Just Who is Creating This Value, and at What Cost?

This post is by J. Richard Finlay of the Centre for Corporate & Public Governance.

It has recently been suggested by some commentators on these pages that CEOs add great value and are entirely deserving of the substantial compensation they have been paid.  The example of Jim Kilts–who, it is claimed, created some $20 billion in share value at Gillette and received total compensation of $150 million for his work–was cited with approval.

I have been observing with considerable skepticism the course of CEO remuneration over a number of years, having dubbed excessive CEO pay the “mad cow disease of the North American boardroom.”  Empirically–as many who have spent much time in and around the boardroom will acknowledge–there is a point where additional tens of millions become marginal as an inducement to higher performance.  In my view, that point occurs very early in the compensation tally.

There is not the slightest bit of evidence that someone who “creates” $20 billion in value and receives compensation of $150 million would have created substantially less if they had been awarded, say, $100 million or even $50 million.  If this were the case, there would also be evidence that CEOs in the lower quartile of compensation in an industry have held back on their performance for lack of sufficient incentive.

A CEO is hired to perform a set of tasks and one expects he or she will exercise their fullest ability, as everyone else is obligated to do in an organization, to achieve the goals that have been assigned.  Giving additional–and ever-expanding–rewards of almost indecipherable sophistication should not be required to motivate CEOs to achieve those goals.  This view is based on the notion, perhaps growing quaint in some circles, that employees are motivated by a strong work ethic, a realistic salary, and what I call a proportionally rational bonus.

This formula worked remarkably well for America (and much of the world) during most of the 20th century, especially the periods of recovery that followed each World War.  Corporate icons–like Owen Young and Reginald Jones of General Electric, Irving Shapiro of DuPont, and Bill Hewlett and David Packard of the company that bears their names–managed for the most part to advance these businesses with a well-tuned understanding of the responsibilities of capitalism.

But we appear to have gone from the “greatest generation” to what I call the greediest generation in terms of boardroom leaders.  I take no satisfaction in that sad development, having spent more than three decades connected with the world of business, but it appears to me an indisputable fact of contemporary corporate culture.  What is truly unfortunate is that the young people I meet studying business today have never known corporate leaders of earlier generations.  They have, however, seen a great deal of the likes of Skilling, Fastow, Kozlowski, Ebbers, Sullivan, and now Conrad Black, who is currently standing trial on fraud and racketeering charges.  The jaded view many have developed of business leadership is in part a consequence of these unfortunate examples.

The fact is that current compensation practices for the present generation of CEOs and directors have made a mockery of the notion of a realistic salary and a proportionally rational bonus.  Salary has become such a miniscule component of CEO compensation that it is now largely irrelevant.  I would argue that compensation is not designed solely to attract and retain top managers.  CEOs are leaders of the team which creates the value; they do not do it alone.  Excessive compensation for CEOs has an effect on the morale of others in the organization–a cost that should also be considered in setting pay.  If salary is treated as merely incidental at the top of the organization, how can it be taken seriously as a fair instrument for rewarding performance elsewhere in the company?  Home Depot is an instructive case in the organizational costs of excessive CEO pay.

There is the additional element of public opinion, which indicates that there is mounting outrage over what is widely perceived to be outsized senior level compensation.  Those who think the only consideration with respect to CEO pay is how much firm “value” is created would do well to recall that capitalism has experienced periods where public opprobrium has translated itself into aggressive–sometimes even punitive–legislative action.  If we are not at that point, we are perilously close to it.  The current wave of abuses involving backdating in stock options has further reduced public confidence in the moral legitimacy of business leadership at a time when it is still recovering from the betrayals associated with Enron, WorldCom, and many others.

One of the defining attributes of the institution of the board of directors over the past 100 years is that many have been chronically tone deaf to the mounting drumbeat of discontent from both investors and the general public.  That is why boards have often claimed to have been unaware of the dangers that eventually caused many companies to fail.  Directors need to draw their compensation decisions from a wider template of variables–and expand the concept of “value” to include the longer-term interests of both the organization and the society upon which its existence depends.  In short, a sea change in boardroom culture is needed to properly inform and shape compensation decisions.

Unfortunately, the current makeup of most boards–which include many former CEOs with an interest in perpetuating a system that has been very good to them–makes reform unlikely in the short term.  It seems certain, therefore, that CEO compensation will continue to attract well deserved skepticism with respect to whether the amounts paid are excessive, whether such compensation is needed to motivate CEOs to create real value for shareholders, whether instruments such as stock options have been properly used, and whether the wider costs of that compensation for the organization have been fully considered.

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  1. M. Hodak
    Posted Friday, March 23, 2007 at 12:24 am | Permalink

    “If this were the case, there would also be evidence that CEOs in the lower quartile of compensation in an industry have held back on their performance for lack of sufficient incentive.”

    That’s not necessarily true. Even if one could create a testable hypothesis around the relationship of firm performance to the behavior of “holding back” and prove it with data (and I don’t see how that would be possible), isn’t it likely that a plan could poorly reward certain CEOs simply because they tried their hardest, but their plans failed? A well designed incentive plan might create such a result, regardless of the CEO’s intent, on the downside as well as the upside.

    The incentive effect of a relationship between pay and performance is never observable–it is assumed by the economic framework in which agency costs are minimized by such a relationship. Notwithstanding the anecdotal evidence to the contrary within this article, research clearly shows a high correlation between CEO wealth results and shareholder returns along the entire spectrum of performance.

    Assuming that any breakdown between a particular firm’s pay and their performance is the result of largely non-market collusion between directors and management, as this article seems to do, underrates both the difficulty of the board’s task in selecting, evaluating, and rewarding management, and the integrity with which the vast number of directors, in my experience, actually do their jobs.

    There also seems to be an assumption, also offered without evidence, that managers are greedier and boards are laxer than they used to be. Such an assumption actually runs contrary to what most board observers would consider a trend of greater vigilance over the last 20 years.

  2. arthur mboue
    Posted Wednesday, March 28, 2007 at 2:47 pm | Permalink

    M Hodak, please read my comments (top and bottom) on this subject. I agree with you whne it comes to the good relationship between CEO wealth and shareholder return. This relationship is the result of a CEO performance based compensation package design. But others questions must also be answered
    Is this performance a real performance?
    Is it a short term performance?
    Is it just an agressive performance?
    How independent are Independent directors, architects of the CEO compensation package and CEO’s appointee ?
    Arthur Mboue

  3. Loren Meddaugh
    Posted Tuesday, April 3, 2007 at 11:24 pm | Permalink

    I just bought an American made car..not really sure how relevent that is any more as many foreign companies build their cars in the U.S. using U.S. workers. But I felt that if it was a close race between a foreign company and a U.S. company I would choose American.

    The big difference I believe now-a-days between choosing between an American company (based in U.S. and covered by U.S. laws) and foreign is the senior management and board of directors.

    I made the wrong choice I feel (by choosing American) as I am now an enabler of American CEO greed and BOD ineptness and cronieism.. U.S. CEO total compensation is about 600 times the average worker!!!!…and BOD members just rub each others’ companies backs as per Warren Buffet! If more people look at purchasing their products that way..by the upper management and BOD character.. these CEO’s (many of them who send the American worker’s jobs over seas) and their croney BOD friends might decide that they don’t really deserve something for nothing…. There is no FREE milk program!!!