Virtually everything Richard Eskow says about CEO pay and SEC rules is wrong

At HuffPo he opines that:

The Census Bureau reports that income inequality between the richest and poorest Americans has reached historic levels. ...

CEO pay, along with that of other senior executives, is a major contributor to this inequality. We need to know more about this phenomenon: Which companies are overpaying their CEOs? How are they performing in the marketplace? How responsibly are those companies being managed?

As I explain in my book Corporate Governance after the Financial Crisis, however, complaints during times of economic distress about supposedly excessive executive compensation are hardly new. In the 1930s, during the Great Depression, for example, a lawsuit challenging executive bonuses as corporate waste gave rise to the aphorism “no man can be worth $1,000,000 per year.”[1] This complaint rested, at least in part, not on a belief that executives were being paid too much relative to their company’s performance but on the belief that the amounts they were being paid were simply too high.

Similar populist themes abound in the rhetoric surrounding the crises of the last decade. A 2008 House of Representatives committee report, for example, noted that “in 1991, the average large-company CEO received approximately 140 times the pay of an average worker; in 2003, the ratio was about 500 to 1.”[2] Delaware Vice Chancellor Leo Strine observed in a 2007 law review article that both workers and investors “feel that CEOs are selfish and taking outrageous pay at a time when other Americans are economically insecure.”[3] William McDonough, the then-Chairman of the Public Company Accounting Oversight Board (PCAOB), complained that:

We saw … an explosion in compensation that made those superstar CEOs actually believe that they were worth more than 400 times the pay of their average workers. Twenty years before, they had been paid an average of forty times the average worker, so the multiple went from forty to 400—an increase of ten times in twenty years. That was thoroughly unjustified by all economic reasoning, and in addition, in my view, it is grotesquely immoral.[4]

The rhetoric of class warfare makes a poor foundation for economic policy. As a justification for regulating executive compensation, however, it is particularly inapt. First, why single out public corporation executives? Many occupations today carry even larger rewards. The highest paid investment banker on Wall Street in 2006 was Lloyd Blankfein of Goldman Sachs, for example, who “earned $54.3 million in salary, cash, restricted stock and stock options,”[5] or about 4 times the median CEO salary from the year before. The pay of some private hedge fund managers dwarfed even that sum. Hedge fund manager James Simons earned $1.7 billion in 2006, for example, and two other hedge fund managers also cracked the billion-dollar level that year.[6] Not to mention, of course, the considerable sums earned by top athletes and entertainers.

Second, regulating executive compensation may scratch the public’s populist itch, but it does little to address inequalities of income and wealth. To be sure, as Brett McDonnell observes, fat cat “CEOs have become poster boys for” the dramatic increase in “inequality in income and wealth in this country.”[7] Even if one assumes that redressing such inequalities is appropriate social policy, however, capping or cutting CEO pay is not an effective means of doing so.

Steven Kaplan and Joshua Rauh determined that executives of nonfinancial corporations comprise just over 5 percent of the individuals in the top 0.01 percent of adjust gross income. Hedge fund managers, investment bankers, lawyers, executives of privately-held companies, highly paid doctors, independently wealthy individuals, and celebrities make up the bulk of the income bracket. They further found that the representation of corporate executives in the top bracket has remained constant over time and that realized CEO pay is highly correlated to stock performance. Accordingly, they conclude that “poor corporate governance or managerial power over shareholders cannot be more than a small part of the picture of increasing income inequality, even at the very upper end of the distribution.”[8]

[1] Harwell Wells, “No Man Can Be Worth $1,000,000 a Year”: The Fight Over Executive Compensation in 1930s America, 44 U. Rich. L. Rev. 689, 726 (2010).

[2] House Report 110-088, at 3.

[3] Leo E. Strine, Jr., Toward Common Sense and Common Ground? Reflections on the Shared Interests of Managers and Labor in a More Rational System of Corporate Governance, 33 J. Corp. L. 1, 10-11 (2007).

[4] William J. McDonough, The Fourth Annual A.A. Sommer, Jr. Lecture on Corporate, Securities & Financial Law, 9 Fordham J. Corp. & Fin. L. 583, 590 (2004).

[5] Jenny Anderson & Julie Creswell, Top Hedge Fund Managers Earn Over $240 Million, N.Y. Times, Apr. 24, 2007.

[6] Id.

[7] Brett H. McDonnell, Two Goals for Executive Compensation Reform, 52 N.Y.L. Sch. L. Rev. 586, 587 (2008).

[8] Steven N. Kaplan & Joshua Rauh, Wall Street and Main Street: What Contributes to the Rise in Highest Incomes, NBER Working Paper No. 13,270 (July 2007).

Back to Eskow:

... there has been a trend in recent decades toward compensating senior executives with stock gifts, stock options, and other "performance-based bonuses." This has become attractive because it allows companies to take tax breaks for the wildly generous sums they give to their chief executives.

This practice has the unfortunate side effect of encouraging CEOs to emphasize short-term stock performance over the long-term financial security and well-being of the company and its stakeholders -- a group which includes customers and employees, as well as shareholders.

What greed-driven CEO in his or her right mind would invest in a corporation's long-term growth if it minimized next quarter's stock performance, and that meant a few million dollars taken off an end-of-the-year bonus?

CEOs have increasingly behaved like stock manipulators, rather than executives of working companies. If they can pump up a stock's short-term performance by buying and selling smaller companies, flipping real estate properties, and engaging in other highly-leveraged transactions, most executives these days are only too eager to do so.

There's some validity to that point, but he's mostly wrong and his prescription is entirely wrong. Back to my book my book Corporate Governance after the Financial Crisis, in which I explain that scholars are divided as to whether this incentive structure causally contributed to either the housing or credit crunch. Grant Kirkpatrick contends that incentive pay encouraged high levels of risk taking.[1] Richard Posner argues that the structure of executive compensation practices encouraged management to cling to the housing bubble and “hope for the best.”[2] In contrast, Peter Mulbert contends that the empirical evidence does not support treating compensation as a major causal factor.[3] What seems clear, however, is that the problem was localized to the financial sector. Whether or not financial institution executive compensation practices contributed to the crisis, there is no evidence that executive compensation at Main Street corporations did so.

[1] Grant Kirkpatrick, The Corporate Governance Lessons from the Financial Crisis, 2009 Fin. Mkt. Trends 1, 2.

[2] Posner, supra note 316, at 93.

[3] Peter O. Mulbert, Corporate Governance of Banks After the Financial Crisis: Theory, Evidence, Reforms (ECGI Law Working Paper No. 130/2009, Apr. 2010).

Let's turn to Eskow's prescription for this supposed problem: "Shareholders should have more responsibility for executive pay decisions."

Piffle. Back to my book my book Corporate Governance after the Financial Crisis, in which I explain 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.[1] 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.”[2]

[1] See Carl R. Chen et al., Does Stock Option- Based Executive Compensation Induce Risk-Taking? An Analysis of the Banking Industry, 30 J. Banking & Fin. 915, 943 (2006) (arguing that the structure of executive compensation in the banking industry pre-crisis induced risk taking by managers); Kose John & Yiming Qian, Incentive Features in CEO Compensation in the Banking Industry, FRBNY Econ. Pol’y Rev., Apr., 2003, at 109 (arguing that if executive compensation induces the interests of managers to “closely aligned with equity interests in banks, which are highly leveraged institutions, management will have strong incentives to undertake high-risk investments”).

[2] Christopher M. Bruner, Corporate Governance in a Time of Crisis 13 (2010), http://ssrn.com/abstract=1617890.

Back to Eskow:

Some Democrats in Congress are now proposing to disallow tax deductions of more than $1 million for senior executive pay -- unless the corporation pays its lowest-paid employees $10.10 per hour or more, in which case that ceiling is lifted.

<SARCASM>Now there's a good idea.</SARCASM> In 1994, President Bill Clinton and the Democrats in Congress passed a budget that changed the tax laws to cap at $1 million the deduction corporations may take for executive compensation. Clinton and the Democrats, however, ensured that performance or incentive-based forms of compensation, most notably stock options were exempt from this cap (as they still are). So if you don't like current executive compensation practices, the blame lies at the Democrats' door. (Of course, the 1994 budget was a major factor in the GOP takeover of the House, which gives folks on my side of the aisle special reason to feel kindly towards it.)

In addition, the 1994 budget teaches us that the law of unintended consequences always comes into play when Congress messes about with executive compensation and tax policy. It didn't limit executive pay and it cost the federal government a lot of revenue:

For all that Section 162(m) is intended to limit excessive executive compensation, it is the shareholders and the U.S. Treasury who have suffered financial losses.

The code does not prohibit firms from paying any type of compensation; instead, they are prohibited from deducting that amount on their tax return. The result is decreased company profits and diminished returns to the shareholders.

Assuming a 25 percent marginal tax rate on corporate profits (a conservative estimate), revenue lost to the federal government in 2010 from deductible executive compensation was $7 billion, and the foregone federal revenue over the 2007–2010 period was $30.4 billion. More than half the foregone federal revenue is due to taxpayer subsidies for executive “performance pay.”

In short, the one thing you can count on is that the Congressional Democrat caucus when it comes to CEO pay is that they'll screw it up. After all, all the Dodd-Frank provisions on CEO pay are nothing more than quaxk corporate governance (see my book Corporate Governance after the Financial Crisis).

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