February 11, 2009
I would like to start off by saying that Professor Gordon’s article provides
a well thought out and comprehensive discussion of the issues involved with
“say on pay”. This is especially useful as it appears that “say on pay” is
going to become a fact of life in the U.S., while not all the issues
surrounding it have been analyzed sufficiently. In particular, I too am
deeply concerned about the possibility that a few proxy advisory firms will
have an outsized say on its implementation along with the use of a cookie
cutter format that will not provide the intended benefits. I also share his
concern that the SEC or state courts may also render “say on pay” proposals
to a form that is not in the best interest of shareholders. What follows are
specific comments as they relate to Gordon’s paper:
In Section 1B. Professor Gordon points out that some of the goals of
executive compensation “are not in a stable relationship with one another.”
While the point is well taken in general, I see no disconnect between the
need to provide incentives for future service and to retain and attract
managerial talent. Indeed, these two are complementary.
Professor Gordon makes a very good point in discussing how the failure to
reprice deep out of the money options may lead to very aggressive risk
taking that is contrary to the shareholders’ interests.
On the matter of CEOs not being able to hedge their equity holdings, I see
no problem as some firms (Exxon, for example) now explicitly prohibit this.
However, I would like to see firms prohibiting senior executive from
margining their holdings. In the last several months, we have seen several
CEOs and others having to dump large amounts of their shares on the market.
I am less concerned with the direct market impact of these activities than
the way in which worrying about margin calls distracts these officers from
effectively running the firm in the interests of the shareholders.
Professor Gordon states that “Stock price measures may imperfectly measure
the value of such investments (involving real options), particularly given
that the firm may resist disclosure to hold on to competitive rents.” I
agree with his general point with respect to not using stock price as the
sole metric of performance. Clearly, some accounting measures should be
used, subject to being aware of how those measures can be gamed.
In the next paragraph, reference is rightly made to the problem of the time
frame over which to measure performance. However, incentive pay can never be
a function of increasing returns alone. One must consider risk-adjusted
returns, or the CEO will surely have the incentive to swing for the fences.
I think that Professor Gordon’s points on compensation consultants are well
taken. In the same section, the idea of “categorizing the shareholder role
in compensation setting” in terms of a 2x2x2x2 matrix strikes me as a good
way to look at the issue.
One of Professor Gordon’s significant contributions is his discussion of
what we can learn from the U.K. experience. As the nature of shareholders
and their role with their firms has been different than that in the U.S, we
(U.S.) shareholders have to be careful about using the U.K. story as
prescription for our own. Of course, there are things about human nature
which are pretty much universal, so there are certainly lessons to be
learned. Thus, the adoption of a “best practices” model can indeed lead to
the herding of compensation practices. We have plenty of evidence from the
social sciences that humans herd, so what we want in compensation practices
is for firms to be willing to experiment, not use the one size fits all
approach. Professor Gordon rightly emphasizes this point again when he says
that the U.K. system with its de facto requirement to consult with the two
major proxy advisors “leads to stasis rather than innovation.”
Professor Gordon is rightly concerned to point out that “say on pay” should
not be subject to the whims of the SEC or on different state corporate laws.
Therefore, a good point is made that we have to be careful about a how a
legislatively mandated “say on pay” can have negative consequences depending
on how the legislation is crafted, not to mention the laws of unintended
Professor Gordon recommends that any mandatory “say on pay’ be limited to
the 500 largest firm by free float of market cap. I would like to see more
justification for the free float criterion, but more importantly, I would
like to be able add more firms, perhaps another 500 of the largest, after
observing a few years (three) of how the system works.
In summary, Professor Gordon’s paper clearly lays out the issues associated
with “say on pay,” and provides a useful roadmap for the important
discussion that needs to take place before its regulations are defined and
Leonard Rosenthal, Ph.D.
Professor of Finance