Addressing CEO Pay

Regarding CEO pay, Nell Minow recently wrote, “there is a little flicker of light at the end of the long, dark tunnel of outrageous pay.” Her signs of hope:

• Required advisory “say on pay” (SOP) vote. Last year after a “no” vote,  Occidental Petroleum’s board reduced the pay package for CEO Ray Irani and announced his retirement. Shareowners have voted down pay plans at several companies already. Additionally, “Some companies are adjusting their pay plans in anticipation of a new level of scrutiny by shareholders, tightening pay-performance links and getting rid of especially unpopular compensation components like “gross-ups” (paying the executive’s taxes).”
• Shareowners at four of seven companies proposing a triennial say when on pay (SWOP) vote instead voted for an annual vote.
• The UK may soon require new additional disclosures.
• “Groups like Public Citizen are working to remove further legislative and regulatory obstacles to shareholder oversight on pay and disseminating information on the bonuses of bailout-company executives.”
• The FDIC is moving forward with rules to requiring pay-performance links in bank executive compensation as part of insurance risk assessment.

“These are all welcome signs that compensation is finally being seen as an essential element of securities analysis and risk management, and that’s what markets are all about.” (The Days of Outrageous CEO Pay May Be Ending | BNET, 2/14/2011).

High CEO pay is symptomatic of a host of issues. An important one for me is income inequality. It seems to me that a disappearing middle class is not good for America. This seems to be a concern of many, but we still seem to be heading in the wrong direction. For some interesting research on American opinion in this area, see The Return of Dan Ariely: The Survey Results Are In (ChrisMartenson.com, 2/7/2011). His conclusion:

Taken as a whole, the results suggest to us that there is much more agreement than disagreement about wealth inequality. Across differences in wealth, income, education, political affiliation and fiscal conservatism, the vast majority of people (89%) preferred distributions of wealth significantly more equal than the current wealth spread in the United States. In fact, only 12 people out of 849 favored the US distribution. The media portrays huge policy divisions about redistribution and inequality – no doubt differences in ideology exist, but we think there may be more of a consensus on what’s fair than people realize.

From Eagle Rock Proxy Advisors, most companies are generally recommending that shareholders vote for say-on-pay votes once every three years. Here is a snapshot of overall board recommendations/ intentions for recommendation at the beginning of the season:

As we previously reported, shareowners are pushing for the annual option, so I expect many more rejections of triennial proposals. See “Say on Pay” to be Annual.  Timothy Smith, Senior Vice President, Director of ESG Shareower Engagement at Walden Asset Management recently sent out an e-mail noting he is among many strongly opposed to the triennial proposals by management and is “frustrated that we even had to have a frequency vote (thanks to Idaho Senator Crapo’s midnight amendment).” But the surge of votes for annual say when on pay SWOP is “helping investors pay more attention to the value and use of SOP votes. In the end this frequency vote may help solidify the importance of SOP to investors vindicating the initiative AFSCME, Walden and others started 6 years ago.”

Yes, with SOP and SWOP votes this year and companies reporting the ratio of executive pay to the average of all employees for the first time, the topic of CEO pay may come into focus more this year than in the past and shareowners will now at least have the power to voice their opinion.

However, I see little evidence that any of the current measures address the “Lake Woebegone” effect documented by Rachel M. Hayes and Scott Schaefer. According to those researchers, “no firm wants to admit to having a CEO who is below average, and so no firm allows its CEO’s pay package to lag market expectations.” (CEO Pay and the Lake Wobegon Effect, December 11, 2008, Journal of Financial Economics (JFE) Their analysis suggests SOP votes might be counterproductive. Before SOP was required by Dodd-Frank, many voices warned it would simply provide boards and managements with cover for a continued upward spiral.  Hayes and Schaefer offer up a “potential solution to the problem of shareholder myopia.”  Delegate pay decisions to directors and motivate them through contracts “to take a longer-term view.” But isn’t that what we’ve been trying all along? Clearly, something more is needed.

India’s Sonia Jaspal does a good job of citing some of the more more relevant papers and issues that have received too little attention to date. (The Negative Impact of CEO Pay & Power on Corporate Culture and Governance, 2/15/2011) Jaspal’s concern was apparently set off by a recent study conducted by Economic Times of India, which showed that in 2009-2010 CEOs of top companies earned 68 times the average pay of employees, up from 59 times their prior year. To Americans facing a pay disparity of 264 (with a high point of 558 in the year 2000), the differences in India may seem paltry. (Mind the Compensation Gap, Portfolio.com, 1/26/2011)

Many of us “feel” an injustice when CEOs earn so much more than average workers, but Jaspal points to academic studies that show the potential impacts are more harmful to society than simply hurt feelings.

When Executives Rake in Millions: Meanness in Organizations.  “Higher income inequality between executives and ordinary workers results in executives perceiving themselves as being all-powerful and this perception of power leads them to maltreat rank and file workers.” Some powerful executives perceive those with lesser power as sub-human. They demonstrate reduced empathy, being inclined to objectify and dehumanize others through behaviors such as sexual harassment and an increase likelihood of  unethical and corrupt behavior.

Jaspal also points to another real impact of this dehumanization, “the fact that CEOs who fired the maximum number of employees during recession in US, received the biggest pay packets.”  They apparently felt little remorse in benefitting from the tragedy they impose on others. “The social and psychological consequences of income disparity are borne by the society” and the consequences may be greater in the United States than it is in India because of the much larger average disparities.

An article published by The Economist titled The psychology of power: Absolutely looks at experiments that appear to confirm Lord Acton’s dictum that “Power tends to corrupt, and absolute power corrupts absolutely.” According to the studies, “The powerful do indeed behave hypocritically, condemning the transgressions of others more than they condemn their own… It is not just that they abuse the system; they also seem to feel entitled to abuse it.” Researchers conclude that “people with power that they think is justified break rules not only because they can get away with it, but also because they feel at some intuitive level that they are entitled to take what they want.”

Of course The Economist comes to a different conclusion than many of us would: “Perhaps the lesson, then, is that corruption and hypocrisy are the price that societies pay for being led by alpha males (and, in some cases, alpha females). The alternative, though cleaner, is leadership by wimps.” I’d say the lesson, instead, highlights the need to ensure leaders remain accountable, knowing corruption and hypocrisy will not be tolerated.

We keep Searching for a Corporate Savior in our CEOs but ending up with charismatic narcissists, with too many focused on short-term profits when we know we should be promoting CEOs from within to move from Good to Great.

Fraudulent Financial Reporting 1998-2007- An Analysis of U.S. Public Companies by  the Committee of Sponsoring Organizations of the Treadway Commission found that CEOs were involved in 72% of the 347 alleged cases of fraudulent financial reporting listed with SEC during 1998-2007 period. The average period of fraud was 31.4 months. Why Do CFOs Become Involved in Material Accounting Manipulations? shows that 46.15% of CEOs involved in fraudulent activity benefitted financially from accounting manipulations. “CFOs are involved in material accounting manipulations because they succumb to pressure from CEOs, rather than because they seek immediate personal financial benefit from their equity incentives.” Since CEO performance and benefits are measured by financial numbers submitted to the stock market, CEOs rationalize the need to report fraudulent financial numbers to protect their own positions.

Based on this analysis, Jaspal makes the following recommendations (I’ve taken liberty to reword some slightly.):

• The law should place a limit on the number of times CEO pay can excede the pay of average workers. This will ensure some balance is maintained.
• Because studies show that some powerful people tend to dehumanize their underlings and studies on emotional intelligence indicate that emotionally intelligent people are aware of their own and others emotions and drivers, we should explore methods to keep CEOs emotionally connected.
• Since research found that women are less likely to feel a sense of entitlement or power we should appoint more women  CEOs to maintain a balance and keep senior management grounded.
• Independent board members should be included on compensation committees. “This will ensure that a realistic view is taken of CEO and other top executives’ salary. Basing salary structures on performance rather than favorable circumstances is required.” (This is already the norm in the United States; unfortunately, it doesn’t appear to “ensure a realistic view.”
• Employees may be empowered by forming trade unions and using whistle blowing lines inside and outside the organization. (Again, we have this in the United States and the whistle blowing tools are improved under Dodd-Frank.)
• Last but not the least, the public should play an active role in curtailing income disparities. The issues should be brought to government and media attention. (Name and shame seems to have little impact but perhaps heightened awareness of the issues will lead to real sanctions.)

It is a nice list. I certainly agree with the idea of keeping CEOs emotionally connected, appointing more women CEOs, and getting the government involved in reducing income gaps. However, for the most part Jaspal’s recommendations don’t provide much guidance for shareowners entering the proxy voting booth. The one exception is placing a limit on the number of times CEO pay can exceed the pay of average workers.

Institutional investors have developed a plethora of guidelines and scorecards for voting down CEO pay. For example, section 3 of the CalPERS Global Principles of Accountable Corporate Governance, which contains too much to cover in this brief post but here are a few examples:

• To ensure the alignment of interest with long-term shareowners, executive compensation programs are to be designed, implemented, and disclosed to shareowners by the board, through an independent compensation committee.
• Executive contracts be fully disclosed, with adequate information to judge the “drivers” of incentive components of compensation packages.
• A significant portion of executive compensation should be comprised of “at risk” pay linked to optimizing the company’s operating performance and profitability that results in sustainable long-term shareowner value creation.
• Companies should recapture incentive payments that were made to executives on the basis of having met or exceeded performance targets during a period of fraudulent activity or a material negative restatement of financial results for which executives are found personally responsible.
• Executive equity ownership should be required through the attainment and continuous ownership of a significant equity investment in the company.
• Equity grant repricing without shareowner approval should be prohibited.
• “Evergreen” or “Reload” provisions for grants of stocks and options should be prohibited.

We can find many more lists, but again they don’t seen to be too helpful for the average investor who isn’t going to hire a proxy advisor or put a lot of time into analyzing the proxy. Last year, the Council of Institutional Investors issued a brief paper, Top 10 Red Flags to Watch for When Casting an Advisory Vote on Executive Pay aimed at addressing this issue. “Many investors, however, lack the time and resources to do deep dives on compensation at each of the hundreds of companies in their portfolios. They need rules of thumb to identify executive pay programs that are ticking time bombs.” That statement might even ring truer for retail investors holding a dozen or fewer companies. Again, even CII’s “top 10” are too extensive to list here because many items are broken into multiple items. Here are the top 10 with much of that elaboration stripped away:

1. Do top executives have paltry holdings in the company’s common stock and can they sell most of their company stock before they leave?
2. Does the company lack provisions for recapturing unearned bonus and incentive payments to senior executives?
3. Is only a small portion of the CEO’s pay performance-based or is the basis a single metric?
4. Are executive perks excessive or unrelated to legitimate business purposes?
5. Is there a wide pay chasm between the CEO and those just below?
6. Stock options should be indexed to a peer group or should have an exercise price higher than the market price of common stock on the grant date.
7. Did the CEO get a bonus even though the company’s performance was below that of peers?
8. Does the company guarantee severance or change-in-control payments not in the best interest of shareowners?
9. Does the disclosure fail to explain how the overall pay program ties compensation to strategic goals and the creation of long term shareowner value?
10. Does the firm advising the compensation committee earn much more from services provided to the company’s management than from work done for the committee?

Key to the the usefulness of CII’s advice is how easily answers can be obtained by individual retail shareowners. A second major concern is even if all this advice is followed, how will we ratchet down the Lake Woebegone effect and decrease the growing disparity between the rich and the rest of us? That seems important if we are to move from a culture of narcism, where many of the rich feel entitled to break the law and treat underlings with disrespect.

Members of the United States Proxy Exchange will soon begin working on a paper to address the issue of CEO pay. I think it is likely to revolve around the issue of what pay packages to vote down. Most retail shareowners don’t subscribe to ISS, Glass Lewis or other services that can rapidly assess pay packages. We need simple metrics so that we can gather all the information we need to vote in just a few minutes. Three possible examples:

• Pay that is over 100 times average pay.
• Pay that takes more than 5% of a company’s net profit.
• Majority of those disclosing votes in advance on ProxyDemocracy.org recommend against.

For less than $4 a month, your voice can be heard by joining in this important effort.