CEO Pay and Corporate Governance in the U.S.: Perceptions, Facts, and Challenges

• DOI: http://doi.org/10.1111/jacf.12013
• Date: 01 June 2013
• Published date: 01 June 2013
• Author: Steven N. Kaplan

VOLUME 25 | NUMBER 2 | SPRING 2013

In This Issue: CEO Pay and Capital Markets

CEO Pay and Corporate Governance in the U.S.:

Perceptions, Facts, and Challenges

8Steven N. Kaplan, University of Chicago Booth School

of Business

How “Competitive Pay” Undermines Pay for Performance

(and What Companies Can Do to Avoid That)

26 Stephen F. O’Byrne, Shareholder Value Advisors, and

Mark Gressle, Gressle and McGinley

How to Design a Contingent Convertible Debt Requirement

That Helps Solve Our Too-Big-to-Fail Problem

39 Charles W. Calomiris, Columbia University, and

Richard J. Herring, University of Pennsylvania

Syndicated Leveraged Loans During and After the Crisis

and the Role of the Shadow Banking System

63 Christopher L. Culp, Compass Lexecon and

The University of Chicago Booth School of Business

The Future of International Liquidity and the Role of China 86 Alan M. Taylor, University of Virginia, NBER, and CEPR

Private Equity and Investment in Innovation:

Evidence from Patents

95 Josh Lerner, Harvard Business School,

Morten Sorensen, Columbia University, and

Per Stromberg, Stockholm School of Economics

Two-Sided Matching: How Corporate Issuers and

Their Underwriters Choose Each Other

103 Chitru S. Fernando, University of Oklahoma,

Vladimir A. Gatchev, University of Central Florida, and

Paul A. Spindt, Tulane University

Discounted Cash Flow Valuation for Small Cap M&A Integration 116 Norman Hoffman, Dominion Enterprises, LLC and

College of William & Mary

8Journal of Applied Corporate Finance • Volume 25 Number 2 Spring 2013

CEO Pay and Corporate Governance in the U.S.:

Perceptions, Facts, and Challenges

* I thank Douglas Baird, Ef Benmelech, Don Chew, Carola Frydman, Austan Gools-

bee, Jeff Miron, Lawrence Mishel, Raghu Rajan, Amir Su, Luke Taylor, and Rob Vishny

for helpful comments. Wei Wu provided excellent research assistance. A version of this

paper appeared in the Cato Papers on Public Policy. This paper also formed the basis for

the 2012 Martin Feldstein Lecture at the NBER. I thank the Cato Institute, the Center for

Research in Security Prices, and the NBER for nancial support.

1. Bebchuk, Lucian and Jesse Fried, 2006, Pay without Performance: The Unfullled

Promise of Executive Compensation, Harvard University Press.

2. Gretchen Morgenson, April 6, 2013, http://www.nytimes.com/2013/04/07/busi-

ness/shareholders-can-slow-the-executive-pay-express.html

3. Natalie Singer, April 8, 2012, http://www.nytimes.com/2012/04/08/business/in-

chief-executives-pay-a-rich-game-of-thrones.html.

BT

by Steven N. Kaplan, University of Chicago Booth School of Business*

here is a widespread perception that the CEOs

of U.S. public companies are overpaid, and that

their boards are la rgely ineective in oversee-

ing both pay practices and performance. ese

perceptions can in turn be broken down into three more

specic claims: (1) the CEOs of U.S. companies are not only

overpaid, but their pay—and presum ably the amount by

which they are overpaid —keeps rising; (2) CEO rewards are

insuciently related (if related at al l) to corporate perfor-

mance; and (3) corporate boards are not doing their jobs as

monitors for shareholders. e ineectiveness of U.S. corpo-

rate governance was a major focus of the inuentia l book by

law and economics scholars Lucian B ebchuk and Jesse Fried,

Pay Without Performance: e Unful lled Promise of Executive

Compensation. ey concluded that “awed compensation

arrangements [in U.S. companies] have not been limited to

a small number of ‘bad apples’; they have been widespread,

persistent, and systemic.”1

In the last decade, t he U.S. government has implemented

two major pieces of legislation designed to improve corporate

governance . e scand als of Enron, WorldCom, a nd others

early in this centur y led to the Sarbanes-Oxley legislat ion in

2002. And the recent na ncial crisis prompted the passage,

in 2010, of the Dodd-Frank legislation, which includes a

requirement that all public companies obta in annual advisory

shareholder votes on top executive pay (now referred to as

“Say-on-Pay”). But despite all the legislation and public

scrutiny, the perception of pay and controversy over it seems

as heated as ever. is spring, Gretchen Morgenson of the

New York Times wrote, “Raises may be hard-won for most

American workers these day s, but for those fortunate few in

the executive suite, the pay increase s just keep on coming.”

2

A

year earlier a dierent ar ticle in the New York Times claimed

that “the top brass generally do much, much better tha n the

rest of us, whether times are good or bad.”3

In this paper, I evaluate the accuracy of these percep -

tions today. What are the facts about U.S. CEO pay? Is it

true that the ty pical CEO of a U.S. company is not paid for

performance? How eective a re public company boards in

monitoring their CEOs and holding them accounta ble for

poor performance? In the proces s of asking and trying to nd

answers to these questions, I a lso try to answer another, more

fundamental quest ion: namely, what are the drivers of CEO

pay? Is their pay driven primari ly by the power they wield

over their boards, causing t hem to be overpaid? Or does

CEO pay reect a competitive market for talent in which

CEOs are largely paid in accordance with the dema nds of

the job, and the skills, ex perience, and opportunity costs of

the cand idates?

Some of the controversy over CEO pay stems from confu-

sion about how to measure and report it. As I explai n in more

detail later, there are two ba sic ways to measure CEO pay. e

rst, which I refer to as “estimated ,” “grant-date,” or awarded

pay, includes salary, bonus, restricted stock, and the esti mated

value of stock options on the day they are gra nted. is is the

expected value of the compensation pack age that the board

has decided to give the CEO for that yea r. e second way to

measure CEO pay, which I call “reali zed” pay, values stock

options at their realized va lues only if and when they are

exercised and realized.

When trying to address the question of what has

happened to levels of CEO pay over time, I use estimated

or awarded pay because that i s the compensation that is

under the board’s control. What I nd is that in 2 011—

the most recent year for which I have reliable dat a on CEO

pay—average esti mated pay for S&P 500 CEOs (adjusted

for ination) had actual ly declined by over 40% since its

peak in 2000 a nd was lower than it was in 1998. Median pay

remains roughly at its 200 0 level.

To determine the extent to which current levels of CEO

pay are the outcome of a market process, it also is useful to

look at what has happened during the sa me period to the pay

of top performers in other professions, such as senior part ners

in law and private equity rms, a nd, perhaps more directly

comparable, the top executives of private companies. Using

an approach to measuring such relative CEO pay i n a study