Corporate governance has dark side and bright side

CEOs are rewarded for good luck — and bad

In a perfect business world, corporate governance and decision-making would follow sound and rational processes. And, indeed, Professor Todd Milbourn has discovered that, at times, executives are compensated appropriately and appropriate decisions are taken. This finding is from what he calls the “bright side” of his research.

Cash can pour into executive wallets, whether deserved or not.
Cash can pour into executive wallets, whether deserved or not.

But, the real world can also serve up Disneys, Enrons, and WorldComs. Not all mismanagement, however, makes the front pages or drives companies into bankruptcy. More commonly it goes on unnoticed or as accepted practice, says Milbourn, associate professor of finance at the Olin School of Business at Washington University in St. Louis. His collaborative research also reveals a “dark side,” where companies reward chief executive officers simply for being lucky and where “yes men” often rule.

The dark side of executive compensation

Milbourn’s forthcoming paper in the Journal of Financial Economics, “Asymmetric Benchmarking in Compensation: Executives Are Rewarded for Good Luck But Not Penalized for Bad,” finds that some firms practice asymmetric benchmarking for executive compensation, in some instances even increasing the number of stock options granted in down markets while not reducing them in up markets.

“A prevailing puzzle in the executive compensation literature is the absence of ‘performance benchmarking’ in CEO compensation schemes,” says Milbourn, who co-authored the study with Gerald Garvey. “Ideally, before a firm awards an executive a substantial reward for say, superior stock price performance, the board of directors should benchmark the firm’s performance to broad market movements. If the entire market was also up, the individual firm’s performance is thereby less impressive. Paying in such a manner is referred to as ‘relative performance evaluation.’ Such apparently sensible benchmarking has not been observed in practice. Instead, it was widely believed that top executives received symmetric increases in pay for good performance and decreases for bad performance, irrespective of how the overall market was doing. However, what we uncovered is that there is relative performance evaluation for executives only on the down side, that is, when the market benchmark is down.”

Todd Milbourn
Todd Milbourn

Using industry benchmarks of performance, they found a significantly lower sensitivity of executive pay to performance when performance is bad (which would reduce bonus compensation) than when it is good, with the average executive losing 25 to 45 percent less in pay in bad times than they gain in good times. Such inefficient executive compensation amounts to an inappropriate transfer of wealth from shareholders to executives, says Milbourn, who also has taught at the London Business School and at the University of Chicago.

“This is bad news for those who say corporate governance is working well,” he says. “When executives still get bonuses for bad news, that’s not consistent with good business governance. Our study shows businesses how to improve governance by paying and penalizing symmetrically.”

“Yes men” and sunflowers

Nor is it all good news in managerial decision-making, according to Milbourn. Working with his executive business students, Milbourn heard much anecdotal evidence suggesting that managers often edit analyses and reports to please an enthusiastic boss rather than throw cold water on a pet project — and perhaps his or her own career.

In his 2003 Journal of Business paper, “Sunflower Management and Capital Budgeting” (with Arnoud Boot, professor of corporate finance and financial markets, University of Amsterdam, and Olin colleague Anjan Thakor, John E. Simon Professor of Finance), Milbourn posits that “yes men” or “sunflowers” — who follow a boss’ lead like the sunflower follows the sun — often make business decisions in light of their own career concerns rather than purely on merit.

“For example,” says Milbourn, “if a boss asks a subordinate for an analysis of a company he likes a lot, the analyst will judge not only on the firm’s attributes but will also assess the project in terms of his own career. When a worker, playing the career-concern game, slants a decision to please a boss, it clouds the analysis and undermines good managerial decision-making.”

Now Milbourn is expanding his investigation of myopic management, thanks to a $10,000 grant from the FDIC’s Center for Financial Research. Working with Olin colleague Michael Faulkender, Milbourn will examine variations in firms’ use of interest rate swaps to time interest rate markets in their attempts to reduce short-term debt costs. The researchers suspect that much managerial behavior in such situations is consistent with short-term myopia and speculation — as opposed to sound, long-term managerial decision-making.

Looking on the sunny side

However, not all of Milbourn’s research shows dysfunctional business practices.

In a utopian business world, says Milbourn, “CEO reputation would matter a lot in determining appropriate compensation.” That is, the stock-based incentives offered to executives with high perceived ability — those who might be expected to be around for a long time — should be higher. “The intuition is that a firm’s own stock price is more responsive to the efforts of the executive when the perceptions of her ability are higher,” says Milbourn.

To test that theory, Milbourn studied extensive data on executive compensation, which public companies have had to file since 1992, with perceived CEO reputation based on the firm’s performance relative to industry benchmarks and a host of other measures, such as the number of times an executive’s name appeared in business publications. With such proxies for CEO reputation, Milbourn uncovered a strong positive relationship between reputation and the prevalence of high-powered, stock-based incentives.

“Most people think reputation matters a lot. The CEO compensation data move in a consistent fashion for strong support of that model,” says Milbourn, “with higher performance bonuses reflecting positive perceptions of CEO ability. My study shows that CEO compensation contracts are generally rational and consistent along these dimensions.”

The study, “CEO Reputation and Stock-Based Compensation,” was published in 2003 in the Journal of Financial Economics.

At the Olin School of Business, Milbourn teaches in the MBA and Executive MBA programs, as well as in Olin’s non-degree executive programs. He has won the Reid Teacher Awards three times on a student vote, in both the Executive MBA and MBA programs, and was awarded the Reid Chair for 2002-2003.