January 27, 2012

The Furor over Income Inequality: Directors Need to Look In the Mirror

In the wake of President Obama’s State of the Union address, the front-page headline in the Washington Post screamed “Obama: Nation Must Address Inequality.” Some claim that the President is playing a class warfare card ahead of the November elections and maybe he is. But that is because he can. Not only is it abundantly clear that the vast majority of those in this country – and around the world for that matter, remember Britain’s actions just this week – are angry about increasing pay disparity, but quite a few experts believe our country’s ability to continue to be a high achiever is at risk because the rich are getting richer at the expense of the middle class. So even more than it was for the last Presidential election, excessive CEO pay will be a lightning rod once a GOP nominee is found and we head into the general election.

So what does this mean for advisors that help set CEO pay? It means a lot because the governance reforms of the past few years have changed only a few practices at the margins – but the bulk of the procedural deficiencies that led to an unsightly climb in pay over the past two decades remain. As I’ve said many times, boards need to get over their heavy reliance on peer group surveys since they are well known to be unreliable given that most boards sought to pay their CEOs in the top quartile for many years – thus tainting the database with a slippery slope upwards. How can boards continue to use these as a crutch when the plaintiff’s bar can so easily prove that the data is unreliable – and thus directors arguably didn’t fulfill a fiduciary duty because they knew they weren’t fully informed by not considering alternatives?

There are still too many cases of underachieving CEOs earning a lifetime’s worth of money in a single year. Sometimes they are fired before a year of service is even over – yet they walk off with a more than generous severance package. And this is not just a handful of outliers – this is the norm. It is far past time to do something about it.

An Alternative to Peer Group Benchmarking? Internal Pay Equity

Recently, a group of trade associations jointly sent this letter to the SEC regarding the need for further research before implementing Section 953(b) of Dodd-Frank, the pay ratio provision. The SEC Staff repeatedly has noted that Dodd-Frank grants the SEC fairly narrow latitude to veer from what Section 953(b) dictates, so I’m not sure how successful this letter will be. And I am well aware of the technical issues – and potential burdensome costs – of how the provision was written by Congress.

But how are boards (and their advisors and trade associations) embracing the spirit of this law? We’ve been touting internal pay equity as an untainted alternative to peer group benchmarking for the better part of a decade. We’ve told the story about how American capitalist J.P. Morgan is reputed to have had a rule that he would not invest in a company whose CEO was paid more than 50% above the executives at the next level. He reasoned that, if the CEO was paid more, he wouldn’t have a team but only courtiers. Internal pay is a primary factor when a company determines how to pay its workforce – why shouldn’t that principle apply to how CEOs get paid?

It’s shocking to me how few companies employ internal pay equity today. It’s use by DuPont, Whole Foods and a handful of others is no secret. And Dodd-Frank’s mandate for disclosure is well known. Shouldn’t boards demand to see what those ratios look like ahead of the mandated disclosure? And even more important, as noted above, shouldn’t boards demand to see those ratios to protect themselves from liability given the known bad data in the peer group surveys they get year after year? Of course, advisors should be willingly recommending the use of this alternative since it’s their job to protect the board. Sadly, most advisors blindly adhere to the status quo as too often happens.

I just can’t see what is wrong with putting together internal pay numbers for a board to consider. Where is the evil here? I suppose the downside is it likely will reveal how badly the board has been doing its job setting CEO pay levels over the past 20 years when historical numbers are crunched. But it’s better to make a fix now than perpetuate the problem. Note that I am not saying boards need to demand the ratios as called for by Section 952(b) as simpler ratios are easy to generate. We have sample spreadsheets posted in the “Internal Pay Equity” Practice Area on

By the way, I also don’t see any problem with using peer group benchmarks either. It’s just that the data in those surveys now are useless due to “pay in the top quartile” craze. There needs to be a reset before that type of data can be relied upon again. This reset will be hard to do, but it’s necessary and certainly doable, particularly if CEO pay levels are brought down to Earth on a widespread basis. The longer boards wait, the harder the medicine will be to take. See Exhibit A: Congress trying to force it upon boards through a misguided formulation of Section 953(b) of Dodd-Frank. If boards hadn’t waited so long to consider internal pay equity, Congress probably wouldn’t have felt compelled to act…

Why It’s Wrong to Compare CEO Compensation to Athlete’s & Actor’s Pay

With the periodic news of a sports star or big-name actor making $20 million per year, I am constantly called upon to remind someone that this is apples and oranges compared to setting CEO pay. For companies that choose to spend that kind of money on a sports star or actor, the decision typically is made via the processes used for any other large asset like a factory (the exception being sports owners who run their teams as a hobby). These processes include a comprehensive evaluation of what the return will be on that investment.

Compare that process to how a board makes the decision about how much to pay a CEO. On the surface, it may seem similar – but in substance, it is vastly different. For starters, the people making the decision are different. But even more important are the differences in the processes – and just as importantly, the end goals of those processes.

Nell Minow makes this point well in this ABC News article from a few years back entitled “Are CEOs and Celebrities Worth the Big Bucks?.” And here are more thoughts from Nell:

It’s a very small group in the stratosphere of pay: rock stars, movie stars, athletes, investment bankers, and CEOs. Of that group, the first four are in the ultimate pay-for-performance category, with a tiny percentage at the very top making millions of dollars, and with deals that evaporate quickly if a movie, a CD, or a business deal tanks. Their pay is set through tough arms-length negotiations.

CEOs are the only ones who pick the people who set their pay, indeed they pay the people who set their pay. And no matter what “independence” standard we try to impose, the board room culture of congeniality and consensus is so powerful that it makes it very hard to object, especially when the compensation consultant helpfully provides an avalanche of numbers designed to justify pay increases. In the wonderful world of CEOs, like the children in Lake Wobegon, everyone is above average. Even Warren Buffett acknowledges his own failings as a director, particularly in approving excessive compensation: “Too often, collegiality trumped independence.” If Warren Buffett, always a significant shareholder in any company on whose board he serves, does not feel able to oppose excessive pay, something is wrong.

– Broc Romanek