Excessive Executive Pay: What's the Solution?

In the search for
culprits in the global financial meltdown, bloated executive pay and
the excessive risk-taking behavior it fueled stand out as prime
suspects. Of the two, pay dominates the headlines and provokes the most
public and political outrage.

Pitchfork populism over the issue reached a crescendo last March
when insurance conglomerate AIG, kept on life support with up to $183
billion in taxpayers' cash, dished out bonuses totaling $165 million to
400 employees in the London office whose derivatives trading nearly
destroyed the company. Lavish pay for poor performance wasn't just an
AIG phenomenon. On Wall Street, it was endemic. Bankers gave themselves
nearly $20 billion in 2008 bonuses, even as the economy was spiraling
downward and the government was spending billions on bailouts.

Politicians pounced. President Obama called Wall Street's outsize
pay packages "shameful," especially for companies in need of federal
bailouts. Such pay, he said, is "exactly the kind of disregard for the
costs and consequences of their actions that brought about this
crisis—a culture of narrow self-interest and short-term gain at the
expense of everything else."

"While boards have improved in recent years, the speed at
which they were improving lagged behind the speed at which solutions
should have been implemented." -Rakesh Khurana

That culture, critics maintain, spawned executive compensation plans
with incentives that encouraged the excessive risk-taking that led to
the financial crisis. And while the intricate details of pay plans
don't evoke the outrage of multimillion-dollar paydays, curbing the
risk-taking incentives embedded in those plans is key to resolving the
current crisis and preventing another. That task falls, by law, to
corporate boards, clubby groups that are widely criticized as the
handpicked "captives" of self-serving management.

With White House support, congressional leaders are intent on
shifting the balance of power in the boardroom away from management.
Senator Chuck Schumer's (D-NY) Shareholder Bill of Rights Act,
introduced May 19, casts shareholders as the antidote to runaway
executive compensation and excessive risk-taking. The bill requires
public companies to conduct annual, nonbinding votes by shareholders on
executive compensation—so-called say on pay; grants substantial
shareholders a new right to have their director candidates' names
included on the ballots sent out by the company (dissident shareholders
now must send out their own ballots); puts an end to staggered boards
at all companies (boards traditionally elect one-third of their members
each year); requires that all directors receive a majority of votes
cast to be elected; mandates the creation of a board risk committee;
and forces companies to split the CEO and board chairman positions.

"The leadership at some of the nation's most renowned companies took
too many risks and too much in salary, while their shareholders had too
little say," said Schumer. "This legislation will give stockholders the
ability to apply the emergency brakes the next time the company
management appears to be heading off a cliff."

Concurrent with Schumer's bill, the SEC voted on May 20 to seek
public comment on a proposal to give shareholders the right to place
board nominees on the company's proxy ballot. Said SEC chairman Mary
Schapiro: "This would turn what would otherwise be a somewhat illusory
[shareholder] right to nominate [directors] into something that is
real—and has a real chance of holding boards of directors accountable
to company owners."

Major business groups lost no time denouncing the reform measures as
vehicles for ceding enormous power to a small number of
special-interest investors, namely, unions and public employee pension
funds that, not surprisingly, favor the reform measures. "Big labor
unions are trying to achieve at the board table what they cannot
achieve at the negotiating table, under the guise of shareholder
protection," said David Hirschmann, president and CEO of the U.S.
Chamber of Commerce's Center for Capital Markets Competitiveness. The
Business Roundtable was no less emphatic. "This is an unprecedented
preemption of state corporate law… that will turn boards of more than
15,000 publicly traded companies into political bodies and threaten
their ability to function," said Roundtable president John Castellani.

Skeptics of government intervention are quick to point out that more
than two decades of well-meaning attempts to constrain ever-soaring
corporate pay and to reform governance through legislation, regulation,
and shareholder pressure have, for the most part, failed or even
backfired.

Nonetheless, the reform debate is fully engaged, and not just inside
the Beltway. At HBS, a group of MBAs last spring crafted and sent to
Washington a bold proposal to create a nonprofit, public-private
Corporate Governance College to employ and train a cadre of
professional directors to serve on corporate boards. And HBS
professors, drawing on their areas of expertise, have attempted to
influence the debate through opinion pieces in major newspapers.

Writing in the Wall Street Journal, HBS professor Jay
Lorsch and coauthors Martin Lipton and Theodore Mirvis—partners of the
New York law firm Wachtell, Lipton, Rosen & Katz—characterized
Schumer's bill as a misguided attempt at reform and blamed
stockholders, not management, for the fixation on short-term financial
results:

"Excessive stockholder power is precisely what caused the short-term
fixation that led to the current financial crisis. As stockholder power
increased over the last twenty years, our stock markets also became
increasingly institutionalized. The real investors are mostly
professional money managers who are focused on the short term.

"It is these shareholders who pushed companies to generate returns
at levels that were not sustainable. They also made sure high returns
were tied to management compensation. The pressure to produce
unrealistic profit fueled increased risk-taking. And as the government
relaxed checks on excessive risk-taking (or, at a minimum, didn't
respond with increased prudential regulation), stockholder demands for
ever higher returns grew still further. It was a vicious cycle....

"The stockholder-centric view of the current Schumer bill simply cannot be the cure for the disease it spawned."

Rather than address specific policy proposals, HBS professor Rakesh
Khurana, who has written extensively on leadership, sees a problem with
the larger system within which boards and executives function. Writing
in the Washington Post, he and Andy Zelleke, a lecturer in public policy at Harvard's Kennedy School, argue for serious corporate soul-searching:

"As a society, we have bought into a system in which we ask little
of corporate leaders beyond the aggressive pursuit of short-term
self-interest. For two decades, this model has formed the core paradigm
taught to our business school students. 'Shareholder value' was of
utmost importance. Notions of obligation to the society in which the
corporation is embedded have been set aside, even mocked. CEOs loved
this model, as it provided cover for their pursuit of kingly riches.
And the rest of us have accepted it because it appeared, through the
workings of the 'invisible hand,' to be consistent with a globally
competitive economy.

"This system—and the predictably reckless choices made by some of
its most powerful players—has brought our economy to the brink of
collapse. To scold business may feel good and may even help move
legislation along. But we need much more than a good scolding and
limits on sky-high paydays. We need to rethink how American business
ought to be run, including changes to fiduciary duties, legal
liability, takeover rules, and business education, among many other
areas."

Lorsch and Khurana will air their views in more detail to an
academic audience when they and Professor Brian Hall, a sought-after
expert in executive pay packages, convene a one-day, on-campus
conference, "Executive Compensation: Broadening the Debate." As
co-organizers, each brings a different perspective to the search for
answers about the past and future of executive compensation and
corporate governance. In recent conversations, they reflected on key
issues. Edited excerpts follow.

Brian Hall focuses his teaching and research on
performance management and incentive systems. He has provided expert
testimony on performance pay before the U.S. Senate and served as a
consultant to many international companies.

The issue of to what extent the financial crisis was driven by
misaligned pay incentives is one of the major concerns that spurred us
to organize the conference. I don't think it's a given that executive
pay practices really had a role in creating the financial crisis. In
some ways, executive compensation practices were supposed to be a
remedy for what happened. Long-term stockholding is something that
really should cause executives to have a longer horizon, not a shorter
one.

Having said that, we need to unpack pay issues to understand why,
for example, many of the executives on Wall Street were given such
large bonuses for one year's performance. That's a practice that needs
to be examined.

Creating a rule [in 1993] that limited the tax deductibility of
executive pay to $1 million, unless the pay is performance-related, did
more harm than good. It caused companies to come up with sham
performance criteria that work on paper but really are not pay for
performance.

I automatically advise any board I work with to make clawbacks a
part of their compensation plan. Why wouldn't you want clawbacks if it
turns out that you've paid for performance based on faulty financial
information? Why wouldn't you want the right to go after that money?
This doesn't mean you don't trust your top executives. It's just good
sound governance, good sound executive pay practice. It's not personal.

Expensing options created a level playing field. Before, if you paid
somebody in stock options, there was no accounting expense. But if you
paid them in stock or anything else, there was an expense. That's sort
of silly. Now all forms of compensation are expensed. And sure enough,
just as I predicted, there's not been a cutback in the amount of
equity-based pay, but there's been a dramatic change in the form of
that pay.

The increasing use of restricted stock is a sea change. It's really
dramatic, and it has been happening since 2005 or so when the
accounting rules on expensing options changed. Some people predicted
that expensing stock options would really cause a huge problem because
options were the lifeblood of companies. But if stock options are a
good idea, then companies will continue to grant them even if they
create an accounting expense. And if they're a bad idea, well, then
they should stop granting them.

Jay Lorsch has written extensively about boards of directors. His book, Pawns or Potentates: The Reality of America's Corporate Boards, with Elizabeth MacIver (1989), is regarded as a landmark work in the discussion of corporate governance.

I'm not convinced that CEOs are paid too much. That's part of the
reason I want to hold this conference. But I am convinced that most
shareholders think CEOs are not paid too much.

In corporate America there is a battle going on for control and
power. Over the last two decades or so you've seen boards of directors
gain more power vis-à-vis managers. The situation has changed in pretty
fundamental ways. I know people who are still beating up on boards,
saying boards aren't doing enough. But the reality is that in general
boards have gotten a better handle on their companies now than they did
when I first started looking at them twenty years ago.

If you look at the typical board of a major public company, you will
find that only one or maybe two directors are members of management,
and everybody else is "independent." To argue against independent
directors is like arguing against patriotism and apple pie. On the
other hand, more and more people are becoming aware that director
independence has a downside, something that I've been preaching for a
long time. Boards look for independent people who by definition are
likely to know very little about the company. Nobody is going to stand
up and say, "We don't want independent directors." Another way to think
about it is to ask, do we have the right legal definition of
independence? My short answer is no.

Several HBS colleagues and I recently did interviews with 35
directors who are leaders on their boards. We asked, "Tell us what you
think needs to happen differently in the boardroom." One of the things
they were most concerned about is their lack of understanding of their
company's business. They cited two reasons. First, there are too many
independent directors in the boardroom, and it takes them too long to
figure out what the business is all about. Second, there's a flaw in
getting information from management, or maybe management doesn't
understand what's going on. As a consequence, if management doesn't
understand, the board doesn't understand.

Rakesh Khurana teaches The Board of Directors and Corporate Governance elective in the MBA Program and is the author of Searching for a Corporate Savior: The Irrational Quest for Charismatic CEOs (2002) and
From Higher Aims to Hired Hands: The Social Transformation of American
Business Schools and the Unfulfilled Promise of Management as a
Profession (2007).

While boards have improved in recent years, the speed at which they
were improving lagged behind the speed at which solutions should have
been implemented. I'm much more of the view that we need to rethink our
corporate governance structure in fundamental ways for the 21st
century.

There are three things we have to think about during the conference.
First, when did executive pay become unmoored from internal labor
market considerations? Executive pay in the postwar period was often
based on what the people below you were paid. One consequence of the
trend in going outside the company to hire a new CEO was that pay
became set across a horizontal spectrum, decoupling it from the
internal labor market as well as the specific culture of the firm.
Maybe that went out of balance.

Second, we need to reconsider the idea that the CEO is somebody who
simply leads an economic entity. We have to think about what it means
in the 21st century for businesspeople to see themselves as part of the
stewardship and leadership of our society. That's built into the
mission of HBS. It's not something you do as an afterthought. And it's
not something you do after you retire. It's part of the job description.

Third, it's not clear that the current system has produced the type
of society that we want. We've had dramatic increases in inequality.
We've had an economic meltdown caused, some people argue, at least in
part by faulty pay systems. The fact that we had an economic crisis
that brought capitalism to its knees raises fundamental questions about
the viability of the system.

Part of a definition of a good society is one in which those who are
charged with running its most important institutions are fairly
compensated, but in a way that doesn't reduce the legitimacy and the
respect of the institutions they are charged with running. One of the
consequences of executive compensation has been a dramatic loss of
trust in business. As somebody who loves the free enterprise system, I
believe excessive compensation has contributed to lowering the
legitimacy of the free market system because it ends up making the
system look more like a game than an institution producing goods and
services that advance the general social welfare.