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But along the way more than a few things went wrong, Mr. Jensen acknowledges, and now he is trying to find ways to fix the flaws that, in his evolving view, often allow mediocre chief executives — even outright failures — to become fabulously rich.
“There are all kinds of mistakes, and we can do a lot better,” Mr. Jensen, a professor emeritus at Harvard’s Graduate School of Business, said in an interview at his modernistic home on Siesta Key, with its huge picture windows overlooking the Gulf of Mexico some 40 feet away. It is one of two luxury houses — the other is in Sharon, Vt. — that reflect an academic life marked by success not just in scholarly pursuits but as a business consultant and popular speaker as well.
The repair work that Mr. Jensen and his co-author, Kevin J. Murphy, an economist and business school professor at the University of Southern California, are proposing in “C.E.O. Pay and What to Do About It,” due early next year from Harvard Business School Press, would require corporate boards to negotiate much tougher contracts with their chief executives. But that is not going to be easy.
“Imposing the constraints that Michael Jensen has in mind,” said Margaret Blair, a professor at Vanderbilt Law School and a specialist in corporate governance, “runs contrary to the culture that has emerged in boardrooms over the last 20 years. Mr. Jensen himself is partly responsible for that culture.”
Even as he seeks to tighten the reins on executives of publicly traded companies, Mr. Jensen applauds the rise of private equity firms. He argues that the managers of these operations are much better stewards of the public companies they acquire than the boards they replace. With their own money at stake, and huge debts to repay, these managers have greater incentive than elected directors to be tough on the chief executives they appoint.
“My way of characterizing the major thing that’s wrong with large public corporations in the United States: the C.E.O. has no boss,” Mr. Jensen said. “Private equity fixes that very well. The C.E.O. has a boss.”
Still, whatever the shortcomings of pay for performance, the upheaval in governance that Mr. Jensen fathered has made large corporations much less “ossified” than they were a generation ago, Mr. Jensen said. He attributes the improvement in part to outsize performance rewards for chief executives, and the motivation such rewards inspire to improve profits and drive up the share price through various methods: reorganization, sharper marketing, innovation, outsourcing, layoffs.
As competition has intensified, corporations have flourished, but not necessarily the communities in which they are located or the workers they employ. Those are shortcomings that Mr. Jensen considers an acceptable price to pay for an American economy that he believes has outstripped Japan and Europe in growth and prosperity.
“We’ve come a long way, and we are in fantastically good shape,” Mr. Jensen said.
The Jensen-Murphy proposals are arriving just as wage stagnation and income inequality, fed in part by soaring chief executive pay, enter the presidential election as thorny campaign issues. Adding fuel to the fire, two prominent chief executives who failed to drive up their company’s share prices — Henry A. McKinnell at Pfizer and Robert L. Nardelli at Home Depot — nevertheless left with severance packages of $200 million or more apiece.
Mr. Jensen and Mr. Murphy say they abhor such payoffs. In his research, Mr. Jensen found that in 44 percent of all contracts for chief executives, even those convicted of fraud or embezzlement cannot be fired without a severance payment. In 94 percent of the contracts, he said, they cannot be fired for unsatisfactory work without a big severance package.
“How in the world can compensation committees sign these contracts?” Mr. Jensen asked. “They are breaching their fiduciary responsibility. It is a scandal of major proportions, and it is hidden.”
At the same time, too many chief executives are well-paid without creating value, according to Mr. Jensen, who raises no objection to pay in the tens of millions as long as it is, by his standard, justly earned. One reason it is not: most such contracts fail to take into account the cost of capital, by which Mr. Jensen means the return that, on average, a shareholder would earn from putting his money into a different, similarly risky investment.
Say the cost of capital is 10 percent and a chief executive holds a bundle of options acquired when a share was worth $100. The share goes to $108, allowing the executive to exercise his options, earning $8 a share. But he has not created any real value, Mr. Jensen argues; he has shortchanged the shareholder, who would have come away with $110 if he had put $100 into a reasonable alternative.
“I would never award the standard executive stock option again,” Mr. Jensen declared, acknowledging that he had failed to take cost of capital into account in his original formulation of pay for performance.
Mr. Jensen would also require chief executives to pay for their options, forcing them to focus on creating value or risk losing their own money. The option with the $100 strike price should cost the chief executive $10, he said. If the stock then rose to $110, a chief would not make any money for two reasons: the $10 cost of capital and the $10 paid to purchase the option. That money would not be returned if the option remained under water, not in the toughened compensation contracts that Mr. Jensen would write.
“So now you would have C.E.O.’s with skin in the game,” he said. “Skin in the game is important. You bet.”
Still, for all its present shortcomings, Mr. Jensen believes deeply in the value of pay for performance, which he first explored in research with William L. Meckling in the 1970s, when both were economists at the University of Rochester’s Graduate School of Management. A seminal article in the Harvard Business Review, written with Mr. Murphy in 1990, outlined the present system, in which a rising share price became the measure of a corporation’s value.
Chief executives were in the key position to increase shareholder value, Mr. Jensen and Mr. Murphy wrote, and their pay, therefore, should be tied to the stock price, through option awards and outright stock grants by independent boards.
Thus pay for performance got rolling, eclipsing six-figure annual salaries and cash bonuses, until then the standard. And as the new payoffs multiplied — taking on a life of their own as companies ratcheted up the bidding for executive talent — so did the criticism.
“Jensen seems fixated on the notion that the only way to get other benefits for society is to achieve shareholder value,” said Jay W. Lorsch, a professor of human relations at Harvard’s Graduate School of Business. “You certainly want shareholder value, but over the long term. When you do it over the long term, other stakeholders — the work force, for example — must also be recognized and rewarded.”
Professor Blair of Vanderbilt adds that pay for performance is too often just a windfall. She argues that many chief executives have simply been the lucky beneficiaries of a generally rising stock market, even if their own performances were not that great.
While Mr. Jensen’s proposals would go some way toward overcoming these objections, he sees even greater promise in the movement toward private ownership of large corporations. He welcomed the Chrysler buyout as a stark, unforgiving and necessary exercise in pay for performance.
Cerberus Capital Management, the private equity firm headed by Stephen A. Feinberg, took on huge amounts of debt to take Chrysler private this summer, and installed Mr. Nardelli, the failed head of Home Depot, as the new chief executive.
Mr. Nardelli’s guidepost for generating value is not the stock price — there is not any stock — but whether he can make Chrysler profitable enough to keep up the payments on its debt and earn more than its cost of capital. And if he cannot, Mr. Jensen said, then he has to answer to only one person, Mr. Feinberg.
To achieve those goals, Mr. Nardelli will almost inevitably turn to slashing costs, particularly labor costs. It is the sort of experience that Mr. Jensen and his father lived through in the 1960s and 1970s.
Both were printers in Minneapolis, members of the Typographical Workers Union. The son learned the trade in vocational high school and, upon graduation in 1957, went to work for a newspaper as a Linotype operator, intending to make that his life’s work, just like his father.
A teacher, however, talked Mr. Jensen into enrolling at Macalester College, in nearby St. Paul; in the end, working full time as a printer became a means of supporting himself through 11 years of college and graduate school at the University of Chicago.
During these years, new technology put Linotype operators out of business. Mr. Jensen made the leap to a new career. In the process he hardened himself, by his own account, to the plight of workers whose skills, like those of the Linotype operators, were no longer worth their wages.
Listening to Mr. Jensen’s story, it is plain that he generated plenty of value as an academic in a career shaped in part by his experiences as a printer.
But his father did not make it into comfortable retirement.
“I had learned all this stuff about economics,” Mr. Jensen said, “and I remember several conversations in which I told him, ‘Dad, you can’t count on anything coming back to you from the union pension fund.’ And he got very angry at me for telling him the union would let him down.”
But it did. The pension fund failed to deliver the promised amount, Mr. Jensen said, and “in their old age, I supported my parents.”