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Dec
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Written by:
admin
12/1/2007
 An outstanding pay riseIn a 2007 special report The Economist had analysed the phenomenon of the ever increasing pay of CEOs in the top 50 companies of the S&P 500. This summary intends to give the main findings for our readers and spare them the long reading.
Two examples above all: Robert Nardelli received $210M when he lost his job at Home Depot. Carly Fiorina, HP, received $180M at the end of her mandate. None of them performed extremely well to justify that money; on the opposite, the shares of their respective managed companies performed poorly during their reign.
Despite arguable performance the trend for CEOs is to increase their pay at fast rate. In the 70’s the ratio of the CEO pay relative to the average worker in the US was “just” above 20 times; it is now above 160 times. Everybody agrees that’s too much, especially amid a social context where workers are afraid of losing their job and seeing their pay erode and even fail to keep up with inflation.
The historical perspectiveReasons like the (arguable) share performance and the relative weakness of boards or collusions between CEOs and boards (the “poor governance” category) cannot explain it all.
The main driver is the widespread use and abuse of share options, encouraged by aggressive accounting practices coupled with favourable tax policies.
Up to the 80s CEO were rewarded for size: their pay was directly proportional to the size of assets they were controlling. But that lead to waste inefficiency, with lots of money wasted on pet projects or personal wishes; shares were less attractive and shareholders instead of trying to change the reward strategy were selling and moving on to other companies. The management buy-out of RJR Nabisco by Kohlberg Kravis Roberts (KKR) changed that paradigm towards efficiency and profits. The ones who benefit from this shift were shareholders who saw a lot of money returned to them. As a result the share options made the CEOs rich. Options are still seen as the main tool to keep the CEOs interests aligned with shareholders' ones.
Shareholder value?The concept of “shareholder value” put pressure on CEOs who finally had to show a set of wider skills thus increasing competition among candidates for the job. Boards started to turnover top executives at faster rate. Experience, track record and even general business education (MBA) started to count. Being at the top meant a lot more risk than in the past, therefore more reward was needed.
Competing for "talent"
An important push was given by the dotcom bull market: many talents were lured away with extreme packages to start their own business and top companies were afraid of losing their executives, as happened to Andersen Consulting.
Another reason is the recruiting policy: typically a sudden departure of a CEO or his/her dismissal by the board happens without immediate or prepared successor. A headhunter is appointed, with the mandate of being very discreet to avoid rumours internally or at the poached companies. The rose of candidates is small, as the tendency is to look at maximum 1-2 internal candidates (and that’s rare anyway) and at the exclusive clubs of existing CEOs. The potential new CEO is taking a larger risk that staying where he/she currently is and can demand a premium and more. It is a long process and pressure is on the board side to act swiftly.
Imperfect share optionsOver reliance on share options has its drawbacks, not last because it encourages short-termism and the manipulation of accounts. Highly valued companies (high P/E ratio) are such because investors believe they will increase profit in the future. It is a dangerous position for a CEO to be in because expectations are high. Pay and job are simultaneously at stake and there are strong incentives to manoeuvring investments and financial results.
What cure?Public disclosure of pay packages is getting widespread in the attempt of putting a moral brake on such trends, at least for abuse cases like the one of Lee Raymond, CEO of Exxon, who got a 400 M$ package at his departure. Whether this will influence significantly executive pay remains to be seen.
Other schemes that further tie grant of options with other performance indicators are being studied, but they do not appear attractive enough for executives who perceive them as an attempt to dump all the risks on them, even those they cannot control (e.g. inflation or oil price). Acceptance for those constraints may even increase the final pay instead of reducing it.
Some large companies, such as Intel and Pfizer, are now explicitly voting for executive pay packages, thus encouraging transparency and probably contributing to trim excesses. These examples may be followed by others.
It is crucial to make progress in this matter as the essence of capitalist and business is at stake.
It's the market, stupidThe conclusion of The Economist is that this trend cannot be explained by poor governance alone. Instead it is due to market forces. The global competition has complicated matters and research for talent is getting increasingly difficult.
US leads the way, but in many other parts of the world, including China, share options are increasingly being used and CEOs around the world are quickly catching up. After all, US companies have been overall and consistently successful also due to the strategic scheme of excessively rewarding top executives. That formula is certainly being followed elsewhere if costs are worth the benefits.
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franco@financialconsultantsguide.com
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