How “Board Capture” has captured the critics

Posted by Marc Hodak on December 9, 2008 under Executive compensation | Be the First to Comment

It’s difficult for me to criticize Jonathan Macey given that I generally agree with his prescriptions. However, his diagnosis doesn’t make sense to me, at least the part with which I happen to have a personal familiarity.

In a recent WSJ editorial, Macey says:

The average pay for chief executives of large public companies in the United States is now well over $10 million a year. Top corporate executives in the United States get about three times more than their counterparts in Japan and more than twice as much as their counterparts in Western Europe… I argue that executive compensation is too high in the U.S. because the process by which executive compensation is determined has been corrupted by acquiescent, pandering and otherwise “captured” boards of directors.

It has become fashionable to argue that CEO pay is “too high,” and most critics blame it on “board capture.” Unfortunately, the “board capture” theory, for all its intuitive appeal, happens to run counter to facts and logic.

Consider Macey’s use of the term “has been corrupted.” That implies a period when boards were less corrupted, more pure. When did the corruption happen? Presumably in the 1990s, when CEO pay made its greatest gains. Unfortunately, nearly every corporate critic would say, and I’m sure Macey would agree, that the ’90s saw boards steadily and significantly gain power at the expense of the CEO, not the other way around. That’s not to say that boards don’t still get captured by their CEOs–it certainly happens. I’ve seen it. But as a trend to explain a general increase in CEO pay, this is a non-starter.

Then there’s Macey’s evidence of high pay–the fact that Japanese executives make a third as much as their American counterparts. This runs counter to his claim that weak boards are the problem. When was the last time a Japanese CEO got fired for poor performance? American CEOs have long experienced forced turnover at rates that Japanese companies would find inconceivable. I haven’t worked with Japanese boards nearly as much as American ones, but my sense is that few boards in the world are as independent and challenging as the typical American board, and few boards as collegial and unlikely to upset the apple cart as a Japanese one.

The fact is that CEO pay has gone up exactly as the relative power of the board has increased. While I haven’t heard a decent rejoinder to that inverse relationship, there is a plausible theory as to why increased board power may lead to increased CEO pay. The thinking is that as boards become more demanding and less forgiving, the CEO’s job becomes tougher and riskier–good reasons to command higher pay. Also, in this more competitive and demanding environment, boards increasingly recognize that they get what they pay for, and know that a little extra talent can mean billions of dollars in incremental returns. In that context, the last few million doesn’t really cost that much.

In the end, I agree with Macey’s prescriptions for a more vigorous market for corporate control.

Hedge funds and activist investors like Carl Icahn are the solution, not the problem. The market for corporate control should be deregulated and the SEC’s restrictions on all sorts of equity trading should be lifted at once.

Note that Mr. Icahn doesn’t operate in Japan or in Europe. Icahn counterparts, in fact, are rather hard to find anywhere outside the U.S. And yet we have higher CEO pay. Could it be that the critics have the theory about what is driving high pay exactly backwards?