Lately, a hot and controversial topic of discussion has been CEO compensation. Some find it excessive, some think it is justified. The CEO compensation has been historically high. Indeed, they are the locust of power in the company, and therefore they should be entitled to higher pay. However, their compensation has always been many times larger compared to salary of an average employee. As of today, for instance, the CEO-to-worker compensation ratio is on average slightly over 200. Are the CEOs overpaid? What is the acceptable compensation if they really do receive excessive pay?
Since 1980s the CEO compensation has been rapidly growing. As a matter of fact, it was the stock-option-based pay that grew the most. The salary portion of compensation has remained relatively unchanged over the course of almost 30 years, according to the Table I. However, the stock-option pay has increased significantly over the past years, up until year 2000. Afterwards it remained fairly unchanged to the present day, with some fluctuations. It might seem reasonable, that the larger part of CEO pay is comprised of stock-options. Indeed, tying the compensation to company performance is in the best interest of the firm – it only seems logical and pragmatic. However, this logic takes primacy of shareholder interests as a main premise, taking an approach advocated by Milton Friedman and his followers. Although stakeholder vs. shareholder debate is not a focus of this writing, it is an issue and will be touched upon later. The CEO compensation, in its current amounts, is by itself a huge concern, in spite of the stakeholder vs. shareholder argument.
Besides income disparity, high CEO pay is also associated with other issues. Some of them are the impact on the company’s performance and ethical implications of such huge compensation. The proponents of CEO high pay argue that they are worth every single penny they receive. This view is articulated very well by notorious Al Dunlap:
The best bargain is an expensive CEO . . . . You cannot overpay a good CEO and you can’t underpay a bad one. The bargain CEO is one who is unbelievable well compensated because he’s creating wealth for the shareholders. If his compensation is not tied to the shareholders’ returns, everyone’s playing a fool’s game.
(qtd. in Perel 381)
Once again, the argument supporting the extremely high CEO compensation seems quite reasonable and rational. Aligning the interests of shareholders and executive officer could easily be the best solution to ensure good performance for the firm. However, could such simple, almost ideal, solution work as intended? The opponents say that the amount of compensation CEOs get is simply unreasonable and there is simply no basis for such decision. Mel Perel suggests that “much of ethical misconduct during the latter half of the 1990s can be blamed on excessive incentive packages offered to CEOs” (Perel 381). However, could we blame the CEOs themselves? Perhaps not, since top managers do not have authority over compensation-committee. In order to assess whether the CEO pay is excessive, we might have to reach into other factors, one of them being the board of directors. Additionally, the Nozick’s and Rawls’s theories of distributive justice seem as appropriate supplements in determining whether the CEO incentive package size is ethical from justice and fairness standpoint.
Let us just assume for a moment that stockholders ought to be the main recipients of CEO’s miraculous work. As mentioned earlier, the way to align shareholders’ and CEO’s interest is the usage of stock-based compensation. Indeed, the major part of executive plan is comprised of stock-options, according to the data above. The idea behind option-based compensation is simple and almost perfect. Individuals that invented option-based pay definitely strove to achieve a beautiful and reductionist model – one that often does not reflect irrational or emotional behavior. Furthermore, the theory behind equity compensation is not supported empirically. “The conventional belief in determining CEO compensation is that a correlation exists between compensation and company performance” (Perel 382). However, “…only a small percentage of the variation in compensation among CEOs could be explained by a change in the financial performance” (Perel 382). If there is no real correlation between the pay and end-result then is it fair to overpay top executives? What is compensation based on then if not on performance metrics? As a matter of fact “40% of variation in CEO pay was statistically correlated to variations in the size of their organization” (Perel 382). In addition, “it seems that regardless of the type of compensation system (performance or behavioral), CEOs are rewarded based on organizational size” (Stanwick and Stanwick). Size of the company is clearly not a performance metric, nevertheless it correlates with compensation. CEOs are receiving huge compensation regardless of their effectiveness and results they achieve, and therefore the company might receive little in exchange for a huge chunk of money paid. Hence, the data suggests that excessive CEO compensation violates Nozick’s principle of justice in transfer, which also states that the transfer of holdings by means of theft is unjust (242-243). Rawls would also find the CEO pay unjust, based on data. Inequality in this case does not favor the society, since CEOs, the endowed ones, do not use their resources to help the least favored (Rawls 218).
In addition to the empirical data, the option-based compensation basically implies transfer of shareholder wealth to CEO. Therefore, in order to satisfy Nozick’s demands for justice in acquisition or transfer, top manager should be entitled to less of stockholders’ money if the expected results are not achieved. Otherwise it would be plain embezzlement, which results in unjust distribution of goods – capital in this case – and unjust system as a whole. It is important to note that, according to Nozick, in order for the distribution to be just, it would be sufficient for the option-based compensation system to adjust the pay according to performance. However, we have to remember that the huge stock grant might induce executives to resort to questionable or even illegal tactics to increase the stock-price. The story of Enron reflects this issue incredibly well. Al Dunlap is also a user of questionable practices, as seen in the Frontline documentary “Bigger than Enron”. It is simply unreasonable to discount human greed, as the enormous CEO compensation offers irresistible temptation. If we factor in human nature, the CEO massive stock grant is indeed unjust according to Nozick’s theory of distributive justice. In case the above argument is not convincing enough to prove the unjust nature of lavish CEO grants, the following issues has to be considered. The massive amounts of stock options dilute a company’s value. Hence, the firm has to repurchase the shares whenever employees exercise the options, in order to minimize dilution. The funding for repurchase comes either from internal reserves or debt. In first case the company reduces its value, while in second it takes upon more leverage. Either way compromises interests of shareholders (Perel 385). Since the firm and shareholders are different entities, CEOs steal from both the firm and its shareholders. Nozick would unlikely find this compensation system just.
Rawls, in response to the same issues in the previous paragraph, would also find the CEO compensation system unjust, but due to slightly different reasons. As mentioned earlier, inequalities, according to Rawls, must benefit the society. His theory of distributive justice lays out several principles of a just society, one of them being Difference Principle, which particularly addresses the inequalities in the way described in the previous sentence (Rawls 214, 217-218). Lavish stock-option compensation plans reduce the value and drain resources of the firm. Therefore, CEOs, being endowed, diminish the company’s ability to function. Hence, the firm is less capable to serve its stakeholder parties, one of which is the shareholder group. As a result, stakeholders, who are less favored in comparison to CEOs, do benefit less from actions of better endowed ones or even harmed in some cases. Hence, the enormous CEO pay would be considered unjust in accordance with Rawls’ theory of distributive justice.
Although the option-based compensation is a significant justice issue, it is not the only one. Another aspect of CEO compensation system that could raise concerns is the incentive package control mechanism, namely board of directors. The board is an entity that has ultimate decision authority for approving CEO compensation (Perel 382). Despite being an overseeing and controlling mechanism, the board of directors often sides with top management, rendering the board’s existence and purpose unnecessary. Nader et al. wrote of corporate governance:
The board of directors … are required … to manage the business and affairs of the corporation. On behalf of the shareholders, the directors are expected to select and dismiss corporate officers; to approve important financial decision; to distribute profits. … In reality, this legal image is virtually a myth. … One man … or a small coterie of men rule the corporation. Far from being chosen by the directors to run the corporation, [the CEO] chooses the board of directors and, with the acquiescence of the board, controls the corporation.
(qtd. in Perel 382).
In order to clarify, it is important to note that the CEOs do not always have a full control of the board. Nader’s description is definitely hyperbolic to illustrate the worthlessness of the board in many cases. The board of directors often either consists of insider directors, who are individuals affiliated with the firm, or does not possess the critical skills for incentive package assessment (Perel 382). The presence of insiders on the board is already an unethical attribute. Board is supposed to critically assess the skills of the CEO and his or her worthiness. Basically, the board’s interest has to balance the CEO’s ambitions, which in turn would lead to a reasonable decision regarding compensation package. However, if the CEO has allies on the board, the system of checks and balances is undermined and cannot adequately lead the decision-making process to the rational equilibrium. Additionally, the presence of inside directors on the compensation committee “motivates them to structure compensation packages in the best interest of the CEO and not necessarily in the best interest of the organization as a whole or its shareholders” (Perel 384). Hence, the compensation amount often depends on some subjective factors, and therefore cannot reflect the true value of executive services. As mentioned earlier, Nozick argues that the process of transfer that involves theft cannot be considered just. Additionally, Nozick emphasizes the importance of goods exchange in the process of just transfer. The insider directors are very unlikely to structure the incentive package in a just manner. In other words, the services of the top executive might not simply be worth the amount of compensation he or she receives. Hence, executives, who take advantage of the insider’s presence to enrich themselves, are not entitled to part of the compensation, perhaps the major part. Furthermore, CEOs richen themselves at the expense of shareholders, as discussed earlier. Top managers are, ultimately, stealing from their shareholders by taking unfair advantage.
What would Rawls say about the board insider issue? Firstly, part of the Rawls’s second principle of justice states that “social and economic inequalities are to be arranged so that they are … attached to position and offices open to all” (Rawls 214). Everybody would agree that the top executive position is definitely a position strongly associated with inequalities in the society, and therefore Rawls’s Second Principle of Justice can be appropriately applied to the assessment of CEO pay. Rawls would not be particularly concerned with the presence of insider directors on the board, since the CEO position is theoretically open to everyone. However, one of the attributes of the job position is the salary; and the compensation opportunities are not open to everybody, due to the subjective factor such as presence of insider directors. Moreover, Mel Perel has revealed that boards tend to hire celebrity CEOs from outside of the company due to various reasons. Khurana noted that boards “routinely bypass thousands of internal candidates for the ninety or so CEO positions that come open in a given year” (qtd. in Perel 383). In the problematic company internal candidates for CEO position are thought to represent the “old” and inferior culture, whereas the external candidate is thought to bring new ideas and some fresh air. Additionally, the celebrity CEO is able to cover the flaws of the company and increase the stock price by his or her sheer reputation. The market for celebrity executives is fairly limited, while the demand is extremely high. This leads to extreme price on each star-CEO. Therefore, the group of people, who could potentially receive the enormous compensation, is quite limited and not open to everyone, violating one of the Rawls’s justice principles.
So far the argument has stayed within borders of shareholder primacy theory. If we expand the reach of the debate to the stakeholder domain, many other issues would arise. However, looking at the excessive CEO compensation issue from the stakeholder perspective uncovers different ethical concerns, some loosely related to the distributive justice theory, others in completely different domain. Nevertheless, despite staying within limitations of shareholder theory, we were still able to reveal ethical issues with the enormous CEO compensation. By applying Rawls’s and Nozick’s distributive justice theories, we came to conclusion that the excessive executive incentive package causes the unjust distribution of goods in society.
What could be the solutions to the present problem with top management pay? It is important to note that ethical issues arise not from the gigantic compensation amount, and therefore simply lowering the pay would not necessarily deal with the ethical concerns. As a matter of fact, the solutions should target the compensation system itself and the control mechanisms, namely the compensation committee and the board of directors. Alas, no complete solution exists at the moment. However, the difficulties should not hinder our ability to explore different directions in quest for the solution to the problem. Since stock-option compensation is one of the unethical epicenters, it is reasonable to address the compensation system. One of the possible solutions, which is actually in use today, is implementation of Long-Term Incentive Plan (LTIP). LTIP is a reward system designed to improve employees’ long-term performance. In a typical LTIP, the executive must fulfill various conditions and/or requirements. The incentives for doing this are usually conditional company shares, which are distributed in two parts. The first part represents an immediate distribution of half of the shares, while the remaining half of the shares will only be presented to the executive if he or she stays with the company for a predefined number of years. Empirical evidence since 1970 has supported the usefulness of LTIP, especially in the stakeholder-oriented companies (Arora and Alam). Mel Perel also suggested in his article fairly radical solutions. One of his suggestions is to impose a “salary cap” to limit CEO compensation. This method of control is somewhat similar to the salary limitation in several major sports leagues. Another solution, proposed by Perel, ensures the independence of the board. All directors have to external, therefore limiting conflict of interests, and have to be appointed through a process regulated by SEC. However, it is impossible to ensure the independence of external directors, since top executives might still bring their friends and allies from outside of the company.
All in all, the debate over the CEO compensation excessiveness has been present for couple of decades, and will probably be around in the near future. Society is slowly arriving at ideas and incomplete solutions, which eventually will resolve the debate. However, the difficulties are mainly associated with implementation of the ideas. Alas, the recipients of ginormous compensation packages also happened to have a lot of power and authority.
Fahlenbrach, R. “Shareholder Rights, Boards, and Ceo Compensation.” Review of Finance. 13.1 (2009): 81-113. Print.
Perel, Mel. “An Ethical Perspective on Ceo Compensation.” Journal of Business Ethics. 48.4 (2003): 381-391. Print.
Stanwick, Peter A, and Sarah D. Stanwick. “Ceo Compensation: Does It Pay to Be Green?” Business Strategy and the Environment. 10.3 (2001): 176-182. Print.
Arora, A, and P Alam. “Ceo Compensation and Stakeholders’ Claims.” Contemporary Accounting Research. 22.3 (2005): 519-548. Print.
Rawls, John. “Chapter VII Rawls: Justice as Fairness. A Theory of Justice” Justice: A Reader by Michael J. Sandel. Oxford: Oxford University Press, 2007. Print.
Nozick, Robert. “The Entitlement Theory.” Anarchy, State, and Utopia. New York: Basic, 1974. Print