The contrast is jarring. As thousands of Americans lose their jobs, headlines are focused on excessive executive compensation and lavish perks — John Thain’s $1.2 million redo of his executive suite at Merrill Lynch (since repaid), Citigroup’s plan to buy a new corporate jet (since scrapped), and recent subpoenas to claw back bonuses handed out at Merrill Lynch.
“It is shameful,” President Obama said last week in reaction to a report that New York financial executives took in $18.4 billion in bonuses while the banking system was receiving billions in a taxpayer-funded bailout. The people on Wall Street “who are asking for help [need] to show some restraint, discipline and … sense of responsibility,” Obama stated. Separately, vice president Joseph Biden offered his take: “I’d like to throw these guys in the brig.”
No one has been locked up, but on February 4, the president announced a set of executive compensation limits aimed mainly at firms that are the recipients of federal aid under the Troubled Asset Relief Program (TARP). The rules place a $500,000 cap on salaries. Any additional compensation will have to be in the form of restricted stock grants that will not vest until after taxpayers are repaid. In addition, all banks must accept new limits on golden parachutes, requirements that shareholders be able to review and vote on compensation packages (the vote would be non-binding), and tougher disclosure rules for spending on travel, office renovations and entertainment.
The new rules will not be applied retroactively to companies that have already received TARP funds. Such firms must show that they complied with existing rules and agree to strict oversight.
Wharton faculty aren’t surprised that the harsh economic climate and resurgent role of government in business has turned a spotlight on compensation. Whether the bonuses are justified or not, they say, executives cannot afford to remain tone-deaf about the appearance of large pay packages and perks at a time when taxpayers are being asked to finance banks and corporations while their own savings shrink and their jobs are at risk.
Before the new rules were announced, Wharton accounting professor Wayne Guay, who has done research on executive compensation, saidit is likely that the government, under the leadership of President Obama and a Democratic-controlled Congress, will attempt to limit executive pay. “It feels like something the public wants.”
According to Guay, government programs that awarded billions in emergency financing to firms make the public and Washington feel entitled to attach strings, including limits on executive compensation. Even before President Obama laid out the new rules this week, TARP recipients faced limits on compensation, including prohibitions against pay based on excessive risk, clawbacks for compensation paid based on inaccurate earnings or other measures, a ban on golden parachutes, and capping tax deductions for executive compensation at $500,000. Treasury Secretary Timothy Geithner had said he would consider extending some of the TARP provisions, including the $500,000 deduction cap, to all U.S. companies.
Guay said furthercurbs on compensation might be justified if proponents can prove that high pay packages contributed to the current economic crisis. Given the global nature of the economic meltdown, however, he suggested that the cause of the collapse was not supersized U.S. executive compensation. “We don’t have a massive corporate governance breakdown in terms of … executive compensation.” At the same time, “there are a lot of public relations issues floating around. Many companies have come forward needing assistance, and they can’t afford to be giving the public a feeling that they’re being excessive in any way, shape or form.”
Wharton finance professor Franklin Allen sees little need to pay financial executives rich bonuses at a time when the industry is shedding thousands of jobs. “Obama has roundly criticized the high bonuses in Wall Street firms. I think this will play for some time to come,” Allen noted. “It is ridiculous that these firms should take hundreds of billions of dollars from the government and at the same time pay out $18 billion in bonuses.”
Wharton management professor Peter Cappelli cited a number of explanations for the apparent disconnect between what executives seem to feel they deserve and how the public perceives their pay.
During the past decade, for example, CEO compensation has been going up at twice the rate of overall pay. As a result, CEOs and other top executives see these historically high rates as the new normal. When the economic environment is good, it is easy to pass along pay increases. When the tide reverses, however, it is painful to go back, and executives resist any push to return to prior levels.
Another reason executives are perceived by the public as out of step with reality is that they base their own expectations about compensation selectively, suggested Cappelli. Executives look at what other senior managers are making and choose to see only those who are paid higher. As each package is negotiated, pay across the corporate landscape inflates even more. “It’s easy to choose self-serving comparisons, and then it is off to the races with what is essentially bad governance.”
Wharton accounting professor Christopher Armstrong has explored executive decision making and compensation through his research into stock option backdating. The results show that executives who participated in backdating did not make much money off the scheme — certainly not enough to balance the risk of getting caught. “The costs of being detected were high given the relatively small benefit,” said Armstrong. Considering that these executives were “already so wealthy, it’s hard to see an economic story for why they did it. Maybe they underestimated the probability of getting caught, or they thought everyone else was doing it and they were entitled.”
In a research paper on the backdating research — titled “Discussion of ‘The Impact of the options backdating scandal on shareholders’ and ‘Taxes and the backdating of stock option exercise dates'” — Armstrong and his co-authors point to another behavioral aspect that may play a part in demands for over-the-top compensation: “It is also likely that some executives exhibit personal characteristics that explain the practice of backdating,” the paper states. “For example, as a result of their success and attainment of a powerful position, executives may view the benefits from backdating as some type of personal entitlement i.e., ‘the rules do not apply to powerful people.'”
Wharton finance professor Alex Edmans, who has done his own research in this area, suggested that, despite some notable outliers, executive compensation on the whole correlates to results. He argues that a CEO who is even slightly better than a competitor is probably worth additional pay. For example, at a $20 billion company, a half-percent improvement in results would translate into $100 million, he said. “Being slightly better can have a huge effect on firm value. It’s really worth paying top dollar for the most talented managers.”
The public accepts outsized salaries in sports and entertainment; why not business, he asks. “You do have a few examples of egregious compensation, such as Thain and [executives at] Enron, but … increased regulation may throw the baby out with the bath water.”
Limiting compensation could drive the best chief executives to foreign firms or into private finance without as much government oversight, he said. Or limits on financial rewards may discourage the risk-taking and innovation that has created great companies such as Google and Microsoft. “Overall, the problem with government regulation is that it may try to target one problem, but doesn’t realize all the knock-off effects.”
Regardless of the consequences, Guay predicted that corporations will begin to respond to public pressure on compensation. Many companies, including Occidental Petroleum and Intel, have started to offer shareholders “Say on Pay” proposals which disclose the pay packages of top executives and ask shareholders to take a nonbinding vote on the proposal at the company’s annual meeting. “It’s a way to get the pulse of shareholders on various aspects of compensation,” says Guay. “We’ll probably see more companies doing that as part of the public relations change that is going on.”
Too Much Government vs. Too Little
Edmans opposes the idea of full regulation of executive compensation, but said some change is clearly needed. “We have to do something. I think we should have greater disclosure of compensation so shareholders have sufficient incentives to make sure CEOs don’t get overpaid if they do a poor job.” Indeed, shareholders, not government, should be making the decisions based on an incentive structure designed to benefit them, said Edmans, adding that in recent years, there have been trends toward more explicit disclosure of compensation — including stock options, pension packages and perks. “These are all positive moves. Rather than the government itself getting involved, we should make [sure] there is enough information that shareholders can have their say.”
Edmans worries that if government places harsh restrictions on compensation at companies receiving bailouts, the best managers will steer clear of those firms. If that happens, he said, the odds that taxpayers’ investment in the companies will pay off in renewed growth will be diminished. Indeed, he noted, there are only a few, highly talented managers who are good at managing the kind of turnarounds now required in many troubled industries.
The problem with applying government regulation to compensation across the board is that different companies require different incentives, depending on their own situation. The CEO of a stable company in a mature industry might require one set of incentives, while a private equity turnaround specialist might respond better to a completely different compensation structure. “When government tries to solve a problem with regulation, it’s always one-size-fits all,” according to Edmans.
Even if the government attempts to add flexibility to its regulatory framework, that creates another set of problems, Edmans believes. Flexibility leads to blurry interpretations. Sensing an opening, companies will devote excessive amounts of legal and other resources to circumventing the rules, at the expense of shareholders and the overall corporation. “The bottom line lies with the shareholders. Government should only intervene when shareholders don’t have the correct incentives.”
For example, government should step in to regulate pollution because shareholders do not directly bear the consequences of pollution, Edmans argues. “I think much of the stimulus may be political rather than rational. If there is a problem, government needs to be seen to be doing something, and that can lead to doing too much.”
Watching out for Widows and Orphans
Cappelli, too, suggested that the key to determining appropriate levels of compensation lies in the incentive structure. In the 1990s, corporate government campaigns did attempt to align compensation with shareholders’ interests by linking pay to performance with stock options and other pay based on results, including share price. “The executives were to act like shareholders and they are. The question is, which shareholders? They act much more like short-term shareholders than the widows and orphans holding the stock for 30 years.”
He said U.S. corporate incentive structures are overly focused on quarterly results. “Compared to the rest of the world, U.S. companies are obsessed ….They are willing to twist themselves into knots to manage short-term performance. So it’s not as simple as just saying we should get them to act like shareholders.”
According to Cappelli, the larger question is whether shareholders are indeed the only group that matters in executive compensation incentives. He said the old, pre-1980s view of the corporation as an organization designed to serve shareholders, but also customers, employees and the larger society, was replaced with the current view that companies are based on “free agency.” The current financial collapse may signal flaws in the new order, but no replacement model has emerged. Until then, Cappelli predicts, little will change.
Indeed, he added, the current crisis will probably serve as an excuse for corporations to reach new levels of disregard for any unwritten social contract between management and workers as they jettison employees. “In the last round of layoffs in 2001, there was still some concern about severance pay and outplacement,” he said. “We’re seeing less of that now. If anything changes, it will have to come from the political side.”