In the latest instance of proxy advisors establishing a governance standard without offering evidence that it will improve corporate governance or corporate performance, ISS has adopted a new policy position that appears designed to chill board efforts to protect against “golden leash” incentive bonus schemes. These bonus schemes have been used by some activist hedge funds to recruit director candidates to stand for election in support of whatever business strategy the fund seeks to impose on a company.
Posts Tagged ‘Bonuses’
On July 5, 2013, the German Federal Council (Bundesrat) decided to raise no objection against the CRD IV Implementation Act passed by the German Federal Parliament (Bundestag) on June 27, 2013. The legislative procedure for this Act, which implements Directive 2013/36/EU (Capital Requirements Directive IV, “CRD IV”) into German law, is thus completed.
Together with Regulation (EU) No. 575/2013 (Capital Requirements Regulation, “CRR”), the CRD IV is part of the so-called “Single Rule Book”. The Single Rule Book enhances the capital adequacy of credit institutions and other institutions regulated by the German Banking Act (“Institutions”), provides for liquidity requirements harmonised throughout the EU, and harmonises the European banking supervisory legislation. Unlike the CRD IV, the CRR does not require implementation; it has a direct and immediate effect on the Institutions.
The Act implementing the requirements of CRD IV will enter into force on January 1, 2014. The German Banking Act (Kreditwesengesetz, “KWG”) will be changed, and a revision of the German Remuneration Regulation for Institutions (InstitutsVergütungsverordnung, “InstitutsVergV”) is expected. Under employment law aspects, the new regulations on bonus caps are of particular importance. This Legal Update outlines the main new regulations and their employment law implications.
The move toward stricter regulation of remuneration in the financial services industry in the European Union has resulted in a confusing web of overlapping European Directives and local EU Member State law and regulation, each of which seeks to place limits on remuneration. This post aims to assist in navigating the new European labyrinth by providing a snapshot of the three main European Directives that regulate remuneration:
- Capital Requirements Directive IV (CRD IV);
- Alternative Investment Fund Managers Directive (AIFMD); and
- fifth Undertakings for Collective Investment in Transferable Securities Directive (UCITS V).
In addition, this post discusses the European Securities Market Authority’s (ESMA) recent Markets in Financial Instruments Directive (MiFID) Guidelines on remuneration policies and practices. The post then considers the additional requirements on remuneration that the UK is planning to impose in relation to the financial services industry.
Editor’s Note: The following post comes to us from Ron Shalev of the Department of Accounting at New York University, Ivy Zhang of the Department of Accounting at the University of Minnesota, and Yong Zhang of the School of Accounting and Finance at Hong Kong Polytechnic University.
In our paper, CEO Compensation and Fair Value Accounting: Evidence from Purchase Price Allocation, forthcoming in the Journal of Accounting Research, we investigate the influence of bonus intensity (i.e., the relative importance of bonus in CEO pay) and alternative accounting performance measures used in bonus plans on the allocation of purchase price post acquisitions. Upon the completion of an acquisition, the acquirer is required to allocate the cost of acquiring the target to its tangible and identifiable intangible assets and liabilities based on their individually estimated fair values. The remainder, namely, the difference between the purchase price and the fair value of net identifiable assets, is recorded as goodwill. The recognition of goodwill has different implications for subsequent earnings than that of other assets. Tangible and identifiable intangible assets with finite lives, such as developed technologies, are depreciated or amortized, depressing earnings on a regular basis. In contrast, goodwill is unamortized and subject to a periodic fair-value-based impairment test. As write-offs of goodwill impairment are infrequent (Ramanna and Watts, 2009), recording more goodwill generally leads to higher post-acquisition earnings.
UBS recently announced it would pay part of the bonuses of 6,500 highly compensated employees with bonds that would be forfeited if the bank does not meet its capital requirements. Taxpayers should applaud this initiative. Other financial institutions should be rewarded for emulating it.
As the global financial crisis of 2007-2009 reminds us, the impairment of large interconnected intermediaries can have devastating effects on economic activity. This threat can induce governments to bail out distressed financial institutions. The direct costs to taxpayers of these bailouts are apparent. Beyond the direct costs, the prospect of bailouts removes much of the downside risk that the owners and employees of financial institutions should bear, distorting their financing and investment decisions, as well as increasing the likelihood and expected magnitude of future bailouts. The UBS “bonus bonds,” which echo a recommendation we made in The Squam Lake Report (French et al, 2010), mitigate these distortions.
The Delaware Supreme Court upheld a Chancery Court determination that a board did not commit waste by consciously deciding to pay bonuses that were non-deductible under Section 162(m) of the Internal Revenue Code (Freedman v. Adams, Del. Supr., __ A.2d __, No. 230, 2012, Berger J. (Jan 14, 2013)). Unlike claims of gross negligence, claims of waste are not subject to exculpation or indemnification by the company and therefore have the potential for personal liability of directors.
The original suit was brought in 2008 by a shareholder of XTO Energy (later acquired by ExxonMobil) as a derivative claim. The suit alleged that XTO’s board committed waste by failing to adopt a plan that could have made $130 million in bonus payments to senior executives tax deductible. The board was aware that, under a plan that qualifies for the “performance based compensation” exception of Section 162(m), the company could have deducted its bonus payments, but, as the company disclosed in its annual proxy statement, the board did not believe that its compensation decisions should be constrained by such a plan. The Chancery Court held that the shareholder failed to state a claim. The Supreme Court agreed, holding that the decision to sacrifice some tax savings in order to retain flexibility in compensation decisions is a classic exercise of business judgment.
Most of the empirical work on executive compensation investigates the role of contemporaneous performance measures in setting cash compensation, ignoring the relevance of past performance measures and the structure of cash compensation. In our paper, The Relation between CEO Compensation and Past Performance, forthcoming in The Accounting Review, we focus on the relation between cash compensation components (salary and bonus) and past performance measures as signals of a CEO’s ability.
We first develop a simple two-period principal-agent model with moral hazard and adverse selection. Our model suggests that salary is adjusted to meet the reservation utility and information rent, and is positively correlated over time to reflect ability. Bonus serves to address moral hazard and adverse selection problems by separating agents into contracts with different levels of risk. Agents are screened and receive different bonus arrangements according to their types. The higher an agent’s type, the more sensitive his bonus is to contemporaneous performance. A higher ability agent receives a larger portion of his compensation in the form of bonus and less as salary. For a given agent, salary increases with his past performance and higher current salary predicts higher future performance. Current bonus, however, is negatively correlated with both past and future performance.
It is common knowledge that people are not driven solely by the prospect of financial rewards. Yet, in business, motivational tools for top executives—particularly the CEO—almost singularly comprise financial incentives. In 1980, only 10 percent of the UK’s largest FTSE100 companies utilized incentive arrangements (in the form of cash and stock-based variable pay). Today, they are universally employed as a matter of best practice and variable pay accounts for approximately two-thirds of total compensation.
Widespread adoption of financial incentives has contributed to substantial pay increases, in absolute and relative terms. In the United Kingdom, the average compensation of FTSE100 CEOs climbed from £1 million in 1998 to £4 million a decade later, with the ratio of CEO pay to average employee pay nearly tripling. (The figures are, of course, higher for American executives.) The rise in top executive pay has far outstripped growth in share price and other indicators of company performance, with certain incentive arrangements proving counterproductive by encouraging excessive risk-taking and accounting manipulation.
Amid growing sensitivity to widening income inequality in many countries, it is no wonder that executive pay has remained a visible target.
Though the global financial crisis of 2008 prompted a seismic shift in attitudes toward executive pay on the part of lawmakers, the public, investors, and other stakeholders, average compensation levels continue to rise or have returned to where they were before the crisis.
Mindful of the outcry over particular elements of pay packages, companies began scaling back bonus awards as well as payments related to “golden parachutes” and other forms of exit pay following the crisis.
Indeed, such components of executives’ total annual compensation declined in fiscal 2009 with some elements, including those dealing with exit pay, continuing to decline modestly into fiscal 2010.
But that has been more than offset through increases in other pay elements, most notably awards tied to company stock. The result is a 37 percent surge in total annual compensation paid to C-suite officers from fiscal 2008 to 2010 with stock awards now constituting more than half of the total pay pie.
As such, this post explores how the executive pay package mix and overall total annual compensation levels have changed since fiscal 2008 and the role played by stock-based awards in fueling the spike in total executive pay.
In the paper, Why Taxing Executives’ Bonuses Fosters Risk-Taking Behavior, we analyze the effect of a bonus tax on the risk-taking behavior of corporate executives in a principal-agent model. In our paper, the firm value (output) depends on the manager’s behavior in two dimensions. First, the manager can increase the firm value by exerting more effort. Second, the manager can choose a project with specific exposure. A project choice with a higher expected return simultaneously implies a higher risk. Therefore, the project choice influences the expected value as well as the variance in the output. For instance, bank managers dealing with credits face this kind of trade-off.
Credit at low interest rates can be assigned to firms with high ratings. Therefore, the bank has low expected profits but also low risks. Otherwise, credit at higher interest rates can be assigned to a start-up firm operating in a promising area but with high uncertainty. Thus, a higher expected return can be achieved by being exposed to higher risks. We assume that the principal offers a salary package consisting of a fixed salary and an incentive-based component (bonus rate). The bonus rate increases with the manager’s output. As the manager can only influence the output by his effort choice and the degree of exposure, the realization or failure of the project is stochastic.