Responses and rejoinders to commentaries

Responses and rejoinders to commentaries on: Shan, Y. & Walter, T. (2016). Towards a Set of Design Principles for Executive Compensation Contracts. Abacus: a journal of accounting, finance and business studies, 52 (4), 619-684. Disciplines Business Publication Details Shan, Y. & Walter, T. (2016). Responses and rejoinders to commentaries. Abacus: a journal of accounting, finance and business studies, 52 (4), 772-780. This journal article is available at Research Online: https://ro.uow. edu.au/buspapers/1180 YAOWEN SHAN AND TERRY WALTER Responses and Rejoinders to Commentaries We are fortunate to have received 13 excellent commentaries on our paper. Each commentary is quite unique, perhaps reflecting how controversial is the topic of trying to set down fundamental design principles for managerial reward systems. Below we provide a brief response to each of the commentaries, setting out a summary of the issues that are raised and pointing out particular aspects that contribute to our ultimate goal of obtaining a consensus among finance and accounting academics on the central issue. Of course, once this set of papers are in the public domain, there will be further discussion and exchange of ideas. In accord with academic norms, we respond to each paper in alphabetical order. Beaumont et al. (2016) conduct an empirical experiment to gauge whether CEO pay is too high in the US, Australia and the UK. They do so by comparing the pay of CEOs to that of athletes in professional sports. The conclusion from this empirical analysis is that in the US ‘the shape and nature of the distribution of CEO pay appears quite similar to that of professional athletes’ (p. xx) and ‘the data suggests [sic] that the bulk of the CEOs receive low pay’ (p. xx). For Australia and the UK (where the sample sizes are much more limited) the conclusion is that Australian CEOs ‘receive roughly twice the compensation of the . professional athletes’ (p. xx) whereas in the UK ‘CEOs earn higher equitylinked salaries than soccer players, but lower base salaries than these players’ (p. xx). While we find this analysis interesting, especially in relation to some of the historical insights that are developed in the commentary, it does not offer any specific recommendations on the principles we set down. We also doubt the validity of a comparison to professional sporting reward systems, remembering that CEO rewards are dominated by stock-based incentive-aligning payments, which do not exist for most professional sports athletes. Our understanding of the remuneration structures for athletes in the major leagues in the US is that they tend to have salary caps with pre-determined maximum tenures, salaries and salary growth rates and are tied to the income of the league. These issues make comparisons to CEO compensation even more dubious. Boyle (2016), while generally sympathetic to the task we have undertaken, offers several insights that we did not canvass in our discussion. In particular, he alludes to a third ‘camp’ of theories of executive compensation, namely the view articulated in Dorff (2014) who rejects both the efficient contracting and managerial power paradigms in ‘favour of a behavioural approach in which psychological factors cause well-meaning but befuddled directors to excessively remunerate CEOs’ (p. xx). Boyle, however, sets this up as a ‘straw man’ because he states in footnote 2 that he finds the view to be unconvincing. Of more importance are the points Boyle makes in relation to compensation consultants, and the conflicts they face in providing advice to boards and CEOs who employ them as consultants. Boyle suggests that truly independent labour economists (and we would add financial economists) be employed to analyze the data. If the data are share prices, and if standard and accepted models of excess returns are employed, perhaps some of these conflicts could be avoided. But this assumes, as pointed out by Boyle (2016), that CEO performance is a primary driver of sharemarket returns for their firms. Suppose there are events, and Boyle provides some examples, where exceptional sharemarket returns are unrelated to CEO skill or effort. For example, exceptional performance might be due to luck or to the resolution of disputes that arose before the CEO was hired. In such circumstances strictly tying bonus pools to excess returns would be counterproductive. These issues have, however, caused us to develop a tenth principle. Specifically, we now propose that the compensation committee be given discretionary power to investigate unusual circumstances in the firm’s sharemarket performance that are unrelated to CEO skill and effort, and make adjustments to the bonus pool. Boyle also provides additional discussion of public sector firms where similar controversies have arisen in relation to CEO pay. However, he cautions us to not venture into this minefield. We accept this advice. Brown and Szimayer (2016) make several valuable contributions to our paper. In particular they concentrate on the ‘value gap’, that is, the difference between the cost to the company of granting stock and option compensation and the value of that compensation to the CEO. They provide several references to papers that collectively show ‘that the key properties of ESOs can pose serious difficulties when attempting to value them, and . can lead to substantial cost overstatements’ (p. xx). The discussion of the value gap concludes the authors’ claim that ‘could easily be 20% or more’. One issue not canvassed in our paper is whether there is an optimal pay–performance sensitivity, and if so, what determines it. While theoretical and empirical research in this area is shown in Brown and Szimayer (2016) to be ongoing it seems from the existing literature that performance vesting is an essential element for effective CEO remuneration design. Brown and Szimayer (2016) also discuss how dividend adjustments might be incorporated and provide practical guidance and precision to the principle we set out. They also propose, in the spirit of making remuneration systems more implementable, the use of a total shareholder return (TSR) rather than the less familiar academic models of excess performance that we propose. The main point we make on this issue is that the bonus pool should be based on a performance benchmark that measures shareholder wealth creation relative to an appropriate benchmarked set of peers. But if accountants and financial executives can come to grips with Black-Scholes option pricing valuations, is it unreasonable to expect that they could also feel comfortable with a market model orf a Fama-French three factor model? We also wish to highlight an issue raised by Brown and Szimayer (2016) with which we strongly agree. In order for our principles to be incorporated into executive remuneration systems it is essential that the compensation committee has the help of independent experts. A conflict of interests potentially exists here because if a remuneration expert demonstrates poor CEO performance that expert may not be re-hired. Da Silva Rosa (2016) provides a lengthy and erudite discussion of three themes of central concern to our objectives. Specifically he argues that (a) there is a plausible case that the controversy over CEO pay is a sideshow with little impact on how CEOs are remunerated, (b) we do not robustly understand the drivers of CEO pay, and (c) we risk asking too much of the market in tying CEO pay to abnormal equity returns. Da Silva Rosa also argues that the Murphy and Jensen (2011) claim ‘that almost all CEO and executive bonus plans are deeply flawed’ is severely overstated. Perhaps this is why the paper remains unpublished. Further, he objects to our second principle, which recommends that the market for managerial talent be used as an input in setting and adjusting CEO pay, arguing that such a recommendation will not contribute significantly to settling the controversy over CEO pay. We believe it will be important for compensation committees to gain access to professional advice so that a proper understanding of current pay arrangements is incorporated. And, of course, there will be negotiations between the board and a new CEO over base pay arrangements. We have, however, as a result of the feedback and suggestions we have received not only from the Da Silva Rosa commentary, added a tenth principle. We believe that this principle alleviates many of the concerns that have been espoused in Da Silva Rosa’s critique. Specifically, we now propose that the compensation committee be given discretionary power to investigate unusual circumstances in the firm’s sharemarket performance that are unrelated to CEO skill and effort, and make appropriate adjustments to the bonus pool. Such committees would need to draw on expert inputs from compensation consultants and might benefit from the advice of labour economists and financial economists. Hillier et al. (2016) offer suggestions on how information from the market for managerial talent might be operationalized in practice. However, they object to our previous suggestion that there should be an upper limit on the size of the bonus pool. We agree that this suggestion might be misinterpreted and hence we have changed the wording in this principle. We do not object to managers who are responsible for huge value creation being handsomely rewarded, and while we do not wish to set a particular percentage on what proportion of shareholder wealth increases might go into a bonus pool, it is in that spirit we suggested a cap on the size of the bonus. It would be entirely self-defeating if the bonus pool was 100% of the shareholders’ wealth increases. Hillier et al. (2016) also propose additional disclosures as to the composition of the peer group used in benchmarking and whether the performance criteria used are set independently. We agree that additional disclosure is a worthwhile topic for further development sub