amounts of market value. In global markets, the difference between a right
move and an almost right move might represent hundreds of millions of
dollars, whereas a generation ago, when the playing field was much smaller,
the difference would have been in the tens of millions. Boards reflecting
this view feel pressed by competition to seek the "very best" CEO and are
obviously willing to pay what it takes to acquire the "stars."
A CEO's compensation has, on average, been tied closely to the market
value of his or her firm. The average market capitalization of an S&P 500
corporation rose from less than $2 billion in 1980 to $26 billion in 2006.
The average market value of the ten largest S&P 500 companies in 2006
was $260 billion. CEO compensation at such large U.S. corporations reportedly
rose by 10 percent annually between 1993 and 2006,* triple the
3.1 percent annual increase of earnings of private-company production or
nonsupervisory workers. In short, virtually all of the gap between CEO and
worker pay reflects increasing corporate value driven by market forces. But
that is CEO compensation on average. Hidden in the average are a large
number of outliers. I suspect much of the visibly egregious "unearned" CEO
compensation results from the need to set executive salaries in advance of
performance. Even the most perceptive boards make regrettable choices
some of the time, and those mistakes show up as hefty compensation paid
for demonstrably inferior outcomes.
In my experience, another significant factor in excess CEO compensation
occurs as a result of a general rise in stock prices, over which the average
CEO has no control. A company's share price, and hence the value of
related options, is heavily influenced by economy-wide forces—by changes
in interest rates, inflation, and myriad other factors wholly unrelated to the
success or failure of a particular corporate strategy. There have been more
than a few dismaying examples of CEOs who nearly drove their companies
to the wall and presided over significant declines in the prices of their
stocks relative to those of competitors and the stock market overall. The
Ther e are arguably other factors in play. But global competition cannot be a major contributor
because executive salaries in Europe and Japan have not gone up nearly as much as those in the
United States. The argument that corporate boards are made up of cronies may explain the
level of corporate compensation but not its accelerated pace in recent years. Corporate cronyism,
if anything, was greater in years past.
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CEOs nonetheless reaped large rewards because the strong performance of
the stock market as a whole pulled up the prices of the forlorn companies'
stocks.*
Using stock or options to compensate top executives should require
that rewards reflect the success or failure of management's decisions. Grants
of stock or options in lieu of cash could be used more effectively by tying
such grants to measures of the firm's performance relative to a carefully
chosen group of competitors over time. Some corporations do tie the value
of stock and option grants to relative performance, but most do not.+
If the gap in CEO compensation relative to that of company workers,
which reached its widest point in 2000, resumes its increase, I hope shareholders
will look beyond their focus on investment returns and pay attention
to CEO compensation. If compensation is inappropriate, it is their
pockets that are being picked. There is no role here for government wage
control. Taxpayer funds are not involved.
I was aware of the tendency toward "excess" compensation a generation
ago. I recall a discussion of the salaries of the senior officers of Mobil
Corporation at a compensation-committee meeting in the early 1980s.
Management had hired Graef "Bud" Crystal, a well-known executive compensation
consultant, to "assist" the committee in determining appropriate
salary levels.* He put up a series of charts showing that the salaries of Mobil's
top officers were only average relative to their corporate peers'. Obviously,
Crystal asserted, Mobil would want its executive salaries to be above
average. That prompted my fellow director, American Express CEO Howard
Clark, to ask with a twinkle in his eye, "Bud, do you recommend that
all corporate executives' pay be above the corporate executive pay average?"
I chimed in, suggesting that Bud's regression analysis of competitive
executive compensation was flawed. In the end, the top Mobil executives
*An individual company's stock value competes with all others for the portfolio choice of investors.
Therefore, if one or more companies do well and their stock prices rise, the stock prices
of less well-performing companies appear more attractive, relatively. This is why price movements
of wholly unrelated stocks exhibit significant correlations.
tStock options are subject to seemingly continuing abuse, as the predating-of-options scandal
of the fall of 2006 demonstrated.
tin a reversal in later years, Crystal became a critic of the process of determining corporate
compensation.
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THE AGE OF TURBULENCE
got much but probably not all of what they had contemplated when they
sicced Bud on the committee.
But even with increasing conformity and comity in CEO-appointed
boards during most of the twentieth century dissonance did arise on occasion
to alter the direction of a company toward a better use of its resources.
Shortly before I left for the Fed, I joined the majority of Alcoa directors in
a rebellion against CEO Charles Parry who was pressing the board to elevate
chief operating officer C. Fred Fetterolf to succeed him upon retirement.
There was no question of Fetterolf s superb understanding of the
internal technical aspects of the company but a number of us outside directors
thought he lacked the broad global perspective that Alcoa was going to
need in the following decade. The dissidents, led by W. H. Krome George,
a former Alcoa chairman, and including me, Paul Miller of First Boston, Paul
O'Neill, president of International Paper, and others, met one evening at
the Links Club in New York and concluded that we had to counter Charlie's
choice of Fred with an alternative. We surveyed the table and settled on
O'Neill, my old friend and collaborator in the Ford administration. Support
from most of the rest of the board and a little arm-twisting of Paul launched
him on a very successful career as Alcoa's chairman until George W. Bush
prevailed on him to become secretary of the treasury in 2001.*
Over my quarter century as an active board member, I observed that,
among large corporations, the CEO, who chose directors, generally sought
demonstrably qualified people, often CEOs of other corporations. However,
I could not always tell if high-level boards were chosen for their knowledge
and advice or if the CEO needed to give the appearance of plurality to
what was in reality an authoritarian corporate regime. Likely, it was both.
Despite its all too obvious shortcomings, U.S. corporate governance
over the past century must have had something to recommend it. For were
it otherwise, the U.S. economy could hardly have risen to its current state
of world economic leadership. There can be no doubt that American corporate
business has been highly productive and profitable. It has been at
the cutting edge of much of the past century's technology. This, along with
my observations of a quarter century of board experience, has led me to
*In any event, Paul O'Neill was about to retire and turn over the reins to Alain Belda.
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conclude, however reluctantly that if owners are no longer the managers,
CEO control and the authoritarianism it breeds are probably the only way
to run an enterprise successfully There do not appear to be credible alternatives
to placing the power of governance in the hands of the CEO and
trusting that even his handpicked directors will hold him to task, or, if they
prove unable or unwilling, that corporate raiders will take over and revamp
management.
When the scandals broke, first at Enron, then at WorldCom, I was a little
relieved that the authoritarian nature of modern corporate governance
did not become an issue, although there was a great deal of justified concern
about the corporate abuses that authoritarianism fostered. Accounting
fraud took center stage. What everyone was about to learn was that modern
corporate accounting is largely based on a series of forecasts that do not
necessarily have to reflect a company's history. This means that a significant
part of corporate reporting involves wide discretion and, too often, is susceptible
to abuse. For example, the calculated pension liability and consequent
charges against income require a number of uncertain projections,
which offer a wide range of potential pension costs, all reasonably defendable.
A bank that receives a monthly mortgage payment cannot know for
certain until the loan is repaid in full or defaults whether a given payment
from the borrower constitutes interest or a return of principal. Depreciation
charges to reflect the decline in economic value of fixed assets are understandably
subject to broad discretion, depending on how rapidly facilities
are expected to be made obsolete by technological advance. No wonder
many corporate managements, running into competitive difficulties, tended
to favorably bias their results to the edge of outright fraud. Some clearly
went over the line. But accounting discretion can cover up only so much.
The roof eventually had to fall in. And it did.
In the aftermath of the Enron and WorldCom scandals, the power of the
corporate CEO has been diminished and that of the board of directors and
shareholders enhanced. As the scandals unfolded, the tone of board meetings
changed. When the CEO entered a board meeting in 2002, the joke went, he
wondered if the first item on the agenda would be a request for his resignation.
The dark humor darkened further. Another saying of that year was that
the average CEO spent half his time with his general counsel, discussing how
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to keep them both out of jail. Exaggeration? Of course. But dark humor is
too often very close to reality. Everyone agreed that the CEO was spending
less time productively expanding the business.
Enron and WorldCom officers' theft of shareholders' assets created a
political firestorm. An anticorporate populism had been lurking under the
surface of American politics at least since the age of the Robber Barons of
the latter part of the nineteenth century. Hastily deliberated and overwhelmingly
approved, the Sarbanes-Oxley Act became law in 2002. To my
surprise, it included useful reforms. One requires the CEO to attest that; in
his or her judgment, the company's accounts truly reflect the value of the
firm. Never mind generally accepted accounting principles (GAAP) and
Financial Accounting Standards Board (FASB) rules; forget IRS and SEC
legalisms; the question to the CEO is: Do your company's books, to the
best of your knowledge, accurately reflect the corporation's underlying financial
state?
This requirement also resolved for me the very thorny issue of whether
the principles-based international accounting standards or the rules-based
U.S. FASB and GAAP standards were a more effective way for a company
to convey its corporate results. The Sarbanes-Oxley sign-off requirement
for chief executives and chief financial officers bypassed the complexity of
such judgments. It placed the responsibility of interpretation of financial
results where it belongs. If the CEO was given the legal discretion to choose
the accounting system and held accountable for the results, the shareholders
would be best served.
But it has become clear, especially in retrospect, that by increasing the
regulatory burden, Sarbanes-Oxley has decreased U.S. competitive flexibility.
Section 404 has proved particularly cumbersome—it requires certain
accounting best practices to be enforced by the companies' auditors, who
in turn are overseen by a new agency, the Public Company Accounting
Oversight Board (PCAOB). The acronym was soon pronounced "peek-aboo,"
connoting clandestine surveillance. The new agency was not amused.
Today, after several years of implementation, few in the business community
would argue that the cost and effort of implementing Section 404,
not to mention the diversion of corporate management from business-
expanding initiatives, have created a net plus for either their company or
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the U.S. economy as a whole. Overall, Sarbanes-Oxley is proving unnecessarily
burdensome, but just as important, it is premised on certain myths
about what level of governance is achievable.
Sarbanes-Oxley has highlighted the role of a company's audit committee
and required that its chairman have professional qualifications. The implication
is that this souped-up committee will have the ability to ferret
out corporate wrongdoing, especially fraud, and present to shareholders a
more accurate financial statement than was done in the past. In my more
than eighteen years as a bank regulator, I recall very few instances of a bank
regulator unearthing fraud or embezzlement through the examination process,
souped-up or otherwise. While admittedly bank supervision isn't looking
for criminal activity, the Fed's bank examiners nonetheless twice gave
high grades to a Japanese bank branch in New York that for years had harbored
a large ongoing embezzlement. A whistle-blower finally exposed the
crimes. Indeed, very few regulators of my acquaintance can give me examples
of fraud and embezzlement unearthed by anyone other than a whistle-
