Executive Compensation

Question 1

What are the two competing goals of executive compensation?

Answer 1

1) Mitigation of manager’s risk aversion

2) Discourage excessive risk taking

Question 2

What is the agency problem associated with executive compensation?

Answer 2

CEOs and directors can get involved with significant conflicts of interest, which can result in over-compensation to persuade them to not take them.

Question 3

What are the two broad theories on how executive compensations is set?

Answer 3

1) Managerial power theory

2) Optimal bargaining theory

Question 4

What is the managerial bargain theory?

Why are directors likely to be too deferential to management ? (5)

Answer 4

The managerial power theory is that executive compensation may result in directors being too deferential to management. So:

1) CEOs may influence re-election of directors
2) CEOS can benefit directors using corporate resources
3) Directors whose appointment was initially facilitated by the CEO may want to be loyal to the CEO
4) Directors want the boardroom to be collegial (arguing about how much the CEO should make is not good for collegiality
5) Because directors own only a small portion of the company’s stock, it is not costly for them to be too deferential when it comes to setting the CEO’s pay.

Question 5

What is the optimal bargaining theory?

Answer 5

Market forces are strong enough to induce directors to pay CEOS in a way that is beneficial to the stockholders.

Question 6

What is a call option?

What is it used for?

Answer 6

A right to buy a share at a specified price called a “strike” price.

It is used to help a CEO overcome his risk aversion by tying in the performance of the firm to his compensation in a more indirect way.

Question 7

Does compensating a CEO in only stock options help mitigate agency problems?

Answer 7

Yes, but it does not help a CEO overcome his risk aversion.

Question 8

What is the problem with call options?

Answer 8

Although further gains to the stock price past the strike price is worth just as much to the CEO as the shareholders, further declines past the strike price do not make the CEO that much worse off.

Question 9

Despite the limitations, how common are call options?

Answer 9

Very. And they are becoming more common.

Question 10

What are some reasons that help explain the rise of call options? (4)

Answer 10

1) Although imperfect, they do help incentive executive officers
2) As with compensation in general, it helps with agency problems
3) Tax rules (historically, corporations could deduct call options as a compensation expense.)
4) There are rules about disclosing how much an executive makes (this helps to hide it in some ways)

Question 11

What are some federal regulations on executive pay?

Answer 11

1) Disclosure requirements (Regulation S-K)
2) clawback provisions
3) Say-on-pay provisions

Question 12

What is the federal executive compensation disclosure requirement?

What does it require? (5)

Answer 12

Regulation S-K.

It requires detailed disclosure in annual proxy statements of the compensation of the firms CEO; this includes detailed discussion of the firm’s compensations policies; an explanation of pay for performance; how the decisions were made; and employment contracts between the company and the executives

Question 13

What is the federal clawback provision?

Answer 13

It is a federal regulation of executive compensation.

It requires a CEO to repay bonuses and gains from stock or option payments within 12 months of any financial statement which is restated due to misconduct.

Question 14

What is the federal say-on-pay provision?

Answer 14

Shareholders must provide an advisory vote on the CEO’s compensation.

Question 15

Are there different standards of judicial review of executive compensation of the fiduciary is a director or an officer?

Is there a further difference if a CEO is a controlling shareholder?

Answer 15

Yes, there are! And we will discuss the differences more later.

And yes, again!

Question 16

If the fiduciary is an executive officer, and the officer is a non-controlling shareholder, what standard of review do we use to scrutinize their compensation?

Answer 16

The BJR

Question 17

If the fiduciary is an executive officer, and the officer is a controlling shareholder, what standard of review do we use to scrutinize their compensation?

Answer 17

It depends on whether or not there is approval from disinterred directors (Special committee is given most deference and will be used in our MFW framework and/or the majority of the minority shareholders

Question 18

If the fiduciary is an executive officer, and the officer is a controlling shareholder, and there is no approval from a special committed or majority of the majority of shareholders, what standard of review do we use to scrutinize their compensation?

Who bears the burden of proof?

Answer 18

We use entire fairness

The defendant.

Question 19

If the fiduciary is an executive officer, and the officer is a controlling shareholder, and there is special committee approval, what standard of review do we use to scrutinize their compensation?

Who bears the burden of proof?

Answer 19

We use entire fairness.

But the burden of proof is on the plaintiff.

Question 20

If the fiduciary is an executive officer, and the officer is a controlling shareholder, and there is majority of the minority of shareholder approval, what standard of review do we use to scrutinize their compensation?

Who bears the burden of proof?

Answer 20

We use entire fairness review

But the burden of proof is on the plaintiff

Question 21

If the fiduciary is an executive officer, and the officer is a controlling shareholder, and there is approval by a special committee and the majority of the minority shareholders, what standard of review do we use to scrutinize their compensation?

Who bears the burden of proof?

Answer 21

We use the BJR

But the burden of proof is on the plaintiff

Question 22

If the fiduciary is a director, what standard of review do we use to scrutinize their compensation?

Answer 22

It depends on whether or not there is shareholder approval. Either entire fairness or the BJR

Question 23

If the fiduciary is a director, and there is NO shareholder approval, what standard of review do we use to scrutinize their compensation?

Who bears the burden of proof?

Answer 23

We use the entire fairness.

The burden of proof is on the defendant

Question 24

If the fiduciary is a director, and there is shareholder approval, what standard of review do we use to scrutinize their compensation?

Who bears the burden of proof?

How specific must the shareholder approval be?

Answer 24

We use the BJR.

The burden of proof is on the plaintiff. (We assume that the BJR is met?)

It must be specific enough to be a valid approval.

Question 25

According to Goldman Sachs, what is the standard of judicial review of executive compensation the BJR if there is sufficient approval?

Answer 25

Yes.

It is applied similarly to the BJR in other situations.

1) What the executive disinterred?
2) Was the executive informed?
3) Did the executive rationally believe that the business judgment was in the best interests of the corporation?

Question 26

If a company has a liability waiver, what do the plaintiff need to show in order to prove that the director was not adequately informed (show liability under BJR)?

Answer 26

They need to show bad faith. This will negate the liability waiver.

Normally, gross negligence is enough.

Question 27

If a company has no liability waiver, what do the plaintiff need to show in order to prove that the director was not adequately informed (show liability under BJR)?

Answer 27

Gross negligence.

Question 28

What can a plaintiff use to overcome the presumption of good faith (and therefore show that the decision was not rational)?

Answer 28

They can show that there was corporate waste. (i.e., the actions were so egregious or irrational that it could not has been based on a valid assumption of the corporations best interests.)

Question 29

According to Tornetta, do we apply the MFW framework to executive compensation situations? (I.e., there is deference given to executive who are controlling shareholders if there is a special committee of independent directors and/or approval from the majority of the minority shareholders?)

Answer 29

Yes!

Question 30

According to Calma, how do we show there is sufficient shareholder approval in order to use the BJR instead of entire fairness review?

Answer 30

It needs to be apparently fair.

An example of non-apparent fairness is that there is a universal plan which covers multiples classes of beneficiaries.