Executive Decisions: How CEO Pay Spun Out of Control

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MONEY FEBRUARY 8, 2012

Executive Decisions: How CEO Pay Spun Out of Control

Before 2014, catch up on the best of The New Republic. For the next few weeks, we'll be re-posting a selection of our most thought-provoking pieces from the recent past. 

During Angelo Mozilo’s tenure as CEO of the subprime mortgage giant Countrywide, he made more than $520 million. At one point, the board’s compensation committee tried to object to the lenient performance goals in his generous pay package. So Mozilo hired a compensation consultant—with the cost covered by shareholders—to squeeze the board for more. He got it, as well as subsidies for his wife’s travel on the corporate jet and for the associated taxes. By the end of 2007, when Countrywide finally revealed the massive losses it had previously obscured—the company had overstated its profits by $388 million and ended up paying $8.7 billion to settle predatory lending charges—Mozilo had made more than $103 million for the year. Countrywide’s shareholders, meanwhile, lost more than 80 percent of their investments.

In most high-paying jobs, people are basically paid according to performance. When a film makes millions at the box office, the star of the movie can demand more for her next contract. Conversely, when actors perform—or behave—badly, salaries slide and endorsement deals disappear. Similar market considerations apply to rock stars, athletes, investment bankers, and just about everyone else who makes eight or nine figures.

CEOs are different: They are almost certainly the only category of Americans who regularly get rewarded for failure with massive amounts of money. Mozilo of Countrywide was hardly an outlier. In 2009, Aubrey McClendon of Chesapeake Energy was among the highest-paid CEOs in the nation, despite a near-60 percent decline in stock price the previous year. He received more than $114 million in total compensation, including a bonus of $75 million. (The sale to the company of his antique map collection for more than $12 million was scuttled when shareholders filed a lawsuit.) When Hewlett Packard CEO Mark Hurd was ushered from the company for filing false expense reports for outings with a former soft-core porn actress, he left with his $12 million severance package intact. In 2011, 97 percent of companies paid their executives bonuses even if performance was below the median level of their industry peers.

The astronomical sums commanded by CEOs are the culmination of a decades long trend. In 1980, the average ratio between CEO salary and the median salary of a worker was 40 to 1. In 2010, it was 325 to 1. Among the top 50 corporations in the United States, the most extreme pay ratio, according to the compensation data firm Payscale.com, is 1,737 to 1. That salary belongs to Stephen Hemsley, the UnitedHealth Group CEO, who received nearly $102 million last year, compared with the median employee salary of $58,700. Even in the midst of a lingering recession, median S&P 500 CEO pay has continued to climb—growing by 36 percent from 2009 to 2010. It is the single biggest factor in the widening income disparity that has occurred in the United States over the past two decades.

 

This accumulation of wealth by a small group of individuals came about for a number of reasons, none of which reflect market forces. The roots of elevated CEO salaries lie in the mergers and acquisitions and leveraged-buyout frenzy of the 1980s, plus the dot.com explosion of the 1990s, which made twerpy twentysomethings into billionaires overnight. I’m a captain of industry, CEOs said to themselves and their boards. Those kids should not be paid more than I am!

These CEOs were aided by a perfect storm of self-interest. The pay-consultant industry came up with new ways to justify higher salaries—and to ensure their own compensation. Boards of directors set the pay for CEOs, who set the pay for the directors. Boards sometimes included CEOs from other companies, who were eager to raise the bar so they could demand the same at their own firm. Something like the Lake Wobegon effect took place: In measuring performance, all CEOs were above average.

The conflict-of-interest problem even extends to investors. Take a financial firm that hopes to land 401(k) business from International Widget. The financial firm also holds a large amount of stock in Widget through various portfolios, which the company manages for thousands of clients. Because the financial firm wants Widget’s 401(k) business, it is unlikely to vote as a shareholder in a way that would upset Widget’s upper management. In other words, the same kind of insider-club dynamics that apply to compensation committees extend outside the company’s board. This situation is, unfortunately, pervasive. Yet the Securities and Exchange Commission and the Labor Department have never enforced the legal obligation of the money managers who handle pension and mutual funds to vote according to what is best for individual investors and pension-plan participants, instead of corporate clients.

Washington has been of little help. Congress’s last attempt, in 1993, to fix the problem of excessive compensation left too many loopholes. Among other things, it allowed CEOs to receive unlimited compensation in the form of stock options. This serves to disassociate CEO pay from performance, since as much as 70 percent of stock-market gains are attributable to the market as a whole and not to individual company performance. Meanwhile, a technicality in current regulations makes it very difficult to pay executives with “indexed” stock options, which only pay out if the company beats its competitors.

In addition, Delaware law—which governs most public companies, since the state’s lax approach has long enticed firms to register there—makes it close to impossible for investors to remove board members who overpay CEOs. Directors are selected by CEOs and only need one vote to get onto the board, as long as they are running unopposed. (Most run unopposed, except in the rare cases when someone undertakes an expensive proxy contest.) The Dodd-Frank financial reform bill included a watered-down version of a “say on pay” measure, granting shareholders the ability to voice dissatisfaction with CEO salaries, but only in a nonbinding fashion. Unless it is possible for shareholders to actually replace directors who overpay CEOs, an advisory vote is unlikely to have any major effect.

The solutions are not complicated. The government can’t, by itself, solve the problem of excessive CEO compensation. But Washington can make it easier to pay executives with indexed stock options and require money managers to justify their votes in order to minimize conflicts of interest. It can also make it feasible for shareholders to remove board members who sign off on pay packages that damage a company’s financial health. With these changes, CEO compensation—like compensation in every other profession—could finally be about getting what you pay for.

Nell Minow is part owner and board member of GMI Ratings, an independent research firm specializing in corporate governance, executive compensation, financial disclosure, and rating boards of directors. This article appeared in the March 1, 2012 issue of the magazine.

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posted in: chesapeake energy, when hewlett packard, widget, united states, angelo mozilo, aubrey mcclendon, mark hurd, politics

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