Should Congress Regulate Executive Compensation?

An editorial in the NYTimes from Sunday asks the intriguing question whether Congress should regulate executive compensation.  The answer that it provides, however, is disappointing and reflects a misunderstanding of many aspects of corporate governance.

The editorial, written by Robert Frank, an economist at Cornell, concedes that a problem exists.  As he notes, "executive pay in the United States is vastly higher than necessary. Executives in other countries, whose pay is often less than one-fifth that of their American counterparts, seem to work just as hard and perform just as well.  The same was true of American executives in the 1980s."

Despite recognizing the problem, the editorial goes on to reject any solution.  It does so by providing a single, untenable solution, then criticizing the solution.  The editorial notes that one possibility is a cap on salary equal to 20 times its average worker’s salary.  Doing so will reduce the pool of talented executives.

• The problem is that although every company wants a talented chief executive, there are only so many to go around. Relative salaries guide job choices. If salaries were capped at, say, $2 million annually, the most talented candidates would have less reason to seek the positions that make best use of their talents.

Moreover, they may go elsewhere.  If "C.E.O. pay were capped and pay for other jobs was not, the most talented potential managers would be more likely to become lawyers or hedge fund operators."  

It is, of course, highly doubtful that those wishing to run a business would collectively opt to become lawyers.  But even if true, the argument is unrefined and not a basis for entirely rejecting a cap.  Compensation needs to be high enough to attract a sufficient pool of talent.  If 20 times the average worker is not enough, then the multiplier should be increased.  After all, there is a lot of room here.  In 2006, the average salary for CEOs was 364 times the amount of the average US worker.  Presumably some multiple less than 364 would be sufficient to attract the necessary pool.

The editorial apparently prefers to allow compensation to be determined by the market.  It answers criticism that these markets are not competitive because the board is packed with the CEOs friends because "C.E.O.’s have always appointed friends, so that can’t explain recent trends."

This is of course not an answer at all.  First, board compostion has changed dramatically in recent decades.  There is a higher percentage of independent directors who are paid lucrative amounts and have every incentive, whether friends or not, to avoid disappointing a CEO.  In other words, they have every economic incentive to provide the CEO what he or she wants. 

More importantly, the editorial ignores the shift in the law arising out of Delaware.  Courts in that state, which determine the law for most public companies, have gradually weakened the standard of review for executive compensation decisions.  Thus, directors can pay top officers excessive amounts and have little fear of liability.  This has effectively resulted in a legal standard that imposes no meaningful limits on executive compensation.  These are discussed in greater detail in the paper, Returning Fairness to Executive Compensation.

What should be done?  The simple solution would be to leave compensation in the hands of directors but impose greater obligations on the board in determining compensation.  In short, the ideal solution is not a cap but overturning the standards imposed by the Delaware courts on directors.  It would be sufficient to provide that in determining the compensation for executive officers, the board had the burden of establishing that the terms of the compensation were fair to the corporation and that directors would be personally liable for any compensation found to be unfair.  A definition of fairness might include a standard that provides that compensation will be reasonable if equal to or less than what a third party would obtain through arms lengh negotiations.

This standard would be broad and allow compensation to vary with the circumstances.  But by making directors personally liable for any excess, it will induce boards to only pay an amount that directors can objectively justify.  This would be a massive improvement over the current system, with directors able to pay any amount without having to show that it was fair.