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Corporate Executives are (Still)

OverpaidJesse FriedHarvard Law School

Date 22 January 2013


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Information Session //2

Do Pay Levels Show U.S. CEOs Overpaid?


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But 3 good reasons to think U.S CEOs

systematically overpaid

(1) logic of CEO power & director incentives (2) evidence of link between CEO power &

CEO pay

(3) the widespread camouflaging of CEO pay


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(1) The Logic of CEO Power and

Director Incentives

The Official Viewof CEO Pay The Reality of Managerial Power



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The Official Viewof CEO Pay (1/3)

- Directors arms-length bargain with CEOs

- CEOs only human- CEOs seek higher pay, regardless of performance

- No more (or less) greedy than rest of us

- But directors are loyal to shareholders- Directors bargain hard with CEOs

- As if paying with their own money- Design CEO pay to properly compensate, incentivize CEOs

- CEO pay is a market, like any other



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underlies most financial economistswork on subject

used by CEOs & directors to justify compensationdecisions to

- shareholders

- policymakers

- courts

if correct, would suggest U.S. CEOs are notsystematically overpaid


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Problem with the Official View


The official arms-length story - is neat, tractable, and reassuring- but fails to account for realities of pay-setting

process

Its not only CEOs whose incentives matter.

- Must look at incentives of directors- Cannot assume directors automatically serve

shareholders in setting executive pay.


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The Reality of Managerial Power


Directors have little incentive to bargain hard w/ CEO- Financial benefits to favoring CEO- Psychological/social reasons for favoring CEO- Pay hard to figure out- Low financial cost of favoring CEO

Thus, CEOs have power over boards- CEOs use power to get better pay arrangements

- Pay is systematically higher & more performance-decoupled

than it would be under arms-length bargaining


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Financial Incentives to Favor CEOs (1/2)


Board seats:- Keeping your board seat

- Board seats valuable ($300K+ per year)- Directors nominated by board nominating committee- 99% of director election uncontested, so board nomination = re-election- Not rocking the boatfacilitates re-nomination by other directors

- Getting other board seats

- Onlyteam playersget invited to join boards

- So:marketfor directorships discourages hard bargaining with CEO

Goodies

- Eg., CEO directs corporation to give to directorsfavorite charities


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Financial Incentives to Favor CEOs (2/2)


Risk

committee

$$$ Donation


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Psycho-social Reasons to Favor CEOs


Friendship & loyalty- Directors grateful to be invited on board by CEO, or at least with his

approval- Many have prior relationship with CEO

Collegiality and team spirit- Not easy to bargain hard with colleague

Cognitive dissonance- Many directors are current or former CEOs

- Psychological stake in believing CEOs not overpaid


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Pay is Hard: Limited Time & Information


Pay arrangements extremely complex- [In part, so hard to figure out how much CEO is getting]

Directors have limited time, ability to assess

Professor Jeffrey Sonnenfeld, Yale School of Management

- I work with several compensation committees, and Iknow that a lot of the time board members don tunderstand the complexity of the documents theyrereviewing. People dont want to look foolish by asking how

some of the instruments work.


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Cost of Favoring CEOs Low


Typical directors owns approximately .005% of firms stock

Cost of overpaying $5m = $250- Vs.

- $300K income from director seat- Maintaining reputation as team player to get on other boards- Financial goodies- Psychological/social benefits of favoring CEO

OPM!


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CEOs Push for Pliant Directors


In the [last] forty years, the CEO has

had an important role determining their [own] compensation.These people pick their own compensation committees. [they]aren't looking for Dobermans; they're looking for cocker

spaniels. It's been a system that the CEO has dominated.

In my experience, boards have done little in the way of thinkingthrough as an owner what they ought to pay these people.

Warren Buffett (2009)


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(2) Evidence of Link b/w Power & Pay


CEOs get more pay, everything else equal, when (e.g.)

* boards are larger (more collective action problem)* directors appointed by CEO

* no 5% outside blockholder

* fewerpressure-resistantinstitutional investors

* state anti-takeover law passed, reducing takeover risk

More power, more pay

- But even CEOs with less power have some power

- Even their pay will be too high


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Camouflage, Pre-1992


An SEC official describes pre-1992 state of affairs as follows:

The information [in the executive compensation section] was whollyunintelligible . . . .

Depending on the companys attitude toward disclosure, you mightget reference to a $3,500,081 pay package spelled out rather than innumbers. .

Someone once gave a series of institutional investor analysts a proxystatement and asked them to compute the compensation received by theexecutives covered in the proxy statement. No two analysts came up withthe same number. The numbers that were calculated varied widely.


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1992: Summary Compensation Table


To reduce ability to camouflage pay, firms requiredto report CEO pay in simple table, by category and

dollar amount

Salary Bonus LT Total

CEO $2M $4M $5M $9M


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Post-1992: Camouflaging (1/2)


Pay designers began relying heavily on- forms of compensation not reportable in table

- Eg, pensions- performance-insensitive pay that can be reported as something other

than salary and thus made to look performance-related.- E.g.: guaranteed bonus

2006: SEC fixestable to capture pensions, etc.


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Post-1992: Camouflaging (2/2)


Option Backdating (uncovered 2006)- CEO option grant backdating to lower exercise price

- Inflated value of stock options under the radar screen- 2000-3000 U.S. firms (conservative estimate)

- $ billions in extra pay- United Health: $500M paid back by CEO (2007)

- Employee option grant backdating- To boost earnings, CEO bonuses and stock-sale

proceeds

- CEO option exercise backdating (shift tax cost to firms)


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Implication of Camouflaging


If CEOs were paid properly, why would firms try tohide their pay?


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Even staunchest defenders of CEO paynow concede role of managerial power


Kevin Murphy, USC (2012)- what makes CEO pay ..complicated is that the efficient

contracting, managerial power, and political paradigms co-existand interact

Steven Kaplan, U Chicago (2012)- Murphy (2012) concludes his.. detailed surveywith the

conclusion that executive compensation is affected by theinteraction of a competitive market for talent, managerialpower, and political factors. That conclusion is hard to disagree

with.


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Conclusion


At this point, no real debate over whether U.S. CEOs

overpaid

Only question is: by how much?


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