My old friend and law school classmate Charles Elson is here today and tomorrow at UCLAW to present his research on the pernicious effects that the peer group methodlogy has in executive compensation. The paper, Executive Superstars, Peer Groups and Over-Compensation: Cause, Effect and Solution, explains that:
In setting the pay of their CEO, boards invariably reference the pay of the executives at other enterprises in similar industries and of similar size and complexity. For this, compensation consultants are retained to construct a “peer group” of such companies and survey the pay practices which are prevalent. Then, in what is described as “competitive benchmarking”, compensation levels are generally targeted to either the 50th, 75th, or 90th percentile. This process is alleged to provide an effective gauge of the “market wage” which is necessary for executive retention.
The article got a nice write up by Gretchen Morgenstern in the NY Times, who explains that:
New research by Charles M. Elson, director of the John L. Weinberg Center for Corporate Governance at the University of Delaware, and Craig K. Ferrere, one of its Edgar S. Woolard fellows, begins by attacking this conventional wisdom. Mr. Elson and Mr. Ferrere conclude, contrary to the prevailing line, that chief executives can’t readily transfer their skills from one company to another. In other words, the argument that C.E.O.’s will leave if they aren’t compensated well, perhaps even lavishly, is bogus. Using the peer-group benchmark only pushes pay up and up.
“It’s a false paradox,” Mr. Elson said in an interview last week. “The peer group is based on the theory of transferability of talent. But we found that C.E.O. skills are very firm-specific. C.E.O.’s don’t move very often, but when they do, they’re flops.”
Broc Romanek comments that:
This new study makes it clear that peer grouping with minimal board discretion is a seriously flawed methodology even when the peer groups are fairly constructed. The authors note their study is the first to document that peer group benchmarking has accidentally become the de facto standard even though it never was designed to determine CEO compensation.
The fact that most CEOs aren't transferable is something that we have been saying for a long time (eg. this blog). And we also have been warning compensation committees that if they rely heavily on peer groups - and don't use alternative benchmarking techniques like internal pay equity instead - they can be in trouble in court since so many have warned that pay has skyrocketed over the past two decades due to peer group benchmarking. In other words, it arguably isn't reasonable to rely on peer group surveys any more (here's my latest rant on this topic). Will boards and their advisors finally wake up on this issue? They should before the lawsuits come - because then it will be too late...
An executive summary of the paper is available here. I think this is a tremendously important development and a major contribution to the debate.
A smart law review editor would be calling Elson today to accept the article. It's going to be widely cited and discussed for a long time.