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Limiting executive pay could be the only way to save capitalism

When managers are free to rob corporate coffers, it shatters the trust of the investors who provide capital to grow the business.

March 29, 2009|Kathy M. Kristof

Proposals to limit executive pay are flying fast and furious in the wake of public furor over retention bonuses paid to executives at American International Group Inc. But here in the capital of capitalism, business leaders and compensation consultants maintain that restricting executive pay could cause more harm than good.

The best and brightest business leaders would flee, they contend. Financial results, and ultimately stock prices, would suffer.

Here's a view from the other side: Limiting executive pay -- voluntarily or not -- could be the only way to save capitalism.

As the titans sputter, I'll explain.

Our $9.9-trillion stock market works on the basis of trust. The long-standing deal between investors and executives was this: You give money to a corporation -- without demanding interest or immediate repayment -- and you'll get a tiny piece of that company in return.

Investors were willing to put up their hard-earned cash -- often their retirement savings -- because they had faith that company shares would become increasingly valuable.

Corporate managers, investors believed, would deploy their assets to produce products and services that could be sold at a profit. As the company became more profitable, the value of investor's shares would rise.

That system works when managers are legitimately deploying corporate assets to their best use.

Instead, over the course of the last two decades, company managers have pocketed an increasing amount of profits.

A study by Harvard professor Lucian Bebchuk found, for example, that pay and perks granted to the five most highly compensated officers at U.S. companies nearly doubled over a decade and now eat up an average of 9% of company profits. And that figure doesn't account for the millions of dollars that companies pay in retirement benefits to executives.

At the same time, the gap between what chief executives pay themselves and what they pay their rank-and-file workers has widened. Where CEOs used to earn about 50 times what their average worker took home, now they're taking home about 350 times that person's wages.

Why does this gap matter? Because workers open the doors, answer the phones, manufacture the products and wait on the customers.

Happy workers make for a better customer experience. Workers who are demoralized by unlivable wages -- and can see by company practice that the CEO thinks he's worth 400 of them -- are unlikely to work as hard and produce as much.

Many of the executives with the richest pay and pensions have shipped jobs overseas and ripped pension benefits away from their workers.

They defend these practices, contending that paying people livable wages and taking care of them in retirement is too expensive.

Yet these same executives -- such as the top dogs as Lehman Bros. Holdings Inc. and Countrywide Financial Corp. -- took hundreds of millions in pay and stock, while their companies faltered.

That pay was not a reasonable use of corporate assets, said David O. Friedrichs, a professor of sociology and criminal justice at the University of Scranton in Pennsylvania. It was grand theft.

"We have no trouble understanding that somebody who walks into a bank with a gun is committing a crime," he said. "CEOs who walk into boardrooms, armed with reports from compensation consultants, who have all sorts of conflicts of interest to push pay as high as possible, are committing grand theft against stakeholders."

When managers are free to rob corporate coffers, it shatters the trust of investors.

If investors become convinced that they can't trust executives to forgo their selfish interests and use investor capital to grow the business, they will start making demands.

Instead of trusting executives to share the profits when we give them our capital, for example, investors will start demanding contractual interest.

In other words, we'll stop investing in stocks and, instead, put our money in corporate bonds, where the company must pay a set rate of return. The shift is already being seen in industry statistics.

Over the last two weeks, investors pulled $22.3 billion out of equity funds while investing $6.5 billion more in bond funds, according to the Investment Company Institute, a trade group for the mutual fund industry.

To be sure, there is still plenty of money invested in stocks. Part of the reason is that some companies still do things right. Consider, for example, Costco Wholesale Corp., the Issaquah, Wash.-based retailer that operates warehouse stores.

Its CEO, James D. Sinegal, earns a salary of $350,000, while his warehouse employees earn roughly $17 an hour -- about $34,000 for a 2,000-hour year. Sinegal can get a bonus of as much as $200,000, but typically recommends less -- something akin to the bonuses paid to warehouse employees, according to the company's proxy statement.

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