Joe Nocera of the New York Times has a good piece today on the Obama executive pay proposals, such that they are. While I have sometimes been hard on Nocera for taking positions that I have found to be a bit too forgiving to the financial services industry, today he gave an articulate rendition of a fundamental problem:
It was another one of those Timothy Geithner moments….
Looking sternly into the cameras, Mr. Geithner read a statement in which he described executive compensation as a “contributing factor” to the crisis. Then he outlined a series of tough-sounding principles, including a “re-examination” of such egregious practices as golden parachutes, a need to align compensation practices with “sound risk management” and the importance of having compensation plans that “properly measure and reward performance.”
But then, as he so often does, he proceeded to follow these tough words with actual proposals that were less than inspiring. The only legislation his department planned to propose — indeed, the only legislation he deemed necessary — were bills that called for compensation committees to be made up of independent directors, along with “say-on-pay” legislation, which would give shareholders the right to vote on a company’s pay plan. That vote, however, would not be binding….
Until the financial crisis, most people, myself included, did not make distinctions between different kinds of companies when it came to executive compensation. It was just one big problem, revolving primarily around the idea that there was something fundamentally wrong about executives taking home giant, multimillion dollar pay packages for mediocre performance or even outright failure — something, alas, that happens with annoying regularity in corporate America.
But if the near collapse of the financial system has taught us anything, it is that there should be a distinction. On the one hand, there are companies whose executives can make awful mistakes, even driving their corporations into bankruptcy, but whose actions have little or no effect on the rest of us. Most companies fall under this category.
And then there are those handful of companies — the too-big-to-fail banks and other large financial institutions that pose systemic risk — whose failure can wreak devastating havoc on the economy. For these latter companies, getting compensation right isn’t just a matter of fairness or improved corporate governance. It turns out to be critically important if we are to prevent a repeat of the calamity that has befallen us. But as difficult as it has been to overhaul executive compensation overall, it is going to be even more difficult to take the tougher measures that need to be taken with the banking system.
Yves here. As much as I support Nocera’s second observation, that there are some big companies where “getting compensation right” is essential, he is incorrect in saying that the fact that many of the others pay egregiously for failure, and often still overpay for success, has “little to no effect on the rest of us.”
The pay practices are part and parcel of a legitimazation of a gaping disparity in incomes, and the promotion of a fantasy that certain people are endowed with skills so rarified that it merits outsized rewards even if the job is botched. Yet the companies profiled in Jim Collins’ Good to Great had CEOs who paid themselves modestly, even when they shepherded their businesses through major transformations. The idea that money beyond a certain level is motivating bears far more examination than it has gotten.The evidence is strongly to the contrary, that the companies with the most lavishly paid leaders were stock market laggards.
But the excessive and highly publicized CEO pay also serves to provide a price upbrella for all sorts of other pay and fees, such as consultants, lawyers, lobbyists, even executive coaches. Even if you are a Serious Player in your field, it would be unseemly to charge more than your clients’ top executives earn. But the flip side is that if you do not charge a lot for your very top professionals, you send the signal that you think you are not in their league. If you are providing services to a seven figure CEO or his board, fees of, say, $500 an hour are way too low. So high CEO pay has pulled up a lot of boats on its rising tide. Back to Nocera:
I think there is a decent chance that the compensation games will come to an end — though it won’t be by doing anything so radical as trying to cap pay, something that simply doesn’t work. (Mr. Geithner was right about that.)
Instead, it will be because boards have come under renewed pressure, thanks to the financial crisis, to control executive pay. It is also because, with the Democrats in charge, the issue is high on the agenda….
Most important, though, it is because the re-energized S.E.C., under Ms. [Mary] Schapiro, is preparing a handful of new rules that will force companies to do a great deal more to spell out their compensation rationales, while making it easier for shareholders to express their displeasure if they feel boards have been too generous. In particular, the S.E.C. has begun laying the groundwork for a rule that will make it easier for shareholders to nominate directors — something that is tremendously difficult right now. Ms.[Nell] Minow is among those who believe that the ability to replace incumbent directors is likely to have the biggest effect in reforming executive pay.
I wish I shared their optimism. These changes may keep pay from moving higher, but I doubt these measures will do much other than stop the worst abuses, such as big checks for obvious underperformance.
The reasons are twofold. First, even if shareholders may be able to secure some board seats, it will still take an effort. And why should they bother? As Amar Bhide pointed out in a prescient and ignored (because too offensive to the orthodoxy) Harvard Business Review article, “Efficient Markets, Deficient Governance,” the US decision to have highly liquid stock markets inherently leads to lax governance. Why?
In liquid markets, shareholders cannot have sufficient information to make a truly informed decision about what stocks to buy. A company, for competitive reasons, cannot disclose the details of its strategy and market situation that an investor would like to have. It would be give competitors insight that they could use to their advantage. The only way an investor can have good enough knowledge is through a venture capital type relationship, where he is privy to a good deal of internal information and can also assess the caliber of management.
So equity investors are inevitably in a position in which they are always at least a bit, if not a lot, in the dark. That means executives can hide their mistakes for at least a while, and probably reap more in the way of rewards than they should.
If an investor becomes unhappy with how management is paying itself, it is much more sensible to sell the stock than to devote the effort to try to bring management to heel. Even with the SEC lowering the barriers, it will not be cost free for unhappy shareholders to locate and nominate their own board candidates and promote their cause to other shareholders.
The second is that even having a board member or two installed by outsiders does not assure success. It is unlikely, given staggered directors’ terms in office, that shareholders could achieve a majority of outside board members and thus gain control of the compensation committee.
The irony of the current arrangement is that these fancy incentives intended to align executive pay with shareholder interests were meant to solve a principal-agent problem. That is, the concern was that CEOs would take advantage of their position and pay themselves well but not work very hard, hence they needed equity based incentives to make sure they did a good job. That view means that the CEOs were presumed to be less than trustworthy.
Yet who was in charge of recommending the compensation packages to the board? Well, outside comp consultants, engaged by the HR department, which of course means the fees are paid by the company. And even if the board hires a comp consultant, the board is nominated by management and the fees of the consultant are still paid by the company. In other words, the people whose possible abuses were supposed to be curtailed are still ultimately in charge of the pay packages. The foxes still are in charge of the henhouse, but with a few intermediaries in between to make it a tad less obvious. So it is any wonder pay skyrocketed?
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Following along with the point that shareholders don't get to know a lot about what's going on in the companies whose shares they own, a corollary is that people should be especially cautious in general about buying public stocks.
Nassim Taleb has stated that if people truly understood the risks they are taking in the public stock market, they would stay away much, much more and demand much better pricing on their purchases.
Pay for results, withoutmanipulating stock: is that so bad? (FYI: it's how corps. pay their sales people.)
My plan for executive compensation reform is here:
The SEC should pass a regulation requiring that all publicly traded companies allow their shareholders to vote on the following (binding) resolution each year.
"The total compensation of both the CEO and the CFO shall not exceed $1 million in the coming fiscal year."
Those who dislike government meddling in business have little to complain of here since the government isn't telling any business how to set salaries. The government is just requiring that business owners be allowed to vote on a specific option.
What would happen of such a regulation were in place? Senior executives would complain long and loudly. Many large shareholders — especially pension funds — would gladly vote for lower compensation. Many mutual funds would feel pressured to do so. My guess is that the resolution would pass at many companies.
There would then be significant (downward) pressure on executive salaries across the board. If you're the CEO/CFO of a big company, there are very few employees who you think should be paid more than you are. Of course, this won't allow you to pay people (much) less than they could get elsewhere, but the number of people for whose services the "market" is willing to pay more than $1 million per year is small. The very best baseball players, rock stars, entrepreneurs and Wall Street traders would still make millions, but only because any attempt to lower their pay would cause them to go elsewhere with their talents.
Some would say that this plan won't work since the companies whose shareholders agree to pay more than $1 million per year (whether they be public or private companies) will snap up all the "best" executive talent. Maybe. But, our ability to measure executive talent is so limited that it would be hard for any company to easily identify a CEO candidate who is significantly better than many other candidates for the job.
There is a sense in which such a scheme, if implemented, would amount to implicit collusion among the employers of senior executives. Perhaps. But collusion in the service of class warfare is no vice.
It appears to me that thinking the problem with the financial system is executive compensation is inane at best and probably a political class warfare play at worst.
If we are concerned about banks being "too big to fail" then our definitions of antitrust would seem to need updating.
If they are too big to fail, then their abilities to become that big should be curtailed.
Not to have some beauracrat dole out favors for this sector versus another. It will NEVER stop if allowed.
Good stuff Yves
Joe Costello, I agree. Very good post. Geithner's inability to follow through on his words with more meaningful action is by design. It is a perfect example of cognitive regulatory capture where he fears the intervention of government so much that he is unwilling to make significant changes from the status quo.
Geithner very much believes in 'free markets.'
Timothy Golem is but a sum of his parts and should not be expected to act other wise. He and others are beasts of nature unable to act agaist their religion, with out ripping it from their flesh first. Significant change is impossible with out new character's in this game.
It is becoming a hallmark of the Obama Administration that no matter the subject or how forceful the declaration the reality is always much less than meets the eye.
Obama had been in office nearly 5 months, the Democratic Congress nearly 6. If capping executive pay was a priority, the legislation would already be enacted. As for the SEC, I suppose a ham sandwich would be a better and more forceful regulator than Cox and his predecessors, but even so I would not expect much regulatory zeal from the business friendly Schapiro.
For executive compensation, I would say treat it all as income, and for any income in excess of $1 million/year (or you name the figure) tax it at a 90% marginal rate.
A big link that never gets mentioned is how top M&A law firms and the investment banks can dangle great pay packages in front of CEOs and help them negotiate them behind the scenes. The tax gross-ups and the buying of derivatives and other hedging schemes by senior managers from investment banks to help them monetize their stock options and restricted stock are all ways to legally bribe CEOs so when the time comes those same CEOs will do the deals that feed the M&A beast. The incentives are completely wrong. We have had twenty+ years of deals that had little more economic rationale than making senior management rich. The conflicts are so deep and abiding it is criminal. Yet everyone claims this is the "market at work."
Sure – if you owned a company 100%, would you hire a CEO, then let that person (usually a guy) use your money to pay for a fancy lawyer that negotiates a pay package that pays him for failure or success, allows him not to be removed for cause except in the most egregious situations, use your money to pay for a fancy pay consultant that reports back that the pay of the CEO's "peers" is huge. Perhaps if you really needed that guy, but something tells me you might push back, at least a little on these demands and you might even think about taking a cheaper guy if the hotshot asks for too much. The sad thing is that never happens because the hand-picked boards just run over and do whatever the CEOs want so the directors can get treats like fat director fees and lots of other freebies to feel important.
I just don't see how anybody can take the concept of "fixing executive compensation" seriously. It's like "fixing" global warming.
Public companies owned by the (uh) "public" will of course attract executive con-artists, probably in direct proportion to the amount of cash these companies can generate. The "public" is comprised of mostly gullible idiots. What OTHER result would be except? Upper management rips-off the stockholders and hires middle-management to rip-off the customer to generate more cash. Like DUH, the business model that made `merica the greatest in the whole wide world, right?
Public corporations exist to divert money into the pockets of the smartest, most aggressive, most confident, amoral con-artists (aka upper/executive management) that run the companies. Likewise, government exists to divert money into the pockets of the owners of politicians. Why would anybody waste a second of time on a problem and ISN’T a problem. The results are exactly what would be expected. If I was smart enough, aggressive enough, confident enough and (most important) amoral/duplicitous enough I'd be doing exactly the same thing; hopefully everybody on here would too.
Global warming can only be fixed by dieing BEFORE the problems start. Hopefully, the majority will be delusional enough to think their children will be able to "fix" the problem before the ever-popular solution of global war breaks out. (Hey, kids, enjoy the future, I'm dieing now – and, us, good luck with that global warming challenge.) Global war is the ONLY possible solution to global warming as it’s the ONLY historical solution that exists.
As the con-artists (oops, I mean management) of the zombie bank I work for often say: with great "challenges" come great "opportunities". They also say things like: we're level-setting the table-steaks and orchestrating our organic strategic core-competencies in a synergized going-forward space. Guess what, it’s all BS.
"The idea that money beyond a certain level is motivating bears far more examination than it has gotten."
No truer sentence has yet been typed about the executive pay fiasco.
Give them red feathers for compensation beyond $1 million per year. The man with the most red feathers gets the girl with the blondest hair and biggest boobs — and that will be the end of it.
The woman with the most red feathers gets to look at herself lovingly in the mirror. She can have Fabio in the bedroom if she wants.
Or she can mate with a big red feather man and they can make a turkey with their feathers — combined.
The 'debate' for an executive pay cap is a sham.
Executive pay was capped at $1M by the IRS in 1992 after Clinton joined those outraged during his campaign against the increasing salaries at the top while thousands of people at a shot were being fired [pardon me, 'downsized'] and benefits eliminated to accommodate the squeeze produced in corporate America by leveraged M&A deals accompanied by the applause of increasingly higher stock market prices.
Stock options instead of cash for executive pay was discussed then and the possibility of their potential toxic effects noted [and ignored]. With passage of the new IRS rule to tax corporations for any pay over $1M, outrage abated -the issue went away and the stock option work around took off.
The people engaged in this 'debate' know or should know that price controls don't work.
Unless I have overlooked a particular view, everyone here (and elsewhere) are all looking through the wrong end of the telescope for a solution. Every investor, large and small needs access to a public forum listing executive compensation – and let the market decide. I'll put my money where they're not greedy. If you want to support exhorbitant lifestyles to feel "important" go ahead be my guest.
I'll be impressed with any form of pay restriction or restructuring when it targets attorneys fees.
Not that you will ever see that from the administration made up almost entirely of lawyers.