When it comes to paying America's corporate executives, the problem isn't that they are paid too much but rather how they are paid that helped lead to some of the spectacular corporate implosions in recent years, according to a University of Colorado at Boulder finance professor.
Sanjai Bhagat of the Leeds School of Business says restricting the stock and stock options in incentive compensation plans for corporate executives would go a long way to help correct the problem of executives being rewarded for short-term growth at the expense of the long-term health of their companies.
"Executive compensation plans should lead to policies that are simple, transparent and focused on creating and sustaining long-term shareholder value," Bhagat said. "The problems thought to have been generated from equity incentive compensation in the past decade, including earnings manipulation and taking on unwarranted risk, are a function of structure, not the level of the incentive payments."
In an essay published in the Yale Journal of Regulation's summer edition, Bhagat and co-author Professor Roberta Romano of Yale University suggest that incentive compensation plans should be more transparent and simplified, but most importantly, executives should be restricted from selling their stock or stock options for at least two to four years after their last day in office.
Paying executives in this way will provide an incentive for them to manage corporations in investors' longer-term interest, and diminish their incentive to make public statements, manage earnings or accept undue levels of risk for the sake of short-term price appreciation, he said.
"The concern today is many executives have done very well with their compensation, but their shareholders have done very poorly," Bhagat said. "So how could it happen that a compensation arrangement whose whole motivation is to increase shareholder value has done quite the opposite?"
Most executive compensation plans primarily consist of two parts. One is cash compensation and the other is incentive compensation consisting of stocks, stock options and a few other types of securities, according to Bhagat.
"The reason for incentive compensation plans, as the name suggests, is to provide incentives to these executives and to create value for the shareholder," Bhagat said. "When the company's value goes up, the value of the shares goes up for the executives and the shareholders."
Prior to the spate of accounting scandals that began with Enron, incentive compensation from stock and stock options was often emphasized as a key to improved corporate performance, and such compensation has been the most substantial component of executive pay for well over a decade, according to Bhagat.
Congress implicitly supported the incentive function of executive compensation when it eliminated the corporate income tax deduction for executive salaries over $1 million, since the elimination was applied only to non-incentive-based compensation, he said.
But the recent accounting scandals revived executive compensation as an issue because the executives of some scandal-ridden firms reported gains in the range of tens to hundreds of millions of dollars from exercising stock options before their firms imploded.
"Our proposal will diminish the perverse incentives to manipulate or emphasize short-term stock prices over long-term value, yet retain the benefits of equity-based incentive compensation plans," Bhagat said. "Managers with longer horizons will be less likely to engage in imprudent business or financial strategies or short-term earnings manipulations when the ability to exit before problems come to light is greatly diminished."
He says the idea of using restrictive stock for executive incentive compensation is not new, but rather an approach that has been lost in the current populist call to reduce, rather than restructure, incentive compensation.
In fact, many firms already have restricted stock plans, Bhagat said. But most plans allow executives to sell these shares a few years after they are awarded while Bhagat and Romano would require executives to hold these shares two to four years after their last day in office.
Even though the proposal would benefit investors and CEOs in the long term, Bhagat says it may be a tough sell.
"Our proposal is not directed at garnering CEO support, our proposal is geared toward looking out for the interests of the investors in this country who are investing their hard-earned dollars in these U.S. corporations," Bhagat said. "By looking out for the investors in the long run, you are also looking out for the CEOs."
To hear to a podcast featuring Bhagat visit /. To view a short video of Bhagat discussing executive compensation visit .