issue of executive pay has resurfaced again in the wake of questionable
AIG bonuses, and exorbitant compensation packages for banking
executives. Pundits see the problem largely as a consequence of a lack
of independence among boards of directors. They criticize compensation
committees for being too cozy with top management – showering them with
lavish pay, outsize option packages, and a host of other perquisites.
The solution, they argue, is to increase the percentage of independent
directors serving on the board, and to provide shareholders the right
to vote on executive compensation. Increasing the number of independent
directors, and allowing a corporation’s owners to vote on pay, should
provide a healthy check to balance the system.

I agree
that boards ought to share some of the blame for a system that has seen
executive compensation rise from about 30 times the average employee’s
salary in the 1970’s to over 100 times the average employee’s salary
today. If of nothing else, board members were guilty of being
complicit. In this sense then, strong independent directors might help
reign in pay at the margin.

But boards are not wholly to blame.

boards can only do so much. Outside directors must rely on management
to provide them the information necessary to fulfill their obligations
as stewards of the shareholders. And when it comes to executive
compensation, boards rely on information provided not just by senior
managers, but also by compensation consultants, who play an important
role in influencing executive pay.

Allowing shareholders to vote
on compensation packages might also help improve the process. But
again, it is no panacea. There is no guarantee that shareholders have
the level of interest and sophistication necessary to evaluate
disclosures on executive pay. Those disclosures are quite complex, as
putting a precise value on pay packages, especially when it comes to
options, is not an exact science. What’s more, the interests of
disparate shareholders do not always converge. It is not as simple as
using compensation to align the incentives of shareholders and
management as if shareholders were a single entity with one
overarching, agreed-upon goal.

The issue is much larger than
these proposed solutions can address. The reasons for the spectacular
rise in executive compensation are complex. The problems are endemic to
a market and institutional system which has radically changed over the
last half century. Therefore, to arrive at an appropriate solution, we
must start by asking ourselves some fundamental questions.

example, we need to ask ourselves, “Who are shareholders?” Although
seemingly a silly question, the answer has important implications for
corporate governance and executive pay.

shareholders were individual company owners (often dispersed) who held
stock for long periods of time. Today, the picture is quite different.
Shareholders are represented less and less by individuals and
institutions holding stocks for the long-term, and more and more by
individuals and institutions looking to make a quick profit - buying
and selling shares with frequency. The rise of such traders who seek to
profit from near-term volatility in stock prices has changed the nature
of the system. These traders are inconsistent with the spirit of the
view of the shareholder as a long-term owner. They are not really
owners, and sometimes have little interest in the long-term survival of
the firm. They often only care about micro-movements in share price in
a very narrow window of time.

This short-termism among
shareholders has spilled over to CEO’s as well. Recall that the
standard assumption in finance and accounting is that firms have an
infinite lifespan, and that firms should therefore maximize the net
present value of all future cash flows. Unfortunately, there is a
fundamental disconnect between some of these assumptions and the state
of the world. Humans do not have an infinite lifespan; firms fail; and
the average tenure of a typical CEO is now fewer than 5 years.

creates a severe incentive problem. What incentive do CEO’s have to
look out for the best long-term interests of the firm if they will only
be around for a few years? In this sense then, CEO’s have an incentive
to increase near-term performance sometimes at the expense of long-term

It has been argued that the market keeps such CEO’s
in check because it penalizes CEO’s (and a firm’s share price) for
making short-sighted, near-term decisions. Unfortunately, the field of
behavioral economics has been showing us that market participants are
not very good at valuing the long-term consequences (with more than a 5
year horizon) of managerial decisions. What’s more, with institutions
interested in trading than in ownership, the incentives of the
institutions align with those of the CEO’s. That is, with institutions
looking to make a quick profit, short-termism on the part of the CEO is
not only condoned, but sometimes encouraged.

This is an often
overlooked factor leading to increased CEO pay - the advent of a
short-termism, consume now pay the consequences later, system.

boards, this presents a dilemma. How are boards to act as stewards of
the shareholder when it is unclear who shareholders are, and which
shareholder’s interests they should advocate? To resolve this dilemma,
boards should abstract from any individual shareholder. They must also
think beyond the lifespan of the CEO. In essence, they must act in the
best interests of a theoretical, long-term owner.

executive pay is a complex problem. An important first step is to
recognize the problem. Our aim should be to find a way to tie executive
compensation to some metric that allows us to assess whether the CEO
and management team leave the firm in a better position than they found
it. That is easier said than done.

In the meantime, until we
solve the dilemma endemic to our current system, an increase in the
independence of director, and measures that improve shareholder rights,
are a step in the right direction. But ultimately, the solution must be
more broad-based than simply applying band-aid type measures.

Salomon is an Associate Professor at New York University's Stern School
of Business. Prior to joining Stern, he was on the faculty of the
Marshall School of Business, University of Southern California.