Financial Times, January 6, 2009 column

Fear of falling
By Francesco Guerrera and Joanna Chung
Published: January 5 2009 19:54 | Last updated: January 5 2009 19:54

Dan Pedrotty can pinpoint the moment he first saw middle America’s rising tide of anger against the gargantuan pay packages of corporate executives. It was during the final few days of last year’s presidential campaign and Mr Pedrotty, a union leader, had taken time off from the AFL-CIO, the giant labour federation, to campaign for Barack Obama.

His job was to call white lower middle-class voters – often called “Reagan Democrats” for their volatile political allegiances – to persuade them to elect America’s first black president.

From the other end of the phone, as respondents voiced their fears and anguish over their ability to cope with the worst downturn in three-quarters of a century, one issue kept coming up over and over again.

“Executive compensation was front and centre for Reagan Democrats. I heard that every day,” Mr Pedrotty says. “The debate has fundamentally changed from a shareholder issue to a taxpayers’ issue. The level of anger and incredulousness around the country is at record levels.”

Business leaders begrudgingly agree. Even Martin Lipton, the influential lawyer who is one of corporate America’s staunchest defenders, acknowledged in his annual letter to boards of directors that the attention executive pay “is receiving from activists, regulators and the general public has reached new heights”.

Some companies have already reacted to the country’s shifting mood. Most of the banks that went cap in hand to the government and received billions of dollars from federal coffers have scrapped executives’ bonuses for this year. Some, such as Morgan Stanley and Citigroup, have even pledged to claw back part of the bonuses due to traders and other high-flying employees if their bets turn sour.

The rest of corporate America is also heeding the message coming from Main Street. Leading companies such as FedEx, Motorola and Caterpillar have slashed pay and bonuses for executives. Many others are planning to follow suit. Three out of four large US companies have already cut, or are planning to cut, bonuses for their current year, according to a poll by the consultancy Watson Wyatt.

But Americans are demanding more. Three-quarters of those surveyed in a Bloomberg/Los Angeles Times poll in early December say banks that have received government money should cancel all bonuses to employees this year. About half of those say that all Wall Street groups, regardless of whether they received government money, should cancel bonuses.

The backlash against outsized executive pay is a fundamental change in America’s attitude to the way it rewards those at the top of the corporate tree. Unlike the UK, where tabloid-fanned ire over “fat cats” has been a recurring theme of the public debate, and the rest of Europe, where social and political traditions have combined to keep a lid on executive pay, the US has had few qualms in showering successful business people with money.

For years, the prevailing wisdom was that when it came to pay, the untrammelled interplay of free-market forces was the best way to attract, motivate and retain top talent and sharpen America’s competitive edge. As one corporate executive says, with more than a hint of regret: “It was part of the American dream. If you worked hard, anyone could become rich and enjoy it too.”

America’s belief in its meritocratic system was reflected in the fact that the gap between the executive haves and the rank-and-file have-nots had been rising steadily since the second world war without really triggering widespread calls for change. By 2007 the average chief executive made at least 275 times the pay of the average worker, according to the Economic Policy Institute, a Washington think-tank (by other calculations, the multiple reached at as much as 369). But few outside the union movement and the pension funds they control had called on boards to restrain executive pay.

The financial crisis changed all that. As share prices plummeted, capital markets froze and the US economy tumbled into recession, the balance of power on executive pay shifted dramatically. “The public perception has been exasperated by the enormous losses and the appalling stock performance of many companies,” says one Wall Street executive. “No one complained when profits and share prices were soaring.”

WHAT BOTHERS BOARDROOMS:

‘You have an environment where it is easy to demonise people’:

Business leaders in the US are not going to succumb to external pressures to curb their pay without a fight. Seen from the boardrooms and corner offices of corporate America, the drive to restrain executive compensation looks like a hasty overreaction to the financial crisis and economic slowdown.

“There is an angry mob out there,” says Ted Dysart, head of the Americas board practice for Heidrick & Struggles, a big headhunter – “and you have a receptive legislature and an environment where it is easy to demonise people who receive high compensation.”

Opponents of measures such as “say on pay” – a proposed law that would give investors a non-binding annual vote on compensation – consider them both counterproductive and misguided. They argue that a yearly shareholder referendum would give activist investors and proxy services, which advise pension funds on how to vote in annual meetings, undue influence over companies’ inner workings.

Some corporate leaders and their advisers suspect the current campaign against outsized executive pay hides a power-grabbing agenda on the part of the labour movement. They see it as no coincidence that the most fervent advocates of pay restrictions and shareholder votes on compensation have been union pension funds and “socially responsible” investors.

As Stephen Bainbridge, a professor at UCLA school of law, wrote in a recent research paper, these moves are “part of an ongoing effort by a handful of activists to shift substantially the locus of decision-making authority” away from executives and directors.

Even among those who play down the notion of a leftwing conspiracy, some maintain that giving investors more of a say on complex matters such as pay could end up harming companies and their shareholders. The Center on Executive Compensation, a Washington-based lobbying group, has warned that some pension funds could be in breach of their duty to maximise the value of their holdings were they to vote against pay packages designed to reward executives for boosting the company’s performance.

Others warn that shareholder powers on compensation could limit incentives. “A change in the design of the incentives might create a system that does not reward performance and simply cuts pay,” says James Reda, founder of James F. Reda & Associates, a compensation consultancy.

The seemingly inevitable legislation could have a subtler consequence for the US corporate system. Some legal scholars regard Congress’s efforts on this issue as another step in the creeping federalisation of corporate laws that used to be the realm of local and state governments.

Just as Sarbanes-Oxley, the law passed in 2002 after the Enron and WorldCom scandals, introduced US-wide standards of corporate governance and accounting practices, so “say-on-pay” laws could take a big area of responsibility away from state legislators. Regulatory competition between states has been called the “genius of American corporate law”. Any such move would only deepen the corporate world’s opposition to investors’ and politicians’ attempts to challenge their right to pay executives as much as they see fit.

The public outrage is almost certain to lead to an outcome that would have been unthinkable for executives before the crisis: new legislation to curb companies’ ability to award princely compensation to their leaders. Barney Frank, the influential Democratic congressman who chairs the House of Representatives financial services committee, says Congress will move quickly on a “say-on-pay” law that will give shareholders a non-binding vote on executive compensation.

Opponents of the legislation argue that even though, in theory, boards could disregard shareholders’ opinions, a high percentage of No votes would put pressure on directors to change their compensation system in a way that could be detrimental to the company’s long-term fortunes. In addition, enshrining in law the principle that shareholders can have a say on executive pay would undermine boards’ traditional primacy on the issue.

When it was first proposed two years ago, the measure, which mirrors provisions already in existence in the UK, Australia, Sweden and the Netherlands, failed to attract enough support to become law. It was approved by the House of Representatives but it was never ratified by the Senate despite the strong support of Mr Obama, its main proponent in the upper chamber.

Emboldened by his presidential election triumph and a clear majority in both houses of Congress, Democrats are confident of getting “say on pay” on to the statutes this time around. In fact, some of their leaders, such as Mr Frank, are already thinking of more sweeping measures to curb the risky activities that pushed Wall Street to the brink of extinction and the US economy into a deep recession.

“One thing we could clearly do is ‘say on pay’,” he says. “But the tougher question is dealing with perverse incentives. If you take a risk and it pays off, you get a bonus. If you take a risk and lose the company money, you break even – that is a bad incentive.

“I don’t care about bonuses going forward as long as we deal with deductions going backward, we have to find some way to make that a law,” adds Mr Frank, suggesting clawback provisions could be enshrined in legislation. “They can have any bonus as long as it’s a two-way street.”

Union-controlled pension funds are backing that drive and are to propose shareholder resolutions at more than 50 companies this year demanding clawback provisions on bonuses. Supporters of greater restrictions on executive pay argue that financial turmoil has demonstrated the failure of many boards and their advisers to link compensation to performance.

“Say-on-pay will enable us to discuss what is wrong with a pay model that focuses on recruitment and retention rather than the value added by the CEO,” says Richard Ferlauto, director of pension and benefit policy at American Federation of State, County and Municipal Employees, a big union. “Not only have these compensation schemes not been performance-based but they have been designed in a way that wasted shareholder value.”

Nevertheless, Mr Frank and most of his colleagues do not appear inclined to back a draconian measure that most corporate executives had begun to fear in the current climate: government-mandated limits on compensation. “I don’t think Congress will have an interest on wage controls for corporate executives,” says Christopher Cox, chairman of the Securities and Exchange Commission who previously served as a congressman for 17 years.

Yet in at least one respect, corporate governance experts say, legislators have in effect created new ceilings on pay by attaching strings to the funds doled out by the Troubled Asset Relief Programme (Tarp), the $700bn government rescue plan for the financial industry. Tarp has rules barring companies from giving “golden parachute” exit payments to certain executives and restricting compensation above $500,000 from being tax-deductible.

To many corporate governance experts, these restraints are long overdue. But the fact that it took a crisis of historic proportions – and aggressive government intervention – to usher in these changes highlights the long-standing failures of boards to set appropriate standards for executive pay.

Harvey Pitt, the former SEC chairman who now runs Kalorama Partners, a consulting firm, says: “It is decidedly un-American to pay people when they don’t perform and don’t do the job they were hired to do. It’s a huge issue that boards have not really addressed in the way they should be addressing it.”

To some observers, boards and executives should have seen this coming even before compensation became a lightning rod for the average American. When Mr Cox launched a review of compensation disclosure rules after he became SEC chairman, his agency received 30,000 comment letters from investors and other interested parties, until then the most ever on a single issue. When the rules came into effect in 2006, they significantly expanded the information companies were required to make about what, how and why they reward their highest-paid executives.

Yet companies still fall short of explaining fully how they evaluate an executive’s compensation. “The fact of the matter is that corporate America has never understood what is required to justify the high levels of compensation paid to senior executives,” says Mr Pitt. “Companies have not really invested the time and energy to focus on what it is they want their senior executives to do and how to measure whether they’ve achieved it.”

He adds: “If the business community is not going to do this, then somebody else will. Congress is understandably upset and is taking matters into its own hands.”

Barney Frank (right), who became chairman of the House of Representatives financial services committee after the Democrats took control of Congress in 2006, has long had executive compensation high on his priority list. The Massachusetts congressman plans to hold hearings on pay and will be among the figures to shape debate and any forthcoming legislation.

First elected in 1980, Mr Frank has been called both a political theorist and a pit bull. He wants to explore ways to constrain incentives for executives to take on excessive risk.

In the Senate, Christopher Dodd, the banking committee’s Democratic chairman, will play a big role. He is concerned that companies receiving assistance through the government’s financial rescue plan – which placed limits on pay – are not doing enough.

As incoming Treasury secretary, Tim Geithner could also shape policy given his discretion to set terms under the bail-out programme.