"Say on Pay" Bill And Yet More Evidence That We Need It

Oddly, there hasn’t been as much chatter in the blogsphere as I would have expected on the House passage on Friday of what is called the “say on pay” bill. The House legislation would give shareholders a non-binding vote on executive pay and golden parachutes. Initially, the Senate wasn’t expected to take it up, but Barack Obama introduced an “identical” measure. The legislation is similar to laws passed in the UK in 2002. However, based on my knowledge, the British requirements haven’t had much impact (compensation consultants apparently have been quite effective in arguing that the largest UK companies have to compete in the global, meaning US, market for talent, and that has had the effect of also ratcheting up CEO compensation at smaller concerns).

Kash Mansouri at The Street Light pointed to an that had an interesting comment and followed it with his :

Investor advocates, union pension funds and shareholder groups have supported the legislation, but GOP opponents expressed concerns it would give such groups an inroad to change a company’s policies.

“It greatly worries me that this bill could set a precedent of giving activist institutional investors, who may have their own political and social agendas unrelated to the financial wealth of the companies, more influence,” said Rep. Mike Castle, R-Del.

Exactly what “agendas unrelated to the financial wealth of the companies” do Republicans think that the owners (i.e. shareholders) of those companies have? I’m curious to know. Do we really think many shareholders buy ownership stakes in a company for reasons other than to increase their wealth?

While I agree with Kash’s sentiment in the America we know today, let me pose a radical idea: what is wrong with shareholders pursuing non-economic objectives if that is what they want to do with their money?

Consider the following: let’s say in ten years that we have a much higher proportion of total investor dollars devoted to promoting corporate social responsibility (if the adverse effects of global warming manifest themselves sooner rather than later, this isn’t implausible). You could see companies pursuing different strategies in the capital markets: some pursuing simple profit maximization, others following CSR strategies, and achieving the best results they can within those constraints.

How is this different that product differentiation we see in other markets? And why would it be objectionable? Shareholders that didn’t like CSR strategies wouldn’t hold those shares. After all, we are told that shareholders who don’t like the executive compensation practices of certain companies should sell their stock. The same logic seems to apply here.

The problem with executives feathering their nest is described in the economic literature as an agency problem, meaning when you hire someone to act on your behalf, you run the risk that they won’t. In public companies, with diffuse, often transient, largely unknown-to-each-other shareholders, it is structurally difficult to get the agents to take their responsibilities to their nominal employers seriously (and if CSR becomes a higher priority with investors generally, I would bet we will see executives resisting shareholder desires, even though they supposedly serve their interests).

In a bit of synchronicity, an article by Floyd Norris of the New York Times, “,” provided yet more evidence that CEOs put their interests ahead of those of shareholders.

Let’s start with the fact that most mergers are bad for the acquirer. Every study ever done says most fail (typical ranges are 60-75%) and the biggest reason cited is that the buyer overpays.

Norris cites a study that determined that CEOs come out ahead financially even after a bad merger, because managers of larger organizations are paid better than those of smaller ones (whatever they might lose on options is more than offset by salaries and new incentive compensation). As a result, CEOs of public companies who aren’t large shareholders are more willing to overpay than other buyers. A second study found that public company CEOs on average paid considerably higher premiums for targets than either private equity firms or public companies where management owned 20% or more of the stock.

We’ve noted before that the desire of many CEOs to increase the size of their institution is due to the increase in pay they will receive; this relationship is generally well understood in the financial community. But it’s good to see it get independent confirmation.

From Norris:

If it’s not your money, you may be quite willing to spend more of it.

That insight may seem obvious, but academic research demonstrating that it is true set off the great boom in equity compensation for corporate management over the last three decades.

As an article in The Journal of Finance this month puts it, a wealth of studies supports the hypothesis that “managers with greater ownership, or managers with more equity-based incentives, are less likely to take value-destroying actions.” Yet over time, few management actions have done as good a job of destroying value as have mergers and acquisitions. Some work out fine, but many do not.

Now academic research offers insights into how the very equity-based incentives — stock options and restricted stocks — that were supposed to make managers think like owners have instead encouraged them to overpay for acquisitions. The bosses win, whether or not the owners lose.

A new study by economists at the University of Pittsburgh and Ohio State University looked at all-cash takeovers done from 1990 to 2005, and found that the premiums paid varied based on who was doing the buying.

On average, public companies made bids that drove up the target share price by 32 percent. But bids from privately held companies were lower, pushing prices up 22 percent. The figure for private equity funds was 20 percent.

That difference means the public companies are paying more — and thus the merged companies are less likely to do well, all other things being equal.

One of the authors, René M. Stulz, a finance professor at Ohio State, told me that he first thought the explanation would be in the type of companies being bought, but that did not prove to be the case.

Nor did it turn out that the ownership position of the bosses of the target company made a difference. Those with big stakes were not more likely to negotiate good deals than those with smaller positions.

Instead, the data showed that the public company differential vanished if managers of the bidder owned at least 20 percent of the equity. Then they acted like private companies, and paid about the same premium.

If a bidding war develops, or negative information surfaces, private buyers are also more likely to walk away from deals than are public companies, concluded the study done by Leonce L. Bargeron, Frederik P. Schlingemann and Chad J. Zutter of the University of Pittsburgh, along with Mr. Stulz.

So why are public companies willing to pay more? An answer may come from the Journal of Finance article, written by Jarrad Harford of the University of Washington and Kai Li of the University of British Columbia.

They found that corporate managers are often richer after a bad merger than they were before.

“While shareholders might assume that their C.E.O.s’ large portfolios of stock and options provide the necessary incentives to discourage them from making bad acquisitions,” they wrote, “the value of the flow of new grants after an acquisition can swamp” any incentive offered by the pre-takeover holdings.

Among mergers that left shareholders worse off than before, the managers emerged wealthier for the experience in three-quarters of the deals.

One important lesson is that the managers’ expectation of the continuing flow of equity grants can provide incentives that sharply differ from the incentives that exist because of the prior grants. A lower stock price can mean better-priced options.

Pay consultants advising boards on pay for chief executives typically start by calculating the compensation at comparable companies. A big merger can catapult a company into a bigger size category, making the old executive-compensation package appear to be very low compared with the new set of comparable companies. So the bosses get big raises long before it is clear whether the merger is going to work out well.

Mr. Stulz says the clear advantages to management of mergers — even if they do not help the shareholders — mean that the board should be involved in merger discussions from the beginning.

“You also want to make sure that you do not compensate management just because the company is bigger,” he said.

More likely, some clever consultant will discover this paper and conclude that the answer is clear: Give management 20 percent of the company to assure they will be adequately motivated to keep the interests of shareholders in mind.

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