Obama's $500,000 CEO pay limit is flawed. Here are four better ways to fix the executive-compensation debacle.

Obama's $500,000 CEO pay limit is flawed. Here are four better ways to fix the executive-compensation debacle.

Obama's $500,000 CEO pay limit is flawed. Here are four better ways to fix the executive-compensation debacle.

Making government work better.
Feb. 18 2009 12:30 PM

The $500,000 Limit Is Not Enough

Four better ways of fixing the CEO pay debacle.

Merrill Lynch CEO John Thain. Click image to expand.
Former Merrill Lynch CEO John Thain 

President Obama's $500,000 pay cap for senior executives at institutions receiving taxpayer assistance is a primal scream of outrage more than it is a coherent policy. But at least it begins a long overdue debate about the outrageous pay that has been tolerated—and, indeed, become the norm—in the senior ranks of corporate America. Americans are appalled by excessive CEO pay because they now recognize that the executives receiving these millions oversaw a grand fleecing of American investors, leading to the collapse of the national and global economy. In 1985, the ratio of the average CEO salary to the average worker's salary was 40-to-1. By 2005 it had metastasized to 450-to-1. Such increasing income inequality was tolerated as long as the rising tide was lifting all ships. Not anymore.

What should really be done about executive pay? First, let us acknowledge that the $500,000 bar is arbitrary. It will be way too low in some circumstances and way too high in others; it affects too few executives; it can be easily avoided through alternative pay techniques; and it injects the government into a sphere where it is uniquely inept—setting private-sector wages.

Advertisement

If we are to stop outrageous pay, the objective should not be to match the foolishness of the Bush ideological embrace of wild-eyed libertarianism masquerading as capitalism with an equally foolish "government knows best" approach that ignores the market. We must create a genuine market for CEO services, generating meaningful competition and socially acceptable results.

This process should begin with some digging into history. The SEC, with its now well-focused resources and newfound vigor, should produce, in no more than 6 months, the authoritative report on the flaws in compensation decisions at major companies. The commission should subpoena the reports from compensation consultants and committees and reveal the biased methods they used to calculate pay, as well as the pressures they felt from their CEO clients. The SEC should map the overlapping and innumerable conflicts that result from service on compensation committees. And it should examine how compensation consultants were hired, by whom, and the representations made by the consultants before they were hired. This report will be deeply revealing and devastating about the back-scratching, fundamentally corrupt nature of executive-pay decisions.

Fixing the compensation debacle will require addressing the behavior of three groups: compensation consultants hired by boards, compensation committees, and, most importantly, institutional shareholders. These groups must rise up and reclaim power from a system that is now dominated by CEOs. Real progress will result not from an essentially arbitrary rule imposed by government but from a rejuvenated system of corporate governance with shareholders—the owners—having an adequate say.

Let's start with the compensation consultants. The underlying structural problem has been that compensation consultants have shown greater allegiance to the CEO than to shareholders. And no wonder: CEOs have played too great a role in selecting the consultants, and the consulting firms are often part of larger organizations performing other contracts for the company that the CEO could terminate. The fix is evident: Create a special shareholder committee to select the compensation consultant. And require these consultants to be stand-alone companies without any possible ancillary business relationships with the company that hires them. If this were done, it would be amazing to see how quickly the severance packages and parachutes would shrink. CEOs would be paid like other workers—for doing their jobs and fulfilling their fiduciary duties. They wouldn't be paid for the illusory concern that the company would collapse in their absence. Most compensation negotiations begin with the premise that the particular CEO is irreplaceable. But, as de Gaulle wryly observed, the graveyards are filled with indispensable people.

There should also be a simple rule relating to compensation committees of boards: Those who participate must be totally independent of the CEO. No conflicts, direct or indirect, should be permitted. They must have no other common board memberships, no overlapping charitable causes, no shared social clubs. Nor should compensation committee members be CEOs or executives of any rank whose own pay will in any way be measured against the pay of the individual whose pay they are setting. Most importantly, shareholders should vote directly on the constituency of compensation committees. It has become all too easy for boards to give away "other people's money" without having to answer to shareholders. Shareholders should vote every member on or off the committee and be able to propose members directly, while the CEO should have no role whatsoever in proposing membership of the committee.

Finally, and most important, it is time to realize that CEO pay is essentially the responsibility of shareholders: If they are willing to tolerate waste, they should pay the price. So, where have shareholders been? The sad truth is that corporate governance is broken because shareholders have let management run roughshod over them. But just as in politics, the power of the vote can reclaim these rights. So, here is a simple proposal: Make senior-executive pay a matter of shareholder vote. Not the "nonbinding" votes that are all the rage. Make them subject to a real up-or-down vote. Give shareholders power again. Force executives to appear in front of their employers and explain why they deserve the packages they are offered.

This shareholder vote would also empower government to play a constructive role, not by mandating a pay threshold but by using its role as a shareholder to vote its fiduciary interests. The government should convert its enormous capital infusions in all these companies into voting shares and then use its shareholder leadership power to make a market decision, like every other shareholder, and to lead a revolt of shareholders if necessary. The federal government could win allies in this from a group that has been disturbingly quiet throughout this process: state treasurers and comptrollers. They control the enormous pension funds of the public employees, perhaps the single largest repository of shareholder strength.

Some will say encouraging government owners to determine CEO pay swings the pendulum too far back toward shareholder strength. But it is time to determine whether we believe in shareholder democracy. This is not nationalization. This is shareholders—public and private—finally saying we are going to reclaim what should be ours. And once public shareholders take the lead, other institutional investors would not be far behind in demanding performance for pay. For all the hundreds of billions of dollars we have invested in the financial services and automotive sectors, we should be able to vote on CEO compensation, not just issue a Swiss cheese $500,000 limit that will be easily circumvented. Warren Buffett would never invest without holding on to that power. Why should we?