Boards Tantrum Over CEO Pay
March 14 2008 by Fayazuddin A. Shirazi
Every time a CEO gets a rocking pay package, a board member loses control. While debates over CEO pay are nothing new, board resentment over the issue is uncomfortable for CEOs themselves, says a recent study jointly conducted by Heidrick & Struggles, the executive recruitment firm, and the Center for Effective Organizations at the University of Southern California’s Marshall School of Business.
The 11th compensation survey revealed that one in three board of directors (about 32 percent) of U.S.-based public companies felt that CEO pay is too high in most cases. This represents a significant increase over the response of board members in the years from 1998 through 2001 when just 25 percent of board members thought it was too high.
CEOs who responded were much less likely to believe CEO compensation is too high than were non-CEO board members. As in the 2006 survey, board members see the actions of compensation consulting firms and the creation of new incentive compensation programs as the major reason for the continuing increase in CEO compensation.
Compensation analysts attribute the consistent rise in the executive pay to the poor link between pay and performance. “The real reason behind the steady increase in the CEO pay is the poor link between pay and performance,” feels Paul Hodgson, senior research associate and director executive compensation, The Corporate Library, an executive compensation watchdog based in Portland, Maine. Hodgson believes while this lenient attitude of the boards goes well with regard to short-term incentives, but when it comes to the long term options, things can go awry. “When it comes to long-term incentives, link between the pay and performance has to be strong, if not there are instances of executives making huge money despite a lackluster performance,” reiterates Hodgson.
However, for Xavier Gabaix, a Harvard-trained economist at New York University’s Stern School of Business, the hike in CEO pay is linked with the rise of market capitalization over the past three decades. Gabaix, who investigated the Corporate Library report – which claimed that the executive pay at big corporations has increased by more than six fold since 1980 – feels that the rise can be explained by the “roughly six fold increase in the market capitalization of big US companies over the same period.” “Asset values have increased six fold because both corporate earnings and the price-to-earnings ratio investors are willing to tolerate have increased by factors of 2.5,” says Gabaix in an article published in The American, noting that the trend lines of market capitalization and executive payouts rose and dipped in near-perfect tandem.
Experts also accuse state laws for the undue increase in the CEO pay scales. “IRS code (Internal Revenue Service, US dept. of Treasury) 162m set the floor resulting in higher pay,” says Paul R Dorf, a compensation expert and the managing director of Compensation Resources Inc, an all-Inclusive compensation consulting firm specializing in executive compensation based in NJ.
Besides, he is also of the opinion that there has been a consistent ratcheting up of executive pay scales from a high base over the past 20 years. “The “GoGo” years took the executive comp far beyond the level of expectations. The companies didn’t bother to keep a tab on the growing comp levels, since every body was making money owing to rising stock market, before the tech bubble finally broke. It is often forgotten that the rewards that are now being reaped are based on stock grants and awards made in the past – as much as ten years ago in most cases,” says Dorf. Besides, he feels that the attitude of companies to hire executives from other companies, rather than looking for people from the ranks of unemployed also has resulted in excessive pay packages. “Companies typically hire executives from other companies and not from the ranks of unemployed, which means the pay package has to be hefty and good enough to attract an executive,” he says.
While the boards have been squarely blaming the pay consultants for the atrocious pay, compensation analysts believe, both the pay consultants and the boards have to share the blame. “Boards themselves have been very loose with handing out awards with little concern over the burgeoning cost to the company,” says Dorf. While the boards have been lax, the pay consultants on the other hand have been trying hard to woo the CEOs for their own benefits, says Dorf. “Consultants mostly intend to please top level executives, for they are responsible for renewing the pay consultant contracts. The potential for them is high, that is, if they keep the top brass happy, it’ll do good for them as well,” quips Dorf.
However, Hodgson begs to differ and feels that attributing entire blame to compensation consultants for the drastic increase in the executive pay is wrong. “I do not think it is possible to attribute all of the increase in CEO pay to the actions of compensation consultants,” he says. Hodgson however, adds that there is sometimes less rigor than would normally be acceptable in the development of data for peer groups. “The problem is not necessarily the make-up of the peer groups themselves, but the data selection, with not enough of attention being paid on the impact the performance might have on the pay results,” remarks Hodgson.
Comp experts are of the opinion that the boards, which are working in close associations with the comp consultants, in drafting the compensation for executives, need to cautious. Analysts say the reason why boards tend to behave leniently is due to lack of accountability. “There are no real penalties if board is lenient with comp awards. Other than a little public criticism, boards do not have much to lose,” says Dorf adding: “Boards need education and they look to consultants for the know-how. While the boards need to understand their responsibilities better, they must also be asking enough of the right and probing questions to the pay consultants.”
Despite all the hullabaloo over the increasing CEO pay, and a bearish market sentiment threatening to cripple the US financial system, pay analysts assume that the executive pay wouldn’t come down. “We have been through several stock downturns since I began covering US CEO pay, and in aggregate the pay has always gone up. Company by company, individual CEO pay can go down, but as a whole it has never been so,” says Hodgson.
However, contrary to Hodgson’s claim, Gabaix indicates that as the markets tanked down, CEO compensation fell as well. “Averaged over the largest 500 companies though, chief executives have not managed to systematically boost their pay during down markets. Indeed, CEO compensation fell from 2000 to 2003, as the market tanked,” Gabaix noted in his study.
The Heidrick survey also found widespread unhappiness among directors regarding disclosure rules about executive compensation mandated by the U.S. Securities and Exchange Commission. The rules were unveiled with great fanfare to give investors and corporate watchdogs better, timelier information about pay and other compensation for top executives. Despite those intentions, most directors said they doubt the rules are meeting the needs of investors.