CEO Compensation: “Cheaters Prosper”

By William K. Black

As financial regulators we have been warning since 1984 that accounting control fraud is optimized by modern executive compensation. Modern executive compensation is so perverse that it creates overwhelming incentives to engage in fraud and the means of committing the fraud that makes it far more difficult to prosecute. The CEO is able to convert the firm’s assets to his own benefit through seemingly normal corporate mechanisms. CEOs also use executive and professional compensation to generate “Gresham’s” dynamics and incentivize fraud by employees, officers, and professionals.

George Akerlof and Paul Romer added their voice to this point in1993 in their article “Looting: The Economic Underworld of Bankruptcy for Profit.” Among the points they emphasized were that accounting control fraud was a “sure thing” and that the way for the CEO controlling a lender to optimize to optimize his looting was to cause the lender to make very bad loans at a premium nominal yield. White-collar criminologists and the National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE) reached similar conclusions beginning in 1993.

In some ways, however, it was remarkable that the intellectual father of modern executive compensation, Michael Jensen, has turned on his creation. Further, he turned on it vehemently – in 2001. Subsequently, scholars who study executive compensation have agreed that it has created perverse incentives.

Jensen wrote in 2001 that when executive compensation was tied to budgeting the result is disastrous. This is the first paragraph of his article.

“Corporate budgeting is a joke, and everyone knows it. It consumes a huge amount of executives’ time, forcing them into endless rounds of dull meetings and tense negotiations. It encourages managers to lie and cheat, lowballing targets and inflating results, and it penalizes them for telling the truth. It turns business decisions into elaborate exercises in gaming. It sets colleague against colleague, creating distrust and ill will. And it distorts incentives, motivating people to act in ways that run counter to the best interests of their companies.”

While he did not use the phrase “Gresham’s” dynamic, Jensen explains how the perverse incentives of executive compensation produce a situation in which bad ethics drive good ethics out of a company or even an industry and fraud and abuse become pervasive. His subtitle says it all:


When the manipulation of budget targets becomes routine, moreover, it can undermine the integrity of an entire organization. Once managers see that it’s okay to lie and conceal information to enrich themselves or simply to hold on to their jobs, they soon begin to extend their dishonest behavior to all parts of the company’s management system and even to its relationships with outside parties.”

Jensen published his article savaging modern executive compensation just as the Enron-era epidemic of accounting control frauds were about to become famous. Jensen also wrote bluntly about how common the perverse incentives were.

“When managers are told they’ll get bonuses if they reach specific performance goals, two things inevitably happen. First, they attempt to set low targets that are easily achievable. Then, once the targets are in place, they do whatever it takes to see that they hit them, even if the company suffers as a result.”

It doesn’t get any stronger than “inevitably.” When the intellectual father of modern executive compensation writes that it has become a monster wielded by CEOs and a grave threat to integrity, shareholders, and creditors and other critics

To review the bidding, modern executive compensation played a major role in creating the criminogenic environments that produced the fraud epidemics that drove our three modern financial crises – the Savings and Loan (S&L) debacle, the Enron-era frauds. Financial regulators, white-collar criminologists, NCFIRRE, economists, and compensation scholars have concluded that modern executive compensation is the problem rather than a solution. Well before the most recent crisis had reached a crisis phase the intellectual father of modern executive compensation was denouncing what his creation had become in practice in the bluntest terms. Each of the modern crises has become far more severe as modern executive compensation becomes ever more criminogenic.

We’ve Run a “Natural Experiment” on How Powerful Corrupt CEOs Are

We know that (1) executive compensation causes catastrophic harm because it causes incentives so perverse that they are often criminogenic, (2) it makes firms considerably less efficient, (3) that is designed and implemented in a manner that is often antagonistic to what virtually all experts recommend, and (4) that it causes severe income inequality that is anti-meritocratic. The obvious question is why such practices can continue. CEOs have intensified the perverse nature of modern executive compensation rather than ending those perverse incentives. This demonstrates that corrupt CEOs typically dominate corporate decision-making and that they use that domination to harm the public and the shareholders while benefitting the CEO. It also demonstrates that corrupt CEOs have the power to continue their perverse compensation practices despite regulatory and legislative authority to end those perverse practices. We live in the era of the corrupt, Imperial CEO.

Three recent New York Times articles demonstrate the imperial nature of the corrupt CEO’s power that allows known abuses to continue and even grow. Two of the articles are by the estimable Gretchen Morgenson. Her October 4, 2014 column is entitled “An Open Window for Insider Sales.” A large share of executive compensation is paid in the form of stock bonuses.

a recent study conducted by three academics at the Haas School of Business at the University of California, Berkeley: Patricia Dechow, Alastair Lawrence and James Ryans. It focused on S.E.C. comment letters, a routine if obscure type of correspondence that the regulator engages in after reviewing company financial filings.

Under the Dodd-Frank law, the S.E.C. must review a company’s filings every three years. These reviews are supposed to be done from an investor’s point of view.

If, after the review, the S.E.C. has questions for a company, it sends a letter outlining them. Within 10 days, the company must justify its practices or detail changes it will make to its reports. The S.E.C. then considers the company’s response and decides privately whether it is satisfactory.

In most cases, the letters are the end of it. But sometimes the S.E.C. deems a company’s answers inadequate, and it begins an enforcement case.

These comment letters have been made public only since 2005. They cover many topics, but those of greatest interest to investors involve complex corporate accounting practices.

One of the biggest issues is revenue recognition — how and when a company records its sales. Accounting rules in this area vary from industry to industry and are devilishly complicated. Poor performance can be masked with clever revenue-recognition practices.

In fact, academic studies show that revenue recognition lies at the heart of more than half of company restatements — that is, when a firm changes its previous financial reports either on its own or under pressure from regulators or auditors. The Berkeley academics found that 20 percent of S.E.C. comment letters in the period from 2006 through 2012 related to revenue recognition.”

Morgenson then explained what the study found.

“Significantly larger insider stock sales during the five days before the revenue-recognition comment letters were published. Those sales were roughly 70 percent above normal selling patterns. The value of those sales, the academics said, totaled $360 million more than what would be randomly expected. Chief executives, chief financial officers, directors and other high-level managers contributed to the selling, the study found.

Then, to narrow the field to companies that might have aggressive accounting, the academics also analyzed insider sales at companies whose shares had attracted significant interest from short-sellers — investors making bets against the company’s prospects. At these companies, the insider selling within the comment-letter window was even more striking: 200 percent higher than normal, the study found.

Finally, the researchers concluded that insider selling at companies fielding revenue-recognition questions from the S.E.C. far exceeded stock sales at companies receiving comment letters involving more mundane questions.”

This study demonstrates that senior officers are willing and able to use their insider information to maximize their effective compensation. The study indicates that when the controlling officers are running an accounting control fraud two of the means by which they can increase the effective nature of their compensation is to inflate the firm’s reported income and the firm’s stock price and to sell stock before the public learns of the inflated income and stock prices.

Her second article was published on November 8, 2014 and under the title “A Blank Page in the S.E.C. Rule Book, Four Years Later. This article explained the SEC’s unwillingness to adopt a rule recovering unwarranted executive compensation as provided by the Dodd-Frank Act. These are called “claw back” provisions. While the scandal of not prosecuting any of the senior officers who were enriched by leading the three epidemics of accounting control fraud that drove the financial crisis for those frauds is well known, the public does not understand that the fraudulent senior bankers have also been able to keep virtually all of the fraud proceeds they received through leading the accounting control frauds.

“It’s something that almost everyone can agree on: Executives should return compensation earned improperly as a result of accounting shenanigans at their companies.

But four years after Congress told the Securities and Exchange Commissionto write a rule making it easier to recover unearned pay that rule remains unwritten. Compensation clawbacks, therefore, are all too rare.”

(As a side note, made salient by my return today from Ireland, I ask writers to stop using the word “shenanigans” as a euphemism for “fraud.”) Morgenson is correct that virtually everyone can agree that executives should not be able to keep compensation that was paid to them on the basis of accounting “profits” that turned out to be fictitious – regardless of whether the executive personally had a rule in inflating income or minimizing reported liabilities. Claw back provisions are powerfully in the interest of the shareholders, but they are contrary to the interests of managers who lack integrity. A well run firm controlled by senior officers and a board of directors of integrity would have in place a strict claw back provision not requiring any showing of guilt by the individual subject to the claw back. That fact should raise five important questions from the firm’s perspective.

  1. How many firms have such provisions?
  2. When the CEO refuses to implement such a provision, how often does the board of directors reverse his refusal?
  3. Since CEOs that object to implementing such a provision have an obvious conflict of interest and because their opposition indicates an unconscionable lack of integrity, how many CEOs have been dismissed by the board of directors for seeking to block the adoption of a claw back provision that is not tied to proof of individual wrongdoing?
  4. How many firms have sought to claw back how much income?
  5. How much income has been successfully clawed back by those firms?

From a neoclassical economic perspective, there should be no need for regulation of compensation because the board of directives should design the compensation so that it would only be received in large amounts after a very long period of successful employment. Further, that compensation would be subject to claw back provisions should the reported net income prove inflated – regardless of how those “profits” were initially inflated. Unfortunately, and for the obvious reason that sound neoclassical economic theory would predict, the CEO actually controls the typical firm and has the most to lose from a well-designed executive compensation plan and the most to gain from a horribly designed system. The CEO’s self-interest is maximized by adopting perverse executive compensation plans with ineffective claw back provisions requiring proof of individual guilt. Unsurprisingly, the CEOs’ self-interest dominates in the real world. The CEOs’ “revealed preference” is overwhelmingly to gain – and maintain – undeserved wealth paid solely because of falsely inflated reported profits. No CEO of even minimal integrity would take such a position. Dodd-Frank was designed to require claw backs without proving individual guilt.

“[T]he authors of the Dodd-Frank law wanted to broaden the possibilities for recouping pay. The legislation told the S.E.C. to write a rule expanding clawbacks to include any current or former executive and to recover pay even if there was no misconduct related to a restatement. (A restatement could be the result of error.) Dodd-Frank also made it possible to take back stock options from executives, which wasn’t possible under Sarbanes-Oxley, and allows for investor lawsuits.”

So, how many CEOs have led their firms to adopt claw back provisions that properly protect the shareholders? It turns out that the more in detail one looks at this question, the worse the answer is to the question. Morgenson explains:

“[A] study [was] published a year ago by Equilar, a compensation analytics firm in Redwood City, Calif. Analyzing policies at the nation’s 100 largest companies, Equilar said that many were waiting to see the S.E.C. rule before they tightened their policies.

For example, Equilar found that while almost 90 percent of the companies had clawback provisions, 82 percent required evidence of wrongdoing before pay could be recovered.

Boeing is an example. Its corporate governance principles state that incentive pay may be recouped when the company’s board determines that an executive engaged in intentional misconduct related to an earnings restatement. John Dern, a Boeing spokesman, said, ‘When the S.E.C. issues new rules in this area, the board will review them and implement them.’

And while Dodd-Frank requires stock options to be subject to clawbacks, most company policies don’t, Equilar found. Only 27 percent have policies involving vested options, and just 38 percent of the companies noted that outstanding options (those not yet vested) could be recouped.

In addition, many company policies give great leeway to their boards when deciding whether to recover pay. Microsoft, for example, states that the company will recover, ‘at the direction of the Compensation Committee after it has considered the costs and benefits of doing so, incentive compensation awarded or paid to a covered officer for a fiscal period if the result of a performance measure upon which the award was based or paid is subsequently restated or otherwise adjusted in a manner that would reduce the size of the award or payment.’”

The problem of trying to claw the money back, of course, would be substantially reduced if firms adopted compensation plans favored by compensation scholars that tied major pay to extremely long-term performance (e.g., a decade). Most accounting errors and scams that overstate corporate profits materially are likely to manifest themselves over the course of a decade.

The SEC has not only unconscionably delayed the claw back rule. It has rarely sought to claw back in its enforcement actions.

Andrew Ross Sorkin’s November 10, 2014 column is entitled “More Transparency, More Pay for C.E.O.s.” Sorkin cites an important compensation study, though his comments about the study are strange.

“[A] study by three professors at the University of Cambridge … shows in devastating detail how compensation consultants — which use the increasingly available public data on compensation to advise boards on how much to pay chief executives — are helping to ratchet up the pay for the nation’s top executives.

Companies have long tried to ‘benchmark’ the compensation of their executives to that of their peers.

But as the cottage industry of compensation consultancy has emerged — along with more detailed information about salaries and bonuses — the increase in compensation has not slowed. In fact, quite the opposite has happened.

‘We consistently find evidence that supports the argument that compensation consultants are hired to justify higher C.E.O. pay to the board, shareholders, and other stakeholders,’ wrote the study’s authors, Jenny Chu, Jonathan Faasse and P. Raghavendra Rau.

In theory, the hiring of compensation consultants — and the publication of compensation plans publicly — should have curbed the rise in executive pay. The various headline-grabbing lists of compensation for chief executives are seemingly meant to shame boards — and the armada of consultants around them — to restrain their largess.

But according to the study, it’s the other way around: Companies that hire compensation consultants for the first time ‘show a 7.5 percent increase in C.E.O. pay compared to other firms, and such companies where C.E.O.s get a pay boost are less likely to turn over consultants the following year.’”

Compensation consultants are not a “cottage industry” that has just “emerged.” They have existed as a well-established field for over three decades.

Sorkin’s claim that “in theory, the hiring of compensation consultants … should have curbed the rise in executive pay” is bizarre. I have never heard anyone who knows anything about compensation consultants make that claim.

In economic and criminological “theory” the hiring of such consultants will materially increase senior executive pay not simply at the firm that hires them but throughout the field due to the “ratchet” effect. Each pay raise is used as the pretext for other firms’ CEO to get pay raises.

The study shows another example of a Gresham’s dynamic. The consultants know they’ve been “hired to justify higher C.E.O pay” and know that if they don’t meet the CEO’s goal they are far less likely to be hired in the future by the same client or future potential clients. This causes “bad ethics to drive good ethics” out of the compensation consultancy field.

Sorkin gets wrong a basic fact in his statement that “Companies have long tried to ‘benchmark’ the compensation of their executives to that of their peers.” “Companies” do not make decisions. Officers make decisions for “companies.” As the study demonstrated, and as we all knew, the pay comparisons are designed to provide a pretext for raises and to create a “ratchet” dynamic that will boost senior executive pay throughout the economy.

Sorkin sometimes asks a question he must know the answer to, but refuses to answer.

“Worse, allowing a chief executive to hire a compensation consultant instead of leaving the task to the company’s board led to a 13 percent increase in pay, the study’s authors found.

Why in the world is a chief executive in charge of hiring a compensation consultant? That’s a good question, but it happens more than you would imagine.”

Sorkin labels his own question a “good question,” but refuses to answer it. It has an obvious answer that theory and practice support. The CEO hires a compensation consultant because doing so will increase his wealth materially. The real questions, however, are (1) why the board of directors would ever allow firms to hire compensation consultants given that everyone involved knows they exist to make CEOs even wealthier and (2) why the board of directors would ever allow the CEO to personally select the consultants? The obvious answer to the second question is the correct answer – the board is dominated by the CEO and the board’s compensation will increase as well.

Sorkin ends with a quotation from Warren Buffett that reveals the far more important problems with executive compensation that go beyond the fact that it is inflated – it creates perverse incentives and a destructive culture.

“‘At Salomon, everyone was dissatisfied with their pay, and they got enormous amounts. They were disappointed because they looked at others, and it drove them crazy.’”

Sorkin, being Sorkin, frames his column as an attack on regulation. He misses the implications of the harm caused by CEOs and the perverse compensation systems they craft that have proven so criminogenic.

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