In the paper, Trading by Bank Insiders Before and During the Financial Crisis, which was recently made publicly available on SSRN, I investigate whether managers of large U.S. banks foresaw the underperformance of their own bank prior to the recent financial crisis. To shed light on this question, I analyze the trades of bank managers in their own bank’s stock. Using banks’ performance during the crisis as an ex-post measure of risk exposure, the paper examines whether the bankers that took the most risk changed their insider trading before the onset of the crisis. The paper also links trading by bank insiders to the developments in the housing market, which played a crucial role in starting the crisis.

The role of bank managers in the crisis has been subject to considerable debate both in the academic literature and in the popular press. On the one hand, Fahlenbrach and Stulz (2011) do not find strong evidence to support the notion that incentive packages contributed to the crisis. Their results indicate that CEOs were holding sizeable equity stakes even as the crisis hit, and did not reduce their ownership in 2007 or during the peak of the crisis in 2008. They conclude that CEOs believed that the risks they took before the crisis would pay off, but that this turned out not to be the case. On the other hand, Bebchuk et al. (2010) criticize the incentive structures of bank managers. They point out that the top managers of Bear Stearns and Lehman Brothers cashed out a substantial amount of options in the period prior to the crisis. Bhagat and Bolton (2011) also dispute that managers had no awareness of the large risks they were facing. They analyze the compensation structure and CEO payoffs of the 14 largest US banks and argue that managerial incentives led to excessive risk-taking. This view is supported also by Cheng et al. (2009), who find a positive relation between excess executive compensation and risk taking. Their evidence suggests that overpaying bank managers who take high risks is positively associated with the level of institutional ownership of the bank.

…continue reading: Trading by Bank Insiders Before and During the Financial Crisis

The SEC enforcement agenda and whistleblower bounty program, CEO succession, executive compensation, and IT risk were among the issues on audit committee members’ minds as they met in December and January at three audit committee peer exchanges hosted by the PwC Center for Board Governance. The exchanges were part of the 2011 Year-end considerations for audit committees seminar held in Arizona, New York and Florida.

PwC Vice Chair, Assurance, Tim Ryan facilitated the exchanges, which included over 200 audit committee members. Following are the major recurring themes at each of the venues.

Compliance

Among all the rulemaking and enforcement actions that have taken place over the past year, one that caused significant consternation among the audit committee members is the new SEC whistleblower bounty program. Many are concerned about the program undercutting existing company whistleblower programs that came into existence following the passage of the Sarbanes-Oxley Act in 2002. That law calls for public company audit committees to oversee whistleblower hotlines.

…continue reading: Top Concerns for Directors in 2012

In our paper, Earnings Management from the Bottom Up: An Analysis of Managerial Incentives below the CEO, which was recently made publicly available on SSRN, we analyze all components of compensation packages for CEOs and for managers at levels below that of the CEO. Pay-for-performance contracts are a critical instrument to align the interests of principals and agents (Jensen and Meckling, 1976). While it can be optimal to make the agent the residual claimant of the firm’s profit, under numerous conditions principals are better off employing weaker incentives. These include situations with poor measures of performance and multitasking environments, when agents reduce their motivation in response to financial incentives, and when principal and agent have differing priors.

Another cost of high-powered incentives is that they provide managers with incentives to manipulate the firm’s reported earnings. For example, equity incentives can entice managers to boost reported earnings just before they exercise options or sell stock. There are now a number of academic studies – and many anecdotes – that document this link between the structure of chief executive officer (CEO) compensation and various measures of earnings manipulation (e.g., Beneish and Vargus, 2002; Bergstresser and Philippon, 2006; Peng and Roell, 2008). These papers generally focus on one component of compensation for the top position—equity incentives for the CEO. In this paper, we extend this literature by analyzing all components of compensation packages for CEOs and for managers at lower levels. To our knowledge, this study is the first that analyzes the relationship between CEO, division manager, and chief financial officer (CFO) compensation and earnings management in a large sample of firms.

…continue reading: Earnings Management from the Bottom Up

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.

…continue reading: Post-Crisis Trends in U.S. Executive Pay

After Jack Welch retired from General Electric it wasn’t until a divorce settlement forced the disclosure of his retirement benefits package that anyone took any notice. At that time, the scandal surrounding Mr. Welch was that his perquisites were valued at $2.5 million a year, and included luxuries such as the use of an $80,000-per-month Manhattan apartment owned by the company, court-side seats to the New York Knicks and U.S. Open, seating at Wimbledon, box seats at Red Sox and Yankees baseball games, country club fees, security services and restaurant bills. No one at the time of his departure had valued Mr. Welch’s full retirement package either, which – at almost $420 million – dwarfs the perks package that Mr. Welch ultimately relinquished.

Since then, multi-million dollar severance and other separation packages, commonly referred to as “walk-away” packages, have become so commonplace for CEOs that when HP fired Leo Apotheker with a $12 million guaranteed cash payment it barely registered. Accelerated equity awards along with substantial pensions and other deferred compensation all but guarantee significant payouts at many of America’s largest corporations in every termination situation except for a termination “for cause.” This report goes back to 2000 to examine the largest golden parachutes and other termination packages of the past decade, many of which have never been quantified before.

…continue reading: Examining the Largest Golden Parachutes

The Business Secretary of the British government (“Government”), Vince Cable, recently announced a package of controversial plans in a bid to transform UK executive pay culture [1]. Under a new-four-pronged approach, shareholders would for the first time be given a binding vote on executive pay packages. Executive boards may also need to become more diverse — including at least two individuals that had not previously been on a board of directors, and people from a broader range of professional backgrounds.

The Government is to finalize the detail of these plans soon. Mr. Cable was careful to admit that “no proposal on its own is a magic bullet”. There is however real concern that in the quest for the perfect alignment between pay and performance, the seemingly scatter gun approach taken by the coalition government has failed to hit the mark. This alert provides an overview of the proposals, and looks at some of the questions and concerns that they have raised.

…continue reading: Transforming Executive Pay in the UK

One thing is for certain: Pay is unique at every company. There are as many iterations of pay as there are companies in America. This uniqueness makes our job as shareholders very challenging. For the most part, we must rely on the members of compensation committees to develop the compensation philosophy and structure in order to incentivize management and align their interests with those of shareholders. We believe that poorly structured pay packages harm shareholder value by unfairly enriching executives at the expense of owners – the shareholders. On the other hand, a well aligned compensation package motivates executives to perform at their best. This benefits all shareholders.

There have been many changes this proxy season and although the evaluation of compensation is still a challenge, we have learned a few things along the way. Given the unique nature of compensation, CalSTRS tried to evaluate pay holistically at every company. We not only looked at the alignment between pay practices and the performance of the companies, but also corporate peer groups, problematic pay practices, and disclosures.

…continue reading: Lessons Learned: The Inaugural Year of Say-on-Pay

Over the past two weeks, Lucian Bebchuk and René Stulz engaged in an online debate on the question: Has Executive Compensation Contributed to the Financial Crisis? Bebchuk supported a “yes” answer, and Stulz argued for a “no” answer. The debate, which was hosted by the World Bank’s All about Finance blog, was followed by a poll in which readers cast their votes. The votes are now in, and 79.9% of the votes were cast in support of the position supported by Bebchuk.

The opening statements by Bebchuk and Stulz are available here and here. The second-round responses by Bebchuk and Stulz are available here and here. The results of the readers’ poll are available here.

As we begin to analyze the first proxy season under “say on pay” in the US, it may be useful to review the evidence from the UK experience with say on pay. In the study, Say on Pay Votes and CEO Compensation: Evidence from the UK, co-authored with David Maber of University of Southern California and forthcoming in the Review of Finance, we examine the impact of “say on pay” in the UK, the first country to adopt a mandatory, non-binding annual shareholder vote on executive pay.

We perform three sets of analyses. First, we examine the market reaction to the (largely unanticipated) announcement of say on pay regulation and find positive abnormal returns for firms with weak penalties for poor performance, e.g. firms with excess CEO pay combined with poor performance and firms with generous severance contracts, which can weaken penalties in the event of poor future performance.

…continue reading: Say on Pay Votes and CEO Compensation

Professor Lucian Bebchuk testified yesterday before the Subcommittee on Financial Institutions and Consumer Protection of the United States Senate Committee on Banking, Housing and Urban Affairs. He participated in a hearing on “Pay for Performance: Incentive Compensation at Large Financial Institutions.” In addition to Bebchuk, the other witnesses testifying in the hearing were Kurt Hyde, Deputy Special Inspector General of the Troubled Asset Relief Program; Professor Robert J. Jackson, Jr., Associate Professor of Law at Columbia Law School; and Michael S. Melbinger, an executive compensation expert appearing on behalf of the Financial Services Roundtable.

In his testimony, Bebchuk explained how compensation practices at financial firms should be reformed to eliminate excessive risk-taking incentives. He described two distinct shortcomings of pay arrangements: first, excessive focus on short-term results; and, second, excessive focus on results for shareholders. He then discussed how pay arrangements should be designed to address each of these problems. In particular, Bebchuk explained how pay structures  should be designed to induce executives to focus on long-term rather than short-term results, as well as to induce such executives to take into account the consequences of their decisions for all those contributing to the bank’s capital (rather than only for shareholders). Bebchuk suggested that the rules proposed by regulators last spring be strengthened to ensure that financial firms provide executives with such incentives. Because of the importance of providing such incentives for financial stability, he concluded, ensuring that financial firms  provide such incentives should be regarded as a regulatory priority.

Bebchuk’s written testimony is available here.