Getting to the Bottom Of CEO Compensation

Since markets turned shaky, a new round of jawflapping about the unseemliness of executive compensation practices has gathered steam. One business magazine that shall remain nameless even called it “The Great CEO Pay Heist.” Of particular fanfare was Apple’s bestowal on Steve Jobs of a stock-option package valued at $548 million. Something clearly has come loose, hasn’t it?

Yes, but this emblematic phenomenon of our times has yet to be explained in any convincing fashion, despite much gnashing of bicuspids. We’re told that CEOs are greedy, but who isn’t? We’re told that boards and compensation consultants are too cozy with management, but cronyism is a human constant and U.S. companies have a reputation for being the most shareholder-responsive in the world.

Let us clear away some of the false gods and standard sophistries. CEO pay is not an attempt to set up a “right” moral universe, though much writing on the subject speaks the language of reward and punishment. The purpose is behavior modification, to shoo management toward an obsession with the share price.

Somehow this idea is hard for people to take aboard. They roll their eyes and talk about “moving the goalposts” when, for instance, companies adjust management’s options to make up for an unexpected drop in the stock price. But the carping is silly. If it makes sense to dangle a pre-emptory share-price incentive in front of executives when times are good, it makes sense when times are bad. And managers aren’t slaves. They’ll just go work someplace else if their options are hopelessly out of the money.

No less misguided is the argument that companies should be required to take a charge against earnings for the imputed cost of management’s stock options. Fans love this proposal not because it would make accounting sense but because it would be embarrassing to CEOs.

Unfortunately, the idea is wrong as a matter of accounting logic. Executive stock options are not paid for out of earnings or revenues. Properly understood, options are a transaction outside the business between shareholders and their hired guns. Shareholders certainly suffer a real cost in giving up some of their ownership to management, but redistributing the pie in this way doesn’t create a new claim on revenues or impinge on profits.

This may seem unduly technical for a family newspaper, but it explains why markets have been relatively relaxed about CEO compensation even as the media and social critics go berserk. Investors may or may not understand that dilution is hanging over their companies, but they get compensated automatically anyway because management’s options become valuable only when and if the stock rises enough to hit the target price.

Hence the biggest canard of all, the claim that stock prices would plummet across the board if the “true cost” of management options were deducted from earnings, as if accounting semantics somehow determine underlying realities. This prediction might at least be right for the wrong reasons if wool was being pulled over the market’s eyes. But it isn’t. Studies show that companies that award large numbers of options pay a price in the market for the impending dilution — as they should.

The real question is why options packages have to keep getting bigger and bigger so boards can recruit or retain the CEOs they want.

Take Mr. Jobs. In theory the world is not short of talented leaders who might find a profitable future for Apple Computer, but the market doesn’t know who they are. In the known universe of available CEOs Mr. Jobs is leaps ahead of anyone else. Indeed, investors at this point would probably abandon faith in Apple’s survival as an independent company if Mr. Jobs were, say, struck down by a meteorite.

Or take the six-year striptease by which GE settled on Jeffrey Immelt to succeed Jack Welch. This was about more than just due diligence — it was about creating a ritual to transfer Mr. Welch’s mystique to his successor.

Such examples testify to the power of managerial celebrity in a market made up of millions of investors. After all, a company’s share price is nothing more than a collective vote of confidence in its future, and what do investors have to go by but management’s record and reputation? Especially since so much of a company’s value these days depends on the intangible qualities of its decision-making and alertness to opportunity.

So the advent of people’s capitalism goes a long way toward explaining why boards will offer the moon and stars to a CEO who appears to have the market’s blessing. But an important countervailing force has gone missing.

It’s no accident that dangling desperately large stock incentives in front of management has become the main way of controlling the corporation since another avenue, the hostile takeover, was closed off in the early 1990s. Herein lies the best fix.

Think about the dilemma facing Disney’s board: It’s hard to imagine whom it could find and peddle to the market as a Michael Eisner replacement, so the board goes on paying him big bucks to stick around. But somewhere an unknown entrepreneur with a plan could be making the rounds among deep-pocketed investors to finance a run at the company.

Better than railing about CEO pay would be reopening the market for corporate control. Nothing would do more to redress the imbalance of power that puts CEOs in the catbird seat. Several large pension funds are already lobbying the stock exchanges to require companies to put their compensation schemes up for shareholder vote. This is OK as far as it goes, but big investors should be pushing harder to force companies to dismantle their poison pills and other antitakeover defenses.

Executive compensation might not drop overnight, but an important form of negative sanction would be restored once the takeover market is resuscitated. Shareholders wouldn’t be stuck relying entirely on bribes to get management’s attention.

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