Executive Compensation: Paying High For Low Performance
University of California, Los Angeles (UCLA) – School of Law
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University of California, Los Angeles (UCLA) – School of Law
August 7, 2015
100 Minnesota Law Review Headnotes __ (2016)
This essay argues that regulatory reforms introduced by the Dodd-Frank Act of 2010 in the area of executive compensation have not yet achieved their purpose of linking executive pay with company performance. The rule on shareholder say-on-pay appears to have had limited success over the five proxy seasons since its adoption. The rule on pay ratio disclosure, adopted in August 2015, and the rules on pay-versus-performance disclosure and the clawback of certain incentive compensation, proposed in April 2015 and July 2015, respectively, are also unlikely to succeed. For the most part, the rules are intuitive and well-intentioned, but a closer look reveals that they are easy to manipulate, counterproductive, and often interact with one another, and with other regulatory goals, in unintended ways. As a result, five years after the passage of Dodd-Frank, the decades-old goal of aligning pay with performance remains elusive.
Executive Compensation: Paying High For Low Performance – Introduction
The heads of CBS, Discovery Communications and Viacom had the distinction of being the three highest-paid American CEOs in 2014.1 At a cool $255 million, the media CEOs’ combined payout looks impressive even when compared to Hollywood’s top-paid stars, Robert Downey, Jr., Dwayne Johnson and Bradley Cooper, who together took in $172 million over a similar twelve-month period.2 These figures might cause even Iron Man’s jaw to drop, but the real problem lies elsewhere. While the actors are guaranteed to draw crowds to the box office, the stock of all three companies lagged the overall market by a large margin and even lost value for the year.
Most would agree that CEOs should not receive outsized pay when their companies underperform. And yet, company boards, shareholders and policymakers have been trying, and largely failing, to put this simple principle into effect for decades. After the recent financial crisis, the Dodd-Frank Act of 2010 aimed to embed the “pay for performance” mantra firmly into federal law. Five years on, we find that the main result has been a thicker executive compensation rulebook, more complex pay structures, and a heavy compliance burden that is only set to increase as a result of major recent SEC initiatives. These include the controversial pay ratio disclosure rule adopted by the SEC on August 5, 2015,4 and proposed rules on the clawback of certain incentive-based executive compensation5 and on additional pay-for-performance disclosure,6 released in July and April 2015, respectively.
Unfortunately, the link between pay and performance is as elusive as ever. Turning back to Hollywood, the median pay of the CEOs of the eleven major media companies was $32.9 million in 2014, by far the highest of any industry group in the S&P 500 index. At the same time, the median total return of those companies was only 10.8%, more than 20% lower than the S&P 500 average of 13.7%. The problem isn’t confined to the entertainment industry. A recent study found that firms headed by CEOs whose pay is in the top 10% in a given year subsequently suffer an 8% drop in stock value in each of the following three years. Indeed, an examination of the most recent developments relating to Dodd-Frank’s four most consequential executive compensation reforms reveals that – much like prior efforts in this area – the Act is proving to be ineffectual, counterproductive, or simply easy to manipulate.
To be sure, Dodd-Frank’s reforms may be well-intentioned and even logical when viewed in isolation. But when implemented within the complex regulatory domains of corporate governance and taxation, where economic actors have strong pecuniary incentives to come up with ways to undercut or evade the rules, the reforms add extra layers of complexity and expense for public companies, without getting us much closer to implementing the pay for performance paradigm in practice.
After decades of attempting to align pay with performance chiefly via enhanced corporate disclosure requirements, Congress and the SEC changed tack in 2010 and sought help from firms’ shareholders via the new say-on-pay regime. The say-on-pay requirement is Dodd-Frank’s most visible and innovative pay-related provision. It requires companies to hold a shareholder vote on executive compensation and golden parachutes at least once every three years. The concept is intuitive enough. Shareholders stand to gain the most from strong corporate performance, and they also stand to lose the most from oversized pay or poor performance. In theory, therefore, shareholders should have a strong incentive to monitor executive compensation and corporate performance, and, if dissatisfied, to vote pay practices down. In reality, however, say-on-pay hasn’t lived up to its promise. Shareholders are almost guaranteed to support existing pay arrangements: in the four proxy seasons between 2011 and 2014, less than 3% of all shareholder votes at Russell 3000 companies resulted in a rejection of current executive compensation arrangements.10 This outcome is even more striking when considered alongside the fact that the largest proxy adviser, Institutional Shareholder Services, recommended a negative say-on-pay vote for 12-14% of the companies holding votes during these four years.
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