Chapter 8

Question 1

The key elements of (executive) compensation:

Answer 1

1. Base salary
   - fixed amount of compensation in accordance with the terms of the contract
   - unrelated to the performance of the company (or the individual manager)
2. Bonus
   - compensation in addition to the amount of pay specified as a base salary
   - linked to accounting performance of the firm
3. Stock options
   - provide managers with the right, but not the obligation, to purchase shares
   - Exercise price and time period are specified
   - Long-term incentive plans (LTIPs) as special case of stock options
4. Restricted share plans (stock grants)
   - Limits on the transferability of shares for a certain time period (vesting period)
   - Stock award may be conditioned on performance goals
5. Pension plans
6. Perquisites (company cars and jets, healthcare, etc.)

Question 2

Manager compensation and outsider perception

Answer 2

Johnson, Porter, and Shackell (1997) CEOs of firms that receive negative media coverage of their
compensation arrangements subsequently
- received small pay increases
- had the pay-performance sensitivity of their compensation arrangements increased
Thomas and Martin (1999) find that CEOs of firms that were the target of shareholder resolutions criticizing executive pay had annual compensation reduced over the following two years by an average of $2.7 million.

Kuhnen and Niessen (2012)  following negative press coverage of CEO pay, firms reduce option
grants, increase (less contentious) types of pay, leaving overall compensation unchange

Question 3

Stealth compensation

Answer 3

 Potentially inefficient compensation structures that hurt managerial incentives and firm performance

 Bebchuk and Fried (2004) document that a substantial amount of performance-insensitive compensation is obscured trough retirement pensions, deferred compensation, postretirement perks, and guaranteed consulting fees

 Minnik and Rosenthal (2014) find stealth compensation to increase compensation by 9% on average, with ‘stealth firms’ experiencing worse operating performance

Question 4

Are CEOs overpaid

Answer 4

Kaplan (2012) summarizes the evidence as follows:
- while average CEO pay increased substantially before and in the 1990s, its level has remained constant since then (adjusted for inflation)
- whether CEOs are overpaid depends on the benchmark: households vs. other top talents
- the increase in CEO pay came along with an increase in return to top talent
- it is likely that similar forces, e.g., technology and scale, have played an important role in driving CEO pay and the return to top talent
- CEOs are paid for performance

Question 5

Pay-performance sensitivity

Answer 5

One way to align objectives of managers with shareholders  link renumeration to performance
Focus should be on relative rather than absolute performance (Holström 1982, Gibbons and Murphy 1990)
What is the right performance measure? (accounting vs market based)
Early compensation were market based  1970 switch to accounting  today again market based

Gibbons and Murphy (1990) report that managerial remuneration depends on:
− Past stock performance
− Past accounting performance
− Relative performance
− However, firm size is also an important determinant (e.g., Murphy 1985)
 Executives might have an incentive to let their companies grow beyond the optimal size (Jensen 1986)

Question 6

Benchmarks

Answer 6

• Managers compensation should not be affected by actions outside their control
• Bertrand and Mullainathan (2001) find that managers are often rewarded for luck
• CEOs are able to set their own (excessive) pay in firms with poor corporate governance (without a large, controlling, shareholder)

Question 7

Stock based compensation

Answer 7

Managers can sell stock/options and undo any motivational effects, may manipulate earnings, or dates of issue to make options more valuable
- Once options are exercised, executives tend to sell purchased shares, effect is stronger for executives with large holdings (Ofek and Yermack, 2000)
- Holding periods and minimum holding requirements meant to prevent managers from undoing incentives

Question 8

Compensation clawbacks

Answer 8

• Clawback provisions have become more common to authorize firms to recoup compensation from executives following financial restatements or executive misbehavior (first introduced by the Sarbanes-Oxley Act)
   →Idea is to enable

Question 9

Option Backdating

Answer 9

Stock returns are high after stock option grants and low before grants to executives
 This suggests opportunistic release of information around grant time, or retroactive setting of grant dates

Question 10

Insider trading

Answer 10

Pre SOX
 Report due on 10th of a month
 Insider can delay reports by 14 day and split trading quantity
 Meant he could avoid price impact until end of the transations

 Insiders use discretion to trade and report strategically: more than 2/3 of sample are part of trading sequence
Value of integrity

Question 11

Incentivizing risk taking

Answer 11

• Pay-performance principle effective in inducing higher effort and productivity
• However, performance-based incentives might inhibit creativity and innovation
• Ederer and Manso (2013) run an experiment over 20 periods  lemonade stand experiment
  Fine-tuning (exploitation) or new product mix (exploration)

Question 12

Conclusion

Answer 12