Can Wild CEO Pay Be Tamed? Probably Not

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    NEWSLETTERS

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    Sign tells the story of financial chaos.

    The guys who ran the recently collapsed Lehman Brothers, Merrill Lynch, Bear Stearns, Fannie Mae and Freddie Mac all prove one thing.

    You don’t always get what you pay for.

    Big paychecks for jobs not well done:

    • Lehman Brother’s Richard Fuld, $40 million.
    • Merrill Lynch’s Stanley O’Neal, $46 million.
    • Bear Stearns James Cayne, $40 million.
    • Freddie Mac’s Richard Syron, just shy of $20 million.
    • Fannie Mae’s Daniel Mudd, $12.2 million.

    As the nation’s financial system was crumbling, the CEOs that were in charge of the most troubled financial firms pocketed the fattest paychecks during their final full year on the job — and that doesn’t include the golden parachutes they walked away with.

    Public outrage over this disconnect has caused government to step in and finally try to do something about skyrocketing executive compensation. But history shows government’s attempts have been lame, at best, when it comes to curtaining CEO riches.

    Why? Because regulators never go far enough in giving shareholders a true voice. It’s difficult to break up entrenched boards of directors that make the decisions on executive compensation.

    Even the $700 billion bailout package introduced this week doesn’t have the teeth to finally put a lid on financial windfalls, experts say.

    Over the past two decades, efforts by government officials to rein in the big payouts, including changes to the tax code and calls for more oversight, have actually contributed to the growth in CEO pay — now 275 times the salary of the average working stiff, according to the Economic Policy Institute.

    “Government regulators are notoriously ineffective at reining in pay and often times the unintended consequences caused greater problems,” says Charles Elson, an expert on corporate governance at the University of Delaware.

    Let’s go back to the mid 1980s when everyone was concerned about executives getting huge payouts as a result of the merger mania at the time. The government and investors wanted to make sure management was selling companies because it was financially prudent, not because they’d end up with huge severance packages.

    This fear ushered in a change in the Internal Revenue tax code in 1986 creating a penalty tax on excessive golden parachute payments more than three times the base pay for an executive.

    What happened after that, says Steve Van Putten, a senior executive pay consultant for Watson Wyatt in Boston, was companies started paying the excise tax for executives, a process called grossing up. And the three-times base pay limit became the standard for many parachutes that were once well below that.

    In 1992, the Securities and Exchange Commission introduced new proxy disclosure rules taking information about executive compensation that was once narrative and thin on numerical values, and putting actual numbers out there for all to see.

    “It became very transparent and a CEO at one company could see what another was making so they’d say, ‘Hey, I want to be making that,’ ” says Van Putten.

    And the big change — one that many compensation experts and shareholder advocates point to as a turning point that led to the obscene CEO paychecks we’re dealing with today — came in 1993 with tax code provision 162(m) that limited tax deductibility for executive pay at $1 million, unless it was considered “performance-based” compensation, like, you guessed it, stock options.

    “As a result, stock options have gone crazy,” explains Mel Fugate, assistant management professor at the Cox School of Business at Southern Methodist University. That meant a CEO could get $1 million in base pay and $400 million in stock options, for example.

    This focus on stock options created a volatile mix, boosting incentives for executives to make risky business moves in order to boost a company’s stock.

     

    That’s exactly what has happened with the subprime mess that led to the downfall of so many old and established Wall Street firms.

    “Certainly, compensation practices at these companies has been a major contributor to the financial crisis,” says Paul Hodgson, a senior analyst at the Corporate Library, an independent governance research organization.

    Alas, government intervention thus far has been “an unmitigated disaster,” adds Alan Johnson, a compensation consultant. “I would think if you went back 20 years or so, you’d see it’s enriched consultants like me, lawyers, accountants. It was wasted time and money and didn’t reduce pay. It was so poorly designed, so full of loopholes, and so silly.”

     

    So, what needs to be done to finally clamp down on CEO pay and incentives that encourage short-term gains, but do little for the long-term health of the nation’s corporations?

    Shareholders can take an overpaid executive or board members that approved pay packages to court. But legally they would have to prove that the board overstepped its bounds in some way, such as back dating options, for example, says Stuart Grant, an attorney with Grant & Eisenhofer, a law firm that has litigated executive compensation cases.

    “I don’t know if there’s ever been a case just solely based on executive pay that’s come to judgment that’s been successful,” he explains. “You have to find some back door.”

    While few industry observers would go on the record defending exorbitant CEO paychecks, compensation consultant Alan Johnson says, “pay for executives is set in the marketplace. ... Do I wish executives got paid less? Absolutely. Is it terrible for society? Yes. But it is the market.”

    If companies want to attract the best and brightest, they have to pay CEOs competitively, says Craig Rennie, finance professor in the Sam M. Walton College of Business at the University of Arkansas. “You can say, ‘maybe we need to restrict executive compensation,’ ” he explains, but then executives will say, " 'we will go live in London where there’s a friendlier regulatory environment.’ ”

    For government regulators, fixing the problem is a matter of finding the right balance, says Houman B. Shadab, a senior research fellow at George Mason University’s Mercatus Center's regulatory studies program. “Compensation decisions should best be left up to shareholders and boards of directors and the way you do that is give shareholders more control.”

    Even before the idea for a bailout, Congress had been reviewing two provisions that many compensation experts say would give shareholders more of a voice.

    The “Shareholder Vote on Executive Compensation” Act, also known as the “say on pay” bill and sponsored by Rep. Barney Frank (D-Mass.), would give shareholders the right to a nonbinding vote on the executive pay packages and golden parachutes. Even though the vote would be nonbinding, Frank has said a vote against a compensation decision would put pressure on the board. It passed the House in April and is pending in the Senate, where Barack Obama is sponsoring the bill.

    Another key proposal that would help is allowing shareholders to vote for board members without engaging in a proxy fight, explains the Corporate Library’s Hodgson.

    Since boards at U.S. corporations are so entrenched, adding just one independent voice could go a long way, he adds. “It would change the psychological dynamic on the board because you’d have a member that says, ‘I am here because the shareholders put me here’ rather than ‘The CEO nominated me,’ ” he explains. “Board members are smart but collectively they become a herd.”

    Neither the “say on pay” or proxy access provisions were in the bail out plan voted on this week, Hodgson adds.

    Another option is creating incentives for board members. Elson, with the Center for Corporate Governance, believes having board members become equity stakeholders in the companies they oversee will also help incentivize them to keep mega pay packages under wraps because they’ll have as much at stake as the shareholders.

    No matter what happens, when you look at exploding CEO pay, there are clearly two reasons things need to change, says Dan Pedrotty, director of the AFL-CIO’s office of investment. “The concern is equality and fairness. But also if we pay for failure at a company that’s less long-term value that a company generates for shareholders,”

    The union, he says, represents not only its working members but also retirees that have a large stake in corporate America through their pensions and 401(k)s.

    For 10 years, the AFL-CIO has been pointing out the excesses of management pay on its Executive PayWatch website with the purpose of “bringing attention to CEO pay abuses and mobilizing public opinion to do something,” says Pedrotty.

    This year’s theme: the link between CEO pay and the subprime disaster.

    “A large part of how we got here, in addition to lack of regulation and greed, was the way the incentive packages were structured to incentivize the executives to take risks,” he notes. “As a result, lots of money was paid to undeserving CEOs.”