Pay Without Performance: Overview of the Issues

Lucian A. Bebchuk and Jesse M. Fried

Journal of Applied Corporate Finance, 2005, vol. 17, issue 4, 8-23

Abstract: In their recent book, Pay Without Performance: The Unfulfilled Promise of Executive Compensation, the authors of this article provided a comprehensive critique of U.S. executive pay practices and the corporate governance processes that produce them, and then offered a number of proposals for improving both pay and governance. This article presents an overview of their analysis and proposals. The authors' analysis suggests that the pay‐setting process in U.S. public companies has strayed far from the economist's model of “arm's‐length contracting” between executives and boards in a competitive labor market. In place of this conventional model, which is standard in corporate law as well as economics, the authors argue that managerial power and influence play a major role in shaping executive pay, and in ways that end up imposing significant costs on investors and the economy. The main concern is not the levels of executive pay, but rather the distortion of incentives caused by compensation practices that fail to tie pay to performance and to limit executives' ability to sell their shares. Also troubling are “the correlation between power and pay, the systematic use of compensation practices that obscure the amount and performance insensitivity of pay, and the showering of gratuitous benefits on departing executives.” To address these problems, the authors propose three kinds of changes: 1) increases in transparency, accomplished in part by new SEC rules requiring annual corporate disclosure that provides “the dollar value of all forms of compensation” (including “stealth compensation” in the form of pensions and other post‐retirement benefits) and an analysis of the relationship between the past year's pay and performance, as well as more timely and informative disclosure of insider stock purchases and sales; 2) improvements in pay practices, including greater use of “indexed” stock and options to limit “windfalls,” tougher limits on executives' freedom to sell shares, and greater use of “clawback” provisions in bonus plans that would force executives to return pay for performance that proves to be temporary; and 3) improvements in board accountability to shareholders, including limits on the use of staggered boards and granting shareholders the right to nominate directors and propose changes to governance arrangements in the corporate charter.

Date: 2005
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