SANJAI BHAGAT, University of Colorado at Boulder - Department of Finance
Email: sanjai.bhagat@colorado.edu
ROBERTA ROMANO, Yale Law School, National Bureau of Economic Research (NBER), European Corporate Governance Institute (ECGI)
Email: roberta.romano@yale.edu

Executive compensation reform should lead to policies that are simple, transparent, and focused on creating and sustaining long-term shareholder value. We suggest that executive incentive compensation plans should consist only of restricted stock and restricted stock options, restricted in the sense that the shares cannot be sold or the option cannot be exercised for a period of at least two to four years after the executive's resignation or last day in office. This will provide superior incentives for executives to manage corporations in investors' longer-term interest, and diminish their incentives to make public statements, manage earnings, or accept undue levels of risk, for the sake of short-term price appreciation.

JOY SABINO MULLANE, Villanova University School of Law
Email: sabino@law.villanova.edu

Congress has enacted a number of tax provisions that aim to penalize companies and their executives when the executive is paid more than Congress thinks is desirable. Congress was motivated to enact these provisions by intense public sentiments regarding executive compensation levels during times of economic turmoil. This article demonstrates, however, that not only are these provisions ineffective at reducing executive compensation levels, but they penalize the wrong people. This article reveals that the penalties do not significantly fall on the executives that Congress was targeting with enactment of the penalties. Instead, these penalties impose costs on a variety of constituencies who are, generally speaking, ordinary Americans. Thus, the actual effect of the tax penalties is to harm the people who were the catalyst for enactment of the tax penalties in the first place.

Who bears the financial burden and is penalized by tax penalties on executive compensation has received almost no attention in the legal literature. Consideration of this issue, however, is of contemporary relevance as Congress has been considering expanding the use of tax penalties in an effort to not only curtail executive compensation but also to raise federal revenue. The article concludes with suggestions for dealing with the underlying problems regarding executive compensation levels in place of enacting tax penalties aimed at the symptoms of these problems.

KAREN C. BURKE, University of San Diego School of Law
Email: burkek@sandiego.edu

Proposals to tax the compensatory portion of a service partner's return as ordinary income have gained momentum and enactment of carried interest legislation seems inevitable, driven by concerns about fairness and revenue. A leading legislative proposal (modified and reintroduced as H.R. 1935) would add new 710 to the Code. Proposed 710 is widely portrayed as taxing distributions to a covered service partner at ordinary income rates, in keeping with the view of taxing distributions to service partners at ordinary income rates as "probably the most appealing policy option," but the actual operation of the new provision is much more complex. The reason is that 710 would recharacterize only a portion of a service partner's distributive share as ordinary income, while the tax treatment of actual distributions to a service partner would depend on the interplay of 710 with the rest of Subchapter K. Such a hybrid distributive-share approach would produce results that cannot easily be reconciled with the broader structure of Subchapter K.

The article explores the exception for a qualified capital interest when a service partner's share of partnership income is recharacterized as ordinary income and distributions are deferred. A simple example is used to illustrate how the statutory mechanics of 710 bifurcate a service partner's profits interest into a stream of compensatory return (taxed as ordinary income) and investment return (potentially taxed as capital gain) on reinvested deferred salary. The article suggests that 707(a)(2)(A) might be modestly expanded to provide a narrower, more focused approach to taxing compensatory arrangements that potentially minimize taxes, without permitting undue deferral. Regardless of which approach Congress adopts, it is essential to consider carefully the interaction of carried interest legislation with the broader framework of taxing deferred compensation under 83, 409A, and 457A.

ROBERT BUCHELE, Smith College - Department of Economics
Email: rbuchele@email.smith.edu
DOUGLAS L. KRUSE, Rutgers University
Email: dkruse@rci.rutgers.edu
LOREN RODGERS, National Center for Employee Ownership
Email: lrodgers@nceo.org
ADRIA SCHARF, University of Washington
Email: ascharf@u.washington.edu

This paper examines the effect of a variety of employee ownership programs on employees' holdings of their employers' stock, their earnings and their wealth. Two major datasets are employed: the NBER Shared Capitalism Research Project employee survey dataset and the 2002 and 2006 national General Social Surveys (GSS). The GSS national survey shows that 29% of permanent, full-time employees with at least one year on the job own their employers' stock, compared to the unsurprisingly higher 87% of employees in the NBER "shared capitalist" firms. The employees in the national sample hold an average of $10,600 of employer stock, compared to $52,800 in the NBER sample. Employee owners in NBER companies with broad-based ownership structures fare better: those in majority-owned ESOPs hold on average $86,000 in company stock and those in broad-based stock option plans hold options worth an average of $283,000. We find no evidence -- either between datasets or between employee-owners and non-owners within datasets -- of substitution of company stock ownership for pay or benefits. Moreover, our analysis suggests that company stock ownership substantially raises total employee wealth, though it appears to have little effect on the overall distribution of wealth. These results suggest that employee ownership tends to raise both ownership stakes and economic resources of American workers across the economic spectrum.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

JOHN M. BIZJAK, Portland State University - Department of Finance, Portland State University
Email: johnb@sba.pdx.edu
MICHAEL L. LEMMON, University of Utah - Department of Finance
Email: finmll@business.utah.edu
THANH LAI NGUYEN, University of Utah - Department of Finance
Email: pfintn@business.utah.edu

Critics contend that the use of compensation peer groups has resulted in inflated CEO pay that cannot be justified based on economic fundamentals. We examine this issue using the mandated disclosure of compensation peers in 2006. Although firms generally select compensation peers based on characteristics that reflect the labor market for managerial talent, we find evidence that the selected peers are chosen in a manner that biases compensation upward. The bias in peer group selection is unrelated to corporate governance and instead appears to be an institutionalized part of the pay setting process. Our estimates suggest that on average, peer group benchmarking, at least as currently practiced, results in excess pay of between $700 thousand and $1.1 million over a typical CEO career of seven years.

ROBIN HOGARTH, Universitat Pompeu Fabra - Faculty of Economic and Business Sciences
Email: robin.hogarth@econ.upf.es
GUEORGUI I. KOLEV, Universitat Pompeu Fabra - Department of Economics and Business (DEB)
Email: gueorgui.kolev@upf.edu

Illusory correlation refers to the use of information in decisions that is uncorrelated with the relevant criterion. We document illusory correlation in CEO compensation decisions by demonstrating that information, that is uncorrelated with corporate performance, is related to CEO compensation. We use publicly available data from the USA for the years 1998, 2000, 2002, and 2004 to examine the relations between golf handicaps of CEOs and corporate performance, on the one hand, and CEO compensation and golf handicaps, on the other hand. Although we find no relation between handicap and corporate performance, we do find a relation between handicap and CEO compensation. In short, golfers earn more than non-golfers and pay increases with golfing ability. We relate these findings to the difficulties of judging compensation for CEOs. To overcome this - and possibly other illusory correlations - in these kinds of decisions, we recommend the use of explicit, mechanical decision rules.

ANA M. ALBUQUERQUE, Boston University School of Management
Email: albuquea@bu.edu
GUS DE FRANCO, University of Toronto - Joseph L. Rotman School of Management
Email: gdefranc@utm.utoronto.ca
RODRIGO S. VERDI, Massachusetts Institute of Technology (MIT)
Email: rverdi@mit.edu

We study the determinants of firms' choice of peers, and how that choice impacts CEO compensation. Our sample includes 678 firms (1,152 firm-years) that disclose peers following the new disclosure rules for executive compensation. Competitive benchmarking predicts that peer choice will be explained by similarity in firm characteristics that capture similarity in the labor market for executives. In contrast, critics argue that managers will act in a self-serving manner when selecting compensation peers. We find that peer choice is driven by economics factors such as similarity in industry, size, performance, investment tangibility, and past return covariance. However, we also find that firms appear to be self-serving when selecting peers. Specifically, firm-chosen peers are larger and pay their CEOs higher compensation compared with predicted peers. Further, the compensation of firms' CEOs is positively associated with CEO compensation at firm-chosen peers, after controlling for economic determinants of CEO compensation.

JOSEPH ENGELBERG, University of North Carolina at Chapel Hill - Kenan-Flagler Business School
Email: Joseph_Engelberg@unc.edu
PENGJIE GAO, University of Notre Dame - Mendoza College of Business
Email: pgao@nd.edu
CHRISTOPHER A. PARSONS, University of North Carolina at Chapel Hill
Email: chris_parsons@unc.edu

We document a strong relation between CEO compensation and the size of his network to other corporate executives and directors. On average, an additional connection increases a CEO's total pay by over $17,000. A CEO can extract an additional premium if his network contains "important" members - executives and directors of large or local firms within the same industry. Geographically isolated firms value connections more so than their counterparts located within industry clusters. Finally, we identify a channel through which networks may enhance firm value. We find that firms with highly connected CEOs have higher industry-adjusted sales, but only in industries where relationships are deemed important.