The Space Between Us
India Inc is better off avoiding the flawed US practice of unrealistically high CEO compensation
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