account. The last people you’d want on your board are those guys
who are on a meager package themselves; because they would
likely curb your dosh as well. Instead, bring in the rich guys;
they’ll make you rich too!
How to justify paying top managers too much
As I said, the level of top managers’ compensation is often a
contentious topic. Basically, most people think these guys get
paid too much. They claim it’s simply the result of the market
mechanism, supply and demand: good managers are scarce
and therefore they earn hefty salaries (like movie stars, football
players and other demigods).
Although there is of course a bit of a market at work, it has to be
said that the people who determine the pay of a company’s CEO
– the board of directors – do face a conict of interest of sorts.
Board memberships are nice jobs to have, in the sense that they
are usually rather lucrative gigs and provide a pleasant dosage of
power and prestige for those who get them. And – this is where
the conict of interest arises – as I explained in the previous
section, it’s mostly the company’s top managers who nominate
new board members. In the spirit of “don’t bite the hand that
just fed you”, board members may be inclined to reward their
benefactors (i.e., the CEO) handsomely by returning the favor in
the form of a nice compensation package.
Moreover, as also discussed above, directors who deviate from
this social norm (and for instance vote for a relatively low CEO
compensation package) will be frowned upon by the rest of the
business elite, spat at and given the cold shoulder until they
“come to their senses” and change their ridiculous behavior.
For this reason, in various countries, boards of directors now have
to justify the compensation packages they give to their CEOs
by explicitly comparing the rm and its performance to a “peer
group”. The idea is that, due to this forced comparison, it becomes
more difcult for boards to step out of line. The tricky thing is, of
course, how do you determine a company’s peer group?
Liaisons and intrigues
It seems most logical to simply pick a group of rms in the
company’s main industry, right? Right – but even rms in the
same industry are usually not entirely comparable: you have
many different types of banks, pharmaceutical companies can be
vastly dissimilar, software companies will not be alike, and one
retailer is not identical to the next one. Therefore, boards have
some exibility regarding who to include in their rm’s “peer
group”. And that’s of course a rather tempting opportunity for a
bit of old-fashioned manipulation . . .
Professors Joe Porac, Jim Wade and Tim Pollock analyzed the
composition of the peer groups chosen by the boards of 280
large American companies. For each peer group, they examined
how many rms were in there that were not from the company’s
primary industry – thinking that there might be something
shy going on. Subsequently, they looked at the nancial
performance of the peer groups, of the companies in the sample,
the performance of each company’s industry, and the size of the
CEOs’ compensation packages.
They found that boards would usually construct peer groups
consisting of rms in the company’s primary industry. On
average, there were some 30 percent of rms in those peer
groups that weren’t in a company’s line of business. But,
guess what: this gure increased signicantly if the rm was
performing poorly; then the board would construct a peer
group of rms (outside the company’s industry) with mediocre
performance, to make the rm look better. They did the same
thing if everybody in the company’s industry was performing
well; then a poorer-performing peer group obscured the fact
that the good performance of the company was nothing
unusual in its industry, again making it look comparatively
Finally, boards would compose peer groups that consisted
of comparatively poorly performing rms from outside the
company’s industry if its CEO received a relatively hefty compen-
sation package; then the seemingly high performance of the rm
would come in handy to justify the CEO’s big bucks.
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