Response to The Myth of CEO Pay and “Greed”

Earlier this month, the Mises Institute, an Austrian education institution, published an article entitled The Myth of CEO Pay and “Greed” in which the author, Matt Palumbo (@MattPalumbo12), argues that the widely touted statistic that CEOs out-earn the average worker 331:1 has been blown out of proportion. The author argues, rightly so, that this statistic (calculated by the AFL-CIO) only represents those CEOs working at S&P 500 companies while there are over 27 million private firms in the United States. In fact, when the Bureau of Labour’s 2013 statistics are used, the average CEO’s pay was $178,400. According to Mr. Palumbo, “[t]he larger sample of CEOs reported by the BLS gives us a much better understanding of “average CEO compensation.”

However, the $178,400 figure is also misleading. Why? Because the Bureau of Labour only includes certain categories of remuneration in calculating pay. The Bureau of Labour’s figures include: base rates, commission, cost-of-living allowances, guaranteed pay, incentive pay related to actual individual or group production, and production bonuses. Most importantly, they exclude stock awards, non-production bonuses and year-end bonuses, categories of pay that can reach many multiples of an executive’s salary.  The Bureau of Labour also excludes many other important elements of CEO pay, including attendance bonuses, perquisites, profit-sharing payments, relocation allowances and severance pay.

The problem anyone has when trying to calculate an overall average is that it is impossible to obtain data on what every CEO at every company is paid. Only those companies that are publicly traded have an obligation to report detailed figures on executive remuneration. Figures from the 27 million private American firms will remain just that – private, except to the extent that certain remuneration figures must be reported to the Bureau of Labour.

Beyond this, the pay of CEOs at small, privately held firms is not directly comparable to the pay of CEOs at publicly traded companies. The CEOs at many of the 27 million private American firms will also be the owners of those companies, or directly beholden to the owner. The CEOs of publicly traded companies are responsible to a board of directors and shareholders who are scattered across the country. The agency problem (shareholders are unable to adequately monitor and supervise the board and CEO who are supposed to be acting in their best interests) is much more pervasive at publicly traded companies than privately held firms. It is this problem that the 331:1 statistic highlights, and it is this problem that regulation tries to address.

Despite the fact that the 331:1 ratio is only based on pay at 350 companies in the S&P 500 index, this does not make the statistic any less accurate in depicting what it does. Pay at the largest companies in our society is out of control, and we need to take steps to rein it in. The problem is not limited to the S&P 500. Let’s look at a company in the Russell 2000 index, an index of small-cap stocks on the opposite end of the spectrum from those in the S&P 500. Since Russell 2000 companies are publicly traded, they are required to disclose detailed figures on executive remuneration. I randomly chose the company Aéropostale from the list of Russell 2000 companies. The CEO of Aéropostale took home a salary of $950,000 in 2013. Add to that, stock awards and other incentives for a total of $13.8 million. This company is not in the top 350. It is not even in the top 500. Yet there is clearly something wrong with this figure.

Mr. Palumbo makes a good point. We need to be clearer about the statistics we are using in order to avoid misleading our readers. We can all do a better job of this. However, we need more than statistics – we also need solutions.

Calma v. Templeton: Choose your peers wisely and your limits carefully

The Delaware Court of Chancery recently released judgment in Calma v Templeton, a decision that has implications for remuneration committees when selecting a company’s peer group and limits on share plan awards. In this case, a shareholder challenged an award of restricted stock units (RSUs) made to non-employee directors under Citrix Systems, Inc.’s 2005 incentive plan. The Plan, which had been approved by shareholders, allowed the board to award RSUs to directors, officers, employees, consultants and advisors. The Plan limited the remuneration committee to a maximum grant of one million shares per year per individual, valued at the time of judgment as $55 million.

In 2010, the compensation committee had granted shares and options with a fair value of $244,968 to Citrix’s non-employee directors, in addition to cash compensation for a total of between $288,718 and $312,040 per person.

In 2011, the compensation committee awarded $339,320 worth of RSUs to each non-employee director, in addition to cash that brought their total compensation to between $386,716 and $425,570. These amounts were significantly higher than the figures from 2010. Similar awards were made in 2012 and 2013, with maximum compensation reaching $662,935.

The plaintiff alleged that the RSU awards to non-employee directors between 2011 and 2013 were excessive, and constituted a breach of fiduciary duty (the duty to act in good faith and in the best interests of the company), a waste of corporate assets and unjust enrichment. The defendants moved to dismiss the plaintiff’s claims prior to trial.

The defendants argued that the claim for breach of fiduciary duty should be dismissed because the Plan had been ratified by shareholders and thus any awards under the Plan were unimpeachable. The directors were merely acting within the confines of a scheme approved by shareholders.

The Court disagreed. Although it is generally true that when shareholders approve a transaction, the transaction will be largely beyond review, it could not be said in this case that shareholder ratification of the Plan shielded every award under the Plan from scrutiny. For example, a decision to award every director the maximum amount of shares allowable under the Plan would be reviewable by the court. This is because the Plan contained no specific limits on the number of shares that could be awarded to each category of beneficiary. Rather, the one-million-share-limit applied to directors, non-employee directors, and employees alike. In approving the Plan’s general maximum limit, shareholders had not approved a certain magnitude of compensation that could be paid to non-executive directors. Non-executive directors, executive directors and employees would all have very different levels of compensation even though they could all theoretically be awarded one million RSUs each.

The court determined that it was required to review the directors’ actions in awarding shares under the Plan to determine whether the awards were entirely fair to the company, resulting from fair dealing and using a fair price. The court found a reasonable basis for conceiving that the awards to non-employee directors were not entirely fair to Citrix. The problematic transactions under the Plan had been justified by the board on the basis of similar awards being made to Citrix’s peer group, which included companies such as Amazon, Google and Microsoft. The market capitalization, revenue and net income of these three companies are completely different from Citrix. As a result, the court found it was entirely possible that RSU awards made on the basis of a comparison with these “peers” were not entirely fair. Thus, the plaintiff was permitted to continue its action for breach of fiduciary duty, as well as unjust enrichment.

This judgment should provide caution to remuneration committees: select your peer group wisely. Use companies that have similar market capitalization, revenue and net income statistics to your own. If your market cap is 12.74 billion, as Citrix’s was at the beginning of 2011, think again before comparing yourself to Microsoft, whose market cap at the time was 235 billion. Small players who consider Microsoft their peer could be exposing themselves to potential legal liability.

Additionally, remuneration committees should set detailed grant limits under share award plans. There should be a limit for each category of beneficiary entitled to an award. For example, one limit for executive directors, one for non-executive directors and a third for employees. If a company fails to set detailed limits, grants under their incentive plans may be viewed as a breach of fiduciary duty even if the plan itself has been approved by shareholders.

*Thanks to @execpaymatters for alerting me to the decision!

Pay considering employment

Remuneration reports typically include a section dealing with “pay and employment conditions within the company,” which usually contains a generic statement about how the remuneration committee considers company-wide pay scales and employment conditions (as well as employee feedback) in setting executive remuneration. Rarely is there much more detail than this.

For the 2014 financial year, HSBC CEO Stuart Gulliver took home a £1,290,000 bonus and a share award valued at £2,112,000. Following the release of its 2014 annual report, it was disclosed that HSBC is allegedly planning to lay off 10,000-20,000 people this year. Since Gulliver took over as CEO in 2011, HSBC’s employment numbers are down by 47,000.

This leads me to wonder whether the remuneration committee considered the feedback of those 47,000 people, and the 20,000 who might follow this year, in setting Gulliver’s bonus and share award. I am sure that a few of those 67,000 former employees have some choice words for Gulliver and the remuneration committee.

I am not saying in any way, shape or form that companies should not be able to restructure, lay off employees, or change direction. Companies obviously need flexibility to adjust when things are not working, costs are too high, or a different strategy is needed. Companies must have the ability to grow or shrink as the case may be.

However, the sticking point is that while executives drive home in nice cars with hefty pay cheques, a large number of employees walk out the door without a job. Not through any fault of their own, but because management decided to change direction, restructure or eliminate a function it used to think was necessary. When management decides to create and fill a position in one year, and then eliminate that position later on, it begs the question whether the decision to create the position in the first place was a sound one. As a result of poor planning, an employee has now lost a job. If the job loss is a result of technological advances, one must ask whether those employees could not have been trained to do other jobs. Rarely does a technological advance take a company by surprise – there is usually some lead up to the decision to adopt and use new technologies that may allow a company to redeploy or retrain existing employees.

I hope these types of questions are being asked by remuneration committees when they contemplate “pay and employment conditions within the company.” If not, they should be. In an ideal world, executives would be encouraged to create even more employment, something all economies need to grow. This aspiration does not necessarily align with the interests of shareholders, who would prefer to reduce costs. However, boards must balance the diverse interests of all of the company’s stakeholders in determining what is in the best interests of the corporation, and an important stakeholder is the employee. Remuneration committees should consider overall employment levels within the company, and provide an explanation for why an executive continues to receive a bonus in the face of downsizing. Especially if that downsizing is not the result of an economic downturn, but poor planning by management.

Pay should consider employment – current levels, growth, and reasons for lay-offs. Until then, let’s hear some feedback from those 47,000 and counting HSBC employees.

Are we in it for the long run?

The Financial Times published an article this weekend blaming the bonus culture for a decline in productivity and investment in the US and the UK. The theory is that because we reward managers highly for achieving short-term targets, we are incentivizing them to focus on short-term gain to the detriment of long-term growth. Managers are better rewarded for boosting profits in the short-term than they are for making decisions to reinvest in the business so that it continues to be profitable in the future.

Support for this theory can be seen from the fact (as reported by the Wall Street Journal and Keith P. Bishop at Allen Matkins) that a study has found that S&P 500 indexed companies spent a median of 36% of their operating cash flow on dividends and buybacks in 2013, up from 18% in 2003. At the same time, the proportion spent on plants and equipment decreased. Management has an incentive to boost returns to shareholders now, while under-investing in the future of the business.

This problem is compounded by the fact that we have defined the ‘long-term’ under executive incentive plans as three to five years. How many capital projects can be planned, executed and become fully operational and profitable within three years? Three years is simply not enough time to achieve the type of reinvestment needed to grow the economy.

The High Pay Centre has published a report calling for an end of the long-term incentive, arguing that it has resulted in the escalation of executive pay with no corresponding escalation in company performance. Instead, companies should only pay executives an annual cash bonus.

The danger with this approach is that if we eliminate all long-term incentives, we compound the problem of executives focusing on the short-term interests of shareholders to the detriment of the future well-being of the company. Thus, those of us who advocate for a “back to the bonus” shift must be sure that we also focus on how bonuses should be structured in order to best align management’s incentives with the company’s long-term interests. We must avoid a situation where executives are paid the right amount of money to do the wrong job. Performance metrics should include measures taken to improve the long-term profitability and productivity of the business. Additionally, the long-term should be longer than a three to five year horizon. If we are to see a real shift in how companies deploy their capital, we must start to reward the long-term investment decisions we want to see.