Want to see executive pay rise even faster? Then push for more regulation.
"What does he do, tow the Mercedes behind the limo?"
– Bloomberg Newscolumnist and executive-pay pundit Graef Crystal, commenting on the retirement benefits of Jack Welch, former chairman and CEO of General Electric Co.
Twenty years ago, popular wisdom says, CEO compensation averaged 40 times the typical worker’s pay; today, CEO pay reportedly has grown to 400 times the average employee’s.
Whether true or not, that statement is usually followed by a declaration that CEOs are not worth 10 times what they were paid 20 years ago. Just look at corporate performance, right?
Fueling this train of thought are reports of the excesses that high executive pay makes possible. Consider the justification of Tyco International’s Dennis Kozlowski’s $6,000 shower curtain. What about the ill-gotten gains of Global Crossing Ltd.’s Gary Winnick and Enron Corp.’s Kenneth Lay, whose wife talks about the rigors of tightening her multimillion-dollar belt?
As a society, angst over such “injustices” quickly consumes us, and we become determined to correct these excesses promptly. Eager to appear responsive to their constituents’ concerns, lawmakers rush to add regulatory constraints that are intended to “control” executive pay.
But history consistently tells us that this is a bad –- really bad –- idea. Regulations that are meant to limit rising compensation in fact often generate precisely the opposite effect.
For example, remember the “golden parachute” regulations enacted after the merger-and-acquisition mania of the 1980s? The regulatory gurus decided that any severance benefit that exceeded three times the average compensation of the past several years was excessive and subject to a tax penalty. So what happened? Executives whose exit packages fell short of the regulatory maximum suddenly felt relative deprivation as that ceiling became the norm.
Consider also Section 162(m) of the 1993 Tax Act, which declares that companies cannot receive a tax deduction for non-performance-related executive compensation exceeding $1 million. This regulation generated a wealth of shareholder-approved performance-related compensation plans, based primarily on stock options, that have contributed significantly to higher executive compensation. These shareholder-approved plans tend to “go for broke” in order to cover every contingency, and the approval process until recently has been just an annoying requirement. The plans are generally so obscurely written that, if we could understand them, we’d see that they generally provide funding for bonus compensation and/or stock option grants under all but the most dire circumstances.
And why have the non-salary “goodies” for executives gotten more elaborate? Because such perks allow boards to sweeten a CEO’s deal without having to report even bigger numbers on their proxies’ summary compensation charts – which already generate sticker shock for shareholders. Reporting of these perks shows up, in tiny footnote type, under “additional compensation.”
Look as well at Sarbanes-Oxley, the latest regulatory missive. Few doubt that, as CEOs and CFOs accept the new and considerable risk required in certifying financial statements, they will expect –- and will receive -- higher compensation. Who would agree to take on more risk without a commensurate reward?
And let’s not overlook the flurry of work-arounds that inevitably flourish on the heels of new regulatory restrictions.
In all of the above cases, it’s the shareholders –- the intended beneficiaries of all this regulation -- who literally pay the price for the unintended consequences.
Supply and demand
The rush to regulate is often fueled by a lack of understanding of the real reason that CEOs and other senior executives are paid a veritable king’s ransom. I’ll spare you the baseball/basketball player analogy as this argument only extends corporate compensation angst into the world of sports.
Simply, CEO compensation is governed by the fundamentals of supply and demand. Every CEO who falls out of the population –- even those who fall out due to treachery and malfeasance –- raises the value of the remaining population. The supply of CEOs with successful track records is small, and those rare individuals command a very high purchase price in this market.
Recall that much of a CEO’s compensation is determined when he or she negotiates an employment agreement upon accepting the position. That contract signed at a time when the board of directors is eager to fill the position -- and likely before the CEO has worked a single day in the job –- governs much of the ongoing compensation. Because the candidate’s leverage is at its peak –- those directors really don’t want to manage the company –- the candidate can generally get whatever he or she asks for. As others learn about the new contract through Securities and Exchange Commission disclosure, the rising tide eventually raises all ships.
Getting shareholders involved
OK, so if we agree that both excessive compensation and the regulatory efforts to limit that compensation cut into shareholder profits, how might the system be altered in a way that respects market realities?
As more well-informed institutional shareholders and private investors increasingly exercise their rights to oversight, we’re sure to see a difference. In 1999, only 21 percent of shareowner proposals received more than 50 percent of votes cast, according to the Investor Responsibility Research Center. By 2001, that figure had increased to 24 percent; by last year, fully a third of proposals won a majority vote.
This year’s Hewlett-Packard Co. proxy included a shareholder proposal from the AFL-CIO requiring shareholder approval for severance packages, and employment agreements with severance clauses, that exceed the golden parachute regulations. This followed a $26 million severance paid to the former president. Shareholders approved the proposal during H-P’s annual meeting last month.
While I may not like every aspect of this particular proposal, I certainly respect that it reflects the wishes of a majority of H-P’s shareholders. And that’s as it should be.
Conclusion
I’m a realist who doesn’t expect CEO pay to fall sharply beyond the adjustment we’ve seen in the paper value of outstanding stock options. And yes, I’d like to see companies require executives to hold the stock realized from the exercise of stock options for some period of time.
But I know that the right way to accomplish these goals is not through regulatory reform but through the oversight of informed compensation committees and shareholders. The next few years should be interesting.
