Mises Daily Articles
Outrageous CEO Pay
Nothing sharpens the sight like envy.
Some legislators who are enjoying six-figure remunerations and seven-figure benefits are dismayed about CEO compensation. They resent the fact that top executives are earning multimillion-dollar-pay packages while lawmakers subsist on such meager fare. CEOs, in their judgment, are greedy executives who thrive on corporate profits when times are good and when times are bad.
Similarly, media commentators and journalists never tire of pointing at apparent excesses of executive compensation practices. One business magazine recently lamented especially about Apple Corporation's issue of a stock-option package valued at more than $500 million, calling it "The Great CEO Pay Heist."
CEO compensation usually is pay-for-performance, consisting of a base pay plus equity-based incentives such as bonuses, stock options, and other equity vehicles. CEO income, therefore, rises and falls with performance. The market way to measure his or her performance is by the size of company profits and the price of the company stock. Numerous stockholders continually judge the efficiency and profitability of a corporation and set stock prices by buying and selling shares. They love and acclaim a CEO who improves the profitability of their company and thereby may add millions of dollars to the value of the company. They offer multimillion-dollar incentives to management so that it may identify with the interests of the owners.
Irate critics of high CEO pay often base their charges on the notion that corporate boards of directors and compensation consultants who make such astonishing recommendations are cozy and "cushy" with management. Cronyism, critics charge, is a strong and habitual business inclination to promote the interests of one another. We may agree that cronyism is a human constant, and not just in business, but it may also conflict with the interests of the cronies. In fact, U.S. corporations probably are the most shareholder-responsive in the world because the shareholders themselves may be judged by the price of the corporate stock.
The U.S. stock market is driven by powerful institutional investors such as mutuals and pension funds that force management to maximize shareholder returns and profits. Institutional investors have assumed the role that wealthy families used to play before the age of confiscatory estate taxation; that is, they have the financial clout and resolve to unseat managements of poorly performing companies. For example, they replaced the heads of IBM, General Motors, Kmart, and American Express with new talent. They may also force CEOs to restructure corporate operations and trim their payrolls to the bone—a tactic that was unheard of and unthinkable in the past.
Institutional investors are forcing management to search for the best possible combination of capital and labor—in other words, achieve the optimum investment of capital with the optimum number of workers assuring the most profitable operation. To employ fewer workers than the optimum is to fail to utilize fully the capital equipment; to employ more is to reduce labor productivity and raise costs. In short, if the number of workers is too small, company profitability will demand the hiring of more workers; if the number of workers is too large, profitability will require that excess labor be discharged.
Giant corporations consist of numerous company divisions, departments, branches, and affiliates. Some are more profitable than others. Some may even suffer losses and rely on the earnings and subsidies of the profitable branches. An alert CEO is quick to recognize the situation—to reorganize the loss-inflicting activity or to terminate it. He does not permit some departments to inflict losses on the owners. To tolerate such failures would soon lead to his dismissal or early retirement.
CEOs may reap unearned windfalls when the Federal Reserve engages in inflationary policies that drive up stock prices. They may pocket undeserved bonuses and exercise stock options that the Fed made profitable. Throughout the 1990s, the Fed managed to create the greatest and longest economic boom in American history, which drove stock prices to unprecedented heights and some executives' pay to astonishing levels. Even mediocre CEOs could reap unearned option profits, as the boom boosted company profits and raised stock prices.
When boom conditions finally turn into economic recession, however, CEO income falls as company profits may turn into losses and stock options lose their value. During boom periods, option profits may rise to 80 or 90 percent of CEO compensation. During recessions these profits tend to vanish. Companies may then readjust management options to make up for the fall in stock prices. The companies have no choice but to create incentives in good times, and especially when times are bad. Capable CEOs may choose to work somewhere else if their options are hopelessly out of money.
Executive stock options impose no costs to the company; they are not paid out of earnings. But they grant ownership to management, which dilutes the ownership of all other stockholders. It dilutes the earnings and book value per share whenever the stock options are exercised. Profit and loss statements usually reveal the "fully diluted earnings per share," if and when the options claim 3 percent or more of company earnings. But stockholders rarely complain, because the options granted become valuable only when stock prices rise to the exercise price, which benefits not only the option owners but also the stockholders.
Options aim to keep CEO eyes on company growth and share prices—which, in this age of political correctness, is no easy task. Powerful political and social forces continually demand the attention of management. There are environmentalists, civil rightists, racists, protectionists, tax collectors, and—last but not least—labor unionists who lay claim to company earnings. Million-dollar stock options fostering individual self-interest constitute a powerful defense against all special interests, yet many managements fall prey to militant demands.
The extraordinary height of some executive compensation reflects not only the stockholders' attempt to overcome the countervailing forces, but also some institutional obstacles to corporate takeovers and management competition. Until well into the 1980s, corporations that were led astray by political pressures—and consequently languished in growth and earnings—became the favorite targets of takeover entrepreneurs.
But, during the early 1990s, many corporations succeeded in practically closing this avenue of corporate control by adopting poison pills and other antitakeover defenses. Their primary aim was the preservation of the firm's current managers' jobs and income regardless of their performance in leading the corporation.
The defensive tactics now include "greenmail," "poison pills," and "golden parachutes." Greenmail is the premium payment to a raider trying to take over a company. By accepting the payment, the raider agrees not to buy any more shares or pursue the takeover any further. Poison pills are various management moves to make a stock less attractive to an acquirer. For instance, it may allow all existing stockholders to buy additional shares at a bargain price after a takeover. Golden parachutes are lucrative employment contracts to provide lavish benefits in case of company takeover resulting in the loss of a job. They may include generous severance pay, stock options, or huge bonuses. All such measures raise the costs of an acquisition and cause dilution, which, hopefully, will deter a takeover bid and keep the newcomers out.
Resuscitation of the takeover market would not lower executive pay overnight, but it would expose all compensation packages to the fresh air of market competition. It would surely redress the imbalance of power and compensation, although it is unlikely that it would appease the social critics and concerned politicians. They resent most what they envy most.