After years of watching the top echelons of corporate management
take home billions, shareholders want to know: Will inflated pay
packages get slashed?
By David S. Hilzenrath
Washington Post Staff Writer
Sunday, December 21, 2008; F01
Angelo R. Mozilo, whose
Countrywide Financial came to symbolize the failings of the
mortgage industry, took home more than half a billion dollars from
1998 to 2007, including $121.7 million from cashing in options last
year alone. Charles O. Prince, who led
Citigroup to the brink of disaster, was awarded a retirement
deal worth $28 million. Now, in a show of purported restraint, top
Wall Street executives are going without bonuses.
What are we to make of all this?
If you're angry that so many
executives got paid so much for screwing up so spectacularly, you
might take solace in the fact that shares they still hold have lost
value, too. But if you think executive pay is finally succumbing to
the force of gravity -- if you'd like to believe that an epic
destruction of investor wealth will fundamentally and permanently
change the way chief executives are paid, or that you, dear
shareholder, have the power to join forces with others just like you
and create a more rational order -- don't bet on it. The nation's
financial crisis could change the rules of executive pay, but if
history is any guide, you'll have a lot more to complain about in
the years ahead.
Through nearly two decades of
tinkering, each new twist in executive pay has proved flawed.
Incentives meant to reward good management have done just the
opposite, and efforts to reform the system have in some respects
made matters worse. From the bursting of the dot-com bubble to the
collapse of companies like
WorldCom, from the rampant backdating of stock options to the
current meltdown of the global financial system, the so-called
pay-for-performance movement has led to colossal windfalls, reckless
risk-taking and fraud.
At a time when the government is
using taxpayer funds to rescue financial titans -- when ordinary
Americans are watching their retirement savings evaporate --
announcing that top executives will forgo bonuses has obvious
public-relations benefits. But unless a bonus was warranted, it's a
hollow gesture. And it does nothing to alter certain underlying
For the most part, executive pay is
set by executives. Executives dominate corporate boards, and
corporate boards are self-perpetuating. As a practical matter,
shareholders have little say in the selection of directors, and once
directors are in the compensation boat, they have little incentive
to rock it.
If you're a director and you go
along with generous chief executive pay, "you get to sit on more
boards," said Fabrizio Ferri, an assistant professor at
Harvard Business School who studies executive compensation.
According to one school of thought,
the scale of executive pay, if not the particular form, is unlikely
to change substantially unless the balance of boardroom power
There are several ways the crisis
could shake things up.
First, short of a revolution in the
way corporations are governed, there are efforts afoot to make it
harder for executives to profit from mismanagement while investors
are left holding the bag.
Some shareholder activists are
calling on boards to hold incentive pay hostage to a company's
long-term fortunes, and investor anger could put pressure on
directors to comply. The American Federation of State, County and
Municipal Employees plans to ask shareholders to vote next year on
resolutions urging boards to take two steps: stretch out the payment
of annual bonuses over multiple years and hold on to a significant
portion of equity awards until the executive has been gone from the
company for two years.
The resolutions are purely advisory.
Second, through its bailout
programs, the government can set conditions for companies that
accept federal funds. For example, the government is requiring
participating firms to eliminate incentives for executives to take
"unnecessary and excessive risks that threaten the value of the
financial institution." It's unclear how companies will apply such a
nebulous standard. In the spirit of both the AFSCME proposal and the
Treasury mandate, the investment firm
Morgan Stanley recently said it will make a portion of annual
bonuses subject to recapture by the company.
Third, either Congress or the
Securities and Exchange Commission could make it easier for big
shareholders to put their own candidates for board seats on the
corporate ballot. In theory, that could make directors much more
accountable. For it to work, shareholders, especially institutions
like pension and mutual funds, would have to take a more active role
than many have had the stomach to play in the past.
The plan could backfire. If
executives are forced to confront shareholders with real power,
would they be any less motivated to deliver short-term results, or
the illusion of short-term results -- even if those compromise the
company's interests over the long run?
* * *
Outrage about executive pay is far
from a new phenomenon.
Back in 1990, two professors warned
that something very bad was taking place in America's boardrooms:
Executives were being paid too little.
"On average, corporate America pays
its most important leaders like bureaucrats. Is it any wonder then
that so many CEOs act like bureaucrats rather than the
value-maximizing entrepreneurs companies need to enhance their
standing in world markets?" professors Michael C. Jensen and
Kevin J. Murphy wrote in the Harvard Business Review.
Executives, not surprisingly,
embraced the idea. In a way, so did their toughest critics. At the
time, some shareholders were up in arms about million-dollar
executive salaries. They demanded that pay be based on performance,
and they bought into the notion that chief executives should be able
to make more money as long as they earned it.
Bill Clinton and Congress got into the act in 1993, dictating
that companies could no longer take tax deductions for executive pay
packages of more than $1 million -- unless the pay was
What followed was a massive
proliferation of stock options, making it possible for executives
and workers alike to attain fortunes that were previously
unimaginable. Options give the holder the right to buy shares of
stock at a fixed price -- ordinarily, the price at which the shares
are trading when the options are granted. If the market price of the
stock climbs, the holder can exercise the options and sell the
shares at a profit.
If the executive is awarded options
to buy 500,000 shares at $10 each and the stock price climbs to $100
-- well, you do the math.
Corporate boards claimed that they
were aligning the interests of executives with those of
shareholders. They were wrong.
Options can reward any increase in
the share price. That became painfully clear in the bull market of
the 1990s when executives benefited from rising share prices even if
their stocks lagged behind competitors or market averages.
Then came an epidemic of accounting
scandals, which showed that options gave executives powerful
incentives to cook the books and kite their stocks. More recently,
many companies were found to have secretly manipulated the terms of
options. By backdating the awards -- in other words, falsely
claiming that the options were granted when the stock price was
especially low -- companies lowered the performance hurdle and made
the options much more valuable.
As an alternative to options, or in
addition to options, many boards shower executives with stock that
vests over a period of years. But those awards are widely mocked as
"pay for pulse" because they have value even if the stock price
falls. Some boards layer on additional requirements -- for example,
the executives can't collect the stock unless the company's profit
or share price hits certain targets. If the targets aren't easy to
hit, they can introduce more incentives to cheat.
Meanwhile, boards have a history of
openly changing the rules to benefit the boss. When performance
targets proved too hard to meet last year, a bunch of companies
dispensed with their criteria and awarded bonuses anyway, according
to a report this month by the Corporate Library.
Government efforts to reform
executive pay have had mixed results.
When the government limited the
tax-deductibility of executive salaries, many boards stuck
shareholders with the added taxes instead of capping the salaries.
When the government mandated clearer disclosure of executive pay, it
gave shareholders fresh ammunition to complain -- but it also gave
executives more information about their peers, which gave them new
leverage in pay negotiations, Joseph E. Bachelder III, a lawyer for
top executives, wrote in the New York Law Journal last year.
In 1992, after the SEC adopted some
of the most significant reforms, one leading compensation critic
suggested that the actions could put him out of business. "I may be
Maytag repairman, with nothing to do, sitting here waiting for
somebody to be overpaid," Graef Crystal joked. Sixteen years later,
Crystal is still fulminating.
At last check, the chief executives
of companies in the Standard & Poor's 500-stock index received pay
packages valued at an average of $10.5 million, which was 344 times
the pay of the typical American worker, according to a study by the
Institute For Policy Studies and United for a Fair Economy, which
says that "concentrated wealth and power undermine the economy."
Murphy, a co-author of the 1990
Harvard Business Review article, predicted that executive pay will
resume its upward climb.
"I think we have a history that
shows that uproars over executive compensation at most create
short-run changes in pay. And then what usually happens is the
government enacts some knee-jerk reactions that at the end of the
day end up increasing executive pay," he said.
Chief executives "prefer to play a
heads-I-win, tails-you-lose game with shareholders, and so far
they've been successful," said Jensen, the other author of the 1990
article. "It's changing, but compensation committees [of corporate
boards] still tend to be under the control of the CEO," he said.
Though it may be counterintuitive,
the current crisis could plant the seeds for a new bumper crop of
As compensation committees ponder
their next round of pay decisions, one of the questions they are
trying to answer, board advisers said, is how to factor in the
decline in stock prices when determining how many shares to award
executives. They could give out the same number of shares as in past
years, delivering much less value. Or they could give out many more
shares to make up for the reduced value of each individual share,
setting executives up for huge gains if stock prices recover.