Tuesday, May 23, 2006

At Arms Length

A the risk of giving visitors to this small cap blog the impression that our only concern is executive compensation, I am mentioning today one more recently published book on the topic. Pay Without Performance: the Unfulfilled Promise of Executive Compensation was published in 2004 by Harvard University Press of Boston, MA. Authors Lucian Bebchuk, a Harvard University finance professor, and Jesse Fried, of the University of California at Berkeley School of Law, provide a somewhat disturbing view on why executive pay often runs to excess.

Executive pay arrangements are commonly described as “arm’s-length” negotiations between the executive and the board of directors. That is to say the executive represents himself and the board represents the shareholders. However, Bebchuk and Fried very carefully demonstrate that the process is anything but at arm’s length as the managerial power installed in the chief executive officer gives that person undue influence over the board of directors in general and the compensation committee in particular.

The professors offer three reform ideas. Greater transparency in company reports and better design of compensation packages to align executive goals with shareholder interests are the first two. The SEC is already attempting the former and I believe the latter will automatically fall into place when the third reform is accomplished.

The professors’ third proposal is to improve board accountability. They argue that it is not enough for directors to be “independent” from management. Directors also need to be more “dependent” upon shareholders. Bebchuk and Fried’s ideas should be music to the ears of corporate governance activists who, like the professors, advocate greater shareholder power to place nominees on the proxy ballot, limits on staggered board elections, and elimination of board veto power over governance changes proposed by shareholders, among other reforms.

The 300-plus pages are a worthwhile read for shareholders looking for solutions to greed in the executive suite and for analysts looking for tools to evaluate the fairness of executive compensation. Importantly, Bebchuk and Fried’s research and their reform ideas apply equally well to large and small cap companies.

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