| FEBRUARY 25, 2009, 11:49 P.M. ET
Are Executives Paid Too
Congress asks the wrong question and
comes up with the wrong answer.
A last-minute provision added to the stimulus
bill President Barack Obama signed into law on Feb. 17 restricts companies
that accept federal bailout funds from paying performance bonuses that
exceed one-third of an executive's total annual compensation. This punitive
measure may be understandable as a reflection of populist fury over bonuses
being paid to heads of failing companies that received billions in taxpayer
money. But it utterly fails to fix the real problem with executive
Our economy didn't get into this mess because
executives were paid too much. Rather, they were paid too much for doing the
There have been nearly as many reasons
proposed for the current crisis as there are experts to propose them. But if
we had to pick one overarching cause, it would be business leaders taking on
excessive risk in the quest to increase next quarter's profits. This
short-term thinking, in turn, was driven by two trends in the business
world: shareholders' increasingly clamorous demands for higher earnings, and
compensation plans that paid managers handsomely for taking on risks today
that would only be realized later.
In the summer of 2006, well before most
economists had any inkling of the calamity that was about to unfold, the
Aspen Institute brought together a diverse mix of high-level business
leaders, investment bankers, governance experts, pension fund managers, and
union representatives. When you put successful people with such disparate
and conflicting backgrounds and loyalties together in the same room, the
result can be a shouting match. But the members of the newly formed Aspen
Corporate Values Strategy Group found they shared an unprecedented
consensus: Short-term thinking had become endemic in business and
investment, and it posed a grave threat to the U.S. economy.
People in all walks of life need months or
years to master a significant new project, whether it be getting a graduate
degree or perfecting a 75 mph minor-league pitch into a 90 mph major-league
fastball. Large corporations operate on a time scale that can be even
longer. They pursue complex, uncertain projects that take years or decades
to reach fruition: developing brand names, building specialized
manufacturing facilities, exploring and drilling for oil and gas fields, or
developing new drugs, products and technologies.
Yet over the past decade, corporations in
general -- and banks and finance companies in particular -- have become
increasingly focused on a single, short-term goal: raising share price.
Rather than focusing on producing quality products and services, they have
become consumed with earnings management, "financial engineering," and
moving risks off their balance sheets.
This collective myopia had many causes. One
cause, the Aspen Group concluded, was the demands of the very shareholders
who are now suffering most from the stock market's collapse. It is extremely
difficult for an outside investor to gauge whether a company is making
sound, long-term investments by training employees, improving customer
service, or developing promising new products. By comparison, it's easy to
see whether the stock price went up today. As a result, institutional and
individual investors alike became preoccupied with quarterly earnings
forecasts and short-term share price changes, and were quick to challenge
the management of any bank or corporation that failed to "maximize
Meanwhile, inside the firm, executives were
being encouraged to adopt a similarly short-term focus through the
widespread use of stock options. The value of a stock option depends
entirely on the market price of the company's stock on the date the option
is exercised. As a result, managers were incentivized to focus their efforts
not on planning for the long term, but instead on making sure that share
price was as high as possible on their option exercise date (usually only a
year or two in the future), through whatever means possible.
Executives eager to maximize the value of
stock options began adopting massive stock-buyback programs that drained
much-needed capital out of firms; jumping into risky "proprietary trading"
strategies with credit default swaps and other derivatives; cutting payroll
and research-and-development budgets; and even resorting to outright
accounting fraud, as Enron's options-fueled and stock-price obsessed
The system was perfectly designed to produce
the results we have now. To get different results, we need a different
Simply cutting executive pay is not going to
get either executives or investors to pay more attention to companies'
long-term health. To get business back on track, the Aspen Group concluded,
it is essential to focus on not just one but three strategies: designing new
corporate performance metrics, changing the nature of investor
communications, and reforming compensation structures.
Starting with metrics, we need new ways to
measure long-run corporate performance, rather than simply relying on stock
price. In terms of investor communications, companies need to ensure
corporate officers and directors communicate with shareholders not about
next quarter's expected profits, but about next year's and even next
Finally, and perhaps most importantly,
companies must change the ways they reward not only CEOs and midlevel
executives, but also institutional portfolio managers at hedge funds, mutual
funds, and pension funds. Executives and managers should be rewarded for the
actions and decisions within their control, not general market movements.
Incentive-based pay should be based on long-term metrics, not one year's
profits. Top executives who receive equity-based compensation should be
prohibited from using derivatives and other hedging techniques to offload
the risk that goes along with equity compensation, and instead be required
to continue holding a significant portion of their equity for a period
beyond their tenure.
It's always tempting in the midst of a crisis
to look for a quick fix. But that's the kind of short-term focus that got
the business world into trouble in the first place. So long as our metrics,
disclosures and compensation systems encourage executives and institutional
fund managers to look only a year or two ahead, we have to expect that that
is what they'll continue to do. It's time for a long-term investment in
promoting long-term business thinking.
Samuelson is the founder and executive director of the Aspen Institute
Business and Society Program. Ms. Stout is professor of corporate and
securities law at the UCLA School of Law and director of the UCLA-Sloan
Research Program on Business Organizations.
Copyright ©2009 Dow Jones &
Company, Inc. All Rights Reserved