Business Law Prof Blog

Executive Compensation and Government Regulation

The article by Joann S. Lublin and Scott Thurm in todays Wall Street Journal ("Behind Soaring Executive Pay, Decades of Failed Restraints") should be required reading in all American business schools and in all American law school courses on corporate law.   It makes the point that with each new law attempting to control executive pay came "unexpected consequences,"  executive pay increased.  Each law had exceptions for pay that the law makers felt was justified, and companies turned the exceptions into uniform practice, increasing pay.

IN 1984, Congress taxed golden parachutes if over three times salary.  Parachutes, rare before 1984, became the norm after 1984 for all companies at -- you guessed it -- three times salary.  Now they are over three times salary and the companies pay the tax (gross up provisions).  In 1992, the SEC forces companies to disclose more on pay packages; after 1992 salaries skyrocket as CEOs now know what each other make and all demand to be in the "top half", ratcheting up the pay scale.  In 1993 Congress caps the deduction for cash salary at $1 million and exempts some kinds of "performance based" compensatory stock options.  Before 1993 most executives did not get $1 million in cash, after 1994, all CEO salaries were at $1 million in cash.  Now cash salaries over $1 million are common; companies do not worry about the deduction. Compensatory stock option grants soared.  By 2001 Larry Ellison took home $706 million in a single year.  When FASB finally required the expensing of stock options in 2003, companies began to distribute "restricted stock."  Severance payments have soared and golden parachutes, a version of severance payments, are up.  Kilts, from Gillette, took home $185 million when he sold Gillette to Proctor & Gamble (and was indignant when anyone suggested that it was too much).  Indignant.  There is the guts of the problem. The man should be ashamed, or at the very least a wee bit guilty (and thankful for his undeserved good fortune). 

Antitrust Problems for Private Equity Funds

The financial news is focusing whether private equity pools violate United States antitrust laws.  Are the private equity players fixing the auctions for selling firms?  As noting earlier in this blog, pooling capital is fine but an agreement among players determining which players can bit on which companies and in what form is not.  Antitrust concerns in our financial markets are not new.  Securities underwriting has an antitrust exemption for pooling, formalized in 1952, and was still subject to claims of monopolization in 1953 (the suit was dismissed).  Market makers, both on the NYSE and on the NASDAQ, have been accused of violating antitrust laws.  The NYSE specialists have an exemption based on SEC regulation; the NASDAQ market makers do not and an inquiry in 1996 resulted in a settlement that changed practices.

The insurance industry exemption is also in the news, as Congress is holding hearings on why policies on flood coverage among companies all look the same.  The insurance industry has an antitrust exemption, from the 40s, on data sharing.  Baseball has a special antitrust exemption for the owners.  The list goes on.

We need to reevaluate all these exemptions.  They are too easy to get if one can make a business argument that looks good on paper (has good business justifications for the industry)  The problem is that what looks good on paper translates into a practice (hard to police because the players are clever) that stifles competition in unhealthy ways.  The private equity pool investigation, if it players out like the others, will be closed without any prosecutions because the prosecutors, who smell the odor of bad practice, cannot find any "smoking gun" documents on any "canaries."

Private Equity Auctions and Antitrust

The Justice Department's Antitrust Division has started an investigation into the bidding practices of the players in the private equity markets.  Private equity funds often group together to make bids for companies (in LBOs).  At issue is whether the players are rigging auctions -- agreeing not to compete with each other for selected companies -- like Persian rug buyers.  This will be a difficult investigation.  To get a sense of the history one must understand the underwriting game -- the private equity players take their cue from the underwriters.  In 1953 the Supreme Court held, in  United States v Morgan, that underwriters could pool to do firm underwritings, spreading the risk among a "syndicate."  Pooling makes sense but it very quickly degenerates into quiet "understandings" about structuring competition, which pose antitrust problems.  The 1953 case has led to an American underwriting fee structure that is the highest in the world and that has "understood" levels -- large companies are charged 7 percent and so on.  Similarly the private equity fund groups could led to similar competition "understandings."  At issue is how the legal system allows what makes business sense, the pooling of capital, and disallows what is destructive to competition -- understandings among potential competitors to reduce competition.  This is a very difficult problem for legal process.  Our approach in the past is to turn a blind eye to the competitive problems until a "smoking gun" series of exchanges appears in a deal, then we prosecute based on the letters (emails).  Smart players know how not to write smoking guns, so we catch the dumb ones and the market structuring continues apace.  My preference would be to be less hospitable to the players who want to pool, putting the burden on those who pool to justify the pooling and keep accurate records of how the deal was put together (and of communications with competitors).  In other words, we should be suspicious inherently of such deals not openly and unquestioningly accepting (as we are now).

Shareholder Voice

Any one who is navy will tell you that it takes some time to turn a battleship around.  The heavy ship has such strong inertial momentum that it responds with agonizing slowness to changes in the helm.  But the ship will turn.

In the last several weeks there has been a steady drumbeat of small news items that indicate that shareholders are slowly gains a degree of control in American corporations. 

Both Exxon and General Motors announced last week that the companies would adopt majority voting requirements in uncontested director elections.  Director nominees must win a majority of the votes cast or submit their resignations to the board.  The two high profile companies join Home Depot, Pfizer, Intel and Motorola in adopting the bylaw.

Several companies, including Federal Department Stores and Baker-Hughes, have, in response to shareholder requests, agreed to hold shareholder votes on whether to do away with “staggered boards” in favor of “straight boards.”  A company with a staggered board elects only third of its directors in any given year.  A company with a straight board elects all its directors annually.

Several shareholders have won victories in proxy fights, traditionally a contest rigged for incumbent managers.  There are more than double the number of proxy fights in 2006 than any previous year.  Nelson Peltz won seats on the board of H.J. Heinz and successfully pressured Wendy’s International for board seats.

Annual shareholder meetings, once held in a lawyer’s conference room, now feature robust exchanges in question and answer sessions with the company CEO.  Wal-Mart holds its annual meeting in a 15,000 seat arena.  Starbucks meetings attract 5,000 shareholders. The Home Depot CEO was embarrassed by a shareholder question asking for an introduction of the company’s directors; they were not there.

Shareholders selling into management led leveraged buyout (LBOs) at Kinder Morgan and United Health are questioning actively the ethics and procedures for the managers, board, and advisers who are pushing the deals.

And in the background is the discussion at the Securities and Exchange Commission on whether to keep or modify its “shareholder resolution” rule that, as recently interpreted by a federal circuit court, that allows shareholders to request company wide votes on whether shareholders could nominate directors for inclusion on the company’s proxy card.

Companies’ new responsiveness to shareholder requests may be, in part, a result of the companies’ attempts to look good for the SEC and thus have more bite to their arguments to the agency to narrow the rule.

Shareholders that use the SEC rule to submit “social-policy resolutions” to a shareholder vote have found that affirmative votes for the resolutions are up.  The resolutions in the past have struggled to get even a small percentage of the vote.  In 2006 there is a thirty-eight percent increase in the number of resolutions that get more than ten percent of the vote.  The favorite is a resolution requiring companies to produce “sustainability reports” on the effect of company operations on the environment.

Embarrassments at Hewlett-Packard have cost top managers their jobs and led to a nation-wide discussion about paranoia over board media leaks.  Managers who back- dated compensatory stock options are facing pressure to explain themselves or resign.

Independent directors, those who are not also on the company’s executive management team, are meeting without the inside directors, developing their own channels of information inside the company, and hiring their own independent advisors.

Yes indeed folks, the battleship of corporate governance has begun to swing around –toward more shareholder voice.