Business 101

4 February 2009 at 11:11 pm 13 comments

| Peter Klein |

In announcing his caps on executive compensation this morning the President noted his outrage that Wall Street executives have “paid themselves customary lavish bonuses.” Apparently he is unaware that executive pay in large companies is set by a compensation committee, and typically by a formula determined well before performance results are realized. I guess he thinks executives just decide how much to pay themselves, based on whatever they feel like. He’s also upset about “executives being rewarded for failure,” suggesting he doesn’t know the difference between absolute and relative performance evaluation. Don’t they teach Business Organizations at Harvard Law?

Entry filed under: - Klein -, Bailout / Financial Crisis, Corporate Governance.

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13 Comments Add your own

  • 1. Bart  |  5 February 2009 at 7:48 am

    I’m picking up a distinct “fair and square” vibe from this blog regarding executive compensation. I think it would be in order to point to the phenomenon that executive salaries are only partially determined by economic forces. As Simon (1957) suggests, there are also social forces that determine norms for the ratio’s which are incorporated into the formula you mention. It is my suspicion that things go a bit haywire when these social forces are exerted by high level executives and compensation committees in determining compensation packages. Are there any empirical accounts availabe on how these negotiations are conducted? It would help the discussion.

  • 2. Warren Miller  |  5 February 2009 at 9:34 am

    Well, I hate to find myself on the President’s side in this debate, but I think he’s closer to being right than others, including valued colleagues on this blog. Take the case of John Thain, who oversaw the payout of $4 billion in bonuses in December to executives who presided over losses of at least $25 billion in 2008, including $15 billion in Q4 alone. These numbskulls decided that the subprime market had bottomed out and plunged back in. We all know that rewarding dimwitted behavior merely ensures that it will recur.

    From a practical standpoint, however, is the straight-face test: How on earth could ANYONE pay out humongous bonuses in the face of such staggering losses? Yes, it is a corporate decision, and, no, the government should NOT be involved. But there is also the issue of self-regulation. Any sector or group that fails to self-regulate responsibly will, sooner or later, find itself subject to the heavy, over-reacting hand of the federal government. We saw it in Sarbanes-Oxley, which occurred largely as a result of the CPA profession’s failure to police itself, and we’re going to see it pop up in several different incarnations now.

    There is no way on God’s green earth that Thain or anyone else can explain these bonuses. His lame (-brained) excuse is that BofA knew what he was doing and approved of it. A WSJ article earlier this week reported that Merrill and BofA had agreed in September 2008 to the payout of $5.8 billion in bonuses. I’m not impressed. The $15 billion hemorrhage in Q4 should have put that ‘agreement’ on the shelf.

    I’m singling out Thain here, but the argument I’m making about responsible self-regulation applies to Wall Street more generally. For years, these jokers have paid themselves ridiculous sums of money. And I do mean ridiculous. If they were PRIVATE companies, that would have been just fine with me. But access to public capital in public markets imposes a new and higher standard of behavior. They can’t have it both ways, and they haven’t, thank goodness.

    The compensation excesses pour kerosene on the fire lit by Comrade Pelosi and her hard-Left playmates pleading for higher taxes. If these firms want to pay out serious money, they should pay it to the shareholders whose capital makes it all possible. Instead, they stick their fingers in the shareholders’ eyes. Well, what goes around comes around.

    To be sure, I don’t know where ‘the line’ is when it comes to compensation. My view is that it is highly fact- and circumstance-specific. But there IS a line, and Wall Street crossed it–laughed at it, in fact–years ago. Well, now they’ve put themselves right out of business with their god-awful business judgment.

    The irony, it seems to me, is that these fools did themselves in by failing to practice the one rule of investing which they, above all, knew and preached to the rest of us: diversify your portfolios. They didn’t, and now they’re out of business. As far as I–and, I’ll wager, millions of other Americans–are concerned, It couldn’t happen to a more deserving bunch of people. Good riddance.

  • 3. Steve Phelan  |  5 February 2009 at 1:57 pm

    Bart, you might want to start with the following book and associated papers:

    Pay without Performance: The Unfulfilled Promise of Executive Compensation
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=537783

  • 4. Andre Sammartino  |  5 February 2009 at 5:46 pm

    But Peter, what if the compensation committee is not truly independent? Or inadequately monitored? Or more attuned to the interests of executives than shareholders?

    Is there genuinely sufficient scrutiny of compensation committee outcomes by institutional shareholders? Are binding votes held at AGMs etc on the committee decisions (i.e. on the packages offered to execs)?

    And is relative performance sufficient grounds for bonuses when there is across the board failures to achieve adeuqate returns?

    I certainly don’t support government intervention into compensation. I would rather there were binding votes from shareholders on compensation, as this would lead to better attempts to “educate” shareholders about the merits and outcomes of such schames.

  • 5. Warren Miller  |  5 February 2009 at 7:10 pm

    Those are great comments, Andre. Compensation guru Graef Crystal has pointed out the lack of independence in Comp Committees and the undue influence wielded by comp consultants. Those pander bears are in the business of telling their clients what they want to hear: that no executive s/b paid an ‘average’ level of compensation because those execs are certainly NOT average. That ‘Lake Wobegon’ mindset ensures the steep rise that we have seen in compensation.

    Institutional shareholders are becoming a little more activist in this arena. However, their activism tends to be at the Board level rather than directly in compensation itself. CALPERS and others have done some of that. Even then, though, there’s not nearly enough such activity, except by the likes of Carl Icahn, et al. Hedge funds, I think, have actually been more effective at pushing this kind of change, at least until the meltdown, when they suddenly needed to start worrying about their own liquidity..

    As everyone who reads this blog knows, accounting ‘profit’ is always overstated because there are no deductions for the cost of equity capital. So, a company can actually show an accounting profit and be in a slow state of liquidation because its economic rate of return is below what investors require for that company in that particular business.

    I do agree w/your idea of shareholder approval of executivie compensation. Besides the greater transparency that would result, such approval would, as you rightly point out, Andre, start to educate shareholders not just about comp, but about the economics of the businesses they invest in, as well as about the people running those businesses, sometimes into the ground.

  • 6. Andre Sammartino  |  5 February 2009 at 9:24 pm

    Down here (in Australia) it is becoming more common to have votes at Annual shoreholder meetings on remuneration reports, but typically these votes are non-binding.

    It may well be the case that this is driving some attenuation of extremes in such behaviour and forcing firms to articulate their rationales more explicitly.

    See some small discussion here:
    http://blogs.law.harvard.edu/corpgov/2008/02/12/say-on-pay-in-the-uk-and-australia-and-now-in-the-us/

    and a paper here:
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=268992

  • 7. bee  |  5 February 2009 at 10:07 pm

    Andrea writes:
    “But Peter, what if the compensation committee is not truly independent? Or inadequately monitored? Or more attuned to the interests of executives than shareholders?”

    Great points! So we turn to Obama and the political class given their truly independent nature, proper monitoring and attuned interests to comment on the situation. Sounds like a great idea – NOT.

    Andrea I cannot but wonder if you are not playing with us. The political class are among the least qualified to opine. Yes, there are imperfections but the real test is not a hypothetical perfect approach but the next best alternative. Obama is not only intellectually not equipped to opine but his motivations are completely suspect.

    Again, to identify imperfections is interesting but not relevant. An alternative approach that addresses the failures is constructive. If we look at the course of business we can conclude that the imperfections that embody the process today still produce greater gains to society than the alternatives being hyped by politicians.

  • 8. David Hoopes  |  6 February 2009 at 12:07 am

    Bee’s point is well taken. I don’t think anyone around here would shed a tear if shareholders managed to pay executives a lot less in many, many companies. However, pushing such decisions to the elected caste would be a disaster. Even if someone was not swayed by personal interest and future elections centralizing how executives were paid would be enormously complex.

    Obama complains about executive compensation. But, his pals at Fannie Mae and Freddie Mac walked off with hundreds of millions. That didn’t bother him.

  • 9. Peter Klein  |  6 February 2009 at 12:32 am

    Good discussion, everybody. Let me first point out that my post didn’t actually defend current compensation practices, but only attacked the popular belief — exemplified by the President’s unfortunate choice of words — that executive pay is not governed by any systematic process at all, but simply reflects the arbitrary whim of the executive. On the merits, I agree with bee and Dave Hoopes. Certainly I, as a comparative institutional guy, would never say unregulated compensation policies are perfect or “optimal” according to some textbook standard, but only that they are less imperfect than the alternative (i.e., compensation policies governed by the political process). I can’t see how the kinds of problems described by Warren are solved with a blanket prohibition on a particular class of compensation policy or an arbitrary limit on total pay (which, as many commentators have noted, is easily contracted around anyway).

  • 10. Bart  |  6 February 2009 at 4:31 am

    Thanks for the pointer Steve!

  • 11. Peter Klein  |  6 February 2009 at 10:22 am

    BTW for a thorough recent survey of the economics and finance literature on executive compensation I recommend Steve Kaplan’s piece:

    “Are U.S. CEOs Overpaid?” Steven N. Kaplan; Academy of Management Perspectives, 2008, 22(2), pp. 5-20.

    And see

    “Are U.S. CEOs Overpaid? A Response to Bogle and Walsh.” Steven N. Kaplan; Academy of Management Perspectives, 2008, 22(3), pp. 28-34.

  • 12. Bart  |  6 February 2009 at 11:39 am

    …..and thank you, Peter!

  • 13. Bart  |  6 February 2009 at 7:05 pm

    Hey, here’s that Bebchuk fellow again

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