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Wednesday, January 04, 2006

CEO Salaries Cry Out For Reform

One of the things that makes me a moderate conservative rather than an extreme-right conservative is that I have never forgotten something my business-law college professor told us – that when government passes a new law or regulation that places limits on what businessmen or markets can do, it’s always because some people acted to excess and spoiled everything. Although the situation has changed slightly for the better, this kind of condition clearly exists in the area of top-executive pay (that of CEOs), and in the aftermath of Enron, WorldCom, Tyco and Global Crossing, cries out for some action.

RATIO
OF CEO PAY TO AVERAGE PAY




From CNN:
“In 2004, the ratio of average CEO pay to the average pay of a production (i.e., non-management) worker was 431-to-1, up from 301-to-1 in 2003, according to "Executive Excess," an annual report released Tuesday by the liberal research groups United for a Fair Economy and the Institute for Policy Studies.

That's not the highest ever. In 2001, the ratio of CEO-to-worker pay hit a peak of 525-to-1.

Still, it's quite a leap year over year, and it ranks on the high end historically. In 1990, for instance, CEOs made about 107 times more than the average worker, while in 1982, the average CEO made only 42 times more.

The cumulative pay of the top 10 highest paid CEOs in the past 15 years totaled $11.7 billion.

And though the specific individuals in each of those annual top 10 lists changed year to year, many bosses did pretty well throughout the entire period. Citigroup's Sandy Weill, for example, has made $1.1 billion since 1990.

"Pay" in this instance refers to total compensation – including salary, bonuses, restricted stock awards, payouts on long-term incentives and the value of options exercised during the year.

The report also compares the growth in average CEO pay – which was $11.8 million in 2004 – to the growth in the minimum wage. Had the minimum wage risen as fast as CEO compensation since 1990, the researchers calculated, it would now be $23.03 an hour instead of just $5.15. And the average production worker would be making $110,126 a year instead of $27,460.

A rebuttal argument might be:
From Askmen.com
“A recent survey of America's top 50 CEOs showed that their pay rose 5% to a whopping average annual salary of $10.7 million. That's a lot of dough, without question, and some of the CEOs are undoubtedly drastically overpaid.

But if one takes into account just how much the top 50 companies earn, it puts matters into perspective. How well did the Fortune 50 do? Well, on average, they generated $4.58 billion in profits from $64.2 billion in revenue -- not too shabby. That means that, on average, a top 50 CEO made 0.016% of the revenue his company generated, or 0.23% of their profits. That's not too much, now is it?

Mind you, this CEO data is a bit skewed. For example, the survey reports that Stanley O'Neal was near the top of the list, having made $32 million in 2004. But O'Neal's company, Merrill Lynch, is not in the Fortune 50, coming in instead at number 58. Merrill generated $3.99 billion in profits on revenue, which means that Mr. O'Neal's salary was equal to 0.11% of revenues... start the witch hunt!

Yet even when taking Mr. O'Neal's income into account, CEO pay is not entirely out of whack. Companies and CEOs both tend to make a lot of money, but they also employ a lot of people and pay a lot in taxes. Do they go out of their way to lay people off so they can make more profits? Sure, they do. Do they go out of their way to pay less taxes? You'd better believe it. Yet this does not make large corporations any different from smaller businesses or individuals, all of whom strive to save money and pay less in taxes. The fact that their profiteering efforts take place on such a grander scale, however, make the corporations seem somehow more guilty.”
PERCENT OF CEO PAY FROM OPTIONS


CONCLUSION
In my view this is a fairness issue that can undermine confidence in the capitalist system that has brought us all such wealth and progress. An average compensation for top CEO’s of $10.7 million cannot be justified and will lead to laws and regulations that could place real limits on the economic growth of individual companies and on the nation as a whole. For a time, in the early 2000’s, there was talk of Congress requiring stock options given to top executives to be expensed on the company’s books, and FASB, the accounting board that sets accounting rules was also proposing to do this. This reform was never implemented, but many companies choose to expense their stock options anyway. (Expensing stock options reduces the profit a company can report). In any event, compensation given top executives in the form of stock options has dropped dramatically as CEO compensation has dropped somewhat, so changing these rules on options and requiring all companies to expense them may do some good. This will undoubtedly hurt start-up companies and high tech companies, but perhaps some provision for exceptions can be made.

Other, more drastic, measures might include establishing a maximum ratio between average compensation and individual compensation within companies, or requiring some portion of CEO compensation to be paid out of after-tax profits. If you think these measures are harsh, remember what my business-law professor told me.
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4 Comments:

At 6:37 PM, Anonymous Roy B. said...

Yes - but the problem is much more complex than just high salaries. A very big part of this problem - and only touched on in the piece, is the issue of "change of control protection" packages for CEOs. Sometimes referred to as "golden parachutes", these provisions are written into the CEO's employment agreement and are designed to "protect" the CEO in the event that a merger or takeover (hostile or planned) occurs during the employment period.

A typical agreement of this type will give the CEO a single payment of up to 3 years salary, full forward vesting of stock options, and 300% of his/her highest annual bonus (over the past 5 years) as well as income tax protection for the special tax applicable to such one time payments. The agreements are rationalized as necessary to attract and retain quality CEOs in this merger prone world.

The reality is that they make the CEO a major financial player in the merger discussions (which is what the CEO wants)and result in a huge amount of the acquisition price of a company going to the senior executives of the acquired company (and to the loss of its stockholders).

To see how this works go to "Edgar" (the on-line SEC repository) and look at any proxy statement for a major company merger in the past few years. Then see how much of the money is going to the senior executives. You will be shocked. However, because the deals are usually at a premium over the stock trading price everybody winks and approves the deal. Single lump sum payments of $25-50 million at the time of merger (to one or a few senior executives) are not uncommon.

It's an outrage and an illustration of raw greed.

Roy B.

 
At 7:26 PM, Anonymous Roy B. said...

Also - for more on this see:" fat Merger Payments for CEOs" at:
http://www.businessweek.com/magazine/content/05_50/b3963106.htm

ROY

 
At 4:56 PM, Blogger RussWilcox said...

It’s really significant that both Roy, an attorney, and I are conservative in our basic outlook and yet are both outraged at this abuse of our capitalist system. Much of the research I did for this post came from the AFL/CIO, and it marks one of the few times that they and I are on the same side of an issue. My point is, I believe there would be widespread support for a government imposed reform in this area, and the real problem will be to avoid throwing out the baby with the bathwater.

We have some professional accountants and economists in our group, so if you have any ideas, let’s hear them. Meanwhile my proposal for discussion would be that any company, in operation for more than five years, should have a limit on the compensation of its CEO of 50 times the company’s average worker salary, the cost of all stock options must be expensed, and the executive rewards (or parachute) from a merger or acquisition must be voted on and approved by the stockholders in a separate vote taken before the merger vote can be taken up. The SEC would define the language to be used in the motion so that the true and entire compensation and its cost be clearly made known to the stockholders.

I would exempt companies in business for less than five years to recognize the special needs of startup and high-tech companies.

 
At 10:44 PM, Blogger Locke said...

Here's my take on CEO overpayment:

I have argued on my website that work is for service. Let's now take that further to the issue of CEO pay levels. I want to argue that most CEOs are massively overpaid. Most of us have a gut feeling that this is true, but we can't say why.
Here is the answer: 'work is for service of the common good, and bonuses should be paid as such'. Let me say that again: 'work is for service of the common good, and bonuses should be paid as such'.
You see, CEOs have two forms of pay. The first is a guaranteed wage. The second is a bonus, which depends on their performance during the year. I want to talk about the bonus, and show why it is so often excessive.
The CEO's bonus is usually tied to the profit performance of the company. If the company increases profit dramatically in a year, the CEO will get a big bonus. If the company decreases profit dramatically in a year, hopefully the CEO will get no bonus. (I say hopefully, because sometimes the CEO still gets a big bonus when profits have slumped!)
The CEO has at least three strategies for increasing profitability, and so for receiving large bonuses. They may be itemised as follows: Item 1: He may purchase another company, merge it with his, layoff workers, and profit through efficiency gains. Item 2: He may grow the existing company by growing sales, or decreasing expenses. Item 3: He may manage his balance sheet better, and run his company more efficiently through better use of debt, or through better use of inventory, or through better management of cashflow.

Now some of these measures serve the company/owners at the expense of others, while other measures serve all of us by making the company genuinely more efficient. CEOs should be paid for the latter and not for the former. At present, they are paid for both.

Regarding item 1: The act of merging companies in this way is usually positive for the common good. Purchasing another company and reducing the work force produces the same output at lower cost. This is usually genuine service to us all. (In saying this however, we must consider whether those laid off can find new ways to support themselves and to serve others through a new form of work.)

But the CEO does not contribute much service under this heading. All he has done is find a company which is similar to his own, and negotiated a price for buying that company, and made a profit in doing so. The point is that all the work in generating this extra profit was done by the present and past workers and owners and creditors of the two companies. Practically none of the work is done by the CEO - he has just seen a possibility of combining the hard work of a stack of different people, and he has arranged for this possibility to become reality. So the CEO does not deserve much, if any bonus for merging companies. He certainly does not deserve the millions that he is likely to be paid in present corporate practice.

Another aspect of a corporate merger for which the CEO does not deserve a big bonus is the price negotiation. You see, negotiating a good price for an acquisition does not serve the common good very greatly. The more one party gains on the price for the acquisition, the more the other party loses. Bargaining on sale price is a zero sum game. Price haggling therefore does little to serve the common good. Since bonuses should be paid according to service of the common good, the CEO deserves very little for good price negotiation. Again, this goes against cuurent market practice.

Regarding item 2: CEOs might deserve bonuses if they have helped to increase sales. But it depends how they have done it. Increasing sales serves the common good if sales are increased through efficiency gains. These gains may lead to selling a better product, to better service, or to cheaper pricing. For their contribution to such efficiency gains, CEOs should be rewarded (as also should the owners and the workers who contribute to these gains, in proportion to their contribution). However, increasing sales through gaining a monopoly, or through cartel pricing does not serve the common good, and so the CEO should not be remunerated for it. (The exception is if the CEO came up with the innovation which justly produced the monopoly). By implication, CEOs of monopoly businesses should not be excessively remunerated. CEOs should not receive bonuses unless they have contributed to efficiencies which serve the common good.

Similarly, driving down expenses may come through CEO innovation, for which the CEO might justly receive a bonus payment. Sometimes workers are being lazy, and it is right that the CEO should be paid for forcing them to work harder. However, forcing the workers to work excessive hours for no extra reward does not serve the common good, and should not lead to extra CEO bonuses.

Regarding item 3: If the CEO takes longer to pay creditors, this action does not serve the common good. Neither does hassling debtors to pay more quickly. This is simply raw self-interest, and does not deserve praise nor bonus payments.

In conclusion, this post aims to show the practical implications of the idea that 'work is for service of the common good, and bonuses should be paid as such' - Note that I do not believe all CEOs are overpaid. I'm all for genuine innovation being well rewarded. You IBM execs, all praise to your development and distribution of the PC. You have served us all massively - spend your bonuses with a clear conscience!!!
Any board member out there, take careful note! You corporate board members are responsible for the present mess, because you choose the bonus levels of our CEOs. The problem begins there, and trickles down through the upper tiers of management.
The big point again: 'work is for service of the common good, and bonuses should be paid as such'

 

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