Fixing Executive Compensation Excesses

The board members who decide a CEO's pay have a fundamental conflict of interest, and shareholders need to have more of a say

What will it take to end the abuses and excesses that exist in CEO and executive compensation? Why do they continue to occur in the face of increasing shareholder outrage, public criticism, and the threat of government action?

Although a few CEOs have volunteered to reduce their compensation for 2009 and others are passing up their 2008 bonuses, it clearly is not the norm for CEO’s to ask for a compensation reduction. Call it greed; call it unrealistic self-assessment; call it being out of touch, the reality remains that most CEOs are certain to continue to make a case for getting what appear to be outrageously high levels of compensation.

CEOs are not alone in thinking that they should be paid very well; athletes and entertainers think the same way. Where they are alone is their ability to influence how much they are paid. Most people’s pay is determined by salary policies, bosses, and budgets that limit what they get paid. In the case of CEOs, they “only” have to get their corporate board to agree to a “fair” level of compensation. Therein lies the most important reason why CEOs are so highly, and in some cases, outrageously paid.

Many boards are not in a position to say no to the CEO. In the U.S., the CEO is usually the chair of an organization's board and also selects its board members. In addition, continued tenure on the board often depends on the willingness of the CEO to support the reappointment of board members. As a result, it is the one place where pay is determined by people who report to the person whose pay is being set.

Boardroom Dissonance

How do board members feel about the level of the executive compensation in the U.S.? We have been focusing on this issue as part of an ongoing survey of board members, conducted by my Center for Effective Organizations at the University of Southern California and Heidrick & Struggles. Board members do acknowledge that CEO compensation is frequently too high. For the last 10 years more than 25% of board members have said it is generally too high, and 50% agree that it is too rich in some high-profile cases.

Given this attitude, one might wonder why board members have not been more active in controlling CEO pay. Part of the answer lies in their opinions about the compensation of their own company's CEO. In our recent survey of 115 boards, 85% of board members report that their CEO's compensation program is effective. Board members tend to feel, "We're okay; it's the other guys who are the problem." Given this and that they work for the CEO, it is not surprising that boards continue to support high levels of CEO compensation.

There are a number of actions that could reduce the level of CEO compensation in the U. S., witness the hard pay caps and regulations that President Obama is imposing on some financial firms. But, before imposing them on most companies, there should be two corporate governance changes. The first is to require that all boards separate the role of CEO and board chair. This is common in Europe and it may not be accidental that compensation levels are much lower in Europe. In Europe, however, the chair is often a former CEO of the company and cannot be described as an independent chair. In order to have an effective chair, the chair needs to be independent of the company and its executives.

The second change is putting executive compensation plans to a vote of the shareholders, for whom the CEO and top executives ultimately work. Because shareholders are "the boss," they are the logical ones to determine CEO compensation. A first step, which has been taken by a few companies, is to make the vote advisory. If this doesn't constrain CEO compensation, then it is important to move on to a mandatory shareholder vote on all top executive compensation plans.

There are a number of pros and cons associated with shareholder votes, but that is the change most likely to leave companies with the opportunity to design effective compensation plans without government intervention—and at the same time satisfy shareholders with respect to the level of CEO compensation. If it fails to have its intended affect then and only then should we consider government mandated restrictions on executive compensation payments.

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