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The Inefficient Market for Corporate Leadership August 1, 2006

Posted by federalist in Finance, Human Markets.
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I rarely disagree with the Wall Street Journal’s editorial board, but today’s essay on CEO compensation is incongruous.

There’s been a lot of griping about executive pay recently, and Hank McKinnell’s severance package, estimated to be worth $83 million, will do little to damp the indignation.

But Mr. McKinnell’s surprise ouster as CEO by Pfizer’s board last week illustrates the flip side of the executive-pay coin: Top executives in the U.S. are paid for performance, and today’s corporate directors are not shy about pushing out those whose performance doesn’t measure up for shareholders.

It’s great to see that boards are firing underperformers, but the thing that really shocks the conscience is the compensation levels.  And the fact that even when they fail these CEOs win.  Walking away with an $83MM severance is not what anyone would consider punishment or failure.

Granted, we have quite a hurdle to clear in assailing CEO pay: Public companies are governed by corporate boards that are accountable to shareholders, not the CEO.  In principle, then, the shareholders’ interests are being served.

I would appeal to common sense to say that while in principle there shouldn’t be anything to complain about, in practice we see that the market for corporate leadership is terribly inefficient.

There are only two reasons to pay a CEO: Incentives, and compensation.  Frankly, I can’t believe that even if they’re a wild success that any CEO of a public company can really claim that he should be compensated for hundreds of millions of dollars in value added.  Even if the company’s market capitalization doubles during his tenure, it does so with shareholder money.  The CEO steers the boat, but that doesn’t mean he has a claim on its cargo when he arrives in port.

Incentives are required to bring the CEO on board in the first place, and in theory also to make sure his interests are aligned with the shareholders.  So the boards grant options, bonuses, and so forth.  But they grant absurd quantities of options.  And bonuses seem to get paid in the end regardless of whether objectives are met — just because the board doesn’t want to lose their CEO.  And they incentivize candidates to accept the position with outrageous compensation packages that pay a fortune even if things don’t work out.  Because that’s what it takes to get the guy they want to leave his current job and take a risk at the helm of a different company.

So given that you can’t tell ahead of time who will succeed why not go with a cheaper candidate?  Corporate boards seem to want to cover their asses by looking only at “star” CEOs — people with such a reputation that even if something goes wrong the board can’t be blamed for picking an unlikely candidate.  But many people are qualified to competently lead companies.  In theory the difference between a good CEO and a great CEO could be billions in dollars in value.  But nobody can predict ahead of time that one CEO candidate is that much better than another for a given company in a given situation.  (Strangely, in many cases boards will woo chiefs who presided over failures at other companies to take even greater responsibility at theirs.)

If the pool of CEOs candidates were expanded from the “rock star” name-brand chiefs to the much broader pool of qualified leaders, the market for corporate leadership could settle back down to a reasonable level.

In the end, the WSJ does identify one other source of friction in this market, and this is worth fixing:

Another good idea would be to repeal the 1968 Williams Act, which requires potential takeover bidders to disclose their intentions publicly before their stake in the target grows too large. At the time, labor unions and business federations were united in their desire to protect senior management. But 40 years later we can see that the effect of the Williams Act has been to tip off other investors and insulate underperforming management from the threat of hostile takeover bids. Higher CEO pay has been one result, since a lever for removing overpaid CEOs was eliminated.

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