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Encouraging Better Behavior on Executive Pay

Brett McDonnell, a law professor at the University of Minnesota, filed this guest post. See prepared testimony here.

Yesterday, Treasury Secretary Timothy F. Geithner and Securities and Exchange Commission Chairman Mary L. Schapiro gave speeches on executive compensation, and today the House Financial Services Committee is holding a hearing on the matter. There are two overarching questions about our system for compensating the executives of large public corporations. First, is it broken? Second, if the answer is yes, is there anything the government can do to help fix it?

Given recent news coverage, one might think the answer to the first question is obvious: Of course the system is badly broken. The absolute level of pay has soared, and too many executives are incredibly well paid even when their companies perform below average or worse. The system rewards taking high risks that increase company stock prices in the short run while doing nothing to increase long-run value.

But defenders of the current system (one of the most prominent, Kevin Murphy, will testify at the hearing today) say that the run-up in compensation largely reflects the run-up in stock prices in recent decades and that executives received a share of that precisely to motivate them to look out for the best interests of shareholders. When stock prices fell in the past year, compensation fell with it.

There’s an ongoing academic debate over the first question. It is not easy to resolve. For every practice that critics point to as illustrating manipulation of the system, defenders can come up with reasons why that practice might make sense.

I think the best answer is the obvious one: The current system has big problems. It is dominated by CEOs who have a big stake in favoring themselves and their fellow CEOs, and critics like Lucian Bebchuk (a witness at today's committee hearing) and Jesse Fried continue to come up with too many widespread practices that have a serious stink to them, no matter how hard apologists try to mask that stench with perfume.

Which brings us to the second big question: Is there anything the government can do to help fix the system? Past efforts are an object lesson in the law of unintended consequences. Revising the tax system to encourage incentive-based compensation played a big part in ushering in the heavy use of stock options that got us here. Extensive disclosure requirements, meant to shame abusers of the system, instead have helped executives figure out nifty ways people at other companies have found to reward themselves, and copy them. State fiduciary duties have encouraged corporate boards to bring in outside consultants, who are key spreaders of abusive practices.

So what else might we try? The SEC seems interested in yet more disclosure. That’s an underwhelming response. I know plenty of corporate lawyers, and they are very good at writing disclosure that is both accurate and useless. The agency's focus in today’s release on how a company manages risk and on the incentive structures created by compensation does get to some critical issues, though.

Other proposals look to various bodies -- shareholders, directors, regulators, courts -- to help shape better compensation practices. “Say on pay,” which Geithner mentioned, would give shareholders a direct but (presumably) non-binding annual vote on compensation packages. But do shareholders know enough to distinguish good from bad? One of the best-known longtime shareholder activists, Nell Minow, will testify at the committee hearing.

Other ideas strive to put more independent directors in charge. So far, the results have not been incredibly encouraging, but you never know -- maybe we will find a way to select directors who are both independent and critically minded yet also knowledgeable and informed enough to make wise decisions. One reform, mentioned in Schapiro’s statement, which might help find more such directors, is to give shareholders more power in selecting board nominees.

One of the most promising recent ideas involves scrutiny by agency regulators. In particular, the administration has suggested that regulators evaluating the safety and soundness of banks might look to the incentives that compensation packages create. This suggestion goes to the heart of the problematic incentives of the current system.

Courts could apply stricter scrutiny to how boards approve executive compensation. My colleague Claire Hill and I are currently writing on this. We don’t think courts will or should go much further in holding directors liable. However, courts, particularly the Delaware courts, do have some ability to help create and spread norms of good behavior. Perhaps via court pronouncements, shareholder activism, truth-telling by some independent directors and general public scrutiny, we may create an environment where executives are finally shamed by some of the more egregious excesses that have taken root in recent years.

I have focused here on how compensation reflects and affects the quality of corporate governance. But I suspect that most ordinary people who care are bothered at least as much by the sheer unfairness and inequality of the system. We are meant to be a republic, not an oligarchy. Some of the suggestions above might incidentally address this concern. But if that is your real concern, it suggests different solutions. Like: Tax the rich, and take away some of those ill-gotten gains.

-- Brett McDonnell, law professor and associate dean for academic affairs at the University of Minnesota Law School

NOTE: The spelling of Nell Minow's name has been corrected.

By Tim Lawson  |  June 11, 2009; 5:58 AM ET
Categories:  Regulation  
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"But defenders of the current system ... say that the run-up in compensation largely reflects the run-up in stock prices in recent decades and that executives received a share of that precisely to motivate them to look out for the best interests of shareholders"

Corporations have liability exemptions granted by government that other businesses do not have. At the same time, boards and shareholders have proved ineffective at governing megacorporations. If corporate executives are going to have autocratic power within the corporation AND take a share of the corporate value, then they should have the personal liability that a small business proprietor has.

It's not only unfair, it contributes to the obscene concentration of wealth that causes bubbles.

Posted by: charliecoop | June 11, 2009 7:43 AM | Report abuse

This may be nitpicking, but there's just one 'n' in 'Minow.'

Posted by: cbeltran | June 11, 2009 7:49 AM | Report abuse

What else might we try? How about denying our tax dollars -- or tax breaks -- to any firm that pays its executives unconscionably more than its average employees receive?

We already deny government contracts to firms that discriminate, in their employment practices, by race or gender. We've decided, as a society, that our tax dollars should not subsidize racial or gender inequality. Why should we let our tax dollars subsidize economic inequality?

Rep. Janice Schakowsky (D-IL) this past April introduced legislation -- the Patriot Corporations of America Act -- that would give preference in the federal contract bidding process to firms that pay their top execs no more than 100 times what their lowest-paid workers receive.

Let's start there.

Posted by: TooMuchEditor | June 11, 2009 10:33 AM | Report abuse

Shareholders already have great insight into pay based on proxy statements. Granted, these read like propaganda and are created by a parasitic executive compensation industry. But transparency isn't the problem - the problem is Board members who either suffer from loyalty or care concerns. For sectors without negative externalities to failure (in other words, non-financial sectors), increased shareholder activism in choosing competent Board members should solve this problem. With the financial industry, further regulation is needed. We should be very careful about this though. The Clinton-era amendment to IRC 162(m) helped create the principal/agent problem of option pay to begin with.

Posted by: Dellis2 | June 11, 2009 12:57 PM | Report abuse

In my corporations course in law school, we spent weeks learning about how the "business judgment rule" and duties of care and loyalty pretty much insulate corporate actors from liability except in the most extreme cases.

On the one hand, I agree that in most cases corporate executives shouldn't be subject to liability for, say, exercising business judgment on a deal that ends up going sour. Not every business deal is going to bring in mega-profits, and sometimes recessions or market conditions or trends get in the way of what might otherwise be a good deal.

But it's quite another thing when EVERY single executive decision from pay packages to John Thain's $13,000 commode and corporate jets can be justified in the name of the "business judgment rule." We don't want corporate actors to be constrained from acting and yet the logical extension of the rule is that it justifies lots of very bad behavior.

Lastly, although I appreciate the "pros" that come with incorporating in a state like Delaware, e.g. a state whose courts have expertise in handling corporate disputes, the predictability of outcomes, etc., I think it's high-time we start recognizing Delaware corporate law for what it's become: a big race to the bottom.

Posted by: pbasso_khan | June 11, 2009 1:00 PM | Report abuse

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