In our forthcoming Journal of Financial Economics paper, Managerial Ownership Dynamics and Firm Value, Rüdiger Fahlenbrach and I examine the dynamics of managerial ownership for American firms from 1988 through 2003 and their relation to changes in firm value. We find that the average and median annual change in managerial ownership during that period is negative. Further, we show that a firm that experiences a large change in ownership is substantially more likely to experience a decline in ownership than an increase. High past and concurrent stock returns make it more likely that a firm will experience a large decrease in managerial ownership. In contrast, there is little evidence that low past and concurrent stock returns increase the probability of large increases in managerial ownership. Strikingly, firm characteristics other than stock returns and stock liquidity, such as proxies for information asymmetry, are mostly unrelated to large decreases in managerial ownership driven by sales of shares by insiders.

The widely held view that higher managerial ownership is valuable for shareholders because it aligns the interests of managers better with those of shareholders would make one concerned about the implications of our finding of decreasing ownership for firm value. However, controlling for the determinants of ownership changes, we find no evidence that large decreases in managerial ownership reduce Tobin’s q. In contrast, we show that large increases in managerial ownership can be interpreted, in our experimental design, to cause increases in q. Using insider trading data and a decomposition of changes in managerial ownership, we show further that the positive relation between large increases in managerial ownership and changes in q is driven by increases in shares owned by officers rather than increases in shares owned by directors or changes in the number of shares outstanding.

Our findings suggest the following interpretation. Managers own shares to maximize their welfare subject to constraints and firms start their life with highly concentrated ownership. The highly concentrated ownership of young firms is partly explained by the fact that early in the life of the firm managerial ownership is a cheap form of financing for financially constrained firms. Later in the life of the firm, when the firm is doing well and their reputation has increased, managers start to reduce their stake to diversify. They do so in a way that does not endanger their position or reduce the value of their remaining shares. As a result, sales have little impact on firm value. By buying shares, managers bond themselves to pursuing policies that benefit minority shareholders more – at least as long as their ownership does not become so high that they become safe from removal. Managers buy shares when this bonding effect is valuable to them because it enables the firm to raise funds on better terms and reduces threats to their position. Managers also increase their holdings when the firm is financially constrained and they prevent the firm from becoming more constrained by receiving shares instead of cash.

The full paper is available for download here.

(Editor’s note: Posts by Brian Cadman and Tatiana Sandino, available here and here also analyzed the role of compensation consultants in setting pay.)

In a recent working paper, Christopher Armstrong, Christopher Ittner and I investigate the relation between the use of compensation consultants and CEO pay levels. We conduct an analysis using proxy disclosures by a diverse sample of 2,116 companies. Consistent with claims that executive pay levels in clients of compensation consultants are higher than justified by economic characteristics, ordinary least squares (OLS) regressions that control for a wide variety of economic determinants of compensation indicate that total pay is higher for clients of most (but not all) of the consulting firms relative to companies without consultants. The OLS results also suggest that pay levels of clients of the larger, most frequently used compensation consultants are higher than those of firms using other consulting firms (most of which are smaller, boutique compensation consultants) in some model specifications. However, when more sophisticated propensity score matched pair analyses are used to relax the stringent functional form assumptions imposed by OLS models and to assess correlated omitted variables problems, most differences between the individual consulting firms disappear, though the statistically higher levels of total pay at companies using compensation consultants persist.

When we add governance variables, we continue to find higher pay in clients of most consulting firms in OLS regressions. In contrast, we find no significant differences in total pay levels between users and non-users of consultants or among the various consulting firms when propensity score matched pair analyses are used. This evidence indicates that once companies with similar economic and governance characteristics are compared and OLS’s strict functional form is relaxed, pay levels are not significantly different, suggesting that governance differences account for much of the unexplained pay differences between consultant users and non-users.

Further analysis indicates that these results are due (at least partially) to pay levels for clients of individual consulting firms varying with governance strength, with weaker governance within clients of a given consultant associated with higher total pay. These results suggest that the higher pay found in consulting clients is at least partially explained by the link between weaker governance and higher pay in companies using consultants. This is consistent with the rent extraction view of the association between compensation consultant use and CEO pay. Finally, we find no support for claims that CEO pay is higher for clients of potentially “conflicted” consultants that offer a broad range of advisory services relative to clients of specialized, “non-conflicted” compensation consulting firms.

The full paper is available for download here.

On June 25, I presented a paper entitled “Shareholder Activism and the “Eclipse of the Public Corporation”: Is the Current Wave of Activism Causing Another Tectonic Shift in the American Corporate World?” at the 2008 Directors Forum of The University of Minnesota Law School. The paper discusses the pressures that have been pervasively eroding the centrality of the board of directors and transforming its role in the governance structure of public companies, with the end game being a new conception of the corporate organization. Against the backdrop of the subprime and leveraged loan financial crisis and other recent events, the paper addresses what I regard as the crux of the issue affecting public companies today: whether the institution of the corporate board can cope with these pressures and survive as the vital governing organ of public companies. Or, will a forced migration from director-centric governance to shareholder-centric governance, along with a concomitant transformation of the role of the board from guiding and advising management to ensuring compliance and performing due diligence, simply overwhelm American business corporations?

The paper is available here.

(Editor’s note: A post on April 30 by Brian Cadman also analyzed the role of compensation consultants in setting pay, and is available here.)

My paper, Executive Pay and “Independent” Compensation Consultants, which I co-wrote with Kevin J. Murphy, analyzes two primary sources of conflicts of interest between consultants and their client firms. First, consultants have a conflict of interest whenever they design the pay packages of the same executives that have the power to reappoint them. Consultants who are hired by, or who work for, top management (rather than the board) have clear incentives to please the firm’s top executives by recommending generous pay packages. Second, while some consultants are “boutique” firms focused exclusively on executive compensation, many are large integrated corporations offering a full-range of compensation, benefits, and actuarial services, and therefore there is an incentive to cross-sell additional services. Consultants recommending a lower-than-expected level of CEO pay can jeopardize the opportunities to cross-sell other more lucrative services to the firm.

We use newly disclosed SEC data for 938 firms to investigate whether these conflicts of interest between consultants and their client firms lead to higher pay for CEOs, other top executives, and outside directors. We test the “repeat business” effect (i.e., the consultants’ concern with being reappointed) by examining whether pay is related to proxies for managerial influence over the decision to appoint (or reappoint) consultants, including whether the consultant is retained by the compensation committee or by management, whether the consultant works exclusively for the committee or also works for management, and whether the consult is described as “independent” in the company proxy statement. We test the “other services” effect by examining voluntary disclosures related to such services in the proxy statements, and by merging our data with 5500 filings with the IRS and Department of Labor that identify which of the consultants used by each of our sample companies also provide actuarial services to those firms.

We find that executive and director pay is higher in companies retaining consultants for pay advice than in companies not seeking advice, even after controlling for size, industry, and the mix of pay. However, we find no evidence that the higher pay is related to conflicts of interest: CEO pay is higher (and not lower) in companies where the consultant works exclusively for the compensation committee rather than management, and CEO pay does not increase when the consultant provides actuarial or other services to their client firms. Interestingly, we do find that pay is higher when the companies retain more than two consultants, suggesting perhaps that companies “shop around” until they get the answer they like!

The full paper is available for download here.

(Editor’s note: This post comes to us from Vidhi Chhaochharia of the University of Miami and Yaniv Grinstein of Cornell University. Their article was recently accepted for publication in the Journal of Finance.)

The purpose of this article is to examine how the new board requirements that were enacted in response to corporate scandals in 2001 and 2002 affected compensation decisions. We use the difference-in-difference approach to compare changes in compensation between firms that were already complying with these requirements and firms that were not complying with them. Our sample consists of 865 firms that belong to the S&P 1500 index for the period 2000 to 2005. To measure level of compliance, we focus on three board structure variables that were required by the rules: the requirement for a majority of independent directors on a single board, the requirement for an independent nominating committee, and the requirement for an independent compensation committee.

We find that firms that did not comply with these requirements significantly decreased CEO compensation in the period after the rules went into effect, compared to the complying firms. The decrease is on the order of 17%, after taking into account performance, size, time varying shocks to different industries during that period, firm fixed effects, and other variables affecting compensation that changed during that time. We also find that the one requirement that is strongly associated with a drop in compensation is the requirement that the majority of board members be independent, and that the significant relative drop in compensation comes from the decrease in the bonus and the stock based compensation. We also find that the decrease in compensation is particularly pronounced in the subset of affected firms with no outside block holder on the board and in affected firms with low concentration of institutional investors. In short, our results suggest that the new board requirements affected CEO compensation decisions.

The full paper is available for download here.

(Editor’s note: This post is by Carol Bowie of the RiskMetrics Group Governance Institute.)

Enhanced proxy pay disclosures, which the SEC believed would assist shareholders trying to assess the efficacy of executive compensation at their portfolio companies, have mainly underscored the elaborate and opaque nature of most pay programs. A new paper from RiskMetrics Group entitled Explorations in Executive Compensation aims to guide shareholders through the maze of terminology and complex processes being detailed in proxy statements and -– importantly -– proposes two innovative techniques that may help both investors and directors clarify disconnects between executives’ pay and shareowners’ interests.

You can view the paper, along with interactive tools that illustrate these techniques, at www.riskmetrics.com/compensation. RMG is seeking a range of feedback to help refine the paper and the potential tools.

The first proposed technique focuses on peer group benchmarking -– long suspected of contributing to spiraling pay levels that cannot be linked to consistently superior returns. Academic literature has demonstrated the importance of benchmarking in the pay process (e.g., see Faulkender and Yang’s, “Inside the Black Box: The Role and Composition of Compensation Peer Groups.” Working Paper). But RMG may be the first to create a model to consistently measure the quality of a company’s peer group in terms of its homogeneity (relative to size and industry factors) as well as the company’s rank within the peer group relative to the benchmarks it targets – identifying where a company that is the smallest in the group targets pay at the seemingly innocuous median level, for example. Do such distortions contribute to pay inflation? The data are revealing.

The second technique brings a financial markets perspective to evaluating how a CEO’s pay package is or isn’t aligned, in terms of risk, with that of shareholders. Understanding that alignment -– or misalignment -– can identify companies where incentives may be motivating a top executive to pursue strategies (e.g., high- or low-risk) that don’t fit with a shareowner’s investment goals or even the board’s declared business strategy.

RMG’s project is ambitious in scope and intent — to help bring clarity to the often thorny and always complex issue of executive pay. But it epitomizes our objective of producing thought provoking research that creates constructive dialogue on the important corporate governance issues facing investors and corporations. The goal is to create a shared language and measures that market participants can use to create, evaluate, and communicate about executive pay systems. The project is offered in the spirit of RMG’s commitment to bringing transparency, expertise and access to all financial market participants, and a vital part of the project is the feedback we get from all market participants. We invite your comments at www.riskmetrics.com/compensation.

(Editor’s note: This post by Praveen Kumar and K. Sivaramakrishnan at the University of Houston is part of the series of posts on corporate governance articles accepted for publication in prominent Finance Journals)

Our forthcoming article in the Review of Financial Studies entitled “Who Monitors the Monitor? The Effect of Board Independence on Executive Compensation and Firm Value” evaluates the efficacy of recent corporate governance reforms that focus on board independence and encourage equity ownership by directors. For instance, both the NYSE and the NASDAQ now require that a majority of directors on corporate boards should be independent, and that the audit and compensation sub-committees should be made up entirely of independent directors. These reforms appear to reflect a widely held belief among regulatory bodies and the corporate world that board independence and equity-based director incentives unambiguously improve board performance and, therefore, enhance shareholder value.

In this paper, however, we show that this belief may sometimes be misplaced. We analyze the efficacy of such reforms in a model where both adverse selection and moral hazard are present at the level of the firm’s management. Delegating governance to the board improves monitoring but creates another agency problem because directors themselves avoid effort and are dependent on the CEO.

We show that as the board’s dependence on the CEO increases, its monitoring efficiency may increase even as incentive efficiency deteriorates with respect to compensation contracts awarded to the managers. The reason is that a more dependent director benefits less from superior information about the firm’s economic prospects generated by monitoring. This endogenous tension implies - contrary to the assumptions underlying recent reforms - that outside shareholders’ value can indeed decrease as board independence increases. Moreover, and again contrary to the general presumption in the literature, higher equity incentives for the board sometimes may increase (equity-based) compensation awards to management.

The full paper is available for download here.

My colleagues, Amy Goodman, Gillian McPhee and I have recently published our thoughts on issues to be considered by boards of directors in setting their own compensation. We outline recent trends in compensation practices, particularly since the passage of the Sarbanes-Oxley Act, and discuss issues confronting boards of directors as they review their compensation programs; the issues include: the appropriate forms of cash compensation and equity compensation; the mix between equity and cash components of compensation; the adoption of stock ownership and retention policies; the use of perquisites; and the process for evaluating director compensation. We find that boards of public companies increasingly seek external guidance on these issues, recognizing that, when the board sets its own pay, it is in an unavoidable conflict of interest situation as are the corporate managers overseen by the board.

The memorandum is available here.

(Editor’s note: This post comes to us from Brian Cadman at the Kellogg School of Management at Northwestern University)

I, along with my co-authors Mary Ellen Carter and Stephen Hillegeist, have recently posted a new working paper entitled The Role and Effect of Compensation Consultants on CEO Pay.

The paper examines how compensation consultants influence the level, form and pay-performance sensitivity of CEO pay for a sample of 880 firms from the S&P 1500 for fiscal year 2006. The sample was collected by looking at the Compensation Disclosure and Analysis (CD&A) report in the annual proxy statement, which is required for filings on or after December 15, 2006. Our final sample of 880 firms all have December fiscal year ends. In addition, 86% of the firms in our sample disclosed that they retained a compensation consultant, suggesting that the use of consultants is widespread.

We find evidence of greater compensation in the presence of a compensation consultant, consistent with theory that these consultants facilitate rent extraction. However, we find no evidence of less pay-performance sensitivity when compensation consultants are hired. Among firms that retain consultants, we also examine whether there is greater rent extraction for clients of consultants with potentially greater conflicts of interest. Using a variety of specifications, we are unable to find widespread evidence of more lucrative CEO pay packages for clients of conflicted consultants despite anecdotal evidence to the contrary. Overall, we conclude from our findings that the potential conflict of interest between the firm and consultant is not a primary driver of excessive CEO pay.

The full paper is available for download here.

(Editor’s note: The blog featured earlier posts on the option backdating and its corporate governance implications by Larry Ribstein here, by Ted Mirvis and Paul Rowe here, and by Lucian Bebchuk here, here, here, here, and here.)

I have just posted on SSRN a paper that analyzes three forms of secret option backdating used by public firms and their significance for various corporate governance debates: Option Backdating and Its Implications. The current draft is available on SSRN here.

The three forms of option backdating analyzed are: (1) the backdating of executives’ option grants; (2) the backdating of non-executive employees’ option grants; and (3) the backdating of executives’ option exercises. The paper shows that each type of backdating less likely reflects arm’s-length contracting than a desire to inflate and camouflage executive pay. Secret backdating thus provides further evidence that pay arrangements have been shaped by executives’ influence over their boards. The fact that thousands of firms continued to secretly backdate after the Sarbanes Oxley Act, in blatant violation of its reporting requirements, suggests recent reforms may have failed to adequately curb such managerial power.

As I am continuing to work on this paper and a number of related projects, any comments would be most welcome.

Up Close and Personal: House Hearing on CEO Pay and the Mortgage Crisis

My colleague Dave Lynn wandered down to the House Hearing on severance pay recently and wrote up these thoughts (for other reports, see the WSJ article and NY Times article):

“The hearing of the House Committee Oversight and Government Reform on CEO pay was a little disappointing. It had all of the potential to be the sort of public spectacle that the same Committee’s hearings on steroid use in baseball had become, but instead it was a relatively straightforward identification of some CEO pay abuses, juxtaposed to the people that are unfortunately losing their houses to foreclosure in the midst of the mortgage mess.

In addition to testimony from some experts on the state of the mortgage crisis and issues with executive pay (which was covered by Nell Minow of The Corporate Library), the hearing featured Angelo Mozilo from Countrywide, E. Stanley O’Neal formerly at Merrill Lynch, and Charles Prince formerly at Citigroup. The respective compensation committee chairmen from those organizations also appeared, including Richard Parsons, Chairman of Time Warner.

The questioning was relatively light – both in volume and in tone – given the sparse turnout from Committee members on an unusual Friday hearing (the day when many members are heading home to their district). Much of the questioning focused on issues outlined in the Committee’s majority Staff memorandum, which outlined a number of issues that tend to be wrong with the CEO pay process – “confusion” about for who a compensation consultant is working (i.e. the CEO, the comp committee or the company), questionable use of 10b5-1 plans, awards that don’t seem to make sense in light of the circumstances or the rationale, extraordinary low performance targets, and payment of performance bonuses and the awarding of retirement and severance benefits even in a year as bad as 2007.

The battle lines were clearly drawn, with Chairman Waxman (D-CA) and his colleagues in the majority pointing out the financial distress that many Americans face while these three executives reaped rich rewards. Meanwhile, Representative Tom Davis (R-VA) repeatedly drew the old sports and entertainment analogy for executive pay – saying that no one expected Ben Affleck and Jennifer Lopez to pay reparations for Gigli.

Both sides were careful not to sully the reputations of the three CEOs who all represented classic American success stories, and clearly the CEOs (particularly Mozilo) seemed to be emboldened as the hearing went on and the “light” touch was evident. The only thing that tripped up Mozilo were questions concerning a threatening email that he sent seeking reimbursement of taxes for his wife’s travel on company aircraft – he apologized, noting that he was an “emotional person” – but Representative Issa (R-CA) was quick to jump to his defense and note that many of his colleagues in Congress fly their spouses all over the world on government aircraft because they need to have their spouse with them when conducting business.

One of the particular areas of questioning was on Mr. Mozilo’s sales of substantial amounts of stock under Rule 10b5-1 plans while Countrywide was conducting an accelerated share repurchase program. Mr. Mozilo asserted that all of his stock sales were done pursuant to a plan to diversify his holdings in anticipation of retirement and were unrelated to the stock repurchase program. The Chairmen of the Merrill Lynch and Citigroup compensation committees noted that these kinds of sales were unlikely at their companies, given their very high stock ownership and retention requirements.

While the Democrats on the Committee may not have been able to establish these CEOs as suitable scapegoats, the majority was certainly able to put some questionable pay practices under the microscope at a time when most people are worried about paying for their house – as opposed to paying for taxes on spousal travel on the company jet.”

My Ten Cents: It’s too bad the committee members did such a poor job of questioning the hearing’s compensation committee members. Had they simply followed the path of the Committee staff’s memo, they could have called for an explanation of each of the actions by the compensation committees (although some of the meaty issues were addressed, like why did Prince get a bonus for 2007?).

My primary “take-away” is that when a successful CEO throws a temper tantrum over pay - even if the demands are unreasonable - the board caves in. My guess is that all too often boards are told the consultant is hard to work with - or is not responsive or does not understand the company - and has to go. Boards comply - and there is typically no explanation other than “the board thought it was time for a change.”

I can’t resist addressing the mistaken comparison between CEO pay and the pay levels in the sports & entertainment industry. Putting aside the fact that only the top 1% of athletes and actors get paid astronomically - remember all those starving actors and baseball players buried in the minor leagues - it’s apple and oranges because the processes by which the relative amounts are established are completely different. I recently addressed this point by posting a comment on this compensation consultant’s blog. I guess the argument that public company CEOs will be flocking to hedge funds doesn’t hold much water anymore…

My partners Michael J. Segal, Jeannemarie O’Brien, Adam J. Shapiro and Jeremy L. Goldstein recently issued Executive Compensation 2008, a memorandum outlining key recommendations for directors to consider as they address executive compensation matters in the year ahead. The memorandum considers the importance of rewarding long-haul performance, paying for performance and retention, planning for executive succession, and using wealth accumulation analyses and internal pay equity studies. The memorandum also discusses the disclosure of executive compensation, including the merits of disclosing the terms of confidential compensation arrangements.

I have just posted on SSRN a paper that put forwards a new approach to improving the structure of executives’ equity-based pay arrangements, Hands-Off Options. The current draft is available here.

The abstract is as follows:

Despite recent reforms, public company executives can still use inside information to time their stock sales, secretly boosting their pay. They can also still inflate the stock price before selling. Such insider trading and price manipulation imposes large costs on shareholders. This paper suggests that executives’ options be cashed out according to a pre-specified, gradual schedule. These hands-off options would substantially reduce the costs associated with current equity arrangements while imposing little burden on executives.

As I am continuing to work on this paper and a number of related projects, any comments would be most welcome.

(Editor’s Note: The post below comes to us from Peter Moon of Universities Superannuation Scheme, Phil Spathis of the Australia Council of Super Investors, and Keith Johnson of Reinhart Institutional Investor Services.)

Verizon, Par Pharmaceutical and Aflac became the first US companies over the last year to adopt policies requiring an advisory vote of shareholders on company executive compensation practices. A network of over 70 institutional and individual investors lead by AFSCME and Walden Asset Management announced in January that adoption of this ’say on pay’ policy is expected to be put on proxies at more than 90 US companies this year. With majority shareholder votes having been cast for similar resolutions at seven companies during 2007, say on pay will be one of the hottest issues in the upcoming US proxy season. In their article, Global Investors Laud Shareholder Votes on Executive Compensation, Peter Moon from the $65 billion Universities Superannuation Scheme pension fund in Britain, Phil Spathis from the $200 billion Australia Council of Super Investors and Keith Johnson from the University of Wisconsin Law School’s International Corporate Governance Initiative describe the impact that say on pay has had in other markets and discuss the benefits it could produce for both companies and shareholders in the United States.

For the subset of the 350 companies that were both reviewed by the SEC’s Division of Corporate Finance as part of the executive compensation review project and have received one of these “all clear” letters from the Staff, you will soon find the SEC comment letter and the company response posted on the SEC’s EDGAR system. It looks like the Staff hung pretty close to the timeline of “45 days since the Staff started informing companies that they were clear,” which is earliest that the Staff can post letters/responses pursuant to its own policy (which was confirmed in the Staff Observations in the Review of Executive Compensation Disclosure). I just took a cursory swing through the SEC’s database over the weekend and found these:

- Allstate - comment letter and response

- Bristol Myers - comment letter and response

- Berkshire Hathaway - comment letter and response

- Travelers Companies - comment letter and response

There’s about 50 more out there and we’ve posted a more comprehensive list on CompensationStandards.com in a new “SEC Comments” Practice Area. Hopefully, somebody can prove me wrong - but it’s quite challenging to run searches on the SEC’s comment letter database - as well as the third-party providers’ databases - to find these letters. The good ole boolean-type searches don’t seem to work for these particular batch of letters…

(Editor’s Note: This post comes to us from Lesley Rosenthal of Lincoln Center.)

The recent governance crisis at the Smithsonian Institution came about through a toxic combination of unchecked arrogance by the CEO, a relatively disengaged Board, and a dysfunctional system of checks and balances. The Smithsonian appointed an independent review committee to take an unflinching look at corporate governance practices there. “How Not to Govern,” which was published in the New York State Bar Journal (Nov/Dec 2007) by Lincoln Center’s General Counsel Lesley Friedman Rosenthal (HLS ‘89), discusses the independent committee’s findings and explores the lessons that may be learned by others in the sector, including chief executives, General Counsel, Corporate Secretaries, board members, outside attorneys, and scholars.

Recently, the New England Chapter of the National Association of Corporate Directors hosted a breakfast panel featuring Vice Chancellor Leo E. Strine, Jr. and Martin Lipton of Wachtell Lipton Rosen & Katz. (John L. Reed of Edwards Angell Palmer & Dodge previously posted on the talk here.)

The NACD has released highlights of the talk, entitled The Delaware Courts, the Corporate Bar, and Being a Director. The summary describes the panelists’ insights on the upcoming proxy season, executive compensation, the committee structure in today’s boards, and the role of independent directors.

The highlights of the panel discussion are available online here.

(Editor’s Note: This post comes to us from Jie Cai and Ralph A. Walkling of Drexel University.)

We have recently released a new paper entitled Shareholders’ Say on Pay: Does it Create Value? The paper examines stock returns around the time of the passage of the Say on Pay Bill in the House of Representatives in search of evidence whether the market views the legislation as creating value. The Abstract of the piece follows:

The post Sarbanes-Oxley Act period is associated with several initiatives designed to give shareholders a greater voice in the boardroom. The latest of these initiatives is the Say-on-Pay Bill (H.R. 1257) which passed the House of Representatives on April 20, 2007 by a 2 to 1 margin. This bill does not limit CEO pay but requires an advisory shareholder vote on executive compensation packages. Using the abnormal return of 1,245 firms surrounding the House passage of this bill, we examine whether the market interprets shareholders’ say on executive pay as adding or subtracting firm value. Stocks of firms with positive abnormal CEO compensation react in a significant, positive manner to the Say-on-Pay Bill. The positive market reaction is stronger among the firms with weaker, but not the weakest governance. In addition, abnormal returns are higher in the subset of firms more likely to receive higher disapproval votes from shareholders and firms more likely to implement changes under the pressure of shareholder votes. Thus, the bill has the greatest impact among the subset of firms most likely to benefit and implement changes. Given the uncertainty surrounding passage, implementation and efficacy of this proposed advisory vote, the results are likely to understate the actual impact of Say on Pay legislation. Our findings suggest that the market views this legislation as value-creating for the companies where it is likely to have the most impact. These results provide important evidence for the current debate regarding the Say-on-Pay legislation in Congress and shareholder access to proxy. Our results also shed light on the role of activist investors.

The full Article is available for download here.

Recently, the Mergers, Acquisitions, and Split-Ups course here at Harvard Law School, co-taught by Professor Robert Clark and Vice Chancellor Leo Strine, Jr., hosted a panel discussion entitled Private Equity Buyouts.  The candid discussion among the expert practitioners on the panel provided rare insights into the internal dynamics of private equity deals.

The panelists included Louis D’Ambrosio, Chief Executive Officer of Avaya, which was recently taken private by the Texas Pacific Group; Robert L. Friedman, Chief Legal Officer of Blackstone; and Eileen Nugent of Skadden, a leading corporate practitioner with extensive experience in leveraged buyout transactions.  In response to questions from Professor Clark, Vice Chancellor Strine, and the audience, the panel shared its insights on matters including the current deal environment for private equity, a board’s fiduciary duties when evaluating a private equity firm’s buyout offer, and the emergence and relevance of “go-shop” provisions in private equity transactions.

A video of the panel discussion is available for download here.

Our firm has recently released a new M&A Commentary on proposals requiring an annual shareholder vote on executive compensation, known as “Say on Pay” proposals, that many public companies are likely to face during the 2008 proxy season. The Commentary, entitled “Say on Pay” Shareholder Advisory Votes on Executive Compensation: The New Frontier of Corporate Governance Activism, provides management and boards with a strategic overview of the issues these popular shareholder proposals are likely to raise–and describes the implications that will follow if the proposals pass. Among other things, the Commentary notes that:

The advent of “Say on Pay” for a company means, as a practical matter, that its executive pay policies and procedures will have to meet ISS guidelines on executive compensation or suffer a very strong risk of ISS recommending that shareholders vote “No on Pay.” Such a negative vote, if not addressed promptly by modifying executive compensation to fit ISS guidelines, will almost certainly lead to an ISS withhold vote recommendation against the compensation committee and perhaps the entire board.

The full Commentary is available online here.

Martha Carter, who heads the design of corporate governance policies at RiskMetrics, recently gave a presentation at the Shareholder Activism class here at Harvard Law School. In her talk, Carter offered an assessment of last year’s proxy season; the issues likely to arise during the coming proxy season; and an account of the issues receiving the most attention from investors.

A video of Martha’s talk is available for download here. The materials accompanying her initial remarks can be viewed online here.

The Delaware Court of Chancery issued a decision last week of both practical and theoretical importance for corporate lawyers. The opinion is Melzer v. CNET Networks, Inc., and there are at least three reasons why this case is noteworthy.

First, the court held that Section 220 of the Delaware General Corporation Law, which is the statutory basis on which stockholders can demand books and records of a company, enables plaintiffs under certain circumstances to receive documents for a period prior to their stock ownership. In order to allow a pleading to be prepared with details of alleged “systemic and sustained” lack of oversight by the board (the well-known Caremark standard), the Court allowed the plaintiffs to access materials prepared before they became stockholders.

Second, the case is interesting because it began as a derivative action filed in federal court in California. The California case was dismissed by the federal judge, however, who instructed the plaintiff to avail himself of the provisions of DGCL Section 220. The parties now appear to be headed back to California, where the plaintiff will be able to amend the complaint in light of the discovery authorized in this opinion.

Finally, the case is striking because the defendant admitted that it engaged in the backdating of stock options, which is the factual basis of the underlying claims. In a separate blog post that can be found here, I offer more analysis of those facts and the court’s application of Delaware law to this fascinating case.

(Editor’s Note: This post comes to us from Jonathan Hayter of the National Law Journal.)

The National Law Journal recently published Programmed Stock Trading Plans Eyed, which highlights recent efforts by corporate boards to ensure that executives’ stock-trading plans meet the requirements of Rule 10b5-1. That Rule permits firms to trade the company’s stock for the benefit of insiders on the basis of a predetermined plan, but corporate directors are concerned that the SEC may be preparing to bring enforcement actions on the ground that executives made changes to their plans while in possession of inside information.

Those concerns, the piece explains, stem from recent allegations that Countrywide Financial executive Angelo Mozilo, who allegedly made changes to his 10b5-1 plan in the midst of recent mortgage-market turmoil. Those claims, combined with the recent conviction of former Quest CEO Joseph Nacchio, have led boards to seek counsel as to whether their executives have made changes to the plans that run afoul of the Rule, especially because the plans are generally prepared by outside brokerage houses rather than in-house counsel or members of the board.

The SEC’s attention, the article explains, has been drawn to the issue in part by a recent study by Alan Jagolinzer of Stanford Business School. That study, which can be downloaded here, found that insiders with 10b5-1 plans managed to generate abnormal forward-looking returns larger than their colleagues who did not have such plans. Following the release of the study, the Director of the SEC’s Division of Enforcement, Linda Chatman, commented that the Commission “wanted to make sure that people are not doing [with 10b5-1 plans] what they did with stock options.” To date, the article notes, the SEC has not yet brought an enforcement case based on changes to a Rule 10b5-1 plan, but boards of directors have begun the process of learning exactly how and when an executive can make changes to such plans.

The full article is available for download here.

The Harvard Law School Program on Corporate Governance just issued my discussion paper, CEO Centrality, co-authored with Martijn Cremers and Urs Peyer. Our abstract describes the paper as follows:

We investigate the relationship between CEO centrality – the relative importance of the CEO within the top executive team in terms of ability, contribution, or power – and the value and behavior of public firms. Our proxy for CEO centrality is the fraction of the top-five compensation captured by the CEO. We find that CEO centrality is negatively associated with firm value (as measured by industry-adjusted Tobin’s Q). Greater CEO centrality is also correlated with (i) lower (industry-adjusted) accounting profitability, (ii) lower stock returns accompanying acquisitions announced by the firm and higher likelihood of a negative stock return accompanying such announcements, (iii) greater tendency to reward the CEO for luck in the form of positive industry-wide shocks, (iv) lower likelihood of CEO turnover controlling for performance, and (v) lower firm-specific variability of stock returns over time. Overall, our results indicate that differences in CEO centrality are an aspect of firm management and governance that deserves the attention of researchers.

The full paper can be downloaded here.

Countrywide Financial is a name that has come to be synonymous with the subprime meltdown that has shaken investors and sent the world’s central bankers scrambling to rejigger their playbook. Less attention has focused on Countrywide’s corporate governance and compensation practices, however. Therein lie some important clues to what is behind the turmoil now being felt by the company and its stakeholders.

The lesson of Countrywide is instructive at a time when there is considerable pressure to retreat from Enron-era reforms, with many claiming they are too costly and not necessary. On the contrary, Countrywide shows that improvement is far from universal when it comes to corporate governance and that, once again, excessive CEO pay is still the Typhoid Mary of the boardroom, showing up time and again just before calamity strikes, as it did with Enron, WorldCom, Tyco, Adelphia, Nortel, and more. It also shows that a single company’s misjudgments can carry profound consequences for other corporations, public institutions and a wider community of interests, which is why society itself has a considerable stake–separate and apart from that of shareholders–in seeing CEO pay returned to reasonable levels.

…continue reading: Countrywide’s Corporate Governance: Definitely Subprime

The Program on Corporate Governance has recently released our paper CEO Tenure, Performance and Turnover in S&P 500 Companies.  As Dennis Berman noted recently, our study identifies two groups of CEOs, ”owner-CEOs” and ”manager-CEOs,” and shows that manager-CEO retirements increase substantially during the fifth year of the CEO’s tenure.  The abstract of the piece is as follows:

The centrality of the CEO is reflected in the empirical literature linking CEO turnover to poor firm performance.  However, less is known about the institutional and personal correlates of CEO turnover.  In this study, we find two CEO characteristics interact with turnover: tenure and ownership.  We interpret our results as indicating that CEOs of S&P 500 firms divide into two groups with different tenure patterns–”owners” (who have large personal shareholdings) and ”managers” (who have smaller holdings).  The tenure of manager-CEOs (as opposed to owner-CEOs) exhibits a term structure loosely similar to the one produced by the tenure process at academic institutions.  Turnover of all kinds is low during a CEO’s first four years on the job.  In contrast, once a CEO reaches his fifth year, retirements begin a multi-year increase and exits via merger exhibit a large one-year spike.  These term effects are strongest for relatively young CEOs, and appear to be independent of such factors as firm performance or retirement norms.  We also find that deals and retirements are partially related, but partially distinct, modes of CEO turnover in other respects, which are similar along some dimensions but sharply different along others.

The full Article can be downloaded here.

Directorship magazine has recently published The Directorship 100, a list of the 100 most influential players in corporate governance.  The list and the reasons for the inclusion of each member appear in the September issue of the magazine.

One of those included on the list is Lucian Bebchuk, Director of our Program on Corporate Governance.  In describing the reason for selecting him, the magazine notes his work on executive pay, including his book Pay without Performance; his advocacy for “Say on Pay”; and his initiation of bylaw amendments adopted by several large public companies.

The magazine’s goal is to recognize those who are driving corporate governance inside America’s boardrooms.  The list of influential players includes business leaders Warren Buffett and Jack Welch; “poison pill” inventor Martin Lipton; Congressman Barney Frank; and CalPERS, the giant public pension fund.  The list also includes two legal academics other than Bebchuk: Columbia Professor John Coffee and Stanford professor and former SEC commissioner Joseph Grundfest.

The full article is available for download here.

The most recent issue of the Journal of Economic Literature contains an essay in which Michael Weisbach, who recently joined us as a Guest Contributor, reviews Lucian Bebchuk’s and Jesse Fried’s Pay without Performance.  Weisbach reviews and evaluates in detail Bebchuk’s and Fried’s normative and positive claims on executive pay.  He concludes that the positive claims–Bebchuk’s and Fried’s account of the executive compensation landscape–are fairly persuasive.  However, with respect to their normative claims, Weisbach expresses doubts as to how effective their proposed reforms are going to be in practice in achieving the improvements Bebchuk and Fried seek.  The full review is available here.

More than thirty academic reviews of–and responses to–Pay without Performance have now been published, including pieces by Stephen Bainbridge; John Bogle; William Bratton; John Core, Wayne Guay, and Randall Thomas; Jeff Gordon; Bengt Holmstrom; Glenn Hubbard; Ira Kay; Arthur Levitt; and Bevis Longstreth.  A collection of those reviews is available here.

One of the most interesting aspects of the recent conviction of Gregory Reyes, the former CEO of Brocade, concerns the use of federal criminal law to police executive compensation matters.  Reyes was accused of participating in a backdating scheme.  The most intriguing fact in the case was that Reyes himself didn’t benefit from the backdating at issue.  (A pending civil case alleges that Reyes benefited from other backdating; that case is analyzed in a recent post here.)  In other words, Reyes used backdating as a form of compensation for other employees–and is now going to jail because of it. The case is part of a pattern of increased federal intervention in compensation decisions. 

…continue reading: The Reyes Conviction and Federal Intervention in Compensation Decisions

The San Jose Mercury News recently published my op-ed piece on the recent criminal conviction of Greg Reyes, the former CEO of Brocade, for securities fraud in connection with options backdating.  The op-ed runs as follows:

Greed, Not Firms’ Well-Being, Was Motive for Backdating

In a recent high-profile trial, former Brocade CEO Greg Reyes was found guilty of criminal securities fraud arising from options backdating.  Many pundits have questioned whether criminal charges were appropriate.  They argue that Reyes, like other CEOs caught in similar scandals, did not personally benefit from backdated options.  According to The Economist, for example, Reyes “made no financial gain from backdating.”  Rather, Reyes–like other backdating CEOs–manipulated option grant dates just to attract talented employees.  But the view that options were backdated solely to benefit the firm, and not to enrich executives, is absurd.

A stock option gives an employee the right to buy the firm’s stock at some point in the future by paying the option’s “exercise” price.  The lower the exercise price, the more likely it is that the option can be exercised profitably and the larger the profit will be.  In almost all employee options, the exercise price is set to the market price on the grant date of the option.  The main reason: Until recently, such options did not have to be recorded as an expense against the firm’s reported earnings.  In contrast, options with a lower exercise price–one below the grant-date price–had to be expensed, just like cash salary or bonus.

Option backdating enabled Brocade and other firms to offer lower-priced options disguised as non-expensed options.  Reyes, with the benefit of hindsight, picked a day when the stock price was much lower than on the actual grant date.  He then pretended that the options were granted on that hindsight-chosen date, and set the option price to that date’s low price.  So Brocade awarded options whose exercise price was below the market price on the true grant date, while accounting for the options as if they had been issued at the grant-date price.  The result: The options were not expensed, boosting Brocade’s reported earnings.  The Reyes jury concluded that this deception constituted securities fraud.

Were Brocade and other companies forced to engage in secret option backdating to recruit top-tier workers?  No.  Had firms wished to openly award lower-price options to their employees, they were free to do so.  To be sure, these options, like the workers’ cash salaries, would have had to be expensed, but that would not have prevented firms from attracting high-quality workers.  Employees care about how much they are paid, not how their compensation affects reported revenues.  No worker has ever turned down a cash bonus because it has to be expensed.

So why, then, did Reyes and other CEOs engage in option backdating?  Because it enabled them to directly and indirectly boost their own pay.  Over a million of Brocade’s backdated options ended up in Reyes’ own hands.  True, the criminal charges against Reyes focused on his backdating of other employees’ options.  But the government’s civil complaint against Reyes shows he also personally received backdated options, including an October 2001 mega-grant of 1.2 million options.  The backdating appears to have lowered the exercise price on the mega-grant by about 50 percent.  This manipulation boosted the value of Reyes’ compensation in 2001 by millions of dollars, none of which was reported to shareholders.

While boosting his actual pay, the backdating of the 2001 mega-grant also enabled Reyes to hide a large amount of his compensation that year.  Brocade disclosed this grant to investors in its 2002 proxy statement, indicating that the exercise price was set to the grant-date market price.  Using this information and a standard formula for calculating option value, analysts tabulating Reyes’ 2001 compensation valued the option grant at $13.2 million.  Had Brocade provided accurate information, the option grant would have been valued at $28 million.  By camouflaging around $15 million of his compensation, Reyes reduced the likelihood that shareholders would find his pay excessive and pressure the board to reduce it.

Even if Reyes had not received backdated options himself, Reyes gained indirectly by backdating other employees’ options.  Much of CEOs’ bonus pay is tied to reported earnings.  So is the price at which executives can unload their stock.  The firm-wide backdating of options jacked up earnings, and the amounts involved were not trivial.  Backdating firms have so far acknowledged over-stating earnings by an aggregate of more than $12 billion.  These inflated earnings, in turn, enabled CEOs like Reyes to fatten their bonuses and increase their profits from selling shares.

The fact that backdating CEOs lined their pockets does not mean that criminal prosecution against them is necessarily warranted; civil liability may be more appropriate.  But one cannot determine the right legal remedy for backdating without a clear understanding of why it occurred: CEOs backdated options to directly and indirectly inflate their own pay, not to benefit their firms.

Editor’s Note: The Reyes case is just one example of the implications of option backdating for firms, regulators, directors, and CEOs.  Lucian Bebchuk, Yaniv Grinstein, and Urs Peyer have described the broader backdating trends in Lucky CEOs and Lucky Directors, which examine the likelihood that CEOs and directors of about 6,000 firms backdated options over a recent 10-year period.  The authors summarized their findings in a December 2006 Financial Times op-ed urging that backdating “deserves all the attention it has been getting and more.”

Stock options have been at the heart of many of the corporate governance scandals over the last decade.  For example, managers’ ability to choose when to unwind their equity incentives encouraged them to manipulate earnings.  And executive influence over the timing of option grants led to backdating and springloading.  The problem is that executives have had too much control over when stock options are granted and when they are cashed out.

As I discuss in a recent Marketplace Radio commentary, one could substantially reduce managers’ influence over their options through the use of what I call “hands-off” options.  The text and audio of my commentary can be found here.

Since I am writing about “hands-off” options for a symposium piece on executive compensation, any comments would be most welcome.  You can reach me at jfried [at] law.berkeley.edu.