Executive Compensation: If There's A Problem, What's the Remedy? the Case for "Compensation Discussion and Analysis"
Gordon, Jeffrey N., Journal of Corporation Law
High levels of executive compensation have triggered an intense debate over whether compensation results primarily from competitive pressures in the market for managerial services or from managerial overreaching. Professors Lucian Bebchuk and Jesse Fried have advanced the debate with their recent book, Pay Without Performance: The Unfulfilled Promise of Executive Compensation, which forcefully argues that current compensation levels are best explained by managerial rent-seeking, not by arm's-length bargaining designed to create the optimum pay and performance nexus. This paper expresses three sorts of reservations with their analysis and advances its own proposals. First, enhancing shareholder welfare is not, as a positive or normative matter, a sufficient framework for understanding the controversy or devising a remedy. Second, many of the compensation practices identified by Bebchuk and Fried as veritable "smoking guns" of managerial power may have benign explanations. Third, in improving the corporate governance apparatus in the executive compensation area, the better remedy is not a wholesale expansion of shareholder power, but a tailored series of measures designed to bolster the independence of the compensation committee. Most important, the SEC should require proxy disclosure of a "Compensation Discussion and Analysis" statement (CD&A) signed by the members of the compensation committee (or by the responsible independent directors for firms without a compensation committee). Such a CD&A ought to collect, itemize, and summarize all compensation elements for each senior executive, providing bottom line analysis and then a justification by the compensation committee of the compensation paid. This process of "ownership," reputation-staking, and publicity will strengthen the committee's hand against managerial pressure and will elicit both shareholder and public responses that necessarily contribute to the compensation bargain. In addition, serious thought should be given to a shareholder approval vote on the CD&A, following the new United Kingdom practice.
There is a clear thesis in Pay Without Performance: The Unfulfilled Promise of Executive Compensation by Lucian Bebchuk and Jesse Fried. It is that the high levels of executive compensation are explained by managerial rent-seeking, not by arm's-length bargaining designed to create the optimum pay and performance nexus. The authors support this conclusion with three sorts of evidentiary claims.
First, various compensation terms, in particular non-indexed stock options, seem poorly designed for the purpose of connecting pay and performance.
Second, "camouflage"-hiding the ball from shareholders through opaque or incomplete disclosure-characterizes certain important forms of compensation that are large in amount but not linked to performance, most particularly, pension benefits and deferred compensation.
Third, various governance arrangements make it unlikely that the board will act as a good faith bargaining agent for the shareholders in an arm's-length process. There are four salient elements in the faulty governance story: (1) the CEO's influence in the selection and retention of directors, which undercuts director independence in the bargaining process; (2) in contrast, the lack of shareholder influence in the director selection process, which could otherwise buttress director independence; (3) interlocking membership among boards of directors that lead to back-scratching among business elite who share a mutual self-interest in escalating levels of executive compensation; and (4) the use of compensation consultants with disabling conflicts of interest, in particular, provision to the firm of a wide range of compensation consulting services.
In reflecting upon the Bebchuk and Fried analysis, sometimes critically, I want to be clear about the importance of the book's contribution in comprehensively setting forth the different elements of compensation packages and in raising many serious questions about compensation practices and the corporate governance institutions that have countenanced them. …