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Journal of Business Ethics (2005) 62: 101–113 Ó Springer 2005

DOI 10.1007/s10551-005-0175-7

Corporate Governance Reform

and CEO Compensation: Intended Ella Mae Matsumura
and Unintended Consequences Jae Yong Shin

ABSTRACT. Recent scandals allegedly linked to CEO of executive compensation, increase institutional investor
compensation have brought executive compensation and involvement in corporate governance (including execu-
perquisites to the forefront of debate about constraining tive compensation), and require firms to expense stock
executive compensation and reforming the associated options on their income statements. We provide a brief
corporate governance structure. We briefly describe the summary discussion of ethical issues related to executive
structure of executive compensation, and the agency compensation, and describe possible future research.
theory framework that has commonly been used to
conceptualize executives acting on behalf of shareholders. KEY WORDS: corporate governance, executive
We detail some criticisms of executive compensation and compensation, independent compensation committee,
associated ethical issues, and then discuss what previous institutional investor, stock-based compensation.
research suggests are likely intended and unintended
consequences of some widely proposed executive com-
pensation reforms. We explicitly discuss the following
recommendations for reform: require greater indepen-
dence of compensation committees, require executives to Recent scandals allegedly linked to CEO compen-
hold equity in the corporation, require greater disclosure sation have brought executive compensation and
perquisites to the forefront of debate about con-
straining executive compensation and reforming the
Ella Mae Matsumura is an Associate Professor in the University associated corporate governance structure. This
of Wisconsin-Madison School of Business’ Department of
paper discusses intended and possible unintended
Accounting and Information Systems. She received her Ph.D.
consequences of recent calls for reform of executive
degree from the University of British Columbia. She teaches
courses on strategic cost management and performance mea- compensation and related corporate governance
surement. Her research includes work on agency relationships, structures. We focus on U.S. publicly traded com-
compensation, performance evaluation, decision-making, cus- panies, which are subject to rules of the relevant
tomer profitability analysis, and audit quality (for example, stock exchange and the Securities and Exchange
fraud detection, second-partner review, and going-concern Commission (SEC). We begin by briefly describing
decisions). Her articles have appeared in leading accounting the structure of executive compensation, and then
research journals. describe the agency theory framework that has
Jae Yong Shin is a doctoral candidate in accounting at the commonly been used to conceptualize situations
University of Wisconsin-Madison. He earned his M.B.A. where an agent acts on behalf of a principal, such as
from Seoul National University and previously was a senior an executive acting on behalf of shareholders. We
researcher in the management consulting division of the Korea
detail some criticisms of executive compensation and
Information Strategy Development Institute (KISDI). His
associated ethical issues, and then discuss what pre-
research interests are in the area of managerial accounting
issues—choice of performance measures in executive compen- vious research suggests are likely intended and
sation contracts, ownership structure and executive compen- unintended consequences of some widely proposed
sation, relative performance evaluation, and performance executive compensation reforms.
effects of management control system design, performance We explicitly discuss reforms related to three of
measurement, and compensation schemes. Business Roundtable’s1 widely supported principles
102 Ella Mae Matsumura and Jae Yong Shin

of desirable attributes of executive compensation in conditions. Finally, unlike the annual bonus that
‘‘Principles of Executive Compensation’’. These six rewards a single year’s performance, many compa-
principles (listed in the Appendix) are intended ‘‘to nies offer a long-term incentive plan based on
serve as best practices for the design, implementa- rolling-average three- or five-year cumulative per-
tion, and oversight of executive compensation pro- formance.
grams at publicly held corporations’’ (Business
Roundtable, 2003). The three Business Roundtable Agency theory framework
recommendations we examine pertain to indepen-
dent compensation committees, requiring executives Agency theory has been the dominant economics-
to hold equity in the corporation, and greater dis- based framework offered for understanding executive
closure of executive compensation practices. We compensation issues (see, for example, Lambert and
then examine two recommendations from other Larcker, 1991). According to this theory, managers
sources: (1) increase institutional investor involve- (executives) who are not also owners are shareholders’
ment in corporate governance, and specifically, agents and will not necessarily act in shareholders’ best
executive compensation, and (2) require firms to interests. Rather, managers are assumed to choose
expense stock options on their income statements. actions to maximize their own expected utility.
Our discussion of recommendations also pertains, Moreover, shareholders are unable to directly observe
directly or indirectly, to the Business Roundtable’s managers’ actions and decisions. Shareholders must
first principle: ‘‘Executive compensation should be therefore rely on reported results, and because of
closely aligned with the long-term interests of uncertainty in the economic environment, are unable
stockholders and with corporate goals and strategies. to perfectly infer whether managers’ actions and
It should include significant performance-based decisions were optimal from the shareholders’
criteria related to long-term stockholder value and perspective.
should reflect upside potential and downside risk.’’ The potential conflicts of interest between
We conclude the paper with a brief discussion of shareholders and managers fall into three broad
ethical issues related to executive compensation, and categories (Lambert and Larcker, 1991). First,
possible future research. executives may enjoy ‘‘perquisites’’ (‘‘perks’’), that
is, nonpecuniary benefits such as exorbitantly
The structure of executive compensation expensive shower curtains or lavish parties. Of par-
ticular note, L. Dennis Kozlowski, Tyco’s former
Although differences may occur across firms or chief executive, reportedly used tens of millions of
industries, most executive compensation packages dollars of company funds for personal spending.
consist of four major components: base fixed salary, Sorkin (2002) states:
annual bonus, stock options and restricted stock
grants, and long-term incentive plan (Murphy, The report [from Tyco] itemized tens of millions of
1999). Furthermore, there is an ‘‘other’’ category of dollars in personal spending that Mr. Kozlowski
broad compensation such as severance payments, made with company money. They include his $16.8
tax reimbursements, and signing bonuses. Base sal- million apartment on Fifth Avenue—along with $3
aries for executives are often determined by million in renovations and $11 million in furnish-
benchmarking salaries of peers in the same industry. ings—and a $7 million apartment on Park Avenue
An annual bonus is usually paid based on a specific for his former wife.
year’s accounting performance, such as earnings per
share or return on equity (Murphy, 1999). Stock According to the report, he also had the company
options, through which a company gives the secretly pay for personal items like an $80,000
executives the right to buy the firm’s shares at a American Express bill; a $72,000 fee to German
pre-specified exercise price for a pre-specified term, Frers, a yacht maker; a $17,100 traveling toilet box;
are also widely used. Firms sometimes grant a $15,000 dog umbrella stand; a $6,300 sewing bas-
‘‘restricted’’ shares that are forfeited under specific ket; a $6,000 shower curtain; $5,960 for two sets of
CEO Compensation Reform 103

sheets; a $2,900 set of coat hangers; a $2,200 gilt over the Board through influencing the director
metal wastebasket; a $1,650 notebook; and a $445 nomination process and director compensation.
pincushion. Bebchuk and Fried (2004) state, ‘‘Directors have
relatively few reasons to oppose higher CEO pay as
Second, executives may be more risk averse than long as it falls within the range of what is considered
conventional and acceptable.’’ Coupled with share-
shareholders, who can better diversify their risk.
holders’ lack of direct power to curb executive pay,
Executive risk aversion implies that they require a
‘‘captive’’ boards of directors may approve executive
higher expected value of compensation as a tradeoff
compensation that is not in shareholders’ best inter-
for increased compensation risk, as occurs with
stock-based compensation. Third, executives may ests, so that the directors appear to be more like
employees than watchdogs of the CEO. Similar to
base decisions on a shorter time horizon than
shareholders wish. For example, in order to boost Bebchuk and Fried, Jensen and Murphy (2004) rec-
ommend that companies ‘‘[c]hange the structural,
short-term accounting performance, and in turn,
increase their compensation, shortsighted CEOs may social and psychological environment of the board so
that the directors (even those who fulfill the
reduce long-term investment, such as research and
requirements of independence) no longer see them-
development spending that sustains firm growth, and
selves as effectively the employees of the CEO’’.
thereby harm long-run firm value. Note that even if
CEO power over the board violates the ethical
managers own shares in the firm, their interests will
not necessarily be fully aligned with shareholders’ standard of procedural fairness, or ‘‘fairness of the
processes used to set and administer compensation’’
interests because, for example, other shareholders
will bear some of the cost of managers’ excessive (Bloom, 2004). Not only the process, but also the
resulting CEO compensation contract may be
consumption of perquisites.
A company’s board of directors has responsibility unethical, in the sense of violating shareholders’
rights or granting grossly inequitable compensation.
to represent shareholders’ interests and mitigate the
conflicts of interest between managers and share-
holders. Typically, the compensation committee (a
Criticisms of U.S. executive compensation
subcommittee of the company’s board of directors)
approves executive compensation. In each annual
Criticisms of U.S. executive compensation and
proxy statement, the compensation committee must
report on the company’s previous fiscal year com- related governance structures abound. Critics assert
that compared to other countries, compensation is
pensation policies for the chief executive officer and
the next four most highly paid executives. The much too high2 and is not tied closely enough to
performance. Specifically, CEOs may earn large
company must describe the compensation paid and
the relationship of compensation to corporate per- bonuses simply because the economy is strong and
growing, and CEOs may be shielded from downside
formance, such as earnings or stock returns. Fur-
risk when they fail to achieve the previously desig-
thermore, the company must show how its stock
nated thresholds for bonuses. Moreover, the ratio of
price performance compares to an appropriate peer
executive to worker pay has climbed dramatically,
group and market index (SEC, 2003). The New
York Stock Exchange (NYSE) and NASDAQ Stock even in the face of worker layoffs and outsourcing of
jobs overseas. After declining for two years, the ratio
Market recently adopted new rules requiring share-
holder approval of stock option plans and other was 301:1 in 2003, compared to 42:1 in 1982
(Anderson et al., 2004). William J. McDonough,
forms of equity compensation.
Ideally, then, the board of directors designs opti- chairman of the Public Company Accounting
Oversight Board (PCAOB),3 has described the
mal contracts for executives to align their interests
with shareholders’ interests. However, Bebchuk and dramatic increase in relative CEO compensation
levels as ‘‘grotesquely immoral’’ (Anderson et al.,
Fried (2003, 2004) highlight the role of managerial
2004) and warned that if executives and boards of
power in the executive pay-setting process. They
directors do not curb excessive compensation, then
argue that the CEO exercises significant ‘‘power’’
Congress will address the issue with legislation in
104 Ella Mae Matsumura and Jae Yong Shin

order to respond to the ‘‘fury at the level of the pension funds depending heavily on the value of
average American’’ (Countryman, 2004). Recent Enron stock, and the broader community. Jayne
scandals concerning excessive perquisite consump- (2003) aptly sums up the tensions among various
tion, such as the report on L. Dennis Kozlowski stakeholders as follows5:
mentioned earlier, have further inflamed the public.
Frequent complaints have raised ethical issues of Chief executive officers’ multimillion-dollar pay
equity, fairness, and justice of the absolute and rel- packets are attracting shareholder anger, compound-
ative levels of executive compensation, as well as the ing employee disaffection and attracting the attention
practice of shielding executives from downside risk. of restrictive regulators. Are these packages really jus-
Putting aside the deserved criticism of fraud and tified and necessary to attract top talent? Or are they
excessive perquisite consumption, arguments exist to the outcome of a self-inflating cycle of competition
support current levels of executive compensation in being pumped by global compensation consultants?
Before long, executives start believing their own
order to attract and retain needed executive talent.
hype and that of the compensation consultants who
For example, Murphy (1995) argues that the effec-
work on ratcheting up the individual’s value to the
tiveness, rather than the level, of executive compen- company. Surveys suggest management risks under-
sation is the core issue. That is, compensation mining its leadership role by alienating itself from
committees, on behalf of shareholders, should design those it is trying to manage. A top-performing CEO
contracts that provide incentives for executives to is a valuable asset to any enterprise. The question is
fulfill their ethical responsibility to shareholders by how best to put a monetary value on that worth in a
increasing the value of the firm. Effective contracts way that both reflects actual performance and does
would motivate executives to take actions to not create an impression that top management is
increase the value of the firm a great deal more than being disproportionately rewarded for its efforts.
the executive’s compensation.4 In a related vein,
Core et al. (2005) argue that what matters is not the Recent calls for executive compensation reform seek
level of executive pay, but rather the magnitude of to balance the tensions among the various
executive incentives that links managerial wealth to stakeholders. In the next section, we describe
firm performance. They point out that U.S. CEOs frequently suggested executive compensation and
who hold much more of their firm’s shares than their related corporate governance reforms, and draw on
European and Japanese counterparts naturally research to suggest likely consequences.
require a higher pay level because they bear more
risk due to their large equity portfolio, consistent
with the economic theory of optimal contracting.
CEOs’ holdings in their firms’ stocks provide a Intended and unintended consequences of
strong link between stock price and CEO wealth. CEO compensation reform
Because the U.S. capital market rewards firms’
meeting or beating analysts’ forecasted earnings, This section discusses research addressing whether
CEOs have incentives to engage in unethical the following three Business Roundtable recom-
‘‘management of earnings’’ and to collude with the mendations will likely result in the intended con-
analyst community to reduce earnings forecasts in sequence of close alignment of stockholders’ and
exchange for potential underwriting business. executives’ interests: (1) require executive com-
The stakeholders include those not commonly pensation to be determined by an independent
included in traditional agency theory models of compensation committee, (2) require executives to
executive compensation. These models include hold equity in the corporation, and (3) require
shareholders and executives (managers), and some- greater disclosure of executive compensation prac-
times debt holders. Clearly, however, a firm’s tices. We then examine two other recommenda-
employees may be greatly affected by executives’ tions: (1) increase institutional investor involvement
decisions that are motivated by self-interest. For in corporate governance, and specifically, executive
example, the fallout from the Enron scandals affected compensation, and (2) require firms to expense
not only shareholders, but also employees with stock options on their income statements. Our dis-
CEO Compensation Reform 105

cussion also pertains to the Business Roundtable’s Prior research on the impact of board composi-
first and overarching goal: ‘‘Executive compensation tion on executive compensation provides evidence
should be closely aligned with the long-term that after the 1992 SEC compensation disclosure
interests of stockholders and with corporate goals rules, the number of committees with management
and strategies. It should include significant perfor- participation steadily declined over time, partly
mance-based criteria related to long-term stock- motivated by public concerns over board indepen-
holder value and should reflect upside potential and dence (Vafeas and Afxentiou, 1998). More recent
downside risk.’’ studies on the composition of firms’ compensation
committees show that on average, insider committee
membership declined from 6.05% of the total in
Business Roundtable principle 2: independent 1991 to 1.42% of the total in 1997 (Vafeas, 2003).
compensation committees Using a sample of U.K. firms, Conyon and Peck
(1998) find that the fraction of independent directors
We begin with Business Roundtable principle 2, in a compensation committee is positively related to
which addresses corporate governance regarding the the sensitivity of pay to performance. Furthermore,
compensation committee: Vafeas (2003) and Perry and Zenner (2001) show that
for firms with committee insiders, the pay for per-
Compensation of the CEO and other top executives
formance relation is lower and the mix of cash-based
should be determined by a compensation committee
to stock-based pay is higher than that for firms
composed entirely of independent directors, either as
a committee or together with the other independent without committee insiders. Bryad and Li (2004) find
directors based on the committee’s recommenda- that the opportunistic timing of granting options –
tions. the board’s tendency to grant options on the days
when stock price are low – is mitigated when com-
A firm’s compensation committee has responsibility pensation committees are more independent.
for assessing executives’ performance and deter- On the other hand, Daily et al. (1998) examine
mining appropriate compensation packages. There- the effect of compensation committee composition
fore, establishing truly ‘‘independent’’ compensation on CEO compensation in a sample of 200 firms
committees has the potential to play a significant role from the 1992 Fortune 500 and find no evidence
in curbing excessive CEO compensation. The that ‘‘affiliated’’ directors8 lead to greater levels of
recently adopted New York Stock Exchange CEO compensation. Anderson and Bizjak (2003)
(NYSE) governance rules6 requiring firms to have also do not find a relation between the CEO sitting
compensation committees composed entirely of on the compensation committee and CEO pay. In
independent directors reflect this belief. The NY- summary, although some evidence points to the
SE’s further requirement that firms remove the CEO importance of independent directors on compensa-
from the nominating committee deserves mention. tion committees, much of the benefit has already
Extant research suggests that firms whose CEO been captured because of previous movement
serves on the nominating committee tend to appoint toward independent compensation committees.
fewer independent outside directors and more gray
outsiders7 (Shivdasani and Yermack, 1999) and that
the level of CEO pay is positively associated with the Business Roundtable principle 4: executive equity holdings
fraction of outside directors appointed by the CEO
(Core et al., 1999). These findings suggest that the We next turn to Business Roundtable principle 4,
key issue is not the fraction of independent directors regarding required executive equity holdings:
on the compensation committee, but rather,
Compensation committees should require executives
whether the CEO appointed the compensation
to build and maintain significant continuing equity
committee directors. Therefore, requiring firms to
investment in the corporation.
remove the CEO from the nominating committee
will help establish a more independent compensation This policy builds on the agency theory view that
committee and board of directors. agency problems result from the separation of
106 Ella Mae Matsumura and Jae Yong Shin

ownership from control. Managers with little or no ted, either by altering the terms of existing options or
ownership of the firm may fail to maximize share- by canceling and reissuing options (Carter and
holder value because they have an incentive to Lynch, 2003). There is a substantial body of evidence
consume perquisites. If this is true, we expect the that firms use stock option repricing to compensate
degree of agency problems to be inversely related to managers for poor performance, shielding CEOs
managerial ownership, i.e., the fraction of a firm’s from downside risk (e.g., Carter and Lynch, 2001),
shares a CEO holds, and granting stock options or probably to prevent CEOs from leaving the firm due
restricted stock to executives will reduce the firm’s to out-of-money options (Carter and Lynch, 2001,
incentive problem. Consistent with this view, Core 2004).13 Option repricing does, however, help to
and Larcker (2002) examine a sample of firms that reinstate the incentive effect of the options.
adopt target ownership plans9 and find that increased Whether a low level of managerial ownership is
managerial ownership in these firms is associated necessarily evidence of sub-optimal compensation
with excess (intuitively, greater than expected) remains an open question. Demsetz and Lehn (1985)
accounting and stock returns, suggesting that the and Himmelberg et al. (1999) argue that the level of
market favorably views the mandatory increase in managerial ownership is endogenously determined
executive ownership. by factors such as the severity of moral hazard
A slightly different perspective on the benefit of problems and firm-specific contracting environ-
stock-based compensation is that compared to cash ments14, suggesting that the optimal level of mana-
compensation tied to short-term accounting per- gerial ownership will differ significantly across firms.
formance, stock-based compensation aligns execu- Furthermore, whether granting stock options or
tives’ incentives more directly with shareholders’ restricted stock to executives will increase manage-
interest in firm value, an inherently long-term rial ownership to a desirable level is also question-
measure. Furthermore, stock-based compensation able. Ofek and Yermack (2000) find that when
encompasses upside potential and downside risk as high-ownership managers receive new options, they
the stock price varies. A renewed emphasis on sell the shares that they previously owned to diversify
shareholder value, changes in executive compensa- the risks. The board also seems to consider the level
tion disclosure10 and tax rules11, and the 1990s bull of managerial ownership when it makes a decision to
market collectively resulted in a huge escalation of grant equity-based compensation. Several studies
stock option grants over the past decade, supported find that executive ownership is negatively related to
by many academics and practitioners (Hall and the granting of stock options, supporting the per-
Murphy, 2003). ception that when executives hold a large fraction of
Nevertheless, a growing body of research provides their firm’s equity, the demand for further stock-
evidence that questions the net benefit of using based compensation is likely to be reduced (Bryan
stock-based pay. Stock options are not efficient et al., 2000; Yermack, 1995).
because of the discrepancy between the economic
value of the options and the value of options to
executives (Hall and Murphy, 2003)12. Moreover, Business Roundtable principle 6: ‘‘complete’’ disclosure of
self-serving CEOs opportunistically time good or bad compensation practices
news to maximize the value of stock options
(Aboody and Kasznik, 2000). Furthermore, there The last Business Roundtable principle we address is
exists evidence suggesting that some CEOs attempt Principle 6, regarding ‘‘complete’’ disclosure of
to maximize their wealth with stock prices boosted executive compensation practices:
by accounting earnings, sometimes fraudulently
Corporations should provide complete, accurate,
(Cheng and Warfield, 2004; Erickson et al., 2003).
understandable, and timely disclosure to stockholders
Another problem arises when firms’ stock price drops concerning all significant elements of executive com-
below the exercise price. The option is then ‘‘out of pensation and executive compensation practices.
money’’, reducing the options’ intended incentive
effects. Repricing stock options involves lowering It has been more than a decade since the SEC
the exercise price on stock options previously gran- adopted regulations aimed at increasing the quality
CEO Compensation Reform 107

and quantity of executive compensation disclosures. become active in monitoring corporate governance
The SEC’s intended goal was to improve corporate (Johnson and Shackell, 1997; Gillan and Starks
governance by encouraging more transparent 2000). It is well documented that public pension
disclosure concerning the level and the ways in funds and union pension funds have become more
which executives are compensated (Lo, 2003a). active participants in the governance of their port-
However, it is unclear whether the SEC attained its folio firms by negotiating with corporate manage-
goal. On the one hand, increased disclosure can ment, publicly targeting corporations through the
benefit a firm through improved governance and media, and presenting shareholder proposals at cor-
eventually decrease information asymmetry between porate annual shareholders’ meetings. The SEC is
managers and investors, leading to a lower cost of considering allowing institutional investors to
capital. On the other hand, the voluntary disclosure nominate at least one director for election. Institu-
literature suggests that disclosure regulation may tional shareholder activists include California Public
impose additional costs on firms. For example, un- Employees Retirement System (CalPERS) and
wanted public scrutiny of executive pay may be College Retirement Equities Fund (TIAA-CREF)
detrimental to firms through high political costs. (Carleton et al., 1998; Nesbitt, 1994).
That is, media and activist attention to executive pay Institutional investors can actively monitor the
may translate into political pressure and public anger, process of evaluating and rewarding CEO perfor-
to which legislators may respond with new regula- mance. Recent empirical research documents that
tions. Furthermore, executive pay disclosure may institutional investors play an important role in
turn executive pay into a ‘‘beauty contest’’, leading monitoring their portfolio firms’ management (Da-
to increased levels of compensation as firms seek to vid et al., 1998; Hartzell and Starks, 2003). Johnson
ensure that their executives are among the higher and Shackell (1997) find that shareholder proposals
paid (Lo, 2003b). Given these two conflicting the- on executive compensation and corporate gover-
oretical predictions, it is difficult to conclude whe- nance sponsored by institutions received greater
ther firms will enjoy a net benefit from fully voting support than proposals sponsored by indi-
disclosing executive compensation. viduals. The findings suggest that institutional
Vafeas and Afxentiou (1998) provide descriptive investors influence executive compensation practice
evidence on the effect of the 1992 SEC com- in accordance with shareholder preferences, i.e.,
pensation disclosure rules in terms of improving institutional ownership concentration is positively
firms’ governance. They document that the related to pay-for-performance sensitivities. How-
number of committees with insider participation ever, the literature provides mixed findings on
steadily declined after the 1992 reform, partly whether institutional investors play a role in
motivated by public concerns over board inde- decreasing the level of executive compensation.15
pendence. Vafeas (2003) also finds a steady decline Alternatively, institutional investors can also influ-
in the number of compensation committees with ence firms’ compensation policy indirectly through
insider participation during 1991–1997. Lo (2003a) their preferences and trading if firms adopt specific
directly tests the economic consequences of compensation plan to attract institutional investors
expanded compensation disclosure. His findings (Hartzell and Starks, 2003).
suggest that consistent with the governance However, one should note that there are
improvement hypothesis, shareholders have actu- heterogeneous monitoring incentives among insti-
ally benefited from the compensation disclosures tutional investors. Although prior research docu-
mandated by the SEC. ments the monitoring role of large blockholders and
activist institutions, it is unclear whether mutual
fund advisors have strong incentives to monitor
Recommendation: increase institutional investor involvement firms’ governance. If institutions generally consider
in corporate governance (executive compensation) liquidity to be more important than monitoring and
trading costs are low enough, mutual fund compa-
As institutional investors have increased their equity nies will simply sell shares of firms that have ‘bad’
holdings in the U.S. financial market, they have governance. Furthermore, it is an open question
108 Ella Mae Matsumura and Jae Yong Shin

whether mutual fund companies are concerned Putting aside whether expensing option is a
about portfolio firm’s governance. In fact, recent ‘‘superior’’ accounting treatment, a growing number
research by Bushee et al. (2004) finds that only 15% of business practitioners and academics argue that
of mutual fund advisors exhibit preferences for better expensing of options will lead to better compensation
governance. Possible business relationships between decisions (e.g., Hall and Murphy, 2003). For
mutual fund companies and portfolio firms may also instance, current accounting rules on stock options
cloud active monitoring by mutual funds. Recent discourage use of all forms of stock options whose
analysis of proxy votes on CEO pay from the 10 exercise price is not set equal to the grant-date stock
largest mutual fund companies during 2004 lends price (e.g., indexed options or performance-based
support to the conjecture that mutual fund advisors options). Current accounting rules on stock options
may not serve as active monitors of executive also contribute to worsening the gap between per-
compensation (AFL-CIO, 2004). Nevertheless, the ceived costs of options and economic costs of options.
recent requirement that mutual fund companies However, the FASB’s recent proposal to require all
disclose how they cast proxy votes is likely to publicly traded companies to expense all forms of
stimulate their incentives to monitor the governance employee stock options has faced immense opposition
of firms they invest in.16 by some politicians and start-up companies concerned
about possible consequences of discouraging compa-
nies from granting options to employees.19
Recommendation: require firms to expense stock options on
their income statements
Current accounting rules effectively do not require
firms to record an income statement expense for Reform proposals and ethical implications
stock options either at the time of grant or exercise.
The relevant accounting standard, APB No. 25, We have discussed likely intended and unintended
states that there is no income statement options- consequences of recent proposals to reform CEO
related expense if companies grant stock options compensation. Although these proposals provide
with a fixed exercise price that is set equal to the some potentially useful remedies for US executive
share price on the grant date (fixed option grant). pay practice, we believe that without a renewed
Most companies grant fixed option grants. In 1995, a emphasis on the ethics of CEOs and ethics within
new standard, SFAS 123, required firms to expense companies, these reforms will not necessarily resolve
stock options based on a fair market value of options the problems and issues as intended. For example, as
granted, but it permits firms to continue reporting we discussed, CEOs who hold substantial amounts
under APB No. 25 as long as they disclose pro forma of their firms’ stock have incentives to manage
net income as if option grants are expensed. accounting earnings and to collude with analysts to
This favorable stock option accounting is often reduce analysts’ forecasts of corporate earnings.
cited as one of the main drivers of the dramatic In addition, to the extent that powerful CEOs can
escalation of stock options as a compensation vehicle award benefits to directors through re-nomination,
during the past decade17 (Hall and Murphy, 2003). higher director pay, and other non-pecuniary forms
The consequence of SFAS 123’s allowing firms to of incentive, regulatory action to increase director
continue reporting under APB No. 25 is that only a independence in terms of the fraction of indepen-
small number of firms chose to voluntarily recognize dent directors on the Board will not achieve the
stock-based compensation as an expense. Although a intended goal of a more ethical environment sur-
number of firms, such as Microsoft and Amazon, rounding executive compensation. Moreover,
stated that they will begin expensing options in independence is inherently virtually impossible to
response to recent accounting scandals, Aboody observe, and its surrogate definition is a rules-based
et al. (2004b) report that they could only identify list of conditions that cannot hold if a director is to
155 firms that voluntarily recognized stock-based be deemed independent. Consequently, firms may
compensation as an expense in 2002.18 focus on satisfying the rules for independent direc-
CEO Compensation Reform 109

tors rather than the broader concept of indepen- on ethical issues arising in the continuing debates on
dence, similar to situations where people focus on executive compensation. For example, Carr and
rules to specify ethical behavior instead of evaluating Valinezhad (1994) describe social comparison theory
whether particular behavior is ethical. and equity theory in relation to executive compen-
sation, and Bloom (2004) discusses various aspects of
fairness in relation to general compensation.
Future research Jensen (2001) proposes a corporate objective of
maximizing ‘‘the long-run total value of the firm’’,
Great public interest in reforming executive com- in contrast to maximizing short-run stock price, the
pensation and related corporate governance struc- apparent objective that has led to accounting scan-
tures will undoubtedly persist. The focus on dals. He argues that in the long run, firms cannot
increasing the independence of boards of directors, maximize firm value if they mistreat or ignore the
including the compensation subcommittee, has led interests of stakeholders such as customers,
to stricter stock exchange governance rules for employees, and communities. Therefore, companies
boards Klein (2003). As these changes take effect, should adopt a combination of enlightened value
research can attempt to discern how effective the maximization and enlightened stakeholder theory in
new rules on independent directors are, perhaps by which ‘‘the objective function – the overriding
examining what effect the more stringent indepen- goal – of the firm is to maximize total long-term firm
dence criteria have on disciplining CEO compen- market value.’’ Although Jensen asserts that ‘‘value
sation. creation gives management a way to assess the
Other forces to discipline executive compensation tradeoffs that must be made among competing
can be examined. One potentially fruitful path for constituencies’’, ethical issues will still arise in mak-
future research could examine institutional investors’ ing the tradeoffs. Moreover, disagreements about
willingness and ability to influence executive pay how to measure value creation or whether particular
practice. Institutions have traditionally paid more decisions will create value present opportunities for
attention to improving general corporate gover- self-interested behavior.
nance rather than executive compensation itself. We agree that undesirable consequences related to
Whether recent reform will shift the institutional current executive compensation are attributable at
investors’ focus from generic governance, such as least in part to current pay practices that encourage
board independence, to more direct involvement in executives to take actions to increase short-term
executive compensation is an open question. shareholder value at the expense of other stake-
However, an ethical dimension arises if potential holders. Given the intrinsic limitations of regulatory
business relationships between firms and institutional actions intended to discipline executive pay, we
investors such as banks, insurance companies, and believe that redefining the corporate objective and
mutual funds preclude institutional investors from designing executive compensation to take account of
realizing their full potential to become actively the interests of a broader group of stakeholders will
involved in aligning firms’ governance and executive help address the current ethical problems with
pay practice with shareholder preferences. executive compensation.
Another path for future research involves broad-
ening the economic framework of analysis beyond
agency theory’s principal/shareholder-agent/man- Appendix
ager model, for example by incorporating the wel-
fare of a broader group of stakeholders or explicitly Business Roundtable (2003) Principles of Executive
modeling an ethical component. A step forward Compensation
appears in Stevens and Thevaranjan (2003), who
incorporate an explicit ethical dimension for the
agent. 1. Executive compensation should be closely
Complementing economic theory with other aligned with the long-term interests of stock-
theories should provide useful insights, particularly holders and with corporate goals and strate-
110 Ella Mae Matsumura and Jae Yong Shin

gies. It should include significant perfor- Roundtable is committed to advocating public policies
mance-based criteria related to long-term that ensure vigorous economic growth, a dynamic glo-
stockholder value and should reflect upside bal economy, and the well-trained and productive U.S.
potential and downside risk. workforce essential for future competitiveness. Business
2. Compensation of the CEO and other top Roundtable ... presents government with reasoned
alternatives and positive suggestions’’ (http://www.busi-
executives should be determined by a com-
pensation committee composed entirely of 2
Jayne (2003) cites a Hay Group study reporting that
independent directors, either as a committee U.S. CEOs are paid up to 500 times more than average
or together with the other independent workers, while the comparable ratios in Australia and
directors based on the committee’s recom- New Zealand are 36 and 12, respectively. Murphy
mendations. (1999) reports a 1997 Towers Perrin compensation
3. The compensation committee should under- study showing that across 23 countries, the highest
stand all aspects of the compensation package average executive compensation occurs in the US, at
and should review the maximum pay-out $901,000 per year. The next highest were Brazil
under that package, including all benefits. ($698,000 per year) and Hong Kong ($673,000). Aver-
The compensation committee should under- age executive compensation was $477,000 in Australia,
stand the maximum pay-out under multiple $398,000 in Japan, and $183,000 in New Zealand. The
compensation study included industrial companies with
scenarios, including retirement, termination
approximately $250 million (U.S.) in annual revenues.
with or without cause, and severance in con-
It must be pointed out, however, that averages can be
nection with business combinations or sale of somewhat misleading. For example, the average CEO
the business. compensation among S&P 1500 firms in 1997 was
4. Compensation committees should require $3.83 million, but the median was $1.9 million and the
executives to build and maintain significant 75th percentile was $3.9 million. This suggests that
continuing equity investment in the corpora- average CEO compensation is heavily affected by some
tion. CEOs with very large salaries.
5. The compensation committee should have The Sarbanes-Oxley Act of 2002 established the
independent, experienced expertise available PCAOB as a private-sector, non-profit corporation ‘‘to
to provide advice on new executive com- oversee the auditors of public companies in order to
pensation packages or significant changes in protect the interests of investors and further the public
interest in the preparation of informative, fair, and inde-
existing packages.
pendent audit reports’’ (http://www.pcaobus.org/). The
6. Corporations should provide complete, accu-
Act states that its purpose is ‘‘[t]o protect investors by
rate, understandable, and timely disclosure to improving the accuracy and reliability of corporate dis-
stockholders concerning all significant ele- closures made pursuant to the securities laws, and for
ments of executive compensation and execu- other purposes.’’
tive compensation practices. 4
Murphy (1995) argues that stock prices provide bet-
ter measures of wealth creation than do accounting
profits. He therefore asserts, ‘‘effective pay-for-perfor-
Acknowledgments mance contracts combine below-market base salaries
with high potential payouts based on stock-price appre-
We gratefully acknowledge helpful comments from ciation and including dividends’’ (p. 722).
Ann Tenbrunsel (guest editor), Sandra Vera-Mu- 5
A firm’s customers and suppliers are also stakehold-
ñoz, and other participants at the 2004 Ethical ers, as are institutional investors such as pension funds
Dimensions in Business Conference at the Univer- and mutual funds.
sity of Notre Dame. Newly adopted NYSE governance rules (http://
1022221393251.html) require that each listed company
Notes have a nominating/corporate governance committee and
a compensation committee composed entirely of inde-
Business Roundtable is an association of approxi- pendent directors, in addition to requiring a majority of
mately 150 CEOs of leading corporations. ‘‘The directors on the board to be independent. The Listed
CEO Compensation Reform 111

Company Manual states, ‘‘No director qualifies as ‘inde- including stock-based pay than firms in other
pendent’ unless the board of directors affirmatively deter- industries because regulation limits managers’ invest-
mines that the director has no material relationship with ment discretion. Accordingly, the incremental im-
the listed company (either directly or as a partner, share- pact of managerial actions on firm value is
holder or officer of an organization that has a relationship relatively small.
with the company).’’ The Manual specifies situations in Johnson and Shackell (1997) examine 169 share-
which a director is deemed not independent. The NAS- holder proposals on executive compensation filed against
DAQ has similar requirements for compensation com- 106 firms by 74 sponsors during 1992–1995 and identify
mittees, though slightly less stringent than the NYSE’s. 83 proposals targeting executive pay level and 20 pro-
‘‘Gray’’ outside directors include retired employees, posals targeting compensation committee independence.
relatives of the CEO, persons having a business relation- Interestingly, individuals sponsored most of the proposals
ship with the firm, and persons with an interlocked on executive pay level and institutions’ proposals tar-
directorship. At least some of these directors would not geted compensation committee independence.
be independent directors under current NYSE rules. The SEC recently adopted a rule requiring mutual
Affiliated directors are defined as non-executive funds and other management investment companies to
directors who maintained some form of personal and disclose proxy votes cast, as well as their proxy voting
professional relationship with a firm. policies and procedures. The reporting deadline was
In target ownership plans, the board of directors August 31, 2004 for the year ending June 30, 2004.
mandates that executives own at least a target amount Another related source of inducement to issue stock
of stock. options arose from the Omnibus Budget Reconciliation
The 1992 rules, for example, stipulated new Act of 1993 (see footnote 11).
requirements that firms provide (1) a graphical five-year Accounting academics generally agree that stock
comparison of the firm’s stock price performance to a option grants constitute a real economic cost that firms
market index and to an index composed of peer com- should deduct from earnings as an expense (Guay et al.,
panies and (2) a three-year summary compensation table 2003). Aboody et al. (2004a) find that investors view
for the CEO and four other highest paid executives. stock-based compensation expense as an expense of a
The Omnibus Budget Reconciliation Act of 1993 firm, rejecting the claim that option expense cannot be
effectively prohibits publicly traded companies from measured reliably enough to be reflected in financial
deducting executive cash compensation exceeding one statements.
million dollars. Because companies were not required to The Stock Option Accounting Reform Act (H.R.
expense stock-based compensation on the income state- 3574), approved by the US House of Representatives,
ment, some people viewed stock-based compensation as mandates the expensing of stock options granted to the
‘‘free’’. Critics hypothesized that the value of total exec- CEO and the next four proxy-named executives of a
utive compensation would actually increase with the company but does not require the expensing of stock
shift to a greater proportion of stock-based compensa- options for all other employees.
tion, because risk-averse executives must receive a lar-
ger expected value in compensation when the
compensation carries risk.
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112 Ella Mae Matsumura and Jae Yong Shin

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New York Stock Exchange: ‘Listed Company Manual’,
E-mail: ematsumura@bus.wisc.edu
listed/1022221393251.html. jshin@bus.wisc.edu