Unintended Consequences: The Briar Patch

By Bill Barnhart

Joint Meeting of the Chicago Literary Club and The Fortnightly

Friday, March 5, 2004

       Despite the suggestion in its name, the news business depends on regularity. As we meet here tonight, the promise of springtime has brought to each department of the newsroom different but perennial obligations.  The arrival of pitchers and catchers at spring training alerts the sports desk that the professional basketball and hockey seasons are fading.  That’s an especially welcome sign in Chicago, where the Bulls and Blackhawks have not been contenders for a decade.  In even-numbered years, the national and local news desks crank up for the primary election season.  Candidates for the top of the Republican and Democratic tickets may virtually be decided this time. But a race for the U.S. Senate is wide open in Illinois.  And in Chicago considerable effort is spent by party activists on behalf of candidates for lesser offices.  In my neighborhood on the Southwest Side, yard signs for judicial candidates have sprung up like crocuses.

     Over on the business desk, where I work, we have our own rite of spring.  Proxy statements, issued by corporations for their annual shareholder meetings in April and May, prompt us to publish the large-denomination pay packages awarded to chief executive officers of public companies.  Aside from the casual voyeurism and envy evident in this annual exercise, executive compensation lists and articles present an opportunity to examine whether shareholders are getting their money’s worth. The surveys are analyzed carefully, not only by the financial press and critics of corporate behavior but also by the compensation experts who devise complex pay schemes for CEOs.  For however elaborate executive pay packages have become, one principle has applied for many years. Like students in Lake Woebegone, all CEOs are above average.

       No board of directors, composed of individuals looking out for their own next pay increase, wants to hire or retain a CEO at the average salary. How would they explain that Roger, the new CEO of Megabank, was hired, after an expensive recruiting effort by prestigious outside consultants, at the average salary of CEOs in his peer group?  This guy must be a real loser.  Moreover, the consultants who constructed the pay package must be second-rate.  You don’t have to be a math whiz to figure out the result of this annual grade inflation.  It’s no wonder that CEO compensation at major companies has gone from 40 times the pay of rank-and-file employees in 1975 to 500 times at many companies today.  There is no evidence, by the way, that higher CEO pay yields better company performance or greater shareholder returns.  The statistics point in the opposite direction.

     Public outrage over CEO pay has been, shall we say, occasional.  During the go-go years of the late 1990s, eight-figure pay packages for CEOs were applauded like salaries of star athletes and entertainers. CEOs were treated as prima donnas, not managers of cooperative enterprises. A professor at Baylor University claimed that the exaggerated difference between CEO compensation and the compensation of everyone else in the company is like the weekly prizes on the PGA golf tour, where the payout for the winner is always disproportionately larger than the also-rans.

      Today, even former defenders of the system say executive pay has gone too far, as we shall see.  But how did things get so out of hand?  For the answer, we have to look back to late 1991.  (Pardon me, if this sounds like Déjà vu in reverse.)  The nation was struggling in a jobless recovery from recession.  The country had an enormous trade deficit.  As he faced his re-election bid in 1992, President Bush the First was taking heat for being more concerned about foreign affairs than about the weak economy at home.  His former attorney general, Richard Thornburgh, had just been defeated in a special Senate election in Pennsylvania by Democrat Harris Wofford, a previously unknown college professor.  Wofford’s campaign message resonated widely: “It’s time for Americans to help Americans for a change; it’s time to take care of our own.”

      To show his commitment to jobs at home, Bush took a trip to Asia in December 1991. Traveling with the president were twelve CEOs of major U.S. corporations, including the Big-Three automakers.  The last stop on the trip was an economic summit in Japan, which was eating the lunch of General Motors, Ford and Chrysler. The White House said Bush would “fight for open markets and more opportunities for American workers.”  To put it mildly, the trip did not go well.  The CEOs, including the outspoken Lee Iacocca of Chrylser Corporation, complained about unfair trade practices.  But reporters focused on a different issue.   Iacocca had collected $4.65 million from Chrysler in 1990.  The average pay of a Japanese CEO was $350,000. CEO pay in Japan was about 16 times the factory-floor worker, compared to about 160 times at major U.S. industrial companies at that time. Executive compensation specialist Graef Crystal had just pointed out this disparity in his book, In Search of Excess, a send-up of the popular management puffery book titled In Search of Excellence.

     The Asia trip was a disaster for Bush and his privileged fellow travelers.  Who can forget that the president became ill during a state dinner in Tokyo and threw up on the Japanese prime minister?  Meanwhile, even the Wall Street Journal unloaded on the highly paid CEO whiners.  Journal columnist Paul Gigot, who now heads the paper’s editorial board, wrote: “There are good reasons other than class envy for disliking the runaway salaries of many chief executives. For one thing, the numbers are outrageous enough to make even a capitalist blush.”  A Wall Street Journal editorial said: “The President should boil down these talks in the next few days to one simple proposition: The U.S. will let in anything that Japan wants to sell, if the Japanese will keep Lee Iacocca.”

     Intense public reaction against CEO pay ensued.  As the annual round of proxy statements emerged in early 1992, CEO pay was a frequent story on nightly network television news, as well as “60 Minutes” and “Nightline.”  The complaints were bipartisan.  Vice President Dan Quayle denounced “exorbitant salaries, unrelated to productivity.”  Republican maverick Pat Buchanan said, “You can’t have executives running around making $4 million while their workers are being laid off.” But the message sank deepest into the political camp of former Arkansas Governor Bill Clinton.  Here is his reaction to the Bush trip to Japan: “How can we run a country with a president who’s coddling the people he ought to be kicking in the fanny.”

Clinton understood Wofford’s winning message. The Clinton campaign brochure in 1992 said: “The rich keep getting richer and the politicians just seem to be taking care of themselves.  It’s time we took care of our own.”  He vowed to “eliminate deductions for companies that ship American jobs overseas and reward outrageous executive pay.” In his first budget as president, for the 1994 fiscal year of the federal government, Clinton proposed to end the business expense tax deduction for CEO pay of more than $1 million, unless the compensation was based on the “performance” of the company.  In endorsing the Clinton proposal, the House Ways and Mean Committee said this: “Recently, the amount of compensation received by corporate executives has been the subject of scrutiny and criticism.  The committee believes that excessive compensation will be reduced if the deduction for compensation (other than performance-based compensation) paid to top executives of publicly traded corporations is limited to $1 million a year.” The measure became law as Section 162(m) of the Internal Revenue Code.  M, as in millions.

      To judge whether “excessive compensation” was reduced, please consult the chart I distributed.  Indeed, CEO salaries held fairly steady for the rest of the decade.  But the law had a perverse effect that reflects the theme of tonight’s presentations – unintended consequences.

     Fortune magazine, in its survey of 1992 executive pay reported, “The explosion of stock option grants – the main CEO pay trend of the 1980s – may finally be slowing.  Salary and bonuses grew faster than stock awards” in 1992. Your chart indicates the decline of stock option awards continued for another year.  Options declined absolutely and as a percentage of total CEO compensation from 1992 to 1993. That was when the Clinton CEO pay cap was enacted.

     Let me pause for some definitions. Employee stock options grant to the holder of the option the right to buy shares of the company at a specified price during a specified period.  If you hold an option to buy shares at $10 and the stock doubles to $20, you can exercise your option by paying the company $10 and then claim a 100 percent profit, not counting taxes and transaction costs.  You never have to own the stock for more than a moment.  But President Clinton’s reform of CEO pay specifically excluded stock option awards.  Options were billed as a way to align the interests of executives with the interests of ordinary stockholders.

      As Roger Lowenstein points out in his new book, Origins of the Crash, options fail as an incentive for corporate performance because they carry no risk.  If a company’s operations decline and its stock price drops, or if the stock price falls for any reason, the options expire worthless and the CEO simply collects a fresh batch of options at the reduced price.  As we learned in the 1990s, short-term stock price movements frequently bear no relation to the intrinsic value of a company or its operating performance. Rolling over a series of option grants, which are free to the executive, virtually guaranteed millions of dollars with no effort at all, especially in a bull market.  It was much simpler to appear on CNBC and tout your stock than actually manage the company efficiently to generate legitimate profits. Indeed, generating profits was a waste of time.  Companies with strong balance sheets and steady profits lagged the market in the late 1990s, a condition that persists today.

      Nonetheless, the House Ways and Means Committee said in 1993, “Stock options…generally are to be treated as meeting the exception for performance-based compensation…because the amount of the compensation paid to the executive is based on an increase in the corporation’s stock price.”

      More than one hundred years ago, the acerbic newspaper columnist Ambrose Bierce, a veteran of the Civil War, began publishing cryptic definitions of words. These were later compiled into a book, The Devil’s Dictionary.  Bierce defined a corporation as “an ingenious device for obtaining individual profit without individual responsibility.”

        I suspect Bierce had never heard of stock options.  But when President Clinton’s compensation deduction cap took effect 10 years ago, individual CEOs and their consultants quickly recognized the windfall that had befallen them. Obviously, it would be poor business practice to collect more than $1 million in cash salary and bonus, thereby losing the tax deduction on the excess business expense.  Stock options, on the other hand, were not only excluded from the new law.  They were not even counted as a business expense, no matter what amount was awarded. They were a “device for obtaining individual profit,” as Bierce put it, that was free of responsibility and financially free to the corporation, even though employee options dilute the ownership stake of other shareholders.

       Stock options as the solution to outrageous executive pay had been validated in 1990 by professors Michael Jensen of Harvard University and Kevin Murphy of the University of Rochester. Their article in the Harvard Business Review was titled “CEO Incentives – It’s Not How Much You Pay, But How.” They advocated greater stock ownership by CEOs.  But the professors made a fatal error by failing to distinguish fully between stock options and the outright stock ownership, in which stockholders face the risk of loss.  They also equated company performance with the market value of its shares, a remarkably naïve assumption in the short-term world of option grants.

      Jensen has acknowledged his mistake. In 2001, he published an article titled “How Stock Options Reward Managers for Destroying Value.”  Today, he says options are like heroin in the executive suite. They induce CEOs to lie, cheat and steal to keep inflating their share prices.  Kenneth Lay, the former chairman of Enron Corp., cashed in $145 million on stock options from 2000 to 2001, just before the company collapsed. Recently Jensen told a Chicago audience that the best solution to corporate governance scandals was lower stock prices.  Academics and others are now calling for the repeal of the cap on executive compensation as an urgently needed reform.

          Still, few ordinary shareholders understand the complex stock option game and its pernicious effects on a company.  Option grants to CEOs continue at a heady pace, even though companies are being forced to count them as an expense.  Since this is the Chicago Literary Club and not the Chicago Investment Analysts Society, I’ll close by paraphrasing that literary genius, Uncle Remus, whose protagonist, Br’er Rabbit, aptly described the executive pay reform of the 1990s: "Roast me if you want, Br’er Clinton, but please don't throw me into that briar patch.”

REFERENCES

BOOKS:

Origins of the Crash: The Great Bubble and Its Undoing, by Roger Lowenstein. New York: The Penguin Press, 2004.

The Devil’s Dictionary, by Ambrose Bierce, New York: Bloomsbury, 2003, p. 20.

ARTICLES, etc:

“CEO Incentives – It’s Not How Much You Pay, But How,” by Michael C. Jensen and Kevin J. Murphy, Harvard Business Review, May-June 1990, pp. 138-149.

“Public Reaction to Economic Ills Again Nudges Washinton, and Nation, Toward Isolationism,” by Jeffrey H. Birnbaum, The Wall Street Journal, December 3, 1991, Section A, p. 16.

“Bush Moves Into Critical Time in Facing Woes of the Economy, but GOP is Divided Over Tactics,” by Michel McQueen and John Harwood, The Wall Street Journal, December 27, 1991, Section A, p. 12.

“Compensation Gap: High Pay of CEOs Traveling With Bush Touches a Nerve in Asia,” by Jill Abramson and Christopher J. Chipello, The Wall Street Journal, December 30, 1991, Section A, p. 1.

“Give Iacocca to Japan,” editorial, The Wall Street Journal, January 8, 1992, Section A, p. 10.

“Executive Pay – An Embarrassment to Free Marketers,” by Paul A. Gigot, The Wall Street Journal, January 10, 1992, Section A, p. 8.

“Campaign ’92: From Quayle to Clinton, Politicians Are Pouncing on the Hot Issue of Executives’ Hefty Salaries,” by Jeffrey H. Birnbaum, The Wall Street Journal, January 15, 1992, Section A, p. 14.

“Explaining Executive Compensation: Managerial Power versus the Perceived Cost of Stock Options,” by Kevin J. Murphy, The University of Chicago Law Review, Summer 2002, Vol. 69, Issue 3, pp. 847-869.

“Background material on the federal budget and the President’s proposals for fiscal year 1994: Prepared for hearings to be held on March 9, 1993/Committee on Ways and Means,” Washington: Government Printing Office, pp. 209-213.

“Pay Day! Pay Day!” by Andrew E. Serwer, Fortune, June 14, 1993, Vol. 127, No. 12, pp. 102-111.

“The Controversy Over Executive Compensation,” Statement of the Financial Economists Roundtable, November 24, 2003.

“Assault by shareholder activists expected on exec pay,” Reuters/Chicago Tribune, February 19, 2004, Section 3, p. 2.

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