Electronic copy available at: http://ssrn.com/abstract=1506742 YALE LAW SCHOOL John M. Olin Center for Studies in Law, Economics, and Public Policy Research Paper No. 393 Reforming Executive Compensation: Simplicity, Transparency and Committing to the Long-Term by Sanjai Bhagat University of Colorado at Boulder - Department of Finance and Roberta Romano Yale Law School, National Bureau of Economic Research (NBER) This paper can be downloaded without charge from the Social Science Research Network Paper Collection at: http://ssrn.com/abstract=1506742

Electronic copy available at: http://ssrn.com/abstract=1506742 Electronic copy available at: http://ssrn.com/abstract=1506742 Professor of Finance, University of Colorado. * Oscar M. Ruebhausen Professor of Law, Yale Law School Research Associate, National Bureau of ** Economic Research Research Fellow, European Corporate Governance Institute. For helpful suggestions on our proposal, we would like to thank Ian Ayres, Lucian Bebchuk, Victor Fleischer, Ronald Gilson, Steven Kaplan, Edward Rock, Karin Thorburn, and participants at programs at the Northwestern, University of Pennsylvania, and Yale law schools and the 4 ECFR Symposium. This th article draws on an essay published in the Yale Journal on Regulation, vol. 26, no. 2, pp. 359-372 (Summer 2009), with permission of the copyright holder, �� Copyright 2009 by the Yale Journal on Regulation, P.O. Box 208215, New Haven CT 06420-8215. For analyses of the government policies, market failure and internal organizational factors contributing 1 to the crisis outlined in the text, see, for example, Charles W. Calomiris, The Subprime Turmoil: What Old, What New, and What Next, Columbia Business School Working Paper (2008), available at Reforming Executive Compensation: Simplicity, Transparency and Committing to the Long-term by SANJAI BHAGAT and ROBERTA ROMANO** * This Article advances an executive compensation reform proposal that is specifically addressed to firms receiving government financial assistance and thought to pose a systemic risk, although we think that all firms should consider its adoption. Executive compensation reform should lead to policies that are simple, transparent, and focused on creating and sustaining long-term shareholder value. With these criteria in mind, we suggest that incentive compensation plans should consist only of restricted stock and restricted stock options, restricted in the sense that the shares cannot be sold nor the options exercised for a period of at least two to four years after an individual resignation or last day in office. We would permit a minor amount to be paid out to executives currently to address tax, liquidity, and premature turnover concerns that the proposal could induce. We believe that this approach will provide superior incentives for executives(and traders whose actions can substantially impact an organization) to manage firms 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. By reducing management incentive to take on unwarranted risk, our proposal would therefore also decrease the probability that public resources will be dissipated in bailouts of financial firms, particularly those deemed by public officials as ���too big to fail.��� I. Introduction A myriad of factors have been identified as contributing to the ongoing global financial crisis, running the gamut from misguided government policies to an absence of market discipline of financial institutions that had inadequate or flawed risk-monitoring and incentive systems.1

Electronic copy available at: http://ssrn.com/abstract=1506742 Electronic copy available at: http://ssrn.com/abstract=1506742 2 http://www1.gsb.columbia.edu/mygsb/faculty/research/pubfiles/3182/What%27sOldNewNext.pdf Gerard Caprio, Jr., Asli Demirg -Kunt and Edward J. Kane, The 2007 Meltdown in Structured Securitization: Searching for Lessons not Scapegoats (2008), available at http://www2.bc.edu/~kaneeb/ Richard J. Herring, Risk Management and Its Implications for Systemic Risk, Testimony before the Senate Banking Committee, Subcommittee on Securities, Insurance and Investment (June 19, 2008), available at http://www.law.yale.edu/documents/pdf/cbl/Herring_Senate_Testimony.pdf. Economists have further analyzed how the spike in subprime mortgage defaults led to the paralysis of the commercial paper and credit markets due to the opacity of securitized assets, creating a modern bank panic in the repo market that financed major financial institutions. See Gary B. Gorton and Andrew Metrick, Securitized Banking and the Run on Repo, Yale ICF Working Paper No. 09-14 (2009), available at http://ssrn.com/abstract=1440752 Gary B. Gorton, Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1401882 (2009). Such government policies include low interest rates by the Federal Reserve and promotion of subprime risk-taking by government-sponsored entities dominating the residential mortgage market so as to increase home ownership by those who could not otherwise afford it, which fueled a housing bubble, and bank capital and institutional investor holding requirements dependent on credit ratings by entities which were either conflicted or incompetent (or both), providing triple-A ratings to securitized packages of subprime mortgages. Identified sources of inadequate market discipline include ownership restrictions, deposit insurance���s inducing moral hazard, ineffective prudential regulation including capital requirements that favored securitized subprime loans over more conventional assets, while internal organizational factors contributing to the crisis include business strategies dependent on high leverage and short-term financing of long-term assets, reliance on risk and valuation models with grossly unrealistic assumptions, and poorly-designed incentive compensation. These factors, taken as a whole, encouraged what was, as can readily be observed with the benefit of hindsight, excessive risk-taking. Yet only one of the items on the extensive laundry list of factors contributing to the crisis has consistently been a focal point of the reform agenda across nations: executive compensation. In the United States, for example, multiple legislative and regulatory initiatives have regulated

Electronic copy available at: http://ssrn.com/abstract=1506742 3 See, e.g., Helia Ebrahimi, Sarkozy Draws Up Plans for Global Bonus Clampdown, Daily Telegram, 2 Aug. 26, 2009, at 2 (regulation in France and Germany) Jill Treanor, Bankers Bow to Pressure on Bonuses: Darling Gets Agreement to G20 Rules a Year Early The Guardian, Oct. 1, 2009, at 26 (UK regulation) EU Will Examine Bonus Stucture of Banks Seeking State Aid, 12 Corporate Governance Report (BNA) 111 (Oct. 5, 2009). In addition, regulating bank executives��� compensation took a prominent place on the agenda of the recent G-20 summit, which produced a set of principles as a guideline for nations��� regulation of financial executives��� pay. Jonathan Weisman, Obama Retakes Global Stage, but With Diminished Momentum, Wall Street Journal, Sept. 19-20, 2009, p. A6 (noting that French President Nicolas Sarkozy threatened to walk out of the G-20 summit if leaders do not adopt strict compensation limits for financial executives) Treanor, supra (referring to UK banks reaching an agreement with the government to adopt G-20 summit���s principles on bonus compensation). See R��diger Fahlenbrach and Ren�� Stulz, Bank CEO Incentives and the Credit Crisis, Ohio State 3 University Fischer College of Business Dice Center Working Paper No. 2009-13 (2009) (assessing the performance of 98 U.S. banks over July 2007-December 2008, and finding no evidence that banks with higher CEO option pay performed poorly and no evidence that those with higher CEO equity ownership performed better) David Erkens, Mingyi Hung and Pedro Matos, Corporate Governance in the Recent Financial Crisis: Evidence from Financial Institutions Worldwide, University of Southern Californai Working Paper (2009) (assessing performance 306 financial firms in 31 countries over January 2007- December 2008, and finding firms awarding compensation in cash bonuses rather than equity incentives, which includes stock options, restricted shares and long-term incentive plans, experience higher losses) Marcia Millon Cornett, Jamie John McNutt and Hassan Tehranian, The Financial Crisis: Did Corporate Governance Affect the Performance of Publicly-Traded U.S. Bank Holding Companies? (2009), available at http://ssrn.com/abstract=1476969 (comparing performance.of publicly-traded U.S. banks in 2003-2006 and 2007-2008, and finding banks whose CEOs had a higher proportion of pay in options performed better during the crisis 2008). It should be noted that the large increases in executive compensation that have been the source of media attention and public outcry, as reviewed in part II, were a function of increased use of stock option incentive compensation. the compensation of executives of financial institutions receiving government assistance. The governments of many European nations have followed a similar regulatory strategy, while the European Union���s Competition Commissioner has announced that it will be examining banks��� compensation in light of government support received during the crisis.2 This turn of events might seem peculiar to an informed observer, however, given the manifold, and more pressing regulatory issues that have been identified as having contributed to the crisis. In particular, the best available evidence suggests that the more questioned forms of incentive compensation did not affect financial institutions��� performance during the financial crisis and therefore it is improbable that they were key contributing factors to the global credit crisis. That being said, 3

4 executive compensation is a perennial media flash point in democratic politics that lends itself easily to political grandstanding, and the current financial crisis is no exception, as it is self- evident that there were egregious instances where financial institutions��� executives and traders did extremely well for themselves while taxpayers have or will be picking up the check. Given an environment in which there is widespread political unease over executive compensation, we advance in this article what we consider to be a superior regulatory approach to that adopted by Congress, and to what existed prior to the barrage of crisis-related compensation legislative and regulatory initiatives. In brief, we advocate providing all incentive compensation in the form of restricted stock and options ��� restricted in the sense that shares cannot be sold nor options exercised until two to four years after an individual���s last day in office ��� albeit we would permit a minor amount to be paid out over time to address tax, liquidity and premature turnover concerns. The proposal meets three criteria that we think compensation packages should meet, not only to provide appropriate incentives, but also to be understandable by investors and the public: it should be simple, transparent and focused on creating and sustaining long-term shareholder value. Although our proposal is specifically addressed to what should be required of financial institutions, given prudential concerns related to protecting the fisc, we are of the view that all firms ought to consider its adoption as well. The article proceeds as follows. We first briefly review the rationale for equity-based incentive compensation, such as our proposal, and why executive compensation, particularly equity-based incentive compensation, has been the principal regulatory target. We then briefly describe the financial executives��� compensation regulation that has been enacted by the United States in response to the credit crisis. Thereafter we explain the mechanics of our proposal, including how it would improve on the approach of Congress, and how it is crafted so as to