Executive Compensation Limits: Pro and Con
Few issues have been lobbied more intensely in Washington over the past few years than executive compensation limits. Today, President Obama joined the fray. At 11 a.m. today, he and Treasury Secretary Geithner announced tougher executive compensation limits on banks that accept TARP funding.
Toward the end of his remarks, President Obama ignited fears in every corporate boardroom that these limits might be expanded to all corporate executives. He said:
"And, finally, these guidelines we're putting in place are only the beginning of a long-term effort. We're going to examine the ways in which the means and manner of executive compensation contributed to a reckless culture and a quarter-by-quarter mentality that in turn helped to wreak havoc in our financial system.
We're going to be taking a look at broader reforms so that executives are compensated for sound risk management and rewarded for growth measured over years, not just days or weeks."
Now we're talking about "moral hazard," as we economists like to call it. That's when executives negotiate huge compensation packages and generous golden parachutes, knowing they're not going to last as CEO for more than three years on average, in hope that they are so skilled or so lucky, or both, that they can generate unprecedented earnings. Of course, anyone who has studied much economics knows that extraordinary returns only come at the cost of extraordinary risks. However, if that CEO is gambling with other people's money and other people's jobs, that compensation package encourages him or her to take those extraordinary risks. This is "MORAL HAZARD." Executive compensation has clearly been one of the key causes of our current economic disaster.
Now the tougher question, what to do about executive compensation? Direct limits run the risk of driving away the best talent from business management and of reducing job creation and economic growth. President Obama is on the right track by linking executive compensation to long-term performance, but that's not easy to do. There are too many factors that affect corporate performance besides CEO behavior to pin all the risk on his or her compensation. Sometime soon, House Financial Services Chair Barney Frank (D-MA) will revive a bill, H.R.1257, which passed the House 269-134 on April 20, 2007, but went no further. It would require executive compensation to be approved by shareholders annually. That may work for some firms, but problems can arise when shareholders demand short-term results, when they might be better off looking for long-term results. Many forget that when President Clinton came to office, in 1993, we adopted Section 163(m) of the Internal Revenue Code, limiting the deduction for executive compensation under the corporate income tax to $1,000,000. However, a big exception was created for performance based compensation, e.g. bonuses and stock options, so the provision actually increased moral hazard by shifting executive compensation towards bonuses and stock options. Check out the gory detail in this excellent Joint Tax Committee analysis. The sorry history of this provision is a prime example of how the collision of market forces and government can come to no good end if we're not careful. I'd like to think that enlightened political leadership can do better. We'll see.
Limits on compensation
I would prefer a limit in the form that no employee can be paid more than the beginning of third standard deviation that results from the pay of all full time employees for any given firm. I would deny any tax deduction for salaries or compensation if any compensation in any form was paid to anyone in excess of that amount.
Even though I'd grant that many banking executives are very talented, there is no reason to suppose that there aren't many talented people who could replace them. What we need to end is the mentality of many execs that seem to want to ransack and pillage the assets for a few years before they are sent packing with as much as they can get away with.
Old Boy's Network
We should follow Germany's example, a director of one company should not be allowed simultaneously to be a senior executive in another company. Similarly, a senior executive in one company should only be allowed to become a Director of another if he gives up his post as a senior executive. Because at present, in America and in Britain, senior executives and Directors are acting to undermine capitalism, through monopoly, they are able to reward each other more than Normal Profit.
We should follow Germany's
We should follow Germany's example, a director of one Public Limited Company should not be allowed simultaneously to be a senior executive in another Public Limited Company. Similarly, a senior executive in one company should only be allowed to become a Director of another if he gives up his post as a senior executive. Because at present, in America and in Britain, senior executives and Directors are acting to undermine capitalism, through monopoly they are able to reward each other more than normal profit with the shareholders suffering in consequence.
Performance-based Compensation is Difficult but Obtainable
The posting mentions 162(m) (inadvertently listed as 163(m)) as a cap on tax deductions for pay above $1 Million. The hole in 162(m)'s definition of "performance" is that it defines the growth of stock price over time as a performance measure. This qualifies nearly every stock option grant given since 1993. In 1993 there were serious downsides to companies rolling out true performance-based vesting equity compensation. Among these were accounting treatment that was punitive when compared to "time-based" vesting, a lack of analysis and details on how such programs could work and essentially no tools for properly managing these plans.
Of these it was the accounting expense that was the worst problem. With the advent of FAS 123R in 2005, the dichotomy between time-based and performance-based vesting was essentially eliminated, but no one thought to look at 162(m) to make a similar modification. Now with TARP 162(m) amounts are being lowered to $500,000, but the fundamental structure of the rule has still not changed. If we want "performance compensation" to work, we need to change how performance is defined in 162(m).
The second piece of this puzzle is that shareholders, advisors and most executives are stuck in a world of "executive summaries". This means focusing on small bullets of information rather than the meat of the topic. Because, we tend to look at performance delivery as the final result, rather than the pieces that drive the final result. For performance to work it must be about achieving the many steps on the road to a result, not just about the result.
Just as coaches and players in the NFL say they "take it one game at a time" and the Super Bowl is just a culmination of all of those games, Executives should be asked to take it one step at a time and the final performance is the result of all the steps that preceded it. This will reduce payouts on false performance and provide accountability in the process.
The result will be more consistent performance that everyone can agree upon. If we start now, we should be able to get it right in the next 4-5 years.