Executive Compensation and Shareholder Agency

[akrowne]

(A highly-compressed version of the letter below was published in the Jan 29, 2007 Barron's "Mailbag" section. Here's my original letter, along with some bookend commentary for iTulip readers).

The following is a letter I sent to Barron's in response to two columns by Thomas Donlan, written in the weeks prior to January 15, 2007, in which he defended extreme executive compensation and argued against more shareholder control (both regarding compensation, and generally).

I don't think I unfairly characterize Donlan's essays when I say his logic basically went like this: "Steve Jobs is God (and Nardelli is at least a demigod); therefore there's no problem with their pay; therefore there is no problem with executive pay in general; therefore shareholders should shut up and sit back for the ride."

I was disappointed in Donlan's uncharacteristically breezy and apologetic argument. Here was my response:

Donlan seems to be conflating a number of key issues in his arguments.

Rewarding good executive performance and doing so ethically are two such separate issues. In his two most recent essays, Thomas Donlan uses two specific examples (Jobs and Nardelli) to argue that performance has justified compensation, while ignoring the ethical questions about the manner in which this was done. This is simply a distraction.

A second pair of confused issues are then thrown into the mix: the right of shareholders to exert agency over companies regarding compensation, and more broadly, the boundaries of shareholder rights in general. I shouldn't have to argue that shareholders should be empowered to control ethical lapses of the companies they part-own -- doubly-so since these lapses might constitute a transfer of wealth away from themselves to a privileged cabal of company executives.

As for their rights in general, that would seem to be a matter for the market to decide: company principals need to come to their own power-sharing understandings with the shareholders they have relied upon for financing. If they cannot, companies are free to put their money where their mouth is and buy back shares or sell out to private equity, minimizing external influence.

As for Jobs and Nardelli, they only make good examples for Donlan's case if one squints very hard. Jobs didn't let his backdated options lie fallow: he had them converted to stock at the questionable valuations. So to argue he didn't "exercise" the options is to dodge the ethical question with a technicality. And Jobs was no passive observer: if he has been so single-handedly responsible for Apple's fortunes (as Donlan argues), then he certainly knew about the compensation rules and practices taking place on his watch -- especially those that pertained to him personally.

Nardelli is a far more egregious case: as Donlan admits (but then discards), Nardelli only improved shareholder returns if one arbitrarily chooses to benchmark from the stock's multi-year low rather than the beginning of his tenure. Ironically, this analysis is very reminiscent of the odious back-dating practices that are now being scrutinized and which Donlan would like us to ignore.

I would suggest that in Nardelli's case, shareholders are concerned not just with share price but with his autocratic take on investor relations and wholesale binding of the company's fortunes to the housing market (to the detriment of customer service). The latter might not play out so well without a home building boom, making Home Depot a far more cyclical company than it used to be. In my opinion, Nardelli deliberately avoided broaching this topic with shareholders.

Regarding executive compensation in general, shareholders are right to be up in arms. Formal studies (e.g., DolmatConnell & Partners, 2006) have gone far beyond Donlan's sample set of two and found that executive compensation is now negatively correlated with performance. It is easy to see why this might be the case: obscene levels of compensation are more likely to indicate managerial dysfunction than rewards well-earned.

So it's no wonder shareholders want more control over compensation practives. I suggest Donlan rethink his apologetic, pro-insider stance. After all, if shareholders and management do not find an equitable balance on these matters, congress just might do it for them. And neither Donlan nor myself would like that very much.

I'll also add that I personally find Donlan's suggestion (which is explicit, mind you) that shareholders are akin to "passive riders on a cruise" offensive. There is no such thing as financing with no strings attached. And why should there be? The financier expects to make a reasonable return -- taking on some risk, of course -- but both the risk and the venture should be well-defined beforehand. Equity is simply a kind of financing where the financier exchanges a predictable return for at least some modicum of control over management. Donlan, on the other hand, seems to view equity as a birthright of corporate chieftans.

Further, his suggestion that shareholders can simply "leave the arrangement any time" is rather specious: if a stock has already crashed due to mismanagement or some sort of scandal, bailing is tantamount to selling low. It's at least as reasonable to want to stick around and right the ship. If Donlan had his way, the board room would have unlimited agency (special rights, dare I say) over shareholders to continue looting their companies into oblivion.

As has been written about extensively here on iTulip, it is quite clear we have entered a new era of "Robber Barrons" -- rhetorical contortions to the contrary notwithstanding. I hope we as a society can accept this fact and constructively search for a solution, rather than embracing the denial.

[Finster]

Re: Executive Compensation and Shareholder Agency

Here here!

I haven't seen this week's Barron's yet (out here in the sticks it comes on Monday), but congratulations on a fine letter. I was tempted to write one myself when I saw Donlan's commentary. FWIW, I have expressed similar views to those you express here on multiple occasions here on iTulip, although perhaps not as eloquently.

Absolutely, the main problem with executive compensation and other corporate governance issues is the distance to which is kept the employers of these executives. A corporation surrenders a certain amount of privacy and independence when it goes public. In soliciting risk capital from would-be buyers of shares, management becomes beholden to a board that represents those owners. Management members become employees under the direction of the board, which in turn is supposed to represent the owners of the corporation's capital. But if the board is beholden to management, the arrangement becomes one of people determining their own pay without the authorization of those who are doing the paying.

Unfortunately, it is not so simple as people having the choice of taking or leaving it. Once upon a time, ordinary working people could put their money in a bank and earn interest sufficient to keep their savings ahead of inflation. But with the advent of the Fed - with a mandate to keep interest rates as low as possible without inciting hyperinflation - it simply is not fruitful to save. (...but ironically we have folks like Alan Greenspan wringing their hands over our low savings rates ...) Virtually every working person with a 401k or IRA is told he must have a certain (generous) portion of his retirement funds in stocks. As a result, massive amounts of funds which once would have gone into traditional savings vehicles are now earmarked for the stock market. Whereas once they might have had nothing but savvy financiers to answer to, now corporate managements have access to cheap, undiscriminating capital. That they have their hands in the cookie jar is no accidental consequence.

[Jim Nickerson]

Re: Executive Compensation and Shareholder Agency

I thought Donlon's editorial was more about his being a dupe of Wall Street.

Bill Bonner's article "Behind every great fortune lies a crime." - Balzac

http://www.safehaven.com/article-6790.htm Bill Bonner 1/28/07

Take Lloyd Blankfein. The Goldman Sachs man took the wheel at the firm after Hank Paulsen went on to greater glory at the Treasury Department. In the six months from the time he took the job until the end of the year, he is reported to have earned $53.4 million. Let's see, that is about $9 million per month...nearly $2 million per week...or about $400,000 every working day.

And here...our eyes roll up to heaven as we wonder: What hath this man done? This is where the theory of meritocratic markets begins to pinch the common man like a starched shirt at a summer wedding. He's sure it's what he wants to wear; but he's beginning to get uncomfortable in it. There is no better system than free and unfettered capitalism, he tells himself. He loathes the thought of mobs at Mr. Blankfein's door...and thinks he is clever enough to resist the meddlers who want to put a limit on how much a man can earn. Still, he senses that there is something not quite right.

How is it that - in a free market system, where people are supposed to be rewarded according to how much they provide to others - today's biggest prizes go to those who provide so little? Mr. Jenkins and Mr. Blankfein do not add in any appreciable way to the world's wealth. Instead, they merely move it around - from middle and lower class taxpayers to the super-rich...from householders to speculators...and, by loading up the world with debt, from the future to the present.

When I think about this, which not uncommonly I do, I keep asking myself what can any human do that is in fact worth $400,000 a day? If anyone proposes knowing the answer to that, I'd like to see it written down. If I were to "earn" $400,000 in a day for something that was considered work, personally I would be embarrassed. Can anyone imagine the egocentricity of anyone who can rationalize that anything he/she might accomplish would be worth $400,000 for a day--even if one worked 24 hours? It is all crap.

So Sinister, is your Barron's subscription such that you do not get it and the WSJ online. I think the online access is less expensive than a subscription to the paper edition, but I may be wrong about that. Are you some old-fashioned sort who revels in getting newsprint on one's fingers, never mind the waste of paper that occurs in the old-fashioned come-in-the-mail edition?

[Finster]

Re: Executive Compensation and Shareholder Agency

When I think about this, which not uncommonly I do, I keep asking myself what can any human do that is in fact worth $400,000 a day? If anyone proposes knowing the answer to that, I'd like to see it written down. If I were to "earn" $400,000 in a day for something that was considered work, personally I would be embarrassed. Can anyone imagine the egocentricity of anyone who can rationalize that anything he/she might accomplish would be worth $400,000 for a day--even if one worked 24 hours? It is all crap.

If the people who are paying him $400,000 a day are doing so knowingly and willingly, then it is not ours to question. The problem is, as AK has suggested in saying "Rewarding good executive performance and doing so ethically are two such separate issues.", is that that is generally not the case.

So Sinister, is your Barron's subscription such that you do not get it and the WSJ online. I think the online access is less expensive than a subscription to the paper edition, but I may be wrong about that. Are you some old-fashioned sort who revels in getting newsprint on one's fingers, never mind the waste of paper that occurs in the old-fashioned come-in-the-mail edition?

It's actually more important for me to read it in the comfort of my La-Z-Boy rocker-recliner than to see it on Saturday morning ... :cool:

[jk]

Re: Executive Compensation and Shareholder Agency

i had an email exchange with donlan several years ago, prompted by a piece of his in which he defended some wall street practice i thought exploitative. i said that his position [on i forget what particular issue] was equivalent to saying that buyer beware meant ponzi schemes should be legal. he replied that he indeed thought ponzi schemes should be legal. apparently, the idea is to let the wolves eat the sheep.

[Jim Nickerson]

Re: Executive Compensation and Shareholder Agency

If the people who are paying him $400,000 a day are doing so knowingly and willingly, then it is not ours to question. The problem is, as AK has suggested in saying "Rewarding good executive performance and doing so ethically are two such separate issues.", is that that is generally not the case.

Now who among us that owns stocks would say that anyone in a leadership role is actually worth $400,000 a day to do a job. It cannot be justified, period. Who are the people paying any dude $400K/day that could justify it? No one can justify it except with BS. It is absolutely a scam that an individual could contrive an employment agreement for such sums. No one has such genius and value (except in his own and his mothers' eyes)--no one of whom I am aware.

On a lesser scale, perhaps, but equally ludicrous and dispicable are guys like Clinton, Greenspan getting $100K for a lecture, Jeez!! Richard Russell recently noted in one of his comments Paris Hilton was asking and getting $1M to show up at parties.

The problem as I can perceive it with all such crap is that our society has no system of value. If fools are willing to pay people who value themselves at inestimable sums for actually producing nothing of real value in return, I think it proves my assertion: we (excluding myself) have no value system.

It's actually more important for me to read it in the comfort of my La-Z-Boy rocker-recliner than to see it on Saturday morning ... :cool:

If a two days late and a couple of bonars short is fine by you, then certainly it is fine by me. :rolleyes:

[akrowne]

Re: Executive Compensation and Shareholder Agency

Unfortunately, it is not so simple as people having the choice of taking or leaving it. Once upon a time, ordinary working people could put their money in a bank and earn interest sufficient to keep their savings ahead of inflation. But with the advent of the Fed - with a mandate to keep interest rates as low as possible without inciting hyperinflation - it simply is not fruitful to save. (...but ironically we have folks like Alan Greenspan wringing their hands over our low savings rates ...) Virtually every working person with a 401k or IRA is told he must have a certain (generous) portion of his retirement funds in stocks. As a result, massive amounts of funds which once would have gone into traditional savings vehicles are now earmarked for the stock market. Whereas once they might have had nothing but savvy financiers to answer to, now corporate managements have access to cheap, undiscriminating capital. That they have their hands in the cookie jar is no accidental consequence.

This is key and I'm glad to see someone say it. This is why I wish we could return to a sound-money, gradual-deflation regime. In such a regime, workers actually have an advantage over Wall Street by default: they make more every year without raises, and their savings rises in value, no matter the amount (even if it is just stored under their mattress!) In the current regime, there's a mad rush to get money to the "experts" to keep it growing faster than inflation, which is secondarily defeated by having worse inflation than widely-acknowledged. So the only ones winning here are those that can pyramid money rapidly and earn percentage commissions and therefore end up managing as much of it as possible.

[akrowne]

Re: Executive Compensation and Shareholder Agency

I thought Donlon's editorial was more about his being a dupe of Wall Street.

Well, this may be, but when he's mostly railing against the government, I find myself agreeing at least half the time =) You could have a lot worse than Donlan -- at least he's not an economist!

When I think about this, which not uncommonly I do, I keep asking myself what can any human do that is in fact worth $400,000 a day? If anyone proposes knowing the answer to that, I'd like to see it written down. If I were to "earn" $400,000 in a day for something that was considered work, personally I would be embarrassed. Can anyone imagine the egocentricity of anyone who can rationalize that anything he/she might accomplish would be worth $400,000 for a day--even if one worked 24 hours? It is all crap.

My take is that it is possible, but unlikely such a person is really earning their keep. At extreme levels of compensation, we should be asking serious questions. For example, Dick Grasso and Bob Nardelli unlikely deserve the full extent of their multi-hundred-million dollar bounties.

But Bill Gates? He's harder to dismiss -- most of the world gets a lot of use out of Windows (not me, but on the other hand, I don't think linux is ready for my grandma). Warren Buffett? Sure -- he's made predominantly good investment calls.

One can tell the illegitimate examples, I think. For those, nearly everyone agrees there is abuse. For the other cases, reasonable people can disagree, which suggests the heavy hand of regulation should not be brought down indiscriminantly.

Now, if we could solve the endless-liquidity problem, we might see lower levels of executive compensation and wealth condensation develop naturally...

[Finster]

Re: Executive Compensation and Shareholder Agency

Well, this may be, but when he's mostly railing against the government, I find myself agreeing at least half the time =) You could have a lot worse than Donlan -- at least he's not an economist!...

FWIW, I usually find myself agreeing with Donlan as well. In this case, I think he is overlooking the fact that a corporation is not a natural entity, but a legal one. And therefore the government through the law establishes the ground rules. It appears Donlan agrees that it is a legitimate function of government to protect property rights ... if he tells a shareholder his only recourse is to sell, then by extension he should also be willing to tell management it always has the option of going or staying private if it doesn't like the oversight.

[Finster]

Re: Executive Compensation and Shareholder Agency

Now who among us that owns stocks would say that anyone in a leadership role is actually worth $400,000 a day to do a job.

I don’t know, Jim, but the amount by itself is not the point. If one person wants a zillion bucks for some service, and another person is willing and able to pay for it, that’s strictly a matter between those two people.

The problem comes in because this is not what is behind egregious executive compensation. It basically boils down to one person wanting a zillion bucks for some service, and the same person deciding he’s going to get it - not the people who are actually ponying up the money.

This is because corporate boards of directors, who are supposed to be representing the interests of the shareholders, are instead often more beholden to management. Management sits on the board. Or management chooses board memebers, directly or indirectly. Or management has some other form of leverage or control over members on the board.

Frequently the problem is that compensation packages are so complex that few shareholders even understand them. They rely heavily on complicated options awards or other contingent compensation that can only be determined after the fact. Sometimes - as in the case of options backdating - they can even be manipulated after the fact. Trying reading an annual report where such things are discussed - you will not be able to determine how much is being doled out. Maybe even the board members who agree to them don’t even understand what they are promising. This appears to have been a factor in the Nardelli case; some analysts have suggested the board had no idea the package would entitle Nardelli to two hundred million plus bucks - especially given the questionable performance.

There’s no excuse for that. But shareholders still have little in the way of recourse because they have little leverage over boards. Often that recourse can only be exercised through the courts, which means years of litigation and large chunks of any settlement going to the lawyers.

It cannot be justified, period. Who are the people paying any dude $400K/day that could justify it? No one can justify it except with BS. It is absolutely a scam that an individual could contrive an employment agreement for such sums. No one has such genius and value (except in his own and his mothers' eyes)--no one of whom I am aware.

Again, this is the problem. The compensation decision is too far removed from those who are doing the paying. The payers simply aren’t being given a say in the matter, while the payee is. If these contracts had to be approved by shareholders, or at least the directors approving them were sufficiently accountable for them, we just wouldn’t be seeing these abuses.

[Jim Nickerson]

Re: Executive Compensation and Shareholder Agency

I don’t know, Jim, but the amount by itself is not the point. If one person wants a zillion bucks for some service, and another person is willing and able to pay for it, that’s strictly a matter between those two people.

With due deference to you, Sinister, the amount itself is probably fully the point. If one reduces it down to the compensation per hour and liberally grants that anyone working in a job of presumed high importance works 10 hours a day, thus $40,000 per hour, compared to the hourly wage of those who fight fires, drive ambulances, sweep the streets, collect garbage, pave the roads, oversee the water supply, pick the oranges, grow the wheat, chase robbers and murderers, teach the children who will be the future, there is no way one man's production, guidance of operations, planning for the future is worth $40,000 an hour.

What two people transact between themselves with one using money he earned (versus inherited, scammed, stole) is highly unlikely in my opinion ever to come down to services being rendered that are worth $40,000 an hour. Even potentates from the Middle East seeking life-saving treatments at Mayo, I doubt pay so much.

Here on iTulip, a lot of short-comings of the financial world are repeatedly pointed out, and the end result for them is that no one is going to do diddle about correcting them until someone is forced into action. You can take one thing to the bank and that is the damned politicians are not going to change things.

Actually something as in the reference I cited above by Bonner about shareholders actually beating down the door of the GS guy, Blankfein, is more likely to bring about change that waiting on government to do it, but as the greedy sheep we are, few, if any as long as they are making a penny, are overly concerned about the guy at the top making thousands times more. But beating down doors and tarring and feathering scoundrels isn't going to happen as long as the shareholders are happy with their pennies, or as long as we as a society are content to allow people to be paid amounts more than they need in multiple lifetimes--while at the same time paying thousands or millions of people less than they need for this lifetime.

I don't expect you, Aaron, or anyone to come up with an answer to this for me or for society. Perhaps the most likely solution is a Aaron suggested, either here or on another thread, is for there to be a deflation that works toward leveling the playing field. I guess in the meanwhile we, or as least I, will continue to bitch while reflecting on the pure idiocy of the entire matter.

[Finster]

Re: Executive Compensation and Shareholder Agency

With due deference to you, Sinister, the amount itself is probably fully the point. If one reduces it down to the compensation per hour and liberally grants that anyone working in a job of presumed high importance works 10 hours a day, thus $40,000 per hour, compared to the hourly wage of those who fight fires, drive ambulances, sweep the streets, collect garbage, pave the roads, oversee the water supply, pick the oranges, grow the wheat, chase robbers and murderers, teach the children who will be the future, there is no way one man's production, guidance of operations, planning for the future is worth $40,000 an hour.

I strenuously disagree. If I get ten cents from someone without their knowing and willing approval, it is stealing just as much as if I took $10,000,000.

What two people transact between themselves with one using money he earned (versus inherited, scammed, stole) is highly unlikely in my opinion ever to come down to services being rendered that are worth $40,000 an hour. Even potentates from the Middle East seeking life-saving treatments at Mayo, I doubt pay so much.

Now you are arguing my point for me. If the compensation were being set in the manner as between two people, with both the payer and payee having full knowledge and assent, we wouldn't be seeing these extraordinary sums.

[Jim Nickerson]

Re: Executive Compensation and Shareholder Agency

I strenuously disagree. If I get ten cents from someone without their knowing and willing approval, it is stealing just as much as if I took $10,000,000.

I cannot disagree with the absolute sense of morality of what you wrote; however, a person starving who steals 10 cents, is not actually the same crook as someone who perhaps is getting a seven or eight figure salary, or even a six-figure salary who in effect takes money from an entity even via a water-tight legal arrangement (employment contract) when there is nothing that person, I aver, can do that actually justifies such earnings of $40,000 an hour. You, Sinister, are the proponet that the value of man's hour does not change--if that is how you might state it. Does any one person produce anything for society for which he is truly worth $40,000 an hour on a prolonged basis--a contract killing might be worth $40K? Is the lowest worker among us sweeping floors at Walmart (and I a sure there are those even lower), worth over 4,000 times less than anyone who weazels a contract grossing $40,000 an hour--which probably does not include use of the company jet, health insurance, you name it in the way of perks. I say not. Is any person's time who is producing something worthwhile for society worth 4,000 times less than any other human's time? I'll sit down and shut up if anyone tells what a person can do that justifies being paid $40,000 an hour.

Now you are arguing my point for me. If the compensation were being set in the manner as between two people, with both the payer and payee having full knowledge and assent, we wouldn't be seeing these extraordinary sums.

But compensation is not set as you note above, so we have a problem (Houston), and it will remain a problem until the poor and downtrodden get so blooming sick of being dumped upon, that one of them will succeed in leading a revolution that will change all this crap. Look at Chavez in Venezuela. Why is he succeeding? Because the poor and sick are tired of being sick and poor--were I one of them I might abandon my abandoment of politics and vote for Hugo. As much as so many here in our wonderful democracy dislike Chavez, if you have ever seen the slums of Caracas it is not hard to imagine that something should be done to either lift the quality of life of the poor or something to eliminate the poor. I expect the latter would be the preference of the super rich. Whether I live to see it happen or not, there will eventually be a change for the betterment of all, and that change will not come from the top down, but rather from the oppressed up.

[Finster]

Re: Executive Compensation and Shareholder Agency

I cannot disagree with the absolute sense of morality of what you wrote; however, a person starving who steals 10 cents, is not actually the same crook as someone who perhaps is getting a seven or eight figure salary, or even a six-figure salary who in effect takes money from an entity even via a water-tight legal arrangement (employment contract)…

Indeed, the contract may be perfectly legal. That’s why the law needs to be revisited. If the law were to allow me to write blank checks on your bank account, I dare say you would think the law needs to be changed!

And this is, when you chew it down to its rotten core, the problem with executive compensation. The executives can write their own checks on the shareholder account. This naturally leads to extravagant figures!

… when there is nothing that person, I aver, can do that actually justifies such earnings of $40,000 an hour. You, Sinister, are the proponet that the value of man's hour does not change--if that is how you might state it. Does any one person produce anything for society for which he is truly worth $40,000 an hour on a prolonged basis …

I do not claim to know. And as long as it’s not "society" that is to pony up the money, it’s none of my business. If Bill Gates wants to hire someone for $40,000 an hour - whether it’s a software whiz or a call girl - as long as it’s his money he is paying with, the matter is strictly between him and his consort.

But if I am a shareholder of Microsoft and he is using corporate funds to do it, it is a very different matter indeed. If the member of the board, charged with the ultimate stewardship over corporate assets, ante up the funds, then they should be accountable to those whose shares represent claims on corporate assets.

But compensation is not set as you note above, so we have a problem (Houston), and it will remain a problem until the poor and downtrodden get so blooming sick of being dumped upon, that one of them will succeed in leading a revolution that will change all this crap.

Exactly. And we may be close to getting some action. Barney Frank, the new Chairman of the Financial Services Committee, has expressed interest in giving shareholders more control over their own capital.

We better hope he succeeds, because some have called for direct imposition of government force to limit pay. This would be tragic, not only because it would merely shift the playing field to politicians, lobbyists, bureaucrats, and lawyers (how many loopholes do you think that would spawn), but because this was supposed to be a free country. The key is that both parties to a transaction need understand and agree to its terms. Not merely have it dictated by one side. So long as that is the case, each party being empowered look out for his own interests will take care of it.