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Study Offers Dissenting View on CEO Pay: Sanity on stock options, not arm's-length governance should be goal, prof says

August 1, 2006

For more information, contact: Benjamin Haimowitz, HHaimowitz@aol.com

As public outrage over excessive CEO pay reaches ever higher peaks, virtually matching the excesses of the compensation itself, some new research offers a dissenting view of the subject.

The authors of a new study to be presented Mon., Aug. 14, at the annual meeting of the Academy of Management (Atlanta, Aug 13-16) do not dispute that there is ample cause for outrage over CEO compensation. But, in their view, the general approach advocated by most corporate-governance reformers in dealing with the problem is misguided.

"Why is it that big CEO payouts cause so much more outrage than the amounts earned by show biz celebrities or sports stars?" asks Charles O'Reilly of Stanford University, a co-author of the study with Brian Main of the University of Edinburgh. "The crucial difference, of course, is that the celebrities and sports stars are awarded that money by the market, while CEOs are awarded money by their boards, with whom they often have friendly relations. That doesn't look right to a lot of people, particularly stockholders, who want to see the boards maintain an arm's-length relationship with top executives, continually monitoring them on shareholders' behalf.

"Unfortunately," O'Reilly says, "this has become on obsession, even though voluminous research over the past decade has been frustratingly inconsistent on whether this arm's-length approach (or agency theory, as management scholars call it) makes much difference either in constraining CEO pay or improving other aspects of company performance."

[In other research questioning the arm's-length approach and its dominance of corporate-governance thinking, James Westphal and Michael Bednar of the University of Texas, Austin, will present a paper at the AOM meeting showing how top managers use interpersonal influence to successfullydisarm institutional investors. The authors find that high levels of institutional ownership prompt top managers to use ingratiation and persuasion to deter institutional fund managers from implementing changes in corporate management of likely benefit to shareholders. They criticize the arm's-length approach for "focus[ing] only on coercive power as a source of influence without recognizing the potential for interpersonal influence...in manager-shareholder relationships."institutional investors. The authors find that high levels of institutional ownership prompt top managers to use ingratiation and persuasion to deter institutional fund managers from implementing changes in corporate management of likely benefit to shareholders. They criticize the arm's-length approach for "focus[ing] only on coercive power as a source of influence without recognizing the potential for interpersonal influence...in manager-shareholder relationships."]

In the study by O'Reilly and Main, the authors broaden the analysis of CEO pay beyond the standard good-governance dictums of the arm's-length approach, which have previously been exhaustively analyzed. They find that levels of compensation are affected relatively little by such standard practices as denying board chairmanship to the CEO or assembling boards with minimal closeness to the chief. CEO pay, they discover, is considerably more affected by psychological ties between the board and chief based on a combination of reciprocity and CEO social influence.

And there's the rub: Although close psychological ties may translate into high pay for the CEO, they probably also translate into even greater benefits for the company. As the study's authors put it: "For firms where the board can provide valuable strategic expertise to the CEO, it may be argued that the value of this relationship easily exceeds the cost."

The study consists of an analysis of determinants of CEO compensation during the year 2003 in 306 firms in the retail or semiconductor industry. Four kinds of factors were analyzed in terms of their influence on CEO pay:

1) economic factors, like industry, companies' size, and previous performance of companies' stock;

2) human-capital factors like age, gender, and length of tenure of CEOs;

3) governance factors, such as whether CEOs were chairmen of their boards or whether boards were large or small or how many independent directors boards had;

4) psychological determinants, reflecting both reciprocity (for example, fees bestowed on directors, including the compensation-committee chair) and CEO social status (for example, the age difference between the CEO and the compensation- committee chair or the extent of the CEO's activity on board committees).

O'Reilly and Main found that psychological determinants accounted for about 46% of the 306 CEOs' total cash compensation, and all the other factors accounted for the rest.

"Among these other factors, company size, industry, and stock returns all have a big influence on how much chief executives make," says O'Reilly. "Add in human-capital elements, like the ages of CEOs, and there is not much left for governance.

"In short, governance factors have little to do in determining CEO pay, not nearly as much as psychological factors."

The average total cash compensation of the CEOs in the 306 companies studied was about $1,250,000, not including the value of stock options, which could not be calculated because of "missing and extreme values." The part of this cash compensation attributable to reciprocity and social influence was, thus, about $600,000, an amount very likely "trivial insofar as the average firm in the sample has approximately $5 billion in annual revenue."

Comments O'Reilly: "We are not advocating coziness or cronyism, let alone corruption, in board rooms. We are simply suggesting that a CEO should be close enough to his or her board so as to be able to make the most of the knowledge, connections, and experience the directors bring to the table.

"Yes, that closeness will raise the tab for CEO pay. But there is reason to believe that it is worth the price. We're talking here about millions of dollars, not the bonanzas of tens and hundreds of millions that have been made possible by stock options.

"One way or another," he concludes, "government and the corporate world will have to deal with the whole matter of stock options. But bringing sanity to CEO stock options is one thing and running companies so that they perform at high levels is quite something else, and the arm's-length approach to corporate governance is unlikely to achieve either."

The paper, entitled "Setting the CEO's Pay: Economic and Psychological Perspectives," will be among thousands of studies presented at the Academy of Management meeting. Marking its 70th birthday this year, the academy is the largest organization in the world devoted to management research and teaching. It has close to 17,000 members in 90 countries, including some 10,000 in the United States. This year's annual meeting will draw about 7,000 scholars and practitioners to Atlanta, Georgia, from August 13th to 16th for nearly 1,500 sessions on a host of subjects relating to corporate organization and investment, the workplace, technology development, and other management-related topics.

Media Coverage:
Reuters. 'Good' governance doesn't cap CEO pay rises-study. (Tuesday, August 15, 2006).

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