It's no secret that CEOs and other high-level managers of publicly traded U.S. companies are well paid. The Wall Street Journal publishes a study every year of CEO compensation at large public companies with annual revenues above $5 billion, and its 2009 study showed median total pay (salary, cash bonus, stock options, and other types of long-term incentives) of $7.2 million. How much and how public company executives are paid is an economic transaction; investors or shareholders who own the companies buy the services of the executives in the market.
In economics, the term "equilibrium" refers to a market where supply, demand, and price are all perfectly aligned. Many believe that U.S. executive compensation is badly out of equilibrium. They think that the price senior executives are charging for their services is too high in relation to their performance compared to people doing similar jobs in other parts of the world, as well as to rank-and-file employees. Those sharing this view are the Obama Administration, most of Congress, organized labor, a number of pension funds and other institutional investors, and probably a majority of the American public.
When prices are not in equilibrium, the reason is that markets are inefficient; or, in proper economic jargon, there are market "imperfections." We should think of executive compensation in terms of these basic economic principles and ask: If the market price for U.S. executives is misaligned or out of equilibrium, can we identify and address the relevant market imperfections to restore equilibrium?
There appear to be four major market imperfections based on repeated criticisms of U.S. executive compensation and the direction of future reforms. They are:
1. The ownership structure of public companies.
Public companies are generally owned by many passive investors with diverse interests and little commonality. They elect directors who in turn hire company management, and those managers have their own self-interests that are sometimes different from the owners'. Does management self-interest enabled by passive owners impact the market? Absolutely, but the impact is less on pay levels and more on how pay is delivered.
In terms of pay levels, self-interest explains the outliers, and there will always be a few in any market. They will continue to be in the headlines and make everyone look bad. But they do not represent the majority of companies.
With regard to pay delivery, the impact of passive owners and management self-interest is more subtle. Over time, the result has been an imbalance in risk and rewards. Look at what happened at the big banks. Large severance was paid to people who were terminated because they did not perform; too much was spent on nonperformance-related pay such as perquisites, and goals were set low enough that performance-based incentive plans are likely to deliver high pay in good years and bad.
2. The corporate governance process.
Elected directors who serve on public-company boards are primarily acting or retired CEOs of other companies along with some investors, lawyers, academics, and former politicians. The boards meet four or five times a year with the bulk of they work done by committees. Board compensation committee members must be "independent" as defined by regulations from the SEC, IRS, and stock exchanges.
Critics of executive compensation look at this system and conclude that the problem is "cronyism." "You be on my board and take care of me, and I will be on your board and return the favor." They are wrong. Most compensation committees function independently of management influence, and the situation has vastly improved since adoption of Sarbanes-Oxley in 2002.
The problem is actually one of time and resources. Compensation committees, with their four or five meetings a year, don't have the full-time professional staffs and paid advisors, as does company management. In response, more comp committees are retaining their own consultants.
Based on current SEC disclosure filings, almost all of the top 100 board compensation committees now have their own consultants—which brings us to the next market imperfection.
3. Conflicted Advisers.
Most executive compensation consultants are part of large, multiline firms that are also insurance brokers or pension actuaries, or have businesses providing human-resources outsourcing or pay surveys and broad-based compensation consulting services. The revenues from these other businesses dwarf the revenues from hourly fees to advise compensation committees, resulting in an inherent business conflict.
Recently, I was invited to testify in Congress before Senator Waxman's Oversight Committee at hearings on corporate governance reform, along with representatives from several of our multiline competitors. My advice to Congress was that compensation committee consultants should be covered by the same standards for independence that apply to directors who serve on the committees. (In fairness, I am biased in my view because my firm, Frederic W. Cook & Co., Inc. provides independent executive compensation advisory services as our only business.)
4. Lack of Transparency.
A lot was missing from the disclosure of executive compensation before 2007. Then, new rules took effect requiring detailed narrative and tabular reporting of virtually every aspect of the compensation-determination process and resulting values for every pay element, including cash, equity, pensions, severance, deferrals, and perquisites.
Does disclosure impact the market by making boards more accountable? The answer is yes, in my experience. Many poor pay practices have been eliminated since 2007. Unfortunately, there is still no clarity. Narrative compensation disclosure often uses verbose and legal boilerplate, while the pay amounts reported for everything except current cash are based on accounting accruals and actuarial values that don't match with the time periods covered by the disclosure or with actual amounts of pay that were delivered.
What's Being Done?
Let's consider each of the market imperfections and how they are being addressed.
By far the most sweeping activity is occurring with regard to ownership structure and unrelated passive shareholders. First, is it happening with the emergence of organizations that advise investment funds on how to vote their proxies on governance-related matters, including executive compensation. The biggest and most powerful of these firms is RiskMetrics Group, which claims to advise investors representing several trillion dollars of capital.
Such companies are a significant force, affecting pay structure by successfully campaigning against "poor pay practices," such as excessive severance, perquisites, tax gross-ups, etc.
Second, there is the soon-to-be-mandated annual advisory vote on executive compensation, referred to as "Say-on-Pay." The Corporate & Financial Institution Compensation Fairness bill (which includes Say-on-Pay), passed in the House and will be considered by the Senate soon. Passage is expected by the end of 2009 and full implementation in time for the spring, 2011, proxy season. Say-on-Pay is designed to increase the dialogue between shareholders and boards on executive compensation.
The House Bill that covers "Say-on-Pay" also includes proposals to tighten the standards for serving on a board compensation committee and would put compensation committee members under essentially the same requirements that apply to audit committee members under Sarbanes-Oxley. Companies would also be required to provide funds to allow compensation committees to retain independent advisors and legal counsel.
However, potentially much more significant are proxy voting reforms, which are part of the same proposed legislation. These reforms would make it easier for dissident investors to nominate their own director candidates, require annual elections by majority vote, and enact other changes to make shareholder voting more representative. In terms of executive compensation, the significance is in giving real teeth to the shareholder-advisory votes. If boards don't take the shareholders' advice as reflected in the "Say-on-Pay" vote, there is a much greater chance they could be voted out in subsequent years.
The third market imperfection is conflicted advisors. The SEC is addressing this through new proxy disclosure rules. We expect that starting next year, companies will have to disclose details of the fees paid to the compensation committee's advisor if the advisor or any firm with whom the advisor is affiliated provides other services to the company. (There is also a provision in the House Bill for the SEC to set standards for the independence of compensation committee advisors.)
There are also provisions in the SEC's proposed proxy disclosure amendments to address lack of transparency, the fourth and final point. The primary proposed change is in the disclosure of equity compensation. I hope the new rules will get it right, because the 2007 rules failed.
Under the proposal, companies will report the value of equity compensation granted in the current year. Current rules call for disclosure of grant values attributable to all prior years that were expensed in the current year. This change is necessary for Say-on-Pay to work, because investors will want to look at the current year's compensation that corresponds with the current year's performance, and they cannot easily do that now.
So, in five years, will anything be different? I believe there will be better program design for performance-related pay. There also will be fewer outliers. However, the $7.2 million median for big companies will be about the same because today's market is not that far off, and most public companies out there are not managing executive compensation for their shareholders as badly as conventional wisdom would have it.