26 December 2012

How Do Publicly Held Firms Set Compensation?

The basic liberal and academic criticism of the way that compensation for related parties, including senior corporate officers, is set in modern American big businesses was set forth succintly by Judge Posner, of the United States Court of Appeals for the 7th Circuit, one of the most distinguished judges in the nation in law and economics matters, in a case where a major mutual fund advisor was sued for gouging investors in its captive mutual funds with fees much higher than what it charged mutual funds that negotiated their fee agreements with it at arms-length. 

Notably, his dissenting opinion and the U.S. Supreme Court's unanimous reversal of the majority opinion, came after the financial crisis in a case that was argued before the appellate courts just a couple of days after Lehman Brothers filed for bankruptcy.  The timing favored a narrative of corporate malfeasance over the opinion of the majority of the appellate panel which called for blind reliance on the workings of an efficient marketplace.

In particular, this criticism of American corporate governance notes that directors of publicly held companies are almost always chosen by Soviet style proxy ballots with a slate of names hand picked by insiders and no meaningful way for alternative candidates to compete for shareholder support, notwithstanding the legal fiction that directors are elected by and meaningfully accountable to shareholders of public companies through the internal director nomination and election process. 

Typically, directors only meaningful discretionary role is (1) to leniently adjudicate the incompetence of a CEO who has already been shown to be manifestly unable to act due to scandal, unbalanced mental health, illness, or utterly disasterous company collapse due to mismanagement, or (2) to fill an unexpected vacancy when the incumbent CEO has not designated a successor.  Directors sometimes also participate in negotiations over share prices when someone seeks to acquire the company in an unsolicited take over bid.  In all other respects, directors act as little more than a self-perpetuating collective ceremonial monarchy in a corporation, sustaining it symbolically, but exercising little genuine power over the management of the company.
[E]xecutive compensation in large publicly traded firms often is excessive because of the feeble incentives of boards of directors to police compensation. Directors are often CEOs of other companies and naturally think that CEOs should be well paid. And often they are picked by the CEO. Compensation consulting firms, which provide cover for generous compensation packages voted by boards of directors, have a conflict of interest because they are paid not only for their compensation advice but for other services to the firm—services for which they are hired by the officers whose compensation they advised on. Competition in product and capital markets can’t be counted on to solve the problem because the same structure of incentives operates on all large corporations and similar entities, including mutual funds.  
Mutual funds are a component of the financial services industry, where abuses have been rampant, as is more evident now than it was when Coates and Hubbard wrote their article. A business school professor at Northwestern University recently observed that “business connections can mitigate agency conflicts by facilitating efficient information transfers, but can also be channels for inefficient favoritism.” She found “evidence that connections among agents in [the mutual fund industry] foster favoritism, to the detriment of investors. Fund directors and advisory firms that manage the funds hire each other preferentially based on past interactions. When directors and the management are more connected, advisors capture more rents and are monitored by the board less intensely. These findings support recent calls for more disclosure regarding the negotiation of advisory contracts by fund boards.” The SEC’s Office of Economic Analysis (the principal adviser to the SEC on the economic aspects of regulatory issues) believes that mutual fund “boards with a greater proportion of independent directors are more likely to negotiate and approve lower fees, merge poorly performing funds more quickly or provide greater investor protection from late-trading and market timing,” although “broad cross-sectional analysis reveals little consistent evidence that board composition is related to lower fees and higher returns for fund shareholders.”
A particular concern in this case is the adviser’s charging its captive funds more than twice what it charges independent funds. According to the figures in the panel opinion, the captives are charged one percent of the first $2 billion in assets while the independents are charged roughly one-half of one percent for the first $500 million and roughly one-third of one percent for everything above. The panel opinion throws out some suggestions on why this difference may be justified, but the suggestions are offered purely as speculation, rather than anything having an evidentiary or empirical basis. And there is no doubt that the captive funds are indeed captive. The Oakmark-Harris relationship matches the arrangement described in the Senate Report accompanying § 36(b): a fund “organized by its investment adviser which provides it with almost all management services.” Financial managers from Harris founded the Oakmark family of funds in 1991, and each year since then the Oakmark Board of Trustees has reselected Harris as the fund’s adviser. Harris manages the entire Oakmark portfolio, which consists of seven funds. The Oakmark prospectus describes the relationship this way: “Subject to the overall authority of the board of trustees, [Harris Associates] furnishes continuous investment supervision and management to the Funds and also furnishes office space, equipment, and management personnel.” Recall Professor Kuhnen’s observation that “when directors and the management are more connected, advisors capture more rents and are monitored by the board less intensely.”
The panel opinion says that the fact “that mutual funds are ‘captives’ of investment advisers does not curtail this competition. An adviser can’t make money from its captive fund if high fees drive investors away.” 527 F.3d at 632. That’s true; but will high fees drive investors away? “[T]he chief reason for substantial advisory fee level differences between equity pension fund portfolio managers and equity mutual fund portfolio managers is that advisory fees in the pension field are subject to a marketplace where arm’s-length bargaining occurs. As a rule, [mutual] fund shareholders neither benefit from arm’s-length bargaining nor from prices that approximate those that arm’s-length bargaining would yield were it the norm.”
- Judge Posner's dissenting opinion in Jones v. Harris Associates, L.P., 527 F.3d 627 (7th Cir. May 19, 2008) in the United States Court of Appeals for the Seventh Circuit.  The decision was subsequently unanimously reversed by the United States Supreme Court at 130 S. Ct. 1418 (2010).

The Control Market Case For Lassiez-Faire Oversight

The leading criticism of the poor governance argument works better in the marketplace in which the equity shares of publicly held corporations are traded than it does in the context of mutual fund fee setting.  The critics argue that poorly managed companies become undervalued relative to their potential under better management, and that someone who knows how to manage a company better will be able to buy control of the company for a premium price while still making a profit in a tender offer with funds from investors who are willing to back up that person's bravado with money that they could lose if the share price of the acquired company does not improve with better management.

This approach to insuring competent management may be a far cry from optimal, and its methods may be crude and costly, but they provide some comfort that there is at least some check on the kind of mismanagement for which excessive compensation packages are a symptom.  A faster and cheaper system of procuring better managers could dramatically improve the health of the economy in a sustainable way.  But, one can hold some comfort in the notion that the current system at least vests decision making in people whose sincerity is insured by the huge sums of money that are at stake.

The practice of selling shares of poorly managed companies and thereby driving down the price of those shares, rather than using the corporate governance process to elect directors who would replace the current management team while continuing to hold shares in these companies, is called the "Wall Street Rule."

Resistance to the Wall Street Rule and a push for better corporate governance has been driven to a great extent by the reality that institutional investors own such a large share of the total capitalization of the U.S. equity markets that they have no choice but to buy some ill managed companies as part of their portfolios.

The Case That Good Hiring Mitigates The Harms Of Poor Director Control Of Incumbents

Another important criticism of the poor governance argument is that not just anybody gets hired to be the CEO of a large publicly held company.  The governance problems in the CEO hiring and compensation process are far less serious than those in the process of firing bad CEOs and controlling CEO compensation.

CEOs, who typically have large ongoing stakes in their former employers, have an interest in picking successors who seem like they will be competent.  A meaningful share of CEOs personally brought their companies to the point where they could go public or personally turned a minor public company into a dominant one - so they had an important role to play in creating the profits that their fat pay packets plunder.  In the rare situations where there is an open CEO seat due to untimely events that create a vacancy for a CEO who doesn't have a successor lined up, the Board of Directors generally makes a sincere effort to pick a competent successor from a pool of very qualified applicants.  Social norms make meaningful prior proven performance a prerequisite for anyone who will be seriously considered for the job.

Some CEOs do a dismal job, but few could have been clearly identified as poor managers by a well intentioned person evaluating them knowing only the information available at the time that the CEO was hired.  The CEO who is hired may not be the most qualified or the best value for the compensation package sought, but the CEO who is hired is rarely an applicant of below average competency either.

Unlike a system of hereditary inheritance of rulership of the kind practiced at some stages of the ancient Roman empire and in many European monarchies (and many modern small and medium sized businesses), idiot black sheep who have nothing to recommend them but their lineage do not get hired to be modern CEOs.  Some more than minimal merit evaluation is involved in these appointments.

Should The General Public Care About Excessive Compensation Per Se?

It is also worth remembering that while excessive CEO compensation for bad CEOs is a problem because it rewards people who are harming the overall economy, excessive CEO compensation for par for the course or reasonably good CEOs aren't really a matter of public concern.  Setting the compensation of decent or good CEOs basically involve distributive disputes between dumb money and the people whose management contributed greatly to their money generating profits.  If dumb money is swindled out of profits they have done little to contribute to personally (and often did little to earn in the first place, in the case of inherited money), the fact that decent management that is making an economic contribution gets a large piece of those profits isn't terribly troubling from a larger civic perspective.  These are fights between rich people on terms that the combatants have agreed to in advance that have little or no negative impact on the larger economy if management is competent.

Many criticisms of excessive executive compensation are directed at the way it creates a class of superrich people in the economy and leads to unequal income distributions.  But, in a world where pre-CEO compensation profits were the same, but investors received larger shares of profits relative to senior managers, there would still be vast inequalities of wealth in our economy, and the middle and working classes would not be much better off.  It would just be distributed among members of the American upper class somewhat differently.  Essentially, the divide between the merely rich, and the superrich senior managerial class (particularly in the financial sector) would be smoothed out somewhat.

The assumption of critics of excessive executive compensation who believe that lower executive compensation would translate into higher compensation for other employees fundamentally misunderstand the nature of the problem.  The factors that cause non-executive employees to have the salaries that they receive are almost entirely separate and divorced from the factors that cause senior executives in big businesses to receive the salaries that they receive.  The process by which middle managers or rank and file employees negotiate salaries with their employers is predominantly a function of the workings of a highly segmented labor market and the alternatives available through self-employment, not a product of deeply flawed self-dealing between senior managers and the directors who are supposed to represent the interests of equity investors. 

Incompetent CEOs can depart from the labor market reality, but since they work in a world constrained by labor market realities, it is far easier for an incompetent CEO to overpay the company's employees than it is to underpay them - a result few reforms are worried about.  An incompetent CEO who doesn't offer high enough salaries will soon find that the company doesn't have enough workers who are able to carry out the company's business.  And, companies that started from a baseline of having bad compensation practices in the first place never get big enough to go public in the first place.

If one believes that workers are undercompensated, despite reasonable free and fair markets for labor, this belief reflects either (1) the systemic effects on the labor market of a lack of collective bargaining (generally by unions) leading workers to accept offers when isolated when the markets could afford to pay more for their collective services if they could organize themselves to get a fair price for them (since in most cases there is a gap between the minimum a worker would work for and the maximum that a firm would pay for that work and employers can capture most of this gap if workers are disorganized), or (2) a sense that workers (or at least some class of permanent important workers) should have both a contractual debt interest in the company's well being and a non-contractual equity interest in the company's performance reflected in some sort of profit sharing plan in the way that Japanese salarymen, or German unionized employees do.  Reforms of either type would require major, institutional changes that go far beyond calls for more democratic shareholder governance of the publicly held companies that they own.

Thus, while good CEOs who are overcompensated at the expense of investors are a concern for the investors themselves, the general public cares only that bad CEOs are fired promptly.  Even overcompensation of bad CEOs is bad mostly not because investors are cheated by management.  After all, if the abuse gets too great, investors will start to favor debt investments over equity so  they have a legally enforceable right to a fair return on their investment.  Overcompensation of bad CEOs itself is bad mostly because this is a symptom that the bad CEOs are unlikely to be fired when they should be fired, which does hurt the overall economy.

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