Executive Compensation: Something Old, Something New Marianna Makri & Luis R. Gomez-Mejia

Hot Topic Executive compensation has been a hot HR topic because of: Executive compensation has been a hot HR topic because of: High visibilityHigh visibility Frequently perceived unfairness (particularly in North America)Frequently perceived unfairness (particularly in North America) ImportanceImportance

Corporate Governance Rating A good corporate governance rating sends a signal to potential investors that the firm is a better investment because presumably the board of that firm is working for shareholders as opposed to cozying up to the CEO A good corporate governance rating sends a signal to potential investors that the firm is a better investment because presumably the board of that firm is working for shareholders as opposed to cozying up to the CEO

Executive Compensation Package Can either be a motivational tool encouraging executives to pursue strategic decisions that are in the best interest of shareholders or it can be designed to reinforce the wrong strategic choices Can either be a motivational tool encouraging executives to pursue strategic decisions that are in the best interest of shareholders or it can be designed to reinforce the wrong strategic choices

The CEO Pay Package Two out of three CEOs have seen their pay go up in the last couple of years Two out of three CEOs have seen their pay go up in the last couple of years Only a small percentage of the differences in pay among CEOs could be explained by differences in the performance of their firms Only a small percentage of the differences in pay among CEOs could be explained by differences in the performance of their firms CEOs who were making more money were also running larger companies CEOs who were making more money were also running larger companies

What Does Pay Mean? Large pay packages are flagged as a sign of weak boards that are too cozy with management and not looking out for shareholders Large pay packages are flagged as a sign of weak boards that are too cozy with management and not looking out for shareholders Low ratings signal that the board is ineffective in monitoring the CEO which can in turn hurt the firm’s stock price Low ratings signal that the board is ineffective in monitoring the CEO which can in turn hurt the firm’s stock price

The Role of Risk in the Executive Compensation Contract Employment risk - the possibility that the executive will be terminated either due to unsatisfactory performance or due to change in control Employment risk - the possibility that the executive will be terminated either due to unsatisfactory performance or due to change in control Compensation risk - the potential unpredictability in the executive’s future pay represented mainly by the proportion of stock options in the total pay package Compensation risk - the potential unpredictability in the executive’s future pay represented mainly by the proportion of stock options in the total pay package

The Role of Risk in the Executive Compensation Contract Continued Business risk - the uncertainty surrounding the firm’s competitive environment Business risk - the uncertainty surrounding the firm’s competitive environment

Components of the Pay Package Fixed pay – salary and benefits Fixed pay – salary and benefits Typically smaller than variable payTypically smaller than variable pay Firms can only write off one million dollars in fixed payFirms can only write off one million dollars in fixed pay Most companies top off salaries at about one million dollarsMost companies top off salaries at about one million dollars

Components of the Pay Package Continued Variable pay – bonuses and stock options Variable pay – bonuses and stock options Draw the CEO’s attention to performance results and can serve to align the goals of the company and its shareholders with the personal goals of the executiveDraw the CEO’s attention to performance results and can serve to align the goals of the company and its shareholders with the personal goals of the executive

Recent Environmental Changes Affecting CEO Risk Shareholder activism Shareholder activism Sarbanes-Oxley Act (SOX) Sarbanes-Oxley Act (SOX) SEC disclosures SEC disclosures

Shareholder Activism Proxy resolutions sponsored by union and public pension funds, aimed at cutting CEO pay, are winning extraordinary victories Proxy resolutions sponsored by union and public pension funds, aimed at cutting CEO pay, are winning extraordinary victories If shareholder activism keeps spreading it will ignite a good amount of reform If shareholder activism keeps spreading it will ignite a good amount of reform

The Sarbanes-Oxley Act (SOX) SOX holds the new generation of CEOs personally accountable for their companies' financial statements SOX holds the new generation of CEOs personally accountable for their companies' financial statements Some worry that SOX forces CEOs to place more focus on the internal control environment and the short term as opposed to focusing on the long term Some worry that SOX forces CEOs to place more focus on the internal control environment and the short term as opposed to focusing on the long term

SEC Disclosures The SEC voted on an expansion in disclosure requirements for executive pay including: The SEC voted on an expansion in disclosure requirements for executive pay including: The dollar value of every benefit that executives derived from their employmentThe dollar value of every benefit that executives derived from their employment Companies should report the extent to which executives sell shares given to them as variable payCompanies should report the extent to which executives sell shares given to them as variable pay

SEC Disclosures Continued Additional SEC disclosures include: Additional SEC disclosures include: Companies should disclose not just the amounts paid but also the criteria based upon which those bonuses were awardedCompanies should disclose not just the amounts paid but also the criteria based upon which those bonuses were awarded Companies should annually disclose the dollar value of the package that each executive will receive upon exit in the case of a change in control, termination or retirementCompanies should annually disclose the dollar value of the package that each executive will receive upon exit in the case of a change in control, termination or retirement

Managing Executive Risk Stock options Stock options Pay for performance Pay for performance Change-in-control provisions Change-in-control provisions

Stock Options Stock options are the right to purchase stock at a predetermined price Stock options are the right to purchase stock at a predetermined price Restricted stock is a right granted to purchase during a specified period, at the market price on the date of the option, a specified number of shares Restricted stock is a right granted to purchase during a specified period, at the market price on the date of the option, a specified number of shares

Stock Options Continued Restricted stock is replacing stock options in executive benefits packages due to changes in accounting standards Restricted stock is replacing stock options in executive benefits packages due to changes in accounting standards Restricted stock is not as tied to organizational performance as stock options Restricted stock is not as tied to organizational performance as stock options

Pay for Performance Tying executive compensation to specific performance guidelines can be counterproductive Tying executive compensation to specific performance guidelines can be counterproductive CEO performance should be tied to broader metrics that go well beyond financial measures such as leadership and innovation CEO performance should be tied to broader metrics that go well beyond financial measures such as leadership and innovation

Pay for Performance Continued SOX provisions increase business risk for CEOs leading to risk averse business strategies SOX provisions increase business risk for CEOs leading to risk averse business strategies Link pay to performance very loosely and motivate them with restricted stock options Link pay to performance very loosely and motivate them with restricted stock options

Change in Control Provisions to Manage Employment Risk Golden parachute clauses have increased in popularity Golden parachute clauses have increased in popularity Golden parachutes are payments in the form of cash, an acceleration of vesting or other benefit that occurs in connection with a change in the ownership or control of a company's stock or assets Golden parachutes are payments in the form of cash, an acceleration of vesting or other benefit that occurs in connection with a change in the ownership or control of a company's stock or assets

Golden Parachute Provisions Typical golden parachute provisions include: Typical golden parachute provisions include: a lump-sum payment equal to typically three times the base salary plus bonusa lump-sum payment equal to typically three times the base salary plus bonus accelerated vesting of deferred compensation and supplemental executive retirement plan (SERP) benefitsaccelerated vesting of deferred compensation and supplemental executive retirement plan (SERP) benefits

Golden Parachute Provisions Continued Additional golden parachute provisions include: Additional golden parachute provisions include: Additional age and service credit during the severance period (typically three years) for purposes of pension calculationAdditional age and service credit during the severance period (typically three years) for purposes of pension calculation Accelerated vesting of equity awardsAccelerated vesting of equity awards

Linking Pay to Performance Individuals in positive contexts can become risk averse while individuals in negative contexts can become risk seeking Individuals in positive contexts can become risk averse while individuals in negative contexts can become risk seeking An ideal level of risk needs to be determined for the executive and the extent that pay is tied to performance An ideal level of risk needs to be determined for the executive and the extent that pay is tied to performance

The Risk Environment Firms operating in highly competitive, high-risk environments need to pay more to attract and retain high quality executives than firms operating in low risk environments Firms operating in highly competitive, high-risk environments need to pay more to attract and retain high quality executives than firms operating in low risk environments

The Risk Environment Continued The proportion of variable pay needs to be balanced by the potential to earn more money The proportion of variable pay needs to be balanced by the potential to earn more money Total pay should be highest in settings where risk is greatest for the CEO such as high technology firms or family controlled firms Total pay should be highest in settings where risk is greatest for the CEO such as high technology firms or family controlled firms

CEO Pay in High Technology Firms High technology firms need to reward CEOs by using multiple performance criteria including: High technology firms need to reward CEOs by using multiple performance criteria including: Financial indicatorsFinancial indicators Emphasis on innovationEmphasis on innovation Support of basic researchSupport of basic research

CEO Pay in Family Firms Family firms differ from non family firms in two major ways: Family firms differ from non family firms in two major ways: Executives who are members of the family exhibit a greater desire to retain control of the firm stemming from a strong personal attachmentExecutives who are members of the family exhibit a greater desire to retain control of the firm stemming from a strong personal attachment Employment and compensation risk is highly concentrated in the firmEmployment and compensation risk is highly concentrated in the firm

CEO Contracts in the Family Business Contracts should be more transactional with specific performance provisions for family CEOs Contracts should be more transactional with specific performance provisions for family CEOs Contracts should be more relational for CEOs outside of the family to protect them from unfair judgment Contracts should be more relational for CEOs outside of the family to protect them from unfair judgment

Conclusion There are a wide variety of ways to design CEO contracts There are a wide variety of ways to design CEO contracts The provisions of these contracts can impact the firm performance The provisions of these contracts can impact the firm performance The environment in which the firm operates should influence the CEO contract The environment in which the firm operates should influence the CEO contract