High pay for good performance at successful companies draws some scrutiny. But especially infuriating to average-paid workers and investors, not to mention politicians, are huge severance packages paid to CEOs who have been forced out for poor performance.
Normally, one might discount election-year criticism as mere campaign posturing, expecting that it would lead to no real action. That might not be true this time. Even President Bush, whose free-market instincts are beyond debate, has spoken out against excessive executive pay. In a January 2007 speech delivered on Wall Street, Bush said, “The fact is that income inequality is real-it’s been rising for more than 25 years.”[1] He also told the audience of business executives: “America’s corporate boardrooms must step up to their responsibilities. You need to pay attention to the executive compensation packages that you approve.”[2]
Bush elaborated in an October 2007 interview with The Wall Street Journal: “Do I think some of the salaries are excessive at the top?
I do. I don’t think it’s the role of government to regulate salary. But I do believe it’s a role of boards of directors to be very transparent with shareholders about these different packages, the employment packages that these executives get.”[3]
Even before those comments, the U.S. Securities and Exchange Commission (SEC) had entered the compensation debate in 2006 by issuing new rules requiring public companies to provide enhanced disclosure of executive pay packages. Bush and the SEC are relying on a free-market approach to the issue by focusing on disclosure and self-restraint, rather than direct government regulation.
So after one full year of operation, how well are the new SEC rules working? Will they help rein in excessive pay packages? Or, in an ironic twist, might the regulations actually serve to accelerate recent increases in CEO pay?
Statistics on Executive Pay
There is still debate about the actual size of executive pay increases, the underlying causes, and even whether high pay for CEOs (or other top officers) is fully justified. As with most controversial issues, one can find varying statistics to support differing views. However, there is little doubt that CEO pay has increased rapidly in recent years, while the pay of the average corporate employee has not kept pace.
This trend is most notable when comparing CEO pay to that for typical employees. The ratio of average CEO compensation at large U.S. companies to the average production worker’s pay was about 40 to 1 in 1980, according to The Economist.[4] The magazine reported that the ratio had risen to 85 to 1 by 1990, and then soared to about 400 to 1 by 2003.[5]
Similarly, a study by two progressive groups, the Institute for Policy Studies and United for a Fair Economy, determined the ratio to be 411 to 1 in 2005.[6] That study’s number was derived from comparing the average CEO pay at 350 companies with revenue exceeding $1 billion to the U.S. Department of Labor statistic of $28,315 as the average pay for all private sector workers in 2005 (including part-time employees).[7] One could plausibly argue that the ratio is likely overstated somewhat by including only 350 large companies for CEO pay, and by considering part-time employees in the average worker calculation.
By contrast, a separate study released in 2006 by a CEO group, the Business Roundtable, concluded that the ratio was starkly lower-179 to 1.[8] This study considered median CEO pay from 1995 through 2005, rather than a mathematical average.[9] Further, by valuing stock options based on the award date, rather than the exercise date, the study might understate the effective value of the options for most CEOs, considering the significant advances in the stock market during that 10-year pe
riod.[10] The CEO pay figure also excluded pension benefits, deferred compensation, and dividends on restricted stock-all potentially significant figures.[11] Considering these factors, one could reasonably argue that the 179 to 1 ratio likely understates the real number, just as the 411 to 1 ratio of the progressive groups’ study probably overstates it.
There is no perfect methodology for calculating this ratio (or otherwise quantifying the precise increase in CEO pay). Still, even if the average CEO is paid only about 200 times as much as the average employee, rather than roughly 400 times, there is little doubt that the ratio in the United States remains far higher than in other industrialized nations. According to The Wall Street Journal, in 2006, the CEO to averag
e worker pay ratio was 11 to 1 in Japan, 15 to 1 in France, 20 to 1 in Canada, 21 to 1 in South Africa, and 22 to 1 in Britain.[12]
Major Provisions of the SEC Rules
Amid rising concern and public debate about executive pay, it is not surprising that the Securities and Exchange Commission felt a need to take some regulatory action. The commissioners unanimously adopted the “Executive Compensation and Related Person Disclosure” regulation in July 2006, which covers any fiscal years ending on or after December 15, 2006.[13]
The rules require annual reports and proxy statements for public companies to include a new “total compensation” calculation for each of the company’s top officers-CEO, chief financial of
ficer (CFO), and the three other highest paid executives. The purpose is to provide a single compensation number for each of these executives that will allow for better comparison of compensation packages across various companies.
The total compensation number is derived from a “Summary Compensation Table” that lists compensation amounts in seven specific categories.[14] The “all other compensation” category includes perks and other personal benefits when the combined value is $10,000 or more, rather than the prior threshold of $50,000. The most significant changes from prior SEC requirements are the inclusion of stock option awards in total compensation (that disclosure previously came in a different location and was not combined with salary and other amounts), greater disclosure of retirement benefits, and a more thorough listing of perks provided to these top officers.
More significantly, the Summary Compensation Table must be preceded by a new narrative section entitled “Compensation Discussion and Analysis” (CD&A). The SEC says the CD&A narrative should address the “objectives and implementation of executive compensation programs-focusing on the most important factors underlying each company’s compensation policiesand decisions.”[15]
The First Returns
As in elections, the early returns on a new regulation are not always indicative of the final outcome. Still, the first results certainly set the tone and may lead to preliminary conclusions about the eventual impact of the new rules. Thus, it is significant that even the SEC itself is not generally pleased with the results after the first year of compliance.
In 2007, many companies were extremely thorough in their Compensation Discussion and Analysis reports-in the number of words, at least. Some of the CD&As were 30 to 40 pages. However, more information alone has not necessarily yielded more clarity. Former SEC chief accountant Lynn Turner gave his impression of the early CD&As to The New York Times: “It’s like reading through Tolstoy’s ‘War and Peace.'”[16]
Complicating the problem, many of the CD&As did not use the “plain English” mandated by the SEC. SEC Chairman Christopher Cox, a conservative Republican and former congressman from California, said he was “disappointed at the lack of clarity” in the initial narrative explanations.[17] The chairman cited readability studies showing many CD&As to be roughly comparable to PhD dissertations.[18]
The SEC’s jawboning on the disclosures went further. Im 2007, the followed up the initial CD&As by sending letters to about 350 public companies asking for additional information about the methodology of pay decisions-especially any performance targets that may be tied to executive pay, and discussion of how difficult it might be for company executives to reach those targets.[19] The responses to those questions did not fully satisfy the SEC, with a majority of the companies receiving a second request for information from the agency.[20]
After reviewing these early compensation disclosures, the SEC’s Division of Corporate Finance released a report in October 2007, identifying two main themes of the comments made to specific companies.
First, the SEC explained that the CD&A “needs to be focused on how and why a company arrives at specific executive compensation decisions and policies. … The focus should be on helping the reader understand the basis and the context for granting different types and amounts of executive compensation.”[21] Companies should clearly explain how their compensation philosophies or decision-making processes yielded the specific pay levels for particular executives, instead of just providing an abstract discussion of pay philosophies or process. In addition, companies were urged to do a better job of disclosing and explaining any performance targets used.[22]
The second theme reiterated Chairman Cox’s comments about the readability of the disclosures. The SEC staff noted that “the manner of presentation matters-in particular, using plain English and organizing tabular and graphical information in a way that helps the reader understand a company’s disclosure.”[23] Also echoing the commission’s warning against “boilerplate disclosure” when the rules were first adopted, the staff summary on the early filings reported asking “a significant number of companies to replace boilerplate discussions of individual performance with more specific analysis of how the compensation committee considered and used individual performance to determine executive compensation.”[24]
In short, and in blunter terms than the SEC would likely employ, the new CD&A report has not yet proven especially useful to investors, or even to the SEC. What remains subject to debate is the cause for this. Did the lengthy, sometimes boilerplate narratives result primarily from public companies’ fear of saying too little in this new and uncharted report, or instead from a desire to obfuscate by wordiness?
Moreover, the SEC’s explanation of its new requirements was in itself so long and convoluted that a company’s compensation committee, faced with the difficult task of providing its first such CD&A report, could fairly easily have failed to identify a specific point of interest to the SEC, or have misunderstood exactly what the SEC wanted to see in these reports. That fact could explain why the SEC has not yet penalized any companies for failing to comply with the new rules-instead using the method of commenting and warning in hopes of obtaining better reports in 2008.
Effect on Compensation Practices
Restraining the trend of rapidly increasing CEO pay was never formally stated as a purpose of the SEC regulations. Rather, they were officially based on the theory that enhanced and clearer disclosure would be useful to investors-the free-market approach to regulation. Still, the hope of many observers (if not the SEC) was that wide public disclosure of the total compensation number might discourage boards of directors and compensation committees from awarding excessive executive compensation. That is at least a plausible theory.
However, one could make an equally good case that greater transparency in pay practices might actually further inflate executive pay. That is because in a competitive, free-market economy, most company directors are not likely to want to pay their own CEO less than what a competitor’s CEO is being paid. Even more so, it is probably just human nature for many CEOs and other top executives to see compensation packages as a type of personal competition, always wanting to be paid more than their rivals and colleagues. If that proves to be the ultimate result of enhanced disclosure, then the SEC’s new rules might even have the unintended consequence of fostering something of an “arms race” in the area of executive compensation, and turn out to be surprisingly counterproductive.
Still, there is at least anecdotal evidence that one aspect of the rules-enhanced disclosure of executive perks-might already be having an effect. Company-provided benefits such as personal use of corporate jets and dues for country club memberships have long been obvious targets for criticism by the media and unhappy shareholders, and this aspect of total compensation can be especially embarrassing when added on top of already high salaries for executives. Some large companies announced the termination of selected perks at the end of 2006 when the new pay regulations were initially taking effect.[25]
For most executives, though, all of these various perks combined make up only a small percentage of their total compensation. Further, it would not be surprising to see some companies simply augment other types of compensation if the SEC rules do indeed prompt more reductions in perks paid to executives or decreases in some other element of total compensation. That demonstrates the difficulty, if not the potential futility, of any government action addressing specific types of executive compensation. If one particular type is penalized or discouraged, that may merely change the method of compensation, rather than the overall amount.
It should also be noted that, after many years of rising CEO pay, one could not reasonably expect massive changes in compensation levels in only the first year of these new disclosure requirements. Many CEOs have long-term contracts that were negotiated before the new SEC rules were adopted. Even in the absence of multi-year contracts, most company boards are not likely to want to reduce the pay of executives remaining in their positions, merely because of a new disclosure requirement.
Conclusion
One can question whether the SEC’s focus on enhanced disclosure alone will have any significant impact on the levels of compensation paid to CEOs and other top executives. Still, it would not be fair to reach any final conclusion on that issue until the rules have had several years to work. Politically, though, that long a waiting period may not be feasible, especially when executive pay could make such an appealing political issue in a presidential and congressional election year.
Ideally, a more effective solution to the executive pay issue would involve true self-restraint-on the part of companies and directors in deciding how much to pay their top executives, and on the part of CEOs and other officers in moderating their own compensation demands. But the realities of human nature and of a competition-based economy mean that is not very likely to happen.
An intermediate step might be for more public companies to voluntarily permit “say on pay” votes by their investors-giving company shareholders an advisory, but not binding, vote on the pay packages for top executives at that corporation. The House of Representatives in 2007 approved a bill that would give shareholders a right to these non-binding votes, but the Senate is less likely to concur.[26]
In the long run, some type of self-restraint or self-regulation by public companies might be in their best interests. Such a proactive step would reduce the likelihood of further reactive legislative or regulatory action by the government-measures that could easily have unintended or even negative consequences.
[1] Michael Abramowitz, Lori Montgomery. “Bush Addresses Income Inequality,” The Washington Post, Feb. 1, 2007, at A4.
[2] Walter Hamilton. “Nation’s Chief Exec Enters CEO Pay Fray; Bush Says Corporate Boards, Not Government, Should Set Pay But Must Take The Duty Seriously,” Los Angeles Times, Feb. 1, 2007, at C1.
[3] John D. McKinnon, Greg Hitt. “Bush Vows Push on Trade, Chides Boards on Pay,” The Wall Street Journal, Oct. 12, 2007, at A1.
[4] “Where’s the stick?” The Economist, Oct. 11, 2003, at 13.
[5] Id.
[6] Sarah Anderson, Eric Benjamin, John Cavanagh, Chuck Collins. Executive Excess 2006: Defense and Oil Executives Cash in on Conflict, survey, Institute for Policy Studies, United for a Fair Economy, http://www.faireconomy.org/files/ExecutiveExcess2006.pdf
[7] Id., 49.
[8] Alan Murray. “CEOs Get Off the Ropes on Executive Pay,” The Wall Street Journal, July 5, 2006, at A2.
[9] Frederic W. Cook. “Research on CEO Compensation for Business Roundtable,” research paper, Business Roundtable, Executive Compensation Research Roundtable.pdf. (no longer accessible).
[10] Gretchen Morgenson. “Is ‘Total Pay’ That Tough To Grasp?,” The New York Times, July 9, 2006, at C1.
[11] Id.
[12] Lauren Etter. “Hot Topic: Are CEOs Worth Their Weight in Gold?,” The Wall Street Journal, Jan. 21, 2006, at A7.
[13] Executive Compensation and Related Person Disclosure, 71 Fed. Reg. 53,158 (Sept. 8, 2006) (to be codified at 17 C.F.R. pts. 228, 229, et al.).
[14] Id. at 53170. The seven categories are salary, bonus, stock awards, stock options (with both stock awards and stock options measured by their value on the award date), other incentive pay, changes in pension value and other deferred compensation, and all other compensation.
[15] “SEC Votes to Adopt Changes to Disclosure Requirements Concerning Executive Compensation and Related Matters,” press release, U.S. Securities and Exchange Commission, Disclosure Executive Press release
[16] Eric Dash. “More Pieces. Still a Puzzle,” The New York Times, April 8, 2007, at C1.
[17] Kathy M. Kristof. ” Exec Pay Data Still Unclear, SEC Says; Proxies are Not in ‘Plain English’ Despite New Rules, Chief Cox Says,” Los Angeles Times, Mar. 24, 2007, at C3.
[18] U.S. SEC Chairman Christopher Cox. “Closing Remarks to the Second Annual Corporate Governance Summit,” speech, U.S. Securities and Exchange Commission, http://www.sec.gov/news/speech/2007/spch032307cc.htm.
[19] Kara Scannell, Joann S. Lublin. “SEC Asks Firms to Detail Top Executives’ Pay,” The Wall Street Journal, Aug. 31, 2007, at B1.
[20] Kara Scannell, Joann S. Lublin. “SEC Unhappy With Answers on Executive Pay,” The Wall Street Journal, Jan. 29, 2008, at B1.
[21] U.S. SEC Division of Corporate Finance. “Staff Observations in the Review of Executive Compensation Disclosure,” report, U.S. Securities and Exchange Commission.
[22] Id.
[23] Id.
[24] Id.
[25] Erin White, Joann S. Lublin. “Companies Trim Executive Perks To Avoid Glare,” The Wall Street Journal, Jan. 13, 2007, at A1.
[26] Shareholder Vote on Executive Compensation Act, H.R. 1257, 110th Cong. (2007).
