CorpGov and Exec Pay

GovernanceMetrics International recently sampled large corporations and found that CEO pay jumped 27% in 2010 to a median of $9 million.

According to William Lazonick, professor at the University of Massachusetts, in 2010 the S&P 500 jumped 12.8%, capping a two-year gain of 39.3%. Companies in the S&P 500 boosted profits by 47% in 2010, not from boosting sales of goods and services, which rose only 7%, but by cost-cutting and layoffs, says Lazonick. (CEO pay soars while workers’ pay stalls, USA Today 4/1/2011) ) Shareowners should question if that strategy is a sustainable or is simply a gimmick to juice short-term stock prices and CEO pay.

In the US, during the period 1993-2003, Bebchuk and Fried found that aggregated pay to the top five executives in their sample of large firms took 6.6% of all corporate net income. That jumped to 10% for the period 2001-2001. CEOs essentially grabbed an extra 3.4% of all net corporate profits.

Shareowners are right to be concerned and this year, thanks to the provisions of the Wall Street Reform and Consumer Protection Act (Dodd-Frank), they have their first chance to express their rage in the form of advisory votes on pay, the frequency of say on pay, and on golden parachutes. As I write this review at the beginning of May 2011, twelve companies have already had their proposed pay packages rejected by shareowners and many more are expected. (Failed Pay Vote Tally Reaches a Dozen, May 3, 2010)

In this atmosphere, Governance and Executive Compensation (part of the Corporate Governance in the New Global Economy series), edited by William Forbes, addresses timely issues surrounding the relationship between governance and executive compensation with an authoritative sample of some of the most important thinkers in the field.

Martin J. Conyon’s research finds that executives do tend to be paid in ways that reflect changes in shareowner wealth, since much of their increase is attributable to stock options. Contrary to popular opinion, more insider directors versus more independent directors does not lead to higher CEO pay.

In summary, high pay itself is not evidence of inefficient contracts but may simply reflect the market for CEOs and the pay necessary to a attract, retain, and motivate talented individuals.

Michael C. Jensen and Kevin J. Murphy conclude, “the critics have it wrong.” Excessive pay is not the issue. The real problem is how CEOs are paid.

The most powerful link between shareholder wealth and executive wealth is direct stock ownership by the CEO. Yet, CEO stock ownership for large public companies (measured as a percentage of total shares outstanding) was ten times greater in the 1930s than in the 1980s.

Why don’t directors do a better job of linking pay to performance? The authors blame, in part, disclosure requirements. Making high pay public is a source of embarrassment.

Picking up on such possible embarrassment and jealousy, Bebchuk and Fried uncover considerable evidence of attempts to “camouflage” executive pay. One of many problems they point to is the continuous escalation of executive pay, since most large companies set compensation at or above the fiftieth percentile of peer groups. Among their major recommendations are proxy access, eliminating staggered boards, and giving shareowners the power to initiate and adopt changes to the corporate charter.

Brian Hall and Kevin Murphy examine the difference to a company granting stock options and their value to the executives who receive them. Briefly, the options are typically worth more to the company than they are to the undiversified executive and while a 5-10 year vesting program “would seem appropriate,” the typical vesting period is three years.

This might be seen to induce a short-termist slash-and-burn psychology amongst executives, where research and development or employee training is seen as worth sacrificing if it makes quarterly earnings per share look healthier.

One remark by the editor is a relatively good guide to the book’s findings: “The basic relationship between executive pay and performance is so weak that we might seriously doubt the two things are related at all.”

The book is an excellent summary of pay issues. Some of the material is dated. However, even dated material can be very instructive, informing readers how cultures have been shaped by historical practices.

For example, there are several papers on options backdating. Jesse M. Fried shows that backdating persisted among perhaps 2,000 companies even after it became a blatant violation of Sarbanes Oxley. While secret option backdating is now unlikely, it is “simply one example of a long-standing practice of boards favoring managers… seeking to hide the amount and performance-insensitivity of the compensation from shareholders.” That, more fundamental, behavior is likely to continue, according to Fried, unless reforms are forthcoming to give shareowners more power.

Really tying pay to performance, as is the main goal of investors with regard to executive pay, is extremely difficult. There is just too much noise… too many variables. Public outrage will continue, especially if pay continues to rise as stock prices slump or if pay is tied more to laying off workers than to boosting sales and the growth of cash flow. Even in the best circumstances, where pay can be tied to performance, we can’t continue to pay an ever increasing proportion of net profits to executives, as if only their performance counts.

As a shareowner, I see little evidence that any of the current measures being utilized by large institutional investors address the “Lake Woebegone” effect where almost all CEOs are considered by their boards to be above average and pay continues to ratchet higher with each passing peer review by compensation consultants. While attention is certainly needed to link pay to performance, every CEO can’t continue to be paid above average or they will soon soak out too much of the potential profits of investors, many of whom depend on their relatively small investments (but large when combined)  for retirement. See Addressing CEO Pay.

One of the problems, as was pointed out by Robert A. G. Monks and Alexandra Reed Lajoux in their recent book, Corporate Valuation for Portfolio Investment, is that most fiduciaries are index investors or they trade on technical signals. Only about 20% of all investors examine intrinsic value. Until they do, and until they vote their proxies based on serious analysis of compensation policies, we are unlikely to see a strong link between executive pay and executie performance.

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