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

Why Occupy Wall Street should occupy corporate leaders' minds

This weekend, the Occupy Wall Street protest will go global. Protests, marches and occupations are planned across the world, with almost a thousand events across every continent scheduled to go ahead on October 15th. Here in Toronto, the financial district around Bay Street is preparing for an occupation that has so far garnered more than 9000 followers on Facebook. In London, social media sites have registered more than 15000 followers for the planned occupation of the London Stock Exchange. Similar smaller scale events are in the offing from everywhere from Alaska to Auckland. Whatever the success of these protests, it is remarkable the speed at which a local event in New York which was hardly reported on two weeks ago, has now been turned into a global movement.

Although the range of issues and demands of the Occupy Wall Street campaign and its various international incarnations are many and diverse, they share a strong single point of focus. The financial sector is very much the villain here. This is in some contrast to the movement that the current events most parallel, the anti-globalization protests that took to the streets in late 1990s and early 2000s, exemplified best by the Battle in Seattle in 1999. At that time, although many of the issues were the same as those receiving attention now, the main point of focus was international finance and trade organizations such as the WTO and the IMF, and meetings of political leaders such as the G8 were major targets. Now, by occupying the financial centers of major cities, the focus is much tighter. The financial sector is public enemy no.1.

In many respects, this is not too surprising. Economies across much of the developed world have been in a constant state of crisis for the past three years. Austerity measures are biting hard. Unemployment is up. And a significant proportion of society feels excluded, exploited, and ready for an alternative. The financial sector is an obvious target because it is here that the systemic risks have been created, and it is here that so much of taxpayers money has ended up, shoring up institutions that are too big to fail. When these same organizations continue to post substantial profits, pay out huge bonuses and generally carry on as before, it is fairly predictable that they will become the focus of so much public ire.

Much of the initial response to Occupy Wall Street has been dismissive. The financial sector, which must be getting quite used to being the bad guy these days, has hardly raised a murmur in response. As of yet, we haven't seen a single press release on the events from major financial services organizations such as Bank of America, Barclays, Citigroup, Goldman Sachs, HSBC, or anyone else. Don't business leaders have anything to say about what's going on?  Don't they want to be part of the conversation? Or are they just so concerned that anything they say will just be ridiculed by the protesters, or simply set them up as even more of a fall guy, that they are fearful of trying to put their position across in public?

But big business, and big finance in particular, needs to take this seriously. Here's why.

First, because governments are looking to be responsive and populist, especially with elections around the corner in the US. That could mean tighter controls, less freedom and more regulation. As even Dominic Barton of McKinsey made clear in the Harvard Business Review earlier this year, "Business leaders face a choice: They can reform the system, or watch as the government exerts control ... there is growing concern that if the fundamental issues revealed in the crisis remain unaddressed and the system fails again, the social contract between the capitalist system and the citizenry may truly rupture, with unpredictable but severely damaging results." Better regulation might fix some of these problems, but knee-jerk regulation, borne of anti-corporate prejudice is not going to be the best fix for the capitalist system, and not necessarily the one that we need.

Second, because the protests create a great opportunity for collective action on the part of business. Problems of financial risk, executive pay and corporate lobbying aren't going to be fixed by individual company initiatives, or even by national government regulation. If one firm or one country reduces its attractiveness by, for example, controlling pay, then talent will likely migrate to more rewarding shores. If one company puts a limit on government influence, then the attention of policy makers will simply be taken up by its competitors. That's the savage logic of the global marketplace. The best recipe for meaningful change is collective action across an entire industry. Like a financial sector executive pay protocol. Or a banking industry code of practice on political influence. But to be effective these would need to include government and civil society participation and include effective monitoring and sanctions across borders. No one is pretending this wouldn't require a huge effort. But crises of trust, like the current protests, could be the context that is needed for collective action such as this to arise and prosper.

Third, because these protests clearly signal that for some proportion of the population, all the money, time and effort expended on CSR simply isn't working. And spending more isn't going to make a difference. These people are looking for a change in the system, in the rules that govern business and it's relationship with government.They're looking for more accountability, less political influence, and if their demands are for better corporate citizenship, they mean the kind of citizenship where you pay your fair share of taxes and don't just simply offshore when it suits you. This requires a very different approach to CSR than the one now predominant in the corporate sector. It means fixing attention on how to devise better rules, not how to behave better within the existing rules.

The challenge here, clearly, is a big one. Perhaps then it is no surprise that corporate leaders have been content so far to just cover their ears and hope it all blows over. But there are fundamental issues that need addressing at the heart of our model of global capitalism. Occupying Wall Street, Bay Street, or the City of London may not be any kind of solution, but that does not mean it should just be dismissed either. Business leaders would be foolish not to see this as an opportunity to create an improved system of capitalism that serves us all better.

Photo by david_shankbone. Reproduced under Creative Commons licence 

Ethics pledges, business schools, and the financial crisis

With all the talk recently of greedy bankers and guilty fraudsters, some people have been looking to business schools as a potential source of some of the problems. The New York Times recently published a stinging criticism highlighting the failure of schools to focus their students' skills and attention on anything more than short term shareholder value. Not surprisingly, it generated a lot of attention, not only in the business school community, but also among the broader readership of the paper.

Obviously schools can not be wholly to blame for sowing the seeds of the financial crisis, but the points made about the inattention to ethics and social responsibility in many MBA programs are well made. Things are changing, but there are still only a few schools (among which we'd count our own) where such critical issues have become deeply and meaningfully embedded in the curriculum. Students meanwhile have demonstrated that they are increasingly attentive to social and environmental issues. Survey evidence, growing course enrollments, and escalating membership of student clubs and competitions around CSR issues are all testament to that. Another way that this has started to surface though is in the emergence of "ethics pledges" - a growing phenomenon, particularly in the USA.


Emanating originally from Bentley University in the USA, the ‘Graduation Pledge of Social and Environmental Responsibility’ is perhaps the best known of these pledges. It is based around a pledge to ‘to explore and take into account the social and environmental consequences of any job’ that signers might consider, and commits signers ‘to try to improve these aspects of any organizations for which [they] work.’ The initiative’s website enables potential organizers to learn about how to organize on-campus campaigns, and to download posters, wallet cards, and other resources. So basically, the pledge is about sticking to your values, regardless of the various pressures or seductions of the workplace. Of course, making career choices can be hard when you want to make a difference in society. What if a potential employer seems to be offering you a great position but you’re not convinced that it shares your values? The ethics pledge aims to help students navigate these tough choices while keeping their commitments to ethics and social responsibility intact.

More than a hundred schools and colleges are using the pledge, but other initiatives have also emerged including the ‘Shanghai Consensus’ pledge organized by the China-Europe International Business School (CEIBS) in Shanghai, and for business leaders, the ‘Business Ethics Pledge’, which begins ‘I pledge allegiance, in my heart and soul, to the concepts of honesty, integrity, and quality in business.’ Unlike the other alternatives, the Business Ethics Pledge even allows you to sign electronically and start advertising your business on-line as a signatory.

As might be expected, such pledges have been particularly popular in North America and, to a lesser extent China and Taiwan, reflecting perhaps the focus in such cultures on individual level agency in business ethics. Those who subscribe to such initiatives clearly believe in the importance of personal integrity and of the power of individuals to make a difference. As the Business Ethics Pledge founder, Shel Horowitz says, ‘This is about changing the world! About creating a climate where businesses are expected to behave ethically, and where executives who try to drag their companies into the unethical swamplands find that nobody's willing to carry out their orders.’

We're not wholly convinced by this - especially since so many of the problems we're seeing today are not so much the result of individual miscreants (well, OK, maybe Bernie Madoff could have done with keeping to a decent pledge), but because of deeper level structural issues in financial markets, governance and remuneration systems, and regulatory problems. But still, when the focus of attention is so much on changing the culture of business, a good old fashioned pledge of allegiance may not be such a bad idea. After all, you've got to start somewhere. And it will certainly show those business schools that've been slow to get their ethics education together that their students mean business. Just not business at any cost.

Ethics of executive pay limits

As discussed in our last blog, executive compensation is a hot ethical issue at the moment. There's been lots of talk about the ethics of excessive salaries, especially for the Wall Street 'fat cats' and the rogue's gallery of bosses who took home big bonuses whilst their firms went looking for government bailouts in the wake of the financial crisis.

But now we have a new ethical question: what about the solution proposed by Barack Obama this week? Should we applaud Obama's proposal to limit the compensation of all senior executives at any companies receiving 'exceptional' government loans to $500,000? Has Obama's executive 'paydar' hit ethical pay dirt?

The executive pay limit has certainly stirred a lot of debate. On the one side are those that view it as an appropriate response to protect the public interest given the amount of public money that is being pumped into failing companies. Many believe that government's have moral duty to ensure that the taxpayer's money does not simply disappear into the pockets of senior executives. On the other side are those that argue that the pay limit will burden already struggling firms with an inability to attract the best executive talent. As one analyst told Bloomberg Television "No one goes into Wall Street to save the world ... compensation is the motivating factor." These folks tend to think that governments shouldn't interfere in labour markets to 'fix' wages as this leads to unnecessary inefficiencies - and can harm the very industries that the government is seeking to rescue.

From an ethical point of view, and put rather crudely, this is largely a question of principles versus consequences. But given that we're off the page at the moment in terms of the usual 'rules of the game', this is pretty much an ethical free for all. No one really can say for sure what the rights or responsibilities are of governments in situations like this because we haven't got too many precedents to work it all out from. And who knows what the consequences will be when no one is very sure at the moment what's going to happen next anyway. These are uncertain times indeed. One thing we do know though is that if the big threat looming over all this is that Wall Street will lose it's best talent because the grass is, well ... greener elsewhere, then maybe we shouldn't really be all that concerned anyway. After all, executives that have no concern for the public interest, who think that paying themselves bonuses while their employees are being laid off is good management, and who pretty much launched us into the most devastating financial crisis of our times might not be exactly the kind of 'talent' we need right now.

But from our point of view, all this ethical to-ing and fro-ing is probably missing the bigger point anyway. The real issue here is not so much the rights or wrongs of the Obama proposal itself, but the bigger message it is sending about executive compensation and corporate governance. Read between the lines and what the US President is saying is this: 'the system isn't working right, so get your act together and fix it or we'll do it for you - and you won't much like the results if we do'. And it's not just in the US - according to the FT, European governments are beginning to float similar ideas too.

Now, it is unlikely that any of these governments will step further than paycaps in bailed out institutions - after all this is where they have a more direct stake. But the writing is on the wall that they will have their eyes on deeper governance reforms if firms continue to revel in what Obama calls 'shameful' compensation deals. Smart firms and industry bodies, not to mention the more forward thinking think tanks and reformers, should be taking this opportunity to get ahead of the curve and start crafting a new moral direction for corporate governance. The deeper questions about what kinds of success should exec comp be rewarding, and how should this be structured to achieve fair rewards for all stakeholders need to be back on the front burner - and quickly so. Time is of the essence before another dirty bomb gets launched into mangled mess of Wall Street.


Photo copyright David Paul Ohmer. Reproduced under Creative Commons license

‘Shameful’.

That was President Obama’s comment on this week's news that Wall Street Bankers had been paid a total of $18.4bn in bonuses for 2008. The very banks in fact that had just received a multibillion dollar bailout package from the government, i.e. the American taxpayer. The most blatant case being Merrill Lynch (annual loss 2008: $15.3bn) which paid bonuses earlier than normal in December, just before being taken over by Bank of America with expected new government funding of $20bn.

The news came on the day when we discussed the corruption perception index of Transparency International in class at Schulich. We had a nice discussion why it is that often poor countries range high on the list and one student suggested that in poorer countries bribes are just that much more seductive as people are relatively poorer, and therefore more tempted to take advantage of a situation. But its not just poverty: comparing Sweden and Italy – countries of similar wealth one could argue – it is interesting to see the difference of more than 4 points on the 10 point scale. Italy is a more collectivist culture, where family ties and long term relationships matter more than in individualistic and meritocratic countries.

From an ethical perspective the question really is: why is it so much more corrupt to succumb to the temptations of poverty or to give preferential treatment to friends and family (earning you a bad score on the TI index) than to do what has been standing practice in business now for decades: to reward managers according to the market performance of the assets under their fiduciary trust?

These practices raise eyebrows and produce anger (one has hardly seen Obama so agitated in 2 years on the campaign trail) now where these bonuses come directly out of the taxpayers’ pockets and happen in the face of utter failure of the rewarded managers. But in our view it just exacerbates the general issue: what exactly is the ethical justification for the explosion of executive compensation particularly in the Anglo-Saxon parts of the world? Being rewarded for success – fine. But more often than not, the link between stock prices and individual managers’ performance is more than tenuous.

This ‘height of irresponsibility’ (Obama) will ask for new rules for the game. Obama will hardly avoid addressing this problem of executive compensation. Certainly in the eyes of most Americans (and the rest of us, for that matter) there is something deeply questionable about these practices. Bank of America CEO Thain has resigned over the scandal. Whether he paid back his bonus though was not reported…