Beyond Disclosure
Forbes, January 19, 2006

By Lucian Bebchuk

Tuesdays Securities and Exchange Commission vote in favor of expanded disclosure of executive pay arrangements is a necessary and very useful step. But we should harbor no illusion that it would be sufficient by itself to fix the problems of U.S. executive compensation.

Reforming the disclosure of executive compensation is necessary because companies have for too long taken advantage of "holes" in existing disclosure regulations to "camouflage" large amounts of performance-insensitive compensation. Firms should not be permitted to fail to provide investors with a complete, accurate and transparent picture of pay packages.

But while improved disclosure is necessary, it is also insufficient. In explaining the rationale for improving disclosure of pay arrangements, SEC Chairman Christopher Cox stressed that "the market for executive talent is no different" from other markets and, like other markets, will perform better with more information. The problem, however, is that the market for executive talent has been operating quite differently from other markets.

Executives' pay is not set by companies' owners, but rather by companies' boards. Insulated from shareholders by existing legal arrangements, boards have not been setting pay arrangements solely with shareholder interests in mind. Indeed, notwithstanding the limitations of current disclosure requirements, some significant flaws of existing pay arrangements have been evident for some time. Given investors' limited power, however, these flaws have persisted.

In a recent study on the growth of pay, Yaniv Grinstein and myself found that the aggregate compensation paid by public companies to their top-five executives added up to about $350 billion during the period 1993 to 2003, and made up 10% of the aggregate profits of these companies during the periods last three years. (These figures do not include the substantial amounts that executives get through executive pensions and other forms of stealth compensation not included in standard datasets.) Although this growth in pay has been presented as essential for providing managers with powerful incentives, pay is less sensitive to performance than is feasible and desirable. Investors have been hardly getting as much incentive bang for their buck as possible.

The evidence indicates that bonus payments and salary increases are little correlated with managers' own performance. The substantial compensation delivered to executives through stealth compensation via retirement benefits is again poorly linked to performance. And most of the payoffs executives get from equity-based pay result from marketwide and industrywide movements, as well as from short-term fluctuations in stock prices rather than from managers' own long-term performance. Arrangements guaranteeing executives a soft landing in the event of failure further contribute to weakening the pay-performance link.

Indeed, not only does most executive compensation fail to produce incentives to enhance shareholder value, but much compensation is paid in ways that provide perverse incentives. Executives continue to enjoy broad freedom to unload options, which enables executives to benefit from increases in short-term stock prices that come at the expense of long-term value. And the standard design of bonus plans rewards executives for increases in short-term financial measures that do not reflect long-term increases in value. Furthermore, as is empirically documented in a recent study on firm expansion and CEO pay by Yaniv Grinstein and myself, existing pay practices reward rather than discourage empire building.

In Tuesdays meeting, an SEC commissioner remarked that, once improved disclosure requirements are in place, the continuation of compensation practices would imply that investors are content with them. Such inference would be warranted, however, only when boards could be relied on to change practices opposed by shareholders. Under existing arrangements, the existence of practices merely implies that directors are content with them, not necessarily shareholders. After all, despite investors pressure on companies to improve their disclosures of pay, an SEC intervention is necessary to get companies to do so.

What is necessary, then, is not only better disclosure but also a fundamental reform in the allocation of power between boards and shareholders. Shareholders have been told that recent reforms, which strengthened director independence, will secure adequate board performance. But even though independence rules out some bad motives that directors might otherwise have, it does not provide the affirmative incentive to serve shareholders that are necessary to counter directors' natural tendency to side with executives.

To provide directors with such incentives, directors must be made not only independent of insiders but also dependent on shareholders. Shareholders' power to remove directors should be turned from a fiction into a reality. Shareholders should be permitted to place candidates on the corporate ballot. Directors should not serve if a majority of the shareholders withhold votes from them. Staggered boards and other impediments to director removal by shareholders should be dismantled. And shareholders should have the power to initiate and adopt changes in the governance arrangements set in corporate charters; their existing power to pass nonbinding resolutions, which boards commonly ignore, is insufficient. (A fuller account of these desirable reforms can be found in my articles on the myth of the shareholder franchise and the case for increasing shareholder power.)

The problems of executive compensation reflect the deeper problems of board unaccountability produced by exiting arrangements. Better disclosure is, therefore, not a substitute for addressing these problems. Shareholders should be given not only more information but also the power they need to use such information effectively.

Lucian Bebchuk, a professor of law, economics and finance and director of the program on corporate governance at Harvard law school, is co-author, with Jesse Fried, of Pay Without Performance: The Unfulfilled Promise of Executive Compensation.