EXECUTIVE PAY POLITICS
Read three typical scenarios about executive compensation.
How justifiable, fair, & equitable are those outcomes? What
are some legitimate criteria for basing your judgments?
A. Medical diagnostic firm captured another 10% of its market &
stock price rose +25%. Its Board gave CEO $1.5 million bonus
plus options to buy 200,000 shares; vice presidents got similar
compensation. Each employee received $800 bonus.
B. Airline company lost 20% of passengers after Sept 11th, share
price plummeted by two-thirds. It laid off 2,000 workers but,
thanks to $15B federal aid voted by Congress, top executives
still took home their 10% bonuses voted by its Board last year.
C. Widget manufacturing firm closed one plant, laying off 300
workers. Executives agreed to take a 10% salary cut and no
bonuses while they try to restructure company operations.
Distributive Justice Principles
Distributive justice theory offers several alternative norms for
allocating goods (wealth) in limited supply relative to demand
All except the first principle involve some correlation
between work performance and rewards:
Strict Egalitarianism: Everyone should be rewarded
identically regardless of their work effort
Contribution: People should be rewarded according to the
value of their work contribution to the social product
Effort: People should be rewarded according to the
amount of effort they expend on their work activity
Compensation: People should be rewarded according to
the costs they incur in their work activity
WHICH PRINCIPLES SHOULD APPLY TO EXEC PAY?
A Widening Gap
Business Week reported diverging ratio of CEO compensation
to average worker pay, sharply increasing during the 1990s:
U.S. vs the World
Executive pay levels in Europe and Japan are lower than in U.S.
Average CEO Pay for
Medium-Sized Firms
(revenues of $250-500 million)
United States
$1,072,400
CEO-worker pay ratios in 1999:
U.S.
34:1
Britain
24:1
France
15:1
Britain
$645,540
France
$520,389
Germany
13:1
Canada
$498,118
Japan
11:1
Average
$480,037
Netherlands
$449,889
Australia
$431,890
Japan
$420,855
Germany
$398,430
Source: Towers Perrin, Worldwide Total
Rewards 1998 (April 1998) p.21
“It’s the European mentality. The
enrichment of the individual on the
backs of the workers is considered
exploitation.”
- Director of German shareholder
protection association (1998)
Are CEOs Underpaid for What They Do?
CEOs deserve huge rewards for undertaking high-risk
tasks where they can’t control macroeconomic conditions
shaping their company’s growth, profits, stock prices
Salary.com, a compensation advisory firm, argues that
corporate executives are worth every penny and more:
• CEO job requires extreme skills and responsibilities
• Limited number of people who can fill this role
• 80% of CEO compensation tied to firm performance
• CEO pay level signals of how well the company is doing
• Yardstick for all other employee benefits and bonuses
Winner-Take-All Contests
Under free market capitalism, executive pay set by supply
& demand for scarce talent, similar to the auctions
bidding up prices for exceptional athletic and
entertainment “stars”:
• Shortstop Alex Rodriguez signed record $252M ten-year
contract with Texas Rangers
• Timberwolf Kevin Garnett held out for $126M over 6 years
• Is Jim Carey really worth $20M per movie (Ace Ventura;
Cable Guy; Dumb & Dumber; Grinch Who Stole Christmas)?
(Socially constructed) scarcity in supply of
top managerial skills, plus large transaction
costs of searching for replacements, makes
company boards willing to pay very high
premiums to attract and hold onto CEOs and
their executive teams.
Sources of CEO Compensation
CEOs & other top executives’ primary compensation not in
salaries, bonuses & perks (planes, clubs), but from stock options
How Do Stock Options Work?
Stock options give employees the right, but not the
obligation, within a specific time span to purchase a pre-set
number of shares at a fixed price (“grant” or “strike price”),
usually set at current share value when option is granted.
Employee hopes stock price will rise, so that selling his
optioned shares at a later date will yield a profit.
EX: Firm X grants a 1-year option to buy 1M shares at Nov
2001 price of $10. If market raises value to $12 per share by
Nov 2002, how much profit could CEO make by buying at the
strike price then immediately selling at the market price?
What if the stock price falls to $8 per share by Nov 2002?
Pay-for-performance incentive: By inducing CEOs
& other employees to take larger stakes in company’s
performance, stock options act as strong incentives
for them to work to improve the firm’s performance
Principals & Their Agents
Agency theory is finance economists’ predominant theoretical
explanation of the link between exec pay & firm performance
Agency relationship: a principal (board of directors)
contracts with an agent (CEO) to perform services requiring
delegation of decision-making authority to the agent
Problem: Transaction cost difficulties for a principal to obtain
accurate information about agent behavior & thus to
safeguard shareholders’ interests:
- how competently is agent performing services?
- is agent deceptively pursuing personal goals
(opportunism = self-interest with guile)?
Solution: design compensation policies that align agent and
shareholder interests – Incentives that reward improving
observable outcomes (shareholder wealth)
Pay for Performance
Systematic evidence about the pay-for-performance
accountability suggests mostly weak relationships
CEOs often risk-averse to having a large percent of their pay
package vulnerable to events beyond their control
To protect their investments & avoid catastrophes, CEOs
may undertake more cautious, less-innovative actions
Jensen & Murphy (1990) found that changes in firms’ shareholder
wealth explained only 3% of the CEOs’ pay variation from 1974-86,
about one week’s income!
They considered this effect “small for an occupation in which
incentive pay is expected to play an important role”
Booming economy further weakens pay-for-performance connection:
A rising stock market means executive stock options usually have
substantial pay-off even when a firm under-performs the other
companies in its industry
Decoupled Performances & Rewards
Annual rite of notorious news reports about CEOs who made
out like bandits despite poor company performances.
Some 2000-2001 “outrages” during the bear market:
Minnesota’s ADC Telecomms paid retiring CEO William Cadogan $45M, but
laid off half of its 22,500 employees and plans to eliminate 150 managers
Staples Inc stock fell -47%; board gave top execs $45M
Novell stock fell from $43 to $5; CEO Eric Schmidt’s salary freeze & bonus cut
was offset by new million-share stock option to "retain and motivate superior
executive personnel."
Pacific Gas and Electric Co. paid $50M bonus to Chairman Robert Glynn and
top execs before declaring bankruptcy; asked federal judge to allow $17M
more to keep senior managers from leaving
General Electric Co.'s Jack Welch made $ 136 million in 2000, an 80 percent
increase over 1999 even as total GE shareholder return fell –6%
Disney’s Eisner cut 3% of payroll to save $400M, but got a $11.5M bonus.
Graef Crystal said, “He’s willing to live by the sword, but not die by the sword.”
One of the Good Guys?
Disney CEO Michael Eisner is often
slammed as poster-boy for excessive
executive pay. But look at his company’s
performance:
• Disney’s stock grew 21.6% annually over
1987-97 decade
• Eisner’s 1997 contract option on 8M
shares may be worth $771M by 2006
Mouse & Friends
But, when Disney’s profits fell –22%
in 1999, top execs lost their bonuses.
Eisner had to live on mere pittance:
$700,000 salary and $50M in
exercised stock options
Graef Crystal, repentant pay consultant, argued “Eisner plays the
game fairly by assuming a relatively high degree of pay risk” (1992)
Playing Board Games
To protect their interests, CEOs have learned to become
skillful corporate politicians who enhance their power at
expense of board of directors’ independence.
CEOS subvert the legal principal-agent relationship by
• Using proxy machinery to stack boards with insiders, friends,
and similar outsiders (“homosocial reproduction”: Kanter)
• Drawing on social capital ties (interlocking director networks)
to perpetuate passive approach to compensation
• Persuading board’s compensation committee to apply low-risk
criteria (subjective judgment of efforts not objective results)
• Controlling information to conceal evidence of poor
performance, incompetence & deceptive behavior
• Using ingratiation (opinion conformity, flattery, favors) &
persuasion (defending policies, blaming external events) to
remove threats of ouster
Farewell to the Chief
CEOs rarely ousted for poor performance by a Board Coup
GM board’s 1992 forced resignation of Robert Stempel
Dismissals disguised as “I want to spend more time with my family”
Nonvoluntary CEO turnover usually preceeded by poor firm
performance & steep share price drop, which trigger:
- Takeover attempts - Shareholder lawsuits - Institutional investor pressures
CEO succession dynamics (Ocasio)
Institutionalization of power: entrenched &
insulated CEO’s inflexible strategies increasingly
fail to solve firm’s performance problems
Circulation of power: Rivals within dominant
coalition emerge to contest for control, force CEO
expulsion, attempt revitalization
Data show rising forced CEO turnovers in past decade
Shorter Writing #11:
Under the U.S. legal system, corporate boards of
directors have a duty to govern in the best interests of
the firm. Despite this shareholder-primacy principle,
CEO pay continues to accelerate and often seems only
weakly related to firm performance.
Discuss at least two aspects of CEO-board relations
that help to explain why directors appear unable or
unwilling to link executive pay tightly to such company
performance indicators as profits & share prices.