First published 20 January 2006.
Soaring executive compensation: deserved or disgraceful?
Earlier this week, the U.S. Securities and Exchange Commission proposed new regulations governing the detailed disclosure of executive compensation. With the collapse of Enron in 2001 (and its auditor, Arthur Andersen, in 2002), U.S. legislators reacted (some say over-reacted) swiftly with the Sarbanes-Oxley Act of 2002. This act mandates greater scrutiny of corporate accounting practices, independence of auditors and more detailed filings to the SEC. In this environment, it was only a matter of time before executive compensation became the subject of increased regulatory oversight. Mr. Terence Corcoran, editor of the Financial Post, unleashed a trenchant editorial yesterday blasting this latest initiative:
For nigh on 70 years, a great parade of demagogic politicians, scheming bureaucrats, leftist academics, corporate activists and ideological knaves have sought to bring down U.S. executive compensation. The latest move came this week in the form of new disclosure rules from the Securities and Exchange Commission. Like all previous attempts to humiliate corporate executives and level the compensation playing field, the proposed new SEC regulations will fail to achieve what everybody really wants: wage controls on CEOs.
What makes it interesting is that the editor of a financial paper should even have to restate basic economics and human motivation. I can understand why the vagaries of market-based compensation might elude most of those outside the private sector, but surely this should not be a mystery to either FP readers or the SEC mandarins of oversight. Corcoran argues persuasively that disclosure does not act as a brake on compensation levels, but the exact opposite — an accelerant.
What history shows, moreover, is that the SEC’s long campaign to expose the evils of executive pay through disclosure has accomplished exactly the opposite of intentions. Each move to new levels of disclosure has produced new heights in compensation. The proposals announced Monday by the SEC will do the same.
The economic logic behind the proposition that pay disclosure equals pay escalation, the sheer obviousness of it to anyone who has ever worked on a factory floor or in a newsroom or an executive suite, appears to have escaped the great minds behind the decades-long movement to punish the world’s business leaders. If everybody learns Mary in accounting is making $55,000, then everybody will want to make $55,000. Or more.
Which is partly why every HR department keeps employee salaries confidential. Sure, these days that information is governed by privacy legislation, but it also makes complete economic sense to keep it hush-hush. You might know that your peers are in the same basic pay band (let’s say somewhere between $58,000 and $89,000 annually), and you might know their longevity of service and can estimate their relative competence in the job. But you won’t know their exact salary, so it’s harder to triangulate a shifting, nebulous figure against your own time-in-service, competence, and value to the organisation. Making it somewhat harder to argue that, in all fairness, you belong somewhere near the $89,000 mark because you know John Doe with the same time-in-grade, similar competency and similar work ethic earns that much.
Making detailed executive compensation figures available to the public is just plain pandering, and will in no way slow the compensation arms race — any more than announcing your own salary to the most junior, underpaid mailroom clerk will shame you into lowering your own salary and foregoing that three-bedroom house in the suburbs, new car lease, or vacation in Bermuda.
Under competitive compensation schemes, disclosure equals escalation because it gives an executive the ability to know what the compensation level is for everybody else, inside and outside his company. It also gives his own board and search firms the ability to know precisely what compensation packages would be needed to keep executives or lure them from other companies.
Reasons for clamping down on “lavish” and “staggering” executive pay vary with the seasons. Envy, moral outrage, Marxist sentiment and political opportunism all play a role. The New York Times writer Joseph Nocera said executive pay today is “out of control, socially corrosive and divorced from any real rationale.” Mr. Nocera favours a new theory called “internal pay equity.” An example was a CEO at DuPont who in the 1990s allegedly accepted a pay level set at 1.5 times the pay of DuPont senior managers. I wonder how many senior managers at DuPont aspired to be CEO of the company as compared with, say, going off to earn 10 times their income by being CEO at another company.
Ad-hominems aside, this is another excellent point. Companies who do not pay market-based rates will suffer a competitive disadvantage — a sort of corporate “brain drain”, if you will. Unfortunately Mr. Corcoran’s otherwise excellent article does not address the big question — whether regulatory agencies should attempt to limit executive compensation via disclosure — in effect trying to shame executives into humility. Our present, limited wage transparency as an accounting and ethical bulwark is one thing; full transparency as negative-values social engineering is another.
Joseph Nocera, business columnist for the New York Times, takes the opposite tack. His article “Disclosure won’t tame CEO pay” (NYT, January 14, 2006) echoes Corcoran’s critcism of the plan, but with an entirely different focus.
But when I asked Mr. Cox whether he thought the new disclosure rules would help rein in executive pay, he punted. ”It is not the role of the S.E.C. to determine the level of compensation,” he replied. ”It is the role of directors and shareholders.” And hence the problem: when the S.E.C.’s new rules are instituted, some months down the road, it won’t be just you and me who are getting a fuller picture of executive compensation — so will the nation’s chief executives. And history suggests that whenever they discover a fellow C.E.O. is getting something they don’t have, they make a grab for it. In other words, as laudable as more disclosure is, there is a real possibility that it will make a bad situation worse.
Take, for instance, 1993, the year Congress passed a law eliminating the tax deduction for any executive salary that exceeded $1 million. What happened? First, the new law accelerated the trend of giving C.E.O.’s hefty stock option grants. Second, it made $1 million the new salary floor. ”In the hall of fame of unintended consequences,” said Nell Minow of the Corporate Library, a corporate governance monitoring group, ”that has to rank right near the top.”
Someone give a medal to SEC Chairman Christopher Cox; he understands, unlike this NYT business writer, that determination of executive compensation lies properlywith the company’s board of directors and the shareholders. This is not what you call a punt, or avoidance of a hard question. It’s what you call beyond the purview of the SEC; beyond the limits of reasonable government interference in free market activity.
If not government, then, what will stand in the way of ballooning compensation packages? The very thing that creates them — the marketplace. Well-run companies that pay high salaries and tie compensation to corporate performance will continue to flourish and attract superior executives. Poorly-run companies that pay high salaries and do not link compensation to company performance will, in the end, leave themselves worse off economically. They, like old and infirm lions, will be taken down by their more efficient, agile competitors. This is of course not an immediate remedy. Poor governance does take a while to trickle down and affect a company’s bottom line. And naturally it will also hurt innocent employees in the process.
So the proposition then, is this: do you want to prop up poorly-governed companies and insulate them from the effects of their inferior practices and ethics by limiting executive compensation? Or do you want to accelerate their demise and let their more rigorous, leaner, nimbler competitors have them for lunch? The answer, I suspect, can be broken down along predictable ideological lines, which is a shame. It’s in no one’s interests to have poorly-run companies in the marketplace, and in no-one’s interest to artificially insulate them from poor decisionmaking. Sarbanes-Oxley may go some distance toward preventing and deterring the most egregious bad actors, but letting poorly-run companies hoist themselves on their own financial petard is exactly what they deserve.