Wealth of Nations April 2006

Shameless Gougers

Year in, year out, the median pay of top executives rises much faster than wages and salaries overall. It's time for shareholders to demand an end to the gouging.

Most CEOs understand, or say they understand, that capitalism needs the tacit support of the public to function well. In fact, to judge by much popular culture, Americans are already fairly distrustful of capitalism—but these things are relative. If Americans were as hostile to big business as, say, the French are, then the tax and regulatory regime for American companies would quickly evolve to become as unfriendly and dysfunctional as France's. When compensation committees vote huge and patently unwarranted pay increases for their nonperforming CEOs, they are working to that end. They are not just failing in their duty to the shareholders whose interests they are paid to uphold, they are hurting the rest of us as well. They are undermining capitalism more surely than its avowed opponents and making its defenders look like spokesmen for base hypocrisy.

Can anything be done about it? For most corporate-governance activists, the remedy of first resort is greater disclosure. The Securities and Exchange Commission has a proposal that will oblige companies to give more information about the total pay of their top executives, making it easier to do a full accounting. This should go further.

In the face of opposition from business leaders, regulators are not pressing for disclosure of the performance formulas (if any) that compensation committees apply in designing CEOs' supposedly performance-related packages. That is a mistake. TCL's research points to cases where compensation committees authorize bonuses that start to pay out if the company stands at well below the median of the chosen measure of success. In other words, even if the company is doing worse than most of the firms in its segment, its CEO can expect to collect a bonus for good performance. Very challenging. Perhaps, if companies had to report schemes as ludicrous as this to shareholders and had to document them in detail, more compensation committees would hesitate to approve them.

The Times drew attention to another anomaly, reminiscent of the conflicts of interest that have plagued auditors and investment analysts. Many compensation committees use outside advisers to guide them and to sanctify the pay schemes they decide upon. But these advisers apparently do lots of other business—worth far more to them than the advice on CEO pay—with the firms concerned. They may design or manage the firm's employee-benefits system, for example. So they are giving advice on how much to pay the CEO at the same time that he or she is deciding how much other business to send their way. At the moment, companies do not have to disclose these relationships.

But one may ask whether greater openness will be enough. Some businesses argue that disclosure will make matters worse—that easier comparisons of CEO pay will ramp up the money even more. It is an insincere argument, of course—"Please don't push my pay up even faster"—but it might actually be true, especially since many compensation committees appear to set pay, or elements of pay, at a percentile of CEO compensation across their industry. What an abject abdication of responsibility to shareholders that is. Moreover, if every CEO expects to be paid at least as well as the average, you have a never-ending upward spiral of cost—and fuller disclosure might then indeed make matters worse.

The answer lies in the combination of greater disclosure and greater power for shareholders. We need both, so that the owners can do something with the information. In short, CEOs need to be made less secure. Regulatory and legal restraints on hostile takeovers—much the best discipline on boards that forget their fiduciary responsibilities—need to be rolled back. Also, public companies should be obliged to put the fully disclosed pay of their top executives to an annual shareholder vote (as in Britain), and (unlike in Britain) that vote should be binding on the company.

Even then, shareholders would have to be willing to exert themselves—something that, in America, they have often been oddly reluctant to do. They lose a lot by their passivity, and so, unfortunately, do the rest of us.

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