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.

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