Our nation has come a long way since FDR challenged the "entrenched greed" of American corporations during the Depression. Since 1970, it has become de rigueur to view CEOs as captains of industry who are solely responsible for a company's success, and who therefore must be compensated accordingly if we are to keep the good times rolling. Reflecting the explosive growth of CEO compensation, a Harvard study found that from 1970-2005, median annual executive compensation rose nearly 600%, from $850,000 to $4.6 million. In contrast, according to the US Bureau of Economic Analysis, over the last five years American workers' share of GDP has fallen 2.5%.
This post explains how we got here, and where we seem headed.
How We Got Here
The growth of executive compensation has been fueled by an array of devices that were originally intended to rein it in, including deferred compensation, signing bonuses and golden parachutes. Most recently, companies relied heavily on conferring mass quantities of stock options, which supposedly aligned executives' interests with those of the shareholders and would avoid the excesses of salary based devices. As recounted in a recent Wall Street Journal article, the move towards options was triggered in part by CalPERS, which in 1990, published a "target list' of overpaid executives. At the top of the list was Rand Araskog, the CEO of ITT Corp., whose compensation the year before had risen 82% despite an 18% decline in the company's stock price. In response to the urging of a shareholder activist group, United Shareholders, Araskog agreed to adopt a stock option plan to supplement compensation, while scaling back salary increases.
Conceptually, this was a reasonable fix, and was extremely popular because options, unlike salary-based compensation, were originally not treated as expenses for financial statement purposes. But soon options became a new source of excess as "executive compensation consultants" developed more esoteric ways of ballooning the value of these options. Companies started "grossing up" options by paying any taxes due on their exercise; "reloading" exercised options by automatically replacing them; and even "spring loading" them by granting them just before good news was announced, thus keeping the exercise price low.
But for some, all that wasn't enough. They sought to maximize the potential profits on their options by backdating them to an earlier date when the company's share price was lower and, therefore, the exercise price would also be lower. As a result, when the options were actually issued they were already "in the money." In many instances, these practices were authorized by Board members.
Then, towards the end of the 1990's, some companies adopted performance incentive plans that enabled executives to reap enormous benefits so long as price or earnings targets were met. Examples included the $1 billion reward held out to executives at Computer Associates, as well as significant sums for Dennis Koslowski at Tyco. The lure of such sums was so great that some executives gave in to temptation and fraudulently inflated results to meet the targets.
The most recent excesses have been the pension benefits that remain undisclosed until the actual departure of the executive (and are payable regardless of the circumstances of the departure). For example, by the time of his termination after a five year tenure as CEO of Pfizer, Henry McKinnell had accumulated $83 million in pension benefits even though during his tenure, Pfizer stock fell 37%; a court recently found that Richard Grasso, former head of the New York Stock Exchange, had failed to disclose the value of his pension benefits to the NYSE directors.
Evasion of Reform Efforts
Regulatory efforts to curb such excesses have been stymied, with perhaps the sole exception being Sarbanes Oxley. Prior to that statute, Congress sought to use its taxing powers. First it required that any salary in excess of $1 million not be deductible for corporate tax purposes. Then it sought to tax any additional benefits in excess of 3 times the salary base. But, as SEC Chairman Christopher Cox recently testified, the effort to tax excess salaries and benefits "deserves pride of place in the Museum of Unintended Consequences" since, as a WSJ editorial noted, "it simply diverted compensation into other tax advantaged modes--such as stock.”
In fact, companies did shift more compensation to options, and ensured that any grants not “in the money” could be treated as an expense for corporate tax purposes (thereby lowering taxes) but excluded for financial reporting purposes (thereby raising profits). Finally, after a great struggle, companies have now been required to report all options as expenses.
More recently the SEC has imposed new rules for far more detailed compensation disclosure. But this assumes that CEOs and compensation committees can be embarrassed, by having to disclose the full panoply of the CEOs' compensation arrangements, into acting more reasonably. This may be wishful thinking. In fact, more disclosure may have had the reverse effect. Highlighting the amounts paid to some executives (e.g., $230 million to Sandy Weill in 1997; $575 million to Michael Eisner in 1998) may have simply added fuel to the fire by stoking the competitive desires of other CEOs to keep up with the Weills and the Eisners.
The Underlying Causes for the Abuses
There are several possible explanations for exploding executive compensation besides "greed." As a WSJ editorial on October 12, 2006 gratuitously suggested, one causal agent could be the very efforts to rein in such practices. But other factors probably played a much stronger hand. One was the increasing utilization of executive compensation "consultants" such as Frederic W. Cook & Co. and others. In the guise of providing objective data and advice on appropriate compensation, such consultants effectively gave their clients what they wanted, i.e., "expertized" justification for significant raises. As Warren Buffett (who himself has railed unsuccessfully against compensation practices) has decried, such consultants should be labeled "Ratchet, Ratchet and Bingo."
Compensation committees were originally formed to independently review salaries. However, these committees more often have been populated with executives from other companies, who were themselves unlikely to adopt restraints that could be used as precedents against them in setting their own compensation.
Finally, while the courts have played a constructive role in protecting corporations from abusive takeover tactics, they have given extremely wide deference to board decisions concerning compensation, as reflected in the decisions in cases that challenged the windfalls paid to Eisner and then Ovitz.
Future Remedial Efforts
It is likely that the backdating scandal will trigger more disclosure and closer scrutiny of compensation. It remains to be seen whether this will reduce, or at least curb, the excessive practices. However, shareholders are not entirely powerless. For example, books and records proceedings can be used to examine the process by which packages were created.
Alternatively, a push could be made to enact legislation or regulatory changes (through the exchanges) that would require more independence of the Compensation Committees. This could be achieved by compelling the inclusion of a state pension fund member on such committees, or alternatively, a workers representative. The SEC could facilitate such reforms by empowering shareholders to have larger roles in the election of directors through the new "proxy access" rules that should be announced soon. A lot may depend on the upcoming elections. If the Democrats take the House, the new Finance Committee Chairman would be Barney Frank, who may be more supportive of activist proposals.
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