The Space Be­tween Us

In­dia Inc is bet­ter off avoid­ing the flawed US prac­tice of un­re­al­is­ti­cally high CEO com­pen­sa­tion

The Economic Times - - The Edit Page - Kr­ish­na­murthy Subra­ma­nian

The de­bate be­tween In­fosys’ founders and the cur­rent man­age­ment and board about se­nior man­age­ment com­pen­sa­tion can be an im­por­tant sign­post for cor­po­rate gov­er­nance in the coun­try.

The key ques­tion is, should share­hold­ers, cor­po­rate gov­er­nance ac­tivists and pol­i­cy­mak­ers al­low In­dia Inc to trans­plant some of the ugly cor­po­rate gov­er­nance prac­tices from Cor­po­rate Amer­ica? While the moral as­pects to mim­ick­ing such ugly features in a coun­try sig­nif­i­cantly poorer than the US re­main open to de­bate, I will fo­cus on eco­nomic as­pects.

Wink and Hood­wink

Be­tween 1992 and 2000, fol­low­ing the bull run in US stock mar­kets, the av­er­age real (in­fla­tion-ad­justed) pay of chief ex­ec­u­tive of­fi­cers (CEOs) of S&P 500 firms more than quadru­pled, climb­ing from $3.5 mil­lion to $14.7 mil­lion. This growth of ex­ec­u­tive com­pen­sa­tion far out­stripped com­pen­sa­tion for other em­ploy­ees. In 1991, the av­er­age large-com­pany CEO in the US re­ceived about 140 times the pay of an av­er­age worker; in 2003, this ra­tio was about 500:1.

When com­pared to the value added by an av­er­age em­ployee, did the val­ueadd by the CEO of an S&P 500 firm quadru­ple in just eight years? What su­per-diet did the CEOs of S&P 500 firms con­sume from 1992 to 2000 to quadru­ple their rel­a­tive con­tri­bu­tion? Did such a su­per-diet quadru­ple a CEO’s strate­gic think­ing abil­i­ties?

Since none of us has heard about any such su­per-diet hit­ting re­tail out­lets, it is safe to con­clude that such qua­dru­pling rep­re­sented the out­come of a game that gets fixed be­tween the CEO and pliant board. Aca­demic re­search,sum­marised­inBe­bchuk(2004), has pro­vided ro­bust ev­i­dence of such match-fix­ing. “In judg­ing whether Cor­po­rate Amer­ica is se­ri­ous about re­form­ing it­self, CEO pay re­mains the acid test. To date, the re­sults aren’t en­cour­ag­ing, War­ren Buf­fett said.

In an ideal world, a CEO would get paid com­men­su­rate to the value he or she adds to the firm. The board would de­sign the com­pen­sa­tion to pro­vide strong in­cen­tive to the CEO to con­trib­ute to share­holder value. But this rep­re­sents a Utopian con­cept. First, for var­i­ous rea­sons, di­rec­tors in a firm sup­port ar­range­ments favourable to the com­pany’s top ex­ec­u­tives. So­cial and psy­cho­log­i­cal fac­tors con­trib­ute to this phe­nom­e­non.

Sec­ond, lim­ited time and re­sources of­ten make it dif­fi­cult for even wellinten­tioned di­rec­tors to do their pay­set­ting job prop­erly. When not well pre­pared for the en­su­ing bat­tle, di­rec­tors can of­ten choose peace within the board­room.

Fi­nally, CEOs ex­ert con­sid­er­able power in shap­ing their pay pack­ages and those di­rectly re­port­ing to them. Re­search shows that CEOs’ in­flu­ence over di­rec­tors en­ables them to ob­tain “rents” — ben­e­fits greater than those com­men­su­rate to the true es­ti­mate of the value they add to the com­pany.

These find­ings fol­lowed re­search on CEO pay in the US af­ter the spate of cor­po­rate scan­dals that be­gan in late 2001 and shook con­fi­dence in the per­for­mance of pub­lic com­pany boards. Re­search now recog­nises that many boards have em­ployed com­pen­sa­tion ar­range­ments that do not serve share­hold­ers’ in­ter­ests. Flawed com­pen­sa­tion ar­range­ments have been wide­spread, and sys­temic, stem­ming from de­fects in the un­der­ly­ing gov­er­nance struc­ture.

CEOs Strike Oil

No one ob­jects to CEO pay that fairly links it to firm’s per­for­mance. The prob­lem stems with the fix­ing of this ga­methrough­whichCEOs­get­paidin ways un­re­lated to firm per­for­mance. CEOs in US firms have used their in­flu­ence to ob­tain higher com­pen­sa­tion through ar­range­ments that have sub­stan­tial­ly­de­cou­pled­payfromper­for­mance. For in­stance, oil com­pany CEOs get paid sig­nif­i­cantly more when the crude oil price in­creases — an out­come in which the oil com­pany CEO had no role. Most CEOs get paid more when the av­er­age stock mar­ket per­forms well; again, the CEO had no role to play in the stock mar­ket’s per­for­mance.

A large por­tion of CEO pay comes in forms other than eq­uity, such as gen­er­ous sev­er­ance pack­ages, salary and bonus, which cor­re­late weakly with firms’ in­dus­try-ad­justed per­for­mance. Ex­am­in­ing the cor­re­la­tion with in­dus­try-ad­justed per­for­mance is im­por­tant be­cause in­dus­try-level growth is, again, another out­come that the CEO can­not con­trib­ute to. Such com­pen­sa­tion has been gen­er­ouslyaward­ede­ven­toman­ager­swhose per­for­mance was me­diocre rel­a­tive to other ex­ec­u­tives in their in­dus­try.

Eq­uity-based com­pen­sa­tion can in­prin­ci­ple pro­vide CEOs with de­sir­able in­cen­tives. But, in prac­tice, eq­ui­ty­based plans have en­abled CEOs in the US to reap sub­stan­tial re­wards even when their per­for­mance was merely pass­able or even poor. In ad­di­tion, firms have given ex­ec­u­tives broad free­dom to un­load op­tions and shares, a prac­tice that has been ben­e­fi­cial to ex­ec­u­tives but costly to share­hold­ers.

Thus, aca­demic re­search un­der­lines the fact that CEO pay is the out­come of a game that gets fixed be­tween the CEO and pliant boards. Given this ev­i­dence in the US, Sebi and cor­po­rate gov­er­nance ac­tivists must watch the de­vel­op­ments at In­fosys care­fully and en­sure that some rot­ten gov­er­nance prac­tices in the US do not de­velop root in In­dia.

The writer is as­so­ciate pro­fes­sor of fi­nance, In­dian School of Busi­ness, Hy­der­abad

I’m go­ing to earth, I’ll launch a startup and earn bil­lions as CEO in a few years

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