Do Shareholders Have the Clout to Rein in Excessive Executive Pay?

Warren Buffett’s latest attack on excessive executive compensation is another chapter in the long-running saga about how much to pay top business leaders, and how to limit the compensation of those who are deemed to be making too much.

 

Buffett, investment guru and chairman of Berkshire Hathaway, accused executives of greed in taking multi-million-dollar compensation packages that bear little or no relation to the performance of their companies and create a wide disparity with other employees in their organizations.

 

At Berkshire Hathaway’s shareholder meeting in early May, he urged investors to oppose the packages of the high earners in a bid to reverse the trend that continues despite periodic attempts by shareholders, institutional investors, politicians and others to impose self-control.

 

The executives in question, he said, are unlikely to restrain themselves. The issue is “not something where all the CEOs in America are all of a sudden going to wake up and read the Boy Scout oath and moderate their behavior,” he said in a recent article in the Financial Times. That follows his comments to shareholders earlier this year lambasting boards of directors for failing to tackle the issue of their executives’ pay.

 

Daring to question the CEO’s compensation level, he said, was “like belching at a dinner party.”

 

Alternative Routes to Avarice

The scale of 2002 compensation packages is familiar but its contrast with the dismal performance of many leading stocks last year is striking. The total compensation of CEO Scott McNealy of Sun Microsystems, for example, rose 31% to $31.7 million while his shareholders’ return plunged 74.7%, according to Equilar, an independent provider of compensation data.

 

Among executives at 100 of the largest companies that had filed proxy statements for 2002, the biggest earner last year was Steve Jobs of Apple Computer, who pulled in $78.1 million while his investors’ return slumped by 34.6%. At Honeywell, CEO David Cote made $68.5 million, about 80% of which was a sign-on bonus for taking over the top job in February 2002. Meanwhile, Honeywell shareholders saw the value of their investments slide by 27.3%.

 

While the S&P 500 plunged 22%, median CEO compensation rose 14% to $13.2 million last year although the average package dropped 23% to $15.7 million, mostly because of large declines for some of the biggest earners, the survey found.

 

The numbers provoke predictable outrage but it’s a lot harder for those advocating restraint to say how that would be achieved. Some argue that it’s neither feasible nor necessary for companies to impose an upper limit.

 

“Capping pay is not an option,” says Wharton management professor Martin Conyon. “It won’t work. If the objective is to circumvent avarice then those so inclined will simply find alternative routes to achieve their goals.”

 

That happened in 1993 when Congress prohibited tax deductions on salaries of more than $1 million. Companies reacted by paying their executives’ salaries up to the limit and increasing their compensation through other means such as stock options.

 

“But what is worse is that pay caps will make the job of recruiting and incentivizing talent very difficult,” Conyon adds. “If an individual really is worth an amount greater than the cap, what does a responsible board do?”

 

In a free market, one company’s decision to cap top salaries will just drive executives to the highest bidder, says Richard Lambert, professor of accounting at Wharton. “If there’s a market for their services out there, and the others are willing to pay more, that’s where the executives will go.”

 

If the level of executive compensation is put in the context of overall company finances, it seems less of a problem, adds Lambert. Compared with the value of most public companies, the amount of money being given to executives is not that large. “Even if you cut the CEO’s salary in half, the effect on shareholder wealth would be very small.”

 

But an executive’s package can affect corporate performance when it alienates lower-paid sections of the workforce, Lambert says. “The level gets to be an issue in terms of what’s fair, especially if the unions have to take pay cuts.”

 

Any solution needs to come from business and not from government, Lambert suggests, because of the likelihood that legislators are not close enough to the issues to write effective laws. “Government involvement is always dangerous because policy tends to be made by people who are not the most expert.”

 

Executive compensation is one of the issues that will be addressed at a June 4, 2003 Wharton Leadership Conference called “Leading with Integrity.” The conference is sponsored by the Wharton Center for Human Resources and the Center for Leadership and Change Management.

 

Golden Parachutes and Stock Options

Shareholders, either groups of individuals or institutions that hold significant blocks of stock, are key to tackling the problem because of their ownership positions, analysts say. Many more shareholders are expressing their unhappiness with the issue through resolutions at annual meetings. According to the Investor Responsibility Research Center, an organization that researches corporate governance issues, 325 resolutions relating to executive pay at U.S. public companies had been filed by May 9 this year compared with 106 for the whole of last year’s “proxy season.”

 

The resolutions contain a range of demands, including that shareholders should have a say in the setting of executive compensation; that they should be able to vote on the so-called golden parachutes given to executives when they are dismissed, and that they can express their views on the award of stock options as part of a compensation package.

 

Executive pay is the “overwhelming focus” of shareholder resolutions this year, accounting for 44% of those received at the beginning of the proxy season in February this year, the IRRC reports on its website.

 

“Shareholders have had enough,” says Michele Soule, director of marketing for the organization. “They are looking at these outrageous numbers and they are used to management turning a deaf ear to their concerns.” The trouble is that shareholder resolutions are legally non-binding and so management has no obligation to act on them. “Even if they win the vote, management doesn’t have to do a darn thing about it.”

 

But there are signs that management is beginning to yield to grassroots pressure. The most prominent recent example was the resignation of American Airlines CEO Don Carty after failing to disclose that senior management would receive significant raises at the same time as most of the workforce was scheduled to accept $1.8 billion in wage concessions in a bid to fend off bankruptcy. Carty’s public apology for the non-disclosure wasn’t enough to quell the anger of the rank and file – or to save his job.

 

At Apple Computer, management agreed to a shareholder resolution to count stock options as expenses at the time they are granted. And at the aluminum manufacturer Alcoa, 64.7% of shareholders voted in favor of a resolution by the AFL-CIO trade union to cap executive severance packages at 2.99 times salary, according to IRRC data.

 

From CEO Domination to CEO Accountability

In an effort to deflect criticism, boards are likely to create stronger links between pay and performance, according to Pearl Meyers & Partners, a New York-based executive pay consultant. In the future, more executives will be rewarded with equity and cash based on long-term financial results and stock performance rather than short-term stock movement.

 

The use of options as compensation will be reduced, Pearl Meyers said in its 2003 report based on a survey of the 200 biggest U.S. companies. And any options are more likely to include a required holding period to encourage long-term ownership.

 

At the same time, companies will increase their use of restricted stock awards to ensure that executives are actual stakeholders in the company rather than just optionees. Ideally, these stock grants will be linked to performance rather than just giveaways.

 

In an effort to regain investor confidence, there will be more demand for board oversight of top management, with a resulting increase in the responsibilities, time commitments and remuneration for the board members themselves. “The board relationship will evolve from one of CEO domination to CEO accountability,” the report said.

 

Ironically, the boards’ effort to moderate their executives’ packages will result in a rise in their own. Directors’ pay is likely to increase by 20% this year, and could double within five years, Pearl Meyers predicted.

 

Companies will be more sensitive to charges that executives are receiving lavish perks such as cars or travel that are not business-related, and so will require evidence that such benefits have a genuine business rationale, the report said.

 

At the institutional level, shareholders are also looking for ways to control executive compensation. Members of the Council of Institutional Investors, an organization representing more than 130 pension funds with total assets of around $2 trillion, are seeking a change in corporate governance rules that would allow shareholders to nominate directors. “Our members find shareholder resolutions can be a very effective way of pushing for reform,” says Ann Yerger, deputy director of CII.

 

Such a change, giving shareholders direct influence over the groups that set executive compensation, would address one of the most important causes of the problem: that compensation committees are often composed of similarly well-rewarded executives who fear their own packages will suffer when it comes to review time if they don’t vote for a big increase.

 

“As long as a significant number of a corporation’s board members are made up of individuals who are also CEOs of other corporations, the abuse of shareholder trust will not end,” David Richards, CEO of the Porter Company, an Austin, Texas-based mechanical contractor, recently wrote in The Wall Street Journal.

 

“If I sit on your board and I vote to end millions of dollars in your prearranged severance package and other forms of legal graft, then you might vote to do the same on the boards you serve on,” Richards wrote. “Shortly, my board would probably be re-examining my compensation package.”

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