Tuesday, January 24, 2012

Solving the executive pay problem

The idea that executive pay can be "too high" is a touchy issue. While many regular Joes are seeing their jobs disappear, or have been forced to endure cut backs to salary and benefits, CEO pay continues to escalate. Bonuses in the financial sector - never popular among the general public - are largely back to their stratospheric pre-crisis levels, much to the chagrin of the tax payers who funded the bailouts that kept them in business. And there is the growing chasm between those at the top and the bottom of the pay ladder that helped galvanize the Occupy movement. According to one recent study, the gap between CEO and average U.S. worker pay was 325-to-1 in 2010. In 1965, it was 24:1.

The business community, of course, continues to argue that it should have the right to determine its own remuneration levels. The global market for executives, they say, forces them to offer high salaries to attract the top talent. But stagnant performance is prompting many to question the logic of that argument. Why should companies be rewarding top executives for failure when everyone else is tightening belts?

Unsurprisingly, regulators have started talking tough. But progress has been limited. Three years ago President Obama announced that he would cap the salaries of executives of companies in receipt of TARP balilouts, yet by 2010 could do nothing to stop those companies awarding huge bonuses, judged to be "ill advised" by his newly appointed pay czar. A more systematic approach was promised with the Dodd Frank financial regulation, but efforts to rein in pay have had limited success. After much sword rattling from senior British politicians, the announcement by the UK government on January 23rd of a new approach to regulating executive pay claims to be the start of a more concerted response to the problem. The trouble is, it is not a very convincing solution. And perhaps even worse, it is not at all clear what the problem really is that they are trying to solve.

The "problem" with executive pay is that it is in fact a whole set of related problems. And each of these require different types of solutions. Income disparity between high and low earners is one thing, whereas CEOs being rewarded for poor performance is quite another. Setting the pay of bailed out businesses is yet another. And so on.

Regulators have to work out which of these problems they are trying to solve and what the best combination of regulation, encouragement, incentives, and sanctions should be to achieve desired results. Take the problem of pay disparity and those troubling pay ratios.  Blunt regulation probably isn't going to be very helpful here. For a start no one really knows what the "right" ratio should be. A maximum permitted ratio of say 100:1 may be feasible in some industries, less so in others. And as many have pointed out, the unintended effects might be that companies start outsourcing any of the low wage jobs they still have to generate a lower ratio.

Incentives, such as tax breaks for companies reaching certain thresholds, may offer more potential, although it would be technically complicated to administer effectively. A pay-ratio credits type market could also be devised whereby those companies failing to meet their targeted ratio could buy credits from those that over-achieve theirs. Much like in carbon markets, these types of systems help to even out differences across industries.

The "transparency" option trumpeted by the current UK government speaks to a more typical way of government providing the framework for corporate social responsibility initiatives. In creating a mechanism for pay ratios to be compared across companies (such as through mandatory reporting of pay, and support for some type of league tables comparing performance) governments can spur companies to improve their ranking. This avoids any necessity of setting limits or levels of acceptable performance and instead relies on competitive forces to drive improvements. As with all these incentives type approaches, it remains up to companies themselves to determine how to improve their performance, whether through increasing the remuneration of lower paid workers or decreasing that of higher paid executives. It stops regulators getting directly involved in setting pay limits and enables businesses the freedom to determine what works best for them from a competitive point of view.

Of course, there are also other less direct ways to encourage better pay equity. George Monbiot the UK journalist and environmental campaigner has recently put forward a spirited defense of a "maximum wage". Others argue for incentives or regulations to encourage increased employee share ownership among the lower paid. Such initiatives avoid the risk of companies simply "gaming" the pay ratio statistics, but also run into other problems, such as resistance from the business community and difficulties in implementation. Still, there is plenty of scope for interesting and imaginative ideas to help solve this and the other executive pay problems, and the UK in particular seems to be at a crucial tipping point in terms of public support for change.

Where the current UK government's proposals largely fall flat is in their over-emphasis on enhancing shareholder control of executive pay. For a start this does nothing directly about pay equity (which is what the public wants) but rather focuses more on the problem of whether senior executives are being rewarded for poor performance. Whilst giving shareholders more input into executive pay is not a bad thing, first you need to have shareholders that are active participants in the companies they invest in. In our dispersed ownership model of financial capitalism where shares are often held for matters of minutes, hours, and days rather than months and years, we often simply don't have sufficient shareholder engagement for such initiatives to make all that much difference. Similar rules imposed by the Dodd Frank Act in the US have done little to curb executive pay.

Clearly the time is right for action on the manifold problems of executive pay. But for those seeking to tackle them, whether in industry, government, academia, or civil society, it is imperative that there is clarity on which problems are going to be addressed. And dealing with such complex issues is going to require more creativity in terms of solutions, and more joined-up-thinking in terms of the causes of those problems, than we've generally seen so far.

Photo by GDS Infographics. Reproduced under Creative Commons Licence

Tuesday, January 17, 2012

Business Ethics enters Politics

Finally. The American establishment is talking about the issues the Occupy Wall Street movement attempted to raise since October last year: the ethics of Wall Street investors, private equity firms, the inequality of income distribution, the unfair taxation system. All these issues are now at the core of the Republican primary. Four of the five remaining contestant use those things in an attempt to stop current front runner Mitt Romney. And apparently he looks guilty on all accounts.

Mind you – let’s not get into the ethics of why these issues are brought up. The Republican base, many of them evangelical Christians, just hates Mormons such as Romney. So any argument will do to stop an heretic on his way to the White House. And while Newt Gingrich, Rick Perry and Rick Santorum are pretty much guilty of most of the things they accuse their opponent of - Mitt Romney as the Ex-CEO of Bain Capital, a private equity firm and the richest of the contestants, is just such a clear cut, stereotypical representative of the ‘One Percent’.

There are a number of reasons why this is worth pondering. The first and obvious one is that none of the Republican candidates was a strong supporter of these classic ‘Occupy’ issues. They all more or less dismissed the movement. In the primary election, in which the Republican base selects the next presidential candidate though it appears that obviously the issues have traction even with conservative voters. Whether this is an indirect result of the ‘Occupy’ movement is hard to tell. But it certainly shows that the role of Wall Street, income inequality and a tax code that favors wealthy people resonates with a far wider constituency of Americans. These issues currently, in the Republican primary, appear to be somewhat engineered and disingenuous; but they will become a core issue of the election later this year, when Romney as the most likely winner of the Republican ticket will run against Obama in the fall.

This turn in the debate is also remarkable as for the first time in a presidential race, a serious candidate with a background in business is assessed on his credentials in business ethics. Not that he is the first business person to do so: Romney stands in a long line of the likes of Mike Bloomberg in New York, Silvio Berlusconi in Italy or Sebastián Piñera in Chile - all examples of this kind of career. But it is interesting, that for the first time the ethics of a businessman-turned-politician's wealth creation is the subject of a debate on whether s/he is fit for public office. Obviously, ethical issues in business resonate with the general public more than ever before. This includes the level at which they have paid taxes, which in Romney's case with just 15% over the last years will make it very hard for him to endear him to the '99 per cent'...

This said then, the crucial ‘ethical’ issue seems to be the question whether Romney’s activities at a private equity firm resulted in job losses for the average American. This is however just a small fraction of what really is the ethical issue with private equity firms. In some ways, the rise of the private equity industry in the US (and beyond) was a result of the Sarbanes-Oxley Act, which attempted at addressing limited transparency and accountability which led to the Enron- and other scandals 11 years ago. With Romney in the race, for the first time there seems to be a real public awareness and scrutiny of what has happened in corporate America in the last decade.

While this makes one feel somewhat hopeful with regard to the potential of politics and the public sphere to not just accept the current state of ‘financial crisis’ and all that has gone along with it, it is also important to not forget about the context in which this happens. In some ways, if we judge Romney by his track record as Governor of Massachusetts – from the perspective of a liberal democracy he looks actually not too bad: as much as he denies it now, he pioneered what Obama now wants to implement as a general approach to health care in the United States. At the same time, characters like Rick Santorum are nothing short of suggesting some sort of ‘Judeo-Christian Sharia’ law, dismissing the rights of gays or women’s rights of abortion, just to name a few. The first country in the world that constitutionally separated state and religion now decides on candidates according to their faith. But that’s a whole new topic.

Picture by LWVC, reproduced under the Creative Commons License