Executive superstars, peer groups, and overcompensation: cause, effect, and solution.

AuthorElson, Charles M.
  1. INTRODUCTION II. PEER BENCHMARKING: THE PROCESS A. Historical Origins B. The Problem with Peer Group Analysis III. EVALUATING MARKET-BASED PAY RATIONALIZATIONS A. Athletes, Musicians, and Corporate Superstars B. The Firm and Industry Leaping Superstars C. CEO Skills: The Generalist D. Evidence on CEO Skill Transferability: Performance E. Evidence on CEO Skill Transferability: Turnover IV. THIN LABOR MARKETS: ROOM FOR PEER GROUP INFLUENCE ON PAY A. The Definitive Peer Benchmark B. Balancing Costs in Setting Pay C. Board Guidance V. CONCLUSION I. Introduction

    The dramatic rise in Chief Executive Officer (CEO) compensation over the past three decades has resulted in tremendous popular and shareholder discord. (1) Two distinct theories have long framed the analysis of this disconcerting trend. The first emphasizes board dynamics, alleging that management-dominated passive boards have allowed powerful executives to extract rent in the form of excessive compensation or perks at the expense of shareholders. (2) The second describes the operation of an efficient market for scarce and valuable executive talent. The rising level of pay observed among executives is then an unavoidable consequence of exogenous market forces and necessary for the retention of rare and able managers. (3) In essence, the theories describe the capture of boards by overbearing management in the former, and by omnipotent markets in the latter. (4) However, the cause of the escalation in pay, as this Article argues, is not fully susceptible to either explanation. (5)

    The theory of management capture, vis-a-vis compensation, argues that the directors of large public companies allow rent-seeking executives to exert an outsized influence over the compensation negotiation process. Directors' personal and professional connections with the management inhibit the board from engaging in effective and autonomous oversight, and the board lacks a meaningful incentive to do so. The argument continues that executive compensation escalated unchecked because boards failed to negotiate rigorously with executives, but calls for reform in the early 90s from scholarly, (6) professional, and popular commentators, (7) and a concerted effort by institutional investors, (8) regulatory agencies, (9) and the Delaware judiciary (10) led to the reformation of modern corporate boards. They called for equity holding, independent directors, and open elections. Many believed that these reforms would serve as a mechanism for improving board performance and corporate accountability while concomitantly remedying the executive compensation conundrum.

    These reforms quickly became accepted standards of practice. (11) Nonetheless, despite the promise that better boards would negotiate more reasonable remuneration, the rise in executive pay persisted. (12) We argue that the successes of such improvements in corporate governance were insufficient to rationalize this upward trend in median pay figures. The strengthening of oversight was successful in increasing managerial accountability for poor performance while also reducing the incidence of flagrantly high compensation awards because of an invigorated sensitivity to shareholder concerns. Nonetheless, while effective at reducing the ability of some managers to subsume rents relative to other managers, the reforms were unable to address that absolute, though possibly benign, ability of managers as a class to do so through institutional factors and norms. The problem is the standard practice of benchmarking pay to that of peers. While the directors may be well-intentioned, the consistent use of this simple referential process, which we later describe and critique, may better explain the persistent continuation of the systemic rise in pay.

    on the other hand, many scholars, particularly financial economists, have derived a powerful ought from the empirical observation of what is by ascribing the cause of rising pay wholly to the operation of a competitive market--the market for scarce and valuable managerial talent. This is the school of thought broadly classified as the theory of "optimal contracting." (13) The operation of large and complex business enterprises is a difficult task. Those who can do it well are exceedingly rare and sought after for the value they can create for investors. Consequently, wages are seen merely to respond to the demand for and value of such skills, while competition precludes the involvement of rents for either party. High wages are the outcome of an efficient bidding for talent and the resultant sorting of managers to firms, which is consistent with maximizing shareholder value. This view has become quite popular, especially subsequent to Xavier Gabaix and Augustin Landier's calibrated general equilibrium model and the explanatory power they claimed it possessed. (14) We question, however, the legitimacy of relying upon such a conception of a competitive market for talent--and as a result the related efficiency claims--in explaining the rising pay of executives. We criticize the competitive markets approach mainly on the basis of market frictions and the characteristics of "thin" labor markets. Specifically, we address the question of executive transferability and the implications for any notion of a centralized market exchange for talent.

    A more recent approach has sought to explain the cause of rising pay from a sociological or an institutional context. (15) The proponents of this view see overwhelming ambiguity as essential to the nature of any appraisal of executive worth and to the corresponding negotiation of compensation amounts. As a result, rather than being founded upon fundamental economic values, the amounts of pay awarded are simply determined through reference to the normative practices within a topography of local networks--in a large part as a response to the need to provide legitimacy to external constituents--and pay is therefore in fact largely unrelated to traditional economic marginal value. Related research has examined the process by which boards then reconcile this inherent ambiguity through the use of a convenient rule of thumb in arriving at a judgment of what they view to be fair, reasonable, and necessary remuneration. In particular, it addresses the use of formal targeting of compensation to that of peer companies. (16)

    In setting the pay of their CEO, boards invariably reference the pay of the executives at other enterprises in similar industries and of similar size and complexity. For this, compensation consultants are retained to construct a "peer group" of such companies and survey the pay practices that are prevalent. Then, in what is described as "competitive benchmarking," compensation levels are generally targeted to either the 50th, 75th, or 90th percentile. This process is alleged to provide an effective gauge of the "market wage," which is necessary for executive retention. (17) In essence, this process creates a model of a competitive market for executives where it otherwise does not exist. The model may, in this case, drive the empirical results rather than the other way around. As we describe, this conception of such a market was created purely by happenstance, and by its uniform application across companies, the effects of structural flaws in its design can have potentially compounding macro effects on the level of executive compensation.

    Both the academic and professional communities have observed that the practice of targeting the pay of executives to median or higher levels will naturally create an upward bias and movement in total compensation amounts. Whether this escalation has been dramatic or merely incremental, the compounded effect created a significant disparity between executives' current pay and a level which would otherwise be appropriate compensation. This is not surprising. By basing pay primarily on external comparisons, this trend established a separate regime which was untethered from the actual wage structures of the rest of the organization. over time, these disconnected systems were bound to diverge. Unfortunately, an executive's pay has a profound effect on the incentive structure throughout the corporate hierarchy. Rising pay thus has costs far greater than the amount actually transferred to the CEOs themselves. To mitigate these costs, pay must be more consistent with internal corporate wage structures. An important step in that direction is to diminish the focus on external benchmarking.

    This Article argues that: (1) theories of optimal market-based contracting are misguided in that they are predicated upon the chimerical notion of vigorous and competitive markets for transferable executive talent; (2) even boards comprised of only the most faithful fiduciaries of shareholder interests will fail to reach an agreeable resolution to the compensation conundrum because of the unfounded reliance on the structurally malignant and unnecessary process of peer benchmarking; and (3) the solution lies in avoiding the mechanistic and arbitrary application of peer group data in arriving at executive compensation levels. Instead, the independent and shareholder-conscious compensation committee must develop internally consistent standards of pay based on the individual nature of the organization concerned, its particular competitive environment, and its internal dynamics. Relevant considerations include the executive's current and historic performance based on a variety of factors and the specific nature of the company or industry, but they must also inculcate the notion of internal pay equity in their formulations. Some casual reference to peer groups may be warranted, though the process must maintain the flexibility necessary to arrive at a reasonable approximation to what is absolutely necessary to retain and encourage talent. Admittedly, our prescription is not concrete or easy to implement, but as the shareholder value movement...

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