The iniquity of equity

The iniquity of equity

Seven or eight-figure salaries are no longer enough. Now senior executives need equity stakes in a company to motivate them. something is not right.

First, a proposition: Cchief executives are among the laziest, most slovenly, most delinquent individuals in our society. When not simply staring out the window, they are inclined to spend hours sleeping under their desks, working on their tans, and playing endless games of tic-tac-toe. Given the opportunity, their tastes tend towards erecting towering statues of themselves in poses reminiscent of Napoleon. Left unrestrained, they are inclined to simply give away vast sums of company money to people met at random in the street. Hmmm, you are thinking: None of this is true. The chief executives you know work incredibly hard. They have to ask their secretaries if they are still married. They last saw their children in 1994. The closest they come to reading a book for recreation is when they glance at the blurb on a Tom Clancy jacket while passing through the airport. So how can I possibly say they are essentially slothful, work-shy and feckless?

Well, here's the news. It's not me saying it; it's a reductio ad absurdum of the modern conviction, in which we all collude, that the only way to obtain an executive's total absorption and loyalty is to pay him or her exponentially greater sums.

The best brains on the consulting block have been applied to the complex and apparently unending task of making sure that chief executives are adequately motivated and incentivised, otherwise they might ... well, what exactly? Stare out the window in dejection? Go to sleep under the desk in protest? Nothing of the kind, of course.

Does anyone truly believe that chief executives would be less effective, less ambitious, less motivated were they paid half as much, a quarter as much, a 10th? If not, then it is hard to argue that they would be twice as productive paid twice as much. Yet on we go.

The fact is that we pay senior executives as much as we do, not because unassailable logic dictates it, but because it has become a social norm. We are apt to speak of the "entitlement culture" that is said to develop among welfare recipients. Yet nowhere in Australia does "entitlement culture" flourish so unrestrainedly as its boardrooms, where directors mouth a host of reassuring platitudes.

They say: Financial incentives, especially equity, inspire company performance. Except that the evidence for this is elusive. Indeed, after reviewing no fewer than 220 studies on the correlation between equity incentives and financial outperformance for the Academy of Management Journal, Dan Dalton of the Kelley School of Business in the United States decided that there was "no relationship whatsoever" between how much of a company was owned by its executives and how it did.

Likewise, a study by the US National Bureau of Economic Research concluded that most schemes to align managerial and shareholders' interests failed, and principally became means for executives' personal enrichment.

Analysing the intensive case histories that formed his best-selling Built to Last (HarperCollins, 1994) and Good to Great (HarperCollins, 2001), James Collins

stated flatly: "The idea that the structure of executive compensation is a key driver in corporate performance is simply not supported by the data."

They say: we must meet the market, because the market is always right. Except, of course, on the occasions when the market is wrong, when it overshoots, when it loses touch with fundamentals sometimes for years at a time, when the seeds of inflation are planted, when artificialities are introduced, as there are in the market for executives - full, as they are, of barriers to entry, inefficiencies, illiquidities, information asymmetries and old-fashioned superstitions.

For as Rakesh Khurana points out in Searching For a Corporate Saviour (Princeton University Press, 2002), the market for executive talent is actually an extremely restricted one, the defining attributes being chiefly three: previous position, performance of individual's previous company and status of that company.

The effect is an artificial scarcity, and a tendency to the choice of look-alikes. He states: "Restricting the CEO labour market to a select set of candidates and then pretending that the outcomes can be justified as a consequence of the market process is a self-serving conceit."

They say: we must be "internationally competitive". This is a phrase that has taken on conspicuously divergent meanings where top and bottom of the salary scale are concerned: workers are always being enjoined to price their labour to compete with the cheapest rival, even as executives seek convergence with the highest common denominator.

Imagine a tender in which the successful bid was not the lowest price but the highest. Absurd. But executive talent is a world of topsy-turvy values. No director ever says: "Hey, look at this bargain-basement chief executive we picked up." They say: "Hey, we're serious about getting the best, and we'll pay top dollar."

Or, even better: "World-class talent deserves world-class pay." One can only wonder how often the latter confers the status of the former.

Bear in mind that it was never decided that corporate executives should be paid the extortionate sums they are paid today; it was theorised, early in the 1980s, that they should be paid differently, in such a way as to align their interests with those of shareholders. Ho w to whip faceless, flaccid, unaccountable executives into shape? Why, make them owners: big ones, too, whether with management buy-outs, or through lucrative stock and option grants.

Now, imagine if there had been a theory 15 years ago that one could make a better tenant simply by giving them half of the house they occupied. The tenants would have done pretty damn well, eh? All they would have needed to do was stand around and collect, and maybe paint a bedroom, or put in new curtains, to make it look like they were honouring their side of the bargain.

But you'd have to have wondered about it from the vendor's perspective, wouldn't you? Well, that's not too dissimilar to what happened with senior executives. Although, of course, the vendors - the shareholders - actually had no say: all this was done on their behalf by a group of lodgers living in the attic who occasionally popped their heads down through the manhole to make sure the tenant hadn't set fire to the place. Also known as the board of directors.

Of course, our imagined tenant would scarcely have deserved the good fortune of their endowment during a housing boom. So how is it that executives are felt to deserve the fruits of long-running bull market cycles in equities and commodities and property?

Chief executives are not, of course, so passive as tenants, nor are corporations so easily and obviously improvable as houses, being at the mercy of a host of exogenous variables. But this makes it more complicated working out what an executive is due rather than less, and slides easily into assumptions that they are very much more capable of manufacturing superior performance than they are.

In their recent book Hard Facts, Dangerous Half-Truths and Total Nonsense (Harvard Business School Publishing, 2006), Jeffrey Pfeffer and Robert Sutton wryly recount a conversation with a senior executive from a Florida utility whose remuneration practices were determined chiefly by profitability:

"The utility's profitability, since in the short run most of its costs were fixed, depended mostly on the amount of electricity sold, and the amount of electricity sold depended on the temperature," they write. "The hotter the summer in Florida, the more power was sold, and the more profitable was the utility ... This executive noted that this incentive system made no sense - unless you believed he could control the weather in Florida."

Acceptance of the limits of executive agency is not a counsel of despair; it is a cognisance of common sense. This is for the very good reason that it was meant to be this way. The whole objective of the modern industrial corporation is to combine the many in one.

As Pfeffer puts it in The Human Equation (Harvard Business School Press, 1998): "In general, the greater the interdependence among various members of the organisation, the more difficult it is to measure their separate contributions. But, of course, intense interdependence is precisely what makes it advantageous to organise people instead of depending wholly on market transactions."

This, of course, challenges all the pieties. If holding shares doesn't make feckless managers behave like responsible owners, what will?

But, oddly enough, the lack of correlation makes a certain sense. Shareholders are not collegial. Ownership is essentially a selfish business; the fortunes of other investors are not your concern.

The historical evidence is that big shareholders have concerned themselves little with smaller ones: think of the generations of entrepreneurs who have devoted lifetimes to screwing their minorities. Why is it assumed that executives holding big clumps of stock will be any different, when they didn't even start the companies they are charged with running?

Money, moreover, is a blunt instrument for securing adherence to goals and authority. In his irreverent study of recognition and remuneration systems Punished by Rewards (Houghton Mifflin, 1993), Alfie Kohn concluded: "Rewards usually improve performance only at extremely simple - indeed, mindless - tasks. And even then they improve only quantitative performance."

To return to where I began, knowing what we do of chief executives' Stakhanovite work habits, why do we imagine that paying more will somehow extract from them greater effort, deeper insight, superior genius?

Incentives over time come to be seen as rights or entitlements, and lose their effect. To achieve continued levels of coercion means that abundance can only be succeeded by greater abundance, with a steady diminution of returns.

Australian Prime Minister Kevin Rudd's recent appeal for executive wage restraint struck many as a shot across business' bows. And if we are about to see another bout of public recrimination on executive salaries - and these customarily coincide with stock prices moving south even as remuneration continues trending northwards - there is one area in which companies look particularly vulnerable: the mouth-watering tax advantages to the "long-term incentive" component of executive remuneration.

With a bit of expert assistance, concessions offered by Section 139E of the Tax Act, originally devised to encourage employee share ownership plans, can reduce the tax payable on the equity portion of a pay package to less than a fifth.

Exercise and sell after a year, and the capital gains tax impost is 22.5 per cent. If the research on the routine undervaluation of options packages is any guide, the $600,000 average equity handout to Australia's top 300 executives is worth about $2.1 million each.

This is a lot of money obtaining preferential tax treatment, and a sizeable burden for others to bear who aren't so lucky in the structure of their pay and conditions. Even if it is assumed that executives are worth every penny, it is hard to see how they deserve tax breaks as well.

For all the belief in money's motivating power among some, furthermore, there seems little recognition of its power to demotivate others. The exorbitant rewards of a boss they do not know, never see and barely understand hardly stirs a worker to greater effort: more likely it leads to disaffection, resentment and the very "free riding" that "performance-related pay" is meant to banish.

Some have criticised modern chief executives for being too obsessed with appearances; on the contrary, they care not nearly enough. Ken Iverson of Nucor, the last American steelmaker worth the name, pointed out in his book Plain Talk (John Wiley & Sons, 1998) what seems to have eluded so many others of his rank and generation:

"The people at the top of the corporate hierarchy grant themselves privilege after privilege, flaunt those privileges before the men and women who do the real work, then wonder why employees are unmoved by management's invocations to cut costs and boost profitability.

"When I think of the millions of dollars spent by people at the top of the management hierarchy on efforts to motivate people who are continually put down by that hierarchy, I can only shake my head in wonder."

Big salaries and share packages are not merely hard to justify; they may be compromising the companies that pay them, turning the so-called "war for talent" into a campaign full of Pyrrhic victories.

Gideon Haigh is a Melbourne writer. His most recent book, Asbestos House: The Secret History of James Hardie Industries (2006), is published by Scribe Publications.

Fairfax Business Media

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