The Ethics of Executive Compensation: A Matter of Duty

June 15th, 2015 by Kara in Case Studies

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By: Aidan Balnaves-James

It is well know that executive compensation growth beats average worker salary growth. By a wide margin. The outperformance contributes to increasingly pronounced levels of income inequality. Subjective peer group referents and benchmarking, combined with ineffectual regulatory instruments, account for much of this trend, despite public anger and media scrutiny. Excessively high executive compensation linked to operational goals, induces unnecessary risk-taking and increased probability of unethical, possibly unlawful behavior. Applying deontological ethics and the concept of fiduciary duty affirms that the current structure and levels of executive compensation is indeed, unjustified.

The Purpose and Composition of Executive Compensation

Executive compensation is a form of monetary incentive for talented individuals to maximize a firm’s value (Moriarty 2009, p. 237). Executive compensation should be structured to remove conflicts of interest between executives and shareholders occurring in the principle-agent dynamic. An initial separation of management control and ownership between shareholders as principles and executives as agents establishes divergent interests. Rational agents will pursue personal utility maximization. Therefore, executives may act to the possible detriment of the shareholders’ interests (Matsumura and Shin 2005, p. 102; Lin, Kuo and Wang 2013. p. 28). Three potential conflicts of interest exist in such cases: (1) exorbitant use of perquisites by executives; (2) executive aversion to certain risks as a result of the inability to diversify such risk and (3) a deficit of attention to long-term investments and corporate goals (Matsumura and Shin 2005 pp. 102-103).

Contemporary executive compensation packages generally comprise a combination of base salary, bonuses, restricted stock, stock options, perquisites and long-term incentive plans (Jarque and Muth 2013, p. 254; Valenti 2013, p. 2). Bonuses, stock options and restricted stock function, attempt to converge the interests of executives with shareholders. These compensation features act as incentives for executives to engage in potentially risky, profit-maximizing activities, which benefit shareholders when ventures are successful (Winkelvoss, Amoruso and Duchac 2013, pp.12-13). As executives cannot diversify risk across firms, a sufficiently high level of these forms of compensation is required to attract talented candidates (Jarque and Muth 2013, p. 256).

Rising Executive Compensation Levels: Empirical Data

Executive pay has continued to rise considerably since the 1960s, as the following points demonstrate:

  • The Economic Policy Institute calculates CEO compensation grew by 937 percent between 1978 and 2013, compared to 10.2 percent for a “typical employee’s” compensation (Mishel and Davis 2014).
  • In the U.S., the average CEO-to-worker compensation ratio increased from 20 to 1 in 1965 to 295.9 to 1 in 2013 (Mishel and Davis 2014).
  • In 2013, the average compensation for the CEOs of the top 350 U.S. firms, including realized stock options exercised, was calculated at $15.2 million (Mishel and Davis).
  • The median total realized compensation for CEOs, from Standard and Poor’s top 500 companies in 2010, recorded a 35 percent increase from 2009 (Murphy 2012, p. 11).
  • From Standard and Poor’s top 250 companies, Bloomberg calculated the highest ratio of CEO-to-average-worker compensation was 1795 to 1, accorded to Ron Johnston, former CEO of JC Penney Co., totalling $53.3 million at the end FY 2012. At No. 250, the ratio was 173 to 1, accorded to William Sullivan, CEO of Agilent Technologies Inc., equalling $10.1 million (Blair Smith and Kuntz 2013).

Why Does Executive Pay Continue to Rise?

A compensation committee of independent directors is generally responsible for assessing and formulating CEO and executive compensation in public companies (Bender 2012, p. 320). There are multiple factors accounting for rising compensation levels despite a climate of public displeasure. This article proposes two major determinants. Firstly, the cogent theoretical framework of ‘leapfrogging’ is a prominent contributor to a generalised increase in executive compensation (DiPrete, Eirich, and Pittinsky 2010). Secondly, ineffective regulatory tools account for the continued upsurge in the face of public vexation. While other considerations, such as a lack of direct shareholder involvement in negotiation procedures are problematic, the primary focus is on governmental responses to public demands.

  1. Efficient Contracting, Rent Extraction or Leapfrogging?

The two predominant sets of paradigms to account for the systemic growth in executive pay are the managerial power theories and efficient contracting theories (Murphy 2012, p. 35). Managerial power theories postulate CEOs and senior executives exert power over the board of directors and compensation committees in extracting rent. Efficient contracting theories maintain executive compensation is a function of market forces (DiPrete, Eirich, and Pittinsky 2010, pp. 1671-1672; Murphy 2012, p. 35).

“Leapfrogging” theory provides a compelling explanation to account for the fluid interaction of micro and macro-level forces and key elements of both aforementioned theories (DiPrete, Eirich, and Pittinsky 2010). Leapfrogging refers to the process in which a few CEOs  during each year, “leapfrog” their peers by getting enormous raises that have little to do with the performance of their companies. Other companies then use the oversized pay of the leapfroggers in subsequent bench marks. This process ultimately pushes up pay for everyone through a contagion effect. The selection of peer groups of executives for comparing compensation schemes by committees is not an objective endeavour, but a subjective assessment. Established periodic benchmarking of compensation in firms occurs through peer group analysis. Particularly noteworthy is the “aspirational” selections of those in higher status. This leads to increases in compensation for individual executives and facilitates system-wide upswings in executive pay (DiPrete, Eirich, and Pittinsky 2010, pp. 1671, 1685-1686). “Counterfactual analysis … says that c caused e, where c and e are individual events, means that e depended counterfactually on c … if c had not occurred, e would not have occurred” (Bennett 1987, p. 368). Research on compensation practices supports leapfrogging theory with counterfactual analysis of statistics from Standard and Poor’s Execucomp database (DiPrete, Eirich, and Pittinsky 2010, pp. 1686-1705).

  1. Ineffectual regulation

Public anger has intensified concerning perceived excessive compensation in the face of increasing income inequality and economic downturn, particularly since the global financial crisis (GFC). News articles such as “CEO pay rises at double the rate of workers” (Srinivas 2014) or “91 BBC executives who are paid more than the Prime Minister” (Infante, Steere, Robinson and Creighton 2014) are frequent and elicit public fury. Opinion polls lean in favour of limiting executive pay. A Gallup poll conducted in June 2009 found 59 percent of Americans support federal government intervention in restraining executive compensation (Jones 2009).

Despite negative public opinion, the upward trend of executive compensation has not abated. Implemented reforms have been unavailing or symbolic, or they have brought about unintended consequences (Suárez 2014, p. 73; Murphy 2012, p. 11). In the United States, executive pay has been subject to a plethora of legislative and regulatory reforms since the Great Depression (Murphy 2012 p. 11). For example, in 1993 the implemented restraint of a $1 million tax deductible for non-performance linked to the compensation of senior executives led to increases in many executive salaries to $1 million. In addition, the legislation facilitated the increased use of options as a form of remuneration, since options are assessed related to performance (Murphy 2012, pp. 24-25; The Economist 2009). Mandatory disclosure of compensation practices in public companies has not led to a subsidence of executive pay growth, despite extensive disclosure requirements in the U.S. (Suárez 2014, p. 90). These include mandated disclosures in proxy statements, disclosures of perquisites, provision of details regarding share options granted in summary compensation tables, and the recent Dodd-Frank Act (Murphy 2012, pp. 12-17). The supposition that disclosing the rules could successfully pressure executives and directors to limit compensation to improve the corporate image has not actualized (Suárez 2014, pp. 89-90).

Pay restrictions following the GFC are a case in point. In 2009, the Obama administration applied restrictions to executive compensation in institutions receiving financial assistance as a result of the GFC. Executives in institutions that accepted extraordinary assistance were subject to a $500,000 salary limit (Weisman and Lublin 2009). “Golden parachute” changes in control-agreement payouts were curtailed and restricted stock prohibited from being sold so long as the institution received government assistance (Suárez 2014, p. 87; Weisman and Lublin 2009). However, direct regulations in particular institutions may reduce the supply of talented individuals, who transfer to organizations offering greater incentives (Kaplan 2010, p. 42). Regarding the banks that were in the Troubled Assets Relief Program, directly regulating executive bonuses provided incentives for self-maximizing individuals to seek executive positions at firms offering more lucrative compensation (Borland 2013, pp. 91-93). Compensation may also be increased through other mechanisms, such as income and fringe benefits (Borland 2013, p. 93). Thus, as these regulations applied only to recipients of government assistance, executive compensation has continued to rise.

Justified Remuneration or Excessive?

The Defence of Current Compensation Schemes

Proponents of current systems and levels of compensation think it is right that directors, elected by shareholders, set compensation packages according to market rates. This ensures skilled executives are employed, whose work ensures all stakeholders benefit (Pelel 2003, pp. 386-387). These executives add market value to the firm and increase returns to shareholders (Kay and Robinson 1994, p.26). For example, when Roberto Goizueta presided as CEO and chairman of Coca Cola, more than $50 billion was added in market value to the corporation. Goizueta was awarded $1 million in restricted stock (Kay and Robinson 1994, p. 26).

The use of pay-for-performance measures, such as restricted stock, stock options and bonuses, links executive remuneration to corporate profitability. This (faulty) connection is said to align the interests of principles and agents (Lin, Kuo and Wang 2013, p. 28). Correlation is evident between corporate profitability, share prices and increasing or decreasing levels of compensation (Kay and Robinson 1994, p. 26). For example, executive compensation at recipient institutions of the Troubled Assets Relief Program decreased during the Great Recession, demonstrating linkage between corporate performance and executive pay (Winkelvoss, Amoruso and Duchac 2013, pp. 14-21).

The Critique of Current Compensation Schemes

Executive compensation should be structured to attract talented managerial candidates and align the interests of executives and shareholders. Public corporations are complex entities that benefit society in their generation of wealth for shareholders, provision of employment, and production of goods and services for consumption. A sufficiently high compensation for CEOs and senior executives is therefore, justified. The question, however, is whether current levels are excessive, and whether the structure of executive pay is advantageous for stakeholders, particularly shareholders, and strategic business interests. There are cogent reasons for concluding this is not the case, as well as concerns of distributive justice. There are ther criticisms, such as the perceived complicity of directors and compensation committees in facilitating excessive increases in executive pay (Pelel 2003, p. 383). In such cases, critics call for greater shareholder control, such as binding shareholder votes and special committees, as opposed to the non-binding shareholder vote implemented under President Obama (Kothari 2010, p. 66; Suárez 2014, p. 87).

Measurements of performance derived from operational indicators exacerbate the pressure for executives to take action to maximize short-term profitability that may be antithetical to long-term survival and growth (Korathi 2010 pp. 55-57). While not explicitly tied to compensation, excessive greed in aim of short-term shareholder wealth has arguably been an underlying factor behind the GFC (Yahanpath 2011). More specifically, stock options as a large proportion of executive compensation can result in excessive risk-taking and unethical behavior (Purcell 2011, p. 7; Pelel 2003, pp. 383). Inevitably, this detracts from the wellbeing of other stakeholders.

High proportions of pay linked to equity levels, such as options and restricted stock, can encourage manipulation of short-term corporate data to ensure high earnings. In 2009, bonds were repackaged in order to augment the perceived performance of particular financial institutions (Kothari 2010, p. 59). In a study of unethical financial restatements, the proportion of share options comprising CEO compensation positively affected the likelihood of such an occurrence (Harris and Bromiley 2007, pp. 356, 362-363). Perhaps, the application of behavioral economics alongside conventional utility maximization finance theory may improve compensation schemes (Harris and Bromiley 2007, p. 352). Unethical behavior is not assured or inherent, but current schemes are flawed in their incentive design. The costs of unethical activity and failures of excessive risk-taking are placed heavily on all stakeholders and are damaging to the long-term interests of shareholders .

High compensation even in cases of substandard performance or operational failure reinforces such financially damaging behavior. Many executive compensation schemes are structured so that unsuccessful ventures still result in large payouts. These include “golden parachute” severance schemes. Successful but excessive risk-taking grants managers prodigious rewards, which in turn are the impetus for such conduct (Blinder 2009).

An analysis of 903 U.S. corporations between 2007 and 2010 finds the number of high-compensating, low-performing firms rose at a substantial rate (Lin, Kuo and Wang 2013, pp. 38-39). The provision of large executive pay packages despite poor performance and in some cases unethical behavior inherently damages the linkage of interests between shareholders and management that incentive programs are supposed to provide.

Distributive Justice

Distributive justice is also critically levelled at current amounts of executive compensation. Distributive justice examines the dispersion of material and immaterial resources, including social, economic and cultural capital in a society, and the rationales for certain inequalities (Calhoun 2002; Blackburn 2014). Income inequality is increasing across the developed world, demonstrated through increases in the Gini coefficient, a numerical indicator between 0 and 1 reflecting the distribution of wealth in a society. (The higher the coefficient, the more unequal the distribution (Bernanke, Olekalns and Frank 2011, pp. 178-179).) From 1995 to 2011, the US Gini coefficient increased from 0.36 to 0.39. In the OECD the coefficient increased from 0.30 to 0.32 during the same time period (OECD 2014). The increasing disparity between CEO compensation and that of average workers may be counted as a contributing factor (Neeley and Boyd 2010, p. 546).

Perceptions of injustice regarding excessive compensation practices can have adverse effects on employee performance, commitment, morale and organizational citizenship behavior (Neeley and Boyd 2010, pp. 548-554). Criticisms were targeted at the CEO of government-owned Australia Post, Ahmed Fahour, who earned AU$4.8 million in 2013 as 900 administration workers were sacked in 2014. By comparison, the Australian Prime Minister’s pay is AU$507,000 (Bourke 2014). Research of low to senior management and executives in 122 firms found that relative inequity in annual compensation between the CEO and lower management increased the probability of turnover (Wade, O’Reilly and Pollock 2006, pp. 532, 540). This adverse effect of pay inequity negatively impacts company performance and is antithetical to the shareholders’ interests.

The Ethics of Executive Compensation

There are multiple ethical issues with executive compensation. These include whether such compensation is excessive compared against provision of service and whether the compensation process is compromised by inadequately transparent negotiation (Perel 2003, p. 381; Moriarty 2009, p. 235). We analyse these issues using a deontological approach.

Deontology concerns the moral duties that apply to us. Accordingly there are acts we are obligated to perform or to refrain from performing to (McNaughton and Rawling 1998, 2011) comply with such duties. Thus, business activity should be pursued within self-imposed moral boundaries (Micewski and Troy 2007).

According to the deontological theory, the principle of fiduciary duty is a moral principle we are obliged to follow. We can therefore, examine the ethics of compensation using this principle. The principle-agent relationship, which is central to executive compensation, generates fiduciary duties for executives and directors to shareholders. A fiduciary duty is embodied in a relationship of trust, where the agent owes allegiance, obedience and fidelity to the principle (Strudler 2009, p. 395). A primary fiduciary duty of a CEO or executive must be acting in the best interests of the shareholders, for acting against the best interests of the shareholders would violate the fidelity owed. Directors, as elected representatives of shareholders, must also hold a similar fiduciary duty (Demosthenous 2000). Therefore, in relation to executive compensation, directors, CEOs and senior executives have a fiduciary duty to negotiate and accept a compensation package that is in the best interests of the shareholders (Moriarty 2009, pp. 236-238).

This includes short and long-term interests. Growth in the share price will increase utility for shareholders, directors and executives in the short-term. However, when this activity, such as excessive risk-taking and unethical, potentially unlawful behavior like financial misrepresentation, comes at the expense of long-term corporate viability, those operational decisions are ultimately go against the strategic interests of shareholders. If all executives and directors acted against the interests of the shareholders, the institutional structure of modern corporate business would be fundamentally compromised and unsustainable. Shareholders, as rational agents, would not invest in public companies, knowing the agent would act in a manner incompatible with their interests.

A particular fiduciary duty of CEOs is to accept no more than the minimum compensation necessary to ensure productive and effective performance in the best interests of shareholders (Moriarty 2009, p. 235). This is logically sound, for if a CEO or executive accepts more than the minimum, they are effectively detracting from the profitability of the business by increasing costs (Moriarty 2009, pp. 236-238). It should be noted that “minimum” does not mean “minute”. The minimum level can be any amount. Theoretically, this particular fiduciary duty could extend to directors and members of compensation committees. However the virtual impossibility of anyone other than the executive in question correctly determining the minimum level renders it infeasible. However, as representatives of shareholders, directors do have a moral duty to ensure decisions enhance operational and strategic corporate value. Given this duty, they must also ensure the structure and amount of compensation guarantees this. As any amount above the “minimum effective compensation” detracts from the firm’s value, the duty of directors and executives precludes exorbitant compensation (Moriarty 2009, pp. 236-238).

Current compensation schemes would be morally permissible if the voluntary actions of awarding such compensation harmonizes with the voluntary actions of all stakeholders, providing justice is upheld (Micewski and Troy 2007, p. 22). However, high amounts of compensation linked to operational goals can encourage unethical behavior to ensure continued pay levels and employment (Perel 2009, pp. 384, 386). Research linking high use of equity-associated pay, such as share options and restricted stock, to unethical behavior such as financial misrepresentation (Harris and Bromiley 2007) indicates structuring executive compensation in this way is not beneficial to long-term corporate interests. An excessive propensity for risk-taking and other detrimental actions to the strategic interests of the firm prevent harmonization of the actions of managers, directors and shareholders and thus may be declared unjust (Micewski and Troy 2007, p. 22). Therefore, excessively high CEO and senior executive compensation does not accord with the fiduciary duty owed to shareholders.

 

More articles on Executive compensation can be found at the High Pay Centre website.

 

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