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The Problem Is Not What Ce Os Get It's Getting Them To Go

Economic Viewpoint


The recession and President Bush's trip to Japan with a cohort of highly paid CEOs focused the attention of both sides of the Pacific on huge executive paychecks. Although some business leaders are surely overpaid, I believe pay is a red herring. The main problem with corporate leadership--and hence competitiveness--is the difficulty in getting rid of CEOs who run their businesses badly. The best way to do that would be to give them fixed-term contracts.

Chief executives who perform poorly are hard to replace because they usually have indefinite tenure, subject only to the board of directors or the grim reaper. But CEOs control most board appointments and thus are protected against removal. Management's slate is unopposed in more than 99% of elections to boards of directors, and even in the small remainder of cases, management prevails over the opposition 75% of the time. The upshot is that, barring a takeover by another company, top management seldom is fired, even when the company does badly.

Legislators, governors, college deans, coaches of college and professional sports teams, and others make do with term appointments. It might be a good idea for college professors, too. And it would be better to replace the tenure of chief executives by a fixed-term contract, perhaps three to five years, which could be renewed. Prior to renewal, the board would evaluate performance--preferably with the help of outside consultants--and report its conclusions and some of their analyses to the shareholders.

The short-term contract wouldn't be a surefire remedy for bad management, since the CEO would continue to exercise much control over the board. Still, it would involve a systematic, regular review of performance that would help expose evidence of incompetent management to stockholders and workers.

HEAL THYSELF. I am not advocating that fixed terms be imposed by the Securities & Exchange Commission or an act of Congress: There is already too much federal regulation of corporate governance. Rather, I would like to see corporate boards take the initiative in providing fixed terms for CEOs, possibly in response to stockholder and public pressure. The performance of these companies could then be studied to determine whether term appointments really are a good idea.

Critics complain that executive pay usually does not fall much when a company's profits and stock plummet. But even though a hefty pay cut for top executives of a loss-making company might make shareholders happy and might improve the morale of employees who suffer losses in pay and jobs, it would not have much direct effect on profits, since executive pay usually is a minute fraction of total costs. And tying compensation more closely to performance would not magically cause an executive to make better decisions. It is possible, however, that linking pay closer to performance would attract more entrepreneurial executives to corporations.

The proposal by Governor Bill Clinton of Arkansas and some members of Congress to penalize a company that pays top executives more than a specified multiple of the earnings of the average worker would be an unwarranted intervention into the market. The issue it turns on--the relationship between executive and average pay--strikes a populist note but isn't particularly important. The same is true of the recent recommendation by the sec that companies allow stockholders to vote on executive compensation, though their votes would not be binding.

A study by economist Steven N. Kaplan of the University of Chicago of top executives in large Japanese and U.S. companies indicates that the heads of Japanese companies appear to earn much less, yet their compensation is no more sensitive to performance than is the pay of American leaders. But Japanese CEOs typically serve for only 6 years, compared with almost 10 for Americans. This is because Japanese executives are older when they reach the top, and they are more likely to be forced out by poor stock performance and low profits.

LEADEN PARACHUTES. It is far more common in the U.S. than elsewhere to replace top management through friendly or hostile takeovers. Obviously, takeover battles are an uneconomic way to replace bad management. A much-criticized but more economic method of dislodging a CEO is to convert an unfriendly takeover into a cheaper friendly one through golden parachutes: liberal severance pay for top executives who are forced out.

It may be unfair to reward a bad CEO with a multimillion-dollar payoff. Yet under present conditions, that's often the cheapest, quickest, and most effective way to get rid of him and replace deeply entrenched management without a bruising fight. Clearly, fixed-term appointments would make it easier to oust incompetent CEOs more rapidly without takeover battles and golden parachutes.

Only bad leaders fail to cut their own pay when workers and stockholders are asked to sacrifice. But the poor performance of a corporation has less to do with executive pay than with the old problem of how to make a change at the top when leaders do not perform well.Gary S. Becker

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