The questions of executive pay and of fairness are exemplified in the court case of former chairman of the NY stock exchange, Richard Grasso. The law of the the state of New York requires that a person's compensation be related in some way to the value of the services rendered. There are at least two reasons to believe that, in this case, compensation did not meet this criterion. But there is a more general social issue at stake and it has to do with what we value in society.
If one is going to pay a person $119.8 million not to work for one's organization, is it reasonable to pay them $80.6 million to continue working for it? According to NYT 04Aug06 p.C2 That is pretty much what the board of the New York stock exchange did a few years ago in awarding compensation for one-time chairman Richard Grasso. The first amount was a retirement account, the second, was salary, bonus, and stock options.
The arguments to date are about reasonability. Those defending Grasso's pay argue that they have the discretion to set it as they wish and whatever they wish is reasonable. They argue that among powerful chief executives such levels of pay are not uncommon in America. Those attacking it point out that American companies in which pay levels are comparable to Grasso's have revenue streams 25 times larger. To understand this question we turned to a useful paper on the topic. How executive pay does scale or ought to scale with company size is an issue worth discussing. Gabbaix and Landier Develop a model of executive compensation that suggests executive pay ought to scale linearly with the market capitalization of a given firm.
They note that between firms pay generally follows what they call "Robert's Rule." Robert's rule says pay varies with the cube root of company size. And they cite six references that, according to them, support Robert's rule. If we take Gabbier and Landier at face value, then Grasso was overcompensated by a factor of the cube root of 25, or about 3. Instead of $200 million, he should have gotten about $70 million. There are reasons to believe that executive pay perhaps ought to scale sublinearly with organizational size, because the bigger an organization is, generally, the more layers of bureaucracy it must have, and all of these layers of bureacracy need to be compensated using some combination of salary and stock. The argument for why executive pay scales in this way depends on some rather involved mathematical modelling.
Gabbier and Landier go to some effort to argue the distinction between variations in compensation that arise in comparisons between firms of various sizes and variations in compensation that arise as a result of time series changes in firm size and financial performance. The purpose of their article, after all, is to prove that it is reasonable for CEO earnings to have increased linearly with financial conditions despite the Robert's rule which would suggest they scale with the cube root of size. I
Grasso's side of the argument is that it is a free market and executive compensation actually is and ought to be governed by the laws of supply and demand. This is also a reasonable argument. But the economic principle it cites as justification is built on an assumption called 'perfect knowledge.' That assumption is that everybody knows everything. Carrying this assumption through to this case would require that every stockholder of the NYSE, every person who might seek Grasso's position, and every person with a stake in his pay be aware of his level of compensation from the start: that they would have approved it knowingly and willingly, and openly. It assumes, for instance, that the firm places an ad in the Economist and the NYT saying "We are planning to hire Richard Grasso for $200 million, anyone with a similar level of talent may apply."
There are, of course, plenty of game theory reasons why a firm would not do exactly this; so it is a rhetorical point. A firm needs to be able to signal that it is willing to pay 'something like' this amount of money, consider all takers, and negotiate the best deal for the firm. But the secrecy with which the Grasso deal was done suggests that those involved, including those now defending the action, knew that it was indefensible. Free-market arguments only hold for light-of day transactions between knowledgable parties representing competing interests.
Another free market assumption is that the entity with which Grasso negotiates his compensation is disinterested. That is, that the entity shares no common interest with Grasso other than that of the share-holders. This would require that nobody on the compensation board has any interest in Grasso getting paid more. It means, specifically, that no part of their pay now or in the future derives from Grasso's opinion of them. It assumes that their interest is only to generate stockholder value. It assumes they have no reporting link to the chairman. It was not true in this case. I wonder how often this assumption is true? Boards are supposed to act independently, and in the interests of the shareholders, but it is sometimes believed that because 'the same people' sit on all the boards, there is a kind of chummy collegiality that causes board members to better serve each others' interests than those to whom they have a greater fiduciary responsibility.
How one might ensure the independence of compensation functions is not clear. Imagine, however, a third party hired to represent the stockholders in salary negotiations with a prospective, new, or continuing CEO. This party would have full authority to negotiate compensation. The authority would be responsible to a committee of non-management board members and other stockholders. This would sever the ties between a compensation committee and the person they hire as a boss. A committee reporting directly or indirectly to the chairman cannot hope to have any fiduciary interest in holding the line on executive compensation. They must rely totally on some sense of propriety being displayed by their boss.
Alternatively, all compensation for sitting on a board could be in the form of stock options vesting in years seven through ten. If boards really acted in the interests of stockholders, they would presumably be compensated in such long term ways.
The court case dealing with Grasso is about how compensation practice violated reasonable standards as measured by what is done locally. But we live in a global economy. So just as it is reasonable to compare Grasso's case to local, American standards, it is reasonable to compare American standards to those of the world. Grasso's case may be won by Spitzer if he can make a compelling case that Grasso's pay was way out of line that of other American executives. And there is every reason to believe that he ought to prevail. But if what is fair locally is judged in terms of what is done in the greater world, then the argument that American executives as a class are over-compensated is probably also an easy call.
A UAW site suggests American Executives earn over 400 times the average worker's pay, while the ratio in Canada, Mexico, and Japan ranges downwards from 45 to 12 times worker's pay. This compensation, of course, includes bonuses and stock options. Some argue that these numbers are a bit decieving. That, in fact, the difference is due to the greater size of American companies. But if Robert's Rule is any guide, then a typical American company in which an exectutive earns ten times what one from Japan or Germany makes would have to be 1000 times larger. This is clearly not the case.
Others have argued that the difference is simply an artifact of how well the equities of American companies have performed financially, and therefore, in terms of stock option grants. This might be related to the right answer. Gabbieux and Landier suggest that compensation committees consistently tend to underestimate the value and the cost of stock option grants in the US. And when the SEC recently began forcing companies to account for the costs more rigorously, the practice suddently became much less generous. But in all cases, the argument is whether American executives get paid three or ten or four hundred times more than executives in other nations in comparison to local workers. In other words the question is not so much "are they overpaid?" as it is "how eggregiously are they overpaid?"
And we need to ask whether, perhaps either definition sets the level higher that it might be warranted when all economic and ethical factors are considered. There is ongoing prosecutorial work designed to determine to what extent option-based compensation has been abused by corporate executives. These cases are not nearly so far along as the Grasso case, but they represent a rather analogous practice. In both cases compensation committees assuming to be acting in the interest of stock holders actually act in ways that cheat stockholders of value and transfer it to chairmen.
There are ethical arguments to be made and there are economic arguments to be made. Clearly, the conditions that would justify the economic arguments do not hold. Not all of the things that went wrong in the Grasso case are wrong everywhere, but some of them probably are. Compensation committees may not always be constituted in ways that represent stockholders interests. This is not an academic question. To the extent that executives are overcompensated, the economy is drained of resources that could be invested in other productive areas. The ethical issue is about fairness.
Fairness is crucial in a democratic society. Democracies that fail to be fair fail to be democracies. So fairness may simply be viewed as an economic cost of democracy. But fairness is also about merit. If people get paid entirely on the basis of class or on the basis of some exercise of power and not on the basis of the goodness of their results, then merit ceases to be a motivating force in the society. When the society has collapsed into two classes, an upper class with everything and a lower class with nothing - not even hope - then there is no reason for people in the lower class to exert attention to school or to acquiring a skill, or to any thing of merit. One simply goes along to get along. The world is full of such societies. And a large portion of the persons with ambition and skill try to get to Europe or America where skill is still at least partially compensated.
Executive pay is both the symbol of and a driving force behind a growing inequality of pay in the US. Income in the US is much less evenly spread about than it is in other rich nations as measured by the Gini coefficient. All the counries of Europe are more equal. So is Japan. So is Russia. There are a number of Latin American states and a few African countries where the distribution is materially worse. And many have had reputations for governmental instability, corruption, internal strife, and vascillation between proto-communism and proto-fascism. These sorts of problems both arise from inequality and re-inforce it.
Grasso's case is, therefore, a case of both real and symbolic importance. It is important to the shareholders of the NYSE because it represents a material loss of shareholder value. Two hundred million dollars is a lot to pay someone out of a billion dollars of revenue, even if it is spread over a few years. Had Grasso single-handedly founded the NYSE and built it to its current size, one could argue whether he deserved such a rich package. But it is an old institution. And any changes he made to it, even fundamental ones, would have probably been made by any reasonably smart chairman.
But the real reason the Grasso case is interesting, the real reason it is important is because it tells us who we have become. Americans have ceased being very interested in performance per se. If there was anything we ought to have brought back with us from the winter olympics, it is this lesson. We are interested instead in personality. We are not interested in skill or judgement. We are interested in flash. We are not interested in steak, but we are much enamored of sizzle. Grasso is personality. Grasso is flash. Grasso is sizzle. We compensate cool. We compensate power. We compensate flash. We compensate sizzle. We do not compensate competence. We do not compensate expertise. Should Spitzer win the case against Grasso it will suggest that there is still some hope for merit in the American version of meritocracy. Otherwise, we might conclude that ours is destined to become a society that neither values nor cultivates merit.
Unlike the one our society was designed to replace, it will no longer be informed by the idea of noblesse oblige. Power will be the only exponent of human existence. Men will ask "why should I get an education?" "Why should I be smart?" "Why should I be accomplished?" If one is born into the right class, all one need do is show up, be cool, and demand a big check. If one is born into the wrong class, what one does is not relevant; so why spend the effort? Only guns and terror and revolution can close the gap. The trend is already starting. Boys are falling behind girls in school. Grasso did not cause this but he is is a symbol for why this is inevitable. It has been an issue of some interest that Grasso's case has made the NYT pages on so many occasions when nothing much has actually happened in the case. It keeps on not being news. The facts keep on being the same. But the facts of the case are important because they remind us of who we are and who we might become. And I am thankful that the NYT editors see the importance of reminding us. This week's article depicts Grasso in a very stylish suit with very cool glasses, smirking coyly in front of a very posh address. Grasso's smirk dares us to become like him. Do we do it? Not for $200 million, thank you.
Copyright: Stephen R. Brubaker, 2006. All Rights Reserved