Risk and Reward in the CEO Suite

“Take the money and run. Like a thief across a neighbor’s yard. Take the money and run. Like a ghost out in the night. Take the money and run. `Cause you found out that it wasn't hard. To take the money and run." - Excerpted from, “TAKE THE MONEY AND RUN”, words and music by Graham Nash, 1975.

It happened again. Another imperious and embattled CEO was forced out of the top spot – sent packing with a tractor trailer load of severance pay. This time it was none other than Bob Nardelli ex-GE superstar and CEO of Home Depot. He exited the company awash in money - some $210 million worth of cash, stock and benefits. Astonishingly, these figures were disclosed by the company via a press release announcing his departure. I know --- the media has covered this story ad nauseum and you are sick of hearing about it. So I won’t yammer on anymore about Nardelli’s Everest- like severance (although there is an ironic symmetry between his $210 million pile and the latest lottery mega jackpot of $254 million).

How Big is Your Slice of the Pie?

Bubbling beneath the surface of this latest “CEO receives excessive compensation” story is the long running saga of the dynamic relationship between capital, management and labor. With stock prices and profits climbing to record levels throughout this decade, both managers and shareholders have been making out like bandits, although there is continuous squabbling between the two over whether each is getting their deserved share of the spoils. The odd man out has been the rank-and-file worker who has received mostly crumbs from the growing economic wealth pie.

Globalization is mostly to blame – with markets expanding and labor pools growing, investors and corporate managers have been having a field day. Profits have zoomed. Share prices have jumped. Shareholders and leaders of companies in the developed world have for the most part cleaned up. Their employees on the other hand have seen their compensation levels barely tick up. The biggest winners of all, it would seem, have been CEOs.

Too Much Reward, Too Little Risk

With CEO average pay now at levels not seen since Internet boom days and gargantuan payouts such as Nardelli’s $210 million and ex-Pfizer CEO Hank McKinnell’s $213 million making the news, some are wondering whether the game is rigged in favor of the boss. The latest Economist Survey on Executive Pay provides some research-based evidence to suggest that it may very well be. Among the research it cites is a paper, “Agents With and Without Principles” by Marianne Bertrand of the University of Chicago and Sendhil Mullainathan of Harvard. They argue that many CEOs are paid extremely well whether they succeed or fail. For example, in the oil industry they found that CEO pay always benefits when the oil price is high, but does not necessarily suffer when the price is low. Their study of the effects on CEO pay of changes over which managers have no control (such as currency fluctuations) concluded that CEOs are often rewarded as much for luck as for good performance. And it’s not just in the value of shares – these researchers found increases in compensation and bonuses – factors controlled by boards of directors. They concluded that many CEOs are in effect setting their own pay by manipulating the compensation committee, and hence the pay determination process itself, to pay themselves what they can.

As for labor, the game seems to be tilted against it. According to Stephen Roach, Chief Economist of Morgan Stanley, writing recently in the Times of London, workers in high-wage industrial countries have been getting the short end of the risk-reward stick. He states that economic theory holds that workers are paid ultimately in accordance with their “marginal productivity contribution”. Yet in the US – the leader in the so-called productivity revolution– gains in real compensation per hour of 1.4% over the past five years have been less than half of the 3.1 percent average rate of productivity growth over the same period. During the period from 2002 to 2006, labor compensation in the G7+ economies dropped from 56% to 53.5% of GDP while corporate profits soared from 10% to slightly under 16% of GDP.

Setting the Wrong Example

A critical characteristic of the best leaders is that they serve as role models through their values, beliefs and actions. By this standard, what kind of role model was Bob Nardelli and the other CEOs acting like him? They negotiate the biggest and most favorable contract possible, one in which they can’t lose regardless of their performance. They win if they succeed, they win if they fail. What kind of credibility do leaders like these have when they preach values like “accountability”?

A leader can devise a brilliant strategy for his/her company but the workforce must successfully carry it out. If employees don’t execute or otherwise do whatever it takes to succeed then chances are the company will not succeed. And if the CEO fails to inspire employees or worse alienates them, then disaster can result. This is apparently what happened to Mr. Nardelli. He instituted changes that alienated and angered many Home Depot workers – for example, replacing knowledgeable full time workers with less savvy part-timers, implementing rigid standardized processes and operating procedures and ultimately diminishing customer service. The company was a leading exemplar of customer service and perennial best place to work list leader but dropped in prestige on both of these fronts under Nardelli. According to Barry Hendersen, an equities analyst at T. Rowe Price who tracks Home Depot, “He damaged morale and he was seen as a real threat to the Home Depot Culture”.

Indeed, as author Jim Collins brilliantly showed in his best-selling book, “Good to Great”, the leaders of the great companies he studied were not only focused on getting results but were also very humble in everything they did. They put the company’s interests first and their employees followed this example. What kind of role model is a CEO that acts like a walking min-max equation, with a ‘can’t-lose’ contract, that manipulates numbers and plays games with customers, workers, board members and investors? Not much of a CEO in my view.

Blame It on the Board?

Capitalists demand steady growth to ensure that the return on their investments constantly increases. CEOs respond to this pressure, doing everything they can to generate growth and profits. It is up to the Board of Directors to make sure that CEOs deliver performance in sensible and ethical ways. But the Boards of Directors of many companies are frequently lacking in independence, beholden to the CEO and subject to manipulation by him/her. Boards are also frequently insular – approving compensation based on the recommendations of compensation consultants who are often the chief purveyors of CEO self-fulfilling interests. Like the residents of the fictitious town of Lake Wobegon, everyone wants an above-average CEO and seems to be easily persuaded that they must pay far above average compensation to get one.

Whatever the reasons, the balance of power between management, shareholders and workers is out of whack and needs to be righted. Companies would be wise to take actions on their own now before their hands are soon forced by governments. CEOs and Boards of Directors have to set a better example by demonstrating the principles and behaviors on which their organizations should operate. There is a fine line between healthy pursuit of self-interest and destructive selfishness and greed. Good leaders should no doubt be well-compensated. But no leader should be able to craft sweetheart deals, avoid the risks of failure, or push their own rewards to stratospheric levels just because they can. Actions like these corrode trust among shareholders and employees. Organizations with these types of leaders eventually falter and fail. And if this kind of behavior becomes pervasive enough so may our system of capitalism.