Column : A problem of caps versus obscenity

Written by Sanjay Banerji | Updated: Oct 30 2009, 03:46am hrs
Mukesh Ambanis recent decision to take a voluntary salary cut of 66% has drawn reactions from all corners. Politicians and ministers lauded his action, saying it had sent a message to other CEOs in the country to follow in his footsteps. Others, mostly gurus with unstinting faith in free markets, expressed strong opinions against government inteference in executive pay. They believe that such pressures on corporations for fixing CEO pay grossly interfere with market mechanisms, which may be inequitable but always promote efficiency, freedom and fairness from the viewpoint of stakeholders.

The Obama administration, much to the chagrin of free market supporters in the US, is initiating attempts to place caps on the salaries and perks of bosses of those financial firms that had received tax payers monies as a part of the general bailout plan. In the UK, the refusal of Sir Fred Goodwin to return a part of his obscene pension settlement (700,000 per year), following his company RBSs loss of 24 bn, still incites public memory.

CEO pay has become very controversial only since the 1990s, that witnessed an unprecedented rise in CEO compensations in all countries, with the US and Western Europe taking a huge lead in this area. CEOs in India, according to a study, on an average, earn 200 times more than an average worker.

Much of the current debate in India and elsewhere is misplaced because the focus here is on the salary, which is just one of the components of the total compensation package. Granting of stocks and options in short durations, lavish bonuses and perks together with handsome severance payments, and other fancy items such as golden parachutes adorn CEO pay packets. Such heterogeneous components, especially the ones with contingent features like severance payments, which get triggered only in extraordinary circumstances, make it very hard for markets to place a value on the total sum.

The problem is even more complicated because some of these components are not tradable at all and one cannot impute any direct monetary figure to them. Imagine the value of severance payments linked to stock price movements. The number of free and private rides in company helicopters or memberships in exclusive clubs could also serve as illustrations. Lack of comparable benchmarks and proper valuation instruments make CEO compensations anything but driven by market mechanisms. All we have is a set of contracts that CEOs enter into with their organisation, and such transactions have little market counterparts. This makes the argument of market forces determining CEO packages completely vacuous and goes against the spirit of free markets.

The process which sets CEO compensation establishes this line of reasoning on even firmer ground. Typically, the board of directors sets up a compensation committee that makes recommendations after comparing remunerations of cohorts in the industry. These are subject to shareholders approval. Though the process appears to be fair, it is far from being ideal in practice. First, in many corporations (in the US in particular), the CEO is also the chairman of the board of directors. Second, many reputed empirical studies have documented that boards of directors and CEOs serve in one anothers companies in reverse categories, which makes this nexus another instance of the old boys network.

Finally, the process of electing the board of directors is often marred by staggered boards (not all posts are filled up at the same time) and multiple voting rightswith owners having more votes than others (in most European as well as Indian and Chinese companies), straight rather than cumulative voting patterns (where small shareholders have a say) and costly proxy contests if a group of shareholders challenges the incumbents. Shareholders may have the right to vote on many issues, but neither can they propose a nominee nor do they enjoy a binding vote on CEO compensations. There are exceptions, but such is the general state of corporate governance in greater parts of the industrialised world. And Indian corporate sectors, with their web of family ties, are certainly not unfamiliar with these processes.

An absence of transparent valuations of the various components of pay packets together with faulty processes for selecting the directors who form compensation committees, reveal many flies in the ointment. Unless the stock exchanges introduce reformsfor example, information disclosures and a fair voting system for electing directorsit is a fair observation that CEO packets only reflect the power of vested groups, who interfere with the forces of competitionthe hallmark of free market capitalism.

The author is reader in finance at the University of Essex