Fried Interview
A Failure in Governance: Why Executive Pay Is Still Broken
Jesse Fried, professor of law and BCLBE faculty co-director, recently published Pay Without Performance, a book written with Harvard's Lucian Bebchuk that examines the continuing controversy over executive compensation. We sat down recently with Fried to discuss the book.
Q: Your book opens with a quote from Harvard Business School Dean Kim Clark asking about the recent wave of corporate scandals: "Is it a problem of bad apples, or is it the barrel?" You seem to take the view that it’s the barrel.
Fried: The focus of our book is on executive pay, and much of the corporate misbehavior we’ve seen over the last several years was either exacerbated or directly caused by flaws in the compensation arrangements that boards provide CEOs—flaws that we identify in our book. These compensation problems have not been limited to a small number of firms, but rather have been widespread, persistent, and systemic. It’s not a few bad apples, it’s the entire barrel. Some people are willing to acknowledge that flaws in compensation arrangements have been common but insist that these flaws have resulted from honest mistakes and misperceptions on the part of well-intentioned boards that can be expected to fix the problems on their own. The problem is the old barrel; the new barrel will be fine. But the problems we identify have stemmed not from faulty thinking; rather, they have stemmed from basic defects in the underlying governance structures that enable executives to exert considerable influence over their own pay.
Q: What problems do you identify with respect to the compensation process?
Fried: We show that directors have persistently failed to negotiate at arm's length with the executives whose pay they set. We identify a variety of factors -- some financial, others social and psychological -- that lead directors to go along with pay arrangements favorable to executives. Executives' influence on pay setting can explain a wide range of compensation patterns, including ones that have long been viewed as puzzles by economists assuming arm's-length contracting. The role of managerial influence also explains why pay is higher and less sensitive to performance in firms where executives are more entrenched or have more power vis-à-vis the board.
The flaws in the pay-setting process likely result in substantively flawed outcomes. Pay has been higher than it needed to be. It has been insufficiently linked to performance. And pay schemes have been designed to camouflage both the amount of compensation and its insensitivity to performance.
Q: What do you mean by the “camouflaging” of pay?
Fried: Firms have used retirement benefits, for example, to provide executives with substantial amounts of stealth compensation. The economic case for such benefits is questionable. They are not tax-subsidized, unlike the benefits offered lower level employees. Nor is there likely a good risk-shifting rationale. Ordinary employees receive defined contribution plans that force them to bear investment risk. If it’s efficient for workers to bear investment risk, it should be even more efficient for wealthy executives, who have considerable assets. Yet executive pensions are defined benefits, shifting investment risk to the company. However, such arrangements can serve an effective camouflage role, providing executives with large amounts of performance-insensitive pay below investors' radar screen. Under current disclosure requirements, firms do not have to place a monetary value on defined benefit retirement benefits and include it in the compensation tables that companies file and outsiders follow. Indeed, the executive compensation figures used by the media and researchers do not include these retirement benefits.
Q: Do you think that the recent corporate governance reforms will address these problems?
Fried: Recent reforms, primarily the new stock exchange listing requirements, seek to improve board oversight by strengthening the independence of directors. Even though these reforms are beneficial, they fall far short of what's necessary. Bebchuk and I show that the new listing requirements weaken executives' influence over directors, but do not eliminate it. Moreover, there are limits to what independence can do by itself. Independence does not ensure that directors will have incentives to focus on shareholder interests or that directors will be well selected. In addition to becoming more independent of insiders, directors also must become more dependent on shareholders. To this end, we should eliminate the arrangements that currently entrench directors and insulate them from shareholders. The SEC proposal to permit shareholders to place director candidates on the corporate ballot would be a step in the right direction.
Q: What was your goal in writing this book?
Fried: We believe that it is important to bring about recognition of the flaws in current compensation arrangements and in the governance processes that produce them. With better understanding of these flaws, institutional investors will be able to pressure companies to make desirable changes. Furthermore, the regulatory reforms we advocate would not be possible unless investors and public officials come to fully understand how pervasive and costly existing flaws are. Pay Without Performance, we hope, will help bring about a better understanding of both the existing problems and how they could be solved.