Tuesday, June 09, 2009

New Standards for Executive Pay

Many people will be lodging complaints about the Obama administration's meddling in the affairs of private companies by imposing controls on CEO pay at firms that have received TARP funds. I'm with those who say that the White House should not be involved in controlling how companies choose to compensate executives. Those companies who have taken TARP funds or bailout money have sacrificed their independence, though, and we should all be concerned about how the heads of these companies are being paid. Does it make sense to have a company that has essentially failed, made bad choices, giving excessive pay to the CEO who was in charge? Shouldn't their be a downside for these guys when they screw up?

The trouble with executive compensation derives from perverse incentives. My beef is with earnings per share. Barely "beating the street" is game companies continue to play. And it works. The street doesn't always care that beating current analysts' estimates might not be best in the long run. Compensating executives on continued earnings or stock growth can lead to short-cutting the company's long-term objectives. But this is only part of the problem. Compensating with stock options often leads management to, again, manage the stock price (or properly manage the street's expectations) and neglect the true well-being of the company.

The real problem, as I see it, is that there is little downside risk to executives. Maybe boards can argue that with enough upside, anything else is downside. We've seen enough companies fail in the last year and executives from those companies walk away with huge packages, that I'm can hardly believe that there is shared risk. A CEO's well-being should depend on the company's well-being. And not just for the current quarter. A pay scheme that allows for a measure of future performance might help align interests. It is easy to believe that some of the drastic job cuts we've seen have been out of management's need to cut costs today, to preserve today's earnings, without regard for the health of the company a year from now. Cutting mid-management professionals, those next-generation executives, will prove to have been a mistake for many companies.

We may object to a government's hand in private industry, but the Obama administration has an opportunity to set standards, essentially guidelines for boards in constructing compensation packages. If they can avoid overreach, they can establish compensation packages that are fair to CEO's and shareholders, and give boards the cover they need to reign in escalating executive pay.

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