Business at a Crossroads Leadership_3 pdf

76 Business aT a Crossroads High levels of inequality cause serious social problems. In their book, The Spirit Level, Richard Wilkinson and Kate Pickett marshal a wealth of evidence showing that social ills, including rates of physical and mental illness, teenage births, crime, obesity and violence, and rela- tively low educational performance and social mobility, all correlate much more closely with the degree of inequality within societies than with absolute levels of income. Inequality is the curse of mature, liberal capitalist societies, particularly of the U.S. and the U.K. Wilkinson and Pickett argue that instead of addressing social ills on a piecemeal basis, policymakers should focus on reducing inequality. 5 It’s not inevitable, of course, that all countries will follow the U.S. and U.K. path toward growing inequality. In Europe, there seems to be a divergence between the U.K. and southern European countries on the one hand, and more egalitarian patterns in Scandinavia and Germany on the other. Moreover, Ginis are influenced by traditions reflected in tax rates, as well as by distributions of value added within companies. It remains to be seen whether such national path dependencies (the tendency for traditional distributions of income and wealth to be maintained) will be strong enough to resist the upward pressure on national Ginis exerted by large, global corporations, organized on Anglo-Saxon lines. This book focuses on the U.S. and the U.K., however, and for these two countries, the danger is clear. We are in uncharted territory. Mature liberal capitalist societies have never been tested by such inequalities. No one knows how they will react. Protests, certainly. Riots, very possibly. Revolts and civil wars, unlikely. But there could well be a political lurch to the left, a return to some form of socialism, and a loss of market freedoms. Those who fear any such developments should be afraid. According to the U.K. Institute for Fiscal Studies (IFS) the U.K. Gini coefficient soared from 0.25 in 1979, to 0.34 in the early 1990s. “The scale of this rise in inequality,” the IFS authors commented, “has been shown elsewhere to be unparalleled both historically and compared with the changes taking place at the same time in most other developed countries.” 6 The proximate causes of riots in Brixton, London; Moss Side, Manchester; and Toxteth, Liverpool in summer 1981 were said to be racial tensions, and the heavy-handed use by the police of the “sus” (suspicion) laws. But in his report on the causes of the Brixton riots Lord Scarman suggested “complex political, social and economic factors” had created a “disposition towards violent protest.” It seems likely that among these factors was the erosion of the public’s percep- 9780230_230941_06_cha04.indd 76 09/09/2009 10:01 4 The deCadenT CorporaTion 77 tion of background fairness during a period in which inequality was rising at an unprecedented rate. The rapidly rising Gini during most of the Thatcher era (after the cuts in marginal tax rates, inequality fell in the mid-1990s) may have contributed to New Labour’s general election victory in 1997. People sensed the rich were getting richer and the fat cats in the City were coining it, resented the growing inequalities, and chose the party with the stronger egalitarian tradition. If this is what they thought, they were disappointed. After falling slightly in the early to mid-1990s at the end of the Thatcher era, the U.K.’s Gini rose again in Labour’s first term to a new peak of 0.35 in 2000–01. During Labour’s second term, it fell slightly, before resuming its growth and passing the previous peak in 2006–07. Insofar as voting for Labour in 1997 was voting against the growth of inequality during the Thatcher era, it was futile. Although there was no recurrence of inner city riots following New Labour’s signal lack of success in reducing inequality, there were rumblings of discontent. In the first of a series of articles in the Telegraph in early 2008 Judith Woods bemoaned the fate of what she called “the coping classes,” who were not in fact, as the IFS later pointed out, but felt impoverished. “While the working class is topped up with family credits and hedge fund managers cream off millions, it is Britain’s beleaguered middle earners who are under siege” claimed Woods. 7 The IFS suggested this feeling of impoverishment among people with rising and well above average incomes may have had something to do with the rapid increase in the highest incomes. The authors looked at the 99 : 50 income ratio; incomes at the 99th percentile (the top 1 percent) relative to incomes in the middle. The ratio rose by over 15 percent between 1997 and 2007 “suggesting that incomes at the very top of the distribution have grown faster than incomes in the middle … This also means, of course, that incomes at the very top have been accelerating away from incomes at the 90th percentile [which had grown at the same rate as the median income]. This may go some way to explaining the sense of injustice allegedly felt by the outwardly affluent ‘coping classes’.” Since a consensus is sustained more by beliefs than by facts, what people perceive to be the case is more important for the future of liber- alism capitalism than the facts of the case. Judith Woods’ “coping classes” are not actually impoverished, but the “millions” being “creamed off ” (interesting metaphor, see Chapter 5) by city fat cats and 9780230_230941_06_cha04.indd 77 09/09/2009 10:01 78 Business aT a Crossroads senior executives make them feel impoverished. This sense of injustice (the feeling that the background fairness that most people demand in return for their compliance with the system, which is by no means confined to the coping classes, of course) is deepened by the publicity now given to what are widely regarded as the excessive sums paid to company leaders. Ordinary people seem to have got it into their heads that city fat cats and company leaders are being paid not only hundreds of times more than the average, but much more than their “fair share”; much more than the Rawlsian difference principle allows; much more than the economic value they add. They are coming to be seen as “robber barons,” accumulating enormous wealth by means that are tantamount to institutionalized theft from the savings of ordinary people. More than fair shares The financial crisis of 2007–08 is likely to be seen in retrospect as a turning point in the evolution of liberal capitalism. The consensus that sustained the system had been undermined by the erosion of background fairness during the previous decade, but had survived because the rising tide of stable economic growth had, as promised, lifted all ships. The difference principle that required inequalities to be in the interests of the disadvantaged seemed to be working, more or less. Ordinary people may have grumbled a bit, but, by and large they trusted the putatively extraordinary people who were managing the system (the CEOs and fat-cat financiers) and toler- ated their manifestly extraordinary pay levels. Executive pay was certainly an irritant, but not a provocation. While the system was delivering the goods, most people accepted these pay packets as the going rates for the allegedly “rare skills” needed to do these vital system management jobs. It was natural that when the system crashed, the system’s managers should be called to account. The irritation with executive and fat-cat pay became indignation, bordering on outrage, when some of the fat cats and CEOs walked away with bulging pockets from the disaster they had helped to bring about. Charles (“Chuck”) Prince resigned as CEO of Citigroup, the largest U.S. bank, in November 2007, shortly before the company announced a fourth quarter loss of almost $10 billion, after over $22 billion of write-downs for subprime mortgages and consumer loans granted on 9780230_230941_06_cha04.indd 78 09/09/2009 10:01 4 The deCadenT CorporaTion 79 his watch. In a farewell statement Prince said: “given the size of the recent losses in our mortgage-backed securities business, the only honorable course for me to take … is to step down.” 8 Honorable, he may have been, but Prince was hardly destitute. His severance package consisted of vested options, deferred stock and restricted shares, and a pro rata slice of his 2006 bonus adjusted for 2007 shareholder returns. That added up to about $40 million. 9 Merrill Lynch, the “thundering herd” financial services group, was forced into a rescue merger with Bank of America after making a $7.8 billion net loss in 2007. Chairman and CEO, Stanley O’Neal, retired in October 2007 taking $161.5 million worth of securities and retirement benefits with him. 10 It was “punishments” for mismanagement such as these that led the U.S. Democrats to insist on the inclusion of restraints on execu- tive pay in legislation giving effect to the government’s $700 billion Troubled Asset Relief Program (TARP). These restrictions, which at the time of writing in early 2009 were widely expected to become a model for comprehensive federal legislation limiting executive pay in general, and reducing tax reliefs associated with it, reflected the nature of public concerns about the way senior executives were being rewarded. TARP restrictions on executive pay Outgoing U.S. President George W. Bush signed into law the Emer- gency Economic Stabilization Act of 2008 (EESA) on October 3, 2008. EESA authorized the Department of the Treasury to use a “Troubled Asset Relief Program” (TARP) to buy up to $700 billion of residential or commercial mortgages, mortgage-related securities, obligations or other instruments originated or issued on or before March 14, 2008 from financial institutions either directly or at auction. 11 In response to the concerns that taxpayers’ money might be used to enrich the executives of firms taking advantage of the TARP, EESA included provisions restricting compensation for “senior executive officers” (the top five most highly paid executive officers) and reducing associated tax deductions under the 1986 Internal Revenue Code, at participating institutions. When a financial institution sells assets directly to Treasury and Treasury gains “a meaningful equity or debt position,” the company has to meet “appropriate standards for executive compensation and 9780230_230941_06_cha04.indd 79 09/09/2009 10:01 80 Business aT a Crossroads corporate governance” while Treasury holds the equity or debt. The appropriate standards include: ■ No incentive arrangements that encourage senior executives to take “unnecessary and excessive risks that threaten the value of the finan- cial institution.” ■ The company must claw back any bonus or incentive payments to senior executives based on financial reports that later prove to be “materially inaccurate.” ■ No “golden parachute” payments to departing senior executives while Treasury holds the equity or debt. When a participating institution sells over $300 million of assets to Treasury, it cannot sign new employment agreements with senior exec- utives that include golden parachute arrangements in the event of an involuntary termination, a bankruptcy filing, insolvency, or receiver- ship, for as long as the TARP is in effect (until December 31, 2009 initially, but it can be extended until October 3, 2010). The tax code’s $1 million a year limit on the deductibility of the pay of top executives of public companies, introduced during Bill Clinton’s presidency, is reduced by EESA to $500,000 for financial institutions that sell over $300 million of assets to Treasury. The exception for performance-based rewards, such as shareholder-approved, equity- based incentive plans, is withdrawn; their income counts toward the $500,000 cap. These lower caps remain in effect while the TARP remains in effect. The tax code imposes a deduction limit on parachute payments after a change in control, and a 20 percent tax on any excess. The EESA extends these provisions to payments to “covered executives” (CEO, CFO, and the three other most highly paid officers) of companies receiving $300 million or more from the TARP, in the event of invol- untary termination of employment by the institution, bankruptcy filing, insolvency or receivership, whether or not there is a change of control. The EESA specifically states that the amounts treated as EESA golden parachute payments cannot be reduced by amounts deemed reasonable compensation in the change-in-control provisions. Here too, the provi- sions apply while the TARP remains in effect. These restrictions on executive compensation at TARP beneficiaries have been criticized for not going nearly far enough, for going so far that institutions affected will be unable to hire sufficiently talented executives, for being unworkable or easily evaded and for not defining key terms, 9780230_230941_06_cha04.indd 80 09/09/2009 10:01 4 The deCadenT CorporaTion 81 such as “involuntary termination,” “golden parachute,” “meaningful equity or debt position,” “unnecessary and excessive risks” and “appro- priate standards” for executive pay and corporate governance. Whether or not any of these criticisms have any merit, and whether or not the TARP rules effectively rein in excessive executive pay, the EESA conditions for TARP participation illuminate the concerns of Americans about executive pay in the midst of a major financial crisis and on the brink of what seemed at the end of 2008 to be an unavoid- able recession, likely to be both deep and prolonged. There were four major concerns. The first was that the incentive plans for top executives designed to reduce agency costs by identifying the interests of executives with those of shareholders, were having the unintended consequence of encour- aging executives to take “unnecessary and excessive risks that threaten the value of the financial institution” or companies in general. This was largely because the incentives were “up-side loaded” – there were rewards for outperformance, but no penalties for underperformance. Some senior Democrats, including Massachusetts congressman, Barney Frank, chairman of the House of Representatives financial services committee, want to outlaw such asymmetry. “If you take a risk and it pays off, you get a bonus,” Frank told the Financial Times. “If you take a risk and lose the company money you break even. That is a bad incentive. I don’t care about bonuses going forward, as long as we deal with deductions going backward. We have to find some way to make that a law … They can have any bonus they want as long as it’s a two-way street.” 12 The second concern was that, because incentive plans were based on numbers in financial statements over which senior executives had a considerable amount of influence, there was scope for “gaming” the plans by fudging the figures. This was why the TARP rules required participating companies to claw back incentive plan payments based on figures that later proved to be “materially inaccurate.” The third “concern,” if that’s not too mild a word to describe the indignation of many Americans at the huge pay-offs to the likes of Chuck Prince and Stan O’Neal (see above), is with the particularly provocative manifestation of upside loading, known as the “golden parachute.” Huge rewards for failure strike people struggling with the consequences of such failures as outrageous affronts to normal stand- ards of fairness. In Rawlsian terms they are gross violations of the differ- ence principle’s implicit requirement that pay should be proportionate to economic value added. TARP conditions ban new golden parachute 9780230_230941_06_cha04.indd 81 09/09/2009 10:01 82 Business aT a Crossroads contracts with senior executives of participating institutions and, at the time of writing, there’s pressure to make them generally illegal. The fourth concern revealed by the TARP rules is that, quite apart from the reckless risk-taking encouraged by the upside loading of incen- tive plans and the unfairness of golden parachutes, senior U.S. execu- tives are paid too much. This is reflected in the halving of the tax code’s $1 million a year limit on the deductibility of the pay of some senior executives of public companies participating in the TARP. The gathering storm A puzzling feature of the U.S. and to a lesser extent the U.K. debates on executive compensation is that, so far at any rate, people seem less concerned about the absolute levels of executive pay than the asym- metry of incentives and rewards for failure. Despite high and growing inequality in both countries (as indicated by their Gini coefficients), there seems to be a wide public acceptance that it is reasonable to pay “C-level” executives orders of magnitude more than ordinary employees. Graef Crystal, doyen of American executive pay commentators, takes an admirably hard line on CEO pay packets, but, as two articles on his excel- lent website in late 2008 showed, he reserves most of his scorn for high pay without high performance. He expressed disgust at the $21 million paid to H. J. Heinz Co.’s CEO, William Johnson, for 2007–08, because Heinz’s performance that year was average, but approved of the $27 million a year paid to Hank Paulson, Secretary of the Treasury in George W. Bush’s government, during his stint as CEO of Goldman Sachs, because the bank handsomely out-performed during his stewardship. 13 Leaving aside, for the moment, doubts the reader may harbor about assigning credit and blame for above and below average performance to CEOs alone, public indignation about executive pay before the crash was focused on high pay for average or below average company perform- ance, rather than on high pay itself. Possible explanations for the hitherto sanguine public attitude to very high levels of executive pay include the belief that they are actually worth what they are paid (this is less plausible and less prevalent since the crash), good public relations (calling senior executive pay “compen- sation” was a PR masterstroke), a lack of resolution in public percep- tions (an extra million or so a year is neither here nor there) and the distinctive American culture (the “American dream”) which idolizes entrepreneurs and admires wealth itself. 9780230_230941_06_cha04.indd 82 09/09/2009 10:01 4 The deCadenT CorporaTion 83 But, as noted at the beginning of this chapter, wide acceptance of the system and, in this case, executive pay, is not unconditional. The consensus must be maintained. Another million here and another million there and pretty soon you’re talking about serious money. People will notice. If they begin to believe the inequalities they’ve toler- ated hitherto are getting out of hand, or that the system is rigged, their admiration for the wealthy and successful could turn to resentment. Executive compensation was already an issue before the crash. When the chairman of the U.S. Securities and Exchange Commission (SEC), Christopher Cox, announced his review of executive pay disclosure rules, the recommendations of which were implemented in 2006, the SEC received a then record 30,000 letters from investors and other interested parties. 12 The crash, and particularly the shower of golden parachutes it ejected, heightened public sensitivity and reduced Ameri- cans’ admiration for wealth. As former SEC chairman, Harvey Pitt, said: “It is decidedly un-American to pay people when they don’t perform and don’t do the job[s] they were hired to do. It’s a huge issue that boards have not really addressed in the way they should be addressing it.” 12 This is a critical period for the liberal capitalist consensus. If board Remuneration Committees (RemCos) do not substantially rein-in Anglo-Saxon senior executive pay levels in the next year or so, popular demands for legislation imposing restrictions much tighter than those contained in the EESA could become irresistible. It will not be easy for RemCos, for political, legal and technical reasons, to achieve such a reining-in. Barriers to reform A Democrat in the White House, and a Democrat majority in Congress provide a more threatening political environment, which should, on the face of it, make it easier for RemCo reformers to insist that, if companies do not regulate executive pay themselves, legislators will do it for them. But there is still plenty of political support for, and opposition to, changes in the status quo in executive pay. Free marketeers have billed plans to reintroduce a so-called “say on pay” law, similar to those in the U.K. and elsewhere, which would give shareholders a non-binding vote on executive pay, as a left-wing bid for power in company boardrooms, and the bill itself as a gross, unwar- 9780230_230941_06_cha04.indd 83 09/09/2009 10:01 84 Business aT a Crossroads ranted intervention in the workings of the market. The original bill was passed by Congress, but got stuck in the Senate, where its sponsor was the then senator for Illinois, Barack Obama. The bill could be law by the time you read this, but some suggest fund managers who vote against pay packages designed to motivate executives to improve performance could be in breach of their duty to fund beneficiaries to maximize the value of their holdings. Given the non-binding nature of the proposed “say on pay” vote and the fairly relaxed attitude to executive pay of most institutional shareholders, apart from union pension funds and a few “socially responsible” investors, the bill was hardly a major threat, on its own, to the status quo. The opposition of American liberals to the bill probably stemmed more from philosophical, than from practical concerns. They saw it as an ominous, if minor, withdrawal of hard-won freedoms; as a small step on The Road to Serfdom (the title of an important libertarian book by the liberal philosopher and Nobel laureate economist, Frie- drich von Hayek). The vigilance of American libertarians in protecting freedoms, and opposing any developments or proposals that could be construed as thin ends of wedges leading to more state control is admirable and healthy, because it’s true that the road to neo-socialism is paved with good intentions. But better the thin end than the thick. A much more potent threat to liberal capitalism than non-binding “say on pay” legislation is the alarming possibility that, rather than moderating in the wake of the crash, for technical reasons relating to options, executive pay could explode again as equity markets recover. When compensation consultants are asked to recommend pay deals for top executives, their normal practice is to identify a “comparator group” of companies of a similar size in the same industry, trade infor- mation with the comparators on total pay, including the value at grant of stock options (estimated with the Black-Scholes model) for the posi- tions concerned, and make recommendations based on the RemCo’s brief. This could be the average for the comparator group, or, if a client wants a reputation for paying well, a higher point in the distribution, such as the 75th percentile (the top quarter). Options are important components of pay packages, because they are seen by investors as identifying the interests of executives with those of shareholders. But a key variable, when estimating Black- Scholes present values, is recent share price performance. If the company has performed well and its share price is high, the Black- 9780230_230941_06_cha04.indd 84 09/09/2009 10:01 4 The deCadenT CorporaTion 85 Scholes value of options will be high on date of grant. This leads to the perverse result that, if the desired position within the comparator group is to be maintained, fewer options can be granted when the company’s share price is high. Apart from making a mockery of the putative incentive effect (when a share price is high, it’s likely to be harder for the CEO to get it higher, so more options are needed to maintain the incentive), this has alarming implications for executive pay rises in the next year or so. We have seen why fewer options can be granted when the share price is high. The reverse is also true. In the absence of agreement between companies to moderate option grants, more would have to be granted when the price was low, if the desired position within the comparator group is to be maintained. Since all share prices plummeted during the 2008 crash, the normal practice for compensation directors and consultants, would be to recommend grants of very large numbers of options in 2009. If, as expected and fervently hoped, equity markets recover over the next few years, these will become very valuable and cause executive pay to rocket. As Crystal put it: “If you think ordinary Americans are pissed now over high executive pay, fasten your seatbelt.” 13 The executive pay explosion may be even larger if RemCos decide to compensate executives for the fact that so many of their pre-2008 options are “under water” (worthless), by granting them even more options than Black-Scholes values may suggest. The same applies to grants of restricted shares that “vest” after a specified period, which have become popular recently for motivating and retaining executives. Extra large grants of restricted shares to compensate for losses on those granted before 2008 will also supercharge pay in recovering equity markets. There’s a ratchet at work here. When markets tumble, Black- Scholes calculations and RemCos anxious to retain executives whose options are worthless and whose restricted shares are worth much less, sow the seeds of another executive pay explosion during the subsequent upswing. A dangerous decadence Although to understand the calculus of executive compensation, is to have some sympathy with the RemCo’s dilemma, it should be clear to company directors, who in their executive roles are among the greatest 9780230_230941_06_cha04.indd 85 09/09/2009 10:01 [...]... considerable venom and indignation It is usually left at that Today’s breathtakingly high levels of senior executive pay are explained as the products of a character flaw that afflicts the tiny fraction of the population who succeed in climbing to the tops of corporate ziggurats There are three implied assumptions in this explanation – greed is bad; greed is unnatural; if others with natural appetites ran... actual pay rate is not the market clearing rate (it may be higher or lower) and, on the far from heroic assumption that it’s higher, sheer unnatural greed is not the only explanation for it It’s one thing to allege a market inefficiency, however, and quite another to demonstrate and describe it 92 Business at a Crossroads Asset-skimming Years ago when I was a young financial journalist I wrote a letter... was the arrival of a new (to most CEOs at the time, at any rate) and, it transpired, influential idea about how companies should be managed It came to be known as “shareholder value” and was, initially, not so much a prescription for a company leader, as a description of how markets valued companies Jack Welch, CEO of U.S giant General Electric (GE), is usually said to have been the first CEO of a. .. Performance.5 It became the bible for a new generation of company leaders dedicated to the maximization of shareholder value I found and still find the idea that the sole purpose of a company is to maximize shareholder value, in the form of capital gains and dividends (“total shareholder returns”), very appealing It seems to me to be true, in the sense that the share price of a company that has a purpose... their explanation; namely, that these rewards are the creatures of capitalism itself, or rather, of the interactions of natural human impulses with the capitalist system Their proposition is that the freedom to indulge our natural human impulses within a free market system leads, inevitably, to huge disparities in income and wealth and such disparities, and the sense of unfairness they foster, are the... to an estate agent who had just sold my mother’s house I was very rude I told the agent that, for a deal in which an aggressive and unscrupulous buyer had “reverse gazumped” my mother (unilaterally reduced the agreed price) the day before she went on holiday, his fee for printing a few brochures and attending a few viewings was much too high I went on to say that what irritated me most of all was that... money, and although a pejorative implication is most certainly intended, it’s arguable whether it’s warranted In the 1987 film, Wall Street, Gordon Gekko, the anti-hero played by Michael Douglas, said in a speech at a general meeting of a company he was planning to acquire that greed was good In the film, this was merely a disingenuous apologia for avarice, cobbled together for the “good prevails over... compared to the average U.K employee’s pay of £24,000 That means the average FTSE 100 CEO was paid 117 times more than the average employee You have to take care with the figures, because some analysts with axes to grind count options when they’re granted (at Black-Scholes 96 Business at a Crossroads values) and when they’re exercised, and so end up with much higher ratios than the EPI’s But all the... of a major company to adopt shareholder value as a fundamental strategic objective, but there were several precursors, including James (later Lord) Hanson of Hanson Trust, who employed shareholder value strategies before they became known as such Alfred Rappaport provided the intellectual basis for the shareholder value revolution in his 1986 book Creating $hareholder Value: The New Standard for Business. ..86 Business at a Crossroads and most conspicuous beneficiaries of liberal capitalism, that the system needs yet another executive pay explosion over the next few years like it needs a hole in the head But they can’t see the wood for the trees They are locked into a comparative, rather than an absolute, way of looking at executive pay They do not want to be too generous relative to their peers because . and the addition of adjectives such as “sheer,” “breath- taking” or “insatiable,” all of us can spit out with considerable venom and indignation. It is usually left at that. Today’s breathtakingly. called to account. The irritation with executive and fat-cat pay became indignation, bordering on outrage, when some of the fat cats and CEOs walked away with bulging pockets from the disaster. This also means, of course, that incomes at the very top have been accelerating away from incomes at the 90th percentile [which had grown at the same rate as the median income]. This may go