In our paper, Dynamic CEO Compensation, which is forthcoming in the Journal of Finance, we present a fully dynamic model of CEO pay that incorporates many complex features of real-life contracting settings. In particular, it considers multiple periods, risk aversion, private saving, and short-termism. In such settings, the optimal contract is typically very complicated and can only be solved numerically, which makes it difficult to see the intuition and understand which features of the setting are driving which aspects of the contract. Our main methodological contribution is to achieve a surprisingly tractable optimal contract. The model’s closed-form solutions lead to transparency, clarity, and simplicity — they allow the economic forces behind the contract to be transparent, its economic implications to be clear, and in particular practical guidelines on how to reform compensation to address issues that manifested in the recent financial crisis. In particular, we propose a compensation structure based on a system that escrows compensation for a set period of years stretching into the executive’s retirement. The longer time frame is designed to prevent the executive from taking short-term actions that may enrich the manager at the expense of the firm’s future profits. The plan also provides a rebalancing mechanism to maintain a constant percentage of compensation in cash and stock, so that the executive always has sufficient equity in the firm to provide performance incentives — even if the stock price falls.

…continue reading: Dynamic CEO Compensation

As in 2011, executive compensation is the single most important corporate governance issue for companies, boards, and investors for the 2012 proxy season. This Director Notes discusses the evolving analytics and issues around pay for performance (P4P) and suggests ways for companies and their boards to analyze the alignment of P4P, counter negative recommendations by proxy advisers, and draft their proxies to obtain shareholder support for their pay programs.

In 2011, approximately 3,000 companies held their first mandatory shareholder say on pay (SOP) and say on frequency votes; approximately 1,500 “smaller reporting companies” are not required to do so until January 21, 2013. Overall, 42 companies that held SOP votes in 2011 received less than 50 percent shareholder support. More than 90 percent of companies received shareholder support of 70 percent or higher, and more than 70 percent received shareholder support of 90 percent or higher. On the issue of say on frequency, shareholders at more than 75 percent of companies supported annual SOP votes, while shareholders at a majority of the remaining companies supported triennial votes, and a few supported biennial votes. Following the votes, the vast majority of companies adopted the vote frequency preference supported by a plurality of their shareholders.

One unexpected development during the 2011 proxy season was the large volume of publicly filed disputations between public companies and Institutional Shareholder Services (ISS) and Glass Lewis, the two most influential U.S. proxy advisers, over their negative SOP recommendations. While some of the negative recommendations and the controversies that followed were related to pay practices labeled “problematic” or “egregious” by the proxy advisers, most of the negative recommendations and controversies stemmed from negative recommendations based on those proxy advisers’ P4P voting policies.

…continue reading: Proxy Season 2012: The Year of Pay for Performance

As we continue to monitor developments in the unfolding 2012 proxy season, here are some key themes that have emerged thus far:

What are the overall vote results?

Of the first 180 companies of the Russell 3000 to report the results of say-on-pay proposals, approximately:

• 65 percent have passed with more than 90 percent support;
• 25 percent have passed with between 70.1 percent and 90 percent support;
• 8 percent have passed with between 50 percent and 70 percent support;
• 2 percent (three companies) obtained less than 50 percent support — Actuant and International Game Technology were discussed in our prior mailing and KB Home is discussed below. In a vote result reported after the cutoff date for the calculations above, news reports indicated that Citigroup Inc.’s say-on-pay proposal received 45 percent of votes cast, making it the fourth company (and the largest company) whose say-on-pay proposal has received less than 50 percent support this year.

Thus far, these percentages are not materially different from the full-year results for the 2011 proxy season.

…continue reading: Continuing Developments in the 2012 Proxy Season

On March 14, 2012, the UK Government published a consultation paper on its proposals to give shareholders of quoted companies a greater influence over executive pay.

The Government proposes to introduce a binding shareholder vote on executive pay policy (possibly requiring a 65% or 75% super majority), a non-binding shareholder vote on the subsequent application of that pay policy and a binding shareholder vote on exit payments in excess of one year’s basic salary.

The new rules would apply to certain UK quoted companies. The new rules would apply to those companies with either a standard or a premium listing on the London Stock Exchange main market and UK incorporated companies listed on the NYSE, NASDAQ or officially listed in another EEA member state but would not apply to companies trading on AIM or the Plus Growth market. The rules would replace the existing requirement for a non-binding vote on the director’s remuneration report.

Existing Regulation of Executive Pay

Since 2003 UK company law has required that quoted companies produce a directors’ remuneration report (which forms part of their annual report and accounts) and seek an advisory vote on that remuneration report. These reports provide detailed disclosure of the pay and benefits for the financial year in question but contain limited information about the bonus and incentive targets for the following financial year.

…continue reading: Proposals for Binding Shareholder Votes on Executive Pay in the UK

The Public Company Accounting Oversight Board is proposing a new auditing standard that relates to the auditor’s evaluation of a company’s relationships and transactions with related parties, and amendments to existing auditing standards that relate to significant unusual transactions and financial relationships and transactions by a company with its executive officers (including incentive compensation arrangements). The new and amended standards are intended to focus auditors’ efforts on areas that may pose an increased risk of material misstatement to a company’s financial statements.

The PCAOB’s proposals largely build upon and enhance existing requirements in these areas, primarily by providing greater specificity around the procedures that must be employed and inquiries that must be made. While the proposals would not directly impact the non-financial-statement disclosure (such as proxy disclosure) relating to related party transactions and executive compensation under SEC rules, companies should anticipate greater auditor focus and additional audit procedures on the financial statement impact of these areas if these proposals are adopted.

Subject to SEC approval, the new and amended standards would be effective for audits of financial statements for fiscal years beginning on or after December 15, 2012. The deadline for public comment is May 15, 2012.

…continue reading: New PCAOB Auditing Standards

In the paper, The Efficacy of Shareholder Voting: Evidence from Equity Compensation Plans, which was recently made publicly available on SSRN, my co-authors (Christopher Armstrong of the University of Pennsylvania and Ian Gow of Harvard Business School) and I examine the efficacy of shareholder voting in effecting changes in corporate policy. We focus on the effects of shareholder voting on equity-based compensation plans on firms’ executive compensation policies for two reasons. First, equity compensation plans are widespread and require shareholder approval, making votes on these plans the most common subject of shareholder voting after director elections and auditor ratification. Second, equity compensation proposals attract much higher levels of shareholder disapproval than most other company-sponsored proposals that are put to shareholder vote (e.g., director elections and auditor ratification nearly always receive in excess of 90% shareholder support), making them a more powerful setting for empirical analysis.

Of the 619 management-sponsored proposals rejected by shareholders between 2001 and 2010, 183 (30%) related to equity compensation plans. For the 2,659 management-sponsored proposals where Institutional Shareholder Services (ISS), a leading proxy advisory firm, recommended a vote against the proposal, 1,719 (65%) related to equity compensation plans. Moreover, ISS recommended against 27% of the 6,270 equity compensation plans considered between 2001 and 2010. Although only 2% of equity compensation proposals fail to receive the required level of shareholder support, this is substantially larger than the 0.07% failure rate for director elections, which have received considerably greater attention in recent research on shareholder voting and executive compensation.

…continue reading: The Efficacy of Shareholder Voting

This column looks at four circumstances having special impact on the governance of executive pay today and then focuses on one of them, proxy advisers (with particular attention to the largest one, Institutional Shareholder Services (ISS)). It concludes with suggestions as to steps that might be taken to better regulate proxy advisers.

Four Influential Factors

Increasing Complexity of the Executive Pay Discussion. Discussions of executive pay in proxy statements are often extremely complex and lengthy (frequently 30 to 40 pages of narrative and tables). Many companies are putting into the Compensation Discussion and Analysis (CD&A) their own tables (most especially their own competing version of the Summary Compensation Table) in order to express their own views on the correct way to explain and justify executive pay at the issuer. It has become a challenge to understand any one company’s executive pay arrangements and an even greater challenge to understand how that company’s executive pay arrangements relate to those at competitor companies.

Institutional Shareholders. Institutional shareholders represent an overwhelming proportion of the vote at publicly traded companies. (They own approximately 75 percent of the market value of exchange- traded companies.) These institutional shareholders owe a fiduciary duty to the persons who own their shares or are beneficiaries of the trust funds managed by them. This duty includes understanding how the companies in which they have invested are managed, including management of executive pay. The explosion of data noted in the preceding paragraph has meant a challenge to these institutional shareholders in trying to understand the executive pay practices at thousands of companies that they (collectively) are investing in.

…continue reading: Say on Pay: Who Is Watching the Watchmen?

In the paper, Shareholder Votes and Proxy Advisors: Evidence from Say on Pay, which was recently made publicly available on SSRN, my co-authors (Yonca Ertimur of Duke University and David Oesch of the University of St. Gallen) and I examine the analyses underlying the voting recommendations issued by Institutional Shareholder Services (ISS) and Glass Lewis & Co. (GL), the two most influential proxy advisors, for the non-binding vote on executive pay mandated by the Dodd-Frank Act, also known as “say on pay” (SOP). We then investigate the effect of these recommendations on shareholder votes, stock prices and firm’s behavior. Due to the complex and highly firm-specific nature of executive compensation, mandatory SOP votes provide an especially powerful setting to examine the analyses performed by proxy advisors and their impact.

Our analysis of the SOP-related part of the ISS and GL proxy reports for S&P 1500 firms in 2011 shows that both advisors provide a quantitative and qualitative examination of the executive pay plan (structured around certain categories, e.g. pay for performance, disclosures), assign a rating for each category and issue a final voting recommendation (For or Against). ISS issues Against recommendations for 11.3% of the firms and GL for 21.7%, suggesting a more aggressive stance by GL. The difference also reflects the different approaches ISS and GL follow in assessing the “pay for performance” category, a key driver of the final recommendation, with ISS focusing its analysis of pay practices mostly on poorly performing firms. Firms receiving an Against from ISS are not a subset of those receiving an Against from GL. Rather, among firms with potentially questionable executive compensation practices (i.e. firms with an Against from at least one proxy advisor), ISS and GL agree on which firms warrant an Against only in 17.9% of the cases. We interpret this as evidence that the complex nature of SOP has allowed proxy advisors to differentiate themselves from each other. Additional analysis suggests that neither proxy advisor applies a “one-size-fits-all” approach in evaluating the compensation plans for the 2011 proxy season. Specifically, there are numerous cases where the proxy advisors identify similar controversial provisions yet issue different recommendations, based on firm-specific circumstances and other elements of the pay plan.

…continue reading: Shareholder Votes and Proxy Advisors

This report examines current evidence regarding the influence of third-party proxy advisory firms’ voting recommendations on shareholder proposal voting outcomes, particularly say-on-pay votes. It also presents the findings of a study, conducted by The Conference Board, NASDAQ, and the Rock Center for Corporate Governance at Stanford University, which shows that proxy advisory firms have a substantial impact on the design of executive compensation programs. However, the impact of those firms on governance quality and shareholder value is still unknown.

A growing body of evidence demonstrates the influential role that third-party proxy advisory firms play in affecting the voting outcome of proposals made to shareholders in the annual proxy, particularly say-on-pay votes, which became mandatory for most public companies in 2011. There is less evidence, however, to establish the extent to which companies respond to this influence by changing the size and structure of executive compensation plans to conform to proxy advisor voting polices. A recent study conducted by The Conference Board, NASDAQ, and the Rock Center for Corporate Governance at Stanford University found that proxy advisory firms have a substantial impact on the design of executive compensation programs.

…continue reading: The Influence of Proxy Advisory Firm Voting Recommendations

In our forthcoming Journal of Financial Economics paper, Stock Options and Managerial Incentives for Risk Taking, we exploit the change in the accounting treatment of stock-based compensation under FAS 123R, which was issued by the Financial Accounting Standards Board (FASB) and took effect in December 2005, to provide new evidence on the role that convexity in compensation contracts plays in providing incentives for risk taking by managers.  An additional rationale that is often stated for the dramatic rise in option-based compensation over time revolves around how stock options were treated for accounting purposes. Prior to the implementation of FAS 123R, firms were allowed to expense stock options at their intrinsic value. Because nearly all firms granted stock options at-the-money, no expenses for option-based compensation were generally reported on the income statement.

Hall and Murphy (2003) argue that, due to their favorable accounting treatment and the fact that there is no cash outlay at the time of the grant, firms act as though the perceived cost of options is lower than their true economic cost. If firms make decisions based on the perceived costs instead of the economic costs, they grant more options than they would otherwise, and options with their favorable accounting treatment are preferred to possibly better incentive plans with less favorable accounting treatment. Consistent with this view, Carter, Lynch, and Tuna (2007) provide evidence that the accounting treatment of stock options affected their use, showing that a comprehensive proxy for financial reporting concerns was positively related to the use of stock options prior to FAS 123R. The implementation of FAS 123R eliminated the ability to expense options at their intrinsic value and instead required firms to begin expensing stock-based compensation at its fair value, effectively eliminating any accounting advantages associated with stock options.

…continue reading: Stock Options and Managerial Incentives for Risk Taking