Yearly Archives: 2009

Executive Compensation: What Obama’s Plan Means

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, February 10, 2009
, ,
More from:
Editor’s Note: This article was recently published by the author, Ben Heineman, in Business Week. Mr. Heineman is General Electric’s former senior vice-president for law and public affairs, and is author of “High Performance with High Integrity”.

The Administration’s attempt to deal with excessive pay is more about procedure than substance and will allow most companies to self-govern

Despite headlines along the lines of “Obama Caps Exec Pay,” the Administration’s executive compensation initiative sets relatively few fixed, substantive requirements for most companies receiving funds under the Troubled Asset Relief Program (TARP).

Primarily, it imposes procedural requirements. To wit: that boards of directors and senior executives develop positions on pay levels, on whether compensation creates undue risk, on “clawbacks” of pay for financial misstatements, and come up with policies on luxury items—and then disclose the results and the reasoning; seek shareholder approval in some instances; and have CEOs certify company compliance with the new approach.

TARP Forces Company Hands
The new compensation rules appropriately force TARP companies to focus on some of the issues that caused the financial meltdown and to make their answers transparent in the belief that in this climate, excess pay will invite public or shareholder denunciation.

These proposals should be seen as just the opening regulatory shot in what will be a months-long or even multiyear debate on a variety of regulatory mechanisms—such as capital requirements, a product approvals process, an enhanced Fed role in evaluating risk to the financial system—that would limit or constrain business decision-making. These various regulatory responses would seek to address the immediate causes of the financial-sector meltdown that has thrown the global economy into crisis: e.g., the failure of risk functions; internal conflicts of interest rather than checks and balances; leadership failures; and a lax culture. Business must ultimately address the root causes: a failure to balance risk-taking with risk management, and to fuse high performance with high integrity.

In addition to opening the “deal with the causes” debate, the executive comp reforms are a necessary political precondition for using the second tranche of TARP money to deal with the direct effects of the meltdown—lack of credit and liquidity—and to gain support for the stimulus package.

READ MORE »

Back to Purchasing Troubled Assets

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Monday, February 9, 2009
, ,
More from:
Editor’s Note: This post is by Lucian Bebchuk of Harvard Law School.

The plan proposed by Treasury Secretary Paulson last September focused on the government’s purchasing “troubled assets” from banks and other financial institutions. Critics (including myself) stressed the huge difficulties that would be involved in the government’s placing a value on troubled assets and the risk that the government would overpay for purchased assets, and the administration abandoned its plan to purchase troubled assets in favor of directly infusing TARP funds into financial institutions.

At the time, I put forward, in an article (available here) as well as a WSJ op-ed piece (available here), an alternative plan to Paulson’s for government-funded purchases of troubled assets. Under the approach I put forward last fall, if the government were to provide capital to get additional liquidity for the market for troubled assets, it should invest funds through a multi-buyer competitive process that uses private parties with appropriate incentives.

According to news reports, the new administration is working on a plan that would involve purchasing troubled assets. This time, however, the administration seems to be considering involving private parties. The WSJ reported yesterday that “Treasury Secretary Timothy Geithner is considering a plan to help purge banks of their bad bets by partnering with the private sector to buy troubled assets, according to people familiar with the matter.” Similarly, the New York Times reported on Saturday that the administration is considering providing capital to, or assuming some of the risks of, private investors purchasing troubled assets.

Appropriately designed, a plan based on multi-buyer competitive process that uses private parties with appropriate incentives can provide the necessary liquidity to the market for troubled assets while maintaining the market pricing that is essential to avoid overpaying for troubled assets. Here is a brief description of (one version of) the proposal I put forward last fall:

Suppose that Treasury believes that the market for troubled assets is not functioning properly due to lack of liquidity and that the introduction of buyers armed with $250 billion could bring the necessary liquidity to this market. The Treasury could establish, say, 25 funds with a capital of $10 billion each. The funds could be funded with TARP funds as well as with some borrowed funds from the Fed.

The key is to have the funds managed by private mangers with appropriate incentives. Each fund should be run by a manager verified to have no conflicting interests. The manager would be promised a fee equal to, say, 5% of the profit its fund generates – that is, the excess return (over the yield on treasury securities) generated by the fund during its period of operations.

This system would not equire Treasury officials to place any value outside a market context on troubled assets. It would be effective because:

(1) The competition among these 25 funds would prevent the price paid for the mortgage assets from falling below fair value, and

(2) The fund managers’ profit incentives would prevent the price from exceeding fair value.

For the above approach to be effective, it needs to be appropriately designed. The devil is in the details. Thus, if Treasury does elect to proceed with a scheme involving the use of private parties for purchasing troubled assets, it will be important to study carefully the details of the design it chooses. Given that purchasing troubled assets is back on the table, I am planning to write again on the subject when more information becomes available, and any comments or suggestions would thus be most welcome.

Moral Hazard and Managerial Compensation

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Sunday, February 8, 2009
, ,
More from: ,

This post comes from Robert A. Miller and George-Levi Gayle of Carnegie Mellon University.

In our recently accepted American Economic Review paper entitled Has Moral Hazard Become a More Important Factor in Managerial Compensation? we estimate a model of moral hazard with data spanning a sixty-year period in order to investigate how well two specific channels explain secular changes in managerial compensation and to assess their relative importance. First, contracts reflect heterogeneity across firms, such as their size, capital-labor ratios, the sectors they belong to, and the dispersion of their financial returns. Consequently, changing the heterogeneity across firms induces changes in the aggregate level and variability of compensation. Second, the optimal contract is a function of the preferences and risk attitudes of managers. Changing those preferences also affects the probability distribution of compensation across executives.

The data for our empirical analysis are drawn from two samples that collectively span approximately sixty years from 1944 with a fifteen year break at 1978. The firms and their managers are selected from three industrial sectors, aerospace, chemicals, and electronics, broadly representative of all publicly traded corporations. Our empirical framework accommodates changes in the processes determining firm size and returns by separately estimating models of managerial compensation for the two samples and by parametrically allowing for the effects of changes on the contracts within each sample.

The welfare cost of the moral hazard is a compensating differential paid to risk-averse managers to hold insider wealth and accept non-diversifiable risk that realigns their incentives to those of the stockholders, who do not price risk from an individual firm’s abnormal returns because of their portfolio choices. We find that the welfare cost of the moral hazard associated with employing CEOs has increased by an estimated factor of more than twenty times in the aerospace and electronics sectors and six fold in the chemicals sector. Subtracting the welfare costs of the moral hazard from the expected compensation paid to top executives, we obtain, for each of the six categories, the average certainty equivalent wage which equates the supply and demand for managerial services for a given firm. The overall increase in the sixty year period is 2.3, the same as the increase in national income. Therefore our results attribute all the difference between the rate of increase in managerial compensation and the rate of increase in national income to the rising welfare cost of the moral hazard. We find the main reason this welfare cost steeply rose, is that large firms pay a higher risk premium than small firms to align the incentives of managers with their shareholders, and average firm size increased significantly over this period.

The full paper is available for download here.

More on the Administration’s Compensation Guidelines

Posted by Broc Romanek, TheCorporateCounsel.net, on
Saturday, February 7, 2009
, ,
More from:

This post is from Broc Romanek TheCorporateCounsel.net. The Administration’s compensation guidelines are available here, and a valuable outline of the guidelines by Davis Polk & Wardwell is available here. Earlier posts on the compensation guidelines on this blog are available here and here.

Related to the recent op-ed piece from Professor Bebchuk regarding the new Treasury executive guidelines, here are key fixes to those new guidelines recommended by Jesse Brill, Chair of CompensationStandards.com:

One key aspect of the Obama Adminstration’s new $500,000 cap that has not gotten sufficient attention is the unlimited amount of restricted stock and stock options that still can be granted under the latest “restrictions.” Equity compensation is the pay component that has gotten most out-of-line over the past 20 years. It (as well as severance/retirement/ golden parachutes) has caused the greatest disparity between CEO compensation and that of the next tier of executives (and employees generally).

The new $500,000 cap provision does prevent executives from realizing the gains in their equity compensation until after the government is paid back. But there are two major problems with how this applies:

1. It does not apply to past equity compensation. Warren Buffet imposed a similar cap on Goldman Sachs’ executives, but his restriction applies to all the equity held by the top executives. It is not limited just to future grants, as is the case with the new government restriction. So Buffett’s provision wisely requires that the key decision-makers keep all their “skin in the game” until he gets paid off.

2. Although it may help protect the government’s investment, it is short-sighted and fails to protect the shareholders’ best long term interests. The holding period should be the longer of age 65 or two years following retirement. That will ensure that the key executives make decisions that truly are in the long-term best interests of the company (as opposed to decisions aimed at a shorter period – after which an executive could depart, taking all his marbles with him).Note that holding-through-retirement also addresses the major concern about top executives’ unnecessary risk taking.

Holding equity compensation through retirement is perhaps the single most important—and fundamental – fix to getting executive compensation back on track because it also addresses all the past outstanding excessive option and restricted stock grants. And, by requiring CEOs to keep their skin in the game for the long term, it will go a long way to restoring public trust in our companies and our market, which is so important to restoring stability to the markets.

READ MORE »

Reactions to Bebchuk on the Administration’s Compensation Guidelines

Posted by Andrew Tuch, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Saturday, February 7, 2009

More from: ,

The Administration’s compensation guidelines are available here, and a valuable outline of the guidelines by Davis Polk & Wardwell is available here.

In response to Lucian Bebchuk’s post from yesterday, Bernard Sharfman writes:

I also agree that the proposed salary caps are mainly symbolic. In 2008, Wall Street paid out $18.4 billion in bonuses to its approximately 164K plus employees. Based on this data and the limited number of firms and number of employees (5 per firm) the pay caps could apply to, I would say that 99.9% of Wall Street employees are safe from the wrath of the proposal. If you want to reduce large company wide bonus payouts in bad years, which I believe was the original intent of these proposed guidelines, that is not the way to do it. However, the real significance of the proposal may be as an implied threat to Wall Street to get its compensation act together or else face something real later on.

For a recently posted paper on how corporate law should respond to Wall Street compensation policies, see Bernard S. Sharfman, “Enhanced Duties for Excessively Risky Decisions.”

Another reaction has come from David Wilson, who writes:

A symbolic $500k salary cap may have unintended consequences. As Mr. Bebchuk points out, firms are still “free to make up for this reduction” with other forms of compensation. Because of this, the cap will alter the form in which executives are paid. Executives will require higher levels of incentive-based compensation to make up for the reduction in their “guaranteed” cash salaries.

Further, a dollar of incentive-based compensation is worth less than a dollar in cash. A CEO who sees his salary cut from $2m to $0.5m will not be in the same financial position if he receives an additional $1.5m in incentive-based pay. Michael Jensen, Kevin Murphy and Eric Wruck point this out in their 2004 paper “Remuneration: Where We’ve Been, How We Got to Here, What are the Problems, and How to Fix Them” ), in which they state “[r]isk-averse executives will ‘charge’ for bearing risk by discounting the value of the risky elements of pay.” If this is true, we can expect to see significant increases in equity-based incentives.

As Mr. Bebchuk points out, a myriad of issues that need to be addressed surround the use of equity incentives.

The Administration’s Executive Pay Guidelines

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Friday, February 6, 2009
, ,
More from:
Editor’s Note: This post is based on an op-ed piece by Lucian Bebchuk in today’s Wall Street Journal.

Critics of the administration’s proposed guidelines on executive compensation say they are a dangerous intrusion into corporate boards’ authority and would make it difficult for financial firms to fill executive positions. These criticisms are unwarranted. If anything, the guidelines are too modest and should be tightened.

Concern that the guidelines would undermine firms’ ability to attract or retain executives has been fueled by media coverage stressing the $500,000 cap on salaries. Because salaries commonly represent a small fraction of total executive pay, and firms would be free to make up for this reduction by providing additional compensation in other forms, the salary cap’s significance would be mainly symbolic. Indeed, I would have no problem with a somewhat higher salary cap, especially if that would facilitate tightening the elements of the guidelines that are practically more significant.

Companies falling under the guidelines will retain the ability to provide large compensation when necessary. The guidelines don’t impose any cap on the total pay; they only influence its form. Indeed, firms which get taxpayer funds under “generally available government programs”—which likely will constitute the lion’s share of firms receiving government capital—will be permitted to provide unlimited compensation in any form they choose provided they disclose it (as is already required) and allow shareholders to have advisory “say on pay” votes on the firm’s pay policy. Even firms that receive “exceptional assistance” (such as provided to AIG or Citibank in the past) will be permitted to compensate executives with unlimited amounts in restricted shares that can be cashed out after the government is paid back.

This is not excessive government meddling. As a major provider of capital to firms receiving exceptional assistance, the government has a legitimate investment interest in executives’ being properly incentivized. The proposed guidelines are a rather modest intervention relative to the control rights that private investors providing so much capital would likely seek.

Furthermore, this modest intervention can significantly improve incentives and performance. In a 2004 book and prior articles, Jesse Fried and I warned that common executive pay practices produce perverse incentives to focus on short-term results. To the extent that such incentives have contributed to the current crisis—as has now come to be widely suspected—the adverse consequences have been dire indeed.

Executives’ ability to profit from early dumping of their equity-based compensation can impose large costs on investors. To protect its investments in firms receiving exceptional assistance, the government is warranted in restricting executives’ freedom to unload their restricted shares quickly, before the government is repaid.

For executives to view any number of restricted shares that cannot be quickly unloaded as inadequate compensation, they must believe the firm will likely fail to repay the government, and that the restricted shares will lose their value if not cashed out beforehand. In such circumstances, the firm should be immediately taken over by the government or otherwise reorganized. It should not continue operating with a structure under which executives may be retained only if allowed to cash out before things fall apart.

After a period of public comment, the Obama administration will finalize the guidelines for firms receiving capital under general programs. I believe the final version should impose tighter restrictions, at least for firms receiving a substantial capital infusion from the government.

While the proposed guidelines seek to encourage companies participating in general programs to use restricted stock, they do not limit how quickly such restricted shares may be unloaded. This should be changed. To provide incentives to focus on long-term results, executives should be precluded from unloading restricted shares for a specified period, say three years, after they vest.

The proposed guidelines also make it too easy for firms participating in general programs to opt out of the restricted stock requirement and compensate executives in whatever form they choose. Companies that opt out only need to adopt “say on pay” votes.

While such votes may be a good governance arrangement for public firms in general, they are merely advisory and, moreover, take place in the year after compensation is awarded. Furthermore, and importantly, because the government can be expected to hold investment rights (such as preferred shares) that are senior to those of common stockholders, these stockholders may prefer executive pay arrangements that would induce more risk-taking and short-termism than would be in the interest of the government as an investor.

In short, the guidelines are a useful step in the right direction. To ensure that executives of firms receiving government capital are well incentivized, however, the administration should use the comment period to significantly tighten them.

SEC vs. Mark Cuban

Posted by Allen Ferrell, Harvard Law School, on
Thursday, February 5, 2009
,
More from:

This post is by Allen Ferrell of Harvard Law School.

I have recently filed an amicus brief on behalf of myself and Professor Bainbridge of the UCLA Law School, Professor Jonathan Macey of Yale Law School, Professor Alan Bromberg of SMU Law School and Professor Henderson of the University of Chicago Law School in the litigation filed against Mark Cuban by the SEC in the United States District Court for the Northern District of Texas.

The SEC complaint essentially alleges that Mark Cuban committed insider trading when, according to the complaint, he sold stock in a company (Mamma.com) in which he was a large shareholder (but not a director or officer) after receiving material, non-public information from the company. The basis for the SEC’s claim of insider trading is the allegation (hotly disputed) that there was a confidentiality agreement with Mr. Cuban covering this material, non-public information.

In our amicus — which can be found here — we argue that even if there was a confidentiality agreement (i.e. accepting all of the SEC’s allegations as true), as a legal matter Mr. Cuban could not have committed insider trading. The Supreme Court in U.S. v. O’ Hagan, 521 U.S. 642 (1997) emphasized that only if a defendant has breached a fiduciary or similar relationship of trust and confidence can the defendant be found to have engaged in the requisite deception through non-disclosure. Under both state and federal common law, a confidentiality agreement alone creates only an obligation to maintain the secrecy of the information, not a fiduciary or fiduciary-like duty to act loyally to the source of the information. As a result, if the SEC’s Rule 10b5-2(b)(1) is read as creating insider trading liability solely on the basis of a confidentiality agreement, this rule is an invalid exercise of the SEC’s rulemaking authority.

Of course, neither I nor any of the professors that signed the amicus brief were compensated in any way for our efforts.

SEC Publishes Final Rules for Credit Rating Agencies

Posted by Annette L. Nazareth, Davis Polk & Wardwell LLP, on
Thursday, February 5, 2009
,
More from: , , ,

This post is based on a memo by Annette Nazareth, Joseph Hall and Michael Kaplan of Davis Polk & Wardwell.

On February 2, 2009 the Securities and Exchange Commission published the text of its new rules for credit rating agencies registered as nationally recognized statistical rating organizations (NRSROs). These rules were adopted at the SEC’s December 3, 2008 open meeting. The new rules are generally scheduled to go into effect on April 10, 2009. The SEC also re-proposed additional rules for NRSROs. Comments on the re-proposed rules are due March 26, 2009.

Final Rules
The rules adopted by the SEC in final form include bans on certain conduct which should be of interest to companies with current credit ratings issued by Standard & Poor’s Ratings Services, Moody’s Investors Service, Fitch Ratings, or another credit rating agency registered as an NRSRO. Since the consequences of violating one of the new bans are severe – requiring the credit rating agency to withdraw its rating – companies should carefully review their policies and procedures for interacting with credit rating agencies.

The new bans include:

• Ban on Recommendations. Under the new rules, a credit rating agency may not issue or maintain a credit rating on an obligor or security where the credit rating agency, or an affiliate, made “recommendations” to the obligor or the issuer, underwriter or sponsor of the security about the corporate or legal structure, assets, liabilities or activities of the obligor or issuer.

Despite concerns raised that a ban on recommendations could unnecessarily chill communications between rated issuers and credit rating agencies, the line between permissible and prohibited communications remains blurred. Attempting to distinguish between a permissible communication and a prohibited recommendation, the SEC stated, for example, that it “does not view an explanation by an NRSRO of the assumptions and rationales it uses to arrive at ratings decisions and how they apply to a given rating transaction as a recommendation.” On the other hand, “if the feedback process turns into recommendations by the NRSRO about changes to the structure, assets, liabilities or activities of the obligor or security that the person seeking the rating potentially could make to obtain a desired credit rating, the NRSRO would be in violation of the new rule.”

Companies and credit rating agencies both will need to exercise care to ensure that their discussions do not cross the line to soliciting or providing an impermissible recommendation.

READ MORE »

The Financial Crisis and the Future of Financial Regulation

Posted by Lord Adair Turner, Chairman, United Kingdom Financial Services Authority, on
Wednesday, February 4, 2009
,
More from:

This is a transcript of The Economist’s Inaugural City Lecture, which was delivered by Lord Adair Turner in London on January 21, 2009.

It is stating the obvious to say that over the last 18 months, and even more so the last four, the world financial system – and particularly but not exclusively the world banking system – has suffered a crisis as bad as any since the stock market crashes of 1929 and the various banking crises that followed. As a result, banking systems in many countries are suffering from an impaired ability to play their vital role in credit extension to the real economy and a process of deleveraging threatens severe adverse effects on real economic prospects. The crisis therefore presents the financial authorities – central banks, regulators and finance ministries – with two challenges:

• The first and most urgent is to design short-term policies so as to at least limit the adverse impact of deleveraging and deflation on the real economy. We cannot make that impact nil, but we do know how to avoid the policy mistakes which turned the initial problems of 1929-30 into the Great Depression. Fiscal and monetary policies need to be carefully designed, and – as we approach a zero interest rate and consider quantitative easing options – need to be increasingly coordinated. And there are a wide range of policies which can be taken to free up financial markets – measures which Ben Bernanke last week labeled “Credit Easing” – funding guarantees, liquidity provision, tail risk insurance, direct central bank purchases of assets, and regulatory approaches to capital regulation which avoid unnecessary pro cyclicality in capital adequacy requirements. The measures announced by the Chancellor of Exchequer on Monday were designed as an integrated package, which will have a significant impact. And if more measures are acquired they can and will be taken.

• It is not, however, on this challenge of short-term economic management – where the lead must be with the fiscal and monetary authorities – that I’m going to talk tonight. But instead on the second challenge: how to design the future regulation and supervision of financial services so that we significantly reduce the probability and severity of future financial crises? Last September, when I took over as Chairman of the FSA, the Chancellor asked me to conduct a review of our regulation and supervision of the banking system, and I will deliver that Review in March, alongside the publication of a comprehensive FSA Discussion Paper. That paper will set out the changes the FSA has already made, those where we have proposals in principle but need to consult on details, and those where we have defined our objectives but now need to play our role in achieving international agreement.

READ MORE »

SOX and Going-Private Decisions

Posted by Ehud Kamar, University of Southern California Gould School of Law, on
Tuesday, February 3, 2009
,
More from: ,

This post is by Ehud Kamar of University of Southern California Gould School of Law.

In my paper Going-Private Decisions and the Sarbanes-Oxley Act of 2002: A Cross-Country Analysis, which was co-written with Pinar Karaca-Mandic and Eric Talley and is forthcoming in the Journal of Law, Economics, & Organization, we investigate whether the passage and the implementation of the Sarbanes-Oxley Act of 2002 (SOX) drove firms out of the public capital market.

Many other attempts to address this question have had difficulty controlling for unobserved conflating factors that could have affected exit decisions around the enactment of SOX. We address this difficulty using a difference-in-differences empirical strategy. This approach compares changes over time in two populations: one subject to a policy intervention (treatment group) and the other not (control group). To evaluate the impact of the intervention on outcome, one needs to compare the outcome change for the treatment group with the outcome change for the control group. Assuming the two groups are similar in all relevant respects other than their exposure to the intervention, this approach screens out changes not related to the intervention. The primary outcome variable in our analysis is a public target’s probability of being bought by a private acquirer rather than a public one, the treatment group is American targets, and the control group is foreign targets. To evaluate the effect of SOX, we compare the change in the propensity of American public targets to be bought by private acquirers rather than by public acquirers to the corresponding change for foreign public targets. The difference between the two changes—the difference-in-differences—is the change we attribute to SOX.

When we examine acquisitions as a whole, we find no relative increase in the rate of acquisition by private acquirers (going private) among American firms. When we differentiate between acquisitions based on firm size, however, we find a relative increase in the rate of going private by small American firms. Moreover, when we differentiate between acquisitions based on their proximity to the enactment of SOX, we find a relative increase in the rate of going private by American firms in the first year after the enactment. Finally, when we differentiate between acquisitions based on both firm size and the proximity of the acquisition to the enactment of SOX, we find that the increase in the rate of going private by small American firms is concentrated in the first year after the enactment.

The full paper is available for download here.

Page 44 of 48
1 … 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48