As the Pay Gets Better, the CEOs Get Worse

Wall Street Letter
January 4, 2004

In his review of our book, "Pay without Performance: The Unfulfilled Promise of Executive Compensation," Tyler Cowen writes that, although our work is "thoroughly researched," he doubts the market for executive pay suffers from significant problems. ("Nice Work if You Can Get It," Leisure & Arts, Dec. 23). But our work provides evidence of problems that are significant, widespread, and costly to America's shareholders.

Mr. Cowen argues that "it could well be that on average chief executives earn their money, as shocking as that may sound." Although our research indicates that the aggregate amount paid by public companies to their top five executives during 1993-2002 was about $250 billion, our conclusion that serious problems afflict pay arrangements isn't primarily based on absolute levels of pay. Examining the pay-setting process at public firms, we found that directors have not been focusing on shareholder interests. Indeed, the evidence clearly indicates that executives with more power vis--vis directors and shareholders obtain more favorable pay arrangements.

Our conclusion was also based on the systematic decoupling of pay from performance and the widespread use of practices that obscure the amount and performance-insensitivity of pay. Mr. Cowen doubts whether a tighter link with pay could improve executives' performance. But there is evidence that executives are influenced by incentives. Moreover, the escalation of pay in the past decade has been primarily justified as needed to provide managers with high-powered incentives. If incentives don't matter, shareholders could have saved a lot of money. Mr. Cowen also suggests that even if "CEOs and boards are in cahoots," outside capital would still be approaching firms "from its own arm's-length point of view," causing firms to set good pay arrangements "to attract capital at a lower cost." But we demonstrate that market forces provide only a weak constraint on pay arrangements. As to the market for equity capital, most existing public firms finance themselves with retained earnings and debt. And even if they issue additional equity, the cost of having to sell shares at a somewhat lower price is borne mostly by public shareholders, not executives and directors.

We welcome Mr. Cowen's view that our proposals, which are aimed at making boards more accountable to shareholders and making pay more transparent and sensitive to performance, "may be worthwhile, even if one doesn't see the 'problem' that they are meant to fix." One can avoid seeing this problem, however, only by ignoring the evidence or by assuming that markets always ensure that we live in the best of all possible worlds.

Lucian Bebchuk
Harvard Law School
Jesse Fried
University of California, Berkeley
Berkeley, Calif.