Detailed disclosure of compensation awards to executive directors is the best way of dealing with the disconnection between executive

pay and performance. Critically assess the validity of this statement.

Introduction The disconnection between executive pay and performance is a widespread phenomenon. After the stock market bubble had burst in 2001, the total returns of S&P 500 companies fell by almost 12%, but the value of stock options granted to their CEOs rose by 43.6% (Economist 2003). An Incomes Data Services report (BBC 2011) shows that CEOs could be paid very well regardless of performance: Name Mick Davis Bart Becht Michael Spencer Sir Terry Leahy Tom Albanese Company Xstrata Reckitt Benckiser ICAP Tesco Rio Tinto Total earnings 18,426,105 17,879,000 13,419,619 12,038,303 11,623,162 Share price change +14.4% -8.9% +39.5% -10.5% +10.2% Profit growth 331.9% 10.4% -5.7% 11.3% 161.8%

High paid chief executives 2010/11 (BBC 2011) As it is the duty of every compensation committee to determine executive pay, this observation points to a boardbased failure for them to act in accordance to shareholders interest, which is to maximize the companys value. Instead of addressing the problem as an internal governance issue, legislators around the world have been trying to address it by enhancing shareholder oversight through detailed disclosure of executive compensation. The effectiveness of this strategy becomes the main subject of this essay. Problems of executive compensation As it is impossible to adequately specify the duty of an executive in contract, a well-design incentive scheme is crucial because it would help align the interests of the executive with the shareholders, reducing the agency costs between them. In the Anglo-American system of market capitalism, a managers primary objective is to maximize shareholder value. Therefore, stock-based incentives such as stock options or restricted stock are the ultimate form of executive compensation. However, in practice, executives are usually awarded other forms of compensation that appear to have little correlation to performance:

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Carly Fiorina, HPs CEO, received a golden parachute worth more than US$21 million after begin forced to resign for poor performance (Wilson 2005). Jack Welch, GEs CEO, collected a US$417 million severance payment upon retirement (Hodgson & Ruel 2012). Hamish Maxwell, Philip Morriss CEO, received options on 500,000 shares upon retirement (Monks & Minow 2011). Bernard Ebbers, WorldComs CEO, received loans worth over US$400 million at a discounted interest rate (Crawford 2005). Charles Conaway, Chief Executive of Kmart, had his US$5 million loan forgiven upon his departure two months after the company has filed for Chapter-11 bankruptcy. (Economist 2003) Mark Hurd, Chief Executive of HP, had in his contract that all his first-year goals were deemed to have been met. (Monks & Minow 2011).

Although it may be impossible to avoid signing a large severance package into contract when the company is demanding for a good CEO, the other arrangements almost have no purposes besides rent extraction. They existed because companies compensation committees, instead of keeping an arms length to the executive directors, are usually under great influence by them. Through relationship with other directors, these executive directors would have power over the pay of the compensation committee (Bebchuk, Fried & Walker 2002) and even their appointment (Sun & Tobin 2012). When the executives want to maximize their pay, it is not entirely clear what the compensation committees incentives are, because they are using someone else s money (Lo 2003b). In addition, back-scratching practices are pervasive between board members, creating an atmosphere which compensation proposals are hardly challenged (Economist 2003). With this level of influence over the people who decide their pay, it should not be surprising that the executive directors would have their compensation containing these many awards that are unrelated to their performances. The need to disclose Underlying the pay-performance disconnection is a severe agency problem. Compensation committees have not been independent and there is a lack of incentives for them to fulfilling their fiduciary duty to the shareholder. There is a huge information asymmetry between the shareholders and the executive directors regarding executive pay. If the shareholders can be aware of the detailed of the pays, their consequences, and have control over their approval, the shareholders would not have to depend on the compensation committee to make compensation more performance oriented. In the language of agency theory, disclosure reduces the information asymmetry and helps lowering the cost of monitoring agents (executives) self-interested behaviours. However, voluntary disclosure did not seem to come naturally as a consequence of market forces (Lo 2003b) and compensation packages had remained mostly out of shareholders sight. As rules mandating particular disclosures are common in principal-agent contexts, it is therefore reasonable to consider the reduction of agency costs as an efficient justification for mandatory disclosure (Mahoney 1995).

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A history of mandatory disclosure in US USs mandatory disclosure of executive compensation began at the Securities Exchange Act of 1934, where all publicly traded companies were required to make periodic disclosures about managements compensation and significant transactions between managers and the company. In 1992, the SEC adopted significant amendments to the proxy rules, requiring detail with respect to noncash compensation such as stock options and stock appreciation rights (Mahoney 1995), and a summary compensation table for the companys five highest paid executives. Then, after the sandals of Enron, WorldCom and Tyco, the Congress passed the Sarbanes-Oxley Act of 2002, which requires reporting on stock transactions of corporate officers. After the Global Financial Crisis, it comes the Wall Street Reform and Consumer Protection Act of 2010, often referred as Dodd-Frank, which brought more provisions on executive compensation. According to Monks and Minow (2011), these provisions include: Company must submit executive compensation to a nonbinding say on pay shareholder vote at least once every three years. Golden parachute payments are also put to a nonbinding vote and companies must make additional disclosures about the relation of pay to performance and the ratio of CEO pay to the median of the companys employees. The compensation committee must have a compensation disclosure and analysis (CD&A) report, a narrative overview explaining the material elements of compensation for the companys named executive offers, focusing on the material principles underlying the companys executive compensation policies and decisions and the most important factors relevant to analysis of those policies and decisions and avoiding boiler-plate and jargon. The results of the rules With better understanding of the compensation policies and decisions, shareholders could in theory exercise more effective oversight and hold the executives and the compensation committees more accountable. Shareholder groups see say on pay as a key cog in mandating greater accountability for corporate executives (McCann 2008). However, studies on the effect of the say on pay rule on UK, Netherlands, Australia, Sweden and Norway find only few rejections on companies compensation proposals (Deane 2007). Similar result was observed in the US after the adoption of mandatory voting (Hemphill 2012). It is unclear if better disclosure has really led to more shareholder activisms, especially when the free-rider problem is still pervasive among individual shareholders. Similarly, whether recent reform will shift the institutional investors traditional focus from generic governance, such as board independence, to more direct involvement in executive compensation is still an open question (Matsumura & Shin 2005). However, the fact that proposals are rarely rejected does not mean that the new rules have had no effects. Instead, according to Deane (2007), investors actually see pay as being more connected to performance. Compensation packages are rejected extremely rarely largely owing to improved communication between investors and board

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members (Dew-Becker 2009). Firms would have been tailored their pay packages in order to signal that they are responsible and to avert shareholder dissent (Singh 2007). Hence, mandate disclosure and say on pay has a sunshine effect. As Richard Breeden (1992), then chairmen of the SEC, once said, The best protection against abuses in executive compensation is a simple weapon the cleansing power of sunlight and the power of an informed shareholder base. In result, following the proxy amendments in 1992, Vafeas & Afxentious (1998) find compensation committees having fewer insiders, meet more frequently, and converge to a moderate size. Cross-sectional variation in CEO pay was explained significantly more by accounting and market performance measures. Then in the period of 2001 2009, Clarkson, Walker & Nicholls (2011) find a strengthening of pay-performance link while controlling for contemporaneous changes in corporate governance practice. It indicates that the strengthening is primarily related to enhanced compensation disclosure and the non-binding shareholder vote on the compensation report. As the landscape of compensation disclosure has been changing, these findings should not be taken as conclusive. There is high incentive for companies and their consultants to innovate on pay packages to limit outside criticism and outrage through dressing, packaging or hiding rent extraction (Bebchuk & Fried 2006). Indeed, Murphy (1996) finds that after the 1992 amendment, companies changed their method of compensation just to decrease the perceived compensation being received by executives. Andjelkovic, Boyle & McNoe (2002) also find that the advent of the disclosure legislation coincides with significant innovations in the setting of executive pay. Historically, when disclosure requirements for executive salaries, bonuses, and long-term compensation have become stricter, firms have increasingly turned to postretirement benefits as ways to compensate managers. In response, governments can further increase the detail of disclosure, demand more clarity and consistency to prevent the hiding of rent extraction, and reduce individual shareholders free-riding by mandating say on pay vote. Yet, unless companies themselves find disclosure beneficial, in which mandatory disclosure become redundant, the constant wrestling between companies and the regulatory bodies would keep changing the linkage between pay and performance. Criticisms of mandatory disclosure Disclosure of executive compensation comes with costs. Direct accounting cost is an obvious example, but indirect costs maybe even more substantial. For example, pay information are generally considered confidential, especially to competitors, and disclosure showing high executive pay may lead to a pressure for higher wages from unions, leading to higher labour costs. Verrecchia (1983) and Wagenhofer (1990) called these the proprietary and nonproprietary costs of disclosure. Prevost and Wagster (1999) find evidence on these costs from the significant wealth loss due to announcements concerning the new executive compensation reporting requirements. If these costs actually exist, partial disclosure is indeed optimal. There is also a political cost from high executive compensation. Media and corporate governance critics often pay a great deal of attention on top pays, making them a subject of public scrutiny (Kaplan and Rauh, 2010). One should realize that we are concerned with the strength of the pay-performance link, not the general level of executive pay. With mandatory disclosure,

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companies could be induced to adversely alter their contracts to mitigate their political costs, even when a higher pay is justified (Jenson & Murphy 1990). Arguably, the 50% decline of compensation of the average S&P 500 CEO between 2000 and 2009 (Kaplan and Rauh, 2010) was a result of this. Alternatively, companies may choose to just match pay close to their stock returns, despite the fact that the latter is driven mainly by market-wide fluctuation instead of executive performance (Lo 2003a). Finally, from a rather distinctive perspective, Edmans & Gabaix (2009) argue that executive compensation set by CEOs themselves can be fully consistent with efficiency. Hence disclosure is costly simply because it invites other parties to decide on the executives pay. The fact that compensation disclosure can subject boards to pressure from media, labour unions and political activists whose primary motivation may not be to increase the pay-for-performance sensitivity of executive pay also creates additional agency problem (Prevost & Wagster 1999). Because performance is determined by the executives ability to maximize shareholder value, these pressures from non-shareholders would result in suboptimal contracting and lead to the weakening of the pay-performance link. Compensation disclosure can as well lead to excessive pay due to peer-benchmarking. It has been observed in both the academic and professional communities that the practice of targeting the pay of executives to median or higher levels of the competitive benchmark will create an upward bias and movement in total compensation amounts (Elson & Ferrere 2012). According to Cioppa (2006), public knowledge of salaries has arguably created in the US a sort of race to the bottom in which companies have to be willing to pay unjustifiable amounts of money to retain good management. Faulkender and Yang (2013) also finds evidence that peer-benchmarking became more severe after the 2006 regulatory requirement of disclosing compensation peers. The combined effect of peer-benchmarking and the tendency to limit executive pay to avoid political costs could lead to a convergence in pay, at least between companies of similar sizes in the same industry. The validity of this claim, however, has to be verified empirically. While executives manipulation of compensation contract can be prevented by detailed disclosure, it does not prevent rent extraction after the contract is approved and endorsed. The motivation to meet Wall Street earnings expectations has led to widespread use of earning management (Levitt 1998). Performance targets and shareholder pressure can cause executives to engage in a similar myopic behaviour to boost their short-term numbers at the expense of more valuable longer-term investments (Hermalin & Weisbach 2012). Hence, betterdisclosed compensation packages would not substitute for more effective internal control and governance. Finally, Elson (1992) argues that most commentators examining the compensation issue have not focused on reform of the internal corporate governance procedures that created the problem. They tend to propose externalbased solutions that will either prove ineffective or hinder effective corporate management, which the regulatory and legislative communities have quickly followed. If shareholders are to decide directly on executive pays, what is the role of the compensation committee? Indeed, executive compensation is a topic that requires case-specific knowledge and thus is best designed by informed decision makers who have some discretion and use it to enhance shareholder value (Bebchuk & Fried 2005). The more correct way to deal with the agency problem would

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be governance reforms that help align the boards interest with the shareholders, such as paying directors their annual fees in restricted company stock (Elson 1992), more regulations regarding the composition of the compensation committee, and reducing impediments to director removal (Bebchuk & Fried 2005). Conclusion It is the duty of the compensation committee to ensure that executives are paid according to performance. The disconnection of the pay-performance link is therefore a failure of this internal governance mechanism. As a remedy to this problem, legislators have been adopting detailed compensation disclosure rules to facilitate the direct oversight of shareholder on executive compensation issues. Over the decades when disclosure requirements become increasing detailed, a clear improvement on the payperformance link can be observed. This suggests that at the current state, benefits of disclosure outweigh its costs, making it a good remedy to the internal governance problem. Improvements seem to be coming more from the pressure of the executives and the compensation committees to signal good governance the sunshine effect rather than from shareholder activisms. However, as the executives and their consultants strive to innovate on their compensation packages, it is unclear whether this improvement can be sustained. As there are costs associated with disclosure and as rules are easier enacted than dismantled, legislators should be conservative on further strengthening of disclosure requirements. References Andjelkovic, A, Boyle, G & McNoe, W 2002. Public disclosure of executive compensation: Do shareholders need to know? Pacific-Basin Finance Journal, 10(1), 97-117. BBC 2011, Directors' pay rose 50% in past year, says IDS report, BBC News (28 October). Available from http://www.bbc.co.uk/news/business-15487866 . Breeden, RC 1992. Open Statement, at the opening meeting of the U.S. Securities and Exchange Commission (15 October). Bebchuk, LA & Fried, JM 2003. Executive Compensation as an Agency Problem. Journal of Economic Perspectives, 71, 92. Bebchuk, LA & Fried, JM 2005. Pay without performance: Overview of the issues. Journal of Applied Corporate Finance 17, no. 4 8-23. Bebchuk, LA & Fried, JM 2006. Pay without performance: The unfulfilled promise of executive compensation. Harvard University Press.

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Cioppa, P 2006. Executive Compensation: The Fallacy of Disclosure. Global Jurist Topics, 6(3). Clarkson, PM, Walker, J & Nicholls, S 2011. "Disclosure, shareholder oversight and the pay performance link." Journal of Contemporary Accounting & Economics 7, no. 2 (2011): 47-64. Crawford, K 2005. Ex-WorldCom CEO Ebbers guilty. CNN Money http://money.cnn.com/2005/03/15/news/newsmakers/ebbers/ . Deane, S 2007. Say on Pay: Results From Overseas. The Corporate Board, 28(165), pp. 1118. Dew-Becker, I 2009. "How much sunlight does it take to disinfect a boardroom? A short history of executive compensation regulation in America." CESifo Economic Studies 55.3-4 (2009): 434-457. Donahue, SM 2008. Executive Compensation: The New Executive Co mpensation Disclosure Rules Do Not Result in Complete Disclosure. Fordham Journal of Corporate & Financial Law, 13(1), 59. Economist 2003. Fat cats feeding Why are company bosses being paid such large sums of money? The Economist, 9 October. Available from http://www.economist.com/node/2119378 . Edmans, A & Gabaix, X 2009. "Is CEO pay really inefficient? A survey of new optimal contracting theories." European Financial Management 15.3: 486-496. Elson, CM 1992. Executive Overcompensation--A Board-Based Solution. BCL Rev. 34 (1992): 937. Elson, CM & Ferrere, CK 2012. "Executive Superstars, Peer Groups and Over-CompensationCause, Effect and Solution." Available at SSRN 2125979. Faulkender, M & Yang, J 2013. "Is disclosure an effective cleansing mechanism? The dynamics of compensation peer benchmarking." Review of Financial Studies 26, no. 3: 806-839. Hemphill, TA 2012. "The US Shareholder Say-On-Pay Vote: What are the First Year Results?." Review of Business (2012): 82. Hermalin, BE & Weisbach, MS 2012. Information disclosure and corporate governance. The Journal of Finance, 67(1), 195-233. (15 March). Available from

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Hodgson, P & Ruel, G 2012. Twenty-One U.S. CEOs with Golden Parachutes of More Than $100 Million. GMI Ratings. Available from http://origin.library.constantcontact.com/download/get/file/110256168627569/GMI_GoldenParachutes_012012.pdf . Jensen, MC and Murphy KJ, 1990. Performance pay and top-management incentives. Journal of Political Economy 98, 225-264. Kaplan, SN & Rauh, J 2010. Wall Street and Main Street: What contributes to the rise in the highest incomes? Review of Financial Studies, 23(3), 1004-1050. Levitt, A 1998. The Numbers Game, SEC Remarks by Chairman Arthur Levitt, Available from http://www.sec.gov/news/speech/speecharchive/1998/spch220.txt . Lo, K 2003a. Economic consequences of regulated changes in disclosure: The case of executive compensation. Journal of Accounting and Economics,35(3), 285-314. Lo, K 2003b. Is Executive Compensation a Beauty Pageant? CA Magazine 136, 12-13. Mahoney, PG 1995. Mandatory disclosure as a solution to agency problems. The University of Chicago Law Review: 1047-1112. McCann, D 2008. Say What? The Battle over Executive Comp, CFO.com (June 4). Available from <http://www.cfo.com/printable/article.cfm/11485334> Monks, RAG & Minow, N 2011. Corporate Governance, Fifth edition, Wiley & Sons. Murphy, KJ 1996, Reporting Choice and the 1992 Proxy Disclosure Rules, Journal of Accounting, Auditing & Finance, 11 (Summer, No. 3), 497-515. Prevost, AK & Wagster, JD 1999. Impact of the 1992 Changes in the SEC Proxy Rules and Executive Compensation Reporting Requirements, (September 1999). Available at SSRN: http://ssrn.com/abstract=179661 Singh, R 2006. Board Independence and the Design of Executive Compensation (September 2006). EFA 2005 Moscow Meetings Paper; Harvard NOM Working Paper No. 673741. Available at SSRN: http://ssrn.com/abstract=673741 or http://dx.doi.org/10.2139/ssrn.673741 Sun, L & Tobin D 2012. Corporate Governance. London: University of London.

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Vafeas, N & Afxentiou, Z 1998. The association between the SEC's 1992 compensation disclosure rule and executive compensation policy changes. Journal of Accounting and Public Policy, 17(1), 27-54. Verrecchia, RE 1983. Discretionary disclosure. Journal of Accounting and Economics 5, 179- 194. Wagenhofer, A 1990. Voluntary disclosure with a strategic opponent.' Journal of Accounting and Economics 12, 341-363. Wilson, H 2005. H-P to pay Fiorina $21M in severance, MarketWatch (14 February). Available from http://www.marketwatch.com/story/h-p-to-pay-fiorina-21m-severance-package .

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