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Pay without Performance: The Unfulfilled Promise of Executive Compensation ReviewIn his letter to Berkshire Hathaway investors in 2004, Warren Buffett wrote:
"In judging whether Corporate America is serious about reforming itself, CEO pay remains the acid test. To date, the results aren't encouraging."PAY WITHOUT PERFORMANCE expands on Buffett's comments and provides a research base to support it. The authors also suggests what needs to be done to effectively deal with this "acid test" of corporate reform.
Lucian Bebchuck is the William J. Friedman and Alicia Townsend Friedman Professor of Law, Economics, and Finance at the Harvard University School of Law. He is also a Research Associate of the National Bureau of Economic Research. Bebchuck has a doctorate in economics from Harvard and a law degree from Harvard. Jesse Fried is Professor of Law at the Boalt School of Law at the University of California at Berkeley. Prior to his academic career, he practiced tax law in Boston. Fried holds degrees in economics and law from Harvard University.
The authors argue that Sarbanes Oxley reforms may have marginally improved the independence of Boards from CEOs. But Board members are still not dependent enough upon the shareholders they are supposed to represent. This dysfunctionality in the system makes it impossible for Compensation Committees to conduct true "arms length" compensation discussions with CEOs.
The result is a CEO compensation system that tends to verbalize pay for performance without actually achieving it for CEOs.
When CEO pay is uncoupled from performance, Board members seek to avoid having to pay "outrage costs" from the shareholders. One of the ways of avoiding paying "outrage costs" is to make it difficult for the average shareholder to truly understand the level of CEO compensation and how that level is unrelated to corporate performance. The authors call these techniques compensation "camouflage."
The authors are quite clear in describing examples and providing research to support their ideas.
They propose remedies that focus on two themes: tying CEO compensation to real corporate performance and tying Boards to shareholders.
With respect to tying CEO compensation to real corporate performance, they would seek to remove "windfall" and "rising tide" factors from CEO bonus/option payments. Windfall factors involve one-time rises in shareholder value. An example might include a sharp rise in stock value because the CEO makes a decision to downsize or receives a large payment from the successful settlement of a law-suit. Another windfall factor might be allowing accounting for revenue to move from one quarter to the next so that the stock will look like it is rising at a steeper angle. "Rising tide" factors would factor out increases in CEO compensation because an average company is benefiting from average industry growth that impacts all average players. These issues merit serious consideration from Compensation Committees. And Warren Buffet is correct in his assessment that most Boards have thus far failed the "acid test."
With respect to tying Boards to shareholders, the authors would terminate staggered Board elections. They would have the entire Board be up for election at the same time. I am reasonably sure that the authors' remedy here would be worse than the disease they are seeking to cure.
A Board of Directors is a work group that is supposed to be thoughtful and deliberative in nature. Their proposal would make the Board a far more responsive body at the expense of thoughtfulness. To make an analogy, the U.S. Senate is a more effective deliberative body because it is less subject to the passions of the moment. And it is less subject to the passions of the moment because only 33% of its members are up for election every two years. The U.S. House of Representative is far less effective as a deliberative body. And one of the reasons is that all members are accountable to the voters every two years.
Regardless of whether you agree or disagree with their analysis, their key theme deserves consideration: if Boards allow CEO pay to be unrelated to corporate performance, it is important to define the problem correctly. The problem is not about greedy or lazy individuals. The problem is about a system that is not rewarding leaders for doing the right things.
As Warren Buffet has said, fixing that system will be the "acid test" of the free enterprise system in the 21St Century.
Larry Stybel
www.boardoptions.com
lstybel@boardoptions.com
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