THE handsome annual compensation packages and generous bonus payouts to company chief executive officers (CEOs) - be it in the United States or Singapore - have been constantly in the news over the past few months.
Do the chiefs of big companies deserve such large sums of money to compensate them for their efforts in managing and growing the business? Some critical thinkers say that there has been a failure of the markets in regulating the pay of top CEOs.
In an ongoing Business Times-Nanyang Business School Roundtable discussion series, senior professors at Nanyang Technological University's business school dissect the issue of CEO compensation and provide insights into how such payments are arrived at and examine if the payouts can in fact be justified.
Panellists:
Dr Jun-Koo Kang, Distinguished Professor of Finance, Nanyang Business School, Nanyang Technological University
Dr Nilanjan Sen, Associate Dean, Nanyang Executive Education; Director, Nanyang Fellows Programme and Associate Professor of Finance, Nanyang Business School, NTU
Dr Wei-Lin Liu, Associate Professor of Banking and Finance, Nanyang Business School, NTU
Dr Suman Banerjee, Assistant Professor of Banking and Finance, Nanyang Business School, NTU
Moderator and writer: Narendra Aggarwal, Director, Public Affairs, Nanyang Business School, NTU
Moderator:
There has been a lot of hue and cry over the huge compensation packages and generous bonuses paid to CEOs of listed companies. Is this public outcry really justified?
Dr Nilanjan Sen:
As the owners and managers of companies can be different groups, the managers' compensation has to be set out in contracts to give them the incentive to perform well.
It is clear that owners, or shareholders, would like the managers to take some risks to derive the best value for their money. If they did not want the managers to take risks, they would have simply put their money in government treasuries.
Incentivising managers for taking risks to grow the business is necessary, as, without such incentives, the managers would simply be too cautious because if something goes wrong with the business, their own job would be on the line.
However, compensation contracts for managers in certain situations may have provided adverse incentives for too much risk-taking in the short term for maximising the value. The public perception is that managers take too much risk without having to pay for it if something goes wrong.
The supply of the top class managerial pool is very limited. So they enjoy an unfair advantage due to the inefficiency and are not adequately disciplined for their failures in the labour market. There are also certain data lag issues.
This year's bonus may not be a complete reflection of the current year's performance. The compensation structure that determines the bonus is often not explained properly.
There is a communication lag. I feel that once there is a better explanation of how the CEO compensation package was arrived at, investors will have a better understanding and appreciation of the remuneration structure.
Dr Jun-Koo Kang:
There are two issues in CEO compensation contracts. One is how much the CEO has to be paid and the other is the pay-performance sensitivity, which is how much his salary increase is to be based on the performance.
Now, most of the media attention is on how much the CEO gets paid, say $100 million and so forth. But I think the attention should not be paid too much on this absolute amount because the amount can increase easily with size.
Small companies pay less, but as the size increases, the bigger the company, the bigger the absolute payment can be made to the CEO.
The more important issue in my view, is to consider the pay-performance sensitivity. The question really is how to measure the CEO's performance, which can be done in two different ways. One is to look at the input, and the other is to look at the output.
For input we have to see what kind of action the manager has taken to get the desirable results for the company, which is very difficult to measure. On the other hand, the output is easier to measure.
But the output is the result of the efforts and the time spent by the manager to get something to happen, as well as the risk (luck) he took. The problem here is that we are not able to measure outputs due to the luck factor.
To design a good managerial compensation package, we need to separate the effort and risk parts, but this is a very difficult job and something that cannot be achieved by regulation or by any kind of simple measure. A lot of research is needed to examine the issue carefully.
Dr Suman Banerjee:
In mid-2007 an average S&P 500 company was worth about US$10 billion. Suppose you were a board member interviewing a candidate for the best CEO and you believe that the best CEO compared to the second best can make a one per cent difference in the company value, which comes to US$100 million.
As you want to make sure that you get the best possible CEO, even if he asks for US$25 million more, you would agree because the value he would bring is worth US$100 million.
Our problem is who contributes what in a company as the contribution comes as an aggregate. How much really does the CEO contribute is the debate, and is hard to find out.
The way a CEO functions is sometimes misinterpreted. His job is about coordinating between people, so how well they function in the company depends on how good the leadership is.
So the CEO's value is in creating that additional value for the company, and measuring that aspect becomes an extremely subjective affair. It is not an objective criteria.
So you have to depend on the board members because general shareholders don't participate in the CEO selection process. The problem is that if you divulge too much information about the CEO to the shareholders and it reaches the general public, the competitors will grab this guy.
Thus we have to rely on the board and the governance mechanism. They truly believe that this guy will bring the one per cent additional value to the company and that is why they gave him that US$25 million extra that he asked for to join as the CEO.
Dr Wei-Lin Liu:
This concern about CEO compensation typically intensifies when things are bad. So it comes back to the issue of whether or not a contract that was originally given to the CEO was correct or not.
A correct contract may sound politically incorrect in bad times because shareholders are losing money and the CEO is walking away with a lot of money based on the contract. So the debate itself is not purely academic, it is more about public sentiment based on what is happening, especially during bad times.
The other issue is that a CEO's performance and input are not tied one to one; there are other uncertain factors and unfortunately in order to separate the two, typically you need to be able to observe the CEO for a very, very long time.
If a CEO works for a company for 10 years, we only have 10 chances to observe him to try to see what exactly was his input and what was the outside influence. From a statistical point of view even that is not long enough for a good assessment.
The problem from an economic point of view even in a perfect world is how the pay performance is to be determined for you to practise its implementation even as you observe the CEO for 10 times at most in most of the cases.
Even if the CEO comes in with just a 0.1 per cent contribution to increasing the value of the firm, the problem is that can easily be made up just by luck.
The same issue applies to fund managers in hedge funds - just how much of the growth was because of a manager's talent and how much was it due to a bubble? If you have a way to separate the two, you can solve the compensation problem.
Moderator:
This brings us to a very interesting point - should CEOs be rewarded for company performance based on the luck factor, meaning they happened to be at the right place at the right time as the business their company is in, say property, may be booming due to market conditions and other external factors?
Also, can one person really add so much economic value to his company to lay claim to huge bonuses?
Dr Sen:
It is not just luck that comes into play at a given point in time. We need to remember that even for the CEOs, the new strategic initiatives, leadership styles and any corporate restructuring are not rewarded immediately due to the lag effect of any change.
This is true not just for corporate managers but applies to politicians as well because the benefits of policy changes by one party may in fact go to the succeeding rival political party due to the lag effect.
We should also remember that investor concerns are not directly related to the dollar amount of compensation package itself but due to certain bad corporate governance practices like the backdating of stock options for CEOs.
The investing community has every right to question such practices that are equivalent to betting on a horse after the race is over.
Dr Liu:
I think there is also the need to differentiate the economic problem in the CEO compensation and the problem that enrages the general public when the CEO commits fraud. They are two separate things.
If the CEO spends millions of dollars of company money in redecorating his office, it is not an issue of how to reward him or not.
It is really an ethical issue and even borders on legal versus illegal. So we need to differentiate the economic problem and the problem of fraud that the public is often concerned about.
Turning to CapitaLand's CEO Liew Mun Leong earning a record $20 million bonus, just think if there was no financial crisis and the company's stock value doubled, would the shareholders be upset that their CEO is getting paid so much?
Dr Sen:
Clearly value has been created in the company by way of the leadership provided by the CEO. As we have been discussing, the value created by the leadership is an intangible thing.
It is extremely difficult to agree on sharing of gains when it is almost impossible to accurately estimate the intangible value of the corporate leadership.
Also, Liew Mun Leong has been there for a while. This is not the compensation package he started with. On an ongoing basis he has certainly convinced the shareholders of the value of his vision and leadership and subsequently earned better packages along the way.
It is much easier to justify a compensation package when the CEO has delivered the results and created value for the shareholders.
Dr Kang:
In the United States, the CEO usually has a five-year compensation contract that contains the basic salary level he will receive during his tenure in the company. As to the question of whether an individual can add huge value to the company, this can be seen by comparing with the valuation of the company under the previous CEO.
When there is a huge increase in the market capitalisation of a company under a new CEO, it means that the market perceives that he is good for the company.
Dr Banerjee:
People like Michael Dell create value for the company. They come with ingenious ideas and create value. A number of people combined may not be able to produce what a person like Michael Dell can produce.
So obviously you need to pay high for good people like him. Dr Kang: Big name CEOs definitely add value to the company not just by their presence and leadership but also by pulling in other top talented people into the company, thereby further increasing its value as measured by market capitalisation.
Again this value-creating contribution by the CEO is difficult to measure.
Moderator:
Is there a broad consensus around the table that the current CEO compensation system is about the best we can get? If not, what improvements would you suggest?
Dr Banerjee:
Every time there is a crisis of some sort and there is a big drop in the overall market value, the question of reforming CEO compensation resurfaces.
From our past experiences and having studied the various options available, we generally come to the conclusion that the system we have is about the best we can get even though there are some micro issues and things like conflict of interest that need to be fixed.
In my view, this is the best system.
Yes, the system has its flaws but the alternatives are much more scary and undesirable. But we cannot stop here. We need to keep on doing more research and thinking about how to develop a better system, going forward.
Dr Kang:
One thing puzzling me is why don't companies look at adopting relative performance of the industry, a kind of peer performance benchmarking in determining CEO compensation as well.
Dr Banerjee:
There is benchmarking in practice in writing the CEO compensation contract, but one of the problems in practice is that the CEO may expose the firm to unnecessary risk because he knows that unless he crosses the benchmark his additional compensation benefits do not kick in.
This is a level of risk which is undesirable from the shareholders' point of view. But the correction to this undesirable action is reputation. When the manager goes back to the job market he would be disciplined by the market for his past actions if he took his company to the tank, which is his reputation.
Dr Liu:
Even if there is no explicit benchmarking, if managers are compensated by some kind of a stock option, the stock price is introducing a relative benchmarking indirectly.
This is because the performance of the company's stock depends on how well the company does relative to the other companies in the same industry. Benchmarking does exist but indirectly.
Dr Sen:
We should definitely provide incentives for CEOs in terms of peer performance benchmarking. Also, the compensation package that includes a market-determined salary needs to be very careful with the incentive component.
The additional compensation from bonus and stock options should kick in only after the shareholders have secured their risk adjusted return.
Dr Banerjee:
Unfortunately, it is not well recognised by the investing public that the resting period in fact is 10 years for most stock option grants before they can be exercised. The problem only arises when the CEO quits as most of the contracts allow him to exercise the option to sell the grants when he leaves.
There is logic to this arrangement in that if he is leaving the company, you cannot force him to hold on to his stock options.
In real life, a lot of top management stock options in fact get exercised in about 3.5 years because of people quitting the job.
Moderator:
In your view, is there any other element that is critical in setting compensation for CEOs? Also, what other things should shareholders look out for?
Dr Kang:
As the CEO compensation is set by the company's compensation committee, the selection of who will be on this committee is very important for setting objective criteria for the CEO's compensation and that the committee members are not influenced by the CEO in any manner.
The selection of reliable people for the compensation committee is very important as the wrong people can actually distort the compensation structure and incentive system in favour of the CEO if they are under his influence in any manner.
Having fair and objective CEO compensation structures is one of the most important internal corporate governance practices. It can also serve as the mechanism that provides top managers with strong incentives to do a better job.
Dr Banerjee:
Shareholders have to remember that the government is there to implement the rules and the company managers are there to create wealth for them. But it is their money and it is ultimately their responsibility to make sure that their money is well taken care of.
At the same time, the stock markets and companies are ways to preserve and create wealth and are not to be treated like a lottery or to gamble. There is no way you can double your wealth overnight or even over a year.
The realisation that the government does not save investors' money is an important one. Investors need to pursue their own goals by being better informed and having the common sense to form their judgments and understand that there is a fair amount of risk involved and take actions accordingly.
Also, as an investor you do not necessarily need to be trained in finance to look after your interests. Quite often, common sense alone would suffice.
Dr Liu:
Given that we have been experiencing difficulties due to what has been going on in the market, people - particularly the small investors who are less powerful and have been experiencing losses - would be upset. But they should lay the blame at the proper place.
While we broadly agree that CEO compensation is largely in line with what economic theory suggests, the investing community should clearly highlight that it will not allow totally unethical or illegal activities.
At the same time, there is a need to call for greater corporate transparency so that companies should feel that it is their responsibility to make sure that the investing public is aware of what is going on in their firm and, based on the information provided, the investors can make a better judgment.
