Creative Destruction

April 24, 2007

Because CEO Pay Isn’t High Enough Yet …

Filed under: Economics,Ethics,Politics — Brutus @ 11:39 pm

According to this article in The New York Times business section, Demoncrats Democrats have introduced (again) a bill that would give shareholders of publicly held companies a nonbinding vote on pay packages and so-called “golden parachute” compensation plans for senior executives. It is an idea whose time has come. Indeed, shareholders of British companies have held this power since 2002 but only voted against an executive pay package once.

What’s especially interesting to me, and probably predictable, is that Republicans oppose the measure. Although the article suggests that such a vote would permit shareholders to exercise considerable influence, I can’t see how a nonbinding vote would be too difficult to ignore. Indeed, decision-makers who award executive pay have ignored economic reality at lots of companies even while those companies are unprofitable or in bankruptcy. And besides, everyone already knows that pay packages have grown from tens of times the lowest yearly company wage to hundreds of times that wage in the span of about 25 years.

If that weren’t rich enough, how about this argument by Representative Spencer Bachus of Alabama of the House Financial Services Committee:

“How many times has this Congress substituted its judgment for the American people? For people in business? That is again what this legislation is doing. Congress should never rush in and begin to change the free-enterprise system, our system of competition between companies.”

Isn’t Congress empowered to substitute its judgment for that of the American people? Isn’t that in fact its job? Bachus is clearly a market fundamentalist, believing that regulation, restraint, and any impediment to free enterprise is uncalled for. Considering just how toothless this proposed legislation is to begin with, why is it necessary to fight it so hard with such overblown rhetoric?

Update: Fixed misspelling of Democrats. And in case my arguments lacked currency, it was announced yesterday that the Chief Executive Edward Whitacre of AT&T will be retiring in June and will receive a $158.5 million retirement package.

According to a proxy filing with the Securities and Exchange Commission, Whitacre’s retirement package will include $24,000 in annual automobile benefits, $6,500 each year for “home security,” access to ATT&T’s … corporate jet for 10 hours a month and $25,000 to cover his country-club fees ….

That report also provides this link to a report last year about CEO pay. Finally, a NY Times column by Paul Krugman titled “Gilded Once More” (sorry, Times select, so no link) reports that income inequality is back to levels known in the Gilded Age. He has a particularly outrageous case in point:

<>Last year, according to Institutional Investor’s Alpha magazine, James Simons, a hedge fund manager, took home $1.7 billion, more than 38,000 times the average income.

So I was wrong in saying that some folks make hundred of times the average yearly wage, it’s now thousands of times.



  1. I find this deeply confusing. Shareholders own the company. Can’t they already vote on anything they want?

    Comment by Brandon Berg — April 25, 2007 @ 3:17 am | Reply

  2. Yeah, I don’t get it either. I’m all for shareholders having the power to tell management to get bent, but as far as I know, they already have that power.

    Comment by Robert — April 25, 2007 @ 2:16 pm | Reply

  3. Well, yeah, collectively they do. But the average shareholder has very little power or interest in any one corporation. The hassle factor of initiating a shareholder proposal and promoting it among all shareholders is huge. Think about it — what would it take to get you to vote for such a resolution? I can’t remember the last time I even opened a shareholder packet, let alone cast a vote.

    In contrast, big shareholders might have the resources and incentive to promote a shareholder resolution. But big shareholders are also likely to be on the board, or even in management, and therefore may not want full disclosure of their compensation packages.

    Thus there’s an inherent conflict. It’s not obvious to me what harm would result from the proposed policy. Admittedly, I haven’t been following the issue.

    Comment by nobody.really — April 25, 2007 @ 3:31 pm | Reply

  4. In contrast, big shareholders might have the resources and incentive to promote a shareholder resolution. But big shareholders are also likely to be on the board, or even in management, and therefore may not want full disclosure of their compensation packages.

    But if that’s the case, then big shareholders also approve of the package. So what’s the point?

    I’m not opposed to this measure per se; corporate governance is indeed problematic these days, and awareness of compensation packages at the shareholder level seems like a good thing. But this kind of seems like passing a law against detonating a nuclear device within city limits; nobody who would obey the rule would do it anyway.

    Comment by Robert — April 25, 2007 @ 3:36 pm | Reply

  5. [T]hen big shareholders also approve of the package. So what’s the point?

    Couple of points.

    1. The aggregate number of shares held by small shareholders may exceed the number held by big shareholders. Thus, it’s possible (although not necessarily likely) that small shareholders would have to power to pass resolutions rejecting a pay package.

    2. There’s a lot of case law about oppression of minority shareholders. (As you have observed in a variety of contexts, you don’t need racism or sexism or whatever to explain a lot of oppressive behavior; much of it can be explained by simple self-interest.) Anyway, board members and officers typically have a fiduciary responsibility to all shareholders, including minority shareholders. So disclosure of unwarranted pay packages could trigger a shareholder suit even if the aggrieved parties could not muster enough votes to reject the package. It’s a “Knowledge is power” thing.

    3. Finally, sunlight may be the best disinfectant. Even if disclosure of a pay package does not result in shareholder votes or suits, it might have other market consequences. If minorities realized they were being oppressed, it would depress the value of the stock, including the value of small amounts of stock sold by big shareholders. Mutual funds that focused on good governance might also decline to buy the stock. And who knows? If the stigma grew large enough, some people might choose not to do business with the firm. It’s a “knowledge is power” thing.

    Comment by nobody.really — April 25, 2007 @ 4:18 pm | Reply

  6. Those seem like good points.

    Comment by Robert — April 25, 2007 @ 4:24 pm | Reply

  7. The proxy vote process is deeply broken. The reality is that the nomination of directors is indirectly controlled by management, and that mounting a proxy fight to propose an alternative set of directors is very hard unless the number of shareholders is very small.

    As a result, the vast majority of shareholder voting opportunities look like Soviet ballots.

    Even when remarkably high numbers of shareholders mobilize (42%, for example, withheld consent for the management slate at the NY Times), the response is often indifference.

    SEC prohibitions on things like trading insider information have been improperly interpreted (sometimes by the SEC itself) to prohibit collusion by institutional investors.

    But, mutual fund diversification rules and similar restrictions, prevent any one institutional investor from having enough voting clout to mount a proxy fight without coordinating with other institutional investors.

    For small investors, the amount of money at stake, and the institutional barriers to collective action of thousands of isolated individuals are virtually insurmountable, except by people acting against their own narrow self-interest for long term strategic purposes funded by third parties.

    There are also long standing corporate policies that discourage institutional investors from using the proxy process to challenge management decisions. The so called “Wall Street rule” says that if you don’t like management’s actions, you should simply sell. But, at the macroeconomic level, this doesn’t work if everybody in big business goes too far.

    Most corporations have shareholder democracy provisions comparable to tinhat dictatorships in the Third World. Absent a purchase of a majority of the shares to get outright ownership, management is aloof from shareholder concerns. It is entirely appropriate for Congress to intervene to stop this flaw in our economy, created to a great extent by Congress itself, so that shareholders can direct the management of their own property more meaningfully.

    Comment by ohwilleke — April 26, 2007 @ 2:44 pm | Reply

  8. A rare exception to the norm, which fits the model I would suggest, is The Take-Two proxy fight. How was this possible?

    The 2004 annual report of the company suggests that it had only about 1000 shareholders (about 1% of those of the larger publicly held companies), and only 122 shareholders of record (most shares of public companies are held by brokers or companies that do nothing but keep track of who owns shares).

    The company’s small size and underperforming operations also reduced the risk of litigation aimed at the institutional investor group.

    About 30% of the company was owned by Oppenheimer Funds, and three other large investors owned much of the rest. So, while it was technically publicly held, the bulk of the shares were owned by only a handful of voters with one dominant player who could take the lead and receive only informal asset from the other major shareholders.

    It would be more common in a larger company for there to be a couple dozen major institutional investors who own 30%-40% of the stock in the aggregate.

    Comment by ohwilleke — April 26, 2007 @ 3:16 pm | Reply

  9. According to this article in The New York Times business section, Demoncrats have introduced

    Is “Demoncrats” a typo or a joke?

    Comment by Daran — April 27, 2007 @ 5:54 pm | Reply

  10. It’s a typo, but ironically, isn’t kinda funny as a joke, too.

    Comment by Brutus — April 27, 2007 @ 10:28 pm | Reply

  11. You can read about the hedge fund compensation at this non-Times Select link.

    Although Mr. Simon’s compensation is high, it should be noted that it is not a salary. It is his share of the profits realized by the hedge fund that he manages. He charges high fees – 44% of profits and 5% of assets – significantly more than other fund managers. His enormous compensation for the year was the result of his fund generating a staggering 84% rate of return; he almost doubled the money of the people who invested with him, in a single year. (Well, after his fees, he added half again to the money of the people who invested with him, which is still staggering.)

    So there is a fairly easy way to cut Mr. Simon’s compensation: don’t invest with his fund. Although, if you invest in some other fund, you won’t make as high a rate of return on your money. But at least you’ll be paying the person who manages it less. 😉

    Comment by Robert — April 28, 2007 @ 4:03 pm | Reply

  12. Thanks for the link, Robert. Let me comment on a couple bits found in the article:

    House Financial Services Committee held hearings focusing on the potential risks to pensioners and the financial system caused by hedge funds.

    There is growing public and governmental concern about the liquidity of capital in unregulated markets. Like swings in national currencies that caused the peso to tank and the British pound to swell, the sloshing around of value — quite independent of reason — looks like the water in a bathtub that’s been mounted on a roller coaster. It can both create vast wealth quickly and destroy fortunes overnight. And it’s a serious risk to overall financial stability.

    Raymond T. Dalio, head of Bridgewater Associates, which has more than $30 billion in hedge fund assets, for example, took home $350 million last year even though his flagship Pure Alpha Strategy fund posted a net return of just 3.4 percent for the second consecutive year.

    This is perhaps the most stark evidence that the system is rigged for the rich. Perhaps you don’t care so much if you’re lucky enough to have gone with Simon instead of Dalio, but it’s worse than the rhetorical “giant sucking sound” associated with NAFTA. It’s the equivalent of fund managers reaching into the pockets of investors and ensuring that the fund manager gets paid before anything else just for the privilege of being a fund manager.

    Comment by Brutus — April 28, 2007 @ 5:42 pm | Reply

  13. This is perhaps the most stark evidence that the system is rigged for the rich.

    Hedge fund investors are rich, or at least well above average. Granted, most of them aren’t $350-billion-a-year rich, but legally you need a net worth of at least a million dollars to invest in a hedge fund. And hedge funds generally have fairly high (hundreds of thousands or millions of dollars) minimum investments.

    And note that the article only said that his “flagship” fund returns 3.4% two years in a row. What about his other funds? Did they do any better? Is this just an off-year? Has he beat the market over a longer period of time? We don’t know. Would a reporter for the New York Times cherry-pick data to create a misleading impression? You bet!

    Comment by Brandon Berg — April 28, 2007 @ 6:54 pm | Reply

  14. There are institutional investors in hedge funds as well, and they represent poor people as well as rich people. (Well, relatively poor people. The garbage dump children of Honduras need not apply.) However, institutional investors are also notoriously prudent at managing their funds; when they have money in a hedge fund, it’s a small fraction of their assets.

    This is rich people f***ing over other rich people – except that the rich people being f***ed over don’t appear to think that they’re being f***ed over. They appear to be happy paying these people to do all this dreary alpha-chasing and beta-optimizing. So it’s really a (relatively) poor person saying that these rich people aren’t using their money the way the poor person thinks they ought to. OK. Noted. I think Jennifer Aniston should have been dating me in the 90s, not that Brad Pitt loser.

    Comment by Robert — April 29, 2007 @ 3:26 am | Reply

  15. Is it possible to object to some structural aspects of our financial systems without crossing over into the questionable terrority of telling people how they ought to be spending their money? I think so. It’s not unlike observing that living on credit (e.g., keeping credit card balances while being charged 20% interest) is perhaps not the best option available.

    Comment by Brutus — April 29, 2007 @ 1:36 pm | Reply

  16. Sure you can. Isn’t that the first part of your post?

    But what’s the objectionable structural aspect of the hedge fund manager’s compensation?

    Comment by Robert — April 29, 2007 @ 2:12 pm | Reply

  17. The objectionable structural aspects in the extreme cases cited above are percentages of profit as high as 44% and payment despite nonperformance based solely on the size of the fund. I guess it can be rationalized by some when the funds still manage to return to investors more than 40% annually or when the investors are themselves rich and can only blame themselves for being suckered into funneling so much money at the fund managers. I find it all obscene.

    Comment by Brutus — April 29, 2007 @ 5:00 pm | Reply

  18. But that isn’t a structural element, Brutus. That’s the price of the manager’s services, which people are choosing to pay. It isn’t like they don’t have a million other choices.

    Comment by Robert — April 29, 2007 @ 5:24 pm | Reply

  19. The Hedge Fund case really is a side show. The bulk of cases of obscene executive pay involve CEOs of large publicly held companies that produce real world goods and services in large enterprises.

    Overwhelmingly, these are not one man shows that largely depend on the CEO’s personal services. They are established businesses capable of running more or less on automatic, which the CEO minds and nurtures.

    Due to the heavily big business oriented structure of our economy, which has more to do with economies of scale than any personal attributes of those who run them, there are a quite small number of top jobs in big businesses.

    The argument for high pay is largely empirical. It argues that the supply of top executive talent is so scarce that there are a few thousand top managers to go around and manage all the big corporations well, so you need to pay top dollar to get a good one. The argument against high pay in contrast, thinks that there is highly suggested empirical evidence to support the idea that there are hundreds of thousands, if not millions of people willing to fiercely compete for thse top job opportunities, and that the people who ultimately get them are being paid far more than a competitive labor market price for their efforts, because the system is rigged with top managers largely controlling the people who set their own pay.

    Comment by ohwilleke — April 30, 2007 @ 12:39 pm | Reply

  20. They are established businesses capable of running more or less on automatic…

    Do you have any idea how laughable a contention this is?

    Comment by Robert — April 30, 2007 @ 1:14 pm | Reply

  21. Of course, it isn’t literally true that big businesses operates on autopilot. But, the whole point of a CEO, is that he has a COO and a bunch of VPs that do day to day work. The CEO’s job is to make bigger picture decisions.

    Most businesses could operate with one less person in the executive suite so long as it isn’t making major innovations.

    Comment by ohwilleke — April 30, 2007 @ 7:34 pm | Reply

  22. It is worth noting that the tax code actually tax preferences the income of Hedge Fund Managers. So, even with $1.7 billion in income, James Simons won’t be paying the 35% top income tax rate. Instead, a variety of tax benefits, most notably preferences for dividends and capital gains, but also others, will drop his rate to closer to 15%.

    At that income level, FICA, which caps out at around $100,000 of top income is also irrelevant, and Medicare taxes won’t be paid either, even though in theory they apply to all self-employment and employment income.

    Comment by ohwilleke — May 1, 2007 @ 6:15 pm | Reply

  23. ohwilleke:
    I’m skeptical. Obviously dividends and long-term capital gains will be taxed at the 15% rate, just like they are for everyone (though this doesn’t necessarily imply favorable treatment of investment income due to double taxation). But I don’t know of a way to get anything other than returns on their personal investments taxed at the capital gains rate. I’d certainly like to know, if there were.

    Comment by Brandon Berg — May 2, 2007 @ 1:10 am | Reply

  24. For full details you can read the Wall Street Journal article and the related tax professor’s law journal article both of which can be readed from this link at the Tax Professor’s blog. One of the main tricks is that “carried-interest distributions” are treated as investment income taxed at low rates, rather than as compensation income, taxed as ordinary income.

    This can’t be done by brokers who are required to report investment income on a “market to market” basis, but the same rules don’t apply to some hedge funds.

    Comment by ohwilleke — May 2, 2007 @ 10:43 am | Reply

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