Elgar Financial Law series
Chapter 3: Theories of securities market operation: principles and flaws
The previous chapter outlined the mechanisms through which executives in modern public corporations are rewarded. It explained that, due to the nature of the current dominant pay-for-performance paradigm, executives to a great extent owe their pay to the levels of stock market and securities prices. The chapter further discussed some of the intrinsic flaws concerning the use of popular remuneration mechanisms, such as stock options, and bonuses contingent on the performance of company stock. These compensation mechanisms, of course, rely on basic assumptions concerning the efficiency of securities prices. If securities prices convey fundamental value, equity-related compensation – in whichever form – may claim to be based on objectively assessed data arrived at through the operation of an efficient market, and therefore demand legitimacy. I have previously highlighted the mainstream criticisms of the systems used to calculate pay, especially stock-based compensation. Whilst these criticisms are certainly warranted, they do not place an appropriate level of emphasis on market pricing imperfections. This is a most important factor for analysis in respect of remuneration policies, as a massive portion of executive compensation is based generally on stock prices and asset price levels. If it can be demonstrated that market prices and, ceteris paribus, stock prices are inefficient – including over the long term – this will cast doubt on the rationale for using remuneration mechanisms linked to stock price performance or market capitalisation, at least in the form these compensation systems take presently.
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