Vol 11 (2014) - Issue 4

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The Derivative Solution to Perverse Incentives and Poor Pay-Performance Sensitivity in Executive Remuneration Contracts – Part One

Introduction
An enduring consequence of the 2008-2009 global financial crisis has been public resentment of 'bankers' bonuses, performance-based compensation which made millionaires of the very people whose actions were perceived as having brought the banks to their knees and in receipt of taxpayer-funded bailouts. Today, successful companies, in particular banks and other financial institutions, must carefully consider remuneration policy for their most senior employees. What combination of salary and performance-related pay will motivate and retain successful executives while remaining affordable for the employer, acceptable to shareholders and free of unintended adverse consequences?
In the first half of this paper, I shall present a summary of current influential opinion on the subject of executive pay and highlight how significant problems remain with existing executive remuneration contracts and corresponding UK regulation. In the second half, I will present a solution to these problems and the long-running debate over how best to link executive compensation to shareholder value and long-term corporate performance by proposing a new payment mechanism based on a derivative contract.
I will begin in Part 1 by describing the objectives of an optimal executive compensation contract before presenting the important work of Bebchuk & Fried (in Part 2) to highlight some of the principal problems with classic pay structures; namely their propensity to incentivise short-term thinking and the 'gaming' of company shares.
In Part 3, I will comment on the current UK regulatory landscape pertaining to executive pay. I will focus in particular on the UK Corporate Governance Code and the FCA's Remuneration Code. I will then apply the concerns highlighted by Bebchuk and Fried to show that these regulations are unlikely to, as their proponents suggest, succeed in preventing short-termism and the gaming of company shares by executives.
In Part 4, I will describe a wider problem with existing pay structures by suggesting that the orthodox view that equity-based compensation has resolved the historical problem of low pay-performance sensitivity is not reflected in practice. Whilst performance is linked positively to pay, the sensitivity of this link is often far too low.

1. The optimal compensation contract
Constructing an optimal compensation contract requires consideration of the principal-agent problem arising from the separation of ownership and control in large companies. In large corporations, shareholders delegate responsibility for managing the company to a board of directors who act as their agents. When an executive makes a decision, however, human nature dictates that he (or she) will assess the benefits and detriments that decision will have on his own private interests. This creates the possibility that the executive may pursue his own economic self interest ahead of that of his principal. The optimal compensation contract must therefore aim to reduce these agency costs by linking, as closely as possible, the executive's own interests to the interests of shareholders.