Last week's issue of The Economist had three letters to the editor on executive compensation that seemed noteworthy:
Regarding executive pay (“Neither rigged nor fair”, June 25th) what harm would come from limiting the pay of chief executives to, say, 40 times that of the average worker? Do we honestly think there would be a tragic exodus of managerial talent? Such limits would help restore workers’ faith in the economic system, which, as Joseph Stiglitz argued in “The Price of Inequality”, would increase productivity. A ratio linked to workers’ pay would also help bosses understand, and even increase, the pay of the rank and file.
Do I think there would be an exodus of managerial talent under such a rule? Yes. If all you do is limit CEO pay, there will be plenty of jobs that pay much higher salaries to which CEO-types could migrate. Your average CEO, after all, would probably do quite well as an investment banker, hedge fund manager, private equity fund manager, etc.... Would such an exodus be tragic? If it resulted in a brain drain out of corporate C-suites, that would certainly not be good for productivity.
Executive salary is a classic agency problem for which there is a simple regulatory fix. Mandatory shareholding for chief executives would force their personal interests to align with the companies they head. Require them to buy shares amounting to several times their total remuneration for the year and hold them for ten years. Those CEOs who really add value will have nothing to worry about. The others will lose their shirts.
Pretoria, South Africa
Taken with the prior letter, this one raises the question of why we care about executive compensation. If all we care about is the interests of shareholders, the latter writer's idea has some merit. It resembles Charles Elson's proposal that corporate directors be required to hold significant amounts of the stock of the company on whose board they serve. But there are some concerns: Could the CEO afford to buy so much stock, especially since the Sarbanes-Oxley Act prohibits companies from loaning money to their officers? There is a tax disadvantage for the company: The company cannot take a tax deduction for the value of the gain the CEO eventually realizes if s/he made a Section 83(b) election to have the gain taxed as a capital gain. Conversely, the CEO may be subject to an unnecessary tax liability if s/he made Section 83(b) election and the stock price declines. In addition, the CEO must pay withholding tax at time of of the grant regardless of when shares are sold. The company experiences an immediate dilution of EPS for total shares granted.
But suppose we also care about the social consequences of CEO pay. In that case, aligning executive and managerial interests may not be a great idea. As I explained in my book, Corporate Governance After the Financial Crisis:
As we have seen, regulators and some commentators identified executive compensation schemes that focused bank managers on short-term returns to shareholders as a causal factor in the financial crisis of 2007-2008. As we have also seen, shareholder activists long have complained that these schemes provide pay without performance. This was one of the corporate governance flaws Dodd-Frank was intended to address, most notably via say on pay.
The trouble, of course, is that shareholders and society do not have the same goals when it comes to executive pay. Society wants managers to be more risk averse. Shareholders want them to be less risk averse. If say on pay and other shareholder empowerment provisions of Dodd-Frank succeed, manager and shareholder interests will be further aligned, which will encourage the former to undertake higher risks in the search for higher returns to shareholders. Accordingly, as Christopher Bruner aptly observed, “the shareholder-empowerment position appears self-contradictory, essentially amounting to the claim that we must give shareholders more power because managers left to the themselves have excessively focused on the shareholders’ interests.”
We are barraged by the left about the unconscionable salaries of chief executives. The average pay of top athletes, pop stars and actors is higher, yet none of them contributes to the jobs, salaries, investment and returns to average investors the same way that a CEO does.
Livonia, New York
Again, it depends on why we care. If what we care about is income inequality, the writer has a good point. On the other hand, athletes, pop stars, and actors bargain at arms'-length with their employers. In contrast, CEO pay arguably is not negotiated at arms'-length. I don't give that argument as much credit as, say, Lucian Bebchuk but it's not completely wrong either. I discuss this issue at some length in my book Corporate Governance After the Financial Crisis. I conclude that the so-called managerial power thesis is mostly wrong, but only mostly.