Our paper, When Less Is More: The Benefits of Limits on Executive Pay, forthcoming in the Review of Financial Studies, addresses the question of whether limits on executive compensation harm or benefit shareholders. In particular, our model shows that if regulation limits executive compensation, this can make it possible for the board to give the CEO incentives that are both more effective and less costly, and for the two parties to create a relationship that is more collaborative. Among the implications—some of which we are exploring in a companion paper in progress—is this collaborative relationship makes it more attractive for the CEO to pursue long-run strategies (e.g., organic growth) that are more profitable than the short-run strategies (e.g., mergers and acquisitions) they would have pursued if firms had to rely on stock-based compensation for their executives.
Posts Tagged ‘Executive performance’
Picture, if you will, the chief executive officer of a Fortune 500 company slumped over a conference table, holding his head in his hands, anguishing over whether the time had come to pull the plug on one of his most senior executives. “Tell me,” he asks in despair, “is it this hard for everybody?”
Yes, it is.
Of all the complex, sensitive, and stressful issues that confront CEOs, none consumes as much time, generates as much angst, or extracts such a high personal toll as dealing with executive team members who are just not working out. Billion-dollar acquisitions, huge strategic shifts, even decisions to eliminate thousands of jobs—all pale in comparison with the anxiety most CEOs experience when it comes to deciding the fate of their direct reports.
To be sure, there are exceptions. Every once in a while, an executive fouls up so dramatically or is so woefully incompetent that the CEO’s course of action is clear. However, that’s rarely the case. More typically, these situations slowly escalate. Early warning signs are either dismissed or overlooked, and by the time the problem starts reaching crisis proportions, the CEO has become deeply invested in making things work. He or she procrastinates, grasping at one flawed excuse after another. Meanwhile, the cost of inaction mounts daily, exacted in poor leadership and lost opportunities.
In our paper, CEOs and the Product Market: When Are Powerful CEOs Beneficial?, which was recently made publicly available on SSRN, we explore what the central factors are that influence when and how powerful CEOs may add value and how the benefits and costs of CEO power vary with industry conditions. In an ideal world, shareholders would grant an optimal level of power, weighing various costs and benefits specific to the firm’s characteristics and the business conditions in which it operates. We hypothesize that the optimal amount of power changes based on product market conditions.
Most recent research has shown that CEO power is negatively associated with firm value and is associated with negative outcomes for the firm. Articles have suggested that powerful CEOs may be bad news for shareholders (e.g., Bebchuk, Cremers, and Peyer 2011; Landier, Sauvagnat, Sraer, and Thesmar 2013). Morse, Nanda, and Seru (2011) provide evidence that powerful CEOs may have more favorable incentive contracts. Khanna, Kim, and Lu (forthcoming) show that CEO power arising from personal decisions can increase the likelihood of fraud within corporations.
Investors, directors and corporate executive management share common interests when it comes to company performance and economic value creation.
Yet, whilst this commonality is laudable, a review of performance measurement and long-term incentive plan design for USA public companies identifies that current practice is less than clear in measuring and aligning these interests in a manner that is robust and meaningful.
CEO compensation in U.S. public firms has attracted a great deal of empirical work. Yet our understanding of the contractual terms that govern CEO compensation and especially how the compensation committee ties CEO compensation to performance is still incomplete. The main reason is that CEO compensation contracts are, in general, not observable. For the most part, firms disclose only the realized amounts that their CEOs receive at the end of any given year. The terms by which the board determines these amounts are not fully disclosed.
The JP Morgan Chase board of directors has vexed the world with its terse announcement in a recent 8-K filing that CEO Jamie Dimon would receive a big pay raise—$20 million in total pay for 2013, up from $11.5 million for 2012, a 74 percent increase.
Not surprisingly, the news sparked strong reactions, from indignant critique to justification and support. Dimon’s raise obviously has special resonance because JP Morgan’s legal woes were one of the top business stories last year as it agreed to $20 billion in payments to settle a variety of cases involving the bank’s conduct since 2005 when Dimon became JPM CEO. But the ultimate question that gets fuzzed-over in the filing and response is one of culture and accountability—whether a long-serving CEO is accountable for a corporate culture that has spawned major regulatory inquiries and settlements across a broad range of legal issues, even though the firm has otherwise performed well commercially.
Standard principal-agent theory prescribes that managers should not be compensated on exogenous risks, such as general market movements. Rather, firms should index pay and use contracts that filter exogenous risks (e.g., Holmstrom 1979, 1982; Diamond and Verrecchia 1982). This prescription is intuitive and agrees with common sense: CEOs should receive exceptional pay only for exceptional performance, and “rational” compensation practice should not permit CEOs to obtain windfall profits in rising stock markets. However, observed compensation contracts are typically not indexed. Specifically, stock options almost never tie the strike price of the option to an index that reflects market performance or the performance of peers. Commentators often cite this glaring difference between theory and practice as evidence for the inefficiency of executive compensation practice and, more generally, as evidence for major deficiencies of corporate governance in U.S. firms (e.g., Rappaport and Nodine 1999; Bertrand and Mullainathan 2001; Bebchuk and Fried 2004). This paper therefore contributes to the discussion about which compensation practices reveal deficiencies in the pay-setting process.
Considerable debate remains among academics and practitioners regarding the economic forces that drive CEO compensation practices in the United States. Some view the market for CEO talent as the main economic force that drives the level and form of CEO compensation (e.g., Rosen, 1992; Gabaix and Landier, 2008). Others argue that these forces have little effect on CEO compensation because of frictions such as managerial entrenchment, asymmetric information, and transaction costs of replacing managers, believing instead that compensation practices are by and large driven by the bargaining power that the CEO has vis-à-vis the board (e.g., Bebchuk and Fried, 2003).
The debate has intensified in recent years due to several controversial compensation practices, a first example of which is the tendency of firms to benchmark CEO compensation to that of other CEOs. While some find benchmarking consistent with competitive compensation (Holmstrom and Kaplan, 2003; Bizjak et al., 2008), others argue it is a way for CEOs to increase their compensation by benchmarking themselves to highly paid CEOs (e.g., Faulkender and Yang, 2010).
Today’s post considers what might be done in the design of executive pay to encourage commitment by executives to the longer-term interests of their employers.
A very interesting examination into design features in an incentive program that puts emphasis on long-term considerations of executive pay is contained in the proxy statement for Goldman Sachs. (Elements of this program discussed below have been developed by Goldman Sachs over a period of years—the CD&A section of the 2013 proxy statement provides a description of the program.) Following are two interesting aspects of that program.
Prior turnover literature documents various signals of poor performance, such as stock returns and earnings, that lead a board of directors to terminate the CEO, but does not explore the underlying causes of the CEO’s poor performance. In many cases, terminated CEOs have been successful earlier in their tenure as CEO. At some point, however, the board decides that the existing CEO’s skills do not fit with the current leadership needs of the firm, and so switches to a new CEO. The question of why these previously successful CEOs are released (apart from retirements or voluntary departures) remains largely unanswered.
In our paper, Adapt or Perish: Evidence of CEO Adaptability to Strategic Industry Shocks, which was recently made publicly available on SSRN, we conjecture that a previously successful CEO may not be able to adapt when the firms within her industry change their business strategy, or more precisely, that strategic shocks within the industry increase the probability that the CEO will suffer from an adaptability problem. If strategic industry shocks alter a firm’s leadership needs, and the board perceives the CEO cannot adapt their skills to fit those needs, then the CEO is more likely to be terminated. For example, assume a CEO has a set of skills that leads them to prefer to conduct manufacturing activities domestically. When faced with competitive forces that dictate a different strategy, some CEOs may be able to adapt successfully to manage foreign manufacturing operations. Other CEOs, however, may have difficulty adjusting their skills to fit the current strategic needs of the firm. If this is the case, the latter type of CEO will face a higher probability of being terminated when the firm’s industry competitors change their strategies. We note that it is certainly the case that all CEOs can adapt to some degree to changing business conditions. The interesting question then, is whether one can identify the types of shocks, if any, that cause CEO adaptability problems.