Speech by SEC Staff:
This was presented as an Invited Lecture on August 29, 2005 at the Swedish Institute for Financial Research Conference on Corporate Governance in Stockholm. The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This presentation expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
It's a great pleasure to speak during the opening morning of the Swedish Institute for Financial Research Conference on Corporate Governance, following the excellent presentations this morning by the outstanding American corporate governance scholars, Steve Kaplan and Jesse Fried. Given the caliber of participants and excellent program I am delighted to participate in the meeting and want to thank the organizers for inviting me. I'm especially pleased since I have had the opportunity to know Per and Ulf since they joined the Carnegie Mellon doctoral program in financial economics in the early 1990s. At the onset of my remarks I should emphasize, that of course, the views and perspectives that I am expressing today are my own and not those of the Commission or my colleagues on the SEC staff.
Today, I would like to draw upon perspectives that I have developed during my service over the last year as the Chief Economist of the Securities and Exchange Commission as well as my expertise as a financial economist and financial theorist to discuss the changing governance and regulatory framework in the capital markets. While historically the approach of the Securities and Exchange Commission has emphasized disclosure and transparency in the marketplace, as a consequence of various abuses several years ago the regulatory framework has evolved also to emphasize the responsibilities of various individuals, including the CEO, CFO, board members and the auditing firm. This reflects an increasing recognition of the potential importance of the differing incentives and possible conflicts of interests among the board, executives, outside monitors and shareholders. These differing incentives are even illustrated by the terminology used by American financial journalists, who now actually distinguish between pro-business and pro-investor regulatory policies.
There's considerable interest in assessing the new regulatory framework reflected in Sarbanes-Oxley. For example, the SEC hosted a "Roundtable on the Implementation of Internal Control Reporting Provisions" in early April and formed the "SEC Advisory Committee on Smaller Public Companies," which has had a series of public meetings and is hard at work on these issues. While it is not straightforward to empirically isolate the market consequences of these important changes to the regulatory framework, I anticipate that economic analysis of these impacts will be crucial to this assessment. While most observers would agree that there is greater trust in the financial markets than a few years ago, the costs of implementing the new framework have also been non-trivial. In public commentary business leaders have highlighted these costs. Researchers are beginning to attempt to isolate some of the effects of Sarbanes-Oxley by looking at a variety of margins. Example of interesting margins include the market reaction across firms as the legislation was enacted, to what extent are cross-listed firms and small companies trying to opt out of the system, what is the cross-sectional structure of audit and internal control fees, and how have director fees and the willingness to serve as directors been altered.1
In my introductory remarks I'd like to also briefly comment on the role of regulation in the financial markets in a general fashion and specifically on an important facet of the Swedish approach to regulation. The economic tradition going back to Adam Smith has emphasized that absent market frictions market allocations are economically efficient. Of course, the role of regulation can be justified from an economist's perspective by the presence of externalities. In recent years the increasing detection of fraud and conflicts of interest in driving financial market decision-making have focused more attention on regulation of the securities markets.
Within the context of regulation the approach in Sweden has been relatively laissez faire. For example, firms are often allowed some discretion in implementing the regulator's perspective through a quasi-voluntary approach of "comply or explain," based upon the approach of the Cadbury Report. In fact, in the context of a few rules, such as the recently adopted mutual fund redemption fee rule, the U.S. Securities and Exchange Commission has used a similar approach, less formally. As an economist, my instinctive reaction would be that firms would not implement rules proposed in such a discretionary fashion. This is just based upon the "revealed preference" idea in economics, i.e., if the firms could have previously adopted the rule completely voluntarily and had elected not to do so, then why would they adopt the rule under a "comply or explain" standard.
But this interpretation does not capture all the relevant nuances. For example, the approach indicates the regulator's thinking about an appropriate way to handle an issue-transferring its knowledge to the firm and putting companies on notice of implicit exposure if they do not comply and the underlying problem arises. At the same time, unlike an absolute mandate, the "comply or explain" approach does allow companies discretion to make rational choices when facing the diverse situations that they might encounter and allows companies discretion provided that they affirmatively assert why their approach is serving the best interests of investors.
An important aspect of governance that deserves much attention is the role of the board of directors and the extent to which a board mitigates existing incentive problems vis-à-vis the senior management and to what extent it creates incentive problems of its own. The role of the board is fundamental, but perhaps not adequately emphasized, at least in the academic literature.2 The board hires the Chief Executive Officer (CEO) and is responsible for managing succession. Yet there is typically a lot of interaction between the board and the CEO, whether or not the CEO serves as Chairman as well. The CEO often has tried to influence the composition of the board; an interesting empirical analysis of this is in Shivdasani and Yermack (1999). This discussion emphasizes that "conflicts of interest" may be crucial. An interesting academic analysis of the importance of conflict of interest in the determination of CEO compensation is given by the widely publicized book by Bebchuk and Fried (2004).3
The board sets the compensation for senior management, including the CEO, by a Compensation Committee. "Benchmarking" is often used, though the approach does not seem designed to produce a lot of effective information. Interestingly, the board is self-perpetuating (with new members selected by a Nominating Committee) and the auditor reports (in part) to the board through the Audit Committee.
The incentives of the board are important. Unfortunately, board members are sometimes disengaged.4 This could be either a consequence or cause of low monetary compensation. The fiduciary responsibility of board members leads to some "sticks." For example, in the WorldCom class action settlement board members agreed to significant personal liability. On an ex ante basis the recognition of the possibility of personal liability could affect the attractiveness to individuals of serving on corporate boards, but also lead to much greater due diligence by board members. Are there sufficient "carrots" as well? I think that both positive and negative incentives are important from both a direct incentive view and to ensure adequate incentives to join boards (e.g., what economists call the "participation constraint").
It is striking how little compensation is offered to board members relative to senior executives; just to illustrate as a mathematical exercise, a board member may spend about 1/20 of the time of the CEO on firm business, but receives far less than 1/20 of the compensation. This seems to me to be one of the most fundamental puzzles in management compensation. Board members often have comparatively far less at stake, unlike the high-powered incentives for the CEO at the helm. Perhaps from this perspective, the lack of attention by some board members is not very surprising. One way to formulate the issue is to ask, why is the division of compensation between the board and key executives so skewed? The skewing in compensation suggests several alternative explanations such as that there is little responsibility in being a board member, the position is very attractive, there are many substitutes for the prospective board member or that the non-pecuniary benefits (such as networking) of being a board member are considerable. But there are many issues about the tradeoffs with respect to board compensation. These arise with respect to both the level of compensation and the implied incentives.
What is the right tradeoff with respect to the setting of board compensation? The answer depends, in part, on the nature of the board's contribution-as a resource for the CEO or as an independent agent of investors. These can conflict, although they are not mutually exclusive and may even be complementary. The balance that is achieved depends upon the level of compensation and incentives.
If it is desirable to have a relatively detached/independent board, for example, the current type of compensation may be appropriate. Because of the role of the CEO in selection or retention of board members, there is a natural reluctance of the board to "rock the boat," if the board positions are desirable and well paid. Of course, this is an argument against paying board members too much. In particular, one downside to higher board compensation could be a reduction in board independence (independence itself may be desired, as long as the board is motivated by the shareholder's interests; this in turn emphasizes the importance of identifying the role of the board and how that should be influenced by senior management). An alternative approach for recruiting engaged board members is to select large stockholders who are strategic (rather than passive) investors. This could at least help mitigate some of the public goods problems that are central in corporate governance and bring to the board sophisticated members whose goals are squarely aligned with the shareholders, who are the suppliers of the firm's capital.
Board members are very dependent upon the information that they receive from the management team and the outside auditor. At least in the past, this raised the issue of how can one ensure that the outside auditor is sufficiently forthcoming with the board. Consequently, it is important to ask good questions. For example, one former board member told me he would ask the auditors what did they discuss with the management team (or among themselves!) that they did not discuss with the board? Indeed, if the board were too adversarial with respect to the management team, management's incentives to communicate to the board would be greatly reduced. This points to a delicate aspect of trying to divorce the CEO from the board selection process-it is important to ensure that the executives are sufficiently forthcoming with their own boards. The contrast between real and formal authority highlighted by Aghion and Tirole (1997) helps illustrate that a less than completely independent board can be optimal in some settings-to the extent that the CEO has the discretion to make most decisions, he will have strong incentives to invest in obtaining the relevant information to make good decisions. Harris and Raviv (2004) emphasize the importance of communication and combining information by the board and senior management in a setting in which each has a partial information advantage and some decisions are delegated to the board to control agency concerns. The communication aspects and the interaction between the board and the CEO point to some of the subtlety in structuring the incentives for effective board behavior.
A crucial aspect of the role of the board is in evaluating and establishing the compensation program for senior management. One of the widely discussed features of executive compensation is employee stock option grants. I'd like to address a number of facets of these next.
Options are a key component of executive compensation.5 One striking feature of these programs is the discreteness of vesting dates and option exercise dates. The option grants tend to occur infrequently, e.g., annually or quarterly. This seems to be rather puzzling. Why is that an efficient form of compensation, for example, as compared to a more continuous set of vesting dates, option exercise dates and option exercise prices? Given that relevant economic decisions are being made more frequently (continuously?), it is hard to rationalize compensation that is so discontinuous. Discontinuous compensation is vulnerable to manipulation, without obvious advantages over a smooth compensation profile. In many contexts it is optimal to impose risk on a risk-averse manager due to incentive benefits, but that type of rationale does not seem to be an obvious explanation for infrequent and lumpy option grants.6 An interesting quantitative question that this suggests is how much the firm could reduce the executive's compensation, while producing the same incentive benefits or the same expected utility for the manager.
In fact, the discussion above emphasizes that discontinuous or spiky compensation may suggest a design flaw in a variety of agency compensation contexts. For example, a salesman often receives discontinuous compensation based upon whether he reaches a periodic quota. If the salesman perceives that the likelihood of hitting the threshold is too low, then the salesman may lack suitable marginal incentives within the relevant measurement interval.7
This discussion also indirectly speaks to a central aspect of many options programs in practice. If the option moves too far out of the money, the firm will sometimes reset the exercise price by granting new replacement options ("re-price" options). While this is often criticized and suggests that the original grant understated the intended compensation, it may be necessary to provide the desired marginal incentives.8 In understanding the incentive structure I think it is useful for firms to focus upon incentives that are "renegotiation proof" and would be consistent over time and not require updating. This would represent a substantial shift from current practice.
I'd like to turn to another facet of employee stock options, i.e., their anticipated expensing. This has been highly contentious issue, particularly among companies for whom stock option grants represent a substantial portion of the effective cost of employee compensation. While the Commission's regulatory role on this issue is only indirect, it's been a subject of considerable attention within the Office of Economic Analysis because of the expertise of our staff in the valuation of options and financial instruments more broadly. Last spring we provided on the SEC web site an "Economic Perspective" on option expensing in conjunction with the Staff Accounting Bulletin developed by the Commission's Chief Accountant.9 As you may or may not know, the Office of Economic Analysis is the chief advisor to the Commission and the SEC staff on all economic issues associated with the SEC's responsibilities.
Interestingly, some firms that use options extensively suggest that it is difficult to assess the cost of these options at the time of the grant. This is an interesting argument, though it does raise the question of how a firm can be comfortable that it is meeting its fiduciary responsibility to its shareholders when a substantial portion of its compensation is paid through a tool whose anticipated cost it does not understand and cannot quantify. If managers are acting in the best interests of investors, we would expect firms to use compensation tools whose costs they clearly understand and can internalize and that instruments whose anticipated cost cannot be identified at the time of the grant would not be attractive. Indeed, some firms who are large users of options are among the strongest critics of the adequacy of existing modeling tools for employee stock option valuation.
Many of the firms that extensively utilize options focus upon the valuation of the option to the employees and point to valuation approaches that emphasize the impact of the employee's risk aversion and barriers to the transferability of the option. Of course, the main measurement goal in firm accounting of disclosure of option expense focuses upon properly assessing the firm's cost rather than assessing the benefit derived by the employees and therefore, the valuation to be disclosed should reflect the firm's costs rather than the potentially more difficult to measure benefit obtained by a risk-averse employee who is unable to transfer his option. Of course, I do agree that employee risk aversion and barriers to transferability will influence the exercise decisions of the employees and therefore, need to be reflected in the valuation. However, as has been argued in the academic literature, the adjustment for the anticipated exercise experience is the manner by which the restrictions imposed upon the option holder and his risk aversion influence the valuation.10 To further adjust would lead to an incorrect valuation of the cost to the firm. To the extent that the firm's obligation is transferable, one could also potentially evaluate the fair market value of the grant by the cost of transferring some or all of the obligation under the grant to a third party.
However, this facet of the debate raises a further question-if the firms using options feel that the valuation to the employee is substantially less than the cost to the firm in light of employee risk aversion, then why is it efficient to compensate employees in this form rather than others in which the differential between the benefit to the employee and the cost to the firm is not as large? While the answer could lie in the often cited incentives benefits to the firm from employee stock option grants, it is sometimes only the most senior executives who make decisions that have broad impact on the value of the firm and have sufficient equity and options that they would internalize a nontrivial fraction of this. However, given the importance of options in the compensation programs of some companies, as an economist my presumption is that in such contexts that the substantial use of options is an efficient component of the compensation contract.
Thus far, my comments about employee stock options have been framed in terms of basic economic principles and some reflections upon the arguments being brought to bear in the broader debate. I also think that it is helpful to make a few observations about the modeling of employee stock options. While the employee's stock option is not hedgable and most employees are risk averse, the valuation cost to the employer of the resulting liability can potentially be assessed. One method of valuing employee stock options is clear from the history of the market for mortgage-backed securities. This analogy is instructive because of the lack of transferability of the mortgage obligation and the importance of the mortgage borrower's risk preferences. The tools for developing the valuation of mortgage-backed securities were developed decades ago.11 In recent years a number of interesting papers explore the valuation of employee stock options.12 Interesting predictions about exercise and forfeiture behavior can be obtained from the mortgage-backed securities perspective and the use of arbitrage principles13 and the valuation tools of modern financial economics can be adapted to the employee stock option context.
However, despite these observations about employee stock option modeling I don't want to suggest that firms necessarily need to rely upon models to determine the valuation of their employee stock options. A few alternatives have been suggested that attempt to develop instruments that would replicate the valuation of these options from the perspective of a market instrument. Issuers may indeed utilize efforts to construct marketed instruments that replicate the cash flows and valuations of employee stock options. Of course, it would be important for the instrument and the associated market distribution and information disclosure to be properly designed in order to provide an estimate of the fair value cost incurred by the firm in issuing employee stock options. Ultimately, the development of such markets and the potential availability of the underlying exercise data and the market prices of these instruments would lead to further refinement of the underlying valuation models and provide benefits even beyond the specific issuer structuring such transactions.
A subject of considerable popular interest is the issue of executive compensation. The current structure of disclosure does not provide complete clarity about the nature or magnitude of executive compensation-disclosure about these aspects of the firm may shed considerable light on decision-making within the firm. In fact, I anticipate that the development of frameworks for employee stock options valuation will ultimately enhance the quality of compensation disclosure. Of course, from an economist's perspective the clear disclosure to the marketplace matters even more than the specific accounting treatment.
In a keynote address that I gave at a conference at the end of last year14 I provided a number of perspectives about the reasons for very high levels of executive compensation building from economic principles. Most fundamentally, high compensation is crucial to attract the types of talented individuals who typically possess outstanding alternative opportunities. Sarbanes-Oxley might lead to a further increase in the CEO's compensation (relative to other executives) due to the potential need for a compensating differential for the CEO to be subject to liability associated with the required certification.15 In addition, I noted that leisure is what economists call a "normal good" so that the demand for leisure is increasing in wealth and consequently, that successful individuals need to be induced to work hard. I also noted that higher wealth can increase the manager's willingness to bear risk because of decreasing absolute risk aversion. Of course, even more directly incentive compensation increases the incentive to bear risk and helps overcome the manager's inherent risk aversion and limited wealth. Yet I don't think that it is especially surprising that the senior executive shares only a limited portion of the firm's risk.16 This is a direct consequence of managerial risk aversion, i.e., limited liability and the executive's limited wealth relative to the capital market as a whole, as well as the need to provide incentives to other key personnel. The issue of executive compensation also should be assessed within a broader landscape identified through agency theory, emphasizing the process by which senior executive compensation is determined and examining the role of the board and external compensation consultants, including the adequacy and thoughtfulness of the benchmarking process for compensation determination. Greater and more consistent disclosure also may be a helpful remedy to ensure that arms length decisions are made by the board with respect to senior executive compensation.
While my presentation suggests solution to a number of the following issues, I think that there are a number of important matters that are deserving of further thought. These relate to both the design of the future compensation plan and whether there are adequate safeguards in the setting of executive compensation so that agency conflicts are adequately mitigated.
I welcome your questions now and during the panel discussion.
Aghion, P. and J. Tirole, 1997, "Formal and Real Authority in Organizations," Journal of Political Economy 105, 1-29.
Bebchuk, L. and J. Fried, 2004, Pay without Performance: The Unfilled Promise of Executive Compensation, Harvard University Press, Cambridge, MA.
Berger, P., F. Li, and M. H. F. Wong, 2005, "The Impact of Sarbanes-Oxley on Cross-listed Companies, University of Chicago working paper.
Bettis, J.C., J. Bizjak, and M. Lemmon, 2005, "Exercise Behavior, Valuation, and the Incentive Effects of Employee Stock Options," Journal of Financial Economics 76, 445-470.
Carpenter, J., 1998, "The Exercise and Valuation of Executive Stock Options," Journal of Financial Economics 48, 127-158.
Chaochharia, V. and Y. Grinstein, 2004, "The Transformation of U.S. Corporate Boards-Recent Evidence," working paper, Cornell University.
Cohen, D., A. Dey, and T. Lys, 2004, "The Sarbanes Oxley Act of 2002: Implications for Compensation Structure and Risk-Taking Incentives of CEOs," University of Southern California working paper.
Core, J., W. Guay, and R. Thomas, 2004, "Is U.S. CEO Compensation Inefficient Pay without Performance?" working paper, University of Pennsylvania.
Dunn, K. and J. McConnell, 1981, "Valuation of GNMA Mortgage-Backed Securities," Journal of Finance 36, 599-616.
Dunn, K. and C. Spatt, 1999, "Call Options, Points and Dominance Restrictions on Debt Contracts," Journal of Finance 54, 2317-2337.
Fich, E. and A. Shivdasani, 2004, "Are Busy Boards Effective Monitors?", European Corporate Governance Institute Working Paper 55/2004.
Harris, M. and A. Raviv, 2004, "A Theory of Board Control and Size," working paper, University of Chicago and Northwestern University.
Jensen, M. and K. Murphy, 1990, "Performance Pay and Top-Management Incentives," Journal of Political Economy 98, 225-264.
Leuz, C., A. Triantis, and T. Wang, 2004, "Why do Firms go Dark? Causes and Economic Consequences of Voluntary SEC Deregistrations," working paper, University of Maryland.
Linck, J., J. Netter, and T. Yang, 2005, "Effects and Unintended Consequences of the Sarbanes-Oxley Act on Corporate Boards," University of Georgia working paper.
Marquardt, C., 2002, "The Cost of Employee Stock Option Grants: An Empirical Analysis," Journal of Accounting Research 40, 1191-1217.
Merton, R., 1973, "Theory of Rational Option Pricing," Bell Journal of Economics and Management Science, 4, 141-183.
Richard, S. and R. Roll, 1989, "Prepayments on Fixed Rate Mortgage-Backed Securities," Journal of Portfolio Management 15, 73-82.
Securities and Exchange Commission, Staff Accounting Bulletin No. 107, March 29, 2005. http://www.sec.gov/interps/account/sab107.pdf
Shivdasani, A. and D. Yermack, 1999, "CEO Involvement in the Selection of New Board Members: An Empirical Analysis," Journal of Finance 54, 1829-1853.
Spatt, C., "Executive Compensation and Contracting," keynote address presented at the Ohio State-Federal Reserve Bank of New York-Journal of Financial Economics Conference on "Agency Problems and Conflict of Interest in Financial Intermediaries" in Columbus on December 3, 2004. http://www.sec.gov/news/speech/spch120304cs.htm
Spatt, C., "Regulatory Issues and Economic Principles," distinguished lunch speaker address presented at the University of Maryland's Sixth Maryland Finance Symposium on "Governance, Markets, and Financial Policy" in College Park on April 1, 2005. http://www.sec.gov/news/speech/spch040105css.htm
Spatt, C., C. Alexander, D. Dubofsky, M. Nimalendran and G. Oldfield, "Economic Perspective on Employee Option Expensing: Valuation and Implementation of FAS 123(R)," Securities and Exchange Commission, Office of Economic Analysis Memorandum to Chief Accountant Donald Nicolaisen, March 18, 2005. http://www.sec.gov/interps/account/secoeamemo032905.pdf
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