Why Executive Pay Will Remain a Big Issue

Corporate governance is a topic that many of us tend to ignore, leaving it to the institutions or corporate raiders that are looking to influence the strategic direction, the capital allocation, the corporate structures or the compensation structures of business.

Yet, the way business is run should matter to us all. We need the goods and services it produces, or the employment it provides. As shareholders, whether directly or through our 401-Ks or pension plans, the long term wealth that corporations create is important for our old age dignity and in fact, the national prosperity. Hence, the governance of corporations affects us all whether customer, employee, citizen or shareholder. The effectiveness of corporate governance is indeed a factor in determining whether companies survive and prosper or stumble and fail.

Some years ago, Jonathan Charkham noted in his book, Keeping Good Company :

It is difficult to escape the conclusion that government has a role here as it is the only power in any land which can strike a balance between the conflicting wishes of competing interests. Furthermore, the framework within which these interests compete is one of government’s own making. Everywhere the corporation is a creature of statue not nature, designed to encourage the continuity of power that the sophistication of modern economies require. It is not government’s role to double-guess individual commercial decisions-but to ensure as best it can, that the structure it creates for companies contains checks and balances that are effective in resolving the tensions between differing legitimate claims.

One does not undermine one’s dedication to capitalism by believing that companies are more than just engines to maximize return on capital. After all, one could repeal child labor laws, ignore plant safety, ignore anti-trust and thereby maximize profitability, but at what cost to society?

Playing for very high stakes has been an ongoing theme in American capitalism probably since Alfred Sloan of GM declared that “The business of business is business.” Excessive and sometimes fraudulent risks, competition, and the increasing size and complexity of organizations: these three factors have been at the heart of every corporate breakdown and crash and burn. The call for greater regulation and greater scrutiny has followed every scandal. For example, the salad oil scandal of the mid-1960’s resulted in more stringent commodity trading regulation after nearly taking down American Express and caused significant loan losses in the
banking system.

So it is little wonder that the Obama administration has begun to scrutinize certain aspects of corporate governance, in particular, an effort to rein in executive compensation. Though far from setting executive pay ceilings at all corporations, the new compensation czar – lawyer and mediator Kenneth Feinberg – will have broad discretion to set the pay for roughly 175 top executives at seven of the country's largest companies, which received billions in government loans. He will set the salaries and bonuses of some of the top financiers and industrialists in the United States including Fritz Henderson (GM), Vikram Pandit (Citigroup), and Ken Lewis (BofA).

The Obama administration argues that poorly designed compensation packages encouraged some Wall Street executives to take on excess risk in the mortgage market and elsewhere, which in turn helped trigger the financial crisis and a global recession. As Barney Frank, chairman of the House Committee on Financial Services observed (italicized words are my emphasis):

It is not the role of government to set policy regarding the amounts that are paid in compensation to top executives, nor to deal with the question of how that compensation is allocated among salary, bonuses, retirement packages, etc. But as Secretary Geithner’s remarks recognized, there are two very important points that we should address.

First, shareholders must be empowered to have a major role in the process of setting overall compensation. While it is not the government’s role to say that a certain amount is too much, it is very much the right of the people who own the company to speak out if they think excessive compensation is being proposed. The system of say-on-pay that was piloted in England is a reasonable way to do this, and I was proud that the House adopted the bill that came from the Financial Services Committee to institute this in 2007. Unfortunately, the bill did not go forward in the Senate, but I am optimistic that with the support of the President, we will be able to enact this important principle into law. Recent evidence in England shows that when shareholders are in fact troubled by excessive compensation, say-on-pay is an effective tool for them.

I also agree with Secretary Geithner’s annunciation of the principles that should guide the structure of compensation – not the amount. But I differ with his view that this can be accomplished by strengthening the independence of compensation committees. Given the inherently close relationship that exists between CEOs and other top executives on the one hand, and boards of directors on the other, it is very unlikely that you will ever get the degree of independence that will allow the boards of directors to be left completely on their own to set compensation. That is part of the reason for say-on-pay. But it is also the reason why legislation should be adopted that instructs the Securities and Exchange Commission to set principles which prevent boards from providing compensation systems that lead to excessive risk taking.

Many proxy statements this year contained “say on pay” shareholder proposals, almost all of which were opposed by managements. I am strongly in favor of such proposals which now appear to become the law of the land. Though these proposals are not enforceable per se, they do provide moral suasion and have had influence in European countries that have adopted the practice for example, Royal Dutch Shell. See also the recent impact in some UK retailers.

Proxy statements frequently contain a report from the compensation committee which generally outlines the company’s philosophy of compensation, what it uses as its peer group for a model of compensation, and what sorts of behavior are being rewarded both short and long term. In general, the compensation committee charter suggests that compensation should align managers’ interests with those of shareholders. An excellent template for what should be part of the compensation committee’s report was recently produced by the California State Teachers Retirement System. Among the points that CSTRS suggests is some specificity regarding the role of risk in incentive compensation:

The role of risk in the context of the executive compensation program, which should include both a defensive perspective (how the committee ensures potential compensation does not incentivize excessive risk), and an offensive perspective (how the program is designed to incentivize appropriate risk and aligns the interests of management with those of long-term owners)

Our summer intern, Drew Levine, recently completed a study of proxies that we have voted at our firm and run some statistics on components of executive compensation trends versus share price performance. If shareholder and management interests are truly aligned, one would expect some degree of correlation between comp and share performance. Sadly, that has not been the case. Here are some of Drew’s observations:

After conducting analysis of executive compensation data, it is safe to say that there is little to no correlation between stock price performance and compensation. The data compiled is from a tumultuous time in the stock market where nearly all of the companies we voted on stocks were down. One would think that because the company's stock performed so poorly the executives' pay would subsequently suffer, but that was certainly not the case in some instances. The strongest correlation in the data was the percentage increase or decrease in bonus compensation in relation to stock price performance. However that measure of correlation was still extremely low at .21 for the CEO and .16 for the CFO. It's shocking to see that there really is no correlation between pay and performance because one would think that would be the most basic and truest basis for compensation. What I found most surprising was the average salary and total compensation growth from 2006-2008. It is amazing to see that although the majority of these companies were struggling with the economic downturn, the average salary growth for the CEO in 2008 was 74.9% and their total compensation growth for 2008 was 25.7%. What this indicates is that executives are increasingly taking more base pay with the knowledge that because their company's stock won't perform well, they will not get the oversized bonuses that they were used to receiving just a few years ago. Although, when looking through the data, it was a relief to see that in most of the companies the executives did not receive bonuses for 2007 and 2008.

In 2007 and 2008, we surveyed 79 and 92 CEOs respectively, and 55 and 81 CFOs respectively. This was due to new hires and fires at the executive positions. From year end 2006 to year end 2007, the average stock price of the companies surveyed was up 26.7%. From year end 2007 to year end 2008, the average stock price was down 40%. The average salary for the CEO in 2007 and 2008 was just over $1,000,000 and the average salary for the CFO during the same time frame was around $600,000. The average bonus for the CEO and CFO in 2007 was over $1,000,000 each with that number decreasing to about $450,000 for the CEO and $300,000 for the CFO in 2008.

For the 2009 proxies we voted, we emphasized voting for "best practices" such as shareholder's votes on executive compensation (say-on-pay) and shareholder's ability to call special meetings. Many people forget that the shareholders are the real owners of the company and that management is working for us. For that reason we find it important to vote every proxy for companies which our clients hold shares and not just throw them away like many shareholders do.

Looking at total compensation for the CEOs rather than just bonuses, the correlation to share price performance is non-existent at -0.03. Apparently, CFO total comp has a somewhat stronger link to share price performance at a still rather weak 0.19. Here is a spreadsheet of our compensation study and the statistical correlations that we observed.

Last year, the CATO Institute published a paper on Executive Pay Regulation versus Market Competition by Ira Kay and Steven van Putten which argues that: “The misperceptions that drive regulatory efforts are grounded in the idea that the market for executives is not competitive and that pay levels do not reflect supply and demand for talent” (pg. 1). Kay and van Putten argue that the “myth of managerial power”, executives control over the board which sets their compensation, leads to greater regulation because lawmakers believe that the market is rigged as they put it. The authors present evidence to the contrary that says that the market is actually competitive and that the appropriate level of executive compensation tracks performance.

This may well have been the case but we face a new reality. We had better become accustomed to the idea of big government as regulations to restore financial order come into force. Jeff Immelt, in a recent address to the International Economic Forum in Montreal stated it most succinctly, “The government has moved in next door and it ain’t leaving. You could fight it if you want but society wants change. And government is not going away.”

Comments

[jstratt:]

What we have seen in the past 2 decades is CEO's controlling Boards and enriching themselves at the expense of shareholders. A huge portion of stocks of successful corporations have little gain or worse losses during this time.

A large number of corporations have enriched only the executives leaving the stockholders little, nothing or losses. In case you havent noticed stocks have not risen in the past decade but their executives are wealthy beyond comparison.

It will take independent boards and government policy changes to make stocks a more viable long term investment alternative.

Make no mistake about it we are in the era where financial leaders are "ticks" on society who probably trained by watching Dracula movies.

If there is nothing for the shareholder a working level wage is enough for CEOs and other company executives.

Jun 11 07:10 PM

[Leftfield:]

They always cry wolf. They always protest that the market sets the compensation for their "talent." That can be said of anyone at the top of a large heap where the rules are all bent in their favor. Stalin, Chavez, Madoff. When their pile collapses, they demand the little people on the losing end to pony up (taxpayers).
The least we can expect is that the upper tier who accrued unmatched wealth as the bottom 95% has slowly sank at the same time can show real leadership. (There has been a strong negative correlation in our society overall).
Something must change. I only hope the trillions quickly shoveled to Wall St. doesn't indicate game over, we're peasants now. Those people have played hardball in a shameless game of, heads we win, tails you lose. I await reasons to hope.

Jun 11 07:25 PM

[LilBob:]

I think what's really going on here is an unspoken form of Social Darwinism. Of course no one wants to call it that because we're all enlightened progressive thinkers now...<thbbbllllppp... The real problem is that the CEO's and Executive board members are absolutely convinced that they really are smarter than everyone else and deserve their enormous salaries. The truly unfortunate part of all of this is that the individuals on Wall Street aren't necessarily the smartest, they're just the only ones schooled in all the complex details of high finance, so they have a reasonably strong platform on which to base their arguments of superiority-even if they are completely wrong.

Human society and behavior always works in waves. First we have one social trend or norm that's dominant, then things turn around and we end up at another extreme. I think people have had enough of globalization and putting their financial well-being into the hands of giant uncontrollable corporations, and I wouldn't be surprised if we see a resurgence of localism in popular investment models. I wouldn't be surprised if with the rise of alternative energy technologies-especially windmills which are a relatively "open," technology in that the science involved is quite simple and there is tremendous opportunity available for design variations-we're going to see a lot more of people investing their money with people they know personally, and in companies that they can travel to the plant and tour it personally with little planning. That's about the only way to end exorbitant executive pay.

Another thing I'd like to see. I find it pretty disgusting that when I'm a recent graduate struggling with student loans, I receive nuisance appeals for donations from my alma mater. My consternation was increased when an article in the local paper from the city surrounding my school publoished an article naming the top ten highest paid executives at the university. There were over ten people who made more than $750,000/year. Personally I'd like to see the "Presidential Salary Cap," that's applied to banks receiving bailout money also applied to non-profit institutions as a condition of 403b status. Honestly, how can you call yourself a "non-profit," when several of those at the top of the food chain are making over 1 million a year? I feel this is justified. After all, how many University deans can you think of that you can honestly say you think that person has more executive talent than Barack Obama?

Jun 11 09:51 PM

[Jeff Nielson:]

An excellent analysis of this issue.

To me, what your research says plain and simple is that there should be LIMITS on executive pay - FAR below the current, insane levels. If spending a total of $10 million/year on a CEO can't guarantee good performance, then set a TOTAL compensation cap of $500,000.

What are these overpaid prima donnas going to do if ALL companies have these limits: refuse to work? LOL!!!!!!!!!!!

And if all the big-name CEO's did refuse to work for a 'paltry' $500,000/year, would ANYONE suggest that you couldn't find a quality executive for $500,000/year - is the talent-pool REALLY that thin?

Jun 11 09:52 PM

[James Quinn:]

They surely deserve what they get.

theburningplatform.com...

Jun 12 10:13 AM

[W. Lippincott:]

First, let me state that I'm not defending the mega salaries earned these days by the nation's Fortune 500 CEOs. Some of them are downright ludicrous, especially considering the pathetic performance of many CEOs, judged not only by share price, but, more importantly, by their firms' financial statements.

However, I think what government is failing to understand in this instance is that CEO greed isn't the problem, but rather it's the perversion of the principal-agent dilemma in which boards of directors are no longer serving the best interests of their true principals: the shareholders. Creating arbitrary compensation caps is a pathetic attempt to Band-Aid the situation and score political points through sensationalized media reports. Plus, it's about as anti-capitalism as it gets. Again, I'm not defending $50MM salaries, but if a board offers anyone such an overpayment to serve as CEO, capitalism says that they should take it. The market is supposed to correct such inefficiencies in pricing, and if it doesn't, CEOs are not to blame, the mechanisms behind the price-setting are.

A more ideal usage of government's regulatory authority is to re-engineer the corporate governance system to better reflect the democratic values that stakeholder theory portends to embrace. It sounds so cliche, but cronyism is still the crux of this problem. And I'd even further that argument by stating that the cronyism extends beyond the walls of the board room. Until institutional investors begin putting weight behind their votes, this problem will not solve itself. Democracy and Adam Smith's "invisible hand" are best equipped to solve this issue, not lawmakers in Washington who are more concerned with re-election than setting intelligent policy.

Jun 12 10:29 AM

[User 357705:]

Executive pay should be no more than 20x the mean pay of all other employees.

Jun 12 11:19 AM

[User 357705:]

The "invisible hand" was genetically modified to not exist under USA's Fuck You Capitalism.


On Jun 12 10:29 AM W. Lippincott wrote:


> Democracy and Adam Smith's "invisible hand" are best equipped to
> solve this issue, not lawmakers in Washington who are more concerned
> with re-election than setting intelligent policy.

Jun 12 11:55 AM

[dw57:]

are you saying the government should force corporations to allow shareholders to vote and approve executive pay? if so, at least its a start. not sure that it won't get corrupted later though


On Jun 12 10:29 AM W. Lippincott wrote:

> First, let me state that I'm not defending the mega salaries earned
> these days by the nation's Fortune 500 CEOs. Some of them are downright
> ludicrous, especially considering the pathetic performance of many
> CEOs, judged not only by share price, but, more importantly, by their
> firms' financial statements.
>
> However, I think what government is failing to understand in this
> instance is that CEO greed isn't the problem, but rather it's the
> perversion of the principal-agent dilemma in which boards of directors
> are no longer serving the best interests of their true principals:
> the shareholders. Creating arbitrary compensation caps is a pathetic
> attempt to Band-Aid the situation and score political points through
> sensationalized media reports. Plus, it's about as anti-capitalism
> as it gets. Again, I'm not defending $50MM salaries, but if a board
> offers anyone such an overpayment to serve as CEO, capitalism says
> that they should take it. The market is supposed to correct such
> inefficiencies in pricing, and if it doesn't, CEOs are not to blame,
> the mechanisms behind the price-setting are.
>
> A more ideal usage of government's regulatory authority is to re-engineer
> the corporate governance system to better reflect the democratic
> values that stakeholder theory portends to embrace. It sounds so
> cliche, but cronyism is still the crux of this problem. And I'd even
> further that argument by stating that the cronyism extends beyond
> the walls of the board room. Until institutional investors begin
> putting weight behind their votes, this problem will not solve itself.
> Democracy and Adam Smith's "invisible hand" are best equipped to
> solve this issue, not lawmakers in Washington who are more concerned
> with re-election than setting intelligent policy.

Jun 12 05:04 PM

[stark naked:]

This is the most sane article on this subject that I have read. The last decade and a half was of Robber Barons and if we do not contol them we will see another destructive cycle in 10 years!
Isnt goverment there to enforce a fair system for all so what is different here?

Jun 12 06:22 PM

[CLH:]

Setting wages either minimum or maximum is pure fascism. This talk does not belong in America.

Jun 13 07:43 AM

[Gregman2:]

Lacking has been accountability and claw backs that allow poor past performance to recapture pirated sums. The so-called "Captains of Industry" have certainly helped flush America down the toilet in terms of offshoring the industrial base. Now, their handiwork has left taxpayers with unsustainable liabilities. No, left to their own devices this class of pirates is dangerous. The Euro model is far more sensible.

Jun 13 10:09 AM

[User 357705:]

Fascism is the melding of the needs of the state with the needs of the corporation. Ya know, like the privatization of profits and the socialization of losses!


On Jun 13 07:43 AM CLH wrote:

> Setting wages either minimum or maximum is pure fascism. This talk
> does not belong in America.

Jun 13 11:34 AM

[LilBob:]

I have to side with User35 on this one. If you want an example of fascism look at the auto bailouts, or Bush's legislation that prevented states from negotiating for better prices for pharmaceuticals for state run health-care plans. My statement about salaries for non-profit executives was a limit on executive pay that would be put in place as a condition of a special tax status. That's not at all fascist, it's just a federal limit that's required so that the organization may be granted a special privilege.

Jun 13 09:25 PM