Ethics @ Work: Executive compensation

Executives can use their positions to give themselves unjustifiably high salaries and "retroactive" stock options, even if they do a lousy job.

May 25, 2006 22:32

A few weeks ago I strongly opposed "maximum wage" legislation for highly-paid executives. At the same time, I acknowledged that executives are often able to use their positions to obtain unjustified benefits. I will use this week's column to elaborate on this problem. Theoretically, top executives, including the chief executive officer are just ordinary employees. They work for the owners, namely the shareholders, and their compensation should be determined in a free labor market by the supply and demand for managerial talent. The fact that quite a number of executives get multi-million dollar salaries does not in itself prove that this approach is wrong. Being a high-level executive in a large firm is an extremely demanding job, requiring great talent and considerable personal sacrifice, and the most effective managers can be immensely productive. As I pointed out in the last column, even executives hired from outside a company, who have no power to "pay themselves," are often offered jumbo compensation plans. Lou Gerstner was hired from outside IBM and received tens of millions of dollars a year. His management turned around a company on the verge of disintegration and compared to previous management created billions of dollars of value. But there is a lot of evidence that executives can ratchet their salaries above their productivity, and a lot of evidence that they do. How can they? Well, since top managers determine compensation policy they can just decide to pay themselves a lot. It's true that the compensation policy is supervised by the board of directors, but there are lots of reasons that this oversight is weak: 1. There is a range of "fair salaries," and managers have the first move. If the process was that the board offered a salary and the executive had to decide whether to accept it, it is likely that salaries would be lower than under the more common system where managers propose a scale and the board has to decide whether it is fair. 2. Corporate boards don't have that much independence, since in most large US companies the CEO is also the chairman of the board, who is thus charged with overseeing himself (or herself). 3. Corporate boards in the past have not been very vigilant in protecting shareholders; in many cases they exercise very perfunctory oversight. 4. Most corporate board members are themselves highly paid executives at other companies and they may not want to rock the boat. 5. Management not only has power, they also have knowledge. They are sometimes able to craft devious compensation schemes to hide the true extent of their compensation from the public and even from the board. 6. In a huge multinational corporation with hundreds of billions of dollars of revenue, a few tens of millions being wasted on inflated management salaries may just not be worth the board's attention. What evidence is there that salaries are too high? Some executives get outrageous paydays even when they do a lousy job. Lou Gerstner may have contributed billions of dollars by turning around IBM. But one executive fingered in a recent article by MSN's Michael Brush averaged over $10 million a year in compensation over a four-year period in which his company lost over 90% of its value. Another hint is the devious compensation schemes being cooked up. Recent weeks have seen the heating up of the "backdated options" scandal, where leading executives at a number of companies were able to retroactively give themselves stock options at market bottoms. In other words, they waited until the stock went up, then pretended that they got options to buy at a low price in the past. On paper it looks they were just lucky, but in reality they were just stealing. In this way the gains are hidden from board and public alike. The scam was uncovered by some intrepid detective work on the part of finance professor Erik Lie, who studied option packages and discovered that the odds against some of them happening by luck were astronomical. Business Week reports that about $35 billion in market value has "evaporated" as a result of the ensuing scandal. Perhaps the most telling evidence for the power of executives to control policy, including compensation policy, is the existence of the "golden parachute" - generous severance packages for failed executives. These packages are intended to convince the parting manager to leave without a fight but, if the owners were really in charge, executives would have no way of fighting in the first place. In one recent high-profile case, Disney president Michael Ovitz was paid $140m. to leave his job. A related example is a "poison pill," which is an anti-takeover policy that keeps stockholders from benefiting from a takeover hostile to current management. (Poison pills basically hold the company for ransom until a "golden parachute" is forthcoming.) The best solution to this problem is more transparency and accountability. Stock options are already being much more closely scrutinized than in the past, and in the US must now be accounted for as compensation, thus rectifying a glaring omission in previous accounting rules. Board members are also being held to a higher level of accountability than in the past for oversight oversight (neglect of supervision). And more could be done. I have long believed that poison pills should be illegal. Meir Heth, a leading Israeli governance expert, has recommended that Israeli CEOs shouldn't be board chairmen. This step would improve governance, but it could come at an excessive cost in effective management, since boards not only oversee the management but also create company strategy. A creative solution was conceived by US congressman Martin Sabo. Some years ago he introduced into the US Congress a bill called the "Income equity act." The act provides that companies can't deduct earnings of a CEO above 25 times the wage of the firm's lowest-paid worker. They can still pay him more than that, but it is not considered an expense. There is actually some justification for this, since at a certain stage bonuses and benefits stop being a "salary" and turn into incentives which are in effect a share of profits, and distributions of profits (i.e. dividends) are not considered an expense. At first glance the tie to the lowest-paid worker seems diabolically clever. Since CEO earnings are effectively tied to the earnings of the lowest-paid worker, if the CEO wants to scheme to increase his own salary, he is now obligated to scheme to increase the salary of the line workers, as well. But in fact this is the weakest link in the legislation. It will give managers a powerful incentive to avoid hiring any low-skill workers at all. Furthermore, since it is tied only to the lowest-paid worker there is still no incentive to improve pay farther up the pay scale. However, these shortcomings could be partially overcome. For example, the tax provision could penalize salaries over 25 times the median income. (This would be around NIS 150,000 a month.) Or it could penalize compensation increases over and above increases of average wages of non-managers. I continue to believe that the fairest and most effective way of dealing with excessive executive pay is to improve corporate governance, meaning more transparency and accountability for management to the board and for the board to the public. But some variation of the "income equity act" could provide a way of maintaining a degree of flexibility in executive pay while providing a meaningful incentive to minimize the growing abyss between executive wages and those of ordinary workers. [email protected] The writer is research director at the Business Ethics Center of Jerusalem (, an independent institute in The Jerusalem College of Technology. He also is a rabbi.

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