Tag: Incentives


Appraisal Arbitrage—Is There a Delaware Advantage?

Gaurav Jetley is a Managing Principal and Xinyu Ji is a Vice President at Analysis Group, Inc. This post is based on a recent article authored by Mr. Jetley and Mr. Ji. The complete publication, including footnotes, is available here. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

Market observers have devoted a fair amount of attention to possible reasons underlying the recent increase in appraisal rights actions filed in the Delaware Chancery Court. A number of commentators have connected such an increase to recent rulings reaffirming appraisal rights of shares bought by appraisal arbitrageurs after the record date of the relevant transactions. Other reasons posited for the current increase in appraisal activity include the relatively high interest rate on the appraisal award and a belief that the Delaware Chancery Court may feel more comfortable finding fair values in excess of, rather than below, the transaction price.

In our paper Appraisal Arbitrage—Is There a Delaware Advantage?, we examine the extent to which economic incentives may have improved for appraisal arbitrageurs in recent years, which may help explain the increase in appraisal activity. We investigate three specific issues.

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Angels and Venture Capitalists: A Match Made in Heaven?

Thomas Hellmann is Professor of Entrepreneurship and Innovation at Oxford University. This post is based on two recent articles authored by Mr. Hellmann, Veikko Thiel, Assistant Professor of Business Economics at Queen’s University; Paul Schure, Associate Professor of Economics at the University of Victoria; and Dan Vo, Research Fellow at the University of British Columbia. Related research from the Program on Corporate Governance includes Carrots & Sticks: How VCs Induce Entrepreneurial Teams to Sell Startups, by Jesse Fried and Brian Broughman (discussed on the Forum here) and Delaware Law as Lingua Franca: Evidence from VC-Backed Startups, by Jesse FriedBrian Broughman, and Darian Ibrahim (discussed on the Forum here).

Are angel investors and venture capitalists friends or foes? Are they synergistic partners in the process of funding entrepreneurial value creation? Or are they distinct funding mechanisms where entrepreneurs have to decide which camp they want to be part of? In a series of two recent papers (Friends or Foes? The Interrelationship between Angel and Venture Capital Markets; and Angels and Venture Capitalists: Substitutes or Complements?), we examine these questions both from a theoretical [1] and an empirical [2] perspective.

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Making Executive Compensation More Accountable

Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s remarks at a recent open meeting of the SEC; the full text, including footnotes, is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff. Related research from the Program on Corporate Governance about CEO pay includes Paying for Long-Term Performance (discussed on the Forum here) and the book Pay without Performance: The Unfulfilled Promise of Executive Compensation, both by Lucian Bebchuk and Jesse Fried.

When it comes to compensation, Americans believe you should earn your money. They also believe, just as strongly, that you should not keep what you did not earn. It’s fundamental to our values. However, when companies have to restate their financial statements because they violated applicable reporting requirements, their executives may not be required to reimburse any incentive-based compensation that was erroneously paid. In other words, they get to keep what they never should have received in the first place.

And, quite often, we are talking about very large amounts. In today’s corporate world, many executives are earning eye-catching sums. Much of the increase in executive compensation is commonly attributed to the impact of incentive-based compensation, including equity and other performance-based compensation plans.

Incentive-based compensation plans are intended to align the interests of company managers and shareholders. However, when a company is required to issue a restatement, and when its executives have been paid compensation based on inflated financial results, this alignment disappears. In such cases, it is only fair that these erroneously awarded payments be recovered.

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Managerial Ownership and Earnings Management

Phil Quinn is Assistant Professor of Accounting at the University of Washington. This post is based on an article by Mr. Quinn.

In my paper, Managerial Ownership and Earnings Management: Evidence from Stock Ownership Plans, which was recently made publicly available on SSRN, I exploit the initiation of ownership requirements to examine the relation between managerial ownership and earnings management. Prior work provides mixed evidence on the relation between managerial ownership and earnings management. Many studies provide evidence of a positive relation between managerial ownership and earnings management, which is consistent with an increase in stock price increasing the portfolio value of high-ownership managers more than the value of low-ownership managers (i.e., the “reward effect”) (Cheng and Warfield 2005; Bergstresser and Philippon 2006; Baber, Kang, Liang, and Zhu 2009; Johnson, Ryan, and Tian 2009). Other work notes that earnings management is a risky activity and posits that risk-adverse managers will be less likely to engage in risky activities as their ownership increases. Consistent with the “risk effect” increasing with managerial ownership, several studies find no relation or a negative relation between earnings management and managerial ownership (Erickson, Hanlon, and Maydew 2006; Hribar and Nichols 2007; Armstrong, Jagolinzer, and Larcker 2010). Armstrong, Larcker, Ormazabal, and Taylor (2013) note that the theoretical reward effect and risk effect are countervailing forces, and the countervailing forces may explain why prior empirical work finds mixed evidence on the relation between ownership and earnings management. By examining stock ownership plans, a governance reform that limits the reward effect, I seek to inform the discussion on the relation between ownership and earnings management.

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Improving Transparency for Executive Pay Practices

Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s remarks at a recent open meeting of the SEC; the full text, including footnotes, is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff. Related research from the Program on Corporate Governance about CEO pay includes: Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here); Golden Parachutes and the Wealth of Shareholders by Lucian Bebchuk, Alma Cohen, and Charles C.Y. Wang (discussed on the Forum here); and The Growth of Executive Pay by Lucian Bebchuk and Yaniv Grinstein.

Today, as part of a series of Congressionally-mandated rules to promote corporate accountability, we consider proposed rules to put a spotlight on the relationship between executive compensation and a company’s financial performance. It is well known that the compensation of corporate executives has grown exponentially over the last several decades, and continues to do so today. It is also commonly accepted that much of that growth reflects the trend towards equity-based and other incentive compensation, which is thought to align the interests of corporate management with the company’s shareholders. Specifically, the idea is that stock options, restricted stock, and other incentive-based compensation encourages management to work hard to improve their company’s performance, because managers will share in the wealth along with shareholders when stock prices rise.

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CEO Stock Ownership Policies—Rhetoric and Reality

The following post comes to us from Nitzan Shilon at Peking University School of Transnational Law. This post is based on his recent study, CEO Stock Ownership Policies—Rhetoric and Reality. He conducted this study while being a Fellow in Law and Economics and an S.J.D. (Doctor of Laws) candidate at Harvard Law School.

I recently published a study titled CEO Stock Ownership Policies—Rhetoric and Reality. This study is the first academic endeavor to analyze the efficacy and transparency of stock ownership policies (SOPs) in U.S. public firms. SOPs generally require managers to hold some of their firms’ stock for the long term. Although firms universally adopted these policies and promoted them as a key element in their mitigation of risk, no one has shown that such policies actually achieve the important goals that they have been established to achieve. My study shows that while SOPs are important in theory, they are paper tigers in practice. It also shows that firms camouflage the weakness of these policies in their public filings. Therefore I put forward a proposal to make SOPs transparent as a first step in improving their content. My findings have important implications for the ongoing policy debates on corporate governance and executive compensation.

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Does Your Executive Pay Plan Create “Drive, Discipline and Speed”?

The following post comes to us from Pay Governance LLC and is based on a Pay Governance memorandum by John D. England and Jeffrey W. Joyce.

At a recent Chief Human Resources Officer (CHRO) conference, two private equity firms’ operating partners observed that executive compensation programs in each and every company in which they invested had to be completely overhauled. “Of course,” quipped one CHRO, “all you need to do is grant large, upfront stock options as a one-time long-term incentive, and you don’t worry about pay after that.” After the chuckling subsided, the operating partners politely demurred. One replied “Actually, we worry every day about whether our portfolio company pay programs create drive, discipline, and speed, for without these three motivations, our investments won’t create value for our investors. The other added, “You need to worry more about these motivations, too.”

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Are Companies Setting Challenging Target Incentive Goals?

The following post comes to us from Pay Governance LLC and is based on a Pay Governance memorandum by Ira Kay, Steve Friedman, Brian Lane, Blaine Martin, and Soren Meischeid.

Do companies set appropriately challenging goals in their incentive plans? How does a compensation committee determine whether management is recommending challenging goals? How important are earnings guidance and analyst expectations in goal setting? Are more challenging goals achieved as frequently as less challenging goals? How much are annual incentive payouts increased by the achievement of incentive goals? How does the stock market react to challenging goals?

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The Benefits of Limits on Executive Pay

The following post comes to us from Peter Cebon of the University of Melbourne and Benjamin Hermalin, Professor of Economics at the University of California, Berkeley. Work from the Program on Corporate Governance about CEO pay includes: The CEO Pay Slice by Lucian Bebchuk, Martijn Cremers, and Urs Peyer (discussed on the Forum here); Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here); and Lucky CEOs and Lucky Directors by Lucian Bebchuk, Yaniv Grinstein and Urs Peyer (discussed on the Forum here).

Our paper, When Less Is More: The Benefits of Limits on Executive Pay, forthcoming in the Review of Financial Studies, addresses the question of whether limits on executive compensation harm or benefit shareholders. In particular, our model shows that if regulation limits executive compensation, this can make it possible for the board to give the CEO incentives that are both more effective and less costly, and for the two parties to create a relationship that is more collaborative. Among the implications—some of which we are exploring in a companion paper in progress—is this collaborative relationship makes it more attractive for the CEO to pursue long-run strategies (e.g., organic growth) that are more profitable than the short-run strategies (e.g., mergers and acquisitions) they would have pursued if firms had to rely on stock-based compensation for their executives.

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Incentive Alignment through Performance-Focused Shareholder Proposals on Management Compensation

The following post comes to us from Steve Fortin of the Accounting Area at McGill University; Chandra Subramaniam of the Department of Accounting at the University of Texas at Arlington; Xu (Frank) Wang of the Department of Accounting at Saint Louis University; and Sanjian Bill Zhang of the Department of Accountancy at California State University, Long Beach. Work from the Program on Corporate Governance about CEO pay includes: The CEO Pay Slice by Lucian Bebchuk, Martijn Cremers, and Urs Peyer (discussed on the Forum here); Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here); and Lucky CEOs and Lucky Directors by Lucian Bebchuk, Yaniv Grinstein and Urs Peyer (discussed on the Forum here).

Corporate boards are conscious of the role that executive pay practices play in improving corporate governance and increasing shareholder wealth (Gammeltoft, 2010). Economic theory suggests that the key to aligning managerial compensation with shareholder interest is to increase the sensitivity of executive compensation to firm performance (Core et al., 2005; Jensen and Meckling, 1976). Firms finance their operations, however, with funds from both shareholders and creditors, e.g., bondholders. Thus, agency theory also concerns shareholder-bondholder agency conflict and the difficulty of concurrently aligning the interests of shareholders, bondholders, and managers (Ahmed et al., 2002; Jensen and Meckling, 1976; Ortiz-Molina, 2007). In the past decade, the business press has focused on excessive CEO pay, observed during the 2001 Enron/Worldcom scandals as well as the recent 2007–2008 credit crisis, e.g., AIG. Critics contend that contracting between CEOs and boards has been shadowed by pervasive managerial influence (Bebchuk and Fried, 2005; Crystal, 1992). Consistent with these concerns, shareholders have begun to use the “shareholder proposal rule” (Rule 14a-8) established by the Securities and Exchange Commission (SEC) to defend their interest and have submitted hundreds of proposals to many of the largest U.S. corporations.

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