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Reforming executive compensation is good for everyone—A Commentary by Sanjai Bhagat and Roberta Romano ’80

The following commentary was published in the Denver Post on February 8, 2009.

Reforming executive compensation is good for everyone
By Sanjai Bhagat and Roberta Romano ’80

Executive compensation has been widely criticized lately for being excessively bloated and for providing perverse incentives for reckless conduct.

The recently enacted financial services industry rescue bill has several provisions directed at limiting executive compensation in companies that sell troubled assets to the Treasury.

Given the public mood, additional measures to restrict executive compensation can be expected. We take this opportunity to review briefly the debate on executive compensation and suggest an approach to executive compensation that will better align incentives with investor interest.

We think the approach that we are suggesting should be put on the table now, especially because the rescue bill compensation provisions instruct the Treasury Secretary to require firms to meet "appropriate" standards, which are largely undefined in the statute .

There is a well-developed and widely-accepted economics literature on the fashioning of incentives to achieve consonance between manager's actions and shareholders' interest through the use of stock and stock option compensation.

Until the spate of accounting scandals that began with Enron, compensation in the form of stock and stock options was often emphasized as a key to improved corporate performance, and such compensation has been the most substantial component of executive pay for well over a decade.

Even Congress implicitly accepted the incentive function of executive compensation when in 1993 it eliminated the corporate income tax deduction for executive salaries in excess of $1 million, since the limitation was applicable only to non-incentive-based compensation.

However, the tide of popular opinion turned against equity and option-based compensation after Enron and other corporate accounting scandals came to light, fueled by repeated assertions in the media from journalists, political officeholders, commentators, and public and union pension funds that executive compensation is unreasonably high.

The heated rhetoric has only intensified with the political backlash to the current financial crisis.

This turn of events is not an altogether surprising development, as executive compensation has a long history of being targeted by populist attacks following market declines and scandals.

The accounting scandals revived executive compensation as an issue because some scandal-ridden firms' executives reported gains in the range of tens and hundreds of millions of dollars from exercising stock options before their firms imploded.

Similarly, executives and employees of the financial institutions being rescued by the federal government received billions of dollars in equity incentive compensation in the years running up to the current crisis.

We think that incentive compensation in the form of stock and stock options is, in general, a highly effective way to align manager and shareholder interests.

However, in light of justifiable public concern over potentially perverse incentives from this form of compensation, we suggest that instead of stock and stock options, incentive compensation plans should include restricted stock and restricted stock option; restricted in the sense that the shares cannot be sold (or the option cannot be exercised) for a period at least two to four years after the executive's resignation or last day in office.

Executives who have a significant part of their incentive compensation in the form of such restricted stock and restricted options have diminished incentives to make public statements, manage earnings, or accept undue levels of risk, for the sake of short-term price appreciation.

The idea of restricted stock is not original to us, but it is an approach that has been lost in the current populist rush to reduce, rather than restructure, incentive compensation.

The proposal to require executives to hold the shares until several years after they leave the firm will diminish the perverse incentives yet retain the benefits of equity-based incentive compensation plans.

Managers with longer horizons will, we think, be less likely to engage in imprudent business or financial strategies or short term earnings manipulations when the ability to exit before problems come to light is lessened.

We note two caveats to the proposal. First, if executives are required to hold the shares and options, then they would most likely be under-diversified. An under-diversification problem can be addressed by granting additional (restricted) shares and options to the executive.

Second, to the extent an executive incurs tax liability from receiving such restricted shares and options, they should be allowed to sell enough shares (and/or exercise enough options) to pay these additional taxes.

The rescue bill's limits on compensation may appease taxpayer anger but it is no solution to executive compensation providing poor incentives.

Empirical research indicates that companies find a way to circumvent congressional limitations on compensation, and the end result is usually higher and more opaque compensation, as adjustments are made to pre-regulation optimal compensation contracts; those adjustments can and have created perverse incentives for executives.

Our proposal will provide better incentives for executives to manage corporations in investors' interest, avoiding the perverse incentives of both an artificial cap on compensation and of unrestricted stock and option compensation plans.

Sanjai Bhagat is a professor of finance at the University of Colorado at Boulder, director of the Leeds School of Business doctoral program and founding director of Burridge Center for Valuation Leeds School of Business. Roberta Romano is a "Oscar M. Ruebhausen" law professor at Yale Law School.