"CEO Salaries, Shareholder Returns and the Future of Our Nation"

Sydney M. Williams

Thought of the Day

“CEO Salaries, Shareholder Returns and the Future of Our Nation”

January 10, 2011

It is the focus on the short term, not the long term, that increasingly dominates how we think and what actions we take. It has created an hedonistic environment where the loci of our focus is, “what’s in it for me?”

This quality of self interest too often today manifests itself in the corporate boardroom. Most CEOs of large, publically traded firms - apart from those who are founders - take on the job for a number of reasons: many simply look forward to the challenge; others have little or no doubt that their personal qualifications have eminently prepared them; for several, the job satisfies an innate aspiration; a number may want to grow the business (or save a failing enterprise) and feel they are the right person for the job; for most, their ego has been assuaged by the search committee and the Board. Compensation, though, is seen by CEOs as a form of scorecard - the higher the pay, the better they must be.

However, if pay is an accurate measurement of the best, should not one expect that to be reflected in the prices of their stock? Sadly, that is not the case. In 2007, a year before he was forced to sell his company (Countrywide Credit), Angelo Mozilo was the third highest paid executive in the U.S., bringing home $124.7 million. A year before he lead his company (Lehman Brothers) into bankruptcy, Richard Fuld was number 13 on the list, earning $71.9 million. What were the directors who authorized the compensation and responsible to millions of small shareholders (most of whose investments were in pension and retirement plans,) thinking?

Increasingly over the past couple of decades the job of CEO has become a means to personal riches. There is nothing wrong with such desires, but in too many cases there is little recognition of the role played by (or on) shareholders. Should the CEO be successful, they are the obvious beneficiaries. But, if he or she fails, they are the victims. As owners of the enterprise, they are the ones paying. Directors’ responsibility is to shareholders, not management. When Hank McKinnell, former CEO of Pfizer was paid $213 million upon leaving the job as CEO, it was not some entity named Pfizer or the Board that paid; the money came from the shareholders - shareholders who had cumulatively lost $160 billion during Mr. McKinnell’s tenure as CEO.

Large public companies are increasingly run by professional managers, hired to boost earnings per share over the immediate future. In essence, they are encouraged to speculate and make short term bets with the company’s capital, money that belongs to shareholders. They are paid to manage expectations on a quarterly basis. Despite the great need of the country and millions of investors to focus on long term goals, these men and women are incented on achieving short term ends. R&D budgets are often slashed, along with departments such as customer support, so that the costs eliminated will flow immediately to earnings per share. Worse, their employment contracts are often written so that should they fail a healthy severance removes any blemishes of embarrassment.

According to research done by two professors from the Kellogg School of Business at Northwestern, there are three reasons why firms grant lucrative severance packages to CEOs with their initial employment contracts: to encourage risk taking, to provide insurance for an incoming executive, and to compensate CEOs for entering into confidentiality agreements. Ironically, the shareholder, who is anteing up the money for the contract is wholly at risk, while the CEO, who stands to benefit the most, takes on no, or very limited, risk. Again, most of us have no problem with CEOs assuming business risk; that is what they are paid to do. But shouldn’t they have real skin in the game?

Were shareholders served well by the directors of Home Depot when they offered Robert Nardelli $82 million ($20 million due in cash within the first 30 days) if he were dismissed? Did the shareholders of Hewlett-Packard get treated properly when the directors offered Carly Fiorina, in accordance with a pre-nuptial, a severance of $21.4 million? Stanley O’Neal steered Merrill Lynch into subprime mortgages in the mid 2000s. He was fired “for cause” in October 2007; nevertheless he pocketed $94 million in 2006-2007. Were shareholders appropriately compensated? Were directors held responsible in any of these cases? Of course they weren’t. The answer does not lie in government mandating executive compensation, ala Kenneth Feinberg; no, the answer lies in a cultural change that causes people to take responsibility for their actions - the good and the bad. And the answer lies in a shift in priorities that emphasize long term investments, not short term results. The problem exists in professionally managed public companies, not those run by founders. Entrepreneurship is to be encouraged.

When Goldman was a partnership, the partners were at individual and collective risk. Betting on any investment, be it subprime mortgages or an equity stake in Facebook, was a function of betting their own money. Bad investments penalized them and good ones rewarded them. Over the decades they made far more good decisions than bad ones and, thus, were well rewarded. As a public company, they now bet with shareholders capital - some of which is their own, but most of which is not. It creates a different ethic and a different culture.

In 1980, according to Business Week, the average CEO was paid 42 times the average hourly worker’s wage. By 1990, the number doubled to 85 times; by 2000 that number had risen to 531 times! Reasons abound: during those two decades the stock market recorded annual compounded returns approaching 18% and CEOs were surely beneficiaries, but to ascribe that advance solely to the competence of the CEO would be to misunderstand the nature of markets.

Blame for the surge in executive compensation, especially that in the last two decades has been principally a consequence of the passage in 1993 by Congress of section 162 (m) of the tax code. That Bill limited the deductibility of annual executive compensation to $1,000,000, unless it was performance based. And options were performance based. The stock market was in the midst of an eighteen-year bull run and the use of options exploded. As a result, CEO compensation for the S&P 500 companies rose from $3.7 million in 1990 to $9.1 million in 2000. Options have long been mis-identified as aligning executive interests with that of shareholders. They do not. A stock option is exactly that, an option to buy stock at a specific price over a specific time. If the stock rises, the option is exercised; if the price falls, the option expires worthless, but no loss is incurred. Holders of options incur no risk, other than that of opportunity. However, should the stock rise during the designated period, they often stand to make millions. Worse, a number of companies re-priced options when stock prices declined, permitting the holders to benefit from the decline in price. Shareholders, on the other hand, own the stock outright, so enjoy gains when the price rises but suffer losses when they fall.

A fixation on short term results has hurt many of our largest companies, impaired our markets, damaged our country and caused losses for millions of workers and shareholders. Nevertheless, we need free and vibrant capital markets. Congress and the President should consider changes to the tax code that encourages savings and investments - lowering or eliminating taxes on long term capital gains and reducing taxes on dividends and interest. While I am not a fan of a VAT, perhaps some form of taxation should be considered on non-essential items. Congress and the President should encouraging people to think of the future – of education and training – and the need to compete in a global environment.