Executive Comp: Let’s Take a Deep Breath

By Sander A. Flaum

When calamity strikes our country, we look for a villain, a punishment, and a swift policy solution that ensures the same thing won’t happen again. This is how we regulate our industries, keep our government honest and, perhaps most regrettably, how we go to war.

Many policies are forged in haste, only to be repealed years later, after it has become clear that they were born out of an overreaction or a misinterpretation.

Today, our nation is at risk to commit another reactionary mistake, one which could sink American industry in the midst of a recession and resonate in the empty office of our most successful corporations for years to come. Congress is toying with the notion of placing artificial caps on executive compensation.

The latest battle in this flawed crusade began on Wall Street. Several years ago, a handful of individuals working in the finance arm of insurance giant AIG began engaging in unconscionably risky behavior that led to heavy losses. The federal government recently bailed out the company with cash infusions exceeding $180 billion. At that point, just as the national media was primed to report on every dollar spent by the company, public disclosures revealed AIG had given out more than $218 million in bonuses—a hefty sum by most standards, but hardly a blip on AIG’s balance sheet, considering its staggering losses.

Still, the public backlash was swift and harsh. A Gallup poll conducted earlier this year showed 85% of Americans surveyed were bothered or outraged by the bonuses at AIG. Pundits and talk show hosts scolded the firm for its irresponsibility. Chief Executive Edward Liddy, who had taken office after the firm’s most egregious recklessness, was subjected to a firing squad on Capitol Hill, where he faced questions to which there could be no right answers.

Now, celebrities, politicians, and average Americans are demanding executive compensation reforms. And they are justified. The regulation of executive pay is imperfect at best. However, the call for broad caps on what executives can earn, without regard for their performance, is not the right solution for our country. In fact, such a blunt tool would ultimately hurt American interests in a recession and put us at risk to fall even further behind.

Congress must understand that arbitrary limits on compensation are not the norm throughout the world. If American corporations cannot assure their A +performers competitive pay in the global business environment, then their top-tier talent is unlikely to remain at home.

“We cannot attract and retain the best and the brightest talent to lead and staff the AIG businesses—which are now being operated principally on behalf of American taxpayers—if employees believe their compensation is subject to continued and arbitrary adjustment by the U.S. Treasury,” Liddy wrote in a letter to Treasury Secretary Timothy Geithner earlier this year.

Whether or not you believe that the remaining staff at AIG is composed of “the best and the brightest,” no corporation can survive without the ability to sufficiently reward its best and brightest top performers.

Of course, no one will argue that a steep income gap between the highest and the lowest players is desirable. However, the manipulation of income is a highly delicate process, one unsuited for government alone. In fact, previous attempts to legislate limits on executive compensation have only escalated the situation. Innovative boards determined to undermine those limits have uncovered alternative legal avenues to pay their talent what they think they’re worth. In 1993, Section 163(m) of the Internal Revenue Code limited the deduction for executive compensation under the corporate income tax to $1,000,000; but corporate America not only found a way around the hurdle by turning to stock options, it used the hurdle as a jumping-off point for setting higher baseline salaries.

“The $1 million limitation on deductibility of senior executive compensation, which became law in 1993, resulted in many companies increasing CEO salaries to $1 million,” Richard Floersch, the executive vice president of McDonald’s and the chairman of the Center on Executive Compensation, said in a statement. “Earlier limitations on exit packages had the same effect—the ceiling became a floor.”

Floersch has called for caution in further legislation. “Policy makers should abjure knee-jerk reforms and carefully consider the actual impact of proposed changes on pay,” he said.

Lawmakers would be wise to take a calmer, more nuanced approach to regulating compensation. They should recognize that they have more tools at their disposal than simply capping what key employees can earn. Here are some possibilities:

  • It may be time to review the relationship between boards of directors and management. Because boards often set executive pay at the highest levels, a chief executive who sits on a board can present a conflict of interests. A more firm separation of the CEO and chairman roles would go a long way toward ensuring the board’s interests lie with the shareholders. This is already a common practice in Europe.
  • Create a closer link between executive pay and performance. Federal Reserve Chairman Ben Bernanke, a Bush appointee, supports new rules tying management’s rewards to its accomplishments. “It is very important that compensation links performance and reward appropriately, and in particular that it do so in a way that doesn't incentivize excessive risk taking,” he said in testimony before the House Financial Services Committee.
  • In an exhaustive study conducted in 1999 at the University of Southern California’s Marshall School of Business, Kevin Murphy found evidence that stock ownership and stock options were more effective drivers of managerial activity and corporate performance than base salaries. One way to increase managers’ stake in their company’s health might be to place stricter limits on the length of time executives must hold on to their stock options before cashing out.
    • Without intervention from Congress, more companies are instituting clawback or recoupment policies, which allow firms to recover money paid to executives when earnings revisions reveal cooked books.
  • Many firms are also using “Say on Pay” policies, in which shareholders are given the opportunity to cast votes on compensation. The vote is nonbinding, but it at least offers a voice in the boardroom difficult to ignore. “There are a number of pros and cons associated with shareholder votes, but that is the change most likely to leave companies with the opportunity to design effective compensation plans without government intervention—and at the same time satisfy shareholders with respect to the level of CEO compensation,” Edward E. Lawler III, the author of “Talent: Making People Your Competitive Advantage,” wrote in BusinessWeek earlier this year. “If it fails to have its intended effect, then and only then should we consider government mandated restrictions on executive compensation payments.”

In sum, there are options for reforming how companies go about rewarding their employees besides setting an arbitrary limit on what they take home. Coming up with a dollar number cap may quiet the crowds for now, but in the long run, it will do the country a disservice.

Because, without the ability to dangle ever larger carrots, it’s going to be awfully tough to move a bigger horse.

Author Bio:
Sander A. Flaum is managing partner, Flaum Partners, Inc., and chairman of the Fordham Leadership Forum, Fordham Graduate School of Business. He is coauthor, with his son Jonathon A. Flaum, of the book The 100-Mile Walk—A Father and Son on a Quest to Find the Essence of Leadership (AMACOM, 2006). Contact him at sflaum@flaumpartners.com.

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