The journalists and executive compensation

I have sounded off on the SEC’s impending executive compensation proposal here (on potential costs), here (on envy) and here (on the politics).

Today the NYT’s Joe Nocera weighs in. In a nutshell he says:

• “[T]he single most intractable problem in corporate America [is]. . . executive greed.”
• Disclosure will only “make a bad situation worse,” essentially because of benchmarking.
• “Even C.E.O.'s who do perform well are often paid too much. There is a huge disconnect between the amount executives are paid and society's expectation of what is reasonable to pay someone to manage a big company.”
• Barney Frank, presumably reflecting one of Nocera’s thoughts, “is leery of trying to legislate the appropriate level of executive pay” because "[i]t is the shareholders' money.
• Nevertheless, perhaps we should set “a ratio between what the C.E.O. makes and what the average worker in the company makes." Edward Woolard did that 15 years ago as CEO of DuPont, though this meant he’d be making much less than his peer managers, because it was "equitable." But Nocera acknowledges that not all C.E.O. are as “public-minded”

The column concludes by asking the readers what should be done.

So, in a nutshell: Everybody knows executive compensation is a problem, we just don't know the solution.

What seems to have escaped Nocera’s attention is that whether there's a problem here depends on whether there is a feasible solution. There is no Platonic “fair” level of pay.  Executive compensation is an agency cost problem. You give power to executives to set their own pay, there’s a risk they’re going to set it too high. But that problem is inherent in empowering corporate executives and other agents.

We might address the problem by monitoring agents' performance, including pay setting, or simply reducing their power. But these are not really solutions if the costs of monitoring or reducing agents’ discretion are higher than the benefits, including reducing executive pay. You might get even worse incentives (Nocera's column suggests this) or be unable to attract the right people because the shareholders, or whoever else is making the decision, don’t know what they’re doing. In fact – that’s why they delegated the power in the first place.

In other words: THE OPTIMAL LEVEL OF AGENCY COSTS IS NOT ZERO. The whole question is the costs and benefits of controlling agents’ performance. You can’t just decide there’s a problem that needs fixing unless you have a feasible fix. Whether there's a problem depends on whether there's a solution.

So are we at the optimal level? I’m not sure, but in my paper, Accountability and Responsibility in Corporate Governance, I suggest a possible approach to agency costs that might work for some firms: partnership-type constraints on managers’ control over the money. If this is feasible, the market can put it in place, through hedge and buyout funds.

But maybe I've got this wrong. Maybe there is a problem that needs to be solved at any price – what I referred to in a recent post linked above as the “envy” problem. If you think that’s the problem you don’t really care about the optimal level of agency costs. You just care that ceo’s are making a lot more than you are.

Nocera does seem concerned about that, though he calls it "greed," just as was Jesse Eisinger at the WSJ, whose column I discussed in my "envy" post. Maybe we do have a way to determine whether executives are making too much:  are they making a lot more than the journalists?  To answer that we'd need to know how much the journalists are making.  All I know is that I'm putting out these blog posts for nothin.  Benchmark THAT.  Your move guys.

Comments

[Robert Schwartz]

I agree with your diagnosis, but, while your cure is in substance correct, I think that it is procedurally defective.

I do not think any extensive enterprise can survive without the centralized management provided by the corporate form. The problems of the form, particularly when financed by common stock are multitudinous.

First, the stockholders while they can, in theory, vote management out face real problems in coordinating. SEC proxy rules make it costly and legally hazardous for shareholders to communicate. generally proxy contests can only succeed when they are accompanied by a take-over bid.

Take-overs themselves are not a good remedy. First, they are random. There is currently no way of forcing a take-over. Shareholders of a truly poorly run company, may wait a long time and loose a lot of value befor anyone take an interest in it. Second, management may rather hold on to their jobs than allow a take-over. They may do it passively by running the company in a sub-standard way so that it will not interest buyers, and they may engagein rule-or-ruin tactics. Roert Farago (thetruthaboutcars.com) seems to think GM is being run that way. In that case, appointing interim management might make the shareholders a lot of money. But, under the current regime, buyers will be buying on an as-is where-is basis.

Other possibilities include preferred stock, but that route is impeded by the tax law and the double taxation of dividends. Further, under existing Chapter 11 rules it is difficult to throw out managemet because of a default on securities.

Shareholder approval of compensation plans has een an obvious failure. It also dilutes the responsibility of the board of directors to supervise management.

My only contribution to this debat is to borrow from Paul Shupack (Cardozo) is to borrow from one of Gilbert and Sullivan's less well known plays:"Utopia Limited," the Public Exploder:

"by our Constitution we are governed by a Despot who, although in theory absolute--is, in practice, nothing of the kind--being watched day and night by two Wise Men whose duty it is, on his very first lapse from political or social propriety, to denounce him to me, the Public Exploder, and it then becomes my duty to blow up His Majesty with dynamite ... and, as some compensation to my wounded feelings, I reign in his stead."

I would however need some modification.