TCS Daily


Excessive Envy?

By Pejman Yousefzadeh - May 5, 2006 12:00 AM

The issue of CEO compensation has returned to the forefront of public attention with a recent NY Times article. We're told Exxon chairman and CEO Lee Raymond has been compensated for his work to the handsome tune of $686 million over a period of 12 years (1993-2005), including more than $400 million that he received in compensation for his final year of work for Exxon.

Needless to say, this causes some to wring their hands in concern:

"... given the recent increases in gasoline prices, to a national average of $2.60 a gallon, the public and politicians are particularly attuned to the fortunes of the oil industry these days. Congress has been considering imposing a windfall tax as well as new legislation to restrict future mergers in the industry.

"'He served his stockholders well and the American public poorly,' said Mark Cooper, the research director at the Consumer Federation of America."

Can anyone glean, with any certainty, what is meant by the comment that Raymond "served his stockholders well and the American public poorly"? Presumably, this is meant to critique Exxon for the fact that it made a profit during a time in which gas prices increased. But it is difficult at best to figure out what Raymond should have done to prevent prices from rising? Can one man thwart the workings of the market? No.

Before determining whether CEO's are indeed overcompensated, we need to work out by what standards someone is to be compensated. Too many commentators fail to do so. For example, law professor Larry Ribstein refers to an article by New York Times writer Gretchen Morgenson decrying the compensation afforded to Pfizer CEO Henry McKinnell. As Professor Ribstein points out -- despite the fact that a Pfizer spokesman claimed that "that the company did use a stringent benchmark" in determining McKinnell's compensation -- Morgenson offers no discussion of what such benchmarks might look like and instead editorializes about the compensation itself.

Morgenson goes on to criticize the supposed lack of "vigilance" about compensation from institutional investors and claims such stems from the fact that they "get investment management funds from the companies in which they also hold stock on behalf of clients" (Ribstein's words). What Morgenson does not say -- and Ribstein does -- is that "[t]he story does not mention whether other institutional investors, not similarly 'conflicted,' also did so." Needless to say, the absence of relevant information in decrying CEO compensation does nothing to help readers and observers make sound judgments on the issue.

Even in cases where we have standards by which to determine that CEO compensation has reached excessive levels, there is a ready check against a corporation and a board of directors that might allow such excess to be reached, and that ready check is called "the stockholders." Stockholders are valuable private sector regulators who can prevent or reverse imprudent actions of the corporations in which they hold stock by effecting a change in the composition of the board of directors. Thus, if Exxon stockholders or the stockholders of any other corporation believe that their boards have gone to excess in compensating CEOs, they are able to effect a change in the corporation's leadership. Again, this will require objective standards by which shareholders can make such decisions, and it would seem most logical to make shareholder returns the prime standard by which such determinations are made. In short, if shareholder returns are weak, a CEO may be earning too much. If returns are robust, however, the chances may be greater that the CEO is making what he-or-she is worth.

Critics demand more "transparency" in the decision-making process surrounding CEO compensation. But even given more transparency, we might still see dramatic compensation for CEOs and such compensation might actually increase. And how exactly will we regulate CEO compensation beyond effecting transparency aids? Just stipulate that a certain percentage -- and not a dime more -- will go to the CEO, with the rest going to other personnel? And what percentages go to which personnel? Will this cookie cutter approach really be good policy?

In the end, the belief that we can tell corporations how they should be spending their money and how they should be compensating their employees is presumptuous in the extreme. How, precisely, can we tell a corporation -- whose history and operations are complex -- what it should be paying its workers? And unless we are shareholders in that corporation, why on Earth should we even bother? If the corporation does not properly allocate its resources, it will be less profitable and stand a greater chance of failing. That, more than any outside regulatory scheme, will help keep smart corporations in check in their resource allocation strategies.

As economist Don Boudreaux points out:

I admit that my proposed solution for many public-policy problems is to say "Let the market handle it." But this response is neither naive nor lazy. It's realistic. It reflects my understanding that almost any problem you name -- rebuilding the Katrina-ravaged Gulf Coast, providing excellent education for children, reducing traffic congestion on highways -- is most likely to be dealt with efficiently, fairly and effectively by the market rather than by government.

Saying "Let the market handle it" is to reject a one-size-fits-all, centralized rule of experts. It is to endorse an unfathomably complex arrangement for dealing with the issue at hand. Recommending the market over government intervention is to recognize that neither he who recommends the market nor anyone else possesses sufficient information and knowledge to determine, or even to foresee, what particular methods are best for dealing with the problem.

To recommend the market, in fact, is to recommend letting millions of creative people, each with different perspectives and different bits of knowledge and insights, each voluntarily contribute his own ideas and efforts toward dealing with the problem. It is to recommend not a single solution but, instead, a decentralized process that calls forth many competing experiments and, then, discovers the solutions that work best under the circumstances.

[. . .]

In brief, to advise "Let the market handle it" is a shorthand way of saying, "I have no simplistic plan for dealing with this problem; indeed, I reject all simplistic plans. Only a competitive, decentralized institution interlaced with dependable feedback loops -- the market -- can be relied upon to discover and implement a sufficiently detailed way to handle the problem in question."

Quite so. And now for the sixty-four thousand dollar question: Why are so many of the critics of "excessive CEO compensation" so determined to be so simplistic about the issue? Are they genuinely seeking the solution to what they perceive in good faith to be a serious problem? Or is it a means of scoring of political points by tapping into people's frustration and envy?

Pejman Yousefzadeh is a lawyer and a TCS contributing writer.

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11 Comments

Free markets are great, but...
Executive compensation is one area where the free market mechanism gets jammed up. Why? Because the foxes are guarding the hen house. You have a bunch of highly compensated individuals making decisions about compensating other highly paid individuals. Now, if the Market works, you'd think that the CEOs that add the most value would be compensated the most, and the slackers would be compensated the least. But many compensation studies directly refute that. Something's not working properly within the Exec Comp market.

The other fallacy (not necessarily in this piece, but surely in others that defend CEO pay) is that any one person is worth that much money. Let's use a baseball analogy: Alex Rodriguez. Now, he's a wonderful player, but is he worth $25M a year? No way, not if the object is to win (check out the record of the Texas Rangers when he was there). He will simply not be able to perform without eight teamates alongside him.

There is also a POLITICAL problem here. It's the same problem that suffuses the whole "income inequality" debate. Most people accept some level of "income inequality" because they recognize intuitively that some people are "better" than others. But if this income gap becomes "too large" (admittedly tough to define), the serfs beome restless and social cohesion suffers.

It's easy to solve this dilemma. Give EVERYONE stock options and TRULY link pay with performance.

Compensation and Corporate Structure
"...TRULY link pay with performance."

A change is standard corporate goverance would help here.
1) The owners (stockholders) elect the Board and votes on Board compensation. Board members should function as full time agents of the stockholders.
2) The Board hires the company management and sets management compensation. Management cannot be on the board, since they report to the board!
3) Also, I would recommend that the SEC not allow ANYONE to serve on more than one board of publically traded companies.
When current board members are allowed to influence their own compensation as managers, there is a built in conflict of interest. The fact that executive compensation has been increasing at a rate faster than stockholder return in the last few decades is evidence of the problem. Until a systemic solution is applied, the problem will continue.

corporate pay
If the stockholders are upset with the compensation package, then they are free to vote out the board of directors.

The reason a baseball team hires a player is not directly to win games. It is to attract fans. The fact that winning helps to attract fans helps, but it is really secondary in nature.

If the presence of Rodriquez causes the Rangers to sell $25 million dollars in extra tickets, then his hiring will have been a success.

Yes, but...
Mark, you write, "If the stockholders are upset with the compensation package, then they are free to vote out the board of directors." And replace them with...who? See, the problem with thousands of shareholders is that few of them know, truly know, the players. It's kinda like how I feel when I go to vote and I have to select some Tom, ****, or Harriet, for District Judge of Wherethehell County. I have no idea who they are. Should I? Perhaps. I'll grant you that much, but pragmatically speaking, the foxes do in fact guard the henhouse.

I think "taBonfils" is absolutely right: there is a fundamental flaw in how corporations are governed and, my angle, "pay for performance" has been anything but.

How funny!
Very funny! The TCS filter wouldn't let me use D-I-C-K! I'm innocent, I tell ya, INNOCENT!!

compensations
does anyone notice how the media covers the pay of those bad ol' business executives, but the extortionist tort lawyers always get a free pass?

sure the company executives bamboozle their shareholders and ,in many people's minds, embezzle funds to the detriment of the company owners. however, the lawyers with their class actions suits embezzle from all of us.

compensations
ever notice how those same media become silent when one of theirs (Katie Courac, for example)is awarded what would appear to be excessive compensation?

replace them with anybody
It's the fear of getting fired that keeps CEO's, and everyone else in line.

the brain dead filter
even removes offending sequences, when it finds them inside other words.

This morning
The CEO of some firm was being given a hard time for making $13million in one year.

This was the same broadcast firm that saw nothing wrong with paying perty Katie Couric $15million, just to ask dumb sounding questions.

Exploiting inefficiency for personal gain
Pejman is good at finding reasons to ignore an obvious problem - executives are clearly ripping off the public companies for which they work, since they are smart and have figured out how to do so. The boards are feeding from the same trough and shareholders have little direct influence - many holdings are small and for these investors the costs of voting on any type of measure typically exceeds the costs. Compensation levels in the US are orders of magnitude greater than what they are in Japan or Europe.

While there is nothing theoretically wrong with class actions, as aresukt of informational and transactional costs/imbalances, class action lawyers similarly have been able to suck up much of the damages that they have been able to extract from defendant corporations.

What's worse in the case of corporations is that any "reform" coming from Washington has tended to favor large public companies over smaller ones - the expense and intrusiveness of Sarbanes Oxley is a good example - and real enforcement has been by Spitzer under the Martin Act.

I am with Pejman that I do not favor more corporate regulation. However, I do think it would be helpful to the perverse mischief that the grant of limited liability to corporate investors has produced. Investors would be much more concerned about corporate management and mismanagement if investors remained on the hook for corporate liabilities. It is the fact that investors are not on the hook that makes possible the huge corporation and the informational disparities that lead to compensation ripoffs.

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