It’s all Lemonade when it comes to Executive Pay

I’ve had to read executive pay studies for some time since Corporate Finance is one of my fields. This is one of those areas where every time they think they come up with a good explanation and plan, we see a complete failure in the real world. This is because it fits under theories of probability where human behavior is poorly quantified. Executive compensation falls under the Moral Hazard area and of course the Lemon’s problem. Believe me, I’ve worked as a corporate consultant and a corporate flunky long enough to know the high level of lemons in the CEO market. It’s one of my main motivators for going back to the halls of academia. I can only slap my forehead so many times before I get a permanent indentation.

One of the first studies on asymmetric information (the lemons problem) is from George Ackerloff (1970).   His example comes from the market for with used cars.  It centers around determining the reason the seller want to sell of the car. One reason is that it might be a lemon. This is considered a situation with asymmetric information. This means the buyer and the seller have different information.  The seller knows if  the car is a cream puff or a lemon, but the buyer has no idea. He only knows the probabilities or the the odds that the car is a lemon.   So, if he’s rational (and remember the assumption is that he is rational), the buyer will demand a deep discount.

So here’s the news today for investors, board of directors, CEOS, and taxpayers who bail out too big too fail and badly managed companies.  Bloomberg reports that the Obama administration is seeking SEC power over executive pay.

The Obama administration will seek new powers for the Securities and Exchange Commission to force firms to let shareholders vote on executive pay and make directors who set compensation more independent, an administration official said.

Today’s proposal, subject to congressional approval, would cover all public companies. President Barack Obama has long supported giving shareholders nonbinding votes on bonuses, salaries and severance packages. The administration also will name a “special master” to monitor compensation plans for firms receiving exceptional assistance in the financial rescue.

The changes are aimed at reducing systemic risks and quelling a political uproar over bonuses paid to executives whose companies were bailed out by the government. Treasury Secretary Timothy Geithner has repeatedly blamed pay standards tied to short-term profits for contributing to the worst financial crisis since the 1930s.

“It clearly is going to force companies to be more transparent with their disclosure” on compensation, said Irv Becker, national practice leader for Philadelphia-based Hay Group’s executive compensation practice. If the measure is implemented, it likely will take several years before shareholders begin to confront management, he predicted.

“It’ll kind of be novel the first year, maybe the first two, and then likely be a little bit more serious in future years,” said Becker, a former head of compensation and benefits at Goldman Sachs Group Inc.

No wonder the banks are scurrying to pay back their TARP loans if they can.  No senior manager want’s a pay cut and it appears those that would be first impacted are those businesses functioning on government largess.    This from Daily Finance.

The announcement of the plan could come as early as today after Geithner meets with SEC Chairman Mary Schapiro, Federal Reserve Governor Daniel Tarullo and executive-compensation specialists at the Treasury. Geithner said yesterday that the Fed and other bank regulators will define “standards and principles that supervisors would use to help bring about reforms in compensation practices in the financial industry.”

The push will be to tie compensation packages to long-term investment and return. Also the administration wants banks to take measures to control risk better.

Pay package changes is just one small part of the Obama administration’s plans to overhaul U.S. financial rules. President Obama plans to unveil his proposals on June 17, but don’t expect any major changes in the current mix of regulatory agencies. Obama seems to be stepping away from the turf wars, adding a layer of overseers rather than reducing the number of agencies.

So, what are the issues here?  Well, the WSJ is likely to be the most pro-market so let’s examine their arguments.  The first big hoopla came when there was a suggestion of a implementing salary cap. This is something that corporations argue cripples their ability to find a top gun to place in a situation that no one would want unless more than adequately compensated.  The salary cap issue is now appears moot.

In a ballyhooed February announcement, the administration said it planned to limit salaries to no more than $500,000 for top executives at firms receiving “exceptional assistance.”

But taken together, the two efforts were more punitive than the administration had intended. The effort spooked Wall Street banks and prompted worries that overseas competitors would swoop in and steal their best people. Government officials have been wrestling with the right mix of restrictions, given the concerns of Wall Street about attracting and retaining talent.

Top officials within the administration felt that restricting salaries would potentially put some firms at a competitive disadvantage by encouraging talented workers to seek employment at overseas firms or hedge funds and private-equity shops. That would hurt the firms and ultimately the government’s investments in them.

Although the compensation rules are weaker than some would like to see, Wall Street banks are going to remain under close supervision from Washington even after they repay TARP funds. The administration is in the final stages of drafting plans to revamp oversight of financial markets that could radically change how big financial firms do business. As part of that, the Federal Reserve has been discussing rules to curb banks’ ability to pay employees in a way that would threaten the “safety and soundness” of the bank.

We of course, now have a “Pay” Czar in keeping with all the other appointments made by the Obama administration to handle public issues with out first having gone under traditional congressional oversight of public appointments.  (But, this is a topic for another day).   If we do get laws that give stockholders more say in compensation decisions, this would be a good move.  Many compensation packages are set by HR folks (of course dutifully bound to senior management) and approved by Board of Directors (usually equally captured by senior management). If this does lead to to transparency, it will help the markets.  However, with Chris Dodd in charge and the major players in negotiations being players in the Finance Industry, I’m not holding my breath.  However, I’m willing to watch and wait.