2010 Vol. 1


executive compensation

Pansy Yang, Ph.D. (Bio)
Executive Director of the Fink Center for Finance & Investments

The disparity in salary between the average employee and executive has only widened in the last decade, and the hefty CEO payouts that have accompanied major financial firms while collapsing have once again launched the topic of executive compensation into the limelight. As public outcry reaches a crescendo, regulators have scrambled to come up with measures to rein in practices such as exorbitant pay packages and guaranteed bonuses regardless of how an employee performs. Partial solutions includes salary caps, shareholder voting rights on executive pay, as well as additional government legislation. They all seek to address the same question that we examine in this issue of the bulletin: How should the optimal compensation package be structured so that managers act in the best interest of the firm and not engage in excessive risktaking behavior?

Richard Roll, Japan Alumni Chair in Finance at UCLA Anderson, contributes the academic perspective with his research on the relationship between option and equity based compensation and long-term IPO operating performance. Based on a theoretical framework and rigorous empirical tests, his paper finds that performance is better when managers receive a balanced form of compensation, a mixture of equity ownership and stock option grants.

Insight into industry practices is provided by George Paulin, Chairman and CEO of Frederic W. Cook & Co. George is an expert consultant specializing in executive and employee compensation. With more than 25 years of experience, he has witnessed the continuing evolution and trends in executive compensation over many market cycles. In this issue, we include a reprint of an interview with George that appeared in the Financial Times in June 2009, and augment it with a few questions of our own.

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Academic Perspective

Richard Roll (Bio)
Japan Alumni Chair in Finance, UCLA Anderson

In the United States, equity-based compensation represents a substantial and increasing fraction of the total remuneration received by top corporate executives (Conyon and Murphy, 1999). Equity-based compensation comes in a variety of forms, but the two most common are undoubtedly awards of shares and grants of options on the firm's stock; both of which are commonly subject to various restrictions on reselling, vesting, etc.

Agency theory suggests that firms endow employees with equity to create incentives and align the interests of managers and owners.1 Stock-based compensation plans can also assist a firm in bringing talented new staff on board (Oyer, 2004; Oyer and Schaefer, 2004) or in retaining that staff (Carter and Lynch, 2001; Callaghan et al., 2003; Subramanian et al., 2007). Stock options might be a particularly effective form of compensation when cash availability is limited in cashpoor start-up firms (Inderst and Müller, 2005). This might be especially important for high technology firms that have intangible assets but little cash (Yermack, 1995; Dechow et al., 1995; Core and Guay, 2001).

In recent years, however, stock option plans have drawn the attention of many critics who claim that they have become too costly, that their costs are not properly reported under current GAAP rules, and that they provide employees with an incentive to abuse the system.2 But despite recent publicity about supposed backdating and corporate scandals involving such high-profile firms as WorldCom, Enron, and Adelphia Communications, the use of employee stock options is still widespread, particularly by high-technology firms.

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1 See also Jensen and Meckling (1976), Haugen and Senbet (1981), Smith and Stulz (1985), Lambert (1986), Copeland and Weston (1988), Lambert et al. (1991), Hirshleifer and Suh (1992), and Hemmer et al. (1999). Other researchers such as Demsetz and Lehn (1985), Himmelberg et al. (1999), Core and Guay (1999), Rajgopal and Shevlin (2002), and Hanlon et al. (2003) base their analyses on the premise that option granting is consistent with firm value maximization.

2 Murphy (2002, 2003) proposes that compensation policies are based on the "perceived cost" of options rather than their true economic cost. Until the recent FAS123 ruling by the Financial Accounting Standards Board (FASB), option grants involved no accounting charges. Also, they resulted in no direct cash outlay. Consequently, many firms may have perceived that option compensation was a low cost alternative to cash compensation.



Industry Perspective

Interview with George Paulin
Chairman and CEO of Frederic W. Cook & Co., Inc.

The following interview with George Paulin, CEO of one of the leading executive compensation consultancy firms, Frederic W. Cook and Co., consists of two parts. The first is a reprint of an interview with the Financial Times (FT) performed by Josh Martin in June 2009; the second part is an exclusive interview with the Fink Center that includes some follow-up questions.

FT: Are caps on executive compensation here to stay?

GP: No, they are temporary. How much a company pays for the services of executives is an economic transaction.

Applied over time, caps on executive compensation would distort the market, causing talent to move between industries, countries, and types of organisations (privately versus publicly-owned) based on where their services were most valued by market forces.

FT: In this environment, how have corporations designed compensation packages that attract, retain, and motivate the most talented executives?

GP: I find that companies with the greatest success in this environment have "balanced" executive compensation programmes, where they have found the right trade-offs between cash versus equity, reward versus risk, short-term versus long-term performance focus, and external competitiveness versus internal equitability.

There is no one-size-fits-all formula. Every company is unique, based on its business and human-resources objectives, cost structure, culture, history, and decision-maker bias.

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Faculty Highlights


Richard RollProfessor Richard Roll, Japan Alumni Chair in International Finance, has been selected as the recipient of the 2009 IAFE/SunGard Financial Engineer of the Year (FEOY). Renowned for his extensive academic and professional achievements, Roll was presented with the 2009 FEOY Award on February 4, 2010 at the New York Stock Exchange. The IAFE/SunGard FEOY Award recognizes individual contributions to the advancement of financial engineering technology.

"It is extremely gratifying to receive this award, which has been given before without exception to financial scholars that I greatly admire," said Roll. "I am truly honored to be included in their company."

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Mark GrinblattProfessor Mark Grinblatt, J. Clayburn LaForce Professor of Finance, is the invited keynote speaker at the European Winter Finance Summit 2010, to be held from March 21-24, 2010 at Saalbach Hinterglemm, Salzburg, Austria. The European Finance Winter Summit is a joint initiative of financial economists from Copenhagen Business School (CBS), Norwegian School of Economics and Business Administration (NHH), and Vienna University of Economics and Business. There is attendance by a substantial number of noted academics from around the world.

Grinblatt is also the invited keynote at the Western Finance Association (WFA) 2010 meeting to be held from June 20 - 23, 2010 at the Fairmont Empress in Victoria, British Columbia. This is a major meeting of financial economists, which has over 1000 paper submissions.

Grinblatt has been on the faculty at UCLA Anderson since 1981. His current research interests include asset pricing, rational expectations equilibria, performance evaluation, stock market anomalies, corporate finance, derivatives valuation, and investor behavior.

Hanno LustigProfessor Hanno Lustig, Nick Roussanov, Adrien Verdelhan were awarded first prize in the 2009 Terker Family Prizes in Investment Research from the Rodney L. White Center for Financial Research at the Wharton School, for their working paper "Common Risk Factors in Currency Markets".

 



Welcome to five new doctoral students entered the finance PhD program this year.

Yaron Levi graduated with a B.A. in Economics (2008) from Haifa University. He is from Tel Aviv, Israel.

Aurelien Phillippot received his MSc in Management (2007), majoring in finance from the HEC School of Management in Paris. His research interests include corporate finance, behavioral finance, market anomalies and firm valuation. His publications include "Corporate raiders et transformation d'entreprises familiales en multinationales", Club Finance-Les Etudes du Club, December 2007. He is originally from Auxerre, France.

Florian Schulz earned a M.Sc. Finance (2008) from the London Business School, MBA (2006) from the University of Iowa and Diploma program (B.Sc. Equiv.) in Economics (2005) from Goethe University Frankfurt. His research interests include corporate finance, incentives, financial contracting, credit risk, and market regulation. He is a native of Berlin, Germany.

Brian Waters graduated with a B.S. in Economics (2007) and Human and Organizational Development from Vanderbilt University. He served as a Staff Economist in the White House Council of Economic Advisers from 2007-2009. He grew up in Coral Springs, Florida.

Xiaolan Zhang received her M.A. in Economics (2009) from Peking University and B.A. in Financial Engineering (2006) from Renmin University of China. Her research interests include corporate finance and financial intermediation. She is originally from Ningde, China.



Upcoming Events

Date: Wednesday, April 14
Time: Noon to 1:30
Location: UCLA Anderson Korn Hall, Reception to follow panel discussion

A discussion on how to balance financial risk and reward in an atmosphere of a near market meltdown that has caused an erosion of trust in financial institutions and the federal government. Representatives from industry, academia, and government will have a dialogue on the future of new regulations for Wall Street and whether or not this type of financial crisis could happen again.

Panelists:

Lynn A. Stout, Paul Hastings Professor of Corporate and Securities Law
Greg Berman, SEC Senior Policy Advisor to the Director, Division of Risk, Strategy and Financial Innovation
Judy Posnikoff, Founding Member and Managing Director, Pacific Alternative Asset Management Company, PAAMCO

Moderator:
Professor Emeritus Michael Brennan, UCLA Anderson

Join the UCLA Anderson finance faculty, rated #1 in intellectual capital, for a weekly seminar given by renowned academics visiting from leading universities all over the world. Seminars are open to the public and held at UCLA Anderson Cornell Hall D301, from 11:00 - 12:15 p.m.

Date

Speaker

Areas of Expertise

March 5

 

Martin Oehmke (Columbia)

 

Financial economics, Asset pricing, Financial intermediation

March 12

 

Markus Brunnermeier (Princeton)

Macroeconomics, institutional frictions, behavioral trading

April 2

 

Harrison Hong (Princeton)

Behavioral finance, stock market efficiency, asset pricing and trading

April 9

 

Monika Piazzesi (Stanford)

Macroeconomics, asset pricing, housing market trading

April 16

 

Joost Driessen (Tilburg)

Liquidity risk, the empirical analysis of derivatives, corporate bonds and credit risk, optimal portfolio choice, and private equity

April 19

Ivo Welch (Brown)

Financial markets, executive compensation, capital structure

April 23

 

Vish Vishawathan (Duke)

Corporate finance and asset pricing, especially to issues related to collateral and market liquidity

May 7

 

Jonathan Berk (Stanford)

Delegated money management, asset pricing

May 14

 

Russ Wermers

Securities markets, mutual funds, pension funds, hedge funds.

May 28

 

Dean Karlan (Yale)

Microfinance programs focused on poverty



The Fink Center for Finance & Investments
UCLA Anderson School of Management
110 Westwood Plaza, Los Angeles, CA 90095