Executive Compensation Argumentative

Wall Street has been under particular heat over the past ten years with the discovery of corporate fraud in companies like Enron and Tyco and more recently in bailout of 2008 in which large banks and mortgage insurance companies received billions of dollars from the federal government. Americans have become increasingly critical of the heads of these large corporations as they see their own supply of available money dwindling in the recession. The problem of executive pay and corporate greed in particular have plagued the United States since the early 20th century and has grown over the past thirty-five years despite the government and shareholders’ attempts at regulation. In our collective paper and presentation we will describe a brief history of executive compensation and how it has changed in scope and composition since the early 20th century. We will then discuss three main reasons why the level of compensation has grown exponentially within the past decade and recent solutions that have been proposed within companies themselves and by the federal government to address these problems.

We will finish by discussing additional addendums that need to be made in the future to limit these issues in the future. Although executive compensation has been a hot topic for the last decade, it has not always been that way. At least it hasn’t been dubbed an “executive compensation” problem. There has always been socioeconomic inequality and manipulation of the economic system, however; it has always seemed that the noble class has been uncomfortably incestuous and suspiciously exclusive. There seems to be a pattern in this topic’s popularity that we hope to highlight for you now. Since the panic of 1893 (probably earlier, but for focus sake we’ll keep it to the last 150 years), inspection of the economic powerhouses always follows a near meltdown of the system. Then, following the crisis, attention is at its peak and regulations and acts are passed and politicians put on a great horse and pony act and the clamor subsides. The regulations and acts quiet the uproar and throw the powerhouses off their game and all is well…temporarily. It’s like the executives and high rollers are viruses and every time the immune system of our society gets them under control, the viruses mutate and infiltrate our defenses and we are back to square one. I’m going to name the main virus: greed (Stevens; Quarterly Journal of Economics, January 1894).

In 1893, the Philadelphia and Reading Railroad companies were at the head of the game and banks were handing out shaky loans left and right because the railroads were a “sure shot” and the bank would collect “guaranteed” interest. These companies and many like them overextended themselves as a result of their insatiable thirst for profit and consequently went bankrupt. The banks that lent to them suffered tremendously. Then, public confidence plummeted resulting in bank runs and the failure of one bank after another. Please note that this domino effect was caused by the greed virus making the banks and railroad companies defenseless against the temptation to capitalize off the interest on the loans and the profits from the rail industry. Shortly thereafter, the Klondike Gold Rush restored confidence and helped to not only reduce attention to greed, but to strengthen its hold on the country. 1907 brought on another economic panic. While there were multiple factors that contributed to the crisis, we’d like to focus on the most infected variable: cornering copper.

Back in the early 1900s, August Heinze Charles Morse owned at least six national banks, ten state banks, five trust companies and four insurance firms. Simultaneously, his family bought up a majority of Untied Copper Company stock. His brother Otis wanted to “corner” the United Copper Market. By buying a vast majority of the stock, which would cause the price to increase. This would also force the short sellers to purchase their borrowed shares from the Heinzes’ who could now name their own price as they have the market “cornered” (EconTrader.com). This scheme failed, Otis overestimated his family’s ownership in the company. The consequences rippled out pretty far. All of Otis’s backers went broke and a result. Backers of his included Knickerbocker Trust Company, New York City’s 3rd largest trust, which suffered an $8 Million run. This patterned repeated itself with 20 other banks and trusts causing a huge financial meltdown (Conservapedia.com). In an attempt to remedy the situation, Congress created the Federal Reserve Bank as well as the National Monetary Commission. And for a time, these were satisfactory.

Twenty years later the economy suffered yet another crippling collapse, The Great Depression. The stock market crash on 1929 was due largely in part by irrational exuberance. Stockbrokers and financial advisors infected with greed were getting rich by selling and trading on margin (with borrowed money). As more and more investors began to take their profit there were less and less shares to cover all that had been sold with borrowed money causing the inevitable crash (Amadeo; The Great Depression of 1929, About.com). After people jumped out of buildings and lost their life savings, while large corporations enjoyed their large stipends and bonuses, the government had to come up with something to take the heat off. This is where the Securities Act of 1933 and 1934 were created and the FDIC, Federal Depository Insurance Corporation and the SEC, Securities Exchange Commission, were established to enforce full disclosure and to prevent corporate fraud (Laura Fitzpatrick, TIME Magazine Nov, 2009). . In the early 20th century compensation practices were closely guarded secrets. This is about the time the country started paying more attention to the financial world and what was really going on behind the scenes.

By 1936 proxy statements were being used to disclose compensation in order to comply with all the new regulations. Proxy statements would list total compensation: salaries, bonuses and long-term incentive plans (Historical Trends in Executive Compensation; Frydman and Saks). World War II understandably stunted economic growth and therefore kept compensation packages remaining fairly constant for about 30 years and the popularity of the executive compensation topic died down. During the 1980s, however, there was a substantial increase in the size of and configuration of executive pay. There are many reasons speculated that seek to explain this change. The first is a steady decrease in union membership dropping to 24.1% in 1979.

Because labor unions work to ensure appropriate wages and conditions for workers, they place a certain pressure on the Board of Directors in devising a corporation’s compensation plans. Their lack of presence, while not the only factor, provides the Board of Director more freedom in designing top executive payment plans (Niekirk, 1991). The second although minimal, is a change in tax laws during this time period, which favored payment in options rather than salary and bonus. The Tax Law of 1986, the second of the Reagan tax cuts, is of particular note because it reduced the personal tax rate of top bracket earners from 50% to 28%. Because non-qualified stock options are taxed at the personal income tax rate at the time they are cashed out, this dramatic reduction in tax rate made payment in options much more attractive (Coviello, 2008). Critics argue that although this tax law provided corporations more incentive to pay executives in stock options, it was actually changes to corporate governance and input from large established investors that brought about the change.

These large investors were responsible for a series of leveraged buyouts and takeovers in the 1980s that favored profitability above all else. Payment in options was a way to align their incentives with that of the CEO (Kaplan, 1998). The passing of the million-dollar rule in 1993 further favored payment in options. The new tax law limited the deductibility for the corporation of executive compensation for payment over one million dollars that was not performance based. Under the law salary increases for specific performance goals reached were not eligible as well as bonuses and stock options. Although it was intended to support pay based on productivity, this law was responsible for many of the outrageous bonuses received by failing CEOs during the bailout in 2008 (Hall and Liebman, 1998).

Although we already discussed certain aspects of executive pay above, in order to discuss the problems and solutions further we would like to illustrate the differences in the various types of compensations that CEO’s receive: 1. Base Pay – compensation received for the core role and responsibilities of the day to day running of the organization. 2. Annual bonuses – compensation received for meeting annual performance objectives 3. Long-term incentive payments – compensation received for meeting performance objectives to be achieved for a two-to five-year period. Also refer to as long-term cash incentives. 4. Restricted stock awards – compensation to assure the executives are strongly aligned with the interests of shareholders. 5. Stock options and stock appreciation rights – compensation for increasing share price and increasing the shareholders’ returns. However, how a CEO’s compensation is decided can be difficult to understand. In recent years there have been several criticisms that CEO’s are paid extremely high salaries while the changes in lower level workers salaries remain somewhat dormant.

According to a study done by Business week in 2007, CEO’s of big companies’ compensation was more than 400 times the pay for average workers in 2006. Some examples of CEO’s with these exuberant salaries are former CEO of Home Depot, Robert Nardelli who received $210 Million and Michael Orvitz of Disney who received $140 Million. In an article “CEO Pay Still on Steroids,” written by Holly Sklar, the highest paid CEO in 2004 made over $230.6 million. A whopping $4.6 million per week! Some may argue that CEO’s pay packages reflect the underlying business fundamentals or uncertainties present during the hiring of a new CEO and that these compensation are negotiated to promote the CEO’s action that are in the best interest of the firm and its shareholders. Nonetheless, such excessive pay in salary raises some concern for many people especially shareholders (Coleman, 2010). There are many explanations as to why CEO’s are compensated so greatly. Among them is the idea that CEO pay is an issue of supply and demand.

CEO’s are paid lots of money because it requires extreme skills and responsibilities to perform the job of a CEO; the amounts of people who are able to fill these roles are limited. Another explanation of the executive compensation problem is an issue of poor corporate governance with most managers using their influence to generate dubious severances. They receive excessive pay as a result of their power. This influence can be seen through the structure of the Board of Directors. In a lot of cases the board of directors of a firm can be made up of former CEOs, and people who have direct link to the CEO. This can be a breeding ground for discrepancies. Another is the trend of over boarding where individuals may serve on several boards. Such can influence heavily in the executive’s compensation. As mentioned in the history above, the soaring use of stock options as compensation for CEOs has also created several problems. Stock options allow the CEOs to purchase shares in the company’s stock at a significantly lower price than what is set at the market value.

CEOs are allowed to sell stock options that were purchased at extremely low prices at very high prices. Because the compensation of stock options is driven by performance on the CEO’s part, CEOs can exaggerate company’s profitability in order to gain quickly. There is also a huge problem with the stock option compensation because the CEO can purchase significant amount of stocks in a company resulting in part ownership of a company (Whelton, 2010). In an attempt to address these issues and maintain a positive image certain companies like Goldman Sachs have issued a claw back policy for bonuses.

These are a type of deferred bonuses that are purposely held from the executive until specific goals are met; if the goals are not met the executive is not given the bonus (Edmans, 2012). The government has also been under particular pressure to regulate and reform the financial sector. The Sarbanes-Oxley Act passed in 2002 after several highly public fraud cases (Enron, Tyco, Adelphia) provided less incentive for directors to engage in fraudulent accounting practices and risk-seeking behavior by requiring certain components to be included in financial reporting (Provisions of the Sarbanes-Oxley Law, 2002). The SEC responded further in the summer of 2009 by reforming a corporation’s proxy statement requirements. The new proxy statement for each company is required to report:

1. Director qualifications- list specific qualities and professional characteristics of director nominees and how these attributes led the Board of Directors in their election decision

2. Compensation determinants/risk management program- reveal criteria for determining executive compensation and any possible risks the company might incur from the compensation plan

3. Diversity factor- the board must disclose whether they consider diversity as a factor in choosing a new director (if they do they must illustrate their diversity considerations on paper)

4. Stock options – stricter rules in disclosing stock and options payment and reporting an estimate on the value of these awards at grant

These new proxy statement requirements, although less strict than the originally proposed requirements, seek to provide shareholders with more information on the process of CEO election and subsequently CEO compensation so they can recognize unfavorable practices (SEC Adopts Final, 2009). The Dodd-Frank Act passed in July 2010 has sought to reform Wall Street reporting standards as well. The Act, which includes 2,300 pages, introduced sweeping financial reforms from risk oversight, banking and investment firm regulation, capital markets, and in particular governance and executive compensation plans. Coupled with the new SEC proxy requirements, the Dodd-Frank Act grants shareholders a role in determining the compensation plans of executives (Morrison and Forrestor, 2010).

Although these internal and government mandated reforms to curtail the growth of executive compensation, many economists believe further action needs to be taken to ensure fair and appropriate executive payment plans.

The first would be to revise the million dollar rule by not offering a tax break on incentive pay unless this type of incentive pay is offered to workers at all levels of the business. Companies like Wegmans and Google have already enacted similar programs and have experienced great success. Offering incentive based pay to more than a select few promotes employee morale, which in turn increases productivity and creativity within any organization (McRitchie, 2011). Or as Corey Rosen of the National Center of Employee Ownership advocated:

“We have become infatuated with the idea that companies rise and fall based on a few key people. Yet study after study (and the rhetoric of CEOs insistent that “people are our most important asset”) show that the level of employee engagement at work is the single most important determinant of corporate performance. Engaged employees come up with the ideas, large and small, that move companies forward.”

However, some believe that incentive based equity pay should be restructured all together to take into consideration real world market features like sales, profits, and investments rather than speculated market expectations which tempt CEOs to engage in fraudulent activities to hype up their share price (Martin, 2009).

Others believe that incentive based pay needs to be changed to include larger payments in debt. This can be in the form of deferred payments or employee pension plans. Economists predict that payment in debt forces CEOs to behave more conservatively with their corporation because they are required to wait a longer period of time before they can receive their payout. It shifts the CEO’s ultimate incentive to the long-term success of the company rather than sharp and short fluctuations in share price.

Because payment in options will continue to be a feature in most executive compensation plans, a longer waiting period to cash out options would be another way to alter CEO vision for the long term (Edmans, 2012).

References

Stevens, Albert. “Quarterly Journal of Economics.” Table of Contents. Web. 14 Mar. 2012. <http://qje.oxfordjournals.org/content/8/2.toc>. Amadeo, Kimberly. “The Great Depression of 1929.” About.com US Economy. Web. 14 Mar. 2012. <http://useconomy.about.

com/od/grossdomesticproduct/p/1929_Depression.htm>.

Fitzpatrick, Laura. “Brief History: Executive Pay.” Time. Time, 02 Nov. 2009. Web. 14 Mar. 2012. <http://www.time.com/time/
magazine/article/0,9171,1931748,00.html>.

Frydman, Carola, and Raven Saks. “Historical Trends in Executive Compensation.” Vanderbuilt.edu. Web. 12 Mar. 2012.

“Executive Compensation.” Salary.com. Web. 10 Mar. 2012.
<http://www.salary.com/executive-compensation-it-starts-with-the-ceo/>.

Whelton, Russel. “Effects of Excessive CEO Pay on U.S. Society.” Web. 8 Mar. 2012.

“Excesses Of The 1980s Paid Off For Executives.” Chicago Tribune. 10 June 1991. Web. 7 Mar. 2012. <http://articles.chicagotribune.com/1991-06 10/news/9102210582_1_executive-compensation-stock-market-stock-options/2>

Anderson, Sarah. “Executive Excess 2008.” Web. 5 Mar. 2012.

“AMERICAN.COM.” Cracking the CEO Pay Puzzle. The American Magazine. Web. 14 Mar. 2012. <http://www.american.com/archive/2008/march-april-magazine-contents/cracking-the-ceo-pay-puzzle>.