The Hindu Business Line : The heat is on CEO pay

The CEOs of large US companies last year averaged $10.5 million (Rs 52.5 crore) each in total compensation, 344 times the pay of the average US worker.

C. Gopinath

A recent article in a US newspaper worried that curbs on executive pay of top managers at the sick financial institutions will limit their ability to attract the talent they need to revive. Now, wait a minute. Didn’t we just find out that the excessive pay at these firms attracted the wrong kind of talent that ultimately led their companies to failure?

An uncomfortable fall-out for corporate America amidst the current financial and economic crisis is the focus on CEO pay. Even the Heads of Government who met in Washington in November 2008 to discuss global coordination to respond to the economic crisis wanted their finance ministers to review ‘compensation practices as they relate to incentives for risk taking and innovation.’

Debate over excessive compensation for the heads of companies has been a fringe topic for some time. It began with a concern that there was no relation of pay with performance. CEO pay seemed to be moving independently of the performance of the companies they ran. Then, many companies began tying part of the compensation to stock price (through options, bonus, etc), thinking this would establish a link between CEO pay and performance measured by what shareholders were expecting from them. But that did not seem to work either, bringing the guarded comment from the G-20 group.

Was the connection between pay and stock price driving them to make risky short-term decisions that drove up stock price while it drove down the company’s competitiveness and long-term stability? That certainly seemed to be the explanation for the rash of financial institutions’ failures that we have started seeing.

Not only were their top management taking home several millions even while their firms were failing, but they were continuing to justify it. The CEOs of large US companies last year, by some calculations, averaged $10.5 million (Rs 52.5 crore) each in total compensation, 344 times the pay of the average US worker. Even the failure of the firms they were leading was not serving as a reality check on their belief systems. In testimony before Congress (i.e., US parliament), the CEO of collapsed Lehman Brothers wanted to correct the figure given by the lawmaker questioning him that his compensation since 2000 was not $480 million (Rs 2,400 crore) but $350 million (Rs 1,750 crore).

Oh, poor thing. Lehman Brothers had even agreed to pay severance of about $23 million (Rs 115 crores) to three executives just a few days before the firm collapsed. Even more recently, John Thain, CEO of Merrill Lynch, the firm that had been rescued by Bank of America, was trying to argue that he should get a bonus of about $10 million (Rs 50 crore) for 2008!

An acceptable discussion

This arrogance, of course, generated a response so loud from the average public that cap on executive pay has now become acceptable as an item of general discussion, and is not being dismissed as a whine of the Left. It made its way into the public psyche in a subtle manner.

The argument was that if the company came to government with its hat in hand looking for a financial bailout, then the government had the right to stipulate that there should be limits on how much the top management could take home. Hence, the Treasury Department (ironically headed by Henry Paulson, a former investment banker, who had benefited immensely from the lax compensation environment) issued rules on executive pay of those firms that participate in the financial sector bailout.

Most immediately, it was applicable to those firms that received equity capital or direct assistance from the government.

The Treasury will broadly ensure that there was ‘no incentive compensation that encouraged unnecessary risk and excessive risk that threaten the value of the financial institution’ (presumably referring to stock options); bonuses based on inaccurate financial reports should be returned; a ban on severance pay; and the firm will not be allowed to deduct executive pay that exceeds $500,000 (Rs 2.5 crore) per year from their corporate tax returns. This did not please those who were looking for a specific amount to be set as a ceiling on executive pay, yet it was a beginning.

The three US automakers, who came to Washington looking for help to bail out their firms, voluntarily offered that they would only take $1 (Rs 50) as their pay. AIG, the failing insurance company, agreed to freeze its payments to a former CEO. About 62 CEOs in the US, The Wall Street Journal reported, have agreed to clauses in their contracts of a pay cut if their company’s performance is poor or if there are pay cuts in the company.

Reaching for the cookie jar

Europeans have also started to pay attention to executive pay. While they never did suffer from the excesses of corporate America, executive pay has been rising in recent years. In Germany, companies have been required, since 2006, to reveal their compensation schemes, and the public began to see the dirty linen. A former chairman and two other executives of UBS, a large Swiss bank, recently agreed to forgo fairly large amounts of money that they were contracted to receive from the bank.

I don’t think the current debate on executive compensation will have a long term effect in America. As the current trough of the cycle ends, you can be sure CEOs’ hands will again become sticky as they reach into the cookie jar. And that is because the trend toward caps is externally driven, not because the CEOs themselves believe that they have been paid too much. So let’s relish this while it lasts.

A scholarly article in the journal, Academy of Management Perspectives, looked at data over a one, three and five-year period prior to the compensation year of CEOs and concluded that there was a strong relationship between realised pay and previous stock performance. Thus, the article concluded that market forces were at work, meaning their pay was justified.

But from a corporate governance perspective, the flaw in this argument is the unstated assumption that the CEO and top managers are solely responsible for the success of the enterprise and are, hence, justified in claiming such a disproportionate share.

Few management theories would support that argument. Others who are not happy with restrictions on pay would argue that even if the CEOs were securing excessive compensation because of their control over the board of directors, market forces would apply a corrective mechanism (have them sacked) if they did not deliver.

But then why is there so much resistance to the move that the compensation of the top managers should need to be approved at the annual meeting of the shareholders? There is no fundamental problem with the argument that executives who take the risk of making the major decisions that take the company to greater glory should be rewarded for it. The problem was they benefited from only the upside and left the downside risk to the company.

Thus, it the stock price went up, they could collect the reward of having aided its movement. But if the stock price went down, no CEO was going to lose a part of his compensation. That should tell us what they themselves thought of their role.

(The author is a professor of international business and strategic management at Suffolk University, Boston, US. He can be reached at cgopinat@suffolk.edu)

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