Monday, January 29, 2007

My Dear Old Mammon

I stumbled across this posting on footnoted.org about Edward Carr's series of articles on executive pay in The Economist and became intrigued enough to go to the source (and the source's source).

Like fn.org, I also found Mr. Carr's justification of high pay as some sort of emotional salve to encourage risk-taking by executives rather dubious. First of all, senior executive positions (especially that of CEO) carry all sorts of non-pecuniary rewards that in my experience carry at least as much weight as greenbacks. These include fancy titles, corporate jets, personal tax planners, and curvaceous journalists breathlessly hanging on your every word. (Well, perhaps the last only if you're Jack Welch or Todd Thomson.)

Secondly, I think the evidence we have seen of backdated option grants, "pay for pulse," and incentive hurdles set low enough for your average turtle to clear with ease argues rather strenuously that most executive compensation schemes have been anything but geared towards risk-taking behavior. Perhaps in private equity land Mr. Carr's formulation holds, but at least there the penalty for underperformance is summary firing and forfeiture of most of your incentive comp. In public corporation land, it is usually cause for immediate vesting of shares, options, and pension plans and a free one-way ride on the corporate jet to Boca.

Apparently without noticing, Mr. Carr does touch on the central issue underlying the public debate on executive pay. He writes:
Between 1993 and 2003 the total pay of the top five executives in the Standard & Poor's 1,500, which accounts for roughly 80% of listed American companies by value, amounted to some $350 billion, according to Lucian Bebchuk and Yaniv Grinstein, of Harvard and Cornell Universities. The share of earnings consumed by those people's pay rose from 5.2% in the first five years of that period to 8.1% in the second five. And this is without counting the value of pensions, which can boost the total by as much as a third.

Looking to the original article by Bebchuk and Grinstein, the time series is even more dramatic: the top five executives' share of corporate earnings jumped from 5.0% in the 1993-1995 period to 9.8% in the 2001-2003 span. I don't know about you, Dear Reader, but my immediate reaction to that little statistic is "Who ordered that?"

Who decided that senior executives' share of the earnings pie should double over the last decade? The last time I checked, the quality and efficacy of CEOs and their ilk has not changed much since 1993, so I doubt they have gotten twice as effective at growing earnings. You could say their pay has gone up so much because the market value of their companies grew so much (the S&P 500 rose 109% over the period), but that implies we should pay them not only for building company earnings—which are at least nominally under their control—but also for general multiple inflation in the equity market.

Mr. Carr as much as implies that:

The lion's share of the executives' bonanza was deserved—in the sense that shareholders got value for the money they handed over. Those sums on the whole bought and motivated the talent that managed businesses during the recent golden age of productivity growth and profits. Many managers have done extremely well over the past few years; but so, too, have most shareholders.

Call me a skeptic, but managing a company in a "golden age of productivity growth" with the equity market wind at your back sounds like a pretty cushy ticket. Furthermore, correlation does not prove causation. The point is not that shareholders have not benefited from the rising tide that has floated all boats, but that we seem to have been paying the captain and crew extra just because the tide came in.

You could say, as some have, that senior executives' shares of corporate earnings were too low at the beginning of the 1990s, and they should be paid with more equity to align their personal financial interests more with those of the shareholders. (This was a popular argument last century among what we used to call "Old Economy" CEOs, as they watched jeans- and sneaker-clad dot.com arrivistes buy basketball teams and leapfrog the waiting lists at their country clubs.) This argument collapses in the face of evidence that Boards of Directors just piled this new equity on top of existing cash compensation and kept increasing the cash anyway. Plus you have the little issue of option backdating, reloading, repricing, etc., which took all the downside (or at least "non-upside") risk out of the equity comp equation.

Look, the issue is pretty clear: fairness. People are not upset about Robert Nardelli's $210 million goodbye kiss from Home Depot because he failed to raise earnings. In fact, he did a pretty good job at that. What steams Joe Shareholder is that he sashayed away with wheelbarrows full of cash while creating—adjusting for inflation and the price of corn—exactly bupkus in the way of shareholder value. I mean, why should we pay this knucklehead 200 million bucks when HD shares flatlined while he was driving the bus?

Americans aren't dumb. We get it. In fact, most of us are more than happy to create gazillionaires out of sharp, aggressive leaders who can create wealth and jobs for the rest of us. They just have to deliver on their side of the bargain.

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