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Abstract:
Currently, we are in the midst of a reexamination of chief executive officer (CEO) remuneration that has more than the usual amount of energy and substance. While much of the fury over CEO pay has been aimed at executives associated with accounting scandals and collapses in the prices of their company's shares, the controversies over GE CEO Jack Welch and NYSE CEO Richard Grasso signal a watershed. In their cases the competence and performance of both men were unquestioned: the issue seems to be the perception that they received "too much" and that there was inadequate disclosure.

We provide, history, analysis and over three dozen recommendations for reforming the system surrounding executive compensation.

Section I introduces a conceptual framework for analyzing remuneration and incentives in organizations. We then analyze the agency problems between managers and shareholders and between board members and shareholders, and discuss how well designed pay packages can mitigate the former while well designed corporate governance policies and processes can mitigate the latter. We say "mitigate" because no solutions will eliminate these agency problems completely. Since bad governance can easily lead to value destroying pay practices our discussion includes analyses of corporate governance as well as pay design. Because optimal remuneration policies cannot be designed and managed without consideration of the powerful relations and interactions between the financial markets and the firm, its top-level executives and the board, we devote significant space to these factors.

Section II offers a brief history of executive remuneration from 1970 to the present. Section III examines and explains the forces behind the US-led escalation in share options. We argue that boards and managers falsely perceive stock options to be inexpensive because of accounting and cash-flow considerations and, as a result, too many options have been awarded to too many people.

Section IV defines and discusses the agency costs of overvalued equity as the source of recent corporate scandals. Agency problems associated with overvalued equity are aggravated when managers have large holdings of stock or options. Because neither the market for corporate control or the usual incentive compensation systems can solve the agency problems of overvalued equity, they must be resolved by corporate governance systems. And few governance systems were strong enough to solve the problems. As the overvalued equity problem illustrates, while remuneration can be a solution to agency problems, it can also be a source of agency problems.

Section V discusses several widespread problems with pay processes and practices, and suggests changes in both corporate governance and pay design to mitigate such problems: including problems with the appointment and pay-setting process, problems with equity-based pay plans, and problems with the design of traditional bonus plans. We show how traditional plans encourage managers to ignore the cost of capital, manage earnings in ways that destroy value, and take actions to deceive investors and capital markets.

Section VI defines and analyzes a new concept: what we call the Strategic Value Accountability issue. This is the accountability for making the link between strategy formulation and choice and the value consequences of those choices - basically the link between internal managers and external capital markets. The critical importance of this accountability, its assignment, and its implications for performance measurement and remuneration have long been unrecognized and therefore ignored in most organizations.

Section VII analyzes the complex relationships between managers, analysts, and the capital market, the incentives firms have to manage earnings to meet or beat analyst forecasts, and shows how managers playing the earnings-management game systematically erode the integrity of their organization and destroy organizational value. We highlight the puzzling equilibrium in this market that seems to suggest collusion between analysts and managers at the expense of investors - an area that is ripe for further research.

Executive Remuneration, Remuneration Policies, Audit Committee, Incentives, Compensation, Incentives, Strategic Value Accountability, Share options, Overvalued Equity, Earnings Game, Corporate Fraud, Corporate Scandals, Overpayment, Agency Costs, Agency problems, Corporate Governance

Abstract:
This paper summarizes the empirical and theoretical research on executive compensation and provides a comprehensive and up-to-date description of pay practices (and trends in pay practices) for chief executive officers (CEOs). Topics discussed include the level and structure of CEO pay (including detailed analyses of annual bonus plans, executive stock options, and option valuation), international pay differences, the pay-setting process, the relation between CEO pay and firm performance ("pay-performance sensitivities"), the relation between sensitivities and subsequent firm performance, relative performance evaluation, executive turnover, and the politics of CEO pay.

Abstract:
A thorough understanding of internal incentive structures is critical to developing a viable theory of the firm, since these incentives determine to a large extent how individuals inside an organization behave. Many common features of organizational incentive systems are not easily explained by traditional economic theory--including egalitarian pay systems in which compensation is largely independent of performance, the overwhelming use of promotion-based incentive systems, the absence of up-front fees for jobs and effective bonding contracts, and the general reluctance of employers to fire, penalize, or give poor performance evaluations to employees. Typical explanations for these practices offered by behaviorists and practitioners are distinctly uneconomic--focusing on notions such as fairness, equity, morale, trust, social responsibility, and culture. The challenge to economists is to provide viable economic explanations for these practices or to integrate these alternative notions into the traditional economic model.

Abstract:
Paying top executives better would eventually mean paying them more. The arrival of spring means yet another round in the national debate over executive compensation. Soon the business press will trumpet answers to the questions it asks every year: Who were the highest paid CEOs? How many executives made more than a million dollars? Who received the biggest raises? Political figures, union leaders, and consumer activists will issue now-familiar denunciations of executive salaries and urge that directors curb top-level pay in the interests of social equity and statesmanship. The critics have it wrong. There are serious problems with CEO compensation, but excessive pay is not the biggest issue. The relentless focus on how much CEOs are paid diverts public attention from the real problem--how CEOs are paid. In most publicly held companies, the compensation of top executives is virtually independent of performance. On average, corporate America pays its most important leaders like bureaucrats. Is it any wonder then that so many CEOs act like bureaucrats rather than the value-maximizing entrepreneurs companies need to enhance their standing in world markets? We recently completed an in-depth statistical analysis of executive compensation. Our study incorporates data on thousands of CEOs spanning five decades. The base sample consists of information on salaries and bonuses for 2,505 CEOs in 1,400 publicly held companies from 1974 through 1988. We also collected data on stock options and stock ownership for CEOs of the 430 largest publicly held companies in 1988. In addition, we drew on compensation data for executives at more than 700 public companies for the period 1934 through 1938.

Abstract:
We combine Simon's conception of relational contracts with Grossman and Hart's focus on asset ownership. We analyze whether transactions should occur under vertical integration or non-integration, and with or without self-enforcing relational contracts. These four models allow us to re-run the horse race Coase proposed between markets and firms as alternative governance structures, but with four horses rather than two. We find that efficient ownership patterns are determined in part by the relational contracts that ownership facilitates, that vertical integration is an efficient response to widely varying supply prices, and that high-powered incentives create bigger reneging temptations under integration than under non-integration.

Note: this paper was formerly titled "Implicit Contracts and the Theory of the Firm"

Abstract:
Our estimates of the pay-performance relation (including pay, options, stockholdings, and dismissal) for chief executive officers indicate that CEO wealth changes $3.25 for every $1,000 change in shareholder wealth. Although the incentives generated by stock ownership are large relative to pay and dismissal incentives, most CEOs hold trivial fractions of their firms' stock, and ownership levels have declined over the past 50 years. We hypothesize that public and private political forces impose constraints that reduce the pay-performance sensitivity. Declines in both the pay-performance relation and the level of CEO pay since the 1930s are consistent with this hypothesis.

Abstract:
We employ a certainty-equivalence framework to analyze the cost, value and pay/performance sensitivity of non-tradable options held by undiversified, risk-averse executives. We derive "Executive Value" lines, the risk-adjusted analogs to Black-Scholes lines. We show that distinguishing between "executive value" and "company cost" provides insight into many issue regarding stock option practice including: executive views about Black-Scholes values; tradeoffs between options, restricted stock and cash; exercise price policies; option repricings; early exercise policies and decisions; and the length of vesting periods. It also leads to reinterpretations of both cross-sectional facts and longitudinal trends in the level of executive compensation.

executive compensation, incentives, stock options, risk aversion

Abstract:
We employ a certainty-equivalence framework to analyze the cost and value of, and pay/performance incentives provided by, non-tradable options held by undiversified, risk-averse executives. We derive Executive Value' lines, the risk-adjusted analogues to Black-Scholes lines, and distinguish between executive value' and company cost.' We demonstrate that the divergence between the value and cost of options explains, or provides insight into, virtually every major issue regarding stock option practice including: executive views about Black-Scholes measures of options; tradeoffs between options, stock and cash; exercise price policies; connections between the pay-setting process and exercise price policies; institutional investor views regarding options and restricted stock; option repricings; early exercise policies and decisions; and the length of vesting periods. It also leads to reinterpretations of both cross-sectional facts and longitudinal trends in the level of executive compensation.

Abstract:
We employ a certainty-equivalence framework to analyze the cost, value and pay/performance sensitivity of non-tradable options held by undiversified, risk-averse executives. We derive "Executive Value" lines, the risk-adjusted analogues to Black-Scholes lines. We show that distinguishing between "executive value" and "company cost" provides insight into many issue regarding stock option practice including: executive views about Black-Scholes values; tradeoffs between options, restricted stock and cash; exercise price policies; option repricings; early exercise policies and decisions; and the length of vesting periods. It also leads to reinterpretations of both cross-sectional facts and longitudinal trends in the level of executive compensation.

Executive Compensation, Incentives, Stock Options, Risk Aversion

Abstract:
The trouble with options is that too many options are granted to too many people. Most options are granted below the top-executive level, and options are often an inefficient way to attract, retain and motivate executives and (especially) lower-level employees. Why, then, are options so prevalent? We discuss several explanations including changes in corporate governance, reporting requirements, taxes, the bull market and managerial rent-seeking. We also offer an alternative hypothesis that we believe explains the over-use of options and several apparent puzzles: boards and managers falsely perceive stock options to be inexpensive because of accounting and cash-flow considerations.

Abstract:
The trouble with options is that too many options are granted to too many people. Most options are granted below the top-executive level, and options are often an inefficient way to attract, retain and motivate executives and (especially) lower-level employees. Why, then, are options so prevalent? We discuss several explanations including changes in corporate governance, reporting requirements, taxes, the bull market and managerial rent-seeking. We also offer an alternative hypothesis that we believe explains the over-use of options and several apparent puzzles: boards and managers falsely perceive stock options to be inexpensive because of accounting and cash-flow considerations.

Executive compensation, stock options, equity-based pay, CEO pay, corporate governance, executive labor markets

Abstract:
Research in incentives has focused on performance measures and pay-performance sensitivities but has largely ignored a third significant dimension: the performance standard. Performance standards generate important incentives whenever plan participants can influence the standard-setting process. I describe management bonus contracts and the role of performance standards, distinguishing between "internally determined" standards that are directly affected by management actions in the current or prior year, and "externally determined" standards that are less easily affected. I show that companies choose external standards when prior-year performance is a noisy estimate of contemporaneous performance. In addition, companies using budget-based and other internally determined performance standards have less-variable bonus payouts, and are more likely to smooth earnings from year to year, than companies using externally determined standards.

Abstract:
We examine the role of discretion in executive incentive contracts, and explore the trade-offs firms face in choosing among imperfect objective measures of individual performance, potentially more accurate but non-verifiable subjective measures, and overly broad objective measures of company-wide performance that include the performance of all agents in the firm. We generate implications and test the model empirically using a proprietary dataset of executive bonus plans. Consistent with our model, we find that discretion is less important in determining CEO pay than the pay of other executives. We also find that discretion is relatively important in determining executive bonuses at larger and privately held firms and that more diversified firms are relatively less likely to compensate their business unit managers based on firm-wide performance. Finally, we consider (and largely dismiss) tax-related explanations for our results.

Discretion; Subjective performance valuation; Executive compensation

Abstract:
Although exercise prices for executive stock options can be set either below or above the grant-date market price, in practice virtually all options are granted at the money. We offer an economic rationale for this apparent puzzle, by showing that pay-to-performance incentives for risk-averse, undiversified executives are typically maximized by setting exercise prices at (or near) the grant-date market price. We provide an operationally useful alternative to Black-Scholes (1973) for the purpose of both valuing executive stock options and measuring the incentives created by options. Our framework has implications not only for exercise-price policies, but also for indexed options, option repricings, exchanges of cash for stock-based compensation, and the design of bonus plans.

Abstract:
Although exercise prices for executive stock options can be set either below or above the grant-date market price, in practice virtually all options are granted at the money. We offer an economic rationale for this apparent puzzle, by showing that pay-to-performance incentives for risk-averse undiversified executives are typically maximized by setting exercise prices at (or near) the grant-date market price. We provide an operationally useful alternative to Black-Scholes (1973) for the purpose of both valuing executive stock options and measuring the incentives created by options. Our framework has implications not only for exercise-price policies, but also for indexed options, option repricings, exchanges of cash for stock-based compensation, and the design of bonus plans.

Abstract:
Although exercise prices for executive stock options can be set either below or above the grant-date market price, in practice virtually all options are granted at the money. We offer an economic rationale for this apparent puzzle, by showing that pay-to-performance incentives for risk-averse, undiversified executives are typically maximized by setting exercise prices at (or near) the grant-date market price. We provide an operationally useful alternative to Black-Scholes (1973) for the purpose of both valuing executive stock options and measuring the incentives created by options. Our framework has implications not only for exercise-price policies, but also for indexed options, option repricings, exchanges of cash for stock-based compensation, and the design of bonus plans.

Abstract:
Executive compensation consultants face potential conflicts of interest that can lead to higher recommended levels of CEO pay, including the desires to “cross-sell” services and to secure “repeat business.” We find evidence in both the US and Canada that CEO pay is higher in companies where the consultant provides other services, and that pay is higher in Canadian firms when the fees paid to consultants for other services are large relative to the fees for executive-compensation services. Contrary to expectations, we find that pay is higher in US firms where the consultant works for the board rather than for management.

Executive Compensation, Compensation Consultants, Conflicts of Interest, CEO Pay, board of directors, director pay, corporate governance, disclosure

Abstract:
This paper reconciles three pronounced trends in U.S. corporate governance: the increase in pay levels for top executives, the increasing prevalence of appointing CEOs through external hiring rather than internal promotions, and the increased prevalence of hiring outside CEOs with prior experience as CEOs. We propose that these trends reflect a shift in the relative importance of "managerial ability" (CEO skills transferable across companies) and "firm-specific human capital" (valuable only within the organization). We show that if the supply of workers in the corporate sector is relatively elastic, an increase in the relative importance of managerial ability leads to fewer promotions, more external hires, and an increase in equilibrium average wages for CEOs. We test our model using CEO pay and turnover data from 1970 to 2000. We show that CEO compensation is higher for CEOs hired from outside their firm, and for CEOs in industries where outside hiring is prevalent.

Executive Compensation, Executive Turnover, Human Capital, Matching, Firm-specific capial, managerial labor market

Abstract:
In about one-third of US IPOs between 1996 and 2000, executives received stock options with an exercise price set equal to the IPO offer price (rather than a price determined by the market). Among firms with such "IPO options", 58 percent of top executives receive a net gain from underpricing, meaning the gain from IPO options exceeds the loss from the dilution of their pre-IPO shareholdings. If executives can influence the IPO offer price, we expect a positive relation between these IPO options and underpricing. Alternatively, executives may be able to influence the timing and terms of their stock options, and this would similarly predict a positive relation between IPO options and underpricing. However, we fail to find any evidence of such a relation. Our results run counter to the emerging literature claiming that managers blatantly take self-serving actions to improve their personal welfare at shareholder expense.

Initial public offering; IPO underpricing; Executive compensation; Stock options

Abstract:
We use new data from recently expanded disclosure rules to analyze the level and structure of compensation for CEOs in 27 countries. We show that U.S. CEOs earn more than their foreign counterparts. The U.S. “pay premium” is explained by differences in firm, industry, and governance characteristics, and the intensive use of incentive compensation in U.S. firms, which in turn seems related to strong legal enforcement and security-market regulation. In addition, we document that CEO pay worldwide is converging to U.S. levels as the premium was sharply reduced from 2000 to 2006.

Executive pay, International pay differences, Corporate governance

Abstract:
Testimony of Kevin J. Murphy before the United States House of Representatives Committee on Financial Services, Hearing on Compensation Structure and Systemic Risk, June 11, 2009.

Executive Compensation, Stock Options, Financial Crisis, Risk

Abstract:
No abstract is available for this paper.

Abstract:
We analyze the role of "implicit contracts" (that is, informal agreements supported by reputation rather than law) both within firms, for example in employment relationships between them, for example as hand-in-glove supplier relationships. We find that the optimal" organizational form is determined largely by what implicit contracts it facilitates. Among other things, we also show that vertical integration is an efficient response to widely varying supply prices. Finally, our model suggests why "management" (that is, the development and implementation of unwritten rules and codes of conduct) is essential in organizations.

Abstract:
Objective measures of performance are seldom perfect. In response, incentive contracts often include important subjective components that mitigate incentive distortions caused by imperfect objective measures. This paper explores the combined use of subjective and objective performance measures in (respectively) implicit and explicit incentive contracts. Naturally, objective and subjective measures often are substitutes, sometimes strikingly so: we show that if objective measures are sufficiently close to perfect then no implicit contracts are feasible (because the firm's fallback position after reneging on an implicit contact is too attractive). We also show, however, that objective and subjective measures can reinforce each other: if objective measures become more accurate then in some circumstances the optimal contract puts more weight on subjective measures (because the improved objective measures increase the value of the ongoing relationship, and so reduce the firm's incentive to renege). We also analyze the use of subjective weights on objective performance measures, and provide case-study evidence consistent with our analyses.

Abstract:
We assert that decision rights in organizations are not contractible: the boss can always overturn a subordinate's decision, so formal authority resides only at the top. Although decision rights cannot be formally delegated, they might be informally delegated through self-enforcing relational contracts. We examine the feasibility of informal authority in two informational environments. We show that different information structures produce different decisions not only because different information is brought to bear in the decision-making process, but also because different information creates different temptations to renege on relational contracts. In addition, we explore the implications of formal delegation achieved through divestitures.

Abstract:
Investment decisions require trading off current expenditures against future revenues. If revenues extend far enough into the future, the executives responsible for designing long-run investment policy may no longer be in office by the time all the revenues are realized. We present evidence that: (1) on average, executives are close to leaving office (relative to the payout period of many investments); (2) bonuses based on accounting earnings constitute an important part of compensation for the typical executive; and (3) executives respond in predictable ways to compensation plans based on accounting measures of earnings. Based on these facts, we hypothesize that existing compensation policy induces executives to reduce investments during their last years in office. In our empirical work, however, we find that investment expenditures on research and development and on advertising tend to be largest in the final years of a CEO's time in office. We offer several possible explanations for this surprising finding.

Abstract:
No abstract is available for this paper.

Abstract:
Ittner, Lambert, and Larcker (J. Accounting Economics (2003)) present compelling evidence that new economy firms rely more on stock-based compensation than do old economy firms, based on 1998 and 1999 data from a proprietary sample of companies. I complement the ILL results by analyzing data over a longer time period (1992-2001) and, more importantly, document the effect of the 2000 market crash on stock-based pay in new economy firms. Finally, I offer evidence supporting the conjecture that differences in pay practices between new and old economy firms reflect accounting considerations, perceived costs, and competitive inertia.

executive compensation, stock options, new economy

Abstract:
We document differences in CEO pay and incentives in the US and the UK for the fiscal year 1997. After controlling for size, sector and managerial position, CEOs in the US earn 35% higher cash compensation and 121% higher total compensation (including share options, etc.). Incentives, too, are higher in the US. The calculated effective ownership percentage (pay-performance sensitivity) in the US implies that the median CEO receives 1.32% of any increase in shareholder wealth compared to 0.25% in the UK. The differences, which are interesting given the similarity of the economies and corporate governance structures, can be largely attributed to greater share option awards in the US arising from institutional and cultural differences between the two countries.

Abstract:
In 1991, defense contractor General Dynamics engaged a new management team which adopted an explicit corporate objective of creating shareholder value. The company tied executive compensation to shareholder wealth creation, and subsequently implemented a strategy that included downsizing, restructuring, and exit. Paying large executive cash bonuses amid layoffs ignited controversy. However, by 1993 shareholders realized gains approaching $4.5 billion, representing a dividend-reinvested return of 553%. The study shows how incentives assist in shaping strategy, illustrates the political costs and economic benefits of downsizing, and demonstrates that even firms in declining industries have substantial opportunities for value creation.

Abstract:
In 1991, defense contractor General Dynamics (GD) adopted an objective of creating shareholder value through downsizing, restructuring, and exit. Facilitating GD's strategy were a new management team and compensation plans that tied executive pay to shareholder wealth creation. The plans became highly controversial as GD's executives reaped rewards amid announcements of layoffs and plant closings. By December 1993, shareholders had realized gains approaching $5 billion, representing a three-year return of 440%. The lessons from the study are applicable not only in firms in the defense industry, but also in firms in a growing number of declining industries saddled with excess capacity.

Abstract:
Disclosure rules adopted by the Securities Exchange Commission in 1992 allowed limited managerial discretion in reporting the value of stock options granted. I provide evidence that managers adopted valuation methodologies that reduced reported or perceived compensation and that also reduced potential accounting charges for stock options. I interpret this evidence as supporting the hypothesis that managers bear non-pecuniary costs from high reported levels of compensation-through increased political or shareholder pressure-and adopt reporting methodologies that reduce these costs.

Abstract:
Disclosure rules adopted by the Securities Exchange Commission in 1992 allowed limited managerial discretion in reporting the value of stock options granted. I provide evidence that managers adopted valuation methodologies that reduced reported or perceived compensation and that also reduced potential accounting charges for stock options. I interpret this evidence as supporting the hypothesis that managers bear non-pecuniary costs from high reported levels of compensation--through increased political or shareholder pressure--and adopt reporting methodologies that reduce these costs.

Abstract:
Shareholders, taxpayers, consumers and voters must be wary of wolves dressed in sheepskin currently attacking executive compensation to achieve their own ends. Many assert that executives are overpaid and paid in a way that is independent of performance. Noteworthy is the lack of accusation of fraud or illegal behavior. Most important, the attack has excited little support on the part of shareholders, who, after all, pay the bill. Shareholders recognize that there is no issue, a conclusion supported by the best scientific evidence currently available. The consensus of more than 60 leading academicians at a recent University of Rochester conference was that executive salaries are determined by the market, and that changes in compensation are strongly related to company performance. Moreover, no one expressed concern that compensation was too
high.

CEO Compensation, executive compensation, corruption, fraud