FINS5526 Week 08 CEO Remuneration

FINS 5526
International Corporate Governance
Emma Jincheng Zhang

School of Banking & Finance
jin.zhang@unsw.edu.au
Session 1, 2017
FINS 3626
International Corporate Governance
Week 08
Executive Compensation
&
Board of Directors
The Compensation (Remuneration) Debate
Questions:
Why are some executives paid so much (i.e., level)?
Why has their pay, in general, increased so fast (trend)?
Is the compensation structured to provide proper incentives
(structure)?
Are they worth the money?
Competing hypotheses:
Optimal contracting (efficient contracting, tournament)
Executive power (managerial power, rent-extraction)
3
Level of executive compensation
in the US
CEO compensation, Frydman and Jenter (2010), Annual Review of Financial Economics
2(1)
in the US
2(1)
in the US
2(1)
Structure of CEO compensation of
S&P 500 firms
Executive compensation: Where we are, and how we got there , Murphy (2012),
http://ssrn.com/abstract=2041679
Long-run trend of the US CEO
pay structure
Trend of the US CEO pay
structure (1992-2008)
Trends in executive compensation
in the US
1. Trends in executive compensation
Sharp decline during World War II and further decline in the
late 1940s
Slow and gradual increases up to the mid-1970s
Rapid growth until 2005
2. During the rapid growth period (1970s 2005), CEO

pay increases faster than non-CEO executive pay
3. CEO pay increases in all sizes of firms during 1992-
2001 and remains stable in the 2000s
4. The CEO pay increase is highly skewed (average is
greater than median)
5. The CEO pay increase is much steeper in larger firms
Features of the US CEO pay structure
1. Up to 1950, CEO compensation mainly consists of
salary and bonus
2. In the 1960s, LTIP started to be provided
3. In the 1980s-90s, stock option grants to CEOs rapidly
increased
The fraction of option compensation (out of the total
compensation) increases
from 20% in 1992 to 49% in 2000
4. In the 2000s, stock option is replaced with restricted
stock grants
The BIG Pay Gap
TARP-bank Executives Cash In
Source: Institute for Policy Studies
12
The Compensation Debate
Optimal Contracting Theory

Executive compensation is
reasonable; its based on supply
and demand for executive talent
(tournament);
Executives are self-interest and
risk-averse large fixed pay,
plus lots of incentive pays.
Optimal contracting Theory
1. Optimal contracting hypothesis presumes that
executive compensation is designed to maximize
the shareholders value by
Addressing the managerial agency problems
Attracting better managerial talent in the labor market
2. The size and structure of managerial compensation
is determined by the following factors:
Productivity of managerial effort/talent
Managerial effort cost
Competition for the managerial talent in the labor market
Presence of alternative governance mechanism
Tax treatment on compensation packages
Executive Power Theory
Some CEOs care about their
own money rather than the
welfare of investors;
Little relationship between
pay and performance;
Executive pay increases in
his/her power, which is
largely due to inefficient
internal and external
monitoring mechanisms.
Executive Power Theory
1. Managerial power in the board:
Executive compensation package is set by the board of directors
Managers may be able to influence the executive pay-setting
process within the board
2. Evidence of suboptimal compensation (Bebchuk and Fried,
2003):
Windfalls: stock or stock option grants compensate the manager
for the price run-up due to the general market or sector trend,
which is not related to the managers performance
Stealth compensation: after-retirement arrangements (e.g.,
consulting fees) or executive loans offered at below-market rates
Severance pay: compensation for leaving executives
Absence of target ownership plans: executives can sell vested equity
at their discretion
Things to think about

The compensation package
Trend of executive compensation over time
Executive compensation and the board
Are executives paid too much ???
17
An ideal compensation package should:

Be sufficient to attract and retain talents;
Incentivize executives to work hard and take
optimal amount of risk;
Be structured to make executives think and act
like an owner (i.e. alignment);
Balance the need for long-term growth and
sustainability, and short-term profitability.
18
A Typical Compensation Package
Executive Compensation (Remuneration)

[1] Fixed remuneration
[2] Non-equity-linked, performance-based remuneration
[3] Equity-linked, performance-based remuneration
[4] Other components
19
Compensation Package in Practice
Composition of annual executive compensation
[1] Base salary (plus allowances, insurances, retirement
benefits, etc.)
[2] Bonuses
[3] Stock options, restricted shares, and stock appreciation
rights (SARs)
20
Compensation Package in Practice (cont.)
[4] Composition of some other components:
Golden handshakes (severance pay)
Executive loans (borrowed from the firm)
Perks (e.g. country club membership, use of corporate jets,
etc.)
21
Salary and Bonuses
Salary
Fixed (pre-determined) and might be tax deductible for the
company.
Performance-based bonuses:
Typically subject to accounting-based (e.g. EPS) performance
benchmark, and sometimes also benchmarked against industry /
market average performance;
It should increase pay-performance association.
Discretionary bonus:
Not related to firm performance;
What purpose does it serve?
22
Salary & Bonus: An Example
In Jan/2014:
Last years salary already given, as pre-determined in Jan/2013;
To set next year (2014) salary level;
In Jan/2014:
Performance-based bonus, 20% of base salary;
Key Performance Indicator (KPI) was set in Jan/2013: a mixture
of absolute production and relative production; non-production
related performance measures;
Cash bonus is based on last years performance;
If KPI met, cash bonus is given immediately.
23
Performance Benchmarks: Potential Issues
Earnings:
Not a forward looking measure;
May be inflated or inaccurate;
Does not encompass market volatility (risk).
Share Price:
Market assessment of future performance;
Volatile measure;
Incorporates factors beyond managers control.
24
Example 1. Managerial incentive
Firm A has a project which creates binary cash flows, represented by
success and failure. The probability of success depends on the managerial
effort as follows:
State Revenue Prob. w/o Prob. w/
effort effort
Failure $0 0.5 0.2
Success $ 100 0.5 0.8
The manager exerts effort by incurring a cost $9, and has a limited liability
(i.e., the compensation should be greater than or equal to zero). The
managerial effort choice is unobservable to shareholders and, thus, is
subject to managerial agency problem.
Q1. What is the optimal managerial compensation contract that
maximizes the shareholders value (after paying the managerial
compensation)?
Example 1. Managerial incentive (sol.)
Shareholders can condition managerial compensation upon the firms cash
flow:
( ): managerial compensation on success (failure)
(Case 1) Shareholders do not induce the manager to exert effort

Managerial compensation: ( , ) = (, )
Shareholders value = $ . = $
(Case 2) Shareholders induce the manager to exert effort
Managers expected wealth w/ effort = 0.8 + 0.2 9
Managers expected wealth w/o effort = 0.5 + 0.5
Manager exerts effort if and only if 0.8 + 0.2 9 0.5 + 0.5
Managerial compensation: , = ,
Shareholders value = ( ) . = $
Example 1. Managerial incentive (cont.)
Firm A has a project which creates binary cash flows, represented by
success and failure. The probability of success depends on the managerial
effort as follows:
State Revenue Prob. w/o Prob. w/
effort effort
Failure $0 0.5 0.2
Success $ 100 0.5 0.8
Q2. Now the managers effort cost increases to $15. What is the optimal
managerial compensation contract that maximizes the shareholders
value?
Q3. Alternately, suppose that the probability of success with managerial
effort decreases to 0.7 while the managers effort cost remains as $9.
What is the optimal managerial compensation ?
Solution to Q2.
Shareholders value = ( ) . = $
Therefore, shareholders are not willing to induce the managerial
effort.
Solution to Q3.
Shareholders value = . = $.
Therefore, shareholders are not willing to induce the managerial
effort.
Key features of optimal
managerial compensation
1. Performance-based compensation:
The managerial compensation increases as the firm value increases
Performance-based compensation provides the manager with
incentives to exert effort
2. The size of compensation, in particular, the performance-
based compensation decreases, as (i) productivity of
managerial effort decreases, or (ii) managerial effort cost
increases (both of which reduces the contribution of
managerial effort to shareholders value)
Larger firms may require higher level of managerial effort, which
increases the size of managerial compensation
Equity compensation
1. Equity compensation is a key component of
performance-based compensation
2. Stock options were more intensively granted in the
1990s and in the early 2000s, while restricted stock
grants become more popular since the mid-2000s
3. Once stocks and options are granted as a part of
the compensation package, executives tend to hold
them for a while
To precisely measure the link between the firm
performance and the wealth of executives, we must
consider the stock and option holdings
Some companies require executives to hold the stocks
during the term of employment
Equity holdings of the US CEOs
2(1)
Restricted Shares
Conditions:
Cannot be sold for a specified period (e.g., 1 year);
After the restriction period, the shares can only be sold gradually;
Notice of sales may be required to be lodged in advance.
Benefits:
Alignment of interests with shareholders;
Reduce managers tendency to focus on short-term goals;
Less sensitive to earnings management.
33
Restricted Shares: An Example
In Jan/2014:
Current stock price is roughly $15;
Granted 1,200 restricted shares, at no cost;
Restriction period is 1 year (upon meeting KPI);
400 of these shares can be sold on or after 01/01/2015;
Another 400 shares can be sold on or after 01/01/2016;
Remaining 400 shares can be sold on or after 01/01/2017.
34
Executive Stock Options
Definition:
Right to buy shares at a specified price on or before a specified
date;
Typically, a vesting period exists (e.g., 3-5 years);
Often have a long maturity (e.g. 5-10 years);
Most executive options are non-tradable and non-transferrable .
35
Stock Options: An Example
In Jan/2014:
Current stock price is roughly $15;
Granted 4,000 stock options, at no cost, with 10-year maturity;
Restriction period is 2 year (upon meeting KPI);
1,000 options can be exercised and converted to shares, at an
exercise price of $15, on or after 01/01/2016;
Another 1,000 options can be exercised, at an exercise price of
$15.6, on or after 01/01/2017;
Remaining 2,000 options can be exercised, at an exercise price
of $16.23, on or after 01/01/2018.
36
Executive Stock Options
Benefits:
Encourage risk-averse managers to invest in risky and profitable
projects (Jensen and Meckling 1976)
Align managers and shareholders long-term interests;
Avoid giving managers too much voting power now;
Cash flows might not be adversely affected.
Costs:
Pricing executive options; financial charges associated should be
recognized as part of profit/loss;
Dilution effect when exercised;
Stock price manipulation or timing: The managers are willing to
have:
Lower stock price before the grant date (i.e., lower strike prices)
Higher stock price before the exercise date
Exercise price can be reset, and they sometimes are reset in
practice;
Might encourage excessive risk-taking (e.g., Enron)
37
Option backdating scandal
1. Option backdating: firms deliberately falsify the stock option
grant date as the date when the stock price is lowest in the
quarter or in the year
Strike price is set at the stock price on the reported grant date
and thus, the stock option is actually granted in the money
This scheme was available because option grants were typically not
reported until 10 days after the end of option grant month
In 2002, SOX required firms to report option grants within two
business days, which limited option backdating
2. SECs investigation on option backdating is triggered by the
study of Eric Lie, a finance professor at U of Iowa, and Wall
Street Journal
3. By August 2009, at least 15 people had been convicted of the
criminal conduct related to option backdating (Murphy 2012)
Stock Appreciation Rights (SARs)
Definition:
Contract to receive a cash $ amount equal to the price
appreciation on a specified number of shares; no need to give
new shares to the executive.
SARs compared to stock options:
Managers are not required to pay an amount to exercise the
SARs; typically, managers simply receive a cash amount that
equals the appreciation;
No additional shares are issued, so no dilution;
Options and SARs are not subject to down-side risk.
39
Options vs. SARs: An Example
Firm XYZ currently has 100 shares, trading at $10 per share.
Stock Options:
The CEO is granted the option to purchase 10 shares, at fixed
price of $10.
Share Appreciation Rights:
The CEO is granted the right to receive price appreciation, above
$10 per share, of 10 shares.
After 1 year, if XYZ share is trading at $11, the CEO will receive:
Options: $11 10 = $110, minus $10 10 = $100 $10
benefit
SARs: ($11 - $10) 10 = $10 $10 benefit
40
Golden Handshakes
Severance (termination, exit pay) Pay

Should be conditional (e.g. no misconduct).
Should vest over a few years.
Golden Parachutes
A particular form of golden handshake, but typically
when there is a change of control (e.g. takeover)
41
Examples of Perks
Perks given to Dennis Kozlowski (of Tyco):

Set of coat hangers: $2,900
Sets of bed sheets: $5,960
Shower curtain: $6,000
Sewing basket: $6,300
Dog umbrella stand: $15,000
Traveling toilet box: $17,000
Apartment (for former wife): $7 million
Source: Boston Herald
42
Examples of Perks
Perks given to Dennis Kozlowski (of Tyco)
Sets of coat hangers: $2,900
Sets of bed sheets: $5,960
Shower curtain: $6,000
Sewing basket: $6,300
Dog umbrella stand: $15,000
Traveling toilet box: $17,000
Apartment (for former wife): $7 million
Who Sets the Pay?
Compensation Committee:
Establish compensation/remuneration packages for
executives;
Participate in preparing the disclosure of executive
compensation;
Oversee and review executive compensation, such as
equity-based compensation;
Liaison with outside compensation consultants;
Evaluate shareholder proposals related to executive
remuneration.
44
Paradox of Board Selection
Theoretically:
Directors are elected or appointed to monitor managers on behalf
of shareholders;
Thus, shareholders should choose the board of directors.
In practice, however:
Director candidates are usually nominated by either the board as a
whole or the nominating committee;
Directors are elected by the shareholders vote in general meeting;
Staggered board: only a fraction (usually one third) of directors is
elected in each year;
Sometimes, CEO and other executives are also directors;
Sometimes, CEO may also be the chairman of the board.
45
Paradox of Board Selection (cont.)
Paradox:
Managers control the perquisites that directors can enjoy;
Managers control the information that directors receive;
Managers can influence the director nomination process;
Directors have influence over management contract and
compensation;
Directors keep their positions if they are judged to be successful in
their monitoring roles.
Managers and directors negotiate over:
Managerial compensation;
Appointments of new board members and re-election of some
directors.
46
Paradox of Board Selection (cont.)
Overtime, managers can make the board less

independent (and, more importantly, less effective):
Managers role in director selection and director
remuneration;
When firm performance is good or appears to be good,
managers has better bargaining power (e.g. Hermalin &
Weisbach, 1998);
Managers can accept lower compensation in exchange for
more friendly directors.
Managers can try to bribe directors;
47
Role of the board
1. The main function of the board is performed by committees
Audit committee
Compensation committee
Nominating/governance committee
Executive committee
Other committees
2. The role of main committees is specified in corporate
charters
3. The board also provides advice to the management
Some high-tech firms have R&D committee which advise the R&D
investments of the firm
Firms that have foreign (independent) directors have better cross-
border acquisitions when the target firm is from the home region of the
foreign directors (Masulis et al. 2012)
Compensation committee charter
of Google
Purpose of compensation committee:
Establish, oversee and administer Googles employee
compensation policies and programs
Review and approve compensation and incentive
programs and awards for Googles executive officers, the
Executive Chairman of the Board of Directors, and the
non-employee members of Googles Board of Directors
Administer Googles equity compensation plans
Perform other tasks necessary to promote sound
corporate governance principles related to leadership
development and compensation at Google
Compensation committee charter
of Google (con.)
Each member of the Committee will be
independent in accordance with the rules and
regulations of the Securities and Exchange
Commission (SEC) and the rules of the
NASDAQ Stock Market,
a non-employee director within the meaning of Rule
16b-3 of the Securities Exchange Act of 1934 and at
least two of the Committee members will qualify as
outside directors under Section 162(m) of the
Internal Revenue Code of 1986.
Independence of directors
1. Non-independent directors may cater to the interest of
executives, rather than strictly monitoring the management
2. SOX requires firms to form the board with a majority of
independent directors who have no material relationship with
the firm, either directly or as a partner, shareholder or officer
of an organization that has a relationship with the company
After SOX, US stock exchanges required the listed firms to have audit,
compensation and nominating committees formed with outside directors
only
3. Actual independence is important:
Some seemingly independent directors may have a network with
executives, e.g., alumni of MBA, the member of social club, etc.
4. Optimal level of independence of the board (i.e., the optimal
fraction of independent directors) is still controversial
The Case of Enron
Enrons Corporate Governance:
Top 100 Best Companies to Work for in America Fortune
Magazine.
6 Green Awards (2000) for Triple Bottom Line Disclosures
(financial, social and environmental).
Numerous awards for structure and disclosure of executive
compensation.
The same year as they filed for bankruptcy, Enron was voted
Most Innovative Company in America for the sixth consecutive
year by Fortune magazine.
52
The Case of Enron: Rubber Stamp Assembly
2 executives: Kenneth Lay and Jeffrey Skilling
15 external directors:
Several law degrees + a dean of a law school.
One current + one emeritus university president.
Multiple Harvard MBAs + one Harvard professor.
One past member of the British Parliament + one elder of a
Presbyterian Church.
Altogether, these directors
had served at least 130 boards.
53
The Compensation Debate, Revisited
Optimal contracting theory: executive pay should be related to
performance and firm complexity.
Executive power theory: implies that pay is not related to
performance in practice.
Does compensation improves performance?
US: In 2001-2002, median CEO compensation rose 14%, while
S&P 500 index was down 22.1%;
Australia: In 2001-2002, median top 100 CEO salary increased by
more than 20%, while All Ordinary Index fell 6.4%;
Overall, empirical research does not always support that higher
pay is related to better performance.
54
Instead, compensation tends to increase when:
Firm grows (empire building);
Greater risk is taken (pay for luck).
Pay without performance argument:

Pay is only sensitive to performance when performance is on the
up;
Managers negotiate for more equity-based pay in advance of
anticipated stock price increases;
Managers sell old shares when receiving new shares or after
exercising their options.
58
The debate continues
There are certainly some high-profile scandals of overly-
paid, greedy CEOs;
There are, however, also many CEOs who work hard to
look after their shareholders and/or stakeholder out of
goodwill;
Shareholders should have some say on how their top
executives are paid (Say on Pay);
In many cases, it is probably more than a governance issue
basic business ethics.
59
Conflict of interest of
compensation consultants
1. Large companies in US tend to rely on compensation
consultants for the design of executive compensation
2. Potential conflict of interests of compensation
consultants
Executives are the main customers of the consultants
Compensation consulting firms may have other business
relationships with the customer firms
3. SEC requires firms to disclose the compensation
consultant, the fees paid more than $120K, and other
services provided by the consulting firms
Consulting firms that focus only on the compensation
advice increases their market share after the new disclosure
requirement
ASX: Remunerate Fairly and Responsibly
ASX CG Principle 8:
Companies should ensure that the level and composition of
remuneration is sufficient and reasonable; and that its
relationship to performance is clear.
Rec 8.1: Remuneration committee;
Rec 8.2: Structure of the committee;
Rec 8.3: Distinguish structure of remuneration packages
for NEDs and Executives.
Rec 8.4: Disclosure of remuneration practice.
61
Australias Strike Deux Law
Historically, shareholders were never able to reflect

directly on executive compensation;
Advisory shareholder votes:

Peter Costello introduced the non-binding vote on
remuneration reports for all Australian public company AGMs
held after June 30, 2005;
Shareholders can vote on executive remuneration matters,
however such votes are only advisory in nature.
62
Australias Strike Deux Law (cont.)
Australia's controversial "two strikes" law:

Introduced in 2011: a company will incur a first "strike" if it
records at least 25% "against" votes on the resolution to
approve the remuneration report at the annual general meeting
(AGM);
If the company receives at least 25% "against" votes on the
remuneration report at the subsequent AGM, the company will
incur a second "strike;
Shareholders must also vote on a "spill resolution to
determine whether a spill meeting should be called to
consider the seats of certain directors on the board.
63
Dodd-Frank Act
1. Enacted in July 2010
2. Put restrictions on the compensation packages of financial
institutions
Must disclose any incentive-based compensation that may lead to
excessive pay
Prohibit from adopting any incentive plan that regulators assess to
encourage excessive risk-taking
3. Governance reforms for all publicly traded firms
Say-on-pay: solicit the (non-binding) approval of shareholders for executive
compensation practices
Clawbacks: recoup payments to executive based on financial statements
that are subsequently restated
Additional disclosure: the ratio of CEO pay to the median pay for all other
employees, employees hedging for the decrease in the stock price, etc.
Compensation committee/advisor independence

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FINS 5526

International Corporate Governance

Emma Jincheng Zhang

2. During the rapid growth period (1970s 2005), CEO

TARP-bank Executives Cash In

Source: Institute for Policy Studies

Optimal Contracting Theory

Things to think about

An ideal compensation package should:

Executive Compensation (Remuneration)

(Case 1) Shareholders do not induce the manager to exert effort

Severance (termination, exit pay) Pay

Perks given to Dennis Kozlowski (of Tyco):

Source: Boston Herald

Overtime, managers can make the board less

Pay without performance argument:

Historically, shareholders were never able to reflect

Advisory shareholder votes:

Australia's controversial "two strikes" law:

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