Directors are now on the hot seat over executive compensation. Although much of the pay controversy has been focused on banks, the public response, with initiatives such as enhanced disclosure or “say on pay,” are aimed at the entire public-company universe. Boards are naturally taking note of the public mood and considering changes to their companies’ pay policies. But as one contemplates remedies, it’s wise to work from a correct diagnosis. Unfortunately, the public response to pay scandals is largely based on myths arising from a simplistic view of compensation. In the past, failure to distinguish truth from myth has led to policies that hurt rather than help shareholders. It’s worth making better distinctions to prevent that from happening again.
Myth 1:
Widespread coverage about bonuses reflects grave concerns about corporate governance.
Truth:
Widespread coverage about bonuses is driven by resentment over certain people making much more than you or me.
Resentment has been focused on the big banks perceived to be responsible for the financial crisis, but has spread far beyond bankers to every highly paid executive. The root of this resentment is a populist sentiment that nobody can be worth millions of dollars.
Legitimate governance concerns exist regarding executive compensation, such as pay that is divorced from performance, or pay that encourages bad behavior. And taxpayers are certainly entitled to raise a fuss about high pay to individuals whose companies survived by the grace of government assistance. But none of these items, nor all of them together, explains the number of headlines about executive pay. The outrage about bonuses is not the product of lofty governance concerns; it is the visceral reaction of an angry mob, encouraged by mass media trafficking in voyeurism and fanning envy in the guise of condemning greed. Those “obscene” payouts going to CEOs or bankers are the next best thing to putting pornography on the business pages.
Myth 2:
CEOs are overpaid because they are greedy
Truth:
CEOs are paid what they are because of what they can negotiate.
It’s easy to call someone else’s pursuit of self-interest greed (of course, we are never greedy pursuing our own interests), but that doesn’t provide a useful distinction in the context of compensation. Every one of us gets what we think we can when we are selling something important, whether it is our house, our car or our labor. CEOs happen to have a rare and valuable talent, and companies are bidding for it.
In negotiating their pay, CEOs are not just exercising their own greed; they are playing on the greed of the owners (or shareholders) to use them to get the highest returns possible. As in any other market transaction, greed is tempered by the fear that the deal might not get done, or might go badly.
Myth 3:
These are not market transactions. CEOs are taking advantage of pliant boards.
Truth:
Pliant boards cannot logically be responsible for high CEO pay.
The explosive growth in CEO pay over the last 20 years coincides with a huge shift of power from management to boards—a shift that is acknowledged by even the most vocal critics of CEO pay. Yet, the background assumption in virtually every report about executive compensation is that managerial power is to blame for CEO pay and steps must be taken to reduce or counteract that power.
Managerial power is real enough. Powerful CEOs are able to extract all manner of perks and privileges from their companies. But the fact that managerial power exists does not save it as the reason for high CEO pay. Quite the opposite; the trend in the shift of power towards directors is impossible to reconcile with the upward trend in executive pay. Any theory that assumes directors are systematically lazy, stupid or corrupt is impossible to reconcile with the experience of those of us who work with boards. In fact, directors are quite conscientious about their work. If anything, they are wary about overpaying the boss, and generally—though not always—able to impose whatever judgments they think necessary to keep that from happening.
Myth 4:
CEOs are overpaid.
Truth:
Some CEOs are overpaid, but most are underpaid relative to their contributions to their firms.
If the job is worth billions or tens of billions a year to the owner of the business, and the person they hire can do it just a little better than the next best person, then the owner can easily justify paying the best what would look like a fortune to the rest of us. Such a judgment can only be made by directors with the information and experience to do the job. That doesn’t guarantee that they will do it right, of course, but it is certain that nobody with less experience or information will do it better. Boards don’t have the luxury of their critics’ 20/20 hindsight.
Of course, some people don’t buy that anyone can be worth millions per year. Our society had to get over a similar hang-up about entrepreneurial wealth during the Carnegie and Rockefeller era before we came to accept the fortunes of Warren Buffett and Bill Gates. We got over Michael Jordan and Brad Pitt earning millions for their performances. We will get over it with top management, too. For now, boards must cut through public cynicism to make difficult judgments about how much their top managers are worth to the company, just as a high-end property broker must judge the value of a prime location, or a master jeweler must appraise a rare gem.
Myth 5:
Perverse incentives in firms are a serious problem that brought our financial system to the verge of collapse.
Truth:
Perverse incentives primarily existed between firms, not within firms.
In 2008, the world discovered the “trader’s option,” i.e., traders make a fortune if they take big risks and win, or leave the shareholders (and, perhaps, taxpayers) holding the bag if they lose. Finance executives have known about the trader’s option for decades and had evolved ways to manage and contain it. What they couldn’t manage or contain, or clearly see, was the degree to which the incentives between firms had been thoroughly distorted by a policy of easy money, politically degraded lending standards and that black hole for questionable securitizations known as Fannie Mae and Freddie Mac. Bankers reacted to these incentives with their usual profit-seeking behavior, including innovations that then enabled smart people to arbitrage these politically created opportunities.
Lehman’s Dick Fuld and Bear Stearns’ Jimmy Cayne had no reason to encourage the behaviors that blew up their firms. A careful study of firm-level incentives was conducted by a pair of well-regarded academics from Switzerland and the United States. They compared the variable pay structure (bonus plans, long-term plans, etc.) of firms that got into trouble during the financial crisis with those that didn’t, and found exactly zero evidence that firm-level incentives were to blame.
Myth 6:
Bonus plans should pay out only if the company performs well.
Truth:
Not if “bonuses” are actually commissions, or rewards for managers saving their firms in a dismal market.
Where pay is intended to be largely variable, as it is in many trading, asset management or investment-banking jobs, then “bonus” is kind of a misnomer. Like a salesman who falls far short of his quota, he still deserves to be paid for the little revenue he brought in. His “bonus” could very well represent lower compensation than he could have made being entirely salaried versus commissioned. And how is it fair to deny a bonus to the person whose portfolio did not blow up in a catastrophic year, or to the investment banker who brought in clients under dismal economic conditions, possibly saving their institution from going under altogether?
If a company’s management team strongly outperforms its hapless peers in a down industry, should they get a bonus? If a mediocre management team in a booming industry sees their profit and stock price jump, do they deserve a bonus? Reasonable people could argue yes or no to either of these examples, but boards must decide these things all the time. An unforgiving critic can always claim that they got it wrong, even if there is no definitively correct answer.
Myth 7:
Boards should offer bonuses solely to align pay with performance, not as a way to simply get more money into management’s pocket.
Truth:
Boards could use bonuses, in part, as a cost-control measure rather than for pure alignment purposes.
Directors must always balance retention, alignment and cost control. For instance, Code 162(m) excludes pay above $1 million from being deducted from taxes.
“Performance-based pay” is exempted from that limit, with bonuses being the non-dilutive version of such pay. So, let’s say a manager can command a $3 million paycheck. The board could pay this executive $3 million in salary and have the shareholders eat about $700,000 in extra taxes, or they can try to save that tax by offering a $1 million salary and a $2 million bonus. Since this bonus is nominally “performance-based pay” one might reasonably ask, “How demanding is the performance to earn it?”
In the past, it might not have been truly at risk because the board was disguising fixed pay as a “bonus” to save on taxes. If they wished to place the bonus amount truly at risk, they would have to offer a higher target bonus, such as $3 million; investors would not accept additional risk without additional potential reward, and their managers are no different.
Boards will have to give up that ploy. They will either have to explicitly guarantee all $3 million and have shareholders eat the taxes, or they will have to pay a total target compensation of $4 million. Either way, the cost to shareholders will go up because directors, unlike their critics, must deal in trade-offs, and the nature of trade-offs is that you can’t get more of everything—retention, alignment, and lower costs—at the same time.
Don’t Yield, Explain
These myths originate in understandable antipathy toward people appearing to make big bucks, sometimes despite poor performance, especially when so many are experiencing difficult economic times. But corporate boards must use their best judgment to deal with compensation on a more economic and granular level. Of course, directors can’t ignore what the media is reporting or what the critics are saying. But they should respond by engaging with the truth, instead of bending their pay programs to conform to a distortion of reality merely to throw off the right “optics.” Boards that best balance these competing demands will likely oversee the strongest performing firms.
Marc Hodak is the managing director of Hodak Value Advisors and teaches corporate governance at New York University’s Leonard N. Stern School of Business.
Great educational piece! We need more like this one and appearing in the mainstream media too.
Remember, the mass psychology and uproar has also been fueled by three contributing sets of stories that get plenty of headlines: (1) financial pyramid schemes that get prosecuted and create a stream of media stories, (2) payment of contractual bonuses amidst failure of some financial institutions that make it seem like all institutions are unconcerned with the broader economy, and (3) stories of extreme expense and benefit abuse by some executives. Like gasoline on a fire, these flare up, meld into one generalized perspective and increase a sense of distrust in ‘them’ or ‘those companies’, while reinforcing a polarizing view of the world as ‘haves’ and ‘have nots’. Those who can not see the light of economic rebound, or how some companies are contributing to that, easily repeat the anger and frustration elicited by past media stories.
I’d like to see
1. Marc Hodak’s post and other like this one on the op-ed pages of the NY Times and LA Times so they get a broader readership
2. More stories of how companies and boards are now contributing to responsible governance and compensation practices (rather than further the assumption that only external government can improve things)
Beautifully written sir.
Remember during the Clinton administration, when federal authorities decided executive pay was out of control and payments over $1M per year should be treated with great prejudice in the tax code?
The market response was overwhelmingly to transfer payments to stock options. It still baffles me why the market on executive pay overwhelmingly ended up writing up options that were already in the money.
Regardless, I believe any analysis on executive pay would show that stock options ended up ratcheting up executive pay exponentially. We seem to forget that it was a response to government meddling in the first place.