INDUSTRY
INDUSTRY
Why is
BIGGER
BADDER.
Big Data’s Empty Promises For Business by GRACE GORENSTEIN
Since the recent financial crisis, the subject of executive compensation has captivated millions of Americans. Regulations in the Dodd-Frank Act have called for increased transparency, while Occupy Wall Street protestors have called for a radical overhaul of how executives are rewarded. Meanwhile, few outside of the academic world have focused on how executives are compensated rather than how much they are paid. Managers are rarely paid a flat cash sum each year. Instead, executive compensation packages are often comprised of salaries, bonuses, and stock options that are tied to shareholder performance. These figures are still colossal compared to those of the average worker. However, the real focus of regulations and outrage
Big Data, despite its perceived potential good, has a dark side.
ought to be directed at the exorbitant paychecks given to executives that oversee poor shareholder returns. In order to diagnose this problem, scholars across the world have conducted studies analyzing the relationship between executive compensation and shareholder wealth. Looking at the depth and detail of any one of these studies could convince a reader that there is a visible and predictable link. Yet many inconsistencies remain. A study by one research team may reveal a positive correlation between compensation and shareholder value, while a report from an equally reputable group of experts may reveal a striking nega-
34 cornell business review FALL 2012
tive connection. These studies have highlighted important trends in executive compensation, but have also shown there is no definite evidence that proves executive compensation is tied to shareholder wealth one way or the other. Perhaps this lack of a definite relationship simply shows there is a middle ground that can be reached. Attempting to find an exact statistical formula for the perfect level of compensation would be impossible and unnecessary, since each company is different. However, there are a variety of regulatory and market-based mechanisms available to control agency costs, and as an investor, it
is important to understand what can stitute, wisely suggests that pay packmotivate a company’s management ages should be flexible by “giving a to boost your return. CEO more stock and less cash after The managerial labor market and company shares plummet, restoring an executive’s career concerns can the CEO’s incentives to boost the longhelp align management’s incentives term share price.” While bonuses can with those of stockholders. Executives be effective, they are often given out may be penalized for poor perfor- annually and do not always reflect the mance, which may lead to a fall in the executive’s performance. At the end company’s stock price. Many executives of larger corpo“The focus of Big Data on rations seek coveted board financial markets has not seats in the future, but if they lose shareholders’ money increased our understandand are voted out of one ing of how our complex company, it is unlikely they and global economies will be welcomed at other companies. From a regulawork. Being able to tory standpoint, stock and identify variables does not bond rating agencies play a lead to an understanding significant role. If managers are mismanaging finances of them.” and accumulating debt, stock and bond rating agencies will raise the cost of running the of 2011, for example, Goldman Sachs corporation by raising interest rates, CEO Lloyd Blankfein was awarded a which in turn may decrease both the $7.2 billion bonus, even though his stock’s value and the manager’s like- company’s stock price fell 46% that lihood of keeping his job. year. Restricted stock thus incentiviz In terms of pay structure, re- es the manager to grow the company stricted stock— stock that has specific over an extended period rather than limitations and is often restricted make decisions that artificially push from being sold until a certain length up the stock price in the short term. of time has passed— may be an ef- By becoming a long-term investor, fective way of tying compensation the manager will see that his comto company performance. Prevent- pensation is more closely tied to the ing executives from selling company wealth of shareholders. stock until several years down the This leads to the central quesroad provides a powerful incentive tion of the financial crisis. Does to think in long-term views. Dr. Alex more money for executives mean Edmans, a research associate at the more problems for shareholders? Economic Corporate Governance in- Not necessarily. At first glance, it is
easy to understand how many observers believe in the affirmative. It is no secret that the majority of corporate executives attain a level of prosperity and privilege that many Americans will never reach. To these onlookers pulling themselves out of recession, executive compensation looks shockingly high. And from a shareholder perspective, there is not much transparency into the mind of someone running your company. In some cases, these people are right, for there are certainly highly paid CEOs who put their own interests before shareholder value. But the answer is not simply to restrict how much executives are given. Instead, the goal should be for companies to construct executive compensation plans that align management’s incentives with shareholders’ interests. This will compel an executive to not only think like a shareholder with a vested interest, but to run his company like one too.
Grace Gorenstein (geg62@cornell. edu) is a sophomore at Cornell University majoring in Economics and History.
FALL 2012 Cornell business revieW 35