Can (and Should) We Regulate Executive Pay?
posted by Michelle Harner
Although hedge funds and derivatives were the initial targets of public anger over the recent economic crisis, executive compensation emerged in 2009 as the primary target—at least for politicians, regulators and the media. This shift in focus was caused, in part, by the realization that numerous institutions receiving federal assistance under TARP paid or planned to pay their top executives handsome bonuses at the end of 2008. Specifically, in December 2008, the media reported that “[t]he 116 banks . . . receiving billions in taxpayer-provided bailout money this year actually paid out $1.6 billion in compensation and benefits to their top executives last year – even though the results at some of these institutions were so poor that they would soon have to turn to Washington for a government-engineered rescue.” The response from Washington was quick and clear: rein in executive pay.
Washington kept its promise. In February 2009, Congress imposed new restrictions on executive compensation at institutions receiving TARP funds, and in October 2009, the administration actually reduced compensation packages at several of those institutions. Simultaneously, politicians called for greater regulation of executive pay, both in the financial sector and corporate America generally. The favored means of regulation, particularly for firms outside of the financial sector, is shareholder “say on pay,” which gives a company’s shareholders a typically non-binding (i.e., advisory) vote on the company’s compensation practices. (For an interesting essay on why “say on pay” alone is not a satisfactory solution for financial institutions, see Lucian Bebchuk’s article in the Financial Times.) In fact, this type of provision is included in The Wall Street Reform and Consumer Protection Act of 2009, which the House of Representatives passed in December 2009.
The reaction to “say on pay” and other types of executive compensation regulation is mixed. I think most Americans believe that executive compensation is excessive, particularly when compared to compensation received by other employees at those same companies. (For a fun discussion of executive pay, see here.) Whether or not commentators agree with that basic sentiment, they diverge on whether executive compensation is a problem and, if so, what is a workable solution. For example, Stephen Bainbridge suggests that no regulation of executive compensation is necessary. Other commentators express concern regarding the effectiveness of the “say on pay” approach (see, e.g., here). And reports suggest that CEO’s oppose the measure and institutional investors (typically a company’s largest shareholders) are indifferent. As Bernard Black noted in a recent article, “We just haven’t seen a huge amount of effort being put out by institutional shareholders to affect compensation levels. . . . Whether it’s because they don’t mind the pay practices or because the money managers are making millions themselves, you don’t see them jumping up and down.”
So where does that leave us? I think the recent disclosure regulations adopted by the SEC are a step in the right direction. Although I appreciate and understand the additional burdens placed on reporting companies by the regulations, I think more information and transparency are essential to mitigating the effects of future economic downturns. (As I will discuss in a future post, I particularly like the disclosures relating to risk management practices in that context.) I am skeptical, however, regarding whether “say on pay” or similar regulations will really rein in executive pay or change corporate compensation practices for the long-term. First, I suspect that public outrage about and attention to executive pay will fade quickly (at least until the next wave of corporate scandals); consequently, corporations will likely return to their old ways just as quickly. Second, I am not convinced that advisory shareholder votes will really persuade corporate boards to completely overhaul compensation practices. America’s corporate culture generally does not seem to respond well to “shaming” techniques or to place much value on fostering long-term relationships. (For a more positive take on shaming, see here and here.) Rather, the American “winner-take-all” mentality seems to stifle consensus-building in corporate governance and business practices generally. (For a brief discussion of cultural differences in the executive compensation context, see here.) Accordingly, I hope that corporations continue to explore alternative ways to align executive incentives with the long-term value of firms, which I believe is in everyone’s best interests.
January 6, 2010 at 8:10 am
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Responses (2)
A.J. Sutter - January 7, 2010 at 5:23 pm
I don’t see how disclosure could be “a step in the right direction,” based on what you say in the preceding paragraphs. If the institutions don’t care, and if companies don’t respond well to shaming, then what’s accomplished by disclosure?
Information and transparency are of most use to the investing class, whereas economic downturns, past, present and future, affect a much broader section of the population. “Transparency” in this context seems to have become a politically-correct version of “trickle-down” thinking. As for disclosures about risk management practices, the issues in the recent downturn went beyond risk, to uncertainty. An excessive orientation toward risk was a contributing factor to the crisis.
A suggestion that’s only partly puckish: how about a regulation that limits the ratio between the compensation of the least-paid and the best-paid employee of a firm? Then if boards wanted to give bigger pay packages (sc., in an absolute sense) to CEOs, they would have to share the wealth. Or would all of our top management talent threaten to move overseas as a result?
Michelle Harner - January 7, 2010 at 7:48 pm
A.J.:
Thank you for the comment; I think you raise some interesting points, and I appreciate the opportunity to discuss them further.
I do not necessarily link disclosure to shaming. Although disclosure certainly can foster change under a shaming theory, I also think is can facilitate change—even if such change is slow—by impacting investor preferences and the firm’s bottom line. As I discuss in the context of risk management (see http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1489586), showing a link between the desired conduct and profitability most likely will influence corporate boards exactly because of the American corporate culture. And I understand why you might characterize my use of transparency as trickle down economics, but I actually intended it in a different sense. I see value in transparency because it is a tool that parties can use to make better-informed decisions, not only about investing in a firm but also about lending to a firm, doing business with a firm, regulating a firm, etc. Admittedly, people may not take advantage of, or appropriately use that tool, but I am in favor of making it available.
It is along those lines that I favor corporate boards adopting and being more involved in enterprise risk management. I completely agree with you that multiple factors contributed to the economic crisis, and I do not think that better risk management would have averted the crisis. I do, however, believe that boards could have responded quicker and perhaps avoided some of the extraordinary losses with a better understanding of their firms’ risk appetite, risk exposure and the interrelation of firm and market risks.
And thank you for responding to my call for alternative thoughts on aligning executive compensation. Although not exactly what you propose, I would note that Congress implemented a similar restriction on executive bonuses in chapter 11 bankruptcy cases, see 11 U.S.C. 503(c).
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