Executive Compensation: A note on Business Ethics
Introduction
Theresa May recently pledged
to tackle ‘unfair executive pay’ in the UK due to concerns that CEOs earn a
salary that is disproportionate to their contribution, in an attempt to reduce the income-inequality gap. Management compensation is an exciting area of
research, especially in the USA where executives earn six times as much as
Japanese executives and twice as much as German executives (Brealey and Myers,
2014). British blue-chip CEOs typically earn around £5m which is 180 times the
average wage and has angered investors since pay seems to be out of line with
corporate performance (Jenkins,
2016b). In his seminal work, ‘The
Wealth of Nations’, Adam Smith
(1776, p. I.8.33) noted that the price of
labour cannot be ascertained with absolute accuracy, not only in accordance to
varying levels of ability among workers but also “according to the easiness or hardness of the masters” that manage
them. Today’s masters are
compensation committees that approve CEO pay whose ‘easiness’ triggered by the lack
of board independence, unsuitable disclosure requirements and perverse
incentives has contributed to unjustifiably excessive executive remuneration.
This is the normative standpoint from which our prospective analytical discourse
is likely grow from. Traditionally, base salary was the prime component of executive
pay. However, stock options, variable bonuses and other long term incentives
now form a much larger portion of CEO pay than base salary. This was because,
given that stock prices fall when investors sense empire building (Brealey
et al., 2014, p. 413), it was realised that the threat
of falling stock prices is an excellent motivator, particularly for top
managers holding valuable stock options.
Literature Review
Executive
compensation is a riveting aspect of corporate finance because of its
association with the 2007 financial crisis and also its role in transforming
the structure of corporate leadership. Incentives that direct CEOs to achieve
the maximum honest share price rather than achieving the maximum possible share
price (Brealey et al., 2014) are not only
in line shareholder interests but are also steps in the right direction to
terminate the prevalent compromise of high performance at the cost of business
ethics. Empirical and theoretical literature has ventured out to explain how
CEO pay is structured and continually reconfigured in light of executive pay
incentives in changing financial climates. News coverage on executive
remuneration has also been extensive, attracting considerable bad press
denouncing unwarranted increases in CEO pay. With agency theory (Ross, 1973) as
the presiding frame of reference, academia investigates structural flaws in
employment contracts to explain the extent to which such public dissent is
justified.
Two
Schools of Thought
More
recent developments have examined ‘Managerial
Power Perspectives’ (Bebchuk
and Fried, 2003), also referred to as ‘Managerial Power Rationales’ (MPRs) by
Murphy (2013) to mend these flaws. While agency theory, also known as ‘Optimal Contracting Theory’ (OCT) holds
that market forces arrive at a state of competitive equilibrium to determine
CEO pay, managerial power rationales assert the importance of managerial
influence on the board of directors in settling final packages. Academic
literature broadly falls within these two schools[1]
of thought as per Kevin Murphy (2013), a leading CEO compensation theorist who
reasons that since both views are not mutually exclusive, it would be ‘unproductive’ to analyse them as
‘competing’ theories. OCT and MPR could be viewed as complementary perspectives
because it is commonplace for CEOs to flex their managerial muscle to
facilitate rent-extraction (Goergen
and Renneboog, 2011) while market forces play
their role in shaping executive contracts. However, they are certainly not
perfect complements because the exclusion of non-traditional factors despite
the joint contribution of OCT and MPR would make any study fall short of
providing a well rounded discussion regarding executive compensation. Disclosure
requirements, accounting rules, tax policies, political conditions and
government interventions are considered to be some of the key non-traditional
factors that have been ignored in executive compensation recent literature.
Unlike Murphy (2013), this proposal narrows its focus to a study the impact of
CEO pay disclosure on IPO performance in light of relevant accounting rules and
selected legislations.
Chahine and Goergen (2011) view OCT in
light of MPR by treating them as coexisting rather than competing paradigms (as
suggested by Murphy (2013)). However, Goergen and Renneboog (2011) state that MPR
can be subordinated to the OCT on empirical grounds, given the lack of strong
academic support. This partly stems from the difficulty in data collection
regarding the exact channels of managerial influence but does not impinge on
the strength of MPS’s conceptual appeal. Engelberg et al. (2013) took an
innovative approach in supporting optimal contracting theory by studying how a
CEO’s worth could be understood by incorporating the price of his Rolodex which
is the sum of his past, professional, university and social connections,
including political ones. His estimate suggests that every extra connection on
a CEO’s Rolodex might be worth as much as $17k. Engelberg et al. (2013) assert that
information sharing through executive networks is valuable not only by virtue
of the informational advantage in itself but also through the opportunity of
demonstrating credibility that builds reputational capital. This reinforces the
conjecture that what the media portrays as ‘excessive’ compensation might just
be a ‘perceived excess’ (though this is not always the case). For instance,
Sundar Pichai’s $200 million compensation package for 2016 might be seen as
excessive by the general public but the compensation committee expressed that
they viewed Sundar’s retention as critical to Google’s success and that his
level of compensation is ‘representative of his value’ (Waters, 2016) and also of
the opportunities available to him in other firms.
Bone
of Contention: High Pay for Poor Performance
High
compensation packages for highly valued executives can easily be understood,
given the global talent shortage for top executives in finance. However,
explaining why huge bonuses are granted to executives despite undisputedly poor
performance remains a challenge. Golden parachute payments are designed to
serve as incentive tools that seek to retain highly valuable human capital.
Even so, paying Joseph Cassano $315 million to resign (Berkowitz and Toay, 2012, p. 52) only to
re-hire him as a consultant at $1 million a month (Mollenkamp et al., 2008) just seems
ludicrous. The Economist (2010) refers to him
as the man behind the biggest risk management failure in the 2007 financial
crash. Arguably, Cassano’s actions directly contributed to the sub-prime
mortgage crisis and led to tax payers being forced to pay the price for his
mistakes. Despite the absurdity at play, there are many other factors to be
taken into consideration such as conflicts of interest between compensation
committee members and CEOs due to previous working relationships or current
friendships. Such conflicts of interests might sway committee members to not
objecting to high bonuses to avoid awkwardness at board meetings which Warren
Buffet likens to ‘belching’ at the dinner table (Lublin and Thurm, 2006). Buffet also
explained his decision to abstain from voting in favour of an excessively high
pay package for a Coca Cola executive saying that he wanted to convey his
disapproval without seeming too aggressive and also since he had never seen a
board member vote ‘no’. Such ‘resting inertia’ takes the form of reluctance of
financial leaders (institutional investors in particular) to stand out from the
crowd by conforming to the prevalent herd mentality (Marriage, 2016). This gives
enough reason to seriously consider Jenkins’ (2016) view that it is high time
for a pay revolution to take its course and also reaffirms the need for
increased board independence as a way of mitigating poor pay performance
sensitivity. Lack of independence induces board members to avoid below-average
compensation. Therefore, if every firm wants to be above average, the average
will ratchet up (Brealey et al., 2014, p. 303). While Goergen
and Renneboog (2011) speak in favour of increased board independence, they warn
that despite its benefits, residual
control mechanisms might still allow for considerable rent extraction.
General
Framework
Regulatory Responses to 2008
and Current Conditions
Seven years after Sarbanes
Oxley (SOX, hereafter), which was largely a response to financial reporting
scandals, Johnston
and Madura (2009, p. 308) found that firms have left
less money on the table during IPOs since SOX. Moreover, despite lower initial
returns of IPOs post SOX, the aftermarket performance of IPOs was found to be
considerably higher after SOX was passed than before its enactment. Since the
imposition of limits on executive compensation in 2009 (Bayazitova
and Shivdasani, 2012, p. 379) under the Troubled Asset
Relief Programme (TARP) and the Dodd-Frank Act (DFA) in 2010, firms have been
subject to new disclosure requirements entailing detailed descriptions about
compensation and consultants’ fees and activities (Zattoni
and Judge, 2012, p. 526). In the second week of May
2016, Patrick Jenkins, the financial editor of the Financial Times published
three articles indicating that a pay-revamp (Jenkins,
2016b) might be round the corner
with city leaders speaking up (Jenkins,
2016a) to curb CEO pay absurdities
ranging from the £14m awarded to BP boss Bob Dudley in a loss making year to the
egregious £70m awarded to MPP’s Sir Martin Sorrell (Jenkins, 2016c). Considering the current state of
affairs, this
research is timely in its pursuit to explore the impact of executive
compensation disclosure on IPO performance by drawing from the literature on
executive compensation, empirical and theoretical research on IPO
underpricing and disclosure regulation
in the context of CEO pay. Interweaving these three aspects brings us into a
fairly unexplored realm of finance that has tremendous practical scope in the
area of reforming ‘unfair’ executive pay that undermines public trust in
business leaders.
Prospective Research Focus:
Executive Compensation and IPO stock options
Since our research interest
lies in exploring executive compensation linked to IPO stock options, it is
essential to understand that as a subset of stock options, an IPO option is a
type of security whose exercise price is directly linked to the IPO offer price
(Lowry and
Murphy, 2007, p. 42)) and is issued on or shortly
after the IPO is issued, such that the offer price is typically equal to the
exercise price. This indicates how IPO performance is linked to the extent of pay
disclosure chosen by the issuer within the relevant securities regulations (Leone et
al., 2007, p. 112) that authorise disclosure of
intended use of proceeds. A voluntary disclosure can be distinguished from a
mandatory disclosure or a commitment (as in Leuz and
Verrecchia (2000, p. 94)) in that the former involves
a choice made after a firm observes the content of relevant information and the
latter requires information disclosure before it knows the content. CEO pay
disclosures can be extracted from an IPO prospectus (Lowry and
Murphy, 2007) which can also provide
information on the number of shares owned by each executive and other important
details to establish how much each executive personally has at stake. Leone et
al. (2007, p. 148) finds a negative association
between specificity of use-of-proceeds and underpricing which means that the
more specific a firm is in it’s disclosure, the less an underwriter needs to
underprice the security (Schrand
and Verrecchia, 2005, p. 2, Hanley and Hoberg, 2010, p. 2821, Johnston and
Madura, 2009, p. 292) in reliance of market forces
of demand to drive up share prices. This is intuitive since more disclosure
implies less information asymmetry.
Use
of Proceeds Disclosure and other CEO Pay Control Variables
Intended use of proceeds
disclosure tends to increase the accuracy of security valuation, offering
helpful information to uninformed investors, hence enabling them to evaluate
the dispersion of secondary market values more carefully (Leone et
al., 2007, p. 128). Since increased specificity
ameliorates adverse selection (Schrand
and Verrecchia, 2005) and reduces subsequent
underpricing, it is surprising that while the average prospectus is comprised
of 34000 words, an average of just 73 words are used to write the ‘use of
proceeds’ section (Hanley
and Hoberg, 2010, p. 2834) which suggests that even
small sections of a prospectus[2]
can carry immense value for investors, despite their brevity.
Among the under-researched
non-traditional factors (that influence CEO pay) noted by Murphy (2013), our
discourse so far has been restricted to one of those factors namely (pay)
disclosure requirements. Therefore, as soon as our prospective dataset is modified
as needed, we can begin running regressions on investor valuation by
controlling for disclosure of ‘use of proceeds’ and other variables such as
compensation components. Thereafter, we can control for tax policies, political
conditions, government interventions and relevant legislations as part of our
future regression analysis (see Murphy (2013)). Another aspect worthy of
mention is the value of reputational capital that has increased, both for
underwriters and companies wishing to go public especially after the 2007
financial crisis and the string of accounting scandals that preceded it. This
is why investment bankers need to be confident of the veracity of information
disclosed by private firms (their clients wanting to go public) in their
prospectus because if post-IPO performance turns awry (as it did during the dot
com bubble), underwriters can be sued for misleading investors[3].
The importance of reputational capital as stated above coupled with Leone et
al.’s (2007, p. 148) finding that the negative association between specificity
of use-of-proceeds and underpricing is especially strong for IPOs with the most
prominent underwriters gives reason to incorporate a proxy for underwriter
prestige as a control variable.
Closing Comments
Disclosure
is a tool capable of reducing agency costs arising from design flaws that limit
the intended benefits of CEO compensation structures. Since IPO stock options
are linked to executive pay and we know that the tone of a prospectus (and
other pre-IPO documents) is strongly related to the pricing accuracy of an IPO,
this preliminary research builds on prior compensation literature, seeking to
go deeper by specifically examining the dynamics of compensation disclosure in
the context of US IPOs. The general direction of this research seems to point
to the prospect of higher returns associated with increased disclosure (as in Beatty and Welch (1996)) but we can
expect reasonable variation in disclosure-specific outcomes considering the
change in regulatory climate over the last two decades and other contributing
factors.
By
using the latest datasets available, it would be useful to examine data
suggestive of increased IPO performance as a result of increased CEO pay
disclosure in pre-IPO documents. Depending on data availability, we can dig
deeper to focus on voluntary[4]
disclosure of executive pay which can guide us in determining whether voluntary
disclosures make any value additions over and above typical disclosures (or by
usage of signalling devices by IPO managers) as in the case of Jog and
McConomy’s (2003, p.126) results that clearly show the favourable impact of
voluntary disclosures of pay estimates (Canadian IPOs) on the extent of
underpricing and post issue IPO performance. Beatty and Welch (1996) who found that
the prospect of higher returns is associated with increased disclosure.
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I.
[2] The
prospectus summary takes up 600 words, on average and is used as an
underwriters’ marketing tool to attract investors, which explains its high
exposure to marketing words Hanley and Hoberg, 2010, p.2856.
[3] As in
the case of Va Linux whose share price dropped from $300 a share to $2 in four
years (Brealey et al., 2014) over a 4-year period with investors alleging that
the prospectus provided was ‘materially false’.
[4] We refer to compensation disclosure as ‘voluntary’
here in accordance to Schrand and Verrachia (2005, p.12) where NYSE and NASDAQ
guidelines were still ambiguous about pay disclosures since they merely
encouraged remuneration disclosure but did not make it mandatory as such. This
could guide our prospective data analysis in that we may be able to study data
pre-2005 when disclosure requirements were less stringent and post 2005 data
which is when provisions of the SOX started coming into full effect followed by
the next decade being the defining regulatory phase of the 21st
century.
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