Executive Compensation Limits - a move in the wrong direction?

Executive Compensation Limits – a move in the wrong direction?

An efficient economy, at virtually any level, depends on a variety of factors to maximize utility and optimize growth potential, and one of the most important of these factors is competition. It is widely recognized that healthy competition breeds lower prices, higher output, and generally is good for American business. However, there’s currently an effort underway to artificially limit one of the most important competitive forces in our country, incorrectly supposing that it will help restore health to our economy, profits to our corporations, and value to shareholders. That force is executive leadership and their compensation packages.

While there are clearly examples of outlandish bonuses accepted by certain executives who have returned terrible performance for their shareholders, these are the exception rather than the rule. By and large, CEO’s and their management teams, in the face of relentless pressure, have worked tirelessly in an effort to maximize shareholder value, and they’ve done so based on compensation agreements which offer monetary rewards as certain goals are met or exceeded. These individuals work for the same reason the rest of us do – to satisfy needs and wants, to feel a sense of accomplishment, and to further various personal agendas. If an employer limits our ability to do these things, then we often become less effective or seek employment elsewhere. If the limits are placed only on one corporation or employer, then the corporation becomes less competitive; if the limits are placed across an industry, then the industry ultimately fades into mediocrity; if they are placed on an entire nation, then that economy repeats the demise of other, centrally-planned governments no longer relevant in today’s economy.

There’s been much made in the media this last year over the compensation offered to executives in many of our major, publically-held corporations. Members of the House and Senate, shareholder advocacy groups, and others have expressed their disapproval at salaries and bonuses paid to CEO’s across the country as those CEO’s corporations have amassed unfathomable losses and experienced devastating declines in shareholder value. In the wake of all of this, media representatives and elected officials, many of whom have annual incomes expressed in terms of millions of dollars per year, have helped stir up sufficient public outrage that there are now credible efforts afoot to limit executive compensation in hopes of restoring fiscal strength to corporate America.

Though many have called for federal intervention in limiting executive compensation for all publically held corporations, the Obama administration has deftly sought limitations only for executives who’s corporations are in receipt of federal ‘bail out’ funds of one form or another. Obama’s economic team appears to understand a few important principals too often overlooked by many: first, we only have a right to influence behaviors in which we are vested; and second, when we limit rewards, we limit motivations to perform.

Through the Federal Reserve, US Treasury, and FDIC the federal government has now pumped trillions of dollars into the financial system, most notably through major banks, insurers, and auto makers. As this has taken place, we’ve come precariously close to ‘nationalizing’ these institutions. Treasury Secretary Geithner has recently asserted the administration’s commitment to stop short of nationalizing our banking system, which pronouncement sent stock values higher across the financial services industry, and obviously calmed investor concerns. However, the administration has also expressed its intent to limit executive compensation in any organization in which federal funds have been invested, specifically imposing, by legislation, a $500,000 annual salary cap, and a possible moratorium on bonus compensation of any kind.

Since the government has a vested interest in these corporations, by virtue of having invested billions of dollars in them, the administration not only has the right to do this, but in many ways the limitations appear to make sense. But will these limitations ultimately be in the best interest of the economy, our country, and our citizenry? Perhaps not.

When facing extraordinary difficulties, corporations need to draw on extraordinary talent, committed leadership, and devoted loyalists. While it might be comforting to suppose that the leadership and management of US corporations will bring these traits to the table out of sense of nobility, it would also be grossly naïve. Even as legislation to limit compensation is being debated, executives and management teams critical to the operation of certain banks which have been the recipients of federal ‘bail out’ funds have announced their departure for organizations that are not expected to be under such limitations. Some of these individuals may well have helped create the problems these organizations have experienced, but others have been responsible for some of the only currently profitable operating groups in these companies.

It is likely that we are only seeing the leading edge of this phenomenon. At exactly the time in which we need the ‘best and the brightest’ directing the affairs of corporations in which we taxpayers have invested massive sums, our futures if you will, we also appear to be standing by while our elected officials put these investments at risk by unwittingly driving out much of the talent with the ability to restore profitability and growth. In fact, many are encouraging this. For some it is an issue of irresponsibility; sadly, for others it is out of ignorance and envy.

The problem with executive compensation is not that is has been too high; rather, it is that it has been too loose. Extraordinary salaries and bonuses were offered, by contract, without the requirement for clearly defined, measureable benefits for the corporation and its shareholders. In most cases, these packages were approved by corporate directors responsible to represent shareholders, and in these cases it is hard to fault those executives who have accepted what was offered them. In cases where fraud or malfeasance was involved, there are legal remedies for these corporations to extract restitution from the offending parties. In many cases, the wrong lies not with the executives and their managers, but with the boards and directors themselves.

Some misunderstand the nature of many compensation packages as they hear figures that climb into the high seven figure range, supposing that these sums were received in cash. Indeed, in some cases, far too much was provided in cash, but again, this was only allowed by approval of the board of directors. Though salaries are most often paid in cash, most bonuses are a mix of cash and stock or stock options. In cases where stock is granted, there is usually a waiting period imposed before the stock can be exchanged for cash or other value, thus giving the beneficiary of the bonus motivation to help protect or increase shareholder value. Where stock options are granted, these are almost always offered in such a way as to only create value if the share value of the corporation increases over time, and are based on the executive or manager’s ongoing service to the corporation; again, a motivator for executive performance.

When understood in this light, two important factors emerge. First, much of the compensation, that which was based on stock price and performance, has been dramatically impacted with the declines in the stock markets, in many cases completely eliminating the potential value of that part of the compensation package. Second, and perhaps more important, is that it is less important to limit the level of executive compensation than it is to address on what basis it is earned and how it is received. Where liquid, or short-term incentives (cash, perks, etc.), are offered as a reward to encourage performance, then short-term benefits are likely to be the outcome. Where less liquid, or longer-term benefits (stock, stock options, deferred compensation, etc.) are offered, there is greater motivation to build long-term value.

Most would agree that appropriate salaries ought to be provided for a job done, well or otherwise, but bonuses should provide incentive for performance that goes beyond the pale. In the early 1980’s, most Wall Street executives received 50% to 90% of their annual compensation by way of annual bonuses, with anywhere between 10% to 80% of that in the form of stock or stock options. In most cases, stock rewards had to be held for no less than three years before they could be sold, and the stock options only became valuable if the recipient remained with the firm for three to five years, and if the stock price rose above a certain value.

While this same formula remains the norm today, the relationship between salary and bonus, and the ratio of bonuses paid in cash versus stock or stock options, began to shift in the mid 1990’s. It is no coincidence that today’s economic crisis has its roots in this same period.

As the administration, House and Senate debate various limitations on executive compensation, they are correct to place the emphasis on salaries being commensurate with the job to be performed, but to limit the opportunity to receive extraordinary rewards for extraordinary accomplishments will only serve to disadvantage those same corporations and industry segments so desperately in need of fresh ideas, innovative solutions, and tireless, ambitious, and motivated executives. Were the administration to place limits on executive compensation across the board, regardless of whether or not an organization has been the recipient of federal funds, not only would it signal a move towards a form of government inconsistent with the interests of our society, but it would serve to limit competition in the US market, our most talented corporate leaders would seek opportunities globally, and our entire economy would suffer greatly.

This is a time period in which virtually everyone agrees that we need to become more competitive, not less. Societies, governments, and corporations are uniquely capable of creating outcomes based on providing incentives for those who perform towards the outcomes desired. Rather than limit opportunity, competition, and rewards, we should focus our energies on determining how we best direct rewards to those who accomplish clearly defined, measurable goals that move us towards a restoration of growth and profitability, and then invite the world to follow and try to keep up.