Thursday, March 19, 2009

Executive Pay

I'm a big fan of Stephen Conroy. I particularly love the story in today's SMH* in which he asked the BCA's loobyist if ay CEOs or their family members had been kidnapped - that being the great fear they all apparently had about disclosure of executive remuneration.

But executive pay really is a tough issue. It is tough first because it is based on erroneous analysis. This is the analysis attributable to Milton Friedman that executive pay needed to be aligned to shareholder interests to ensure they acted in the interests of the shareholder. This was a response to a supposed principal/agent problem, that CEOs and execs (the agents) had different motives than shareholders (the principal).

The facts of this "problem" had been detailed in a sudy by Berle and Means - who found execs did do things like grow the company's reputation because it made them look good and a whole lot of other stuff. But the error comes in assuming that the purpose of the company is "to create shareholder value". It never is.

When someone forms a new company they do so because they have seen a need in the market that they think they can fulfill, and can do so better or cheaper than someone else. To fulfill that ambition they need capital, and they convince shareholders to subscribe that capital. But the purpose of the company is meeting that market need, returning a return to investors is the price for getting their money.

Unfortunately, the motivation to create shareholder value actually sees executives mostly pursuing strategies quite divorced from that true purpose. Most particularly it feeds a motivation to monopolise markets.

Expecting boards to get tough is naive Boards won't get tough until the erroneous paradigm is removed. If the plan to kerb payouts pushes base salaries higher that is probably no bad thing - CEOs will stop engaging in strategies to manipulate stock markets and focus instead on customer satisfaction and production efficiency.

The ones to really feel sorry for as the US politicians who have to deal with the fact that companies bailed out with Government money still pay bonuses. That's because the whole idea of "at risk" pay itself has been a fraud. That and the fact that there is a labour market for executives. AIG can't trade itself out of where it is if it can't get execs. And the exec labour market is quite well informed (at the top end) about the going rate for their skills, because the disclosure laws ensure there is plenty of market information.

The big solution is to get off the "at risk" kick. It has never really worked. to align interests pay execs a share of compensation (that could be variable with performance) in the form of Zero Priced options. These should be covered by the Fringe Benefit Tax rules (valued at market at point of issue and tax paid by company). Ideally these are in a form of escrow for three to five years, the exec gets the dividends but can't sell the securities till they come out of escrow. The issued options don't "expire" on resignation - the exec remains concerned about the future of the company after they leave.

Slightly harder for non-listed companies - but actually not impossible.

* Note to the SMH - he is a Stephen with a "ph" not a "v".

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