Download EXECUTIVE COMPENSATION, CORPORATE ... and more Exams Corporate Finance in PDF only on Docsity!
EXECUTIVE COMPENSATION,
CORPORATE GOVERNANCE, AND
THE PARTNER-MANAGER
Richard A. Booth*
In the debate over executive compensation, the assumption
seems to be that the CEO of a publicly traded corporation is ulti-
mately an employee of the corporation. According to the conven-
tional view, the business belongs to the stockholders. Executive com-
pensation is an expense like any other business expense that must be
subtracted from income in reckoning stockholder return. The central
problem has been that the CEO has too much power, and the board
of directors has not acted as an effective monitor. Thus, the problem
of executive compensation appears to be a thinly disguised problem
of self-dealing.
Professor Booth argues here that partnership law offers an al-
ternative model that may explain some of the more puzzling aspects
of executive compensation. Simply stated, if one sees a publicly
traded corporation as a partnership between management and stock-
holders, the fact that a substantial share of gains goes to management
does not seem problematic. For example, it is well-known that using
stock options as the primary form of executive compensation serves
the purpose of focusing a CEO on stock price rather than second best
metrics such as earnings or assets. What is less well-recognized is that
options also force managers to assume additional risk. As a result,
CEOs naturally insist on the prospect of greater returns. In effect,
CEOs have bargained for a substantial piece of the action. They have
come to insist on returns more consistent with those of a partner
rather than an employee. It should thus come as no surprise that suc-
cess will be more richly rewarded.
In addition, Professor Booth addresses several misconceptions
about executive compensation that may be clarified somewhat by the
partnership model. First, he shows that in the aggregate, executive
compensation (including option-based compensation) has been re-
markably stable over the last twenty years, suggesting that the percep-
tion of excess may be the result of redistribution and undue focus on
those who have gained from the evolution to options. Second, he ar-
- Professor of Law, University of Maryland School of Law.
270 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2005
gues that unlike other forms of compensation, stock options are self- regulating and thus inherently less worrisome than other more fixed forms of compensation. Finally, he contends that the partnership model of the corporation sheds new light on the debate over how to account for stock options. If stock options are seen as a way for CEOs and other high-level managers to participate as equity partners in company returns, it makes little sense to treat the grant of stock op- tions as an expense that reduces reported earnings.
I. INTRODUCTION
Executive compensation has always been a problem for corporation
law as it relates to publicly traded companies because CEOs effectively
set their own salaries. The traditional view is that executive compensa-
tion is akin to a duty of loyalty problem, albeit one based on an unavoid-
able structural conflict of interest.^1 That view is ultimately based on the
idea that a corporation is owned by its shareholders. The shareholders
elect the board of directors. The board of directors hires a CEO who as-
sembles a management team. Under this view the shareholders are enti-
tled to the return generated by the corporation except to the extent that
they may agree to share it with management. In short, the CEO is a
hired gun.^2
To be sure, the board of directors, which has the ultimate authority
to decide how much to pay the CEO, is supposed to act as a check on
CEO overreaching. As a matter of good practice, the CEO should not
be involved in that decision (although presumably the CEO may negoti-
ate on his own behalf). But most boards of directors are handpicked by
the CEO and largely are under the CEO’s control. Even if the board of
directors has a nominating committee or other procedures designed to
ensure independence, the relationship between the board of directors
and the CEO is not ultimately an adversarial one.^3
- For example, the ALI, Principles of Corporate Governance, treats compensation decisions under the duty of fair dealing. PRINCIPLES OF CORPORATE GOVERNANCE: A NALYSIS AND RECOMMENDATIONS § 5.03 (1994). On the other hand, Delaware law tends to ignore such structural conflicts and to apply the duty of care and the business judgment rule to situations in which conflict is unavoidable. Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720–22 (Del. 1971); s ee also Larry E. Rib- stein, Why Corporations? , 1 BERKELEY L.J. 183, 199–200 (2004); Lucian Arye Bebchuk et al., Mana- gerial Power and Rent Extraction in the Design of Executive Compensation , 69 U. CHI. L. REV. 751, 754 (2002).
- In this essay, I focus on the CEO rather than the entire management team even though com- pensation problems may extend beyond the CEO. I do so to some extent out of convenience. In other words, one may usually substitute the phrase “management team” wherever CEO appears. On the other hand, the CEO typically presents the most acute compensation problem. First, the CEO typically gets the biggest pay package. Second, and more important, the CEO may serve as an inde- pendent arbiter in connection with compensation decisions for all lower-level executives. Thus, the only truly unavoidable conflict of interest problems relate to CEO compensation.
- The typical board is more an advisory body that seldom meets more than once a month and whose primary function is to advise and monitor the CEO rather than engage in active management. Although the relationship may be acrimonious at times, it is not intended to be so. Teamwork and
272 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2005
One can push the analogy even further. A CEO who accepts com-
pensation mostly in the form of options, in effect, works primarily for a
share of the growth of the company—just as a new partner buys into an
existing firm in order to gain a share of the profits going forward. As in a
partnership, the optionee must make a significant capital contribution to
the company when exercising options. To be sure, the CEO need not
pony up any money until it is known whether stock price has increased
and the options are in the money.^8 Thus, the CEO bears no risk of loss
other than the risk of being paid a minimal salary. But that is not an un-
usual arrangement even in a true partnership following the advent of the
LLP.^9 Moreover, the risk of minimal pay may be equivalent to the risk of
loss if the CEO could have negotiated for a higher fixed salary. And the
risk of being fired may be even more significant than the risk of financial
loss that attends a classic partnership. In a partnership one remains a
partner even if the business has losses. It is quite unusual for a partner to
be fired.^10
Which view of the CEO’s relationship to the company is the more
accurate? Which view best comports with what the shareholders want?
And, is that the proper criterion? Do shareholders want managers who
view themselves as employees working primarily for a salary, or do they
want managers who view themselves as partners working for a share of
the company? It is not clear that we must choose between these models.
The answer may depend on the company. The traditional model may
better fit an established company, while the partnership model may bet-
ter fit a growth company.^11 Or it may be a matter for negotiation. Some
executives may prefer to work for a salary and bonus. Others may prefer
to work for an ownership interest.
Restricted Stock , WALL S T. J., Mar. 3, 2003, at B1 (documenting the trend away from granting options among twenty-nine major U.S. corporations).
- If the company does not increase in value, neither will its stock. If the company simply chugs along meeting expectations, stock price should not rise. In effect, the shareholders maintain their capi- tal contribution, and the services partner gets nothing. Of course, stock price may rise because divi- dends are withheld or because the market as a whole rises. Indeed, for this reason, options may dis- courage dividends. But it is easy to control for such manipulation, as well as for supposed windfall gains from a rising market (though it is not clear that one should control for the latter). 9_. See generally_ Stephen M. Bainbridge, Contractarianism in the Business Associations Class- room: Kovacik v. Reed and the Allocation of Capital Losses in Service Partnerships , 34 GA. L. REV. 631, 667 (2000).
- The partnership model is also consistent with increased mobility of the labor force in which know-how and information may be more important than hard assets. The analogy of a law firm part- ner who is more or less free to move around with her clients comes to mind. A law firm partner is nonetheless somewhat bound to the firm by capital contribution and works in progress. See, e.g. , Meehan v. Shaughnessy, 535 N.E.2d 1255, 1261 (Mass. 1989). 11_. See_ RIBSTEIN , supra note 1, at 196; cf. Ronald J. Gilson, Evaluating Dual Class Common Stock: The Relevance of Substitutes , 73 VA. L. REV. 807, 824–32 (1987) (suggesting that takeover de- fenses such as dual class stock may be a legitimate defense for a growing company that has natural incentives to meet investor demands, whereas such defenses may not be appropriate for a mature company that has little need for new capital and thus need not please the market).
No. 1] EXECUTIVE COMPENSATION 273
Models matter. Although a model may be developed in an effort to
explain a puzzle of academic interest, a model may come to be so ac-
cepted that its implications affect the evolution of law. The idea, for ex-
ample, that a corporation is owned by its shareholders is ultimately a
model, but it has real world implications. How we view the relationship
between a CEO and a corporation, and the proper function of options
within that relationship, may also have real world implications. For ex-
ample, if options are viewed as a way of working for a share of the busi-
ness rather than as a substitute for cash compensation, the argument that
an option grant should be treated as an expense for accounting purposes
makes little sense.
Recent history suggests that the partnership model of executive
compensation has been gaining ground on the traditional model.^12 The
cynical view of this trend is that it is the result of management opportun-
ism enabled by a variety of accounting and tax gimmicks. But there is
another much more compelling view. Indeed, one can argue that the
trend toward equity compensation was and is necessitated by the invigo-
ration of the market for corporate control that began in the late 1960s.
II. T HE RISE OF O PTIONS AS COMPENSATION
To make a long story short, the rise of hostile takeovers forced
CEOs to focus on stock price and ultimately induced a shift to compensa-
tion packages heavy on the stock options to encourage CEOs to maxi-
mize share value. But the long version of the story is much more inter-
esting.
The story begins with the rise of hostile takeovers, which began in
the late 1960s and peaked in the 1980s, though the roots of the takeover
movement can be traced to the 1950s. There were three primary factors
that fueled takeovers.
The first factor was the growth of highly diversified risk-neutral in-
stitutional investors such as mutual funds and pension plans. As is well-
known, institutional investors came to dominate the market.^13 What is
less well-known is that the rise of diversified institutional investors effec-
tively forced all investors to diversify. Diversified investors avoid com-
12_. See_ Stabile, supra note 4, at 153–58.
- Domestically, institutional investors own sixty percent of equities. UNITED S TATES CENSUS BUREAU, S TATISTICAL A BSTRACT OF THE UNITED S TATES 2003, Table 1198 (2002 data). In that cal- culation, the holdings of nonprofit organizations (which includes the substantial holdings of university foundations, and the like) are grouped with individual investors. Thus, the sixty percent figure is pre- sumably on the low side. To be sure, not all institutional investors are well-diversified. Many com- pany-sponsored pension plans are heavily invested in the stock of the employer company. See John Leland, All the Nest Eggs in One Company Basket: Corning Shows Risk of Betting Fortune on Em- ployer , N.Y. TIMES , Apr. 11, 2004, at 29 (reporting that nationally about twenty-five percent of 401(k) assets are in employer stock, and 11.5% of 401(k) accounts consist almost solely of the stock of the employer); Gretchen Morgenson, Lopsided 401(k)’s All Too Common , N.Y. TIMES , Oct. 5, 2003, at C3.
No. 1] EXECUTIVE COMPENSATION 275
tions did not serve shareholder interests well, and diversified investors
developed a distinct distaste for them.^18 It is much cheaper for share-
holders to diversify than it is for companies to diversify. Shareholders
can easily adjust the mix of companies in which they invest. Why would
they want prepackaged diversification when they could form their own
custom portfolio or choose from thousands of mutual funds? Perhaps
even worse, management of a diversified company tends to be less fo-
cused than that of a company in a single line of business. In other words,
the CEO of a conglomerate company tends to be a jack of all trades but a
master of none. Finally, market analysts have a tough time setting a
value on a collection of companies in a wide variety of businesses.
For all these reasons, the market did not like diversified conglomer-
ate companies and drove down their price relative to more focused com-
panies. Hostile bidders discovered that they were able to sell the pieces
of such companies for more than the price of the whole. And with the
advent of the junk bond market, they could borrow the money to do it. 19
As a result, most such companies are gone as a result of bust-up take-
overs.^20
One early reaction to the threat of hostile takeovers was the golden
parachute, an attractive severance package designed to compensate an
ousted CEO for losing his job. Many commentators saw golden para-
chutes as just another managerial abuse, but some noted that a properly
tailored golden parachute would allow management to consider dispas-
sionately the merits of a takeover bid from the point of view of the
shareholders.^21 It is a small step from the golden parachute to the stock
cheaper for investors to achieve diversification by investing in a conglomerate company. Tax law also precluded shareholders from forming their own investment companies. I.R.C. § 351(e)(1) (2005). All of this suggests that stock options should have been popular at the time, because they were a relatively safe bet. But it does not appear that they were. Rather, managers seem to have been paid primarily on the basis of aggregate earnings or assets, which effectively rewarded empire building. 18_. See, e.g._ , David J. Ravenscraft & F. M. Sherer, The Profitability of Mergers , I NT ’ L J. I NDUS. ORG. 7 (1989).
- There is a potential contradiction here in that I argue that shareholders prefer firm-level lev- erage but dislike firm-level diversification. There is a good reason for the distinction. Diversification is costless for shareholders, but expensive for companies. Leverage is just the opposite. First, compa- nies can often borrow at lower rates of interest than individuals (though admittedly margin rates are very low). Second, margin borrowing is limited by law. Investors may prefer more leverage than they can legally create on their own. Finally, margin borrowing creates the risk of a disruptive margin call. If a company defaults, the damage is isolated to that one company and does not jeopardize the entire portfolio. Company-level leverage affords a variety of limited liability that is similar to that enjoyed by a parent company that does business through several subsidiaries. Thus, investors presumably pre- fer company-level leverage.
- Prominent examples include ATO, ITT, LTV, and Gulf + Western. See Geoffrey Colvin, A Concise History of Management Hooey , FORTUNE, June 28, 2004, at 166; Confused Conglomerates , THE ECONOMIST , Jan. 10, 1987, at 68. But see Peter G. Klein, Were the Acquisitive Conglomerates In- efficient? , 32 RAND J. ECON. 745 (2001) (arguing that conglomerate diversification may have added value during the 1960s—but not thereafter—by creating internal capital markets); Morey W. McDan- iel, Bondholders and Corporate Governance , 41 BUS. LAW. 413 (1986) (arguing that conglomerate companies may gain by coinsuring debt of diverse acquired firms).
- Richard A. Booth, Is There Any Valid Reason Why Target Managers Oppose Tender Offers? , 14 S EC. REG. L.J. 43 (1986).
276 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2005
option as compensation. If golden parachutes are such a good idea, why
not further align management and shareholder interests by using stock
options as the primary form of compensation? Incidentally, stock op-
tions minimize the need for cash and even raise capital for the corpora-
tion upon execution. In any event, managers learned the lessons of the
1980s well, and stock options became the primary form of compensation.
Hostile takeovers may be less common now than they were in the
1980s. The evidence is somewhat equivocal, but the market for corpo-
rate control was even more active in the 1990s than it was in the 1980s.^22
The reasons for mergers and acquisitions changed somewhat. Consolida-
tion and competing in global markets became major motivations. 23 Nev-
ertheless, the process of deconglomeration that began with the bust up
takeover of the 1980s continued during the 1990s through spin-offs and
the issuance of tracking stock.^24 In short, the takeover is not dead. It has
just gone in-house. To be sure, one reason may be that potential target
managers hope to preempt a hostile takeover. But takeover defenses
have become virtually impenetrable. So why does management so often
choose to sell? The simple answer may be stock options and the in-
creased equity stake that so many executives have in their companies.
III. P ROBLEMS WITH O PTIONS AS COMPENSATION
There is a dark side to the foregoing story. Stock options are not
perfect. Even if management could be compensated exclusively with
stock, perfect alignment of interests is impossible. Management interest
will always diverge from shareholder interest because shareholders are
free to diversify. With diversification, an investor can eliminate the risk
that some companies in a portfolio will underperform the market. For
every company that underperforms, there will be another that exceeds
expectations. You win some and you lose some. Only the average really
matters.^25
Thus, a diversified shareholder cares little about risk at the com-
pany level. A diversified shareholder prefers that management maximize
return even if it entails extraordinary risk. For example, if ten companies
each bet the farm on ventures that offer a 50% chance at a 100% return,
half will succeed and half will fail. The diversified shareholder will get
the expected 50% return. But half of the managers will get nothing (ex-
cept possibly fired).
22_. See generally_ John C. Coates IV, Measuring the Domain of Mediating Hierarchy: How Con- testable Are U.S. Public Corporations? , 24 J. CORP. L. 837 (1999); John C. Coates IV, Takeover De- fenses in the Shadow of the Pill: A Critique of the Scientific Evidence , 79 TEX. L. REV. 271 (2000). 23_. See generally_ HAMILTON & BOOTH, supra note 15, at 317–54.
- Susan Pulliam, More Parent Firms Are Setting Units Free, WALL ST. J., Feb. 3, 2000, at C1. 25_. See_ Richard A. Booth, Stockholders, Stakeholders, and Bagholders (Or How Investor Diver- sification Affects Fiduciary Duty) , 53 BUS. LAW. 429 (1998).
278 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2005
negotiate for more options as compensation for added risk, and that pub-
lic companies will come to be owned increasingly by management.
Therefore, it should not come as a surprise that pay packages have grown
significantly.^29
IV. T HE COMPENSATION CONTROVERSY
It seems clear from the foregoing that shareholders today are sel-
dom satisfied with bureaucratic management. A diversified shareholder
has a strong preference for a CEO who acts like he owns the company—
or at least like an equity partner. Thus, shareholders should be willing to
pay the CEO accordingly. Indeed, if you want a CEO to act like an
owner, the CEO should have a meaningful equity stake in the company.
To paraphrase Michael Jensen and Kevin Murphy, “If you pay a CEO
like a bureaucrat, he will act like a bureaucrat.”^30
Shareholders should recognize the need to pay CEOs more. But it
is legitimate to worry about how much more. Substantive regulation of
the amount of pay—for example by the courts—is unlikely to work.
Thus, the controversy has focused on process, disclosure, methods, and
measurement. Some of these efforts have been more controversial than
others. Undoubtedly the most controversial proposed reform has been
that the yearly coefficient of variation (standard deviation / mean) for officer compensation in compa- nies with income is 0.122% while it is 0.330% in companies with a loss. In other words, compensation varies year to year in companies with losses by nearly three times as much as it varies in companies with income, which clearly demonstrates that the risk born by officers is significant. Moreover, officer compensation in companies with losses varies more than the number of companies with losses varies, though less than the amount of loss as a percent of income varies. This is precisely the pattern that would seem desirable in that it indicates that officers would suffer lower pay a bit more from poor per- formance relative to the market as a whole, but would not suffer quite as much from marketwide con- ditions that cause large aggregate losses. On the other hand, management has a variety of ways that it can reduce the risks of options and indeed stock ownership. Insiders are privileged to use inside in- formation in deciding not to buy or sell. See Jesse M. Fried, Insider Abstention , 113 YALE L.J. 455, 455 (2003). And indeed the rules against insider trading have been somewhat softened for management shareholders. See SEC Rules, 17 C.F.R. § 240.1065-1, 240.1065-2 (2004); cf. SEC v. Adler, 137 F.3d 1325, 1337–38 (11th Cir. 1998). It has also been suggested that one reason for the boom in options is that management is largely free to coordinate the grant and exercise of options with lows and highs in market price which themselves are somewhat controllable by management. See Charles M. Yablon & Jennifer Hill, Timing Corporate Disclosures to Maximize Performance-Based Remuneration: A Case of Misaligned Incentives? , 35 WAKE FOREST L. REV. 83, 86–87 (2000). Both of these practices are akin to insider trading. Then again, some commentators have argued that insider trading may be seen as a legitimate form of compensation under many circumstances. See Richard A. Booth, Insider Trading, Better Markets , WALL S T. J., June 28, 1991, at A12; Henry G. Manne, Options? Nah, Try Insider Trad- ing , WALL S T. J., Aug. 2, 2002, at A8.
- Incentive compensation is more important in a publicly traded company than it is in a closely held company. Obviously, those who manage a closely held company usually also own a large stake and keep the returns from it. But both managers and passive investors in a closely held company are usually undiversified and therefore risk averse. They do not necessarily favor high-risk profit maximi- zation over pursuit of a merely adequate return at lesser risk. 30_. See_ Michael C. Jensen & Kevin J. Murphy, CEO Incentives—It’s Not How Much You Pay but How , HARV. BUS. REV ., May–June 1990, at 138; see also Brian J. Hall & Jeffrey B. Liebman, Are CEOs Really Paid Like Bureaucrats? , 113 Q.J. ECON. 653 (1998) (discussing increase in option com- pensation in the 1990s which—notably—followed the Jensen and Murphy article).
No. 1] EXECUTIVE COMPENSATION 279
to require that the grant of stock options be treated as an expense for in-
come statement purposes.^31 It is remarkable that debate over an ac-
counting rule can be so passionate, but the stakes in this case are high.
Although many critics appear to believe in good faith that options should
be expensed as a matter of good accounting practice, there is little doubt
that many think that expensing will serve to limit the use of options by
forcing companies to report lower earnings. To be sure, options have
been less in the news in the last few years because of the bear market. 32
But as the market recovers, they have emerged from hibernation. And
on March 31, 2004, the FASB once again proposed a rule requiring the
expensing of options. 33
The remainder of this section addresses three discrete misconcep-
tions swirling around option-based compensation. First, despite percep-
tions to the contrary, executive pay has not increased significantly as a
percentage of corporate income in the last twenty-five years.^34 Indeed, it
has arguably declined. Second, executive pay is not out of control. Al-
though it is difficult say how much is too much when it comes to a tradi-
tional salary and bonus, there are natural limits on stock options that
make them effectively self-regulating. Third, option grants do not need
to be treated as an expense for accounting purposes. To do so compli-
cates rather than simplifies financial reporting and its interpretation.
A. The Amount of Executive Compensation
As in the classic case Rogers v. Hill , the complaint seems to be that
executive compensation has become excessive because the mechanisms
by which pay is calculated (primarily stock options) are somehow defec-
tive.^35 Management appears to have lost the knack for self-control and
independent boards of directors appear to have been captured by ever
more powerful CEOs. Although executive compensation should be
regulated by the market, takeover defenses are formidable. Moreover,
there may have developed a self-reinforcing pay race to the top in which
each subsequent CEO cites the salary of the last CEO as the number to
beat. Thus, even a truly independent compensation committee advised
by a high-priced compensation consultant will find it difficult to discern
an objective standard by which to set CEO compensation. There ap-
pears to be no natural upper limit. The situation smacks of market fail-
ure and suggests that CEO compensation must ultimately be limited by
31_. See_ Iman Anabtawi, Secret Compensation , 82 N.C. L. Rev. 835 (2004). 32_. See_ Janice Kay McClendon, Bringing the Bulls to Bear: Regulating the Executive Compensa- tion to Realign Management and Shareholders’ Interests and Promote Corporate Long-Term Productiv- ity , 39 WAKE FOREST L. REV. 971, 973–75 (2004).
- EXPOSURE DRAFT , Proposed Statement of Financial Accounting Standards, Share-Based Payment No. 1102-100, § 15 (Financial Accounting Standards Bd. 2004). 34_. See_ Appendix, Table 1: Compensation of Officers—1980 to 2000.
- Rogers v. Hill, 289 U.S. 582 (1933).
No. 1] EXECUTIVE COMPENSATION 281
Second, it may be that the distribution of compensation has
changed. If options are the primary form of compensation, then winners
get more and losers get less (as a percentage of the pot). In other words,
pay may have been redistributed from companies that underperform the
market to companies that outperform the market. Minimal pay at a
company whose stock is flat does not make the news. But a doubling or
tripling of pay at a company whose stock has beaten the market makes
headlines. Moreover, the greater the proportion of pay that is taken in
options, the more risk the recipient assumes. Again, as of 2001, CEOs of
the 200 largest U.S. companies took about ninety percent of their pay in
some form of equity and most of that in options. 38 It thus stands to rea-
son that one who accepts options as compensation will insist on a lot of
them. By the same token, it is unfair to view gain from options as the
dollar-for-dollar equivalent of cash pay. Part of the gain is compensation
for risk. And although one hears plenty about those who win, there are
plenty of losers too. The last two columns of the chart show the percent-
age of companies with a loss and the aggregate loss as a percent of in-
come. The ratio of income to loss is a rough surrogate for the odds of
management success in any given year. For example, in the year 2000,
the last year for which data is available, 24.7% of companies reported no
income compared to 21.0% the prior year. In other words, the odds that
a given company would have a profitable year dropped from about four
in five in 1999 to about three in four in 2000. But aggregate pay in-
creased during the same period from 7.7% of income to 8.3% of income.
Thus, pay tends to be higher as a percentage of net aggregate income in
years in which the odds of success are lower, which is precisely the rela-
tionship one would want to see if pay is designed to encourage managers
to assume risk. 39 Finally, it may be that CEOs have come to command a
larger portion of the pay within individual companies. Perhaps the num-
ber of officers has been reduced or CEO pay has risen while the pay of
lesser officers has remained flat.
Third, many critics have focused on the discrepancy between CEO
pay and the pay of lower-level employees. But it may not be entirely fair
to compare the pay of a CEO even to that of a lower-level officer. To
some extent, a CEO is paid for perseverance—for making it to the top.
The prospect of a significant bonus creates competition. Lower-level of-
ficers work harder than they otherwise might. So some portion—
perhaps most—of a CEO’s pay should be viewed as winnings from an of-
fice pool. It is not necessarily clear that this system of jackpot compensa-
38_. See_ Appendix, Table 1: Compensation of Officers—1980 to 2000; see also I.R.S., supra note 37, at http://www.irs.ustreas.gov/taxstats/article/0,,id=112834,00.html.
- Yet another way to see this relationship is to compare the standard deviation of pay as a per- centage of income (0.7% on a median of 5.8%) with the standard deviation of the percentage of com- panies with losses in a given year (8.3% on a median of 26.3%).
282 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2005
tion is optimal, although it seems to be the norm in many other settings.^40
CEOs undoubtedly want some security, and lower-level officers and em-
ployees presumably want incentives. It is unclear what the mix should
be. But it is quite clear that we should give companies wide berth in de-
vising incentive compensation. 41
Although it is not at all obvious that executive compensation is ex-
cessive, many critics cite two specific problems with the way option plans
work, asserting that option plans tend to inflate the amount of compensa-
tion.
First, many critics argue that because stocks tend to rise and fall
with the market, options tend to overcompensate management when the
market is rising. Thus, they argue that options should be indexed—that
the exercise price should be adjusted upward (or maybe even downward)
by whatever percentage the market has moved. At least a few compa-
nies have modified their option plans accordingly. 42
Commentators have also argued that conventional nonindexed op-
tions are exceedingly expensive for the granting company because a suc-
cessful company ends up issuing very valuable shares at a fraction of the
price for which they could be sold to investors. Saul Levmore notes that
indexed options should be cheaper for the paying company because em-
ployees would avoid the risk of a falling market and would therefore be
willing to accept fewer options. 43 As he also notes, many commentators
have cited accounting rules and tax law as explaining this seemingly
counterproductive compensation strategy, though he doubts, as do I, that
either of these explanations is adequate.^44 Ultimately, Levmore con-
cludes that the relative unpopularity of indexed options is attributable to
the fact that they would lead employees to pursue excessively risky
strategies in an effort to beat the market and would often result in re-
warding employees (or some of them) even though shareholders (and
possibly other employees who accept conventional options) lose.^45
- One of the dangers of jackpot compensation is that observers—including shareholders and fellow employees—will confuse ex post results with an ex ante bargain. We can all be envious of the guy that wins, but it is important to recognize the emotion for what it is.
- Many high technology companies spread the wealth of options quite broadly and thus use many more options. To require that a grant of option be treated as an expense may therefore skew the competition between various forms of compensation. Indeed, the relatively high level of employee ownership in high technology companies may constitute the emergence of a new form of organization akin to partnership in which stock ownership (or option holding) serves as a surrogate for fiduciary duty or intellectual property law. Moreover, options are cheap and tax efficient, and may serve in part to minimize the capital needs of a new business. Thus, the greater danger may be that compensation models will be standardized and that companies that want to follow a different drum beat will be forced into a traditional compensation scheme. If so, we should not use accounting rules to stack the deck in favor of one model or the other. 42_. See_ Saul Levmore, Puzzling Stock Options and Compensation Norms , 149 U. PA. L. REV. 1901, 1906–07 (2001). 43_. Id._ at 1916, 1920. 44_. Id._ at 1908–15. 45_. Id._ at 1922.
284 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2005
idea of options. It is important that options and other incentives be reset
periodically. It is those that are not that turn out to be abusive (as is il-
lustrated in Rogers v. Hill ).^52 Again, it is common in a partnership for
partners to renegotiate periodically the way they share the gains. Thus,
repricing may be easier to understand if one thinks of a CEO and the
shareholders as partners.
Admittedly, the arguments against indexing on the upside would
also seem to argue against repricing on the downside. But it does not
necessarily follow that repricing is abusive just because indexing is a bad
idea. The truth is more complicated. If the market as a whole falls (as
we have seen that it can), it takes most stocks with it. Thus, options may
fall far out of the money for reasons having nothing to do with bad man-
agement. Moreover, even if the market price has fallen while the rest of
the market has risen, who is to say that a stock’s price might not have
fallen even further but for the efforts of the management team? Indeed,
it is arguable that a well-crafted option plan should be indexed down-
ward but not upward.
Finally, options entail more risk for managers who cannot diversify
than for shareholders who can. Repricing may thus be seen as a way of
managing the risk faced by managers and, in fact, making their position
more consistent with that of shareholders. Diversified shareholders do
not really assume the risk of business failure. It is not clear that an opti-
mal compensation system requires that managers must do so. For exam-
ple, a CEO might agree to accept a smaller number of options in ex-
change for some protection on the downside. Even if management is
responsible for the decline in the stock price, it is not obviously abusive
for the board to grant additional options as an incentive to reverse the
decline. Indeed, it may be important to offer a bigger stake if the com-
pany is playing catch up. Indexing could in theory avoid the need for re-
pricing but at the cost of eliminating any reward on the upside for good
performance that falls short of beating the market average.
There are no easy answers here. In the end, the wisdom of repricing
is a decision that must be trusted to the sound business judgment of the
board. After all, the board can always sack the CEO, and does so from
time to time. But incentives usually work better than penalties. Again,
although repricing seems inconsistent with the hired-gun management
model, it is much more palatable if one views the relationship between
the CEO and the shareholders as a partnership.
123 (Financial Accounting Standards Bd. 1995). The need for repricing often stems from some limita- tion on the number of shares authorized in the articles of incorporation or the stock option plan. See, e.g. , Lewis v. Anderson, 692 F.2d 1267, 1269 (9th Cir. 1982). Repricing may also be a way of avoiding the appearance of making an unusually large grant following a decline in market price.
- Rogers v. Hill, 289 U.S. 582, 591 (1933) (“[T]he payments under the by-law have by reason of increase of profits become so large as to warrant investigation in equity in the interest of the com- pany.... [The by-law]... cannot... be used to justify payments of sums as salaries so large as in sub- stance and effect to amount to spoliation or waste of corporate property.”).
No. 1] EXECUTIVE COMPENSATION 285
B. Self-Regulation and Optimal Incentives
Even if management effectively sets its own pay, it does not follow
that executive compensation is out of control. One of the distinct advan-
tages of options as compensation is that they are self-regulating. No ra-
tional CEO would ever seek so much in options that the grant would de-
press the price of the company’s stock. Aside from the fact that it would
reduce the value of the options themselves, the company would be that
much more exposed to takeover because of a lower stock price. Rather,
an utterly self-interested CEO would seek options that would maximize
gain by balancing the forces of dilution against anticipated increases in
stock price.^53 This is not to deny that sometimes companies may propose
plans that are too rich, but the market will likely veto any such plan.^54
- One might think that any grant of options would have the effect of depressing stock price simply because of potential dilution. But an option will be exercised only if the price of the stock rises. Thus, there is no danger of dilution unless the price rises and no reason for the mere grant of options at market to ever cause the price of a stock to fall. (On the other hand, one might argue that a stock’s price inherently includes anticipated future price increases, and that a grant of options could thus de- press stock price. This is a classic example of “double think.” To the extent that the price of a stock reflects anticipated future growth, it is already impounded in the stock price. Furthermore, growth will result in further increases in the future.) As time passes, however, dilution becomes a concern because in-the-money options are likely to be exercised and to dilute per share returns (irrespective of how they are reported). On the other hand, exercise entails payment of the option price to the corpo- ration and increases firm value accordingly, but never by quite enough to counter fully the effects of dilution. There are two ways to deal with this problem. One solution is to do nothing. As long as earnings per share meet expectations, there should be no adverse effect on stock price. In other words, some- times a company will be able to absorb the effects of dilution. Another, more common, way to deal with dilution is to repurchase stock (either directly or by using various derivative strategies). By re- ducing public float, a company may eliminate the effects of dilution. It is even possible by such means to report higher earnings per share and thus (presumably) to cause the stock price to rise, making op- tions that much more valuable. While such practices are common—at least to the extent of countering dilution—they have been criticized strongly as the next thing to insider trading when used to prop up or enhance market price (even though the practice is perfectly legal). See Jesse M. Fried, Insider Sig- naling and Insider Trading with Repurchase Tender Offers , 67 U. CHI. L. REV. 421 (2000) (discussing repurchase tender offers); see also Bebchuk et al., supra note 1, at 796–824. Such practices may also be viewed in a much more positive light as part of a complex self-regulating system of executive compen- sation. There is a limit to the amount of cash available to management for use in countering the forces of dilution. For example, it was reported in one recent year that Microsoft had used cash in an amount roughly equal to two-thirds of the year’s earnings to repurchase stock and equivalents in connection with managing dilution. Roger Lowenstein, Intrinsic Value: Microsoft and Its Two Constituencies , W ALL ST. J., Dec. 4, 1997, at C1. Presumably, management has every incentive to modulate option grants in accordance with the cash available to counteract dilution as well as the other cash needs of the business. It also bears noting that management must fight dilution whether or not options are exercised. Thus, a fair amount of planning is required. Accordingly, one could argue that investors should view a generous grant of op- tions as a positive signal of the prospects of the company rather than a sign of reprehensible manage- ment opportunism. Options effectively force companies to distribute available cash through repur- chase, thus achieving one of the ultimate goals that motivated many hostile takeovers in the 1980s. (Most commentators favor repurchases over dividends as a more efficient mode of distribution, al- though the arguments for repurchases are somewhat less powerful now that the tax rates applicable to dividends and capital gains have been equalized). The use of options as compensation thus tends to foster a liberal distribution policy in addition to beneficial company-level strategies such as spin-offs. To be sure, options may discourage the payment of dividends, because dividends have the effect of decreasing stock price. Thus, a well-crafted option plan should provide for adjustment of exercise
No. 1] EXECUTIVE COMPENSATION 287
shareholders as a dividend and sacrificed a significant tax benefit.^58 Man-
agement argued that the market would react adversely if the loss were
taken (as if the market did not already know what the DLJ stock was
worth). As it turned out, the American Express bonus plan paid man-
agement based on earnings.
Stock options focus management attention where it belongs—on
maximizing the value of the company rather than on second-best indica-
tors like sales or earnings. It is difficult to believe that so many compa-
nies in the 1990s would have been so quick to spin off underperforming
divisions, or to split themselves into pieces, if management had not been
induced to maximize share price by taking most of its compensation in
the form of options. Again, a partnership analogy comes to mind. It is
relatively easy to dissolve a partnership and divvy up the assets. Thus, a
partnership tends to be a much more fluid collection of assets.
In any event, it would seem counterproductive to discourage the use
of options in favor of basing compensation on some highly manipulable
number like earnings, particularly at a time when earnings manipulation
seems to be the real problem. Indeed, because stock options ultimately
depend on the stock market, which is exceedingly difficult to manipulate,
they are essentially self-regulating. That is not to say that managers do
not try to fool the market. But it is unclear that they often succeed. To
be sure, this may sound like a strange claim in the wake of Enron, World
Com, and other corporate scandals. But it is not necessarily the case that
the market was wrong about those companies given the false information
they disseminated. Lying is one thing. Manipulation is another.
Some critics have asserted that the problem with options as com-
pensation is the options themselves. The argument—which is not with-
out irony—is that because options are risky, too many must be granted to
substitute for cash compensation. The better argument is that focused
management assumes more risk and therefore requires more return.
Nevertheless, it has been suggested that payment in stock (which is re-
ported as an expense) would make more sense because it would give
management the same kind of stake as an investor.
The argument misses a key feature of stock options. It is not
enough that management merely maximizes stock price. Rather, inves-
tors expect ever increasing stock prices. After all, to hold is to buy.
Thus, the question every investor asks of management—no matter how
58_. See_ Kamin v. Am. Express Co., 383 N.Y.S.2d 807, 809–11 (Sup. Ct. 1976). Similarly, a CEO whose compensation is based on sales may be inclined at the extreme to sell goods at a loss. (Such tactics led to the downfall of Sunbeam. See, e.g. , Martha Brannigan, Sunbeam Audit to Repudiate ‘ Turnaround , WALL S T. J., Oct. 20, 1998, at A3.) Or the CEO of a bank whose compensation is based on the dollar amount of loans outstanding may be tempted to make loans at below market rates. Cf. Joy v. North, 692 F.2d 880, 883 (2d Cir. 1982). It recently has been reported that officers at Shell Oil Company may have been motivated to overstate oil reserves in part because of the bonus system there. See Chip Cummins et al., SEC Examines Shell’s Bonus Awards , WALL S T. J., Mar. 11, 2004, at A3.
288 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2005
successful it has been in the past—is “What have you done for me
lately?” The best way to induce management to increase stock price is
stock options. In contrast, with a grant of stock, management assumes
the risk that stock price will fall—and not simply fail to increase. The in-
centive created by a grant of stock is thus somewhat ambiguous. At the
very least, management will have some interest—and perhaps an overrid-
ing interest—in undertaking conservative strategies designed to maintain
stock price. In the context of a bear market, creating incentives to main-
tain stock price may sound like a pretty good idea. Then again, if one is
interested primarily in safety of principal, or even a reliable return, there
is always the bond market. It makes no sense to invest in stock unless
one seeks a higher return. So it makes no sense to create incentives for
management to pursue a conservative strategy. Here again, investor di-
versification is key. A diversified investor prefers that each portfolio
company maximizes return even if it means that a few may go belly up.
If one is adequately diversified, the winners will usually outperform the
losers by more than enough to generate a superior return. Most CEOs
would not be disinclined enough to bet the farm as often as investors like
if it were not for stock options.
A proposal that is closely related to the idea that stock grants
should be favored over stock options is that CEOs (and presumably
other high-ranking officers) be prohibited from selling option shares un-
til they leave office.^59 Those who favor such lock-ups agree that diversifi-
cation is dandy for employees and other investors. But they seem to sus-
pect that diversification is an excuse for CEOs to take the money and
run. There is some merit in this argument. Although rational investors
diversify, they also prefer managers who are focused on the business and
not on some market index. On the other hand, a CEO who sells his
shares still has much of his wealth—not to mention virtually all of his
human capital—invested in his company: There are always more options
waiting to mature or be granted. Requiring a CEO to retain option stock
increases the risk inherent in accepting options as compensation. Other
things being equal, if one must assume more risk, one will insist on more
return, or the prospect of it. The bottom line is that requiring a CEO to
retain option stock will cause the CEO to demand more options.^60
Moreover, CEOs (and anyone else to whom the rule applies) will be
forced to resign in order to cash out. Or companies will turn to contrac-
- Senator John McCain of Arizona has been a particular advocate of this reform. See The McCain Solution (July 12, 2002), available at http://www.salon.com/politics/feature/2002/07/12/mccain/ index.html?cp=rdf&dw=310.
- Aside from the foregoing, the difference between market price and the price paid for option shares is taxable income. How is one to pay the taxes without selling some shares? Ask anyone who exercised options in early 2000 and did not immediately sell enough stock to pay the tax on the gain. When NASDAQ collapsed many found that there was not enough value left in the stock they owned even to pay the tax they owed. Many ended up in bankruptcy court. Gretchen Morgenson, Some Suf- fer Tax Hangovers from Microsoft Option Spree , N.Y. TIMES , Apr. 18, 2001, at A1.
