Executive Compensation & Corporate Governance - 2-Nov-2008 - The Long Run Blog Critical Thinking on Money, Finance, and Economics

http://thelongrunblog.wordpress.com/2008/11/02/executive-compensation-corporate-governance/

We
hear a lot of rhetoric about executive compensation, the majority of it
is critical of CEO pay. Yet CEO pay continues to climb and little seems
to be done about it. Is exec pay out of control and if so, why has it
not been curtailed?

The issue is complicated, so lets begin with some background. In
any publicly traded company, like IBM or Wells Fargo, a Board of
Directors is elected by the shareholders. A Board is tasked with
governing the company on behalf of the owners or shareholders. This
duty includes hiring managers (CEO) to actually manage the company’s
operations and strategic direction. Part of hiring management and
officers is to determine their pay.

Running a large Fortune 500 company successfully is no easy task. It
is a 24×7 job requiring not only the ability to manage and lead, but
also demands strategic vision. This is the big leagues- just because
your were first string in college, doesn’t mean you even get to try out
for the pros. And much like pro ball, some excel in the big leagues and
some don’t. There are few pros and even fewer that excel at their task.
Just like professional athletes get paid a lot and don’t always win, so
do CEOs. They won’t always be right and they don’t always win, but they
do play hard despite their scarcity.

It bears mentioning that many of the compensation amounts you see in
headlines are not necessarily disclosed in context. For example, you
may hear “XYZ CEO received total compensation of $120 million in 2007″.
What you typically do not hear that their salary was a few million and
the rest was “bonus”. Not feeling better yet? “Bonus” in the world of
CEO pay is not the same as your $1,000 Christmas bonus. This figurative
term refers to incentive pay that may have been accumulating for a
decade and just now “vested” or became available to the CEO. Typically
these incentive packages are in the form of company stock and subject
to meeting certain company objectives like sales and profit targets. In
other words, that pay may be the end result from many years on the job
and having that bonus ride on the company stock. Not only is that pay
at risk, but it aligns the CEO’s interests with the shareholders-
making the company successful and resulting in a rising stock.

Having discussed CEO pay in a favorable light so far, do not think
for a moment that all is right with this scheme either. Too often pay
is not tied to the right variables. A board may neglect to put
conditions on the targets such as sales growing faster than inflation
or competitors. When this happens, the bar is being set too low. Or
CEO’s can receive golden parachutes which put them at odds with
shareholders. In these cases, which are widespread, one must blame the
Board.

If you went to your boss and said “you need me, give me a $200,000
raise or I quit”, you would expect to be out of a job. But if your boss
said “you have a point, we’re giving you $150,000 and another $50k that
doesn’t vest for 5 years”, you would take it and convince yourself you
deserved it right? I can’t blame anyone for trying to get as much as
the market will bear. Yet we can blame the boards that give it to them.

So how do the boards justify such pay? Like A-Rod and Jeter, some
boards deem the pay worth it to the success of the company. Some boards
are successful in getting more for their pay dollar. And some boards
ought to be taken out behind the barn and, well you get the point.

Poorly performing boards exist for a variety of reasons, one being
the same reason bad presidents do- apathy and ignorance in the
[shareholder] voter population. Many of you own stocks, but have you
read the annual report and proxy? Did you vote your shares? Did you
check to see how the CEO was compensated and whether they were worth
it? Mutual funds are another problem- they vote on investor’s behalf
and must now make their votes public. Ever check to see how your mutual
fund voted? What would you do if you disagreed with one or some of
their votes?

Another reason is that corporate governance is not always set up to
be shareholder friendly. Board seats are often staggered, which means
you can only vote out a few at a time. Very often board member
candidates are chosen by the Chairman who sometimes happens to be the
CEO too, or by other board members. Getting an outsider on the board is
difficult. These are the practices most in need of reform, for the
other practices stem from an all too comfortable board. In my opinion,
more needs to be done in empowering the shareholders directly. Until
shareholders collectively say ‘no’ to CEO pay, CEO’s can demand and
largely get big pay.

I read a study recently that measured CEO pay relative to company
size in terms of sales, profits and market capitalization. Its
conclusion was that CEO’s today are compensated about the same as
several decades ago relative to the organizations they run. (For the
life of me, I can’t find the study anymore, sorry).

Finally, a comment about “Wall Street” compensation. All news
sources I have read recently muddy the water when discussing
“compensation”, Wall Street and the government’s actions. The main cost
in financial services is people. Most companies, take Catepillar for
example, must buy raw materials and transform them into their final
product. Labor costs are only a portion of their total expenses. In
financial services such as investment banking, market making, research
and trading- Wall Street’s main services- the biggest cost is
compensation to the troops. There is no “input” such as steel, wheat or
energy, only the brains providing service, some real estate and
technology (cost of capital is another, but it is primarily a balance
sheet item).

Over the decades, Wall Street has honed its compensation practice
which amounts to a very simly formula: about half of the revenue
generated by people is doled out to workers in the form of compensation
(that includes benefits, bonuses, payroll taxes, etc.) Naturally, some
of this is skewed toward management and the vast majority to
“productive” workers who generate that revenue and not HR, IT,
janitors, etc. Most of this comp is accrued throughout the year and
given in the year end bonus. Typically, a Wall St bonus might be
50-300% of a trader, banker or analyst’s salary. Given how rank and
file producers across the board are surely not responsible for the
entire mortgage related plight of Wall St, it is fair to reneg on their
compensation under the premise that “Wall St enabled this mess”? Surely
many in the mortgage securitization business are accountable, but not
the other hundreds of thousands who did no wrong?

Once again the issues are not highly transparent and finger pointing
is difficult. You can rest assured that comp practices are going to
change- not only is there downward pressue on comp levels, but the
revenue streams themselves are becoming harder to generate. Many in the
mortgage securitization businesses are either out of job or generating
only a fraction of past years’ revenue. Entire business on Wall St have
been destroyed along with the value of company stock- another important
compensation tool.