Outrageous CEO Pay

From: Dickey, Michael F (michael_f_dickey@groton.pfizer.com)
Date: Wed Sep 05 2001 - 14:20:12 MDT

This is an article I came across relating to some recent discussions...

Michael D


Outrageous CEO Pay

by Hans F. Sennholz
   Critics of executive pay demonstrate their lack
   of understanding of economics with their attacks
   on high compensation. (08/21/01)
by Hans F. Sennholz
[Posted August 21, 2001]
Nothing sharpens the sight like envy.

Some legislators who are enjoying six-figure remunerations and seven-figure
benefits are dismayed about CEO compensation. They resent the fact that top
executives are earning multimillion-dollar-pay packages while lawmakers
subsist on such meager fare. CEOs, in their judgment, are greedy executives
who thrive on corporate profits when times are good and when times are bad.

Similarly, media commentators and journalists never tire of pointing at
apparent excesses of executive compensation practices. One business magazine
recently lamented especially about Apple Corporation's issue of a
stock-option package valued at more than $500 million, calling it "The Great
CEO Pay Heist."
CEO compensation usually is pay-for-performance, consisting of a base pay
plus equity-based incentives such as bonuses, stock options, and other
equity vehicles. CEO income, therefore, rises and falls with performance.
The market way to measure his or her performance is by the size of company
profits and the price of the company stock. Numerous stockholders
continually judge the efficiency and profitability of a corporation and set
stock prices by buying and selling shares. They love and acclaim a CEO who
improves the profitability of their company and thereby may add millions of
dollars to the value of the company. They offer multimillion-dollar
incentives to management so that it may identify with the interests of the

Irate critics of high CEO pay often base their charges on the notion that
corporate boards of directors and compensation consultants who make such
astonishing recommendations are cozy and "cushy" with management. Cronyism,
critics charge, is a strong and habitual business inclination to promote the
interests of one another. We may agree that cronyism is a human constant,
and not just in business, but it may also conflict with the interests of the
cronies. In fact, U.S. corporations probably are the most
shareholder-responsive in the world because the shareholders themselves may
be judged by the price of the corporate stock.

The U.S. stock market is driven by powerful institutional investors such as
mutuals and pension funds that force management to maximize shareholder
returns and profits. Institutional investors have assumed the role that
wealthy families used to play before the age of confiscatory estate
taxation; that is, they have the financial clout and resolve to unseat
managements of poorly performing companies. For example, they replaced the
heads of IBM, General Motors, Kmart, and American Express with new talent.
They may also force CEOs to restructure corporate operations and trim their
payrolls to the bone-a tactic that was unheard of and unthinkable in the
Institutional investors are forcing management to search for the best
possible combination of capital and labor-in other words, achieve the
optimum investment of capital with the optimum number of workers assuring
the most profitable operation. To employ fewer workers than the optimum is
to fail to utilize fully the capital equipment; to employ more is to reduce
labor productivity and raise costs. In short, if the number of workers is
too small, company profitability will demand the hiring of more workers; if
the number of workers is too large, profitability will require that excess
labor be discharged.

Giant corporations consist of numerous company divisions, departments,
branches, and affiliates. Some are more profitable than others. Some may
even suffer losses and rely on the earnings and subsidies of the profitable
branches. An alert CEO is quick to recognize the situation-to reorganize the
loss-inflicting activity or to terminate it. He does not permit some
departments to inflict losses on the owners. To tolerate such failures would
soon lead to his dismissal or early retirement.
CEOs may reap unearned windfalls when the Federal Reserve engages in
inflationary policies that drive up stock prices. They may pocket undeserved
bonuses and exercise stock options that the Fed made profitable. Throughout
the 1990s, the Fed managed to create the greatest and longest economic boom
in American history, which drove stock prices to unprecedented heights and
some executives' pay to astonishing levels. Even mediocre CEOs could reap
unearned option profits, as the boom boosted company profits and raised
stock prices.

When boom conditions finally turn into economic recession, however, CEO
income falls as company profits may turn into losses and stock options lose
their value. During boom periods, option profits may rise to 80 or 90
percent of CEO compensation. During recessions these profits tend to vanish.
Companies may then readjust management options to make up for the fall in
stock prices. The companies have no choice but to create incentives in good
times, and especially when times are bad. Capable CEOs may choose to work
somewhere else if their options are hopelessly out of money.

Executive stock options impose no costs to the company; they are not paid
out of earnings. But they grant ownership to management, which dilutes the
ownership of all other stockholders. It dilutes the earnings and book value
per share whenever the stock options are exercised. Profit and loss
statements usually reveal the "fully diluted earnings per share," if and
when the options claim 3 percent or more of company earnings. But
stockholders rarely complain, because the options granted become valuable
only when stock prices rise to the exercise price, which benefits not only
the option owners but also the stockholders.

Options aim to keep CEO eyes on company growth and share prices-which, in
this age of political correctness, is no easy task. Powerful political and
social forces continually demand the attention of management. There are
environmentalists, civil rightists, racists, protectionists, tax collectors,
and-last but not least-labor unionists who lay claim to company earnings.
Million-dollar stock options fostering individual self-interest constitute a
powerful defense against all special interests, yet many managements fall
prey to militant demands.

The extraordinary height of some executive compensation reflects not only
the stockholders' attempt to overcome the countervailing forces, but also
some institutional obstacles to corporate takeovers and management
competition. Until well into the 1980s, corporations that were led astray by
political pressures-and consequently languished in growth and
earnings-became the favorite targets of takeover entrepreneurs.

But, during the early 1990s, many corporations succeeded in practically
closing this avenue of corporate control by adopting poison pills and other
antitakeover defenses. Their primary aim was the preservation of the firm's
current managers' jobs and income regardless of their performance in leading
the corporation.

The defensive tactics now include "greenmail," "poison pills," and "golden
parachutes." Greenmail is the premium payment to a raider trying to take
over a company. By accepting the payment, the raider agrees not to buy any
more shares or pursue the takeover any further. Poison pills are various
management moves to make a stock less attractive to an acquirer. For
instance, it may allow all existing stockholders to buy additional shares at
a bargain price after a takeover. Golden parachutes are lucrative employment
contracts to provide lavish benefits in case of company takeover resulting
in the loss of a job. They may include generous severance pay, stock
options, or huge bonuses. All such measures raise the costs of an
acquisition and cause dilution, which, hopefully, will deter a takeover bid
and keep the newcomers out.
Resuscitation of the takeover market would not lower executive pay
overnight, but it would expose all compensation packages to the fresh air of
market competition. It would surely redress the imbalance of power and
compensation, although it is unlikely that it would appease the social
critics and concerned politicians. They resent most what they envy most.
Hans F. Sennholz, emeritus professor of economics at Grove City College, is
an adjunct scholar of the Mises Institute. Send him
<mailto:hans@sennholz.com>, and see his Mises.org Archive
<http://www.mises.org/articles.asp?mode=a&author=Sennholz> and his Personal
Website <http://www.sennholz.com>.

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