How Capitalism Will Save Us (27 page)

Even in good times, it can be hard for people to comprehend the immense compensation paid to CEOs—including those as successful as Larry Ellison of Oracle. Number one on the
Forbes
2008 list of top-paid executives, Ellison received a six-year average annual pay of $71 million, and he received a total of $192 million in 2007.

Oracle, the software company that he founded, in addition to creating enormous wealth for stockholders, employs some 86,000 people. Although Oracle’s stock price has declined with the market, investors nonetheless have done well in the long term. If you had invested $100 in Oracle in 1990, it would be worth $4,000 today, despite the volatile ups and downs of the market.

Ellison created immense wealth for shareholders before the stock market meltdown. Shareholders considered Ellison a sufficiently good deal in 2008 to vote against a “say on pay” provision that would have enabled them to curtail his compensation. They decided that Ellison’s package—high though it may appear—was not an overly steep price for leadership that has produced a financially healthy company generating more dollars for salaries and jobs.

Another way to look at Ellison’s pay is to boil it down to the cost of each share of stock. Ellison’s $71 million average annual pay amounts to a cost of less than two cents per share.

CEO compensation should be viewed in terms of the billions of dollars top executives help their companies generate. Executive-compensation consulting firm Watson Wyatt calculates that the top-five executives at U.S. companies receive only about 2 percent to 3 percent of the value they create for shareholders.

Of course, not every CEO is a Larry Ellison. Few would dispute that Countrywide Financial CEO Angelo Mozilo was a miserable deal for employees and shareholders. The lender’s concentration in risky subprime mortgages was a disastrous strategic decision that led to the ultimate implosion of the company and its distress sale to Bank of America. At the bottom of the
Forbes
list of worst-performing CEOs, Mozilo ran his company into the ground while being paid around $66 million a year.

What about Robert Nardelli? Before becoming head of troubled Chrysler, he received an astounding $210 million golden parachute after being fired from Home Depot, setting off a firestorm of public outcry.

What’s going on here? Isn’t the stratospheric compensation of some CEOs the perfect example of “the rich getting richer” at other people’s expense—in this case, the bosses making a fortune at the expense of the workers and shareholders of their companies?

The real question should be “Why do these pay packages persist in spite of decades of criticism?” The reason is that despite emotional claims to the contrary, they make sense in Real World economic terms. The benefits that good CEOs can deliver are enormous and far exceed the dollar value of their compensation.

Unfortunately, CEO pay packages are negotiated before an executive takes a job and his or her performance is known. High pay can be necessary to get a talented executive to give up an existing position with enormous pay and benefits. To get a top-tier CEO to take on a risky assignment, you have to pay what he or she is commanding on the open market. That was the case with Robert Nardelli. Home Depot had to entice him to come over from GE, where he had been one of three finalists to succeed the legendary Jack Welch. Almost all of his $210 million severance package was what Nardelli would have received had he stayed at GE. Controversial Ford CEO Alan Mulally—who received $28 million in his first four months on the job—had to be persuaded to give up a highly lucrative job and successful career at Boeing.

Actually, most CEOs who get fired don’t get massive payouts. Megamillion-dollar golden parachutes are exceptional, which is why they make news. The average CEO makes about $14 million per year in total compensation—i.e., salary and the gains from the sale of stock options.
²¹
Still, for most people, this is enormous. But so is the CEO’s job. A top executive of a public company can preside over a corporation the size of an
American city. As we mentioned, Oracle has 86,000 employees. That’s nothing compared to Procter & Gamble, which has 138,000. These massive corporate communities—for that’s what they are—encompass divisions and thousands of people in countries around the globe. Guiding them requires a singular combination of skills. A good CEO needs to know far more than how to make and sell a company’s products. He or she needs to understand finance and where global markets are going. Chief executives must also communicate with countless constituencies—workers, unions, customers, and suppliers, as well as regulators and media that are constantly scrutinizing their activities. It’s more than a twenty-four-hour-a-day job.

Just as there are few people who have the skills and talent of a top baseball player like Alex Rodriguez or a singer like Rihanna, there are probably even fewer people who can run companies like IBM or P&G and do so successfully. Ford CEO Mulally, for example, aggressively downsized Ford—selling Jaguar for $2.3 billion while competitor GM was dithering about what to do with Saab and Hummer. Mulally also aggressively raised cash, both to develop new products and to give the company a financial cushion. As a result, Ford has not taken a government bailout, while GM and Chrysler were forced into government-orchestrated bankruptcies costing taxpayers tens of billions of dollars. GM has defaulted on its debts, while Ford is still making payments at this writing in the spring of 2009. While it’s unclear what the future holds, few would question that the millions paid to Mulally were a good investment not only for Ford but for the American taxpayer.

Contrary to what activists allege, CEO pay is usually not the result of executives cutting sweetheart deals with crony boards of directors. Boards today are more independent than they once were. Shareholders can—and sometimes do—hold the line on pay considered excessive.

Proof that market forces are what’s driving executive pay is provided by the fact that even higher CEO salaries are paid by private equity funds like TPG, Kohlberg Kravis & Roberts, and the Blackstone Group, firms run by veterans of corporate suites and sharp-eyed MBAs who have to answer to sophisticated clients obsessed with investment returns. American-style CEO salaries and bonuses are increasingly being paid in Europe, including in socialist France, where top executive compensation at the biggest companies increased 58 percent in 2007.

Another reason CEO salaries have gotten bigger is because American corporations have gotten larger. According to a report from the National Bureau of Economic Research, “the sixfold increase of CEO pay between 1980 and 2003 can be fully attributed to the sixfold increase in market capitalization of large U.S. companies during that period.” Why this increase? One reason is the boom in stock ownership that has taken place over the past three decades. Sixteen million American households owned stock in 1983; 57 million do so today. Thus, today’s CEOs are responsible not only for managing bigger corporate entities, but for creating more value for more investors.

Should there be caps on CEO pay? As we have said, executives command high pay because of their value in the marketplace. Corporations will therefore seek to pay desirable executives what they are worth, regardless of the efforts of bureaucrats. For this reason, past attempts by government to override the market and impose unnatural constraints on executive pay haven’t worked and have only made things worse. In 1993, President Clinton signed legislation designed to discourage high CEO pay by allowing deductions of no more than $1 million in CEO salary on corporate tax returns. What happened? Companies started paying executives with bonuses and stock options that can balloon in value. CEO pay packages grew even bigger.

A more fruitful way to exert pressure on executive pay would be to remove certain barriers to shareholder challenges to management. Hundreds of publicly held companies protect themselves against hostile takeovers with “poison pill” measures—such as making it harder to get board control by limiting the number of directors who can come up for election each year. If companies could not resort to such poison-pill measures, managers would be less able to insulate themselves from shareholders seeking to install new management. They might be more sensitive to the appearance of their pay packages.

This approach is distinct from “say on pay” measures, which give shareholders approval rights on individual executive compensation packages. Shareholders can’t micromanage companies. Businesses must have flexibility to operate day to day. If they don’t perform over time, shareholders should be able to make changes.

There’s no question that some CEOs are overpaid. But the bottom line is that CEO compensation, astonishing as it may be to some, reflects
market forces—high demand for top-level talent that’s in extremely short supply.

W
hen stories about Paulson came out in late 2007, even free-market believers wondered: How could anyone legitimately make $3.7 billion
in one year?
Could this be a spectacular case of, to use a favorite term of left-leaning economists, “market failure”—a socially destructive fluke that should not have happened and that really should be prevented?

Our reply: not only does Paulson “deserve” his $3.7 billion; his profit makes sense in Real World economic terms.