Pay Czar Targets Pay

October 7th, 2009 - 26 Comments

The Wall Street Journal reports that “the Obama administration’s pay czar is planning to clamp down on compensation at firms receiving large sums of government aid by cutting annual cash salaries for many of the top employees under his authority.”

However, according to Smeal’s Tim Pollock, it’s going to take a cultural shift, not a government edict, to really rein in exorbitant CEO salaries:

The problems with executive compensation can’t be solved with regulation, or by a pay czar, because they are deeply embedded in the culture of Wall Street, in the case of financial services, and in the culture and belief systems of the executive suite and boardroom, more generally.

CEOs and senior executives, while always well compensated, were not always as lavishly compensated as they are today. What we see now largely began in the 80s when stock options began to be used more widely as a consequence of proscriptions derived from the logic of agency theory, which argues that executives will act in a risk averse and self-interested manner unless provided with incentives to behave otherwise.

The problems with stock options are that, unlike actual stock, which can go down in value as well as up, stock options can’t go below zero in value. And until recently they received favored accounting treatments that essentially made them a “free good”. As a consequence of the former problem, executives really face no downside risk from stock options. Thus, rather than take reasonable risks, they are more likely to take excessive risks because they bear no real costs from failure; they just might not (in theory) make any gains. However, even this rarely comes to pass, because boards swoop in to reprice the options, or to give the executives new grants at lower exercise prices, in order to keep them sufficiently “motivated.”

This problem was exacerbated by the Clinton administration’s well-meaning but disastrous attempt to limit executive pay by limiting  its tax deductibility unless it was tied to firm performance, which meant more stock options. Further, the favored-accounting treatment options received made them a cheap form of compensation, so it was easy for boards to load CEOs up with huge option grants that turned into phenomenal amounts of compensation in the 1990s’ bull market, which, by the way, raised all boats, even those of marginal and incompetent CEOs. Because it was easier to ascertain the value of an executive’s compensation package due to the new reporting requirements implemented in 1993, CEO pay packages could be compared to each other, and the executive pay arms race was off and running.

Today, the use of stock options, and the phenomenal levels of pay that CEOs, investment bankers, and traders receive, have become taken-for-granted parts of the corporate landscape. Restricting or modifying the pay of a few executives and firms by the government will not lead to a sustained change in pay practices,  and could lead to the poaching of the competent individuals left at the troubled firms by firms not bound by these restrictions. We’ve already seen that it’s business as usual again at most Wall Street firms.

Until executives feel real pressure from shareholders, and each other, to rein in pay, not much is going to change, I’m afraid. This isn’t going to happen as long as the mantra of “maximize shareholder value” (And what does this even mean? Over what time frame? In what way? If firms compete successfully in delivering the best products and services, won’t this happen anyway?) continues to drive decision making.

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This entry was posted on Wednesday, October 7th, 2009 at 3:49 pm and is filed under News. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.

26 Responses to “Pay Czar Targets Pay”

  1. Travis says:

    “It’s going to take a cultural shift, not a government edict, to really rein in exorbitant CEO salaries”

    I couldn’t agree with you more! Oh well, they Admin will either learn or stay stuck on stupid.

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