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Image courtesy of interviewee. November 14, 2024

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The discussion revolves around the rise of Relative Performance Evaluation (RPE) in CEO compensation structures over the past decade and a half. RPE ties a CEO's pay to how their firm performs relative to similar companies rather than in absolute terms. This video approach allows firms to filter out random economic shocks, providing a clearer assessment of a CEO's effectiveness.

A notable consequence of RPE is that it incentivizes CEOs to focus on the performance of their peers. They may engage in strategies that involve leaking negative information about competitor firms to improve their own relative standing, potentially increasing their compensation, even if this means disclosing harmful information about peers rather than lying or disseminating misinformation. The evidence suggests that firms are carefully sharing genuine negative insights to manage stock prices effectively, enhancing overall market efficiency.

Moreover, companies in RPE peer groups tend to become more proactive in sharing their own negative information to control narratives and mitigate risk from potential leaks by others. The speaker also poses questions about potential retaliation strategies from firms targeted by RPE peers, suggesting that firms may need to manage the risks posed by their peers more effectively.

From a regulatory perspective, the findings indicate that while there may be some ethical concerns, there don't appear to be significant grounds for intervention since firms generally operate within existing regulations and disclosing negative information can enhance information efficiency in the markets.

Lastly, the speaker critiques the common practice of structuring RPE as rank order tournaments, which can cause severe incentive distortions, creating complacency among some performance levels or excessive risk-taking among others. Alternatives like simpler linear compensation models could provide more consistent incentives and better align CEO actions with shareholder interests without fostering the negative behaviors associated with tournament structures.

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Here are five key points from the video:

1. **Relative Performance Evaluation (RPE) in CEO Compensation**: The growth of relative performance evaluation is significant in CEO compensation plans. These plans assess performance based on a CEO's relative performance compared to peer companies, rather than on an absolute performance basis.

2. **Strategic Disclosure of Information**: CEOs may disclose negative information about their peers to boost their own companies' relative standing. By bringing legitimate negative information to light about peer firms, even if it hurts their own firm's stock price slightly, they can enhance their compensation based on how well their performance compares to others.

3. **Preemptive Disclosure by Peer Firms**: Companies that find themselves as RPE peers may proactively disclose bad news about their own performance to control the narrative and protect themselves from potential negative market reactions initiated by competitors targeting them.

4. **Implications for Market Efficiency**: While this behavior may seem ethically questionable, it can lead to faster revelation of information and more informed market trades. This could enhance market efficiency by facilitating quicker adjustments of stock prices based on new information.

5. **Concerns Over Compensation Structures**: The current practice of using rank order tournaments in RPE compensation plans can create incentives for manipulation and complacency. This structure may lead to excessive focus on performance thresholds, encouraging unethical behavior in order to achieve bonuses, suggesting that simpler, linear compensation structures might be more beneficial for shareholders.

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Here are some key quotes extracted from the video that capture the essence of the discussion on relative performance evaluation (RPE) in CEO compensation:

1. **Definition of RPE**:
- "Relative performance evaluation, you can think of this as grading performance on a curve. We're not gonna pay you just based on how your firm did in an absolute sense, but how did you do compared."

2. **Benefits of RPE**:
- "There are a lot of good reasons to do this. There's random shocks that happen in the economy. If you benchmark relative to other companies exposed to those same shocks, you can filter them out and get a better sense of how your firm is handling the convideo in which they're in."

3. **Strategic disclosures**:
- "If you can disclose information to the capital market well on a relative basis, even if the disclosure had no effect on your own stock price... you gain relative standing and you get higher compensation from doing that."

4. **CEO behavior and RPE**:
- "We find... compelling evidence that this is something that firms are doing... bringing legitimate negative information to light about those peers, but they're doing it strategically in order to boost their relative performance and get larger compensation awards."

5. **Peer firm reactions**:
- "These companies that are used as RPE peers... seem to recognize that this exposes them to this risk of bad news leaks and they become more forthcoming about their own bad news in sort of preemptive anticipation."

6. **Impact of compensation structures**:
- "By and large, I would say that firms are doing things largely right... they tend to choose a peer group of other companies that they do share a lot of risk exposure with."

7. **Concerns about rank-order tournaments**:
- "The problem with these rank order tournaments... you have these regions of complacency, there's no point in improving my performance, I'm not worried about my performance slipping."

8. **Potential for manipulation**:
- "When you have these sharp thresholds... you have arbitrarily high, potentially infinite incentive intensity... compensation gaming, manipulation, doing a whole bunch of nefarious stuff."

9. **Ethical considerations and market efficiency**:
- "My view would be... this is a societally good thing... it's impounding this negative news more quickly into prices allowing for more informed trades, more efficient prices, bolstering allocative efficiency in the capital market."

10. **Advocating for better RPE structures**:
- "Let's just look at the median or the average performance among our RPE peers and we can have a simple linear contract that ties compensation to how well did you do relative to that moving target."

These quotes reflect the nuances of the discussion on RPE, the impact on CEO behavior, market dynamics, ethical implications, and suggestions for more effective compensation structures.

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We got interested in this topic

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because over the last decade and a half

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or so, there has been a huge growth in the use of

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relative performance evaluation.

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Or I'll often just say RPE in CEO compensation plans

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and the way these plans are structured.

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So relative performance evaluation, you can think of this

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as grading performance on a curve.

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We're not gonna pay you just based on

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how your firm did in an absolute sense,

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but how did you do compared

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to other economically similar firms?

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And there are a lot of good reasons to do this.

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There's random shocks that happen in the economy.

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If you benchmark relative to other companies exposed

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to those same shocks, you can filter them out

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and get a better sense of

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how your firm is handling the context in which they're in.

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But sort of an interesting side effect of these RPE plans is

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that when you tie performance

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or compensation to what's your performance relative

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to other companies, all

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of a sudden those other companies performance outcomes

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also matter to the CEO.

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And if the CEO can do things

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to affect their performance outcomes,

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well they can get higher compensation

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potentially from doing so.

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And that's one of the things that we're exploring in this

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paper is when A CEO is paid based on RTSR relative

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total shareholder return,

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how your company's stock price

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due relative to your peer groups.

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Well, if you can disclose information to the capital market

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that is harmful to those peer firms stock values,

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well on a relative basis,

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even if the disclosure had no effect on your own stock price

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or maybe even hurt it a little bit, as long

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as it hurt your peer stock prices by even more, you gain

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relative standing and you get higher

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compensation from doing that.

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So we were interested to see if,

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if CEOs were indeed engaging in this practice,

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and we find, I would say, fairly compelling evidence

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that this is something that firms are doing.

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They seem to be routinely leaking negative information about

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their RPE peers, specifically when it's price based RPE,

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not if it's based on relative profits

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or something along those lines.

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Uh, but they don't seem to be lying to the capital market.

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They instead seem to be bringing legitimate negative

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information to light about those peers,

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but they're doing it strategically in order

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to boost their relative performance

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and get larger compensation awards.

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There are sort of two ways you could think about an

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interest, you know, that I think I would

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be interesting to explore.

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One would be, do firms protect themselves against this?

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Do they, you know, retaliate against this

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after it happens, et cetera.

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Now on the protection side, we do see some evidence.

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I'm working on a new paper now also with Merko Hela who is

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with me on this project, and a former PhD student of ours,

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Irina Leva, she's now an assistant

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Professor at the Stern School.

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And we wanted to explore

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what do these peer firms do when they find themself in some

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other company's RPE peer group, right?

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They didn't choose to put themselves there,

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they just ended up in that peer group

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and now they know we've got a target on our back.

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If they have some bad news about us,

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they have a financial incentive to provide that information

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to the capital market, get that information into prices,

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get a bigger bonus or a stock award or whatever.

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It's, so what do these companies do?

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And the hypothesis that we had was

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if these managers at these peer firms

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care about being the bearers of their company's bad news,

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they're gonna want to get ahead of these stories to,

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you know, control the narrative, maybe

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to avoid some shareholder litigation,

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if they can be the first ones to bring this to market.

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Uh, and that is indeed exactly what we find.

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These companies that are used as RPE peers by a lot

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of other firms, they seem to recognize

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that this exposes them to this risk of bad news leaks

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and they become more forthcoming about their own bad news

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in sort of preemptive anticipation.

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Like, well, if you're about to say something bad about me,

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I'd rather be the one to say it first.

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So let me get ahead of this.

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Let me be the one to tell the market.

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So we do see some evidence on the sort

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of preemptive protection side in terms of retaliation.

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To my knowledge, there is not yet any work examining that,

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but I think that would be a really interesting

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area to explore.

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Uh, and I think there are credible arguments

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to make in either direction as to whether

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or not we would expect to observe retaliation in practice.

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If you imagine a company is just, you know,

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we're gonna craft a disclosure policy

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that we think maximizes our stock price,

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just I think a fairly generic view for

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what companies are doing with their disclosure practices.

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Well, if somebody says something bad about our company,

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our stock price takes a little dip,

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and if they said something wrong,

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maybe it's in our best interest to clear it up.

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But if they said something true, you know, we just kinda,

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you know, we move on, it's a sunk cost at this point,

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our stock price went down.

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But if it didn't make sense for us

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to say something bad about that other company beforehand, if

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that wasn't helpful for our stock price, no clear reason

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that's helpful for your stock price now.

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And so I think there's a credible null here

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where firms might just eat it and not retaliate.

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But if we lengthen our time horizon here

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and we start thinking about a dynamic game,

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maybe these firms realize it's advantageous

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to cultivate a reputation as the type of company

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that pushes back when this happens.

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And so, you know, maybe they would

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retaliate for that reason.

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And lastly, there could be sort of a behavioral

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economics explanation here.

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Ultimately, these firm disclosures are made

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by human decision makers with behavioral biases,

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with egos that they want to protect.

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And when someone says

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Something bad about you, you might wanna hit them back.

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But so far we don't have any evidence that I'm aware of.

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But the ethical, and, you know,

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potentially regulatory implications, I,

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I think it's another interesting question,

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but I would say my view is like, sort of long story short,

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my view would be nothing to regulate here, right?

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So the evidence in our paper suggests

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that firms are saying bad things about their RPE peers

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and pushing down their stock prices,

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but they're not doing this through disinformation campaigns,

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misleading capital market participants into lowering their

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valuations of these peer firms.

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They're just bringing legitimate negative

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information to light.

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And so I would say one could incredibly argue

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that this is a societally good thing, right?

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It's an antisocial behavior.

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We kind of have this intuitive distaste for this behavior,

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but it is accelerating information revelation, right?

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It's impounding this negative news more quickly into prices

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allowing for more informed trades, more efficient prices,

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bolstering allocative efficiency in the capital market.

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So my view would be right, this is a societally good thing.

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Add into this, as we just discussed, these peer firms are

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reacting to the threat of these leaks

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by becoming more forthcoming themselves, further adding

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to this better information environ.

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Now, if you're a shareholder of these companies

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and you know, this is what your CEO is doing,

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you maybe don't love the compensation gaming aspect of it,

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but you're gonna get compensation, gaming, you sort of,

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no matter what compensation approach you're using,

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I don't really think that there's any major

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ethical problem here.

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Nothing that regulatory intervention would be

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necessary to solve.

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We already have rules

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and regulations in place, given those rules

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and regulations, it seems that by

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and large firms are providing legitimate information.

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Now, if we removed all these regulations,

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then maybe the disinformation campaigns would start.

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That would clearly be bad.

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And there may be some instances of firms

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using disinformation in order to depress pure stock prices.

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By and large, the evidence in our paper suggests

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that not seem to be prevalent,

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but if firms are doing that here

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or there, right, we have rules on the books

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that say you're not allowed to do that.

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And you know, enforcement against

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that absolutely would be called for.

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There could also be violations of contractual NDAs

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that might be at play.

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You might have shady corporate espionage behavior

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to acquire the negative information

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that they use in these peer harming disclosures.

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And we have rules on the books there as well.

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And so if that is going on, in some cases we would just need

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to enforce the existing regulations.

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But I wouldn't call to, you know, the SEC

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and say, we need new rules put in here

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to prevent these disclosures.

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I think if anything, the SEC should be by

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and large happy with this sort

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of new information environment

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with these firms more willingly sharing

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Negative information about their peers

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and as well about themselves.

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I would say the the biggest way that sort of firm, firm

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strategy strategic considerations intersects with

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a voluntary disclosure practice, something

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that's been studied sort

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of at length in the accounting literature for the last,

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you know, 40 years at this point.

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Uh, primarily it's been focused on what's been called the

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proprietary costs of disclosure.

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So focusing on information withholding due

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to strategic considerations, right?

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You can imagine a firm has a ton of information

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that would be super helpful

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to shareholders in valuing the company,

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assessing risk exposures for that company,

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helping them rebalance their portfolios to be hedged the way

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that they want to, but

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that they understand firms are never going

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to voluntarily provide,

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nor would they want these firms to provide it,

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because they know this information will not just be used

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by capital market participants for valuation and hedging,

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but it's also gonna be out there in the ether for, you know,

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product market stakeholders, competitors, customers,

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suppliers, et cetera, to use this information in a way

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that would be negative

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for the firm's real operating performance, right?

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You're not gonna leak your trade secrets,

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even if it helps an investor value the company hedge risk

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exposure because it'll help other companies

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undercut your prices, mimic your product, et cetera.

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That's where sort of the bulk

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of the focus has been on the intersection

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between disclosure policy and firm strategy.

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More recently, there's been a growing literature examining

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sort of the flip side of this.

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It's not, Hey, what's the information?

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I'd love to get to shareholders, but I can't

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because my competitors are listening.

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But rather, what's the information I'll disclose

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because my competitors are listening

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and I want them to hear this.

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And so this could be voluntary disclosure to,

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you know, maybe facilitate some anti-competitive end.

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I want to disclose information

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that's gonna help me coordinate in broad daylight

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with these other competitors on, you know,

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what prices I'm gonna charge.

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So maybe they follow suit,

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what product segment I'm gonna move into so

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that they stay out and they move into a different one.

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There's plenty of emerging evidence now

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that firms are engaging in these, these are

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what I would consider unethical practices violating

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antitrust law and the FTC

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and the DOJ do pay careful attention to this.

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Um, but it can also in some cases serve

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pro-competitive ends.

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You know, it might be a firm sort of signaling

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to the market, Hey, we're gonna be really aggressively

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competitive here, right?

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And they might be doing that for entry deterrent

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or to soften competition from rivals.

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But in, in many cases, the net effectiveness is actually

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good for consumers

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and they end up with, you know, higher production volumes

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and lower prices firms compensation plans

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and their use of relative performance evaluation or RPE in

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Particular are actually relatively well

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designed by and large, right?

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I I wouldn't go so far as to say optimal,

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but firms do seem to be very careful

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and deliberate in their compensation design choices.

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They choose to use RPE based on an understanding

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of the risk sharing benefits as well as how

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that trades off against the cost of sabotage.

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When they choose to use RPE, they tend

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to choose a peer group of other companies

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that they do share a lot of risk exposure with.

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So they're doing a, a relatively good job with sharing

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that risk, filtering out those common risk factors.

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And when they do have to worry more about sabotage,

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you often will see very thoughtful, sensible adjustments

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to the peer group to try

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to mitigate those potential side effects, right?

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So maybe you have an oligopolistic firm, you know,

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if you benchmark against all the other companies in your

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product market, it's gonna encourage incredibly aggressive

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competition because they wanna sabotage their peers.

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Maybe you take one

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of their product market competitors outta the peer group

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and replace them with a supply chain partner

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or replace them with a somewhat related company from another

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industry or sector that is not going

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to elicit the same type of sabotage.

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So by and large, I would say

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that firms are doing things largely right.

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There is one thing though that sticks out in my mind as sort

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of a, a puzzling,

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and to my mind almost certainly suboptimal pervasive

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practice in relative performance evaluation.

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And that is related to the payout structure of these plans.

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So by and large,

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when RPE plans are used in a CEO pay plan,

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specifically when it's relative to a, a peer group

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that the firm is constructing,

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it's almost always implemented as a rank order tournament.

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Which means that the way

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that the compensation award is determined is you say, well,

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here's our peer group of, you know,

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other companies we benchmark against often like 10

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to diff you know, 10 to 20 different companies in there.

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And at the end of the day we're gonna say,

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what was our performance

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and where does that stack up in the ranking relative to

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that, you know, 10 to 20 other companies.

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So if we've got 14 RPE peers, there's sort of now a ranking

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of 15 companies, our company plus the 14 others,

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and there's a big payout

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for winning being better than all 14

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and another, almost as big payout often

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for being second place or third place.

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And then it sort of drops.

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It's not necessarily a unique payout

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for every different ranking.

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Sometimes it'll be sort of bucketed up, no payout if you're

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below median, and then some payout if you're in

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that next quartile.

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And then a unique payout for each rank USN from there.

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But they are almost always structured as some form

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of rank order tournament.

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And the problem with these rank order tournaments,

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right? As a researcher,

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I love this 'cause it allows for all sorts

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of interesting research designs.

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We leveraged this design very heavily in our peer harming

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disclosure paper to identify, you know,

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who's the specific peer this company wants

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to leapfrog in the rankings and target right now.

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Um, but if I am a shareholder of these companies,

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if I'm a proxy advisory group,

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I'm saying I don't understand this

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rank order tournament structure.

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Because what you effectively have is compensation

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that looks kind of like a staircase if you, you know,

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plot compensation versus performance.

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So you have these regions, if you're in the middle

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of a stair step, you have this region

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of zero incentive intensity, your performance could go up,

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your performance could go down.

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If you're not changing steps, there's no change in pay.

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So you have this region of complacency,

355
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there's no point in improving my performance,

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I'm not worried about my performance slipping.

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Whereas if you're at the edge of a stair step, you're,

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you know, just trying to climb up one more

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or you're really worried about falling down one, right?

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Arguably, and the tiniest excellent change in your

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performance could be the difference

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between one rank versus the other.

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Well, here you have arbitrarily high,

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potentially infinite incentive intensity,

365
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and that might sound good.

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Oh, we want managers to have these incentives.

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But when you have these sharp thresholds with these,

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you know, incredibly high localized incentive intensities,

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often what this leads to is not high effort aligned

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with shareholder incentives,

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but instead, compensation, gaming, manipulation,

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doing a whole bunch of nefarious stuff

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because you really want to get that next rung up

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or you really wanna avoid slipping down

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below this next rung.

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And this is something I think that firms should,

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should probably be abandoning.

378
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Again, as a researcher, I would hate

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to see this structure go 'cause it, I'd so fascinating

380
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to study, but as a shareholder, as a proxy advisor,

381
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I would say these firms would almost certainly be better off

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with much simpler plans.

383
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Say, Hey, you know, let's just look at the median

384
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or the average performance among our RPE peers

385
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and we can have a simple linear contract

386
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that ties compensation to how well did you do relative

387
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to that moving target?

388
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It's still RPE because the target's gonna move up

389
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and down with your peer group's performance.

390
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Uh, but you're gonna avoid this stair step pattern.

391
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You're gonna avoid these regions of complacency

392
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and these regions of high incentive intensity that,

393
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you know, fosters, gamemanship,

394
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and you know, all sorts of bad behavior

395
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and instead have stable incentive intensity that's gonna,

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you know, I would say almost certainly lead to better,

397
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more shareholder aligned behavior.

Exploring CEO Compensation Through Relative Performance Evaluation

00:00:00 - We got interested in this topic because over the last decade and a half or so, there has been a huge growth in the use of relative performance evaluation. Or I'll often just say RPE in CEO compensation plans and the way these plans are structured. So relative performance evaluation, you can think of this as grading performance on a curve. We're not gonna pay you just based on how your firm did in an absolute sense, but how did you do compared

00:00:33 - And there are a lot of good reasons to do this. There's random shocks that happen in the economy. If you benchmark relative to other companies exposed to those same shocks, you can filter them out and get a better sense of how your firm is handling the context in which they're in. But sort of an interesting side effect of these RPE plans is that when you tie performance or compensation to what's your performance relative to other companies, all

00:01:05 - also matter to the CEO. And if the CEO can do things to affect their performance outcomes, well they can get higher compensation potentially from doing so. And that's one of the things that we're exploring in this paper is when A CEO is paid based on RTSR relative total shareholder return, how your company's stock price due relative to your peer groups. Well, if you can disclose information to the capital market

Strategic Disclosure and CEO Compensation

00:01:38 - well on a relative basis, even if the disclosure had no effect on your own stock price or maybe even hurt it a little bit, as long as it hurt your peer stock prices by even more, you gain relative standing and you get higher compensation from doing that. So we were interested to see if, if CEOs were indeed engaging in this practice, and we find, I would say, fairly compelling evidence that this is something that firms are doing.

00:02:07 - their RPE peers, specifically when it's price based RPE, not if it's based on relative profits or something along those lines. but they don't seem to be lying to the capital market. They instead seem to be bringing legitimate negative information to light about those peers, but they're doing it strategically in order to boost their relative performance and get larger compensation awards. There are sort of two ways you could think about an interest, you know, that I think I would

00:02:35 - One would be, do firms protect themselves against this? Do they, you know, retaliate against this after it happens, et cetera. Now on the protection side, we do see some evidence. I'm working on a new paper now also with Merko Hela who is with me on this project, and a former PhD student of ours, Irina Leva, she's now an assistant Professor at the Stern School. And we wanted to explore what do these peer firms do when they find themself in some

Preemptive Disclosure in Competitive Peer Groups

00:03:08 - They didn't choose to put themselves there, they just ended up in that peer group and now they know we've got a target on our back. If they have some bad news about us, they have a financial incentive to provide that information to the capital market, get that information into prices, get a bigger bonus or a stock award or whatever. It's, so what do these companies do? And the hypothesis that we had was if these managers at these peer firms

00:03:40 - they're gonna want to get ahead of these stories to, you know, control the narrative, maybe to avoid some shareholder litigation, if they can be the first ones to bring this to market. and that is indeed exactly what we find. These companies that are used as RPE peers by a lot of other firms, they seem to recognize that this exposes them to this risk of bad news leaks and they become more forthcoming about their own bad news in sort of preemptive anticipation.

00:04:11 - I'd rather be the one to say it first. So let me get ahead of this. Let me be the one to tell the market. So we do see some evidence on the sort of preemptive protection side in terms of retaliation. To my knowledge, there is not yet any work examining that, but I think that would be a really interesting area to explore. and I think there are credible arguments to make in either direction as to whether or not we would expect to observe retaliation in practice.

Strategic Disclosure Practices and Stock Price Management

00:04:41 - we're gonna craft a disclosure policy that we think maximizes our stock price, just I think a fairly generic view for what companies are doing with their disclosure practices. Well, if somebody says something bad about our company, our stock price takes a little dip, and if they said something wrong, maybe it's in our best interest to clear it up. But if they said something true, you know, we just kinda, you know, we move on, it's a sunk cost at this point, our stock price went down. But if it didn't make sense for us

00:05:13 - that wasn't helpful for our stock price, no clear reason that's helpful for your stock price now. And so I think there's a credible null here where firms might just eat it and not retaliate. But if we lengthen our time horizon here and we start thinking about a dynamic game, maybe these firms realize it's advantageous to cultivate a reputation as the type of company that pushes back when this happens. And so, you know, maybe they would

00:05:42 - And lastly, there could be sort of a behavioral economics explanation here. Ultimately, these firm disclosures are made by human decision makers with behavioral biases, with egos that they want to protect. And when someone says Something bad about you, you might wanna hit them back. But so far we don't have any evidence that I'm aware of. But the ethical, and, you know, potentially regulatory implications, I, I think it's another interesting question, but I would say my view is like, sort of long story short,

Legitimate Negative Disclosures: A Positive Impact on Market Efficiency

00:06:14 - So the evidence in our paper suggests that firms are saying bad things about their RPE peers and pushing down their stock prices, but they're not doing this through disinformation campaigns, misleading capital market participants into lowering their valuations of these peer firms. They're just bringing legitimate negative information to light. And so I would say one could incredibly argue that this is a societally good thing, right?

00:06:43 - We kind of have this intuitive distaste for this behavior, but it is accelerating information revelation, right? It's impounding this negative news more quickly into prices allowing for more informed trades, more efficient prices, bolstering allocative efficiency in the capital market. So my view would be right, this is a societally good thing. Add into this, as we just discussed, these peer firms are reacting to the threat of these leaks

00:07:15 - to this better information environ. Now, if you're a shareholder of these companies and you know, this is what your CEO is doing, you maybe don't love the compensation gaming aspect of it, but you're gonna get compensation, gaming, you sort of, no matter what compensation approach you're using, I don't really think that there's any major ethical problem here. Nothing that regulatory intervention would be necessary to solve. We already have rules and regulations in place, given those rules

Regulation and Corporate Information Practices

00:07:45 - and large firms are providing legitimate information. Now, if we removed all these regulations, then maybe the disinformation campaigns would start. That would clearly be bad. And there may be some instances of firms using disinformation in order to depress pure stock prices. By and large, the evidence in our paper suggests that not seem to be prevalent, but if firms are doing that here or there, right, we have rules on the books that say you're not allowed to do that. And you know, enforcement against

00:08:16 - There could also be violations of contractual NDAs that might be at play. You might have shady corporate espionage behavior to acquire the negative information that they use in these peer harming disclosures. And we have rules on the books there as well. And so if that is going on, in some cases we would just need to enforce the existing regulations. But I wouldn't call to, you know, the SEC and say, we need new rules put in here

00:08:45 - I think if anything, the SEC should be by and large happy with this sort of new information environment with these firms more willingly sharing Negative information about their peers and as well about themselves. I would say the the biggest way that sort of firm, firm strategy strategic considerations intersects with a voluntary disclosure practice, something that's been studied sort of at length in the accounting literature for the last, you know, 40 years at this point.

Strategic Disclosure in Competitive Markets

00:09:18 - proprietary costs of disclosure. So focusing on information withholding due to strategic considerations, right? You can imagine a firm has a ton of information that would be super helpful to shareholders in valuing the company, assessing risk exposures for that company, helping them rebalance their portfolios to be hedged the way that they want to, but that they understand firms are never going to voluntarily provide, nor would they want these firms to provide it,

00:09:50 - by capital market participants for valuation and hedging, but it's also gonna be out there in the ether for, you know, product market stakeholders, competitors, customers, suppliers, et cetera, to use this information in a way that would be negative for the firm's real operating performance, right? You're not gonna leak your trade secrets, even if it helps an investor value the company hedge risk exposure because it'll help other companies undercut your prices, mimic your product, et cetera.

00:10:21 - of the focus has been on the intersection between disclosure policy and firm strategy. More recently, there's been a growing literature examining sort of the flip side of this. It's not, Hey, what's the information? I'd love to get to shareholders, but I can't because my competitors are listening. But rather, what's the information I'll disclose because my competitors are listening and I want them to hear this. And so this could be voluntary disclosure to,

Ethical Implications of Competitive Disclosure Practices

00:10:55 - I want to disclose information that's gonna help me coordinate in broad daylight with these other competitors on, you know, what prices I'm gonna charge. So maybe they follow suit, what product segment I'm gonna move into so that they stay out and they move into a different one. There's plenty of emerging evidence now that firms are engaging in these, these are what I would consider unethical practices violating antitrust law and the FTC and the DOJ do pay careful attention to this.

00:11:25 - pro-competitive ends. You know, it might be a firm sort of signaling to the market, Hey, we're gonna be really aggressively competitive here, right? And they might be doing that for entry deterrent or to soften competition from rivals. But in, in many cases, the net effectiveness is actually good for consumers and they end up with, you know, higher production volumes and lower prices firms compensation plans and their use of relative performance evaluation or RPE in Particular are actually relatively well

00:11:58 - I I wouldn't go so far as to say optimal, but firms do seem to be very careful and deliberate in their compensation design choices. They choose to use RPE based on an understanding of the risk sharing benefits as well as how that trades off against the cost of sabotage. When they choose to use RPE, they tend to choose a peer group of other companies that they do share a lot of risk exposure with. So they're doing a, a relatively good job with sharing that risk, filtering out those common risk factors.

Adjusting Peer Groups in Relative Performance Evaluation

00:12:34 - you often will see very thoughtful, sensible adjustments to the peer group to try to mitigate those potential side effects, right? So maybe you have an oligopolistic firm, you know, if you benchmark against all the other companies in your product market, it's gonna encourage incredibly aggressive competition because they wanna sabotage their peers. Maybe you take one of their product market competitors outta the peer group and replace them with a supply chain partner or replace them with a somewhat related company from another

00:13:06 - to elicit the same type of sabotage. So by and large, I would say that firms are doing things largely right. There is one thing though that sticks out in my mind as sort of a, a puzzling, and to my mind almost certainly suboptimal pervasive practice in relative performance evaluation. And that is related to the payout structure of these plans. So by and large, when RPE plans are used in a CEO pay plan,

00:13:40 - that the firm is constructing, it's almost always implemented as a rank order tournament. Which means that the way that the compensation award is determined is you say, well, here's our peer group of, you know, other companies we benchmark against often like 10 to diff you know, 10 to 20 different companies in there. And at the end of the day we're gonna say, what was our performance and where does that stack up in the ranking relative to that, you know, 10 to 20 other companies.

Incentive Structures in Rank Order Tournaments

00:14:12 - of 15 companies, our company plus the 14 others, and there's a big payout for winning being better than all 14 and another, almost as big payout often for being second place or third place. And then it sort of drops. It's not necessarily a unique payout for every different ranking. Sometimes it'll be sort of bucketed up, no payout if you're below median, and then some payout if you're in that next quartile. And then a unique payout for each rank USN from there.

00:14:45 - of rank order tournament. And the problem with these rank order tournaments, right? As a researcher, I love this 'cause it allows for all sorts of interesting research designs. We leveraged this design very heavily in our peer harming disclosure paper to identify, you know, who's the specific peer this company wants to leapfrog in the rankings and target right now. but if I am a shareholder of these companies, if I'm a proxy advisory group, I'm saying I don't understand this

00:15:13 - Because what you effectively have is compensation that looks kind of like a staircase if you, you know, plot compensation versus performance. So you have these regions, if you're in the middle of a stair step, you have this region of zero incentive intensity, your performance could go up, your performance could go down. If you're not changing steps, there's no change in pay. So you have this region of complacency, there's no point in improving my performance, I'm not worried about my performance slipping. Whereas if you're at the edge of a stair step, you're,

Rethinking CEO Compensation Structures

00:15:46 - or you're really worried about falling down one, right? Arguably, and the tiniest excellent change in your performance could be the difference between one rank versus the other. Well, here you have arbitrarily high, potentially infinite incentive intensity, and that might sound good. we want managers to have these incentives. But when you have these sharp thresholds with these, you know, incredibly high localized incentive intensities,

00:16:19 - with shareholder incentives, but instead, compensation, gaming, manipulation, doing a whole bunch of nefarious stuff because you really want to get that next rung up or you really wanna avoid slipping down below this next rung. And this is something I think that firms should, should probably be abandoning. Again, as a researcher, I would hate to see this structure go 'cause it, I'd so fascinating to study, but as a shareholder, as a proxy advisor,

00:16:48 - with much simpler plans. Say, Hey, you know, let's just look at the median or the average performance among our RPE peers and we can have a simple linear contract that ties compensation to how well did you do relative to that moving target? It's still RPE because the target's gonna move up and down with your peer group's performance. but you're gonna avoid this stair step pattern. You're gonna avoid these regions of complacency and these regions of high incentive intensity that,

Optimizing CEO Incentives for Shareholder Alignment

00:17:29 - and you know, all sorts of bad behavior and instead have stable incentive intensity that's gonna, you know, I would say almost certainly lead to better, more shareholder aligned behavior.

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