Corporate Executives are (Still) Overpaid Jesse Fried Harvard Law School Date 22 January 2013

Information Session //2 Do Pay Levels Show U.S. CEOs Overpaid?

Information Session //3 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

(1) The Logic of CEO Power and Director Incentives The “Official View” of CEO Pay The Reality of Managerial Power Information Session //4

The “Official View” of CEO Pay (1/3) -Directors arm’s-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 Information Session //5

The “Official View” of CEO Pay (2/3) Information Session //6

The “Official View” of CEO Pay (3/3) Information Session //7 underlies most financial economists’ work on subject used by CEOs & directors to justify compensation decisions to -shareholders -policymakers -courts if correct, would suggest U.S. CEOs are not systematically overpaid

Problem with the “Official View” Information Session //8 The official arm’s-length story -is neat, tractable, and reassuring – -but fails to account for realities of pay-setting process It’s not only CEOs whose incentives matter. -Must look at incentives of directors -Cannot assume directors automatically serve shareholders in setting executive pay.

The Reality of Managerial Power Information Session //9 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 arm’s-length bargaining

Financial Incentives to Favor CEOs (1/2) Information Session //10 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 boat” facilitates re-nomination by other directors -Getting other board seats -Only “team players” get invited to join boards -So: “market” for directorships discourages hard bargaining with CEO Goodies -Eg., CEO directs corporation to give to directors’ favorite charities

Financial Incentives to Favor CEOs (2/2) Information Session //11 Risk committee $$$ Donation

Psycho-social Reasons to Favor CEOs Information Session //12 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

Pay is Hard: Limited Time & Information Information Session //13 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 I know that a lot of the time board members don’t understand the complexity of the documents they’re reviewing. People don’t want to look foolish by asking how some of the instruments work.”

Cost of Favoring CEOs Low Information Session //14 Typical directors owns approximately.005% of firm’s 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!

CEOs Push for Pliant Directors Information Session //15 “ 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 thinking through as an owner what they ought to pay these people.” Warren Buffett (2009)

(2) Evidence of Link b/w Power & Pay Information Session //16 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 * fewer “pressure-resistant” institutional 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

(3) Widespread Camouflaging of Pay Information Session //17 Managerial power is not unlimited One constraint: fear of shareholder outrage -More outrageous an arrangement is perceived to be, greater market and social costs to executives and directors Fear of outrage creates desire to camouflage (obscure or justify) amount of pay Widespread camouflaging further evidence that pay is systematically high, too decoupled from performance

Camouflage, Pre-1992 Information Session //18 An SEC official describes pre-1992 state of affairs as follows: “The information [in the executive compensation section] was wholly unintelligible.... Depending on the company’s attitude toward disclosure, you might get reference to a $3,500,081 pay package spelled out rather than in numbers. ………. Someone once gave a series of institutional investor analysts a proxy statement and asked them to compute the compensation received by the executives covered in the proxy statement. No two analysts came up with the same number. The numbers that were calculated varied widely.”

1992: Summary Compensation Table Information Session //19 To reduce ability to camouflage pay, firms required to report CEO pay in simple table, by category and dollar amount SalaryBonusLTTotal CEO$2M$4M$5M$9M

Post-1992: Camouflaging (1/2) Information Session //20 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 “fixes” table to capture pensions, etc.

Post-1992: Camouflaging (2/2) Information Session //21 Option Backdating (uncovered 2006) -CEO option grant backdating to lower exercise price -Inflated value of stock options “under the radar screen” 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)

Implication of Camouflaging Information Session //22 If CEOs were paid properly, why would firms try to hide their pay?

Even staunchest defenders of CEO pay now concede role of managerial power Information Session //23 Kevin Murphy, USC (2012) -“what makes CEO pay..complicated is that the efficient contracting, managerial power, and political paradigms co-exist and interact” Steven Kaplan, U Chicago (2012) -“Murphy (2012) concludes his.. detailed survey…with the conclusion that executive compensation is affected by the interaction of a competitive market for talent, managerial power, and political factors. That conclusion is hard to disagree with.

Conclusion Information Session //24 At this point, no real debate over whether U.S. CEOs overpaid Only question is: by how much?

Information Session //25