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Friday, September 30, 2011

Executive Compensation (Part II): Paying Failure

In late September 2011, Léo Apotheker was fired after 11 months as CEO at Hewlett-Packard. As a reward, he walked with $13.2 million in cash and stock, in addition to a sign-on package worth about $10 million, according to the New York Times. A month earlier, Robert P. Kelly received severance worth $17.2 in cash and stock when he was fired as CEO of Bank of New York Mellon. Even his clashing with board members and senior managers did not obstruct his nice severance package. A few days later, Carol Bartz was let go as CEO of Yahoo with nearly $10 million in spite of the company’s poor performance. Back in April 2011, John Chidsey, the CEO of Burger King, had departed with a severance package worth almost $20 million in the fact that McDonalds had been outcompeting Burger King. Baxter Phillips, the CEO of Massey Energy, got a package worth over $34 million in spite of “presiding over a company barraged with accusations of reckless conduct and with legal claims stemming from one of the deadliest mining disasters in memory,” according to the New York Times. Unfortunately, the list goes on and on. Is this a system of pay-for-failure? Moreover, do chief executives, who seem to outward appearances to be almost exclusively motivated by what they can get in additional compensation, have too much leverage over boards, and thus over even the owners as well? If so, is corporate governance itself severely broken? I answer in the affirmative.

“We repeatedly see companies’ assets go out the door to reward failure,” Scott Zdrazil, the director of corporate governance at a major bank’s investment fund that sought to tighten the restrictions on severance packages at three oil companies in 2010. He claims that investors are frustrated that boards of directors have not prevented such windfalls. Even the Dodd-Frank financial reform law has its mandated “say on pay” stockholder votes on a non-binding basis. It is as though stockholders have given up their property rights in favor of the “rights” having been taken or assumed by their agents—the directors and upper echelon managers. It is as though the business judgment rule trumps property rights even where the compensation of executives who typically control their boards is at issue. The conflict of interest here is extraordinary even as it is assumed to be obviated by the fiction of board independence from management. To be sure, a board of directors is supposed to hold management accountable.

Don’t look to public policy to shore up the property rights of stockholders any time soon. Eric Dash of the New York Times avers that the Obama administration “seemed to lose its bully pulpit for compensation reform after most of the nation’s biggest financial companies repaid their government loans.” Never mind that the administration allowed at least four of the mega-banks to repay early based on the bankers’ desire to avoid limitations on their own compensation.

The bottom line is that CEOs are not really all that interested in serving the owners of the companies; the top executives are primarily interested in their own gain, be it in terms of position/power or compensation. Structuring the latter in stock options with vesting periods and looking to outside directors for accountability are not sufficient checks on the single-minded pursuit of CEOs of their narrow self-interest. Even when a bank is in dire circumstances, such as Merrill Lynch was on September 15, 2008, a CEO can be obsessed with “letters”—statements on his or her compensation (as well as that of other top execs) being honored by the acquiring company.

As negotiations dragged on into the wee hours of Monday morning, Ken Lewis of Bank of America was utterly disgusted with John Thain’s fixation on what he and others at Merrill would get as bonuses (for a year of losses, by the way), even as Merrill and its stockholders held in the balance after midnight (when Lehman filed for bankruptcy). Lewis could only look over at Thain and think to himself, The only thing these Wall Street guys are concerned about is themselves. Even in the midst of a financial system collapse, Thain was focused on getting what he thought he deserved in spite of the huge losses. In fact, he had put off even talking to Lewis at Bank of America—repeatedly rebuffing his president’s (Fleming) lobbying—because the CEO did not like the idea of having to work for Lewis! Do you suppose the Merrill stockholders wanted to risk their entire investment in the bank because Thain didn’t want to end up working for someone else? The board of directors left the contingency plans up to him, so he didn’t have to worry about any pressure to start merger talks. Merrill’s stockholders were at best an afterthought to him, and yet the directors, who had been elected by the owners, had hired him. The eventual $29 per share price, by the way, was a result of Fleming’s negotiating for the stockholders; Thain was still looking for a line of credit from Goldman—risking an entire loss to stockholders so he could retain control of Merrill rather than turn it over to Lewis.

Even after Merrill Lynch had announced a $5.1 billion loss ($5.56 per diluted share) for the third quarter of 2008, Thain was insisting on a cash bonus of $40 million. Fleming and McCann were to get $25 million, while two other senior managers would get $15 million a piece. Thain subsequently admitted that a $20 million cash bonus for himself would be more "realistic." Given Merrill's losses in 2008 and the fact that the bank had to be sold, it is crazy that any cash bonuses would be paid for any senior manager. Thain's suggestion to the board's compensation committee that the bonuses be viewed as "success fees" for the top managers' efforts in putting together the sale of Merrill to Bank of America is nothing less than bizarre, if not comical. Failure as successs? What planet was Thain from? That a man like him ever got to be the CEO of a major bank (one too big to fail!) suggests that major flaws exist in how business practitioners view and value leadership and in how corporate governance is designed and operates.

When times were good, the finance crowd had lauded Thain as a “superman” for modernizing the NYSE. The business world tends to invent “superheroes”--even calling them rockstars!--while ignoring the more ignoble underbellies of its idols. In other words, leadership is worshipped without any clear grasp of the leaders' real contributions, while failure at the top is generally underplayed or ignored, at least financially speaking. This lack of proportion and balance is not by accident, as it is fully in the financial interests of the so-called "leaders." As for the followers and bystanders, these incredulous groupies--retarded court jesters wearing grizzled suits--happily allow themselves to get played as fools. They are dominated, not led, for the weak can dominate but not lead the herd animals.

Besides pointing to the utter bankruptcy and banality of business leadership, the case of Thain demonstrates that the system of corporate governance in the U.S. is broken even as it continues on as the status quo. Sadly, stockholders as a group are severely over-exposed to risk as a result. As long as top executives get what they believe they are worth, they will see to it, in a “by the way” fashion, that stockholders do not lose everything, but is this enough? Must stockholders (and society itself) settle for this? Are they even aware of the risk to their wealth as CEOs risk all to make sure they are taken care of? In academic terms, the system of corporate governance is incurring huge agency costs, yet I suspect we (and stockholders) are blind to their magnitude. As a society, Americans have a bad habit of taking the word of vested interests, who get away with making excuses or simply opining that there is no problem, after all. We assume that executive compensation is set by the invisible hand of the marketplace because it is in the executives’ financial interest that we take this bait and swim along with it in our gullible mouths. We are like fish that do not even realize that there are hooks in our mouths!

It does not occur to us, or to stockholders, that competent managers are out there who would gladly take top management positions for much, much less. Corporate executives have engineered a coup of sorts, having separated ownership from control at the expense of stockholders and even systemic risk in the financial system. The suits have even captured the government, such that stockholder votes on compensation are legally non-binding. This is not the invisible hand connecting demand and supply in the labor market; rather, it is a result of a rich velvet coup under the subterfuge of capitalism and democracy—with the electorate completely beguiled. Let’s not pretend this is the free market doing this, or that the governments in the U.S. are oriented to protecting the interests of stockholders and the public at the expense of the corporate managerial class.


Eric Dash, “The Lucrative Fall from Grace,” New York Times, September 30, 2011. http://www.nytimes.com/2011/09/30/business/outsize-severance-continues-for-executives-even-after-failed-tenures.html

Gred Farrell, Crash of the Titans (New York: Crown Business, 2010). On Thain's bonus, see chapter 16.