt 162 (m), w mts t tx tt mst t $1 m ss s mst sm-s. T s ws t 1993 s ms mt xt , t t tsqs. Bs ts q s m-based compensation, Section 162 (m) inadvertently providedincentives or public corporations to shit signicantly towardoption-type contracts, which are oten held to be responsible sss t st st s tt t t t

ss sst wt t tm . Sm,Cm P (2009) sw tt sintended to curb specic pieces o compensation could lead tocompensation squeezing out through other means, oten atan additional cost to shareholders. As Kevin Murphy (2009)wts, t tt wt s ts s ttw ks wi mrg i ususpcd pcs.

W com dow o h sid o rpig cio 162 (m) t IRS . I t s tt tords r o xrcisig hir ucio, h mor ppropri

2

4

6

8

10

12

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1990 1995 2000 2005

Year

Average CEO Compensation of S&P 500 Firms ($M)

11. See Bebchuk, Fried, and Walker (2002), Bebchuk and Fried (2003); and Ber -

trand and Mullainathan (2003).


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Figure 3 Average CEO Compensation vs Market Capitalization of S&P 500 Firms ($M)

0

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10,000

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20,000

25,000

30,000

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1990 1995 2000 2005

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AverageCEOCompensation

MarketCapitalization

and Kaplan (2003) point to the superior stock-market peror-m U.S. ms (t t t E As tts ) t 1980s 1990s, h, i U.. CEO compsio hs xcssiv, h coss s xsss tw t ttt s t wt t

mmts. A ss sstt wt ts mt,Gabaix and Landier (2008) show that the increase in both thelevel o CEO pay and its ratio to that o the average worker hasbeen accompanied by a commensurate increase in the size andcomplexity o publicly traded rms over the last three decades(s Figur 3). orovr, s c so s i h gur, hvriio ovr im i vrg CEO py pprs o rfc hph o vrg rm vu.

Policy responses: Ist t t t level or structure, we support better compensation governancerrgms.

Improvements in board governance.o icrs h iki- tt t xt mst-stt ss sconducted on an arms-length bargaining basis, we believe thereshoud suci idpdc o h corpor ord d qmt st t mmso h compsio commis.

First, we support the view that the compensation commit-t ms t ts. , tmmtt s t t mst s-s who r rcruid y h ord d o y h CEO.

Second, t s xts tcompsio commi so h h commi udrsdst t t stmts s xt

compsio.

Bt t m msmsis mixd. gm hs h cr poi o ifuc ormt t mt ts t mstmmtt t , t xt f t t- s. Ts, t s tt mmtts tt stxcuiv compsio ck idpdc. Bu h vidc

w hv dos o cr or cosis sory.I st s sm 105 ms (

1984) whr h compsio commi mmrs wr soxts t ms, OR, , Cst (1988) tt CEO ws st t t mmttmms . Bt st t t tsm h py-sig procss, Adrso (1997) comprd h py o50 CEOs who sat on their compensation committees (and werer rmovd) o h CEO py o coro smp; d usigthe 1985-1994 proxy data, he ound that the CEOs who sat onhir ow commis cuy rcivd lowervs o py dhad veryhigh stock ownership, acting much more like manager/

ws t s-s ts. Csstt wt ts ,Core, Holthausen, and Larcker (1999) present evidence o only w m t tw mss m tgovrc d h v d srucur o CEO py.

Wts m, s m t s ssth CEOs do o xpoi hir posiio o xrc xcss py, wt msts t s ts. I t, (2002) mks cs gis such r xrcio sd o h Zj (2003), w s ttt ss mst w x mby proessional CEOs hired rom outside the rm, as opposedo isidrs promod rom wihi.

t t t qst, Hmstm


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vo oy i i ivd i hd suci cus o do so.

Do Performance Incentive Features in CompensationLead to Manipulation?

W qt ts t ts, tcan also create perverse incentives or executives. Opportunisticxts ts t mt t-tiessuch as accounting restatements, earnings management,d imig o discosuro shor up h curr sock pricand cash out by exercising vested options and then selling sharesat infated prices.12 Managers can also delay the announcement ws t t st t ts t tstock price low when option strike prices are being set. Tus, tothe extent a compensation system conditions incentives on thecurrent stock price, it could lead to abuses to infate the currentpric d csh ou. Tis viw is chod i poicy d isiu-

tional circles. For instance, it is widely believed that short-termgains can be generated rom stock options when the rm simul-taneously uses aggressive accounting, or even raud, to supporth ovrvud prics.

O w s tt t s mtt t s - sss. A ss s t s compsio corcs shoud cosidr how xcuivs rt s st t s. Ets t tmipuio coud so ris. For isc, iciv ursi compsio srucurs xpos xcuivs o highr risk sw s rwrdig hm or r prormc. o rduc hrisk o compensation structures, there is evidence that managers

resort to risk management as well as directly undertake transac-ts tt sm t t ts. I t,they may manage or manipulate earnings, risks, disclosure, andv hir pr group.

Risk manipulation.s t ws thedge against the risks o exposure in high-powered contracts. st, ts s s s s ts t m-s s.13 It s t w ts tts ms tt xts t mpropr icivs, or rprs ci rcigs o xcu-t ts w m-s s xss. Btihr wy, is impor o rcogiz h xcuivs my

mpd o pursu ici hdgig civiis wh hr ispoor corpor govrc d ovrsigh.Earnings manipulation. Tere is evidence that the structure

xt ts ts xts t mcorporate inormation. For example, Gao and Shrieves (2002)nd evidence that the amount o stock options and bonuses ispositively related to the intensity o earnings management. Tevidc is icocusiv or h cs o og-rm icivs stt st mst s m-mt. Bs K (2003) tt ms tt up announcing large negative restatements have granted about

Tird,w st t w tt tsts xtst tsts tt s-cy c h ssiiviy o xcuiv py o h vu o hm ss t t t mst

commi.Say on Pay: Empowering shareholders.O mt

s s tt t-mmt mst ssalary, equity-linked compensation, and severance packagesasw s mt s ts s, mst ss t x t. Pts tts s xts t f t, t mst mmtt t,ss m t msm fh v d srucur o xcuiv compsio.

S ssms tt t ss sm x ssss s s t

mms t ts. st t ssare made by the board rather than shareholders precisely because mms t m tt t t tissues conronting the rm, and so bring about better outcomest w st m t s t. O mtargue that the situation is no dierent with executive compensa-tion. Shareholders are not necessarily as well-inormed about thecomplexities o executive compensation or the dynamics o theCEO or mrk s r mmrs o compsio commi-ts. T wt s s s m w tlimit this concern, since such groups specialize in understandingh iriccis o py srucur d my i r posiio

o vu compsio ps riv o ohr rms.In addition, Karpo, Malatesta, and Walkling (1996) and

Gillan and Starks (2000) have both reported that non-bindingshareholder resolutions appear to have no consistent eects oncorpor prormc d shrhodr vus. Tis vidcsuggests that advisory say on pay is not likely to aect corporate s, t t m s tt stt compis wih govrc iurs.

B Sm (2009) m t mtst s ms. Bs sms ts xss s-t,s t t m s s-

t mmt qt sts m s t t ss -ssrgy.

O c, w dors advisorysy o py o groudsthat compensation committees should have an understandingo the views o shareholders. But we do not support abindings . Bs s t t t s-tion to design sophisticated pay packages that are appropriate t m s w tt t t tmt. I ms stt s w, ts w s t s s

12. See Burns and Kedia (2003) and Ferri (2003). 13. Core, Guay, and Larcker (2002).


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st w xts mst t m ss t t t ts xt . Wst m xt ss xt mst.Disclosure should cover all elements o executive compensation,

including retirement benets, severance packages, perquisites,d ohr dirc or idirc schms o compsio. I ourw, ms s both smm m-hsiv did discosurs. Whi summry umrs shoud q ssssmts s, t-ogic dvcs shoud usd o provid did discosur tst ss, s s sttts tt wt tivsig spcs o h compsio pckg.

Reforms in options: W s st ms topios compo o xcuiv py. O cours, h dsig ocompsio pckgs shoud h rsposiiiy o corpo-t s, t s s ttt t t

w msms tt mtt t sicivs h w discussd rir.

First, we support the view that vesting improves the linkageo py o og-ru corpor prormc d rducs ic-ts t mt t st s. Hw,vesting requirements should be transparent. For example, stockt s s stt t st topio gr d h priod or h sock r h xrcis oh opio. Second, iciv ps shoud cosidr sps hwoud void rwrdig or puishig xcuivs or oucomsh r yod hir coro, icudig som orm o idx-io o py or opios corcs o idusry- or mrk-wid

prormc chmrks.Reforms in bonus pay: Bouss shoud pid oy wh

managerial actions generate long-term benets, perhaps using amechanism that parallels stock option vesting. We support thes w- ss m-t ssi css whr prormc provs o hv mporry orh rsu o ourigh mipuio. Arivy, w suppordelayed payment o bonuses until the perormance metric usedo ccu h ous c dmd r o mipuio.

Role of Executive Pay in Financial CrisisExt mst s mt s

target o regulators and policy makers in response to the crisis.Te responses have diered among nancial markets. Te U.K. Ss Att w ts t t stt t tm w t t sstt t s t w- ss. It U.S., mst s ms qttt mts tmou, srucur, d imig o compsio pyms oop-pid xcuivs compis rcivig ARP uds. Adt xs ts t s s w compd.15

50% m st ts t t t xts t sprior to the announcements than companies in a control groupmchd y siz d idusry.

Peer Group Manipulation.Pt t ss s

tm xt mst s t stt pr group gis which mgri py pckgs r ch-mrkd. T mdi py his pr group is usd s guidin setting the compensation levels or rm executives. Choiceso compsio pr group mmrs d o xpid sthose companies with which the rm competes or talent, andr m o rprs h comporous py vs i hCEO or mrk.

Bt t w Y (2009)mts tt w t mst t st x st sst t s,t s sm m t s s w. Cms

wt xts m t s smmrs o h pr group, s qu, icrsig h vo median pay at the peer group and so providing a mechanismor the manipulation o executive pay. When highly paid peers -st mst s CEOpay is strongly infuenced by the median pay o the peer group, st w t tt CEO sover the last ew decades. Such gaming is reported to be stron-gr i compis whr CEOs hv prviousy oud ohv grr ifuc ovr h ord.

Disclosure manipulation.T s sst ttxts m ss t tm t

qt ts. Ym (1997) s stm ts t t ts ssts tt x-tives time option grants prior to the release o good news. Tus,xts t t -t-m ts, though the grants are nominally at-the-money at the time o thegr. T rsuig discou is rd o h quiy o corpo-t , wt sts sst wt govrc. Compmry vidc is providd y Aoodyand Kasznik (2000), which nds that executives delay disclosureo good ws d ccr d ws prior o grs.

As s ss s t t mst t ts t ss ws.

(2003) mts st t run-ups ollowing the repricings o executive options betweencases when CEO options are repriced (an 11.8% 20-day CAR)and cases when they are not (2.7%). Te signicant dierencetw t tw ss ssts tt CEOs m w tsciv discosur prior o h rpricigs.14

Policy responses: mt ts mexecutive compensation can be limited in a variety o ways. Inpricur, w suppor hcd d improvd discosur.

Disclosure reform:Disclosure helps shareholders to under-

14. Options backdating is also one mechanism for manipulation (Heron and Lie,

2006). It is the practice of recording grant dates that are earlier than the actual date of

grant. With the recent SEC disclosure rules, this practice has virtually evaporated.

15. See, e.g., Fed Hits Banks With Pay Limits, The Wall Street Journal (October

23, 2009).


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h quiy icivs hp ks void d mrgrs d dos h cr vu.

I t t st mst stts tmj U.S. s, DY, P, Y (2009) tthat the level o top management compensation at major U.S.banks is not signicantly dierent rom the level at non-nan-ci rms. Howvr, h iciv srucur o py is dir, ts ms s t t

Gramm-Leach-Bliley Act o 1999 that liberalized the scope onancial rms. As summarized in Figure 4 (which is reproducedrom hir ppr), h mos impor dig o his sudy ish h vg, or ssiiviy o voiiy, o op mgmmst s tw s -s t1999, m CEO wt m sst t ttt. T ts tt t s s tt xt s ms t t 1999At s s-t, s ft levels o credit risk, non-interest income, and private mortgagestts, w sm mmortgages.16 One consequence o this orm o risk-taking is an

elevated level o systemic risk in which banks become especiallysrssd durig coomic dowurs.O tst w ssts tt s

sss t t t-uted to problems with bankers compensation. Along with their(rir rpord) dig h k quiy owrship ds o sst wt ss s t sss 31 ts,Es, H, ts (2009) s tt stttowrship d ord idpdc, rdiioy rgrdd s

good mss, w t st t t

A key question in these policy responses is whether, and towhat extent, fawed compensation structures at nancial rmstt t t ss. W m ms sm tbelieve that compensation played an important role, the issue isar rom settled and the subject o a vigorous academic debate.W rviw som o h rc work i his r.

Fhrch d uz (2009) d h U.. k CEOswt m qt ts s ms wt sss

during the 2008 nancial crisis and that their rms perormedws t ts. (2009) ms sm t,sw tt t xt ss t ARP s 84%, s m t 20% o-ARP ks. As oh o hs sudis suggs, h xo the losses suered by these bank executives suggests that theyhd srog icivs o void xcssiv risk-kig.

I ss t ts mt, B Sm(2009) t tt s (ex post) sss tss tt t mst ts wpropry srucurd (ex ante). I ohr words, k xcuivs t sst sss t st

m t s t t xss ss w t s ws tw t ss,which r or i rg pr y U.. xpyrs.

Ater studying losses at 206 banks in 31 countries, Erkens,Hung, and Matos (2009) conclude that both ex anterisk-taking ex postsss t w CEOs sous compsio. A h sm im, hy d h highrlevels o equity compensation generally have the opposite eect mt s-t sss. A sstt wt ts, , U, Y (2009) st

16. But we advise caution in interpreting these results since the authors do not estab-

lish that higher vega caused greater risk taking. Both higher vega and greater risk-taking

could coincide with the passage of the Gramm-Leach-Bliley Act. This is an area meriting

further work.

Figure 4 Mean Vega: Banks and Non-Banks

0

50

100

150

200

250

300

350

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

$

thousands

Banks

Non-Banks

Source: DeYoung, Peng, and Yang (2009)


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might well choose to build up excessively risky loan portolios.I t ws, t mmts tsts wih shrhodrs, ihr pry my hv suci cocrou h siiy o h kig sysm.

And this incentive and externality problem is compounded t m m sst wt stts. Dst-s s s tt sts t DIC. At - ms,ts t stts s-t tts t t s-t t ts t t tts t tt wt tm. I t s banks, the FDIC acts as an insurer and should be able to placesm stts s-t. t xtt ms-tion contracts contribute to risk-taking, it is reasonable or theFDIC to place covenant-like restrictions on the compensationtts sttts tt t m st s.

A st J, Ss, St (2000) sws tt dposi isurc wr pricd o rfc h iciv urs mmt mst, s w t -mmt t mst stt tt ss-ms wt ts t mt t t-ts t s s s , s , maintain the stability o the banking system. As an alternative,bankers compensation could be adjusted to include paymentstt ft t jst t ts t qt, t t s tdposiors, odhodrs, d ohr cims. I such cs,mst w t t w mrhr h h quiy sic o.

s mst s t ts t t s-t. T mt t xss s-t s tt ts twhile losses are socialized. o control this aspect o risk-taking,t mt s stmts s swts. Gmt ws wts w t t t smmt t stt ts sss tw txs ss. Ts,s s J, Ss, St (2000), wt ss wts s s s tt ss, mt ws wts s preventcriss rom risig i h rs pc y rducig h ex

anterisk-kig y ks. A y r, h riv mu opprochs coud usd o compm d srgh htraditional approach o relying on capital or liquidity adequacyt t s-t, w s qt tcox o h curr crisis.

Policy response: It is interesting that compensation incen-tives were eectively ignored by the regulatory schemes aroundh word ui h dv o h go crisis. Tr is ow increasing recognition that the manner in which bank manag-rs r compsd shoud cr o kig rguio, t t st t sstm. W-s mst t stt, xss

s-t, m, t tm ss s t s-

sss. I t w, t ss st-tm ts msttts ts ts t xss s-t.Csstt wt ts w, s ss t t st-tmprormc wr so ri prdicors o osss.

Ts w s s t st t st m Hd Tum (2009), which ds h k osss i 2007-2008 sm 27 Gm s w ss wboards had less business experience, specically nancial experi-ence. Tey argue that board competence and nancial expertise t st s mtt s mst mt sss.A ms ts st wt t Ams(2009) that director pay is signicantly lower at U.S. comparedo ovrss ks cus o h pos-OX mphsis o dirc-or idpdc (which civy xcuds pop wih psxcuiv xpric i ks), o coud rch h surprisigconclusion that SOX reorms have led to an unintended decline

i h quicios d xpric o U.. k dircors.I sm, wt fw mst ts w

h criic drivr o h ci crisis rmis mpiricyinteresting question or uture research. Murphy (2009) arguestt mst ts sm t .I s w, t t stts s s t t o i impici gurs or rg ci isiuios, dts w st s t -s s ts mt ts ft t tgcis, wr mor dirc cuss. Wh sms mos iky ous is that, while other causal actors clearly played major roles,mst sms t m t ts

t t fws t tt txss s-t. T m mt t t-ikgs d h chis o cusiy rmi irsig dwid-op vu or rsrch.

The Design of PayT t t s m tt wt s tt st st mtts t st t d goy. Tis xriy provids rio or kig t t t s mst tks.

Bs m sss w ts

tt m ft wt t t tsts t sowrs d hos o sociy rg. o s how h hvioro k mgrs migh cd y hir icivs, cosidr s mmt mst stt wtt mts: s, s, qt tt. Ih compsio cosisd oy o sry, h k mg-m woud proy com oo cosrviv i or ot tt m mst. I tscs, h k woud iky d up kig v o risk h iss stm. I, t t , t mstsst qt tt, t t tsts mmt ws w mt

aligned, bank managers working in the interests o shareholders


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Michael Faulkenderis an Assistant Professor of Finance at theUniversity of Marylands Robert H. Smith School of Business.

dalida kadyrzhanovais an Assistant Professor of Finance at theRobert H. Smith School of Business.

nagpurnanand prabhalais an Associate Professor of Finance atthe Robert H. Smith School of Business.

leMMa Senbet is the William E. Mayer Chair Professor of Finance andDirector of the Center for Financial Policy at the Robert H. Smith School

of Business.

Disclaimer: Morgan Stanley holds an equity interest inNYSE Lie U.S., the utures exchange o NYSE Euronext, asannounced on October 30, 2009.

Morgan Stanley is currently acting as fnancial advisor to

Broadview Security (Broadview), ormally known as BrinksHome Security Holdings, Inc., in relation to its potentialacquisition by yco International Ltd (yco) and subsequentcombination with Tycos ADT security business. .

Te proposed transaction is subject to approval by the share-holders of Broadview and other customary closing conditions.

In accordance with its general policy, Morgan Stanley currentlyexpresses no rating or price target on Broadview or Tyco Interna-tional Ltd. Tis report and the information provided herein is notintended to (i) provide voting advice, (ii) serve as an endorsemento the proposed transaction, or (iii) result in the procurement,withholding or revocation o a proxy or any other action by a

security holder.Broadview has agreed to pay ees to Morgan Stanley or its

fnancial advice, including transaction ees that are contingentupon the consummation of the proposed transaction.

ReferencesAms, R, 2009, G t

Crisis, ECGI Working Paper No. 248/2009, http://ssrn.com/src_id=1398583.

As, R., 1997, Cmst Cmmtts: Itrs Who s Py, Wshigo d L Uivrsiy.

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ts ts, m t t tt s t st j t tsiiy o h kig sysm.

Concluding NoteWe provide a research-based perspective on the debate over thelevel and structure o executive pay and the pay-setting process.Despite decades o research, the evidence is inconclusive aboutwhether average CEO pay is excessive. CEOs retain signicantf t -stt ss, t-ties or them to manipulate the setting o their compensation.Pay-or-perormance sensitivity has signicantly increased over

time, improving the alignment o CEOs with shareholders, butso pprs o hv hd uidd cosqucs.

We examine the rationale and evidence or several propos-als or pay reorm, including many that have been advanced inpoicy d cdmic circs u o y rody dopd. Ourysis suppors umr o rorm proposs:

Wecomedownagainsttaxanddisclosurerulesthataresmmt ss t mts . Ts, St162 (m) t IRS s mt. Lws, wvor v pyig d or discosur h is h sm or dirc d idirc orms o compsio.

Wesupportsomereformsthattargetcompensation

stts, s s xt t w m-srhr h gr mrk prormc, d cwck provi-ss t t t m ms s t ouss ur ou o dsroy vu.

Wealsobelievethatcompaniesneedtopaymoreatten-t t tprocess stt ts ss. I tmso process, boards should have compensation committees andconsultants that are truly independent, and companies shoulds tt mmtt mms st xts vuig ci isrums usd o covy py. Comp-is shoud skadvisoryu o mdorysy o py.

Wefavorexpandeddisclosureofnotonlypaybutother

tsts xts, t tststhat hedge or unwind the pay-perormance sensitivity o execu-ivs.

Wealsoarguethatbanksarespecialandmayneed t st ms tt t ,regulation, and deposit insurance in a coherent and incentive-compi rmwork.

, s m tt xt ws t t t ss t s tt s pay alone may not prevent another occurrence. Tese proposalsshould be considered as part o a much larger nancial regulatoryrestructuring that also addresses too big to ail bailout policies,

xcssiv vrg, d ususi dig prcics.


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