The False Promise of Pay for Performance

The False Promise of Pay for PerformanceMany, including this reviewer, called Bebchuk and Fried’s Pay without Performance: The Unfulfilled Promise of Executive Compensation the best corporate governance book of 2004. James McConvill’s The False Promise of Pay for Performance: Embracing a Postive Model of the Company Executive, largely a critique of Pay Without Performance, deserves similar attention.

Bebchuk and Fried clearly demonstrated that many features of executive pay are better explained as a result of shear managerial power, rather than arm’s-length bargaining by boards of directors. Their recommendations on improving executive compensation are aimed at eliminating or reducing some of the most egregious problems and are written to shareholders, since such reforms are not likely to be raised by “independent” directors, as independence is currently defined. One of their major points is that board members should not only be independent of CEOs, they should also be dependent on shareholders.

McConvill does not dispute that managerial power has led to the decoupling of pay from performance but he takes issue with Bebchuk and Fried’s failure to clearly reject agency theory, which “derives from a narrow – and ultimately false – understanding of human motivation and behavior.” McConvill contends “the managerial power thesis assumes that only economic factors (based on agency theory) influence executives in their attitude towards remuneration…” He further writes that Bebchuk and Fried “suggest that managerial power provides a complete explanation” for the decoupling of pay and performance. (my emphasis)

Despite what I believe is exaggerated rhetoric, since I did not read such assertions of certainty into the work of Bebchuk and Fried, McConvill’s book is critically important as one of too few works that begin to explore alternatives to homo economicus in corporate governance.

The book should find immediate appeal among the mostly liberal proponents of socially responsible investing, who also embrace the notion that we are not driven by money alone, and among conservative pro-management organizations like the Business Roundtable because of McConvill’s assertion that “positive corporate governance” will do away with the need for external regulations. However, the book should also be read by anyone open to at least to thinking about alternative avenues of motivation.  

McConvill’s main point is that it is not money that motivates CEOs but company performance, trustworthiness, job satisfaction, ego, and status. Unfortunately, too many tend to take pay as a proxy measure of these motivating factors. I like the starting point though. Acknowledging that statistics show a very weak link, if any, between pay for performance, Bebchuk and Fried ask how we can improve that link, while McConvill is more focused on increasing executive productivity through other means. Both areas warrant attention.

There is something to the argument that economists have convinced many in business and law that their discipline is more rigorously scientific than psychology, sociology, and management studies. Equating rationality with being driven by self-interest may actually contribute to a self-fulfilling prophecy whereby managers do, indeed, turn out to be cheats and devious idlers.

Most people conform to trends. As McConvill notes, “informational cascades” prompt us to base our beliefs not on what we know but on what people do or say. Even though we know a decision may be wrong, we tend to go along with the majority to stay in their good graces, resulting in a “reputational cascade.” How we are socialized and the words we use have real world impacts. Do we really want to reinforce the notion that CEOs should be primarily driven by the acquisition of personal wealth? 

McConvill goes on to describe differences between the predominant “law and economics” movement and the “behaviorial law and economics” movement, which seeks to better understand how human beings truly behave – frequently in unselfish ways. He cites lessons from game theory to support the notion that cooperation and trust are vital to personal well-being and the well-being of society. Placing too much emphasis on external rewards, such as pay, may have the effect of diminishing internal incentives to do our best.

McConvill’s research finds a stronger correlation between democracy and happiness than wealth and happiness. He might have cited studies by the National Center for Employee Ownership that more democratic companies are also more productive. He does note that relative wealth is more important than absolute wealth. So as long as CEOs measure their own self-worth by how much they earn in comparison with others, boards will face inflationary pressure. “Pay for performance is flawed in the sense that it accentuates, and to a large extent depends upon, the continuation of the social comparison treadmill – with executives always keeping their eyes and ears alert to who is earning more than them.”

McConvill calls for what he terms “positive corporate governance,” borrowing from positive psychology which sees beyond what have become traditional concerns with treating the sick to also using social science to build what is right – strength, virtue and the highest qualities of civil and personal life. With most material wealth needs met, more people are focusing on meeting their need for meaning in life. Happy people don’t follow the money; they follow their passions. We need CEOs who are passionate about making the best products, having the most creative or satisfied employees, and creating sustainable companies.

He admits that his critics “will consider much of the argument underlying positive corporate governance as being not only counterintuitive but pure fantasy.” Such criticism would not be without reason. McConvill should give us pause when he writes, “If we can be confident that executives are naturally inclined to pursue what is best for the company, and doing so is an incentive in itself, external regulation can be dispensed with.” (my emphasis) Even if we could do that by checking their DNA, I’m not sure having a CEO who is inclined to do what is best for the company would warrant dropping all external controls.  

While such statements and his attacks on Bebchuk and Fried are liable to win support among BRT members, his notions could also be used to promote a path toward sustainability.

In the end, he appears to want to ground management in positive professional norms. “Education is the key to positive corporate governance working, in terms of promoting the virtues of adhering to a professional ideal, and the rewards which flow on from this, as opposed to emphasizing the need for external incentives and sanctions to influence certain outcomes.”

He has a point but I wouldn’t throw out agency theory altogether. We need to align pay with performance but we also need to promote sustainable norms into our business model, not just by requiring business ethics courses for all MBA candidates.

The key for the success of “positive corporate governance,” as envisioned by McConvill might be for organizations such as the Business Roundtable to hold up as an ideal for executive pay CEOs like Costco’s Jim Sinegal. Last year he earned a salary is just $350,000, plus a $200,000 bonus. Costco’s average pay for employees is $17 an hour; 42% higher than its rival Sam’s Club. By many measures, including its health plan, Costco’s model is more sustainable, in terms of treating its employees, host communities and even its shareholders better in the long run than Wal-Mart. [(How Costco Became the Anti-Wal-Mart, NYTimes, 7/17/2005) (Disclosure: The reviewer is a Costco shareholder)]

McConvill says he does not attempt to construct a new pay-setting approach, although he suggests “best practice” might tie executive compensation to “15-20 times average weekly earnings” of employees. He also cites a study in New South Wales that found excessively high pay levels for CEOs coincide with lower corporate earnings. Christopher Mann of Moody’s recently authored a report that found businesses that offer their CEOs unusually large bonuses or option plans have higher bond-default rates and more frequent and deeper rating downgrades than their peers, (Report Links Defaults, Excessive CEO Pay,

The False Promise of Pay for Performance will get you thinking. If widely read, it could help move us from a narcissistic model of corporate governance, that “greed is good,” to one that encourages all employees, including the CEO, to be more fully human at work.

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