10 July 2006

The CEO Pay Crisis

When even the conservative Republican Governor of Florida is saying that CEO pay is out of control and a "threat to capitalism," you can believe it.

Large rewards for great results can still be attacked, but they're very defensible. But if the rewards for CEOs and their teams become extraordinarily high with no link to performance - and shareholders are left holding the bag - then it undermines people's confidence in capitalism itself.

The linked article makes a thoughtful, if anecdotal analysis of the problem. The problem is very basic. The board of directors of a publicly held company in the United States, almost all of whom hold Soviet style elections with no competing candidates nominated by the incumbents on the board, is not an effective check on CEO pay.

In a true Pogo moment ("We have met the enemy and he is us"), 75% of outside directors agreed in a PricewaterhouseCoopers poll last fall that "U.S. company boards are having trouble controlling the size of CEO compensation."

Most corporate directors are little more than a collective Vice Presidency, ready to step in when a CEO dies, goes mad, or otherwise finds himself in extreme disgrace, under indictment, for example. In all other circumstances, it is little more than a rubber stamp.

The article linked above also manages to catch one of the usual suspects, Warren Buffett, offering the correct solution to the problem:

[T]he only cure for better corporate governance is if the small number of very large institutional investors start acting like true owners and pressure managers and boards to do the same.

Buffett's observation was true when I took securities law in the early 1990s, and it it still is true.

Disclosure helps, but it doesn't cut it. In any case, sufficient disclosure flows naturally from a sufficiently assertive board of directors who owe their positions to outside institutional investors and major stockholders, rather than the their friendly relations with the CEO and senior management.

Tax incentives also help, but can't solve the fundamental problem of contract negotiations managers and members of the boards of directors who are eager to give away the farm to senior management. For the most part, it will only change the form of the deal, not its magnitude. Incentive based compensation schemes don't work very well if, as has been the case in stock option compensation, standards are set miserably low.

On the other hand, genuine investor representatives will drive a more reasonable bargain. Now, this doesn't solve all social problems. A majority of publicly held company stock is held by less than 5% of the population. While there are many small shareholders, in dollar terms (and hence in voting power), their aggregate share of the pie is tiny. CEOs keep compensation for everyone below the senior management level under control the old fashioned way, with bona fide compensation negotiations. The only real issue is who gets what is left over, the CEO or the shareholders. Economically, the most important piece of a stronger investor class is not that it makes more money available for underlings, but that CEOs are more likely to be held accountable for their performance, and hence, more likely to manage the companies that make up the bulk of the American economy better.

What is needed? Something not unlike a state election code for publicly held companies. This election code for board members needs to set reasonably low thresholds for shareholders to nominate candidates without the involvement of the existing board, needs to provide candidates with the ability to provide information from outside candidates to shareholders on a level playing field basis with board nominees, and needs to allow big investors (or large numbers of little investors) to plot strategy and coordinate their efforts without fear of legal liability. Indeed, in the case of institutional investors, there needs to be a legal duty to be pro-active in investor democracy as part of the prudent investor rule that has long been a part of every fiduciary's duties. With some basic reforms like these in place, the CEO pay crisis would disappear and American big business would be better managed.

Hat Tip to Unbossed.

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