Wednesday, October 25, 2006

More on Executive Compensation

Mark Thoma and Brad DeLong have picked up the theme of this earlier post on executive compensation. Brad makes three points:

First, at-the-money options do not make CEOs "long" their company as much as long the volatility of their company. It's clear that direct ownership of stock--ideally, restricted stock--is a better mechanism for aligning managers' interests with shareholders.
I agree with Brad's conclusion--restricted stock is a better method of aligning the interests of managers and shareholders.
Second, when I looked at the data I thought I saw an important difference between entrepreneurial-CEO-owners (like Bill Gates, with stock) and manager-CEO-nonowners (with options). I think there is an important difference.
True as well--there is an important difference. My point in the original post is that there are very few examples one can find in which, through options, manager-CEO-nonowners accumulated ownership stakes that were large enough so that their compensation was meaningfully different from what Jensen and Murphy were describing in the data. My issue with Krugman's column was that he was implicating J&M in the option mess--I don't think that's warranted.


Third, we do have a big organizational problem here. We need diversity of ownership--both to raise capital on the scale required for modern business organizations and to spread risk. But once you have diversified ownership, monitoring and supervising managers becomes a public good from the shareholders' perspective, and it is very hard to get market or market-like or indeed voting political mechanisms to adequately supply public goods: the difficulties of collective action by dispersed owners of corporations has been one of the institutional flaws of modern capitalism for more than a century.

The fear today is that mechanisms of corporate control and governance that used to constrain the ability of top managers to raid the corporation have broken down even more than in the past. Why and how much and indeed whether this is true is a very hard question. To say that "corporate boards are failing" to do their job is true, but leaves the questions of why they are failing and whether they are failing any more than in the past unanswered.
True again. The problems resulting from the separation of ownership and control in large corporations are the central problem in corporate finance. I did not intend to raise the two questions posed at the end of Brad's post but only to assert that corporate boards are the last line of defense against problems of corporate governance. If the recent use of options is perceived as abusive, hold the Boards that were complicit or clueless to account.

3 comments:

Craig Horizon said...

Yes, holding boards accountable for options is a good thing. If they are complicit or clueless they should be taken to task on that.

Nikki said...

So I write to y'all about my perspective as high school senior and the proposed college early decision changes, move on to homeowrk a few weeks later and there, in an article about gas taxes, Pigou...in NY Times by Daniel Gross, the pieces come together as you both are mentioned as Bush economic advisors. So now that it's a legit conspiracy, I can probably dedicate some more time to reading and addressing your blogs (oh, yea, good quiz, I'm a Centrist, with a decided Left/Libertarian leaning).
I've been following the CEO compensation posts and thought it was funny that so many economists answered with so much emotion about fair and unfair. Then finally someone added, base compensation on company performance relative to a specific industry, and I thought that made sense but here is what I think:
(1) Give stock options that depend on overall market performance (present system). Then address the issue of a rotten CEO getting lucky as his (or her...) company's stock price rises with the tide by making this only one component of a stock option plan (so if you're getting 100 options, now 30 would be based on overall stock performance - the specific numbers can be decided later, it's the concept of several components to a plan that matters). I include overall stock performance because a company is essentially competing with all other possible investments (stock, bond, real estate...) so why insulate it now?
(2) Another part is option group based on performance relative to peers in same industry group (basically what the blog poster wrote). I don't like this as a sole determinant because it can encourage gaming. A CEO may responsibly hedge a portion of energy costs and reduce performance every year by 1%, but now be at a disadvantage to companies who do not follow suit, but expose themselves to a 20% underperformance in a given year. The hedging CEO may be smart to give up 1% a year to save perhaps a 20% underperformance every 10 years, but he will be penalized all those non-event years for his vision. I guess the CEO has to make his strategy known and the market will reward the planning by delivering a higher stock price. The determining factor has to be stock price and not income because a CEO might cut back R&D and the market has to vote on whether wise or not. Similarly the market can punish a CEO who watches oil go from $50 to $75 dollars a barrel, do nothing, then hedge the next 20 years at $72, only to watch oil come back below $60 as his perhaps airline, has to sell headsets and drinks at $20 a shot for the next 20 years.

(3) Part 3 of the compensation comes not from net profit and one time accounting gains, but from cash flow from actual businesses.

Extra Credit: In terms of simply resetting options: intuitively, "no." If you want to reset a CEO's options from $40 to $20 because the stock is worth half as much, then give all the stockholders $20 to reset them as well. Since that won't happen, what you can do is reset the options to a market price and then extend the time that the CEO has to wait to exercise. Don't bring them all the way to the market (in this example $20), but perhaps to $30 and then they vest in 5 rather than 3 years. Now the interests of the CEO are more closely linked to shareholders. CEO decisions will be based on longer term horizons.

Another possibility is to give shares rather than options (as mentioned in blog) but reduce number of shares. That way CEO not encouraged to gamble because his wealth, even if reduced if stock lower, is still tied to shareholders. There is no all or nothing as the CEO will still have value in $20 shares (even if they were granted at $40 market price).

You mentioned a Princeton economist and I read his paper and I disagree with one of his assertions but think that it presents a source for coming up with a solution. His third argument about CEO pay was that CEO s had to be paid so much because of the risk that they were subject to in terms of job security. I don't think this is such a strong argument because where else are the CEOs going? They can't decide to play football, become surgeons....basically walk away. They can move between firms but I have to think companies would realize that (other than founders with vision...) there are likely several managers who can run their companies well. Cut pay from 20 to 10 million and the CEO won't be happy, but where is he going to go?

Basically give the CEO many opportunities to make money, but cut out as many shortcuts as possible by including several indices that measure the market and business performance of the company and make concessions that give 2nd and 3rd chances but that demand a longer commitment from the CEO. You'll get more commitment, a willingness to invest in the future (Xerox:"we don't need no stinking PCs, that's why they call it 'xerox'"), and less rolling the die (Long Term Capital Management: "these spreads never go wider than this"). Okay see y'all in Stockholm.

nikki said...

So I write to y'all about my perspective as high school senior and the proposed college early decision changes, move on to homeowrk a few weeks later and there, in an article about gas taxes, Pigou...in NY Times by Daniel Gross, the pieces come together as you both are mentioned as Bush economic advisors. So now that it's a legit conspiracy, I can probably dedicate some more time to reading and addressing your blogs (oh, yea, good quiz, I'm a Centrist, with a decided Left/Libertarian leaning).
I've been following the CEO compensation posts and thought it was funny that so many economists answered with so much emotion about fair and unfair. Then finally someone added, base compensation on company performance relative to a specific industry, and I thought that made sense but here is what I think:
(1) Give stock options that depend on overall market performance (present system). Then address the issue of a rotten CEO getting lucky as his (or her...) company's stock price rises with the tide by making this only one component of a stock option plan (so if you're getting 100 options, now 30 would be based on overall stock performance - the specific numbers can be decided later, it's the concept of several components to a plan that matters). I include overall stock performance because a company is essentially competing with all other possible investments (stock, bond, real estate...) so why insulate it now?
(2) Another part is option group based on performance relative to peers in same industry group (basically what the blog poster wrote). I don't like this as a sole determinant because it can encourage gaming. A CEO may responsibly hedge a portion of energy costs and reduce performance every year by 1%, but now be at a disadvantage to companies who do not follow suit, but expose themselves to a 20% underperformance in a given year. The hedging CEO may be smart to give up 1% a year to save perhaps a 20% underperformance every 10 years, but he will be penalized all those non-event years for his vision. I guess the CEO has to make his strategy known and the market will reward the planning by delivering a higher stock price. The determining factor has to be stock price and not income because a CEO might cut back R&D and the market has to vote on whether wise or not. Similarly the market can punish a CEO who watches oil go from $50 to $75 dollars a barrel, do nothing, then hedge the next 20 years at $72, only to watch oil come back below $60 as his perhaps airline, has to sell headsets and drinks at $20 a shot for the next 20 years.

(3) Part 3 of the compensation comes not from net profit and one time accounting gains, but from cash flow from actual businesses.

Extra Credit: In terms of simply resetting options: intuitively, "no." If you want to reset a CEO's options from $40 to $20 because the stock is worth half as much, then give all the stockholders $20 to reset them as well. Since that won't happen, what you can do is reset the options to a market price and then extend the time that the CEO has to wait to exercise. Don't bring them all the way to the market (in this example $20), but perhaps to $30 and then they vest in 5 rather than 3 years. Now the interests of the CEO are more closely linked to shareholders. CEO decisions will be based on longer term horizons.

Another possibility is to give shares rather than options (as mentioned in blog) but reduce number of shares. That way CEO not encouraged to gamble because his wealth, even if reduced if stock lower, is still tied to shareholders. There is no all or nothing as the CEO will still have value in $20 shares (even if they were granted at $40 market price).

You mentioned a Princeton economist and I read his paper and I disagree with one of his assertions but think that it presents a source for coming up with a solution. His third argument about CEO pay was that CEO s had to be paid so much because of the risk that they were subject to in terms of job security. I don't think this is such a strong argument because where else are the CEOs going? They can't decide to play football, become surgeons....basically walk away. They can move between firms but I have to think companies would realize that (other than founders with vision...) there are likely several managers who can run their companies well. Cut pay from 20 to 10 million and the CEO won't be happy, but where is he going to go?

Basically give the CEO many opportunities to make money, but cut out as many shortcuts as possible by including several indices that measure the market and business performance of the company and make concessions that give 2nd and 3rd chances but that demand a longer commitment from the CEO. You'll get more commitment, a willingness to invest in the future (Xerox:"we don't need no stinking PCs, that's why they call it 'xerox'"), and less rolling the die (Long Term Capital Management: "these spreads never go wider than this"). Okay see y'all in Stockholm.