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E M P L O Y E E B E N E F I T S , C O M P E N S A T I O N
& P E N S I O N L A W
Vol. 3, No. 11: June 6, 2002
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Publisher: LSN Employment, Labor, Compensation & Pension Journals
a division of
Social Science Electronic Publishing, Inc. (SSEP)
and Social Science Research Network (SSRN)
Editor: PAMELA PERUN
Urban Institute
Mailto:pamela@planetnow.com
Copyright: SSEP, Inc. 2002. All rights reserved.
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Topic of This Issue:
Pay Policies
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T A B L E of C O N T E N T S
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NEW and FORTHCOMING ARTICLES
"Mitigating the Pain of Equity Compensation in a Down Market"
Tax Notes, Vol. 93, No. 8, November 19, 2001
MICHAEL E. MOONEY
Nutter, McClennen & Fish, LLP
"Managerial Remuneration: The Indirect Pay-for-Performance
Relation"
Journal of Corporate Law Studies, Vol. 2, December 2001
JOSEPH A. MCCAHERY
Tilburg University
LUC D.R. RENNEBOOG
Tilburg University
Department of Finance
WORKING PAPERS
"Entrenchment and Severance Pay in Optimal Governance Structures"
ANDRES ALMAZAN
University of Texas at Austin
Red McCombs School of Business
JAVIER SUAREZ
Centro de Estudios Monetarios y Financieros (CEMFI)
Centre for Economic Policy Research (CEPR)
"The Price of Doing Good: Executive Compensation in Nonprofit
Organizations"
PETER FRUMKIN
Hauser Center, Kennedy School, Harvard University
ELIZABETH K. KEATING
Northwestern University
Kellogg Graduate School of Management
"Do Underwater Executive Stock Options Still Align Incentives?
The Effect of Stock Price Movements on Managerial
Incentive-Alignment"
LI JIN
Harvard Business School
LISA K. MEULBROEK
Harvard Business School
"Restoring the Link Between Pay and Performance: Evaluating the
Costs of Relative-Performance-Based (Indexed) Options"
LISA K. MEULBROEK
Harvard Business School
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EDITORIAL POLICIES
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Benefits, Compensation & Pension Law we do not referee working
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Benefits, Compensation & Pension Law whose topics suit the
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N E W and F O R T H C O M I N G Articles
_________________________________________________________________
"Mitigating the Pain of Equity Compensation in a Down Market"
Tax Notes, Vol. 93, No. 8, November 19, 2001
BY: MICHAEL E. MOONEY
Nutter, McClennen & Fish, LLP
Contact: MICHAEL E. MOONEY
Email: Mailto:mem@nutter.com
Postal: Nutter, McClennen & Fish, LLP
One International Place
Boston, MA 02110-2699 UNITED STATES
Phone: (617) 439-2342
ABSTRACT:
The dramatic decrease in equity values since early 2000 has left
many executives and directors, and the companies with whom they
work, facing the dilemma of how to deal with awards made under
equity compensation programs at what appear now to be inflated
values. In this report, Mooney explores ways to mitigate the
adverse impact of these value reductions and the tax and other
consequences of doing so. He concludes that there are several
ways to deal with an unexpected price decline, but warns that
time may be of the essence in achieving an effective solution to
the problem.
JEL Classification: J33, H24, H25
______________________________
"Managerial Remuneration: The Indirect Pay-for-Performance
Relation"
Journal of Corporate Law Studies, Vol. 2, December 2001
BY: JOSEPH A. MCCAHERY
Tilburg University
LUC D.R. RENNEBOOG
Tilburg University
Department of Finance
Contact: JOSEPH A. MCCAHERY
Email: Mailto:J.A.McCahery@kub.nl
Postal: Tilburg University
Faculty of Law
Postbus 90153
5000 LE Tilburg, NETHERLANDS
Phone: 31-(0)13-466-2306
Fax: 31-(0)13-466-2323
Co-Auth: LUC D.R. RENNEBOOG
Email: Mailto:luc.renneboog@kub.nl
Postal: Tilburg University
Department of Finance
Warandelaan 2
P.O. Box 90153
5000 LE Tilburg, NETHERLANDS
ABSTRACT:
This article examines the relation between executive cash
compensation and corporate governance in Europe. Most research
performed on the pay-for-performance relation has been conducted
in the United States and the United Kingdom, because the widely
held nature of shareholding makes the potential agency conflict
between shareholders and management most prominent. Arguably, a
stronger relation between pay and corporate performance might be
expected in market-oriented than in control-oriented regimes.
This is not, however, the case. Instead, there is recent
evidence which shows that CEO cash-based compensation in the
United Kingdom (a market-oriented system) hinges more on
corporate sales growth. Conversely, executive compensation in
some control-oriented systems appears not to depend solely on
corporate sales growth, but relies, to a large extent, on share
price and accounting performance. In particular, executive
directors of Spanish firms controlled by strong investor groups
receive increases in cash remuneration if their companies
generate increases in shareholder value. In contrast, Spanish
executives' cash compensation is linked to accounting
performance if the company's equity concentration is diffuse.
Keywords: corporate governance; executive pay
JEL Classification: D23, G32, J33, J44, K22
______________________________
W O R K I N G P A P E R Abstracts
_________________________________________________________________
"Entrenchment and Severance Pay in Optimal Governance Structures"
BY: ANDRES ALMAZAN
University of Texas at Austin
Red McCombs School of Business
JAVIER SUAREZ
Centro de Estudios Monetarios y Financieros (CEMFI)
Centre for Economic Policy Research (CEPR)
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=293562
Other Electronic Document Delivery:
http://www.afajof.org/prog2002.shtml
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Paper ID: AFA 2002 Atlanta Meetings
Date: October 2001
Contact: ANDRES ALMAZAN
Email: Mailto:Andres.Almazan@bus.utexas.edu
Postal: University of Texas at Austin
Red McCombs School of Business
Finance Department
21st Street & Speedway
Austin, TX 78712 UNITED STATES
Phone: 512-471-4368
Fax: 512-471-5073
Co-Auth: JAVIER SUAREZ
Email: Mailto:suarez@cemfi.es
Postal: Centro de Estudios Monetarios y Financieros (CEMFI)
Casado del Alisal 5
28014 Madrid, SPAIN
ABSTRACT:
This paper explores how motivating an incumbent CEO to undertake
actions that improve the effectiveness of his management
interacts with the firm's policy on CEO replacement. Such policy
depends on the presence and the size of severance pay in the
CEO's compensation package and on the CEO's influence on the
board of directors regarding his own replacement (i.e.,
entrenchment). We explain when and why the combination of some
degree of entrenchment and a sizeable severance package is
desirable. The analysis offers predictions about the correlation
between entrenchment, severance pay, and incentive compensation.
______________________________
"The Price of Doing Good: Executive Compensation in Nonprofit
Organizations"
BY: PETER FRUMKIN
Hauser Center, Kennedy School, Harvard University
ELIZABETH K. KEATING
Northwestern University
Kellogg Graduate School of Management
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=292253
Paper ID: Hauser Center for Nonprofit Orgs. Working Paper No. 8
Date: October 2001
Contact: PETER FRUMKIN
Email: Mailto:peter_frumkin@harvard.edu
Postal: Hauser Center, Kennedy School, Harvard University
79 John F. Kennedy Street
Cambridge, MA 02138 UNITED STATES
Phone: 617-495-8057
Fax: 617-495-0996
Co-Auth: ELIZABETH K. KEATING
Email: Mailto:e-keating@nwu.edu
Postal: Northwestern University
Kellogg Graduate School of Management
Dept of Accounting and Information Management
2001 Sheridan Road
Evanston, IL 60208 UNITED STATES
Paper Requests:
Contact Corinne Locke, Project Coordinator, Postal: Kennedy
School of Government, Harvard University, Hauser Center for
Nonprofit Organizations, 79 JFK Street, BT 214, Cambridge, MA
02138 USA. Mailto:corinne_locke@harvard.edu Phone: 617-496-0192.
Fax: 617-495-0996. Hard copy paper fee: $5 domestic, $10
international. Checks should be made out to Harvard University.
ABSTRACT:
This article examines whether nonprofit executive pay patterns
are consistent with the espoused social mission of these
organizations. We find that nonprofit CEOs are paid a
significant fixed component, and many CEOs also receive
additional pay associated with managing larger sized
organizations. Our analysis indicates that nonprofit executive
compensation is not significantly related to CEO performance, as
measured either by improved fund-raising results or better
administrative efficiency. This weak pay-for-performance link
may be due in part to nonprofits' concern about violating the
non-distribution constraint in the sector, which prohibits the
distribution of excess earnings. While nonprofits may not be
breaching the letter of the law, some organizations appear to
challenge its spirit: We present evidence that CEO compensation
is significantly higher in organizations where free cash flows
is present, as measured by commercial revenues, liquid assets
and investment portfolios.
______________________________
"Do Underwater Executive Stock Options Still Align Incentives?
The Effect of Stock Price Movements on Managerial
Incentive-Alignment"
BY: LI JIN
Harvard Business School
LISA K. MEULBROEK
Harvard Business School
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=291571
Paper ID: Harvard Business School Working Paper No. 02-002
Date: November 2001
Contact: LISA K. MEULBROEK
Email: Mailto:lmeulbroek@hbs.edu
Postal: Harvard Business School
Morgan Hall
Soldiers Field
Boston, MA 02163 UNITED STATES
Phone: 617-495-6992
Fax: 617-496-7357
Co-Auth: LI JIN
Email: Mailto:ljin@hbs.edu
Postal: Harvard Business School
Morgan Hall
Soldiers Field
Boston, MA 02163 UNITED STATES
Paper Requests:
Contact Harvard Business School Publishing, 60 Harvard Way,
Boston, MA 02163. Phone: (800)545-7685 or (001)617-783-7600
(outside US & Canada). Mailto:custserv@hbsp.harvard.edu
Web: http://www.hbsp.harvard.edu or contact author(s)directly.
ABSTRACT:
The concern that out-of-the-money stock options are not an
effective way to motivate managers has led boards of directors
to consider measures such as lowering the exercise price of
underwater options, or issuing new option grants, to restore the
incentive managers have to increase shareholder value. This
paper explores whether such measures are needed: do
out-of-the-money options lose their power to align incentives?
We address this question by estimating how the
incentive-alignment power of options changed over the course of
the year 2000, a year that for many firms marked the derailment
of the long-running bull stock market. Examining the sensitivity
in the value of the manager's stock option to changes in the
firm's stock price (one metric for incentive-alignment power),
we find that in general the ability of options to align
incentives remained remarkably intact. This resilience in
incentive-alignment power stems from the long maturity of
executive stock options, the relatively high stock price
volatility of firms that experienced stock price declines, and
to a lesser extent, the increase in volatility levels that
accompanied weakening stock prices. We test the robustness of
these results to the metric of incentive-alignment power,
replacing market values with the value that managers place on
their stock and option holdings, adjusting for managers'
inability to fully diversify their portfolios. We also test how
sensitive our results are to volatility assumptions. We conclude
that even a steep decline in stock price can leave incentive
levels intact, so restoring incentive-alignment is seldom a good
justification for resetting the stock price or issuing new
option grants. Before rejecting such measures, however, boards
must examine whether the ability of stock and option holdings to
retain key managerial talent deteriorated as the stock price
declined, for our findings suggest that in selected firms or
industries, the value of those holdings declined substantially.
Keywords: Executive compensation, Stock options, Incentives,
Underwater options
JEL Classification: G32, G34, J33, J44, M52
______________________________
"Restoring the Link Between Pay and Performance: Evaluating the
Costs of Relative-Performance-Based (Indexed) Options"
BY: LISA K. MEULBROEK
Harvard Business School
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=294442
Paper ID: Harvard Business School Working Paper No. 02-021
Date: December 2001
Contact: LISA K. MEULBROEK
Email: Mailto:lmeulbroek@hbs.edu
Postal: Harvard Business School
Morgan Hall
Soldiers Field
Boston, MA 02163 UNITED STATES
Phone: 617-495-6992
Fax: 617-496-7357
Paper Requests:
Contact Harvard Business School Publishing, 60 Harvard Way,
Boston, MA 02163. Phone: (800)545-7685 or (001)617-783-7600
(outside US & Canada). Mailto:custserv@hbsp.harvard.edu
Web: http://www.hbsp.harvard.edu or contact author(s)directly.
ABSTRACT:
Conventional stock options, say their critics, do not adequately
discriminate between strong and weak managers because their
value fluctuates with the performance of the overall market.
Such critics propose replacing conventional stock options with
options whose payoff depends on firm performance relative to
some market or industry benchmark. While these
relative-performance-benchmarked options (also referred to as
"indexed" options) offer the benefits that accrue from a tighter
link between managers' pay and their performance, they also have
costs. This paper compares the "deadweight costs" of
relative-performance-benchmarked options to those of
conventional options. By "deadweight cost," I mean the gap
between the firm's cost of granting the option and the value of
that option to less-than-fully-diversified managers. This gap
arises because managers compelled to hold stock or options to
align incentives cannot fully diversify their portfolios, and
must therefore bear more risk than would well-diversified
investors. The less-than-fully-diversified managers will
therefore always value their stock and option-based compensation
at less than its market value. I estimate the cost of this lost
diversification, and find that, perhaps surprisingly, the gap
between the firm's cost (the market value) and the manager's
private value of an option is 57% greater for
relative-performance-based options than for conventional
options. The relative-performance-based options have larger
deadweight costs because, by design, they strip away the
manager's exposure to all systematic risk, leaving her with a
portfolio with an expected return no better than the risk-free
rate. One practical implication of this insight is that firms
implementing a relative-performance-based compensation system
should not boost the number of options awarded over the number
that they would have otherwise awarded in a conventional stock
option plan, even though indexed options have a lower market
value than conventional options. Instead, firms should increase
the cash component of managers' pay, which has the effect of
decreasing the deadweight losses of the compensation plan while
maintaining or even improving its power to align incentives.