“Why get out of bed and go to work if you’re only gettin’ paid $4 million in stock options?

” An Analysis of Executive Compensation By Gabriel Lopez and Michael Ross

“A gorgeous woman slinks up to a CEO at a party and through moist lips purrs, ‘I’ll do anything ⎯ anything ⎯ you want. Just tell me what you would like.’ With no hesitation, he replies, ‘Reprice my options.’” (Buffet, 2002). Warren Buffet used this joke in his 2001 annual report to illustrate the excessive greed involved in executive compensation. Currently, corporate boards across America liberally grant enormous stock option packages to their CEOs. In 2000, the average CEO earned over 531 times the average hourly worker. In 1990, the average CEO earned only 85 times as much (Reh). While many critics argue that such compensation packages are grossly excessive and downright unethical, the executives who earn them see no problem. It is often argued that if executives earn what they are paid, then there is no ethical problem with such a high salary. The question then becomes: Are they actually earning what they are being paid? The following, we believe, are justifications CEOs would offer in explanation of their pay. We will address each of these justifications and ultimately demonstrate that there is no certainty that their compensations are justified. While we cannot prove whether or not executive compensation is excessive, we believe that absent the market efficiency barriers described below, the pay packages CEOs receive would be substantially smaller. In short, we believe market inefficiencies leading to high transaction costs result in excessive executive compensations.

Justification #1: A good CEO creates value greater than his compensation. A typical CEO will argue that a large compensation package is justified because he creates a large amount of value for the firm. Surely it is ethical to accept such a large amount of options because without that CEO, the firm would not be nearly as valuable. But how is the 1

value created by a CEO calculated? Can a CEO really take credit for value creation in such a large corporation with thousands of employees? Let us take for example the value created by a professional baseball player, like Barry Bonds. Barry hits lots of home runs, which helps his team win games. Fans pay money for tickets to see Barry, which creates value for the franchise. If Barry strikes out more and hits fewer home runs, then his team will likely lose more games and fewer fans would pay for tickets. It is clear that Barry is compensated for the value he creates for his team. If Barry thinks he is underpaid, then he can seek employment with another team. If Barry performs below expectations, then his team will reduce his pay or trade him to another team. However, the situation of a high-paid CEO is much more complex. Unlike baseball, corporations have thousands of contributing team members and each corporation plays a different sport. When a corporation wins, it is due to the hard work of thousands of people; each of them creates value for the firm. The complexity of recognizing value created by the employees in a large corporation is greatly magnified, and therefore more difficult to assign a specific amount of created value to each contributing employee. For example, if a large software corporation successfully launches a new product, should the CEO get credit for the increase in shareholder wealth? Do the increased profits for the company justify the million dollar bonuses the CEO receives? What about the value created by the other 10,000 employees? The new product was likely successful for a number of reasons: The talented software engineers labored diligently to produce the product. The marketing department worked tirelessly to effectively advertise. Salesmen relentlessly sought out new customers. These employees also deserve credit for the value they create. Employees in fact, are often rewarded for such value creating efforts in the form of stock options. It seems then, that the CEO is being awarded stock options for the same value creation that the lower level employees are being compensated for. In the baseball example, other players (such as pitchers) are recognized for the value they create and 2

are compensated accordingly with high salaries. The baseball franchise knows that Barry is not the only one who creates value. Obviously, a company should recognize that a CEO does not

create all the value for a firm, yet companies often pay their CEO as if he does just that. Many CEOs also get paid large amounts even when the company performs poorly. A recent Wall Street Journal article by Joseph Hallinan illustrates such an instance. At Conseco, the previous CEO was given a $13.5 million severance package. The CEO before him was given a $45 million signing bonus. Conseco however, lost billions during the tenures of these two CEOs (Hallinan, 2004). Clearly, these executives were not paid for any value created. If this is the case, then the forces of an efficient market should react to such a discrepancy between compensation and value creation, which leads to the next justification.

Justification #2: There market for executives is efficient and fair. A highly paid CEO will likely argue that his compensation is subject to market forces. If a CEO is overpaid or underperforming, then the market for executives can provide the company with another qualified person to do the job. This argument however, assumes that the market for executives is both efficient and fair. The market for executives is not efficient however, because companies face high transaction costs associated with finding and employing a new CEO. For example, the switching costs associated with firing an old CEO and hiring a new CEO are tremendous. Also, a CEO who is fired is often entitled to a large severance package as part of his contract. Getting an unsuccessful CEO to walk quietly is not easy, especially if that CEO has strong relationships with board members. Finding the new CEO can be costly as well. A company may have to spend millions of dollars searching for the right CEO to manage the company. The uncertainty associated with a new CEO can create market apprehension. Many companies face volatility in their stock prices due to this uncertainty. This volatility can hurt the 3

loyal shareholders that the board is trying to protect. The possibility of these problems creates additional apprehension for the board of directors. For this reason, boards are often more hesitant towards changing CEOs. The board of directors should then try to eliminate this problem by finding and hiring the best CEO possible. However, board members are often inclined to hire executives whom they know and trust. They may hire an executive who is also a friend, or an executive from another very large company that they are familiar with. As John Nirenberg points out: “The same names come up over and over again. So the anxiety around the uncertainty of the selection outcome and the fear of failure encourages boards to select from what looks like a pool of tried-and-true candidates” (Nirenberg, 2001). The door is then unfairly closed to many very qualified executives who would make great CEOs. These market barriers and transaction costs prove that the market for executives is neither fluid nor fair. Obviously, the market for executives cannot be efficient under such constraints. These barriers must be removed in order to foster a more fair and efficient market. The concept of market fairness is further explained in the next section as it relates to compensation.

Justification 3: If CEOs were not worth their salaries, their bonuses would be reduced or they would simply be fired. Much of this discussion can go back to the efficient market problem that was previously addressed. However there is an additional force that comes to bear on this justification. Boards recognize the substantial costs of switching CEOs and desire to keep them from moving to a different company. In fact this is one of the most frequent justifications explicitly stated by boards with respect to the enormous pay packages. The claim is they are simply trying to be competitive with the pay packages offered to CEOs of firms similar in size or business. A study conducted by Maria Hasenhuttl and H. Richard Harrison of the University of Texas examined 4

CEO turnover in 1,233 companies from 1995 to 1997 (Hasenhuttl, 2002). The authors of the study concluded that the level of CEO compensation had no significant effect on turnover (Hasenhuttl, 2002). The premiums that boards are paying for stability are completely without justification. In an article for The Conference Board, John Nirenberg observed that boards become fixated on a candidate and, when committed, are willing to pay far more than what makes sense (Nirenberg, 2001). The board and the CEO, or potential CEO, get locked in a bilateral monopoly. Nirenberg highlights the point by using Carly Fiorina as an example. Firorina secured a compensation package worth about $85 million in 1998 (Nirenberg, 2001). The package was given to Fiorina before she had even worked a day on the job! The continually rising size of the pay packages has led candidates for executive positions to expect them and has led boards to fear, often without reason, the consequences of not fulfilling those expectations. Jeffery Skilling, the former CEO of Enron, even tried to justify the large packages, which are often largely composed of options, by explaining that “you issue stock options to reduce compensation expense and, therefore, increase your profitability” (Broad, 2002). Warren Buffet responded to this line of reasoning by saying "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it?” (Mann, 2004). Buffet was right in asking these questions. Compensation is clearly an expense and Skilling’s claim merely plays off the much debated handling of options in earnings reporting. The options don’t actually reduce expenses, they just happen to be excluded from the calculation of earnings.

Justification 4: Directors must be paying the CEO the right amount because the board has the interests of the shareholders in mind. The fundamental problem with this argument is that it assumes the interests of shareholders are effectively aligned with the interests of the board members. However, until 5

recently directors were largely compensated with cash. This provides little incentive to make decisions based on the interests of shareholders. In a 2003 article in Directors and Boards, the shift to an increased level of equity compensation over cash compensation is highlighted (Canavan, 2003). They cite a Conference Board survey which found that only 26% of companies surveyed have stock ownership guidelines for independent directors (Canavan, 2003). This shift has been accompanied by a decline in the use of other compensation methods previously used such as retirement income plans. Until these changes occur on a larger scale it is not entirely clear that the interests of board members are in fact aligned with the interests of shareholders. The return argument would be that if shareholders were displeased with the decisions that members of the board were making they could simply vote them out and install directors who would have shareholder interests in mind. This argument is defeated almost immediately when one considers that the process requires a proxy vote on the part of the shareholders. The cost of such a procedure is extremely high, not to mention the costs of informing all the participants and agreeing on a suitable replacement. Additionally, there is too little independence on boards. There are many ties between the various members of the boards that create objectionable conflicts of interests. There have been positive changes as a result of both Sarbanes-Oxley and requirements of board independence by the major exchanges. These new rules should help to mitigate the impact of conflicts in eroding the ties between board members and share holders.

Justification 5: The CEOs in place are the only ones qualified for the positions. Many CEOs have suggested that the success of their companies is completely dependant on their role as CEO. Most recently we have seen this from Michael Eisner with Disney and his insistence that he is the right person for the job, and perhaps that he is even the only person for 6

the job. CEOs would quickly cite the fact that when companies conduct searches for replacements the candidates are consistently people with previous experience as CEOs. This is more likely a symptom of the board’s reluctance to choose someone outside the normal pool of candidates for fear that if they fail, the board will take the blame. Companies are also doing far too little to develop new executives who can rise up through the chain of leadership. GE has demonstrated that this is entirely possible if done with intentionality and consistency. Rarely does the performance of a company change dramatically after a CEO switch, for better or for worse. Boards should not allow themselves to get trapped into negotiations with CEOs believing their CEO is irreplaceable. In conclusion, the likely justifications CEOs would provide for their high compensation are largely unsubstantiated. The inflated pay appears to be more a result of market inefficiencies and barriers than a true reflection of the market value of executives. These inefficiencies and barriers can be mitigated by linking the interests of boards more closely with the interests of shareholders, widening the pool of potential executives, and gradually lowering the size of executive compensation packages (and the level of expectations along with them). There are many complex considerations that impact how, and to what extent, executives are paid, but it would be a disservice to shareholders and employees for boards to concede to the demands of executives and claim they are powerless to stop them.

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Bibliography
Broad, Kenneth. (2002, July 18). Why the Options Party is Over. News.com. Retrieved September 30, 2004 from the World Wide Web: http://news.com.com/2010-1071944782.html. Buffet, Warren. (2002). Letter to Shareholders. Retrieved September 30, 2004 from the World Wide Web: http://www.berkshirehathaway.com/2001ar/2001ar.pdf. Canavan, Judy & Gallo, Donald. (2003). Director Pay: Overhaul in Progress. Directors & Boards. 49-53. Hallinan, Joseph T. (2004, August 17). It Still Pays to Be a Conseco CEO. The Wall Street Journal. C1. Hasenhuttl, Maria & Harrisn, J. Richard. (2002, September). Exit or Loyalty: The Effects of Compensation on CEO Turnover. Dallas, Texas: Authors. Retrieved September 30, 2004 from the World Wide Web: http://www.utdallas.edu/~harrison/Richard%20Harrison's%20homepage_files/w ork1.doc. Mann, Bill. (2004, March 17). The Best Stock Options Model. The Motley Fool. Retrieved September 30, 2004 from the World Wide Web: http://www.fool.com/news/commentary/2004/commentary040317bm.htm. Nirenberg, John. (2001). What Leadership Crisis? Across the Board. Retrieved September 30, 2004 from the World Wide Web: http://www.conferenceboard.org/articles/atb_article.cfm?id=162. Reh, F. John. CEOs are Overpaid. About. Retrieved September 30, 2004 from the World Wide Web: http://management.about.com/cs/generalmanagement/a/CEOs Overpaid.htm.

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