Financial crisis of 2008: the shareholder role

As Capitol Hill tries to craft bailout legislation, executive pay (and corporate governance more generally) has suddenly become part of the drama. Congressional leaders are determined not to let Wall Street executives waltz away from the meltdown with big severance packages. They seem to want to punish the current crop of execs (as a politically necessary offset to the cost taxpayers will have to pay) and to provide an example that will discourage future executives from gambling with the financial system.

My sense is that the government will have trouble imposing effective limits on the pay of departing execs. These executives’ golden parachutes are part of incentive contracts signed by boards of directors according to corporate bylaws. If the execs did something illegal they might be sued and forced to surrender some of their pay, but as far as I know none of them did anything illegal. If there was a “clawback under restatements” provision in the compensation contract, the CEO might be required to surrender pay in the event that earnings statements need to be revised, but as far as I know this will not happen either. (The “clawback” provision is a common shareholder proposal; searching ProxyDemocracy you find about forty of these in the last few years.) This article in today’s NYT suggests that Congress is considering retroactively introducing a clawback provision on existing contracts, but that wouldn’t hold up in courts. (This article in BusinessWeek provides further discussion of these issues.) Based on what I’ve read, I expect any legislative provisions in the bailout that address the pay of current execs to include admonishments but no real effect. Barring successful shareholder litigation or a voluntary move by a humiliated CEO or two, I think we can expect executives at these companies to keep the pay that their contracts promised.

But reforms adopted as part of the bailout plan, or in the next legislative session, may make it easier for shareholders to keep watch next time. Lawmakers are reconsidering a couple of proposals to increase shareholder oversight that have previously been rebuffed by lawmakers and the SEC, and knowing how crisis drives policymaking, this might be the occasion for their adoption. The BusinessWeek piece says that draft legislation includes a provision advocating “say on pay,” i.e. the practice of allowing or requiring an advisory vote of shareholders about executive pay packages. Instructing the SEC to act on this would be a very natural way to address public concern about excessive CEO pay while respecting the rights of the firm’s owners. The BusinessWeek article also mentions that the draft language raises the idea of “proxy access,” which is the practice of allowing big shareholders, or a coalition of shareholders, to propose director candidates for board elections. Shareholder activists have pushed proxy access proposals very hard over the past few years but the issue stands tabled by the SEC. The current crisis may provide exactly the environment that is necessary for something to finally get through.

I think “say on pay” and proxy access could be effective ways of making companies more responsive to shareholders, and the systemic effects could be considerable. The severity of the mortgage crisis might have been lessened if boards had been less complacent and if executive compensation contracts had been devised in a way that led senior managers to better manage systemic risk. As always, there are limits to what shareholders can be expected to do in overseeing corporate management, because the shareholder’s incentive to stand and fight for change at a mismanaged company will usually be weaker than the incentive to sell or even short-sell. And much of the blame for the current crisis should be placed on a regulatory system that encouraged systemically unsustainable risk-taking. Still, shareholders do have relatively strong incentives to see that their companies navigate risk effectively. As has been pointed out by Treasury officials defending the bailout, shareholders of the failed banks have mostly been wiped out. They have been hit harder than taxpayers will be, and they therefore have stronger incentives to make sure that this kind of thing doesn’t happen again. They should be given the tools needed to protect our economic system from future corporate myopia.