Say what? on CEO pay

Say on pay was based on the mistaken belief that the root cause of high CEO pay was poor oversight by boards and investors

James Surowiecki, author of the bestselling Wisdom of Crowds, recently penned an article in The New Yorker called “Why CEO Pay Reform Failed,” regarding the Dodd-Frank mandated “Say-on-Pay” rule.

He correctly notes that say-on-pay has, against the hope of its proponents, done “approximately zero” to stop the rise in CEO pay, and that shareholders have almost universally endorsed these pay levels with overwhelming support. He offers some reasons:

“Why have the reforms been so ineffective? Simply put, they targeted the wrong things. People are justifiably indignant about cronyism and corruption in the executive suite, but these aren’t the main reasons that CEO pay has soared. If they were, leaving salary decisions up to independent directors or shareholders would have made a greater difference. As it is, studies find that when companies hire outside CEOs — people who have no relationship with the board — they get paid more than inside hires and more than their predecessors, too. Four years of say-on-pay have shown us that ordinary shareholders are pretty much as generous as boards are. And even companies with a single controlling shareholder, who ought to be able to dictate terms, don’t seem to pay their CEOs any less than other companies.”

In other words, the very things that people are “justifiably indignant about” appear, in fact, to not be justified. But he is writing in The New Yorker where indignation about CEO pay is a matter of religion, so Surowiecki has to find something, anything, to justify it. He concludes that:

(a) Boards of directors are deluded in thinking they can actually distinguish CEO talent, and are thus irrationally paying more for talent they cannot discern, and

(b) Investors have been hoodwinked by an “ideology” that CEO talent is rare, and that higher rewards can lead to better CEOs. (In other words, maybe certain crowds aren’t that smart.)

If this seems like more than a bit of reaching, consider his sources. The first, law professor Michael Dorff says, “It’s very hard to show that picking one well-qualified CEO over another has a major impact on corporate performance.” It would no doubt upset my client directors to think of all the time and energy they have spent fretting about the quality of their top management as pretty much wasted. I understand that Prof. Dorff has some literature behind his assertions. Nevertheless, his conclusions ring as “academic” in the worst connotations of the term.

As if to support Dorff’s claim, Surowiecki then cites Gabaix and Landier as saying that the difference between the average S&P 500 CEO and the top CEO is worth “only” .016 per cent higher returns. OK, that’s not a major impact. But if Surowiecki did the math, he would find that this measly spread is still worth over $20 million per year for a typical S&P 500 firm. Maybe the mass of S&P 500 investors on average vote overwhelmingly for the average S&P 500 CEO pay of $15 million because, in their collective wisdom, they think 25 per cent off is a bargain. Just something for Surowiecki to consider for the next edition of his bestseller.

Surowiecki then grasps far over the ledge for a falling leaf by citing a particularly poorly specified study on recent executive compensation that claims, among other things, that “higher pay fails to promote better performance.” So, all those directors with all those years of collective experience have been wasting not only immense amounts of time, but also all that money based on a mistaken believe in the power of incentives. Wow. Unlike Dorff, who ends up in the same alley via a slightly different route, these authors appear to conflate pay-for-recruiting with pay-for-performance.

Which leads Surowiecki to his ultimate conclusion:

“So whether or not the people who sit on compensation committees can accurately predict CEO performance — Dorff argues that they can’t — they’re happy to spend an extra five or ten million dollars in order to get the person they want.”

This one sentence manages to contain three wrong assumptions:

1. Compensation committees do not try to predict the performance of CEOs in determining what they ultimately pay them; instead they pay out the bulk of their awards based on historical performance, which is generally known.

2. These committees set target pay at an expected value of compensation (without knowing exactly what will end up getting paid out) in order to be competitive; they are rarely happy about what they have to offer, but accept it as the cost of attracting the talent they think they need.

3. Notwithstanding the difficulty in distinguishing CEOs for the purposes of hiring them, or distinguishing their performance for the purposes of paying them, these are critical tasks of the board, and they have every reason to expect that they can do it better than a coin toss.

In other words, one can believe that directors think “paying more will result in better performance” only by woefully mischaracterizing how boards actually think about their work.

So, why have the reforms been so ineffective? Indeed, they have targeted the wrong things. Sayon-pay was based on the mistaken belief that the root cause of high CEO pay was poor oversight by boards and investors. What we are seeing can easily be concluded as proof that boards are not lazy, stupid, or corrupt, and that investors — a very large and diverse crowd — are getting pretty much what they pay for, and they know it.

Easy to conclude that boards are not lazy, stupid or corrupt