Restructure Rather Than Limit Executive Pay to Benefit Shareholders, CU-Boulder Prof Says - 30 Sep 2009

Restructure Rather Than Limit Executive Pay to Benefit Shareholders, CU-Boulder Prof Says

September 30, 2009

Sanjai Bhagat

When it comes to paying America's corporate
executives, the problem isn't that they are paid too much but rather
how they are paid that helped lead to some of the spectacular corporate
implosions in recent years, according to a University of Colorado at
Boulder finance professor.

Sanjai Bhagat of the Leeds School of
Business says restricting the stock and stock options in incentive
compensation plans for corporate executives would go a long way to help
correct the problem of executives being rewarded for short-term growth
at the expense of the long-term health of their companies.

"Executive
compensation plans should lead to policies that are simple, transparent
and focused on creating and sustaining long-term shareholder value,"
Bhagat said. "The problems thought to have been generated from equity
incentive compensation in the past decade, including earnings
manipulation and taking on unwarranted risk, are a function of
structure, not the level of the incentive payments."

In an essay
published in the Yale Journal of Regulation's summer edition, Bhagat
and co-author Professor Roberta Romano of Yale University suggest that
incentive compensation plans should be more transparent and simplified,
but most importantly, executives should be restricted from selling
their stock or stock options for at least two to four years after their
last day in office.

Paying executives in this way will provide an
incentive for them to manage corporations in investors' longer-term
interest, and diminish their incentive to make public statements,
manage earnings or accept undue levels of risk for the sake of
short-term price appreciation, he said.

"The concern today is
many executives have done very well with their compensation, but their
shareholders have done very poorly," Bhagat said. "So how could it
happen that a compensation arrangement whose whole motivation is to
increase shareholder value has done quite the opposite?"

Most
executive compensation plans primarily consist of two parts. One is
cash compensation and the other is incentive compensation consisting of
stocks, stock options and a few other types of securities, according to
Bhagat.

"The reason for incentive compensation plans, as the name
suggests, is to provide incentives to these executives and to create
value for the shareholder," Bhagat said. "When the company's value goes
up, the value of the shares goes up for the executives and the
shareholders."

Prior to the spate of accounting scandals that
began with Enron, incentive compensation from stock and stock options
was often emphasized as a key to improved corporate performance, and
such compensation has been the most substantial component of executive
pay for well over a decade, according to Bhagat.

Congress
implicitly supported the incentive function of executive compensation
when it eliminated the corporate income tax deduction for executive
salaries over $1 million, since the elimination was applied only to
non-incentive-based compensation, he said.

But the recent
accounting scandals revived executive compensation as an issue because
the executives of some scandal-ridden firms reported gains in the range
of tens to hundreds of millions of dollars from exercising stock
options before their firms imploded.

"Our proposal will diminish
the perverse incentives to manipulate or emphasize short-term stock
prices over long-term value, yet retain the benefits of equity-based
incentive compensation plans," Bhagat said. "Managers with longer
horizons will be less likely to engage in imprudent business or
financial strategies or short-term earnings manipulations when the
ability to exit before problems come to light is greatly diminished."

He
says the idea of using restrictive stock for executive incentive
compensation is not new, but rather an approach that has been lost in
the current populist call to reduce, rather than restructure, incentive
compensation.

In fact, many firms already have restricted stock
plans, Bhagat said. But most plans allow executives to sell these
shares a few years after they are awarded while Bhagat and Romano would
require executives to hold these shares two to four years after their
last day in office.

Even though the proposal would benefit investors and CEOs in the long term, Bhagat says it may be a tough sell.

"Our
proposal is not directed at garnering CEO support, our proposal is
geared toward looking out for the interests of the investors in this
country who are investing their hard-earned dollars in these U.S.
corporations," Bhagat said. "By looking out for the investors in the
long run, you are also looking out for the CEOs."

To hear to a podcast featuring Bhagat visit www.colorado.edu/news/podcasts/. To view a short video of Bhagat discussing executive compensation visit www.youtube.com/watch?v=N_valvlezBY.

Contact

Sanjai Bhagat, 303-492-7821
Sanjai.Bhagat@Colorado.EDU
Greg Swenson, CU News Services, 303-492-3113
Greg.Swenson@Colorado.EDU

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