Column

The right way to measure CEO pay has nothing to do with 'shareholder value'

The SEC's proposed new rule on CEO compensation will merely enshrine a faulty metric

The latest initiative by the Securities and Exchange Commission to give shareholders more information about their CEOs' pay has revived an old question: What's the right way to judge if a CEO is making too much?

The SEC's proposal, which is now open for public comment, accepts as a given that the best metric is to compare top executives' compensation to shareholder return — that is, stock price appreciation plus dividends. Its goal is to give shareholders a better picture of that relationship: clearer and more thorough disclosure in the annual proxy statement of what the chief executive earns, including pension and stock awards; and more data on total shareholder return, including figures over time and in comparison with other similar corporations.

The goal, the SEC said, is to "allow shareholders to be better informed when they vote
to elect directors or vote on executive compensation."

Yet nothing in the SEC proposal addresses the core issue with the pay of American CEOs: It's way out of line with the rest of the economy.

The first problem with the SEC plan is that shareholder return is at best an imperfect gauge of the success of a corporation and therefore of the appropriateness of the CEO's pay. As my colleague Jim Peltz observed last week, "Using total shareholder return might provide a fairly uniform measure for the public, but the number might not always represent the true health of an underlying company."

For one thing, the metric is overly sensitive to short-term changes in a company's capital structure and the vagaries of the broader stock market. A merger using lots of debt might drive the stock price higher over the short term; a bull or bear market might drive a company's shares higher or lower independently of its own performance or prospects; it's rare to see a CEO's compensation clawed back if stock-market gains evaporate (though not so rare for executives to be paid a makeup bonus if a stock-market slump reverses).

By some reckonings, the best-paid American CEO last year was Nick Woodman, the founder and chief executive of GoPro, the maker of wearable sports cameras, who received a 4.5 million-share stock grant a few weeks before the company's initial public offering in June. The stock soared in the turbo-charged IPO market of mid-year but has fallen by about 46% since its peak in early October and 20% this year alone. Nevertheless, Woodman's grant is still worth about $225 million today. (He also received $2.7 million in cash salary and bonus last year.)

A bigger problem with the SEC rule is that it examines the CEO's pay only in the context of the shareholders' welfare. This reflects the notion that the corporation exists only to benefit its shareholders — that creation of "shareholder value" is the be-all and end-all of management.

That's been the prevailing idea in corporate strategy since it was advanced by conservative economist Milton Friedman in 1970.

Business leaders who argue that business should take seriously "its responsibilities for providing em­ployment, eliminating discrimination, avoid­ing pollution and whatever else may be the catchwords of the contemporary crop of re­formers," he wrote, are "preach­ing pure and unadulterated socialism." The only "social responsibility" of business, he wrote, is to "increase its profits."

But Friedman was wrong. His formulation hopelessly distorts corporate behavior and deserves heavy blame for the disastrous distortions in the U.S. economy that have arisen over the last four decades.

Friedman's notion that the "corporate executive is an employee of the owners of the business" and the owners are the shareholders was disdained by business experts and leading CEOs at the time. In 1979, Kenneth Mason, the president of Quaker Oats, called it "a dreary and demeaning view of the role of business and business leaders in our society." Management guru Peter Drucker, writing in 1973, asserted, "there is only one valid definition of business purpose: to create a customer.... The customer is the foundation of a business and keeps it in existence." 

Even Jack Welch, whose reign as chairman and CEO of General Electric was often held up as the epitome of the quest for shareholder value, eventually called Friedman's formulation "the dumbest idea in the world" (in 2009, after his own retirement).

Welch put his finger on its shortcoming, which was that it incorrectly relegated all other stakeholders in corporate performance to second rate status: "Your main constituencies are your employees, your customers and your products," he told an interviewer. "Managers and investors should not set share price increases as their overarching goal."

But Friedman's notion was picked up by spokespeople for the shareholding class — wealthy collectors of unearned income in the form of capital gains and dividends. Over time, the idea of shareholder value as the goal of the corporation became so ingrained in American business policy that it seemed to have existed forever rather than merely since the end of the 20th century.

Moreover, it's regarded as a legal imperative, although nothing in the law requires the shareholders to come first. As business commentator Yves Smith put it last year in her Naked Capitalism blog, "Equity holders are the lowest level of financial claim. It’s one thing to make sure they are not cheated, misled, or abused, but quite another to take the position that the last should be first."

The harvest is that CEOs are now judged not by how well they serve all the other constituencies mentioned by Welch but by how much distance they can put between their welfare and that of the shareholders. Investors applaud layoffs and squeezes on the pay and benefits of workers, bid up the share prices of companies that impose them and thus enrich the CEOs whose pay is based largely on those share prices. The explosion in the CEO-to-worker compensation ratio, which was about 30-to-1 in the 1970s and 300-to-1 today, is a direct reflection of this phenomenon.

Predatory pricing, skimping on product quality, mistreatment of suppliers, and the manipulation of local communities to extract tax breaks and subsidies for factory locations all reflect the drive to upstream all corporate returns to the shareholders. 

The SEC's executive compensation proposal further chisels the myth of shareholder value into the rules of corporate behavior. Instead of proposing a metric that balances the CEO's service to all corporate constituencies, it takes the primacy of shareholder return as gospel and tries only to make sure that it's measured accurately.

This may help shareholders decide if their own interests are being well served and their CEOs properly compensated for that service, but it will do nothing to rein in the growth of CEO pay, which is the scourge that the SEC should be most concerned about.

The SEC's dodge is that, as imperfect as shareholder value is, it's the best proxy we have for corporate performance. But it relies on far too narrow a definition of corporation performance.

What makes the myth of shareholder value dangerous is that the behaviors it rewards are unsustainable, even in the short term. The stock market crashes of 2000 and 2008, and the long, grinding recession since 2008 were artifacts of its effects; the working class was so hollowed out by layoffs and pay cuts designed to shift income to the shareholders that they resorted to debt to maintain their standard of living. Eventually their ability to consume collapsed, taking down corporate profits along the way.  

Yet the SEC still aims to measure CEO performance by this deeply flawed metric, which only fools us into thinking that the obscene compensation of many of today's CEOs is rational. It's time to bury the dogma of "shareholder value" for good.

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