A pair of recent studies show that about a quarter of the compensation earned by CEOs is now paid as restricted stock. Furthermore, one of the studies notes that an increasing portion of that stock is being granted based on performance rather than automatically vested over time, and that stock price is one of the most common performance measures used to determine the number of shares granted. In other words, if the stock price goes up (or goes higher than some benchmark), then the executive would benefit from both the larger number of shares granted and the higher price per share. If the stock price goes down, the executive will get fewer shares at a lower price, or maybe no shares at all. The governance mavens are praising this trend.
There is a lot to like about ‘performance share’ plans, and stock-based stock grants provide an exceptional level of motivation and accountability for total shareholder returns over a wide spectrum of performance over time. So, I’m wondering: Why is this kind of plan legal?
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The other Steve
Steve Ballmer announced his resignation, and Microsoft’s stock price shot up seven percent. Ouch.
That investor verdict is far more damning than anything shareholders could have conveyed through a proxy vote. It tell us pretty directly what the market thinks about Ballmer or, more specifically Ballmer’s leadership relative to anyone that Microsoft is likely to hire as his replacement.
One way to read this reaction is that Ballmer has been a roughly $19 billion drag on his company. This deficiency might have been inferred by the fact that Microsoft’s stock has gone exactly nowhere* in the decade that Ballmer has been CEO, significantly underperforming the Nasdaq, not to mention its closest competitors Oracle, Google, and especially Apple. I’m sure Steve Ballmer is in for many unflattering comparisons to Steve Jobs in the upcoming weeks.
I’m not here to bury Ballmer, or to praise him, but to highlight how this coda of his tenure reflects on the value of a “typical” CEO. I often hear how a CEO doesn’t do it alone–he or she is part of a team. I often hear people questioning whether the average CEO is worth the $15M to $20M per year that they get paid, or whether any CEO “needs” the $100 million they may have gotten paid in a year of outstanding performance. I have answered these questions in prior blog posts, so I will encapsulate them here.
1) Sure, a CEO is just one person on a team, but the CEO ultimately selects and manages that team, amplifying or cancelling their talents. His or her marginal contribution is still very large.
2) Ballmer illustrates that a CEO may be worth much less than $20 million per year. Other CEOs, like Jobs (OK, I’m starting the comparisons), are worth much more than $20 million per year. The stock reaction when Jobs announced his resignation was a drop of about $10 billion, although his announcement was not entirely unexpected. So, how plausible is it that the average CEO is worth about $20 million per year? More plausible than $2 million or $200,000 per year, although the value variance around that average is obviously very high.
3) No person “needs” $20 million or $100 million or any such astronomical sum. But nobody this side of the Soviet Union gets paid according to their need. If things are working right, they get paid what they’re worth. This correspondence is never perfect, but we haven’t yet found a better way.
By the way, Ballmer earned about $1.3 million per year in salary and bonus as CEO of Microsoft, much less than a typical Fortune 500 CEO, but not out of line for someone whose personal net worth likely went up and down about $100 million a day due to his MSFT stock holdings which, as mentioned earlier, didn’t net him anything more than he started with over his tenure. In other words, alignment wasn’t an issue for Ballmer. Maybe he just decided he didn’t need any more? Maybe he wasn’t greedy enough?
* I’m being generous here by tagging the stock’s fall in his first year as an artifact of the dot-com bust.
I am often dismayed by the popular response to “dollar-a-year CEOs.” These bosses give the media a feel-good story: You don’t have to be greedy. You can be a not-so-fat-cat!
Apparently it’s not just John Q. Public–several times removed from the real world of compensation governance–that buys this stuff. Just last week, a tech company CEO in a WSJ “expert” panel praised the dollar-a-year standard, and the swell guys and gals who adopt it, saying that all CEOs should be so virtuous.
These are people that are out to change the world. They are owners. They are builders. They bleed for their company and what they are creating. It’s not about the money.
His examples were Steve Jobs, Larry Ellison, Mark Zuckerburg, Meg Whitman, Larry Page. Do you see a pattern (besides all the money)?
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The birth of a new British heir once again causes us governance geeks to scratch our heads at the succession mechanism formally known as primogeniture, the winner-take-all system whereby the first-born (generally male, but not always) becomes heir to substantially all of the parents’ titles and property. In the context of a monarchy, has anyone ever believed that such a mechanism would consistently yield good leaders?
The answer, of course, is “No,” but the question assumes the wrong purpose. In fact, primogeniture did not evolve as a way to select a certain quality of leader; it evolved as a way to enable society to accumulate capital.
For most of history, it was extremely difficult to preserve and grow capital from one generation to the next. Before the 19th Century, the lives of ordinary people–how they labored and what they had in their homes–were virtually indistinguishable from that of their grandparents. Things were hardly better among the aristocracy. For them, accumulated property was basically an invitation to plunder. Consequently, from the Fall of Rome to the Industrial Revolution, the vast majority of capital created by the upper classes was in the form of weaponry, and most of that was consumed in battle. It was in this neo-Hobbesian war of all against all that primogeniture evolved as a way to select kings.
The customary transfer of allegiance of powerful nobles from their king to a royal heir greatly reduced the odds of a civil war. Societies that tended to avoid civil war tended to accumulate far more capital. More capital made them more powerful, economically and militarily, creating a dynamic that eventually led to the institution of monarchical succession via primogeniture spreading throughout most of the world.
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This week we celebrate the 65th anniversary of the Roswell crash landing, a watershed event for conspiracy theorists everywhere. I sympathize with the hapless Air Force officers looking at the wreckage of their high-altitude weather balloon, the glass, rubber, and metal strewn around, probably including a reflective saucer-shaped instrument shell, and having to explain within the bounds of military secrecy what happened that night, only to be met with the suspicion of people wearing tin-foil hats. The chagrin of those officers must have turned to alarm as the fallen balloon was figuratively resurrected, and the flying saucer took off as one of the enduring stories of our time: A crash landing by stray aliens being covered up by the U.S. government for its own nefarious, if unspecified, purposes.
The reason I can easily sympathize with the government on this is because I have seen an even bigger conspiracy theory that I personally know to be equally ludicrous—the conspiracy of corporate leaders to control the U.S. political and economic machinery to their personal benefit. A whole phalanx of academics, journalists, and elected officials has benefited from the public’s credulous acceptance of this theory, especially with regards to executive pay.
Lest I be accused of creating my own anti-“corporate conspiracy” conspiracy theory, let me quickly add that each of these parties has participated in their part of the anti-corporate crusade according to their own particular incentives, i.e., to publish in select journals, sell newspapers or airtime, or win higher elected office. No coordination was necessary to blow this balloon beyond what reality could contain.
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As we celebrate the birth of our country this week, I think it’s worth reflecting on the United States as history’s most daring experiment in governance.
Most of us were taught the Constitution in middle or high school as a series of clauses defining the various workings of our federal government. Some concepts such as “checks and balances” managed to penetrate our pubescent fog because the idea of constraints on authority is innately appealing to young people. But few of us were left with a sense of how bold an innovation our Constitution was at the time of its adoption, or how fragile was the republic that it created. Understanding those things greatly enhances one’s appreciation of the American civilization that would emerge from that experiment.
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Lynn Stout published the The Shareholder Value Myth late last year, and it has created some stir. In the book, she blames meltdowns like Enron and disasters like BP’s Macondo on “shareholder value thinking,” and suggests that managers and directors loosen up on this obsession. I’m always surprised when people use Enron and BP–companies that miserably failed their shareholders–as examples of shareholder value thinking run amok. But Stout is a respected legal scholar, and her arguments deserve a more thorough appraisal.
In yesterday’s WSJ, an article reported rising criticism of directors’ pay from institutional investors. Many of the quotes came from one such investor, T. Rowe Price.
Current pay structures don’t give directors enough of a stake in making sure the company does well, and boards need to be more creative about tying their compensation to performance, said John Wakeman, a vice president and portfolio manager at mutual-fund giant T. Rowe Price Group Inc.
“If bad people are going to be on these boards, we’ve got to stop it,” said Mr. Wakeman. “We owe it to our fund holders.”
“When you’ve gone to restricted-stock world, basically directors get paid more or less for showing up,” Mr. Wakeman said.
If Wakeman were referring to the portion of director fees paid in cash, then he would have a point about directors being paid for just “showing up,” but even that ignores the value of getting good directors to show up. Being a good director means working. In the world that Mr. Wakeman and I share, very few people beyond commissioned salespeople are expected to show up with zero guaranteed pay. Does he want directors compensated with purely variable pay?
But in alluding to “pay for showing up,” he is not referring to the fixed fees earned by directors, but to their restricted stock, which accounts for more than half of their total pay. Calling this “pay for showing up” is a curious accusation. To some extent, someone getting restricted stock compensation is almost certain of having something of value at the end of their tenure. But the value of restricted stock goes up and down with the share price. You don’t get any more performance-based than that. In other words, given both its retention and incentive characteristics, restricted stock may be the perfect compensation instrument for directors.
The point of bad people on a board is not how we pay them, but how do we prevent them or get rid of them. It may have been the writer instead of Mr. Wakeman who conflated these appointment versus compensation issues, but such a conflation does not help us determine the right way to either get good directors onto boards or to pay them.
The article also notes that some activist investors are experimenting with incentive pay programs for directors. The clear premise is that directors don’t have enough incentive in their current pay programs, which raises the question: what kind of pay package would be better than a program of fees plus restricted stock?
One can argue that the proportion of that pay mix ought to be more in favor of restricted stock than it is now, or that the stock restrictions should be more demanding, such as requiring that most of the stock be held to retirement. But as someone who has designed these things for many boards, and thinks deeply about compensation design every day, I would caution against too much experimentation. The three basic alternatives to restricted stock are:
1. A restricted stock-equivalent, such as a cash-settled stock appreciation plan that pays off exactly the way restricted stock would. I would favor such a plan only because it creates an income opportunity for those of us who design them. Otherwise, the shareholders get the same retention and alignment benefit as if they award restricted stock.
2. An alternative equity instrument, such as stock options. This would likely create an asymmetrical risk/reward profile for directors versus shareholders–the kind of thing that contributed to Wall Street’s troubles during the financial crisis.
3. A non-equity based incentive plan. This would be asking for trouble, as the Coke example in the article showed. The only body in a company than can certify achievement of performance results is the board of directors. Asking the board of directors to certify performance relating to their own pay creates an inherent conflict of interest. This is a fine recipe for either manipulation of corporate results, or the continual appearance of such manipulation. I would never institute a directors’ non-equity incentive plan for any company I advise (and have actually lost business for my refusal to do so).
The real story, here, is that pay is becoming the magic elixir for fixing all governance problems. We don’t have a significant problem with lack of alignment between directors and shareholders. We just have some companies that don’t perform well, and some of that lack of performance reasonably attributable to lax oversight by the board. Too much experimentation with director pay would only make the problems worse because it would be attacking the wrong problem.
The actual title of the article was Regulators Get Banks to Rein In Bonus Pay, but it might have been the title of this post. The germ of this article is:
Since the financial crisis the Fed has urged banks to cap bonuses in cases where they could encourage executives to take too much risk. Before the crisis, banks erred by focusing too much on short-term profits and too little on risk when designing bonus plans for employees and executives, according to the Fed.
The Fed’s intent has devolved into policies advocating the use of measures besides profit, and the capping bonuses at something less than two times target bonuses. These two policies ignore two, basic propositions of incentive compensation:
1) An incentive to perform is indistinguishable from an incentive to cheat
2) A cap on bonuses is tantamount to a cap on performance
These policies are nevertheless being advocated despite any evidence whatsoever that they help shareholders. That is not surprising, however, since the Fed is not accountable to shareholders, but to political interests that could care less about investors.
I don’t usually offer investment tips, but here is one that is consistent with research on this matter: Invest in companies that pay for profit growth, and don’t limit how much their executives can make. In other words, bet against what the government is advocating.
And that means a new flood of stories about CEO pay. In the past, the stories have almost uniformly been of the “can you believe…” variety. Can you believe that CEO whose company stock dropped 20 percent still earned $5 million? Can you believe that CEO who was canned got $20 million on the way out the door? So, I was surprised to finally see an example of intrepid journalism entitled “Pay for Performance’ No Longer a Punchline.” Apparently the relationship between pay and performance is improving.
The shift in how CEOs are paid highlights the growing role of investors in shaping executive compensation—and their push to align pay more closely with corporate results.
While a welcome the change in tone, I think that both the shift to improved alignment and the role of growing investor involvement are overstated. To see why, consider two items about CEO pay that are approximately true:
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