Saving Capitalism
Page 11
3 “Income” is usually measured as a yearly flow of earnings. “Wealth” is the pool into which yearly flows of unspent income accumulate. It is usually held in the form of stocks, bonds, real estate, and other assets. Wealth also generates its own income: interest and dividends from savings and investments and rental income from real estate.
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The Hidden Mechanism of CEO Pay
Anyone who still believes people are paid what they’re worth is obliged to explain the soaring compensation of CEOs in America’s large corporations over the last three decades, relative to the pay of average workers—from a ratio of 20 to 1 in 1965, to 30 to 1 in 1978, 123 to 1 in 1995, 296 to 1 in 2013, and over 300 to 1 today. Overall, CEO pay climbed 937 percent between 1978 and 2013, while the pay of the typical worker rose just 10.2 percent.
Starting in the mid-1990s, CEOs of big companies became especially comfortable. Consider that in 1992, the average total compensation of America’s five hundred highest-paid corporate executives was $8.9 million (in 2012 dollars). Most of that came from realized gains on stock options and awards, which I’ll explain in a moment. Twenty years later, the average had exploded to $30.3 million, again including such realized gains. Even in 2009, when the economy hit the bottom of the worst downturn since the Great Depression, average CEO pay, adjusted for inflation, was almost twice its level in 1992.
Not only did CEO pay explode; the pay of top corporate executives just below them soared as well. Consider Comcast, whose formidable economic and political prowess I examined earlier. In 2012, Comcast CEO Brian L. Roberts’s total compensation was $29.1 million, according to the corporation’s 2013 proxy statement, ranking him tenth among the nation’s highest-paid CEOs. Roberts was hardly alone at Comcast. Steve Burke, the president and CEO of NBCUniversal, a Comcast subsidiary, received $26.3 million that year. Comcast’s chief financial officer, Michael Angelakis, received $23.2 million. Neil Smit, president and CEO of Comcast Cable Communications, got $18.3 million, and David Cohen, a Comcast executive vice president, $15.9 million.
The share of corporate income devoted to compensating the five highest-paid executives of large public firms went from an average of 5 percent in 1993 to more than 15 percent in 2013. Not incidentally, this was money corporations could have invested in research and development, additional jobs, or higher wages for average workers. In addition, almost all of it was deducted from corporate income taxes, which means the rest of us paid more taxes proportionally in order to make up the shortfall.
One justification is that CEOs and top executives are worth their soaring pay because the stock market has also soared during these years, and the job of CEOs and top executives is to maximize shareholder returns. Ergo, they have accomplished their mission. As Harvard economist N. Gregory Mankiw argues, for example, “The most natural explanation of high CEO pay is that the value of a good CEO is extraordinarily high.” But even assuming maximizing shareholder returns should be their goal (I’ll get back to this later), it hardly follows that CEOs are worth so much more than they used to be. The entire stock market boomed over this period. Even had a CEO locked himself in his office and played online solitaire for these three decades, his company would still have become far more valuable. Unless the company did better than the stock market as a whole, there is no reason to suppose the CEO did anything in particular to justify his escalating pay.
Besides, as noted, the stock market surge has had a great deal to do with changes in the rules that have favored big companies and major banks—stronger and more extensive property rights, especially for intellectual property; increasing market power in large firms, particularly in the form of control over standard platforms and networks (and declining market power for average workers, who no longer have strong unions negotiating on their behalf); coercive contracts that bind employees, borrowers, customers, and franchisees to one-sided terms favoring big corporations, along with insider trading, to the detriment of small investors; bankruptcy rules favoring big banks and corporations over employees and small borrowers; and enforcement mechanisms benefitting the biggest corporations and Wall Street banks. It is true that some CEOs may have contributed to such favorable outcomes through their lobbying and other political activities—making and bundling generous political contributions and offering jobs to pliant government officials—but these are not the sort of activities normally used to justify mammoth CEO pay.
So why, exactly, did CEO pay skyrocket, even though these top executives may have made no direct economic contribution to the growing values of their companies? One theory is that CEOs play large roles in appointing their corporations’ directors, for whom a reliable tendency toward agreeing with the CEO has become a prerequisite. Directors are amply paid for the three or four times a year they meet and naturally want to remain in the good graces of their top executives. Being a board director is the best part-time job in America. In 2012, the average compensation for a board member at an S&P 500 company was $251,000. In addition, boards consist of other CEOs who have considerable interest in ensuring their compatriots are paid generously. To advise on executive pay, boards typically hire people euphemistically called “compensation consultants,” whose actual roles are more akin to that of the oldest profession in the world. Such consultants typically establish benchmarks based on the pay of other CEOs, whose boards typically hire them for the same purpose. Since all boards want to demonstrate to their CEO as well as to analysts on Wall Street their willingness to pay generously for the very best, pay packages ratchet upward annually in this faux competition, conducted and directed by CEOs for CEOs, in the interest of CEOs.
Corporate law in the United States gives shareholders at most an advisory role on CEO pay. “Say on pay” votes are required under the 2010 Dodd-Frank financial legislation, but the votes are not binding on a corporation. Billionaire Larry Ellison, the CEO of Oracle, received a pay package in 2013 valued at $78.4 million, a sum so stunning that Oracle shareholders rejected it. That made no difference, because Ellison controlled the board. In Australia, by contrast, shareholders have the right to force an entire corporate board to stand for re-election if 25 percent or more of a company’s shareholders vote against a CEO pay plan two years in a row. That rule has contributed to the far more modest pay raises Australian CEOs have been granted in recent years relative to their American counterparts, in 2013 averaging only seventy times the pay of the typical Australian worker.
Such cronyism in American boardrooms has been common for decades. Although it explains why CEOs are paid a great deal, it fails to explain why CEO pay has surged in recent years. To answer this you need to understand that since the mid-1990s, a steadily larger portion of CEO pay has come in the form of shares of corporate stock, which boards have eagerly doled out to CEOs and other top executives in the form of stock options (the chance to buy shares at a given price) and stock awards (activated when share prices reach a certain level). When share prices dip, boards readily provide additional options and awards to make up for losses, so that when share prices rise again—even if the rise is temporary—CEOs can realize the gains by copiously cashing out.
This form of pay gives CEOs a significant incentive to pump up the value of their firms’ shares in the short run, even if the pumping takes a toll over the longer term. Professor William Lazonick of the University of Massachusetts Lowell has documented that a major means by which corporations accomplish such pumping is to use their earnings, or to borrow additional money, to buy back shares of stock. This maneuver pumps up share prices by reducing the number of shares owned by the public. A smaller supply effortlessly increases the price of each remaining share. In recent years, such buybacks have become a major corporate expenditure. Between 2001 and 2013, they accounted for a whopping $3.6 trillion in outlays of companies in the Standard & Poor’s 500 index.
Corporations must disclose publicly when boards have approved buybacks and the overall amounts, but they do not have to announce when they are actually enterin
g the stock market to buy back shares of stock. Buybacks are executed anonymously through the company’s broker. So share prices can rise without investors having any idea buybacks are the cause. (If they knew of the artifice, they might be less willing to buy or hold the shares of stock.) Yet CEOs can use their own inside knowledge of when the buybacks will occur and how large they’ll be in order to time their own stock sales and exercise their own stock options. Presumably, they’ll time them to coincide with the rise in share prices, which all too often is temporary.
If this sounds a lot like insider trading, or a conflict of interest with the CEO’s fiduciary duty to shareholders, it is no coincidence. Between 1934 and 1982, the Securities and Exchange Commission regarded stock buybacks as potential vehicles for stock manipulation and fraud. It required companies to disclose the volume of their buybacks and prohibited companies from repurchasing more than 15 percent of the value of their stock on any given day. But in 1982, John Shad, the new chairman of the SEC, appointed by Ronald Reagan, removed these restrictions. Henceforth, CEOs could use buybacks to manipulate the prices of their companies’ shares.
Adding to the allure of stock options was a subsequent decision by the SEC, in 1991, to permit top executives, even though technically company insiders with knowledge of the timing of their company’s stock buybacks, to quietly cash in their stock options without public disclosure. Then, in 1993, the Clinton administration decided to allow companies to deduct from their taxable income executive pay in excess of $1 million if that pay was linked to corporate performance—that is, if it came in the form of stock options and awards linked to share prices. Not surprisingly, stock options thereafter boomed.
Corporate buybacks thereafter soared because they became a ready means for top executives to pump up stock prices and cash in their stock options. Between 2003 and 2012, the chief executives of the ten companies that repurchased the most stock (totaling $859 billion) received 68 percent of their total pay in stock options or stock awards. In 2013 alone, companies in the Standard & Poor’s 500 index repurchased $500 billion of their own shares, thereby disposing of a third of their cash flow. That was close to the record level of buybacks reached in the bubble year of 2007.
Not only do stock buybacks enrich CEOs and other top executives at the expense of smaller investors who do not know about the timing or amounts of buybacks, they also drain away money the corporation might otherwise spend on research and development, long-term expansion, worker retraining, and higher wages. Every dollar CEOs “realize” from their sale of shares whose price has been pumped up by buybacks requires that many more corporate dollars be dedicated to making the repurchases. The perverse effect on corporate priorities is unmistakable. In the first three decades after World War II, major American corporations typically retained and reinvested their earnings. But beginning in the 1980s, a steadily increasing portion of corporate earnings went to share buybacks.
Between 2003 and 2012, S&P 500 companies put most of their net earnings into stock buybacks that boosted share prices—and, not incidentally, also boosted CEO pay. IBM, for example, once prided itself on giving its workers lifelong employment and making long-term investments in technologies of the future. But in the 1990s IBM shifted priorities—laying off employees, scrimping on research, borrowing heavily, and using the money to buy back its shares of stock. Between 2000 and 2013, it spent $108 billion buying back its own shares, thereby pumping up share prices even though revenues remained flat. By 2014, IBM showed signs of reaching the end of the game. As its stock price finally began to sink, The New York Times said that “all these ‘shareholder friendly’ maneuvers have been masking an ugly truth: IBM’s success in recent years has been tied more to financial engineering than actual performance.” Nevertheless, the strategy had paid off for IBM’s CEOs, whose cumulative pay between 2003 and 2012 was $247 million, mostly in stock options and stock awards.
Hewlett-Packard followed a similar formula. It, too, had a lifelong employment policy, but by the late 1990s was firing employees and from 2004 to 2011 spent $61.4 billion on buybacks—more than its entire income—followed by a $12.7 billion loss in 2012. Between 2003 and 2012, Hewlett-Packard’s CEOs received a total of $210 million, more than a third of it in options and awards. In 2013, Apple borrowed $17 billion and used most of it to buy back its shares of stock. Not incidentally, Apple CEO Tim Cook received $73.8 million in compensation in 2013, almost all in stock options that he’d presumably cash in when the buybacks had maximum effect.
Stock options and restricted stock grants have become by far the largest portion of CEO pay. Time Warner chief executive Jeff Bewkes was paid $15.9 million in stock awards and options in 2013, along with a base salary of a modest $2 million. His contract with Time Warner extended through 2017 and included a generous exit package. But Facebook’s Mark Zuckerberg takes the prize. In 2013 he cashed in $3.3 billion worth of stock options. His base salary that year was $1.
CEOs are “worth” their pay, then, in the perversely narrow sense that the prices of their companies’ shares typically rise before CEOs cash in their stocks, as they did in 2007, just before the stock market crash of 2008. Stock prices also rose to nose-bleeding heights before the Great Crash of 1929. The more pertinent question is the relationship, if any, between CEO pay and the longer-term profitability of the companies they run.
One recent study provides an answer. Professors Michael J. Cooper of the University of Utah, Huseyin Gulen of Purdue University, and P. Raghavendra Rau of the University of Cambridge studied 1,500 large companies and how they performed, in three-year periods, from 1994 to 2011. They then compared these companies’ performance to other companies in their same fields. They discovered that the 150 companies with the highest-paid CEOs returned about 10 percent less to their shareholders than did their industry peers. In fact, the more these CEOs were paid, the worse their companies did. Companies that were the most generous to their CEOs—and whose high-paid CEOs received more of that compensation as stock options—did 15 percent worse than their peer companies, on average. “The returns are almost three times lower for the high-paying firms than the low-paying firms,” said Cooper. “This wasteful spending destroys shareholder value.” Even worse, the researchers found that the longer a highly paid CEO was in office, the more the firm underperformed. “The performance worsens significantly over time,” they concluded.
In theory, companies that do badly over the longer term could claw back the stock options and awards their CEOs cashed in when the company’s stock prices were riding high. This is not unheard of. In 2013, following a disappointing fiscal year, Sony CEO Kazuo Hirai and his top executives returned roughly $10 million in bonuses. But it seems doubtful this practice will become the norm. Twenty-first-century America already has a rich tradition of moving in the opposite direction—CEOs raking in millions after screwing up royally. On the list: Martin Sullivan, who got $47 million when he left AIG, even though the company’s share price dropped by 98 percent on his watch and American taxpayers had to pony up $180 billion just to keep the firm alive; Thomas E. Freston, who lasted just nine months as CEO of Viacom before being fired, and departed with a severance payment of $101 million; Michael Jeffries, CEO of Abercrombie & Fitch, whose company’s stock price dropped more than 70 percent in 2007, but who received $71.8 million in 2008, including a $6 million retention bonus; William D. McGuire, who in 2006 was forced to resign as CEO of UnitedHealth over a stock-options scandal, and for his troubles got a pay package worth $286 million; Hank A. McKinnell, Jr., whose five-year tenure as CEO of Pfizer was marked by a $140 billion drop in Pfizer’s stock market value but who left with a payout of nearly $200 million, free lifetime medical coverage, and an annual pension of $6.5 million (at Pfizer’s 2006 annual meeting a plane flew overhead towing a banner reading “Give it back, Hank!”); Douglas Ivester of Coca-Cola, who stepped down as CEO in 2000 after a period of stagnant growth and declining earnings, with an exit package worth $120 million; and, as I have not
ed, Donald Carty, former CEO of American Airlines, who established a secret trust fund to protect his and other executive bonuses even as the firm was sliding into bankruptcy in 2003 and seeking wage concessions from the airline’s employees. If anything, pay for failure appears to be on the rise. In September 2011, Leo Apotheker was shown the door at Hewlett-Packard, with an exit package worth $12 million. The list of shameless CEOs continues to lengthen.
Meanwhile, you and I, and other taxpayers, are subsidizing all this. That’s because corporations deduct CEO pay from their income taxes, requiring the rest of us to pay more proportionally in taxes to make up the difference. To take but one example, Howard Schultz, CEO of Starbucks, received $1.5 million in salary for 2013, along with a whopping $150 million in stock options and awards. That saved Starbucks $82 million in taxes. The 1993 provision allowing corporations to deduct from their tax bills executive compensation in excess of $1 million if tied to company “performance” soon became a sham. Even Senator Charles Grassley, the Republican chairman of the Senate Finance Committee in 2006, saw through it: “It was well-intentioned,” he said. “But it really hasn’t worked at all. Companies have found it easy to get around the law. It has more holes than Swiss cheese. And it seems to have encouraged the options industry. These sophisticated folks are working with Swiss-watch-like devices to game this Swiss-cheese-like rule.”