This is a hot button topic for sure, in today’s floundering economic conditions. Opinions are all across the spectrum between regulation and “free market” economics. What are the nuances between these two extremes?
At the “free market” side of the argument, we’re told what we’ve heard for years – it is not wise to put restrictions on this. The market decides what they should make. Their roles are challenging. The Board of Directors has a compensation committee anyway to regulate this. Shareholders can vote and express their opinion if they are not happy. Others offer similar pay so a company has to do this to retain top talent at the top. The list goes on. What we have seen recently is that the distance between these statements, and reality, has been slowly increasing.
Let’s start with the Board and compensation committees. Scandals like that of Aubrey McClendon at Chesapeake Energy might seem very extreme, but a cursory search online for similar news articles will reveal several similar stories. The underlying issue is that when the Board is filled with friends of the CEO or friends of friends of the CEO, it is hard to do an arm’s length evaluation of pay for several of the reasons outlined in my earlier post on board of directors. At the same time, given the massive overlap between people serving on many similar corporate boards, “fair comparison” between companies is harder to do as well. Compensation consultants are hired at some firms, but even these are not arm’s length transactions in many cases.
Then there is the myth of shareholder freedom to express their opinions. Given how corporation-friendly Delaware laws are, resulting in over 60% of incorporations happening there, it is very hard for shareholders to get any rulings in favor, despite the reality. They can file derivative suits and enter into lengthy and expensive litigation, but their ask of replacing a CEO or questioning conflicts in the Board are incredibly hard to get granted in Delaware courts. For example, take the case of one unique exception, thanks to the perseverance of the founder of Friendly restaurant who refused to take no for an answer. Not all stories have endings like this where clearly unfair behavior is accounted for and actions taken. Zweig and Gillespie’s book referenced in an earlier post talks at length about several examples.
One of the associated issues that has come up over the years is the pay ratio. Prof. James Cotton at Texas Southern had come up with this a few decades ago as a measure of “fairness” within a company. Currently section 953(b) of the Dodd-Frank Act also aims to introduce reporting requirements on this pay ratio for a company, defined as the ratio of the CEO pay to the median pay within the company for all employees excluding the CEO. SEC is currently facing bitter opposition to implement this, for several reasons.
If reading this far has made you worried about over-regulation, you are not alone. I’m not suggesting that a one-size-fits-all pay ratio metric is the answer. As critics of this piece of legislation state, this ratio will vary widely based on the type of industry. It also varies based on how you define the metric and different industries and their lobby firms might have vested interests in defining this differently. The bottom line though is that disclosing this ratio would be a step in the right direction. I don’t think you can legislate away the problem, but disclosure requirement seems to be a fair ask. If a company can justify the premium that they have compared to the market, and their investors are happy, then more power to them.
Another angle here is around the whole issue of human capital as an asset for a corporation and how you can attribute some value to them. This has been attempted by a few firms in the recent past, notably Infosys. Attempting to do this exercise within corporations gives them a perspective of seeing employees not just as cost centers, but as assets with replacement costs and opportunity costs. Of course one cannot measure employee happiness or satisfaction very easily and add that as a metric, but a lot of work has been done on this front as well – more about that in some future post.
In summary, blind legislation and requiring ceilings on a federally regulated pay ratio may not be the right answer. Empowering board of directors to be truly independent and evaluate compensation at arm’s length is definitely a start. Publishing these statistics is a good faith action towards transparency and will be perceived as such by shareholders. What do you think?