naked capitalism

Joe Nocera of the New York Times has a good piece today on the Obama executive pay proposals, such that they are. While I have sometimes been hard on Nocera for taking positions that I have found to be a bit too forgiving to the financial services industry, today he gave an articulate rendition of a fundamental problem:

It was another one of those Timothy Geithner moments….

Looking sternly into the cameras, Mr. Geithner read a statement in which he described executive compensation as a “contributing factor” to the crisis. Then he outlined a series of tough-sounding principles, including a “re-examination” of such egregious practices as golden parachutes, a need to align compensation practices with “sound risk management” and the importance of having compensation plans that “properly measure and reward performance.”

But then, as he so often does, he proceeded to follow these tough words with actual proposals that were less than inspiring. The only legislation his department planned to propose — indeed, the only legislation he deemed necessary — were bills that called for compensation committees to be made up of independent directors, along with “say-on-pay” legislation, which would give shareholders the right to vote on a company’s pay plan. That vote, however, would not be binding….

Until the financial crisis, most people, myself included, did not make distinctions between different kinds of companies when it came to executive compensation. It was just one big problem, revolving primarily around the idea that there was something fundamentally wrong about executives taking home giant, multimillion dollar pay packages for mediocre performance or even outright failure — something, alas, that happens with annoying regularity in corporate America.

But if the near collapse of the financial system has taught us anything, it is that there should be a distinction. On the one hand, there are companies whose executives can make awful mistakes, even driving their corporations into bankruptcy, but whose actions have little or no effect on the rest of us. Most companies fall under this category.

And then there are those handful of companies — the too-big-to-fail banks and other large financial institutions that pose systemic risk — whose failure can wreak devastating havoc on the economy. For these latter companies, getting compensation right isn’t just a matter of fairness or improved corporate governance. It turns out to be critically important if we are to prevent a repeat of the calamity that has befallen us. But as difficult as it has been to overhaul executive compensation overall, it is going to be even more difficult to take the tougher measures that need to be taken with the banking system.

Yves here. As much as I support Nocera’s second observation, that there are some big companies where “getting compensation right” is essential, he is incorrect in saying that the fact that many of the others pay egregiously for failure, and often still overpay for success, has “little to no effect on the rest of us.”

The pay practices are part and parcel of a legitimazation of a gaping disparity in incomes, and the promotion of a fantasy that certain people are endowed with skills so rarified that it merits outsized rewards even if the job is botched. Yet the companies profiled in Jim Collins’ Good to Great had CEOs who paid themselves modestly, even when they shepherded their businesses through major transformations. The idea that money beyond a certain level is motivating bears far more examination than it has gotten.The evidence is strongly to the contrary, that the companies with the most lavishly paid leaders were stock market laggards.

But the excessive and highly publicized CEO pay also serves to provide a price upbrella for all sorts of other pay and fees, such as consultants, lawyers, lobbyists, even executive coaches. Even if you are a Serious Player in your field, it would be unseemly to charge more than your clients’ top executives earn. But the flip side is that if you do not charge a lot for your very top professionals, you send the signal that you think you are not in their league. If you are providing services to a seven figure CEO or his board, fees of, say, $500 an hour are way too low. So high CEO pay has pulled up a lot of boats on its rising tide. Back to Nocera:

I think there is a decent chance that the compensation games will come to an end — though it won’t be by doing anything so radical as trying to cap pay, something that simply doesn’t work. (Mr. Geithner was right about that.)

Instead, it will be because boards have come under renewed pressure, thanks to the financial crisis, to control executive pay. It is also because, with the Democrats in charge, the issue is high on the agenda….

Most important, though, it is because the re-energized S.E.C., under Ms. [Mary] Schapiro, is preparing a handful of new rules that will force companies to do a great deal more to spell out their compensation rationales, while making it easier for shareholders to express their displeasure if they feel boards have been too generous. In particular, the S.E.C. has begun laying the groundwork for a rule that will make it easier for shareholders to nominate directors — something that is tremendously difficult right now. Ms.[Nell] Minow is among those who believe that the ability to replace incumbent directors is likely to have the biggest effect in reforming executive pay.

I wish I shared their optimism. These changes may keep pay from moving higher, but I doubt these measures will do much other than stop the worst abuses, such as big checks for obvious underperformance.

The reasons are twofold. First, even if shareholders may be able to secure some board seats, it will still take an effort. And why should they bother? As Amar Bhide pointed out in a prescient and ignored (because too offensive to the orthodoxy) Harvard Business Review article, “Efficient Markets, Deficient Governance,” the US decision to have highly liquid stock markets inherently leads to lax governance. Why?

In liquid markets, shareholders cannot have sufficient information to make a truly informed decision about what stocks to buy. A company, for competitive reasons, cannot disclose the details of its strategy and market situation that an investor would like to have. It would be give competitors insight that they could use to their advantage. The only way an investor can have good enough knowledge is through a venture capital type relationship, where he is privy to a good deal of internal information and can also assess the caliber of management.

So equity investors are inevitably in a position in which they are always at least a bit, if not a lot, in the dark. That means executives can hide their mistakes for at least a while, and probably reap more in the way of rewards than they should.

If an investor becomes unhappy with how management is paying itself, it is much more sensible to sell the stock than to devote the effort to try to bring management to heel. Even with the SEC lowering the barriers, it will not be cost free for unhappy shareholders to locate and nominate their own board candidates and promote their cause to other shareholders.

The second is that even having a board member or two installed by outsiders does not assure success. It is unlikely, given staggered directors’ terms in office, that shareholders could achieve a majority of outside board members and thus gain control of the compensation committee.

The irony of the current arrangement is that these fancy incentives intended to align executive pay with shareholder interests were meant to solve a principal-agent problem. That is, the concern was that CEOs would take advantage of their position and pay themselves well but not work very hard, hence they needed equity based incentives to make sure they did a good job. That view means that the CEOs were presumed to be less than trustworthy.

Yet who was in charge of recommending the compensation packages to the board? Well, outside comp consultants, engaged by the HR department, which of course means the fees are paid by the company. And even if the board hires a comp consultant, the board is nominated by management and the fees of the consultant are still paid by the company. In other words, the people whose possible abuses were supposed to be curtailed are still ultimately in charge of the pay packages. The foxes still are in charge of the henhouse, but with a few intermediaries in between to make it a tad less obvious. So it is any wonder pay skyrocketed?