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CEOs Behind the Veil of Ignorance

October 31st, 2006 · 1 Comment

My friend David Kirby passed along an interesting article from the Harvard Business School Web site proposing a novel method of executive compensation. A perennial problem for shareholders is that you want to give your CEO a personal incentive to improve performance by making her compensation dependent upon it in some way. The trick is how to prevent her from gaming the compensation setup in a variety of ways—say by making sure profits spike right before her options vest—in ways that help her bottom line, but not the long-term interests of shareholders.

The authors propose a Rawls-inspired strategy for preventing this: Let the new hire know the value of her compensation package, but not the mechanics of how it works. This is supposed to give the executive an incentive to maximize the performance of the company overall, rather than focusing myopically on whatever trigger metrics are built into the package. It’s clever on face, but there’s one big reason I’m inclined to think boards would be better off just tailoring their metrics better: The executive now faces the flipside of the problem that shareholders do under the status quo. That is, she knows the present value of her compensation, but can’t be sure whether it’s been rigged to peak at the time of her hiring, even if she does generally improve performance. They could, of course, give her quarterly updates of the package’s value, but this would presumably make it possible to reverse-engineer its mechanics, defeating the purpose of the scheme. And bar that, even if the executive trusts the board to set everything up fairly, she has to eat the risk of cashing out when the value of her compensation is unusually low for whatever reason. So the compensation probably has to be significantly higher to balance out this added risk. Maybe it’s still worth doing, because eliminating self-interested CEO gaming is worth more than the necessary increase, but it’s odd that the authors don’t seem to consider this factor at all.

Tags: Economics



1 response so far ↓

  • 1 FinFangFoom // Nov 1, 2006 at 7:15 pm

    The problem with such a plan is that:

    1. It would require that the company limit disclosure of a lot of the terms of its executive compensation plans. Insufficient disclosure is the cardinal sin of corporate governance.

    2. Nobody would believe that the board wouldn’t tell management. First, management is also usually on the board. Second, management gets to nominate the directors, and management’s nominees almost always win.

    3. Management needs to release financial reports and needs managerial accounting to run the company. I have no clue how this could be done and still keep them in the dark as to the value of the compensation package.

    4. Management would just demand much larger cash salary payments, which would trigger even more excise taxes (for excessive compensation) and be totally counterproductive to the goal of bringing management and shareholders interests in line.

    5. There are lots of other problems with the idea, but I am lazy.

    Additionally, the backdating problem is one that is located pretty firmly in the past. The companies most involved were tech companies back in the late 90s. SEC reforms that require grants of options to be disclosed almost immediately have made this problem mostly disappear.

    As to metrics, the problem is that the only real metric is share price. Options are popular because if the strike price is the price of the shares on the date of the grant (or it could be more I suppose), a corporation won’t be taxed on them. The only thing that you could really fool with is the vesting period, since management doesn’t really like any kind of metric other than share price and thats all the shareholders care about anyways.