The Problem of Executive Compensation 

 

 

"In judging whether Corporate America is serious about reforming itself, CEO pay remains the acid test. To date, the results aren't encouraging." [1]  - Warren Buffett

 

 

Executive Compensation Has Grown Exponentially

 

According to the Corporate Library's recent CEO Pay Survey[2], the median total compensation received by CEO's increased 30 percent in fiscal 2004, with the average increasing 91 percent (driven by 27 CEOs receiving compensation over 1,000 percent greater than their previous year's pay).  The 2004 increase come on top of median increases of 15 percent for fiscal 2003 and 9.5 percent in fiscal 2002.

 

Another report, done by USA Today,[3] found that the median CEO compensation in 2004 was $14 million (with one CEO pocketing $84 million exercising options, and receiving new grants worth more than $130 million).  In comparison, the same study found that the average rank-and-file worker's pay increased 2.5%. 

 

This disparity has grown significantly over the last few years.  In 1991, the average large-company CEO received approximately 140 times the pay of an average worker; in 2003, the ratio was about 500:1.[4]  The amounts have risen so far so fast, that they can no longer be explained by traditional valuations.  Even when adjusting for other variables (e.g., company size, performance, industry classification, inflation), studies find executive compensation is far higher today than in the early 1990s.[5]

 

 

Executive Compensation Is a Significant Cost to Shareholders and the Economy

 

While these numbers are themselves concerning, they also reflect real costs to shareholders and the economy.  In 1993, the aggregate compensation paid to the top five executives of U.S. public companies represented 4.8% of company profits; by 2003 the ratio had more than doubled to 10.3%. [6] and the total amount paid to these executives during this period is roughly $290 billion[7]  (that is ten times the 2005 discretionary budget for the Department of Homeland Security).

 

Many Compensation Schemes Create Perverse Incentives For Executives to Shirk Duty to Shareholders

 

In addition to concerns about the sheer size, these compensation schemes may give executives a perverse incentive to shirk their fiduciary duty to shareholders in a number of ways, for example: 

 

Earnings Manipulation.  Putting aside outright earnings fraud, because accounting standards like FAS 133 are not always clear, excessive compensation (particularly enormous bonuses based on meeting "Wall Street expectations") give executives an incentive to use "aggressive" accounting methods that maximize his/her compensation.[8]  Years (or months) later, when the company is forced to restate its earnings - and shareholder value plummets - the executives retain their bonuses.[9]

 

Unprofitable Mergers/Acquisitions.  Because senior executives often receive additional compensation when they buy a new company or sell their current one (and are responsible for negotiating the overall deal), there is a natural conflict of interest between the executives' interest (i.e. closing the deal and obtaining his/her "golden parachute") and the company's interest (i.e. maximizing shareholder value).  For example:

• James Kilts made $153 million in the merger of Gillette and Procter & Gamble.[10]  

• John Zeglis, former CEO of AT&T Wireless, made $32 million when the company was sold to Cingular for $15 dollars a share-which was half the price of the stock when the company went public in 2000.[11]

• Top executives at AT&T made $31 million (including $10.3 million to CEO David Dorman) when its SBC deal went through.[12]

• When Harrah's acquired Caesar's Entertainment last year, Caesar's CEO Wallace Barr received nearly $20 million.[13]

Studies of mergers have found that target CEOs were willing to accept lower acquisition premiums when the acquirer promised them high-ranking managerial post after the acquisition.[14]  Why would similar results not follow when CEOs receive direct monetary compensation?

 

Camouflaging Compensation.  Even senior executives and boards' actions suggest that compensation is per se excessive: why else would they go to such lengths to avoid shareholder scrutiny and hide executive compensation?

 

 

Growth In Compensation Is Not Tied To Performance

 

As Congress has seen first hand, even executives of institutions that lose money, restate earnings, and face extensive regulatory scrutiny have received (and retained) substantial compensation packages.  After being forced out of Fannie Mae because the company used faulty accounting - and announced a $9 billion restatement that could go up - Former Fannie Mae, CEO Frank Raines will receive a pension worth roughly $1.4 million per year for life and prorated portions of incentive stock awards that could be worth millions of dollars.[15] Unfortunately, Raines is hardly the exception. 

• In the year before Refco sold shares to the public (and then promptly made the fourth-largest bankruptcy filing in US history) insiders at the firm drained more than $1 billion from the company.[16]

• The top three executives at Viacom  (CEO Summer Redstone, and co-presidents, Tom Freston and Leslie Moonves) received at total compensation of $160 million last year.  Viacom lost $17.5 billion and its share price fell 18 percent last year.[17] 

• HP paid outgoing CEO Carly Fiorina a severance package of $21 million (and within a month paid incoming CEO Mark Hurd a $20 million "welcoming package").[18] 

• Former Disney President Michael Ovitz made $140 million in 1996 after only 14 months on the job. [19] 

• US Airways CEO David Siegal collected $4.5 million upon leaving as the carrier faced its second bankruptcy.[20]

• Procter & Gamble CEO Durk Jager left the company with over $9.5 million package after overseeing a 55% drop in share price.[21]

• Although Morgan Stanley's Former CEO Phillip Purcell was due to receive $62 million in retirement, he was paid an additional $44 million plus administrative support and executive medical benefits when he recently left Morgan Stanley under a cloud of problems.[22]