Pay Day

Your paycheck and the CEO’s – side by side

David Brancaccio Aug 21, 2012
Pay Day

Your paycheck and the CEO’s – side by side

David Brancaccio Aug 21, 2012

The payday for one group of people gets a lot of attention: Company bosses.

In part because we know what they make – they’re not supposed to keep their compensaiton secret. But now Congress is demanding companies go further — and compare CEO pay to what everyone else makes at a company.

This has sparked a fiery controversy that seems to have touched everyone in the corporate sector except for the man who helped dream up the idea. This is the story of an idea that took decades to formulate and percolate. It took so long that that you have to adjust for inflation. When James Cotton says millions, think tens of millions.

“You’re working with this guy and he seems to be pretty intelligent but, dang, he doesn’t look like he’s worth two million dollars a year!” Cotton tells me.

Cotton is now 72 but in the 1970s, he was a corporate lawyer at IBM where he dealt with financial statements. So in an occupation full of price-to-earnings ratios: “That’s how it really got started in my head,” he said.

Cotton came up with his own ratio: Take the CEO’s compensation and divide by the average of everyone else’s pay at the company. If the CEO makes $20 million a year and everyone else averages $100,000, then that’s a 200 to 1 ratio. The bigger the ratio the wider the gulf between the boss and everyone else.

“The top executives earn a significant amount of money and there are people who are manufacturing the actual machine that’s providing this money and are not making nearly as much money,” Cotton said. “And I thought about it and I said, ‘There’s something wrong with this situation.'”

It was Cotton’s thought that the government should force public companies to calculate and report this ratio. He later left IBM to become a law professor at Texas Southern. In 1997, he published his case for a pay ratio in a law review, hoping it would attract attention.

“Maybe some will see the significance of it,” he recalled.

Turns out no one did. I was the first guy to contact Cotton about it. Cotton is now legally blind and can’t follow the financial news as much as he used to. I had called bearing the news that two years ago Congress put a ratio very much like Cotton’s into the big financial reform law called Dodd-Frank.

“Dodd-Frank!,” Cotton replied enthusiastically.  “That is great news if it’s actually in the statute?”

It is in the statute, but the SEC has been taking a while to implement this ratio because companies are very resistant to this.

“Yup!” Cotton noted with a laugh. “I know I know how resistant they are.”

So until the SEC determines the rules, public companies don’t have to cough up the ratio, law or no law.

Nell Minow at GMI Ratings is a fierce critic of outsized CEO pay. She says companies are terrified they’ll get ranked and the ones with the biggest gap will face public shame. “Yeah the companies went ape over that,” she notes.

So there’s a fight, in part about how to do the calculation.

“What I think is hilarious is that these people who keep telling you how much they know about finances and numbers have been arguing that they don’t know how to do the math to get the answer on that,” Minow said.

Bill George, the former CEO of Medtronic, is now at the Harvard Business School. He’s also on the boards of several companies you’ve heard of, including Goldman Sachs and ExxonMobil. He says a wide gulf between the pay of the CEO and everyone else can sow internal tension, which can hobble a company.

“If it gets out of alignment, where all of a sudden a CEO is making huge multiples of what everyone else then you start to lose trust,” George said.

But he believes pay ratios are unfair because they make certain kinds of companies look bad for reasons that may have nothing to do with an overpaid boss. A supermarket chain might have an alarming-looking ratio because it’s comparing the CEO to all the low-wage checkout clerks typical of this sort of company.

“I think it’s very hard to legislate compensation,” George said. “I don’t think that’s gonna get there.”

Instead he says you keep executive pay in line by getting the board of directors to stand up to the boss, which doesn’t always happen.

“A lot of people just back off and let the CEO influence compensation and that’s wrong,” George added.

Minow concurred: “The difference between CEOs and everybody else is the CEOs pick the people who set their pay.” She says to look around a boardroom when that pay is on the table.

“We’ll see there’s the CEO’s golf buddy, there’s the guy who’s on the charitable board with him, there’s the guy at the local university and the CEO chairs the university board of trustees,” Minow said. “These are not exactly arms length transactions, or if they are, the arms are very very short.”

Having your own posse decide what you get paid is a luxury that much of the rest of the workforce does not enjoy. Tomorrow on our series “Payday”, a look at how pay gets determined for the rest of us.

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