HLS Professor Jesse Fried '92
Having a “say on pay”
Jesse Fried ’92, a leading expert in executive compensation, corporate governance, bankruptcy and venture capital, joined the HLS faculty in the fall from the University of California at Berkeley.
In your 2004 book, “Pay without Performance,” with Lucian Bebchuk, you described problems that have since become widely recognized in the wake of the financial crisis. What caused these problems?
We identify a number of ways in which pay arrangements in public companies have not served shareholders’ interests. Many executives are overpaid, and compensated in ways that fail to give them incentives to create shareholder value. Indeed, pay arrangements frequently reward managers for decisions that destroy firm value. One of the main problems we highlight is executives’ ability to profit from short-term results, even when those results are later reversed.
The root of these problems, we argue, is that directors have been more attuned to the interests of the CEO than the interests of shareholders, especially when it comes to things like the CEO’s own pay. This is not surprising. CEOs have played a much more important role than shareholders in selecting directors. If directors wish to be renominated to the board, or invited to serve on other boards, there may be a cost to haggling with the CEO over his pay. At the same time, directors reap little benefit from reining in the CEO’s pay or ensuring it creates proper incentives—directors pay the CEO with shareholders’ money, not their own. A simple cost/benefit calculation naturally leads directors to refrain from bargaining aggressively over CEO pay.
The recent financial crisis highlighted what can go wrong when pay arrangements are not properly structured. There is now mounting evidence that badly designed bonuses played a major role in bringing down many large financial institutions. Even Wall Street executives have admitted that there were serious flaws in their pay arrangements, and have begun taking steps to fix them. Unfortunately, this recognition is coming a little too late for many of these firms and the taxpayers who were called upon to bail them out.
How can executive compensation arrangements be improved?
First, equity arrangements should focus executives’ attention on the long term. Currently, executives are free to cash out their equity once it vests, typically one to three years after the grant date. Instead, firms should require executives to hold most of each equity grant for a fixed number of years after vesting. This would better tie executive’s equity payoffs to long-term shareholder value.
Some compensation reformers have advocated executives holding their equity until retirement. I think this would be a mistake. Such arrangements would perversely give the most effective executives an incentive to retire prematurely. In addition, the ability to cash out all of one’s equity upon retirement would give executives on the verge of retiring an incentive to focus on the short-term rather than long-term. Both of these problems would be avoided if equity must be held for a fixed number of years after vesting, rather than until retirement.
Second, compensation should be structured to reduce executives’ ability to use inside information to time equity transactions as well as to manipulate the stock price around these transactions. Consider stock sales. Executives routinely use inside information to time large sales of stock, and often manipulate the stock price shortly before the sale. In a paper published last year, I urged firms to use “hands-off” arrangements under which each equity grant must be cashed out gradually on a series of dates specified when the grant is made.
Hands-off equity would leave the executive no discretion over when her equity is cashed out. It would not just reduce executives’ ability to use inside information to boost their sale profits, but eliminate it altogether. I also showed that the gradual unwinding under a hands-off arrangement would ensure that executives have little incentive to manipulate the price around each disposition of their stock.
In June, the Obama administration unveiled a plan to help rein in executive compensation. How do you assess its likely effectiveness?
The administration’s June statement did not really offer a comprehensive “plan” for dealing with executive pay. Rather, it indicated Obama’s intent to propose or support legislation in two specific areas: (1) making compensation committees more “independent,” in part by ensuring that they hired their own compensation consultants and (2) giving public shareholders a nonbinding “say-on-pay” vote.
I am skeptical that legislation targeted at compensation committees will do much to improve executive pay arrangements. The thinking is that compensation consultants have an incentive to recommend pay arrangements favorable to the CEO because the consultants are often selected by management or with their input. Having the compensation committee itself select and hire pay advisers, it is argued, will give directors access to better information and thereby lead to more shareholder-serving pay arrangements.
But requiring compensation committees to use their own consultants does not alter directors’ continuing incentive to favor the CEO on pay issues. Suppose the consultants hired by the compensation committee propose a shareholder-serving pay arrangement, but the CEO rejects it. The compensation committee will simply go back to the consultants and tell them to come up with “Plan B”—an arrangement more palatable to the CEO. The consultants will promptly comply. Otherwise, they won’t be rehired by the committee next year. Most consultants will simply start with Plan B. As long as directors fail to bargain aggressively with CEOs over pay, legislation requiring directors to hire pay consultants directly is likely to have little effect on the pay arrangements emerging out of this process.
I am more hopeful about the second area of legislation, “say-on-pay.” One important constraint on executive pay is directors’ fear of negative publicity and shareholder outrage. Say-on-pay shines a spotlight on a board’s compensation decisions, and provides shareholders with an efficient mechanism for indicating their approval or disapproval of these decisions. Because disapproval is embarrassing to directors, enactment of say-on-pay should make directors push harder for pay arrangements that better serve shareholders’ interests. Indeed, say-on-pay in the UK has led to more communication between boards and shareholders over pay arrangements, and an improved link between pay and corporate performance. I expect it to yield similar results here.