In 1991, Bill Clinton read a best seller on corporate greed by compensation guru Graef Crystal and came up with what seemed like a great idea to curb the soaring paychecks of U.S. corporate executives: use the tax code to curb excessive pay. Clinton wanted to permit companies to write off executive compensation amounts of more than $1 million only if executives hit specified performance goals. (At the time, corporations were allowed to deduct all compensation to top executives.) According to BusinessWeek, Clinton’s remedy became “the biggest inside joke in the long history of efforts to rein in executive pay.”
This June it was announced that Britain will legislate to give shareholders the power to reject company director pay deals in a bid to link compensation to performance and calm public anger over soaring executive earnings, Business Secretary Vince Cable said on Wednesday. “At a time when the global economy remains fragile, it is neither sustainable nor justifiable to see directors’ pay rising at 10% a year, while the performance of listed companies lags behind and many employees are having their pay cut or frozen,” Cable said. Pay increases for top executives in the United States have also slowed in response to shareholder pressure, although they still gained by 14% in 2011. “High pay for success is perfectly acceptable, it is high pay for failure that needs to be addressed,” said Mark Boleat, Policy Chairman at the City of London Corporation, which promotes the capital’s financial sector.
If the revisions to the Internal Revenue Code enacted by the Clinton administration that attempted to tie compensation to objective performance metrics failed to rein in executive pay, is there reason to believe that the new legislation in Britain will fare any better?
Lynn Stout Distinguished Professor of Corporate & Business Law at Cornell University Law School and author of the recently published The Shareholder Value Myth and Cultivating Conscience: How Good Laws Make Good People (Princeton University Press, 2011) agrees that executive pay is out of whack. But Stout is opposed to pay for performance incentives that are set out in advance. “Incentive-based pay schemes tend to suppress conscience, and so encourage opportunistic and even illegal behavior that conscience otherwise would keep in check,” she says.
In a 2011 paper titled Killing Conscience: The Unintended Behavioral Consequences of ‘Pay for Performance,’ Stout offers three reasons to explain why the Clinton administration’s revisions to the Internal Revenue Code (I.R.C. Section 162(m)) didn’t work and why the new legislation in Britain may not either:
First, incentive schemes frame social context in a fashion that encourages people to conclude purely selfish behavior is both appropriate and expected. As a result, pay-for-performance rules “crowd out” concern for others’ welfare and for ethical rules, making the assumption of selfish opportunism a self-fulfilling prophecy. Second, the possibility of reaping large personal rewards from incentive schemes tempts people to cut ethical and legal corners, and for a variety of reasons, once an individual succumbs to temptation, future lapses become more likely. The result can be a downward spiral into opportunistic and unlawful behavior. Third, industries and firms that emphasize incentive pay tend to attract individuals who, even if they are not psychopathic, nevertheless are more inclined to selfish behavior than the average.
“If it makes good sense to tie compensation of top executives to the financial performance of their firms, it is also wise to gauge that compensation in relation to other corporate performance factors,” says Peter Madsen, Distinguished Service Professor for Ethics and Social Responsibility at Carnegie Mellon University. “Sometimes called the ‘triple bottom line’ – the annual financial condition of a firm along with any social and environmental impacts it has had – might just be a very feasible standard by which to set top executive pay.”
It isn’t easy, however, to find companies that specifically state that the compensation of their executives is tied to more than financial performance. PepsiCo, for example, has established Performance with Purpose, a global initiative that makes an effort to deliver sustainable growth by investing in a healthier future for people and our planet. However, the company is cautious about linking executive compensation to the results of this program. According to PepsiCo, “Our executive compensation approach is in line with other major consumer package goods companies. Performance with Purpose is a long-term business strategy for PepsiCo, and our employees embrace the responsibility that comes with ensuring we remain financially healthy and deliver results while pursuing our sustainability commitments.”
Aron Cramer, President and CEO of BSR, a CSR consulting firm that works with a global network of nearly 300 member companies, believes that financial performance is inevitably linked to social and environmental performance. “The ability of a company to execute its strategy, and bring new products and services to market, are directly linked to a company’s understanding of the social and environmental context in which this happens,” says Cramer. “Executives that overlook these questions are taking an unnecessary risk, and missing out on opportunities to build economic value. An executive team’s understanding of this aspect of business is central to their stewardship of the company’s assets, and Boards should therefore reward executives based in part on these principles.”
Cramer’s emphasis on rewards rather than incentives is consistent with Professor Stout’s point of view. “We should set financial compensation ex post, on the basis of the employers’ subjective satisfaction with the employees’ performance,” writes Stout. I think she would also agree with Madsen’s perspective that “a firm has made progress and been successful when it provides its shareholders with a good return on their investment, while not harming society or damaging the environment. Corporations that only do well financially, while still building poor reputations because their operations provide less than safe working conditions or contribute to the continued decimation of habitat areas, would not be said to be truly successful and so the executives of such businesses should not reap windfall increases in their incomes.”
Ironically, the new imperative for corporations to be socially responsible could be jeopardized by attempts to tie executive compensation more closely to corporate responsibility through pay for performance incentives. Stout writes that revisions to the Internal Revenue Code (I.R.C. Section 162(m)) did not produce measurably better corporate performance. “To the contrary, it has been accompanied by disappointing investor returns, an outbreak of corporate frauds and scandals, and the near-collapse of the financial sector,” she says. She cites the example of Bradley Birkenfeld, one of many UBS bankers who had built careers helping their clients evade U.S. taxes. The judge who heard Birkenfeld’s plea asked him why he chose to participate in this scheme when he knew he was breaking the law. The banker replied, “I was incentivized to do this business.”
If pay for performance schemes that are intended to limit irresponsible executive compensation can cause executives to operate their companies irresponsibly, what’s a better approach? Stout believes that the vast majority of individuals are willing to sacrifice their own material payoffs to follow ethical rules and to help avoid harming other people. “Firms that can attract conscientious rather than purely self-interested employees – teachers who want students to learn, doctors who want to help patients, CEOs who want to leave a legacy rather than simply take as much money as possible – have an advantage,” says Stout. “Behaviroal science suggests that for many tasks, emphasizing nonmaterial rewards – greater job responsibilities, a better parking space, an ‘Employee of the Month’ plaque – may work as well or better than emphasizing material rewards like cash bonuses or stock options.”
In 1970, Milton Friedman wrote an article for The New York Times Magazine that posited “the social responsibility of business is to increase its profits.” While Friedman’s position is seen as a historical anathema by the CSR movement, it’s interesting that at the time of Friedman’s article, and prior to Clinton’s failed attempt to curb excessive executive pay, corporations may have been operating more responsibly than they do today, at least at an executive level.
Britain’s move to rein in executive earnings is to be commended. Let’s hope they do this in a way that builds on the progress that’s been made by the CSR movement over the last decade and doesn’t encourage more irresponsibility.
Originally Posted on Forbes.com
Paul Klein founded Impakt in 2001 to help corporations become social purpose leaders and is considered a pioneer in the areas of corporate social responsibility. Paul is regularly featured in the media as a corporate social responsibility source, was included in the Globe and Mail’s 2011 Leading Thinkers Series, and was recognized as one of America’s Top 100 Thought Leaders in Trustworthy Business Behaviour. You can follow Paul on twitter at paulatimpakt