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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. 5, No. 7: April 8, 2004
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Publisher: LSN Employment, Labor, Compensation & Pension Journals
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Editor: PAMELA PERUN
Urban Institute
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Copyright: SSEP, Inc. 2004. All rights reserved.
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Topic of This Issue:
Executive Compensation
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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
"Governance Matters: Convergence in Law and Practice Across the
EU Executive Pay Faultline"
Journal of Corporate Law Studies, Vol. 2, 2004
GUIDO ALESSANDRO FERRARINI
University of Genoa
Law School
European Corporate Governance Institute (ECGI)
NIAMH MOLONEY
Stockholm University
School of Law
European Corporate Governance Institute (ECGI)
CRISTINA VESPRO
ECARES, Université Libre de Bruxelles
European Corporate Governance Institute (ECGI)
"The Tax Efficiency of Stock-Based Compensation"
Tax Notes, Forthcoming
MICHAEL S. KNOLL
University of Pennsylvania
School of Law
University of Pennsylvania
Real Estate Department
"Excessive Executive Compensation - (Principal Symptom of Poor
Corporate Governance) Causes and Remedies"
Pennsylvania Bar Institute (Philadelphia Bar Association
Tax Section Fall CLE) - Executive Compensation Post
Sarbanes-Oxley Act, PBI No. 2003-3567
DON W. LLEWELLYN
Villanova University
School of Law
WORKING PAPERS
"Is There a Link Between Executive Compensation and Accounting
Fraud?"
MERLE ERICKSON
University of Chicago
MICHELLE HANLON
University of Michigan at Ann Arbor
Business School
EDWARD L. MAYDEW
University of North Carolina at Chapel Hill
"Active Institutional Shareholders and Managerial Compensation"
ANDRES ALMAZAN
University of Texas at Austin
Department of Finance
JAY C. HARTZELL
University of Texas at Austin
Department of Finance
LAURA T. STARKS
University of Texas at Austin
Department of Finance
"Executive Pay, Earnings Manipulation and Shareholder Litigation"
LIN PENG
Baruch College, City University of New York -
Zicklin School of Business
AILSA A. ROELL
Princeton University
Bendheim Center for Finance
"Executive Compensation, Incentives, and Risk"
DIRK C. JENTER
Massachusetts Institute of Technology (MIT)
Sloan School of Management
S S R N I N F O R M A T I O N
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N E W and F O R T H C O M I N G Articles
_________________________________________________________________
"Governance Matters: Convergence in Law and Practice Across the
EU Executive Pay Faultline"
Journal of Corporate Law Studies, Vol. 2, 2004
BY: GUIDO ALESSANDRO FERRARINI
University of Genoa
Law School
European Corporate Governance Institute (ECGI)
NIAMH MOLONEY
Stockholm University
School of Law
European Corporate Governance Institute (ECGI)
CRISTINA VESPRO
ECARES, Université Libre de Bruxelles
European Corporate Governance Institute (ECGI)
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=498362
Contact: GUIDO ALESSANDRO FERRARINI
Email: Mailto:guido.ferrarini@giuri.unige.it
Postal: University of Genoa
Law School
Via Balbi, 22
16126 Genova, ITALY
Phone: +39-010-2099894
Fax: +39-010-2099890
Co-Auth: NIAMH MOLONEY
Email: Mailto:niamhmoloney@eircom.net
Postal: Stockholm University
School of Law
28 University Square
Belfast BT7 1NN, IRELAND
Co-Auth: CRISTINA VESPRO
Email: Mailto:cvespro@ulb.ac.be
Postal: ECARES, Université Libre de Bruxelles
Ave. Franklin D Roosevelt, 50 - C.P. 114
B-1050 Brussels, BELGIUM
ABSTRACT:
This paper considers the regulation of executive pay practices
in listed companies in the European Union and the empirical
evidence of pay practices, based on the FTSE Eurotop 300
membership's annual report for 2001. The analysis is placed in
the context of the dispersed ownership/blockholding ownership
faultline which runs across EU corporate governance, and in
light of recent EU initiatives, particularly the Commission's
May 2003 Company Law Action Plan.
The outstanding feature of executive pay in the EU is the
extent to which it reflects the interconnection between pay and
corporate governance or ownership structures. Executive pay,
regarded as a management incentive contract, is a key
agency-cost control mechanism in dispersed ownership systems.
Legal controls on pay are accordingly at their most
sophisticated, in terms of promoting the adoption of an optimal
contract for shareholders, in those EU Member States where
dispersed ownership dominates. These systems also see the
heaviest reliance in practice on high-powered, equity-based,
incentive-driven pay contracts. In blockholding systems,
controlling shareholders can, in theory, monitor management
directly without the need for an incentive contract. Pay
controls are accordingly less sophisticated and, as revealed by
the FTSE Eurotop 300 evidence, the prevalence of high-powered
equity-based incentive contracts is reduced. Different concerns
arise, however, as to the protection of minority shareholders
from controlling blockholders.
At present, notwithstanding a growing pan-EU concern with
executive pay, it cannot be regarded in a monolithic fashion for
pan-EU reform purposes. A shift to more pervasive equity
ownership across the EU may, however, bring the problems
currently associated with pay practices in dispersed ownership
systems. The governance and disclosure matrix proposed by the
Commission's Company Law Action Plan to address the conflicts of
interests inherent in executive pay setting may, therefore, be
important as a precautionary measure. The Action Plan's
executive pay proposals also reflect the growing convergence
among Member States, on both sides of the governance faultline,
as to the importance of full, individualized disclosure of
executive pay and of the remuneration committee in managing
conflicts of interests in the executive pay process.
JEL Classification: G3, G38, J33, K22
______________________________
"The Tax Efficiency of Stock-Based Compensation"
Tax Notes, Forthcoming
BY: MICHAEL S. KNOLL
University of Pennsylvania
School of Law
University of Pennsylvania
Real Estate Department
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=511143
Contact: MICHAEL S. KNOLL
Email: Mailto:mknoll@law.upenn.edu
Postal: University of Pennsylvania
School of Law
3400 Chestnut Street
Philadelphia, PA 19104-6204 UNITED STATES
Phone: 215-898-6190
Fax: 215-573-2025
ABSTRACT:
Over the last two decades, the use of company stock and options
thereon to compensate and motivate employees has become
widespread. Defenders of stock-based compensation argue that it
creates value for shareholders because it encourages employees
to work harder and with a common purpose. Critics, however, are
less sure and stock-based compensation has come under heavy
attack from investors, commentators and academics. Critics argue
that it imposes excessive risk on employees and overstates net
income. To date, there has been very little detailed legal or
economic analysis of the tax efficiency of stock-based
compensation. What serious work there has been has generally
concluded that such mechanisms are inefficient, perhaps highly
inefficient. Clearly, given the heavy use of stock-based
compensation and thus the substantial tax costs firms would
incur if it were tax inefficient, measuring the tax saving or
cost from stock-based compensation is an important gap in the
debate over the wisdom of its heavy use.
In this paper, I define tax efficiency and develop a
methodology for assessing whether a compensation mechanism is
tax efficient. I then apply that methodology to various forms of
stock-based compensation. I show that there is no general answer
to the question whether stock-based compensation mechanisms are
efficient. Instead, I show that the tax efficiency of such
mechanisms depends upon several factors, including tax rates,
what investment (if any) the grant displaces, and how the
displaced investment would have been held. As a result, the
efficiency of stock-based compensation can vary across employers
and even across employees of the same employer. Accordingly, I
cabin the efficiency cost of stock-based compensation over a
wide range of circumstances and show that under reasonable
assumptions stock-based compensation can produce a joint net tax
benefit to employer and employee.
JEL Classification: G32, H25, J33, K22, K34
______________________________
"Excessive Executive Compensation - (Principal Symptom of Poor
Corporate Governance) Causes and Remedies"
Pennsylvania Bar Institute (Philadelphia Bar Association
Tax Section Fall CLE) - Executive Compensation Post
Sarbanes-Oxley Act, PBI No. 2003-3567
BY: DON W. LLEWELLYN
Villanova University
School of Law
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=499842
Paper ID: Villanova Law Public Policy Research Paper No. 2004-3
Contact: DON W. LLEWELLYN
Email: Mailto:llewellyn@law.villanova.edu
Postal: Villanova University
School of Law
299 N. Spring Mill Road
Villanova, PA 19085 UNITED STATES
ABSTRACT:
Advantageous accounting and tax treatment caused service-based
stock options to be the major contributor to excessive executive
compensation. All of the decision makers knew or should have
known that such treatment was bogus. The lawyers and accountants
were the enablers but the members of the corporate compensation
committees were happy to have the cover.
It appears that the abuses will end. Hundreds of corporations
have voluntarily rejected the bogus accounting treatment, and
the Financial Accounting Standards Board will soon change the
accounting treatment for all corporations.
The most important step, however, is the new rules adopted by
the Nasdaq and the NYSE that will require independent directors
to fix executive compensation. (The original publication
referred to those rules as proposed - they have since been
finalized). Those rules will be more effective than the
Sarbanes-Oxley provision passed by Congress in stopping the
abuses.
______________________________
W O R K I N G P A P E R Abstracts
_________________________________________________________________
"Is There a Link Between Executive Compensation and Accounting
Fraud?"
BY: MERLE ERICKSON
University of Chicago
MICHELLE HANLON
University of Michigan at Ann Arbor
Business School
EDWARD L. MAYDEW
University of North Carolina at Chapel Hill
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=509505
Date: February 24, 2004
Contact: MICHELLE HANLON
Email: Mailto:mhanlon@umich.edu
Postal: University of Michigan at Ann Arbor
Business School
701 Tappan Street
Ann Arbor, MI 48109 UNITED STATES
Phone: 734-647-4954
Fax: 734-936-0282
Co-Auth: MERLE ERICKSON
Email: Mailto:merle.erickson@gsb.uchicago.edu
Postal: University of Chicago
Graduate School of Business
1101 East 58th Street
Chicago, IL 60637 UNITED STATES
Co-Auth: EDWARD L. MAYDEW
Email: Mailto:edward_maydew@unc.edu
Postal: University of North Carolina at Chapel Hill
McColl Building
Chapel Hill, NC 27599-3490 UNITED STATES
ABSTRACT:
This study investigates the association between the structure of
executive compensation and accounting fraud. We study 50 firms
accused of accounting fraud by the Securities and Exchange
Commission (SEC) during the period 1996-2003 as compared to
firms not accused of accounting fraud during the same period. We
find that the probability of accounting fraud is increasing in
the percent of total executive compensation that is stock-based
(termed stock-based mix) after controlling for governance
characteristics, financial performance, financial distress, firm
size, and the likelihood of management wanting to obtain
external financing. We find that while the unconditional
likelihood of accounting fraud is small, a one standard
deviation increase in the proportion of compensation that is
stock-based increases the probability of an accounting fraud by
approximately 68%.
For managers to undertake fraud they must perceive positive
benefits from it. We examine the extent to which managerial
wealth was overstated prior to the alleged fraud by measuring
the decline in managerial wealth once the alleged fraud was made
public. We find that the value of managerial stock holdings in
firms accused of fraud declined by 49% at the median over the
six months following the accusation of fraud.
We do not conclude from this evidence that stock-based
compensation is inefficient. Rather, the evidence suggests that
compensation committees face a trade-off between the positive
incentive effects afford by stock-based compensation and the
negative effect of increasing the probability of accounting
fraud.
JEL Classification: G30, G32, J33, K22, M41
______________________________
"Active Institutional Shareholders and Managerial Compensation"
BY: ANDRES ALMAZAN
University of Texas at Austin
Department of Finance
JAY C. HARTZELL
University of Texas at Austin
Department of Finance
LAURA T. STARKS
University of Texas at Austin
Department of Finance
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=500262
Date: February 2004
Contact: JAY C. HARTZELL
Email: Mailto:Jay.Hartzell@mccombs.utexas.edu
Postal: University of Texas at Austin
Department of Finance
1 University Station B6600
Red McCombs School of Business
Austin, TX 78712 UNITED STATES
Phone: 512-471-6779
Fax: 512-471-5073
Co-Auth: ANDRES ALMAZAN
Email: Mailto:ANDRES.ALMAZAN@BUS.UTEXAS.EDU
Postal: University of Texas at Austin
Department of Finance
Red McCombs School of Business
Austin, TX 78712 UNITED STATES
Co-Auth: LAURA T. STARKS
Email: Mailto:lstarks@mail.utexas.edu
Postal: University of Texas at Austin
Department of Finance
Red McCombs School of Business
Austin, TX 78712 UNITED STATES
ABSTRACT:
Although evidence suggests that institutional investors play a
role in monitoring management, not all institutions are equally
willing or able to serve this function. We present a stylized
model of institutional monitoring and executive compensation to
illustrate how potential business relations with the firm and
the liquidity of the firm's stock can affect the intensity of
institutional monitoring. The model predicts that institutions'
influence on managers' pay-for-performance sensitivity and level
of compensation is reduced when institutions have greater
potential for business relations with the firm, but that these
effects are attenuated in firms with low liquidity. Our
empirical results are consistent with these implications.
JEL Classification: G34, G23
______________________________
"Executive Pay, Earnings Manipulation and Shareholder Litigation"
BY: LIN PENG
Baruch College, City University of New York -
Zicklin School of Business
AILSA A. ROELL
Princeton University
Bendheim Center for Finance
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=488148
Date: December 2003
Contact: LIN PENG
Email: Mailto:lin_peng@baruch.cuny.edu
Postal: Baruch College, City University of New York - Zicklin
School of Business
New York, NY 10021 UNITED STATES
Phone: 646-312-3491
Fax: 646-312-3451
Co-Auth: AILSA A. ROELL
Email: Mailto:aroell@princeton.edu
Postal: Princeton University
Bendheim Center for Finance
26 Prospect Avenue
Princeton, NJ 08540 UNITED STATES
ABSTRACT:
The paper examines the role of executive compensation in
inducing management behavior that triggers private securities
litigation. Incentive pay in the form of options is found to
increase the probability of securities class action lawsuits,
holding constant a wide range of other firm characteristics. In
contrast, base pay levels and restricted stock grants do not
have a significant impact on lawsuit incidence. Firms whose
executives hold restricted stock only, and no options, induce
less shareholder litigation. Our results suggest that
option-based compensation may give executives too strong an
incentive to target the short term share price, which may be
harmful to long term shareholder value. We further identify
earnings manipulation as an important channel linking
compensation and litigation: incentive pay has a significant
impact on earnings manipulation, which in turn significantly
affects the probability of litigation. However, our
accrual-based measure of manipulation does not capture the full
impact of compensation on litigation, suggesting other channels
are important.
JEL Classification: G30, G34, J33, K22, M41, M43
______________________________
"Executive Compensation, Incentives, and Risk"
BY: DIRK C. JENTER
Massachusetts Institute of Technology (MIT)
Sloan School of Management
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=490662
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Paper ID: MIT Sloan Working Paper No. 4466-02
Date: April 2002
Contact: DIRK C. JENTER
Email: Mailto:djenter@mit.edu
Postal: Massachusetts Institute of Technology (MIT)
Sloan School of Management
Cambridge, MA 02142 UNITED STATES
Phone: 617-258-8947
Paper Requests:
Contact Mailto:docs@mit.edu, Phone: 617-253-5668, Fax:
617-253-1690.
ABSTRACT:
This paper analyzes the link between equity-based compensation
and created incentives by (1) deriving a measure of incentives
suitable for both linear and non-linear compensation contracts,
(2) analyzing the effect of risk on incentives, and (3)
clarifying the role of the agent's private trading decisions in
incentive creation. With option-based compensation contracts,
the average pay-forperformance sensitivity is not an adequate
measure of ex-ante incentives. Pay-for-performance covaries
negatively with marginal utility and hence overstates the
created incentives. Second, more noise in the performance
measure implies that the manager is less certain about the
effect of effort on performance, which in turn makes her less
willing to exert effort. Finally, the private trading decisions
by the manager have first-order effects on incentives. By
reducing her holdings of the market asset, the manager achieves
an effect similar to "indexing" the stock or option grant,
making explicit indexation of the contract redundant.