Outlook: Wall Street Needs More Than Just a Pay Cut

Rakesh Khurana
Outlook Contributor and Harvard Business School Professor
Monday, February 9, 2009; 11:00 AM

"President Obama is now three weeks into his new job -- annual salary $400,000 -- and already he and his team are working overtime to make sure that no one at the helm of a bailed-out firm will pocket much more than he does. It's time, the president said last week, for "restraint," not millions in bonuses... With business executives seemingly oblivious to the nation's crisis, it's easy to see the appeal of capping exorbitant pay and wild spending. But corporate America's problem is more fundamental than that."

Harvard Business School professor Rakesh Khurana was online Monday, February 9 to discuss his Outlook article, co-authored with Andy Zelleke of the Center for Public Leadership at Harvard's John F. Kennedy School of Government, on the role CEOs have played in the economic crisis, and whether limits on executive pay will help address the problems on Wall Street.

A transcript follows.

Archive: Transcripts of discussions with Outlook article authors


Rakesh Khurana: Hi, this is Rakesh Khurana of Harvard Business School. I'm looking forward to discussing with you the article on executive compensation published in yesterday's Washington Post.


Baltimore, Md.: Interesting article, but I'm wondering what exactly happened in the mid-80's to start this trend towards enriching senior executives that you describe. Also, you mention short-term investors as a reason the executives can get away with this, but I'd appreciate it if you'd discuss other factors, such as the boards which set these obscene pay packages.

Rakesh Khurana: Great question--to answer it, we need to go back to the 1970s. It was during this period that we shifted from what academics called 'managerial capitalism' to 'investor capitalism.' During the 1970s, the US economy underwent a dramatic decline. The shock was in part created by the OPEC oil price spikes, but it was also part of a more secular trend in which the US economy was shifting from a manufacturing based economy to a service economy. During this period, US wages began to stagnate, as did US corporate profits. For the first time since WW II, the US faced significant threats from international competitors, e.g. Japan, Germany. Originally, when US corporate profits declined, many business executives and politicians blamed excessive US regulation and unionization. There was a strong belief that deregulating business would enhance US competitiveness.

Consequently, beginning under President Carter and then accelerating under Presidents Reagan and Bush (I), the US economy underwent a dramatic shift. One consequence was that there was a massive empowerment of shareholders during this period. At first, shareholder involvement took the form of takeovers, later it took the form of firing CEOs.


Lebanon, Ill.: Do you think that shareholder activism and greater influence is largely irrelevant to reducing the problem? If not, what specific steps/laws/SEC rules might help shareholders rein in executive pay, and otherwise exercise influence over a company (for good or evil)?

Rakesh Khurana: I am not sure. Having shareholders have a greater voice in governance cuts both ways. For example, we mentioned in the article yesterday that the average share of NYSE stock is held for less than year now. These are not really individuals thinking about the long-term. At the same time, without discipline boards are apt to be rubber stamps and ineffective. I think we need to think about the relationship between our capital markets and corporate governance more deeply.


New York, N.Y.: My understanding is that a company's compensation committee creates the pay structure for the executives. How much influence does the CEO have on who is on the committee?

Rakesh Khurana: Excellent question. Research suggests that board composition is heavily influenced by the CEO's preferences. Despite calls for greater board independence, few executive search consultants or board members, would appoint a director a CEO did not want.

As far as compensation committee membership, the major stock exchanges require independent directors. The problem is that independence is defined 'structurally' e.g. no consulting money from company, no prior relations. It is not defined psychologically. There is a great deal of pressure inside the board rooms to 'get with the program' and 'fit in.' These pressures are fairly strong, with even powerful individual directors describing the social pressures.


Gaithersburg, Md.: I recall a discussion during the 80's when a tidal wave of MBA candidates was washing into the workforce. The point made was that the extreme profit motive was occurring in a dynamic that was devoid of ethics. How has the educational community changed or how will it change to re-introduce ethics into the MBA curriculum?

Rakesh Khurana: Excellent question. I think our education institutions should engage in a great deal of self-reflection. At the moment, while some individual schools may be doing some, it is now happening at a collective level. There has been little explicit or 'official' discussion of the type of ethos and values that our business education model has inculcated into its students. We need to re-animate questions about why our students want to go into business. Is it simply to make money and get rich? That cannot and should not be acceptable, especially in a university subsidized by American taxpayers. At the same time, many of our theories have dis-enchanted our students about the possibilities of the wonders of business and the meaningfulness in creating a built-to-last institution.


Silver Spring, Md.: The media focus on executive compensation on Wall Street obscures the fact that "worker bees" at these firms such as secretaries, administrative assistants, not to mention traders, all make far in excess of 6 figures. Several years of steady employment on Wall Street routinely turns high school graduates into life-long millionaires. How can this fragile economy sustain such excesses at the lowest levels of Wall Street firms, and why isn't the media focusing on the "workers" of Wall Street as much as on the executives? Auto "workers" have become the targets of fierce criticism for their union pay and benefits.

Rakesh Khurana: I think this is a critical issue--one that has been obscured by lots of noise and confusion. Some of the noise and confusion comes from academics around the question of how to measure growing inequality in the United States, but a lot of it comes from politicians who try not to focus too much on the fact that the average American worker makes less money, in real terms, than they did three decades ago.

We need to recognize that the legitimacy of corporations and, indeed, an effective market system, is its ability to create broad social benefits, not just benefits for a few. As a staunch believer in the importance of markets, my view is that markets work best when they benefit large groups of people. Markets, also, however, are not natural creations. They are created by society. They require active debate and discussion. Voters need to ask what type of economic system will produce the healthiest society. For too long, we've let a narrow group of individuals define what is good for us. We need to be more vocal about our expectations, especially around issues of making sure benefits are broad and deep, and don't undermine the long-term stability of our nation.


Atlanta: The newest thing I hear is that Barney Frank wants to regulate pay in all industries (presumably, all levels). I'm not sure that could happen - but that would certainly make me and my husband leave the country. That is no joke (we've even been discussing that lately). Aren't the consequences to what the Dems are talking about that people won't be wanting to work at the companies getting the bailout money? And the 'best and brightest' will go to the ones not taking the money? The flip side to that is this. Both my husband and I have worked at corporations - and most of them are incredibly risk averse. So they only promote people who think exactly like those doing the promoting. There are plenty of people who are good who never get promoted because they think differently. Will this possibly get the good but not promoted people up in the higher ranks?

Rakesh Khurana: I don't agree with the idea of regulating pay in all industries (and I say this as a voter in Congressman Frank's district).

I do, however, believe, that we are choosing the 'wrong' type of leader. Over the past two decades, the US shifted toward hiring 'celebrity' CEOs. Many of them from outside the company. This 'savior' model has proven disastrous. First, outside CEOs often lack the deep industry knowledge to be successful. There is a great deal of research highlighting this fact. Outsiders create a short-term boost to a firm's performance (most often by cutting and slashing), but long-term benefits do not emerge. Second, outside 'celebrity' CEOs demand outsized pay packages. Pay is no longer set against internal benchmarks (e.g. how much the COO makes), but rather against external benchmarks. These external benchmarks are often 'negotiated' and moreover boards set the pay at the 75th percentile, resulting in an accelerating pay package. Third, outside CEOs usually demand a buy-out of their current stock options as well as an air-tight golden parachute. The result is that you get paid, whether you succeed or not.


Baltimore, Md.: I was struck by the publication of your article, just a day after Roy Smith's article, "Greed is Good," in the Wall Street Journal. He argues that we need to keep rewarding risk taking, and that the market for "top managers" continues to be intense. How would you reconcile the differences between your and his perspective?

Rakesh Khurana: With great respect, I believe that Mr. Smith's article is misguided. An effective capitalist system does not rest on greed. As any serious student of capitalism would argue, capitalism is a complex institutional system that rests on a system of legal rights, norms toward delayed gratification, implicit trust that contracts will be upheld, and a series of balancing institutions that enable constraints on externalities, such as pollution. Max Weber, one of the great students of capitalism, once quipped (and I am paraphrasing here): the idea that an effective capitalist system can be built on unbridled greed belongs in the kindergarten of social thought. If you want to see capitalism without rules and built on greed, you only need to look around the world. The result is system of weak trust, unenforceable contracts, in which a Hobbesian world now rules.


Alexandria, Va.: Talk to me a little about peer pressure. Are these competitive CEOs driven by making more than other CEOs? At any point does something old fashioned like "shame" come along? If a CEO is cashing a check for amounts in excess of $30 million and up, do they ever say... "you know what, this is too much money. Let's spread it around to others in the company." Aren't they embarassed by all this excess... or don't they care?

Rakesh Khurana: I think this is an important question. Shame is an important motivator. Somewhere along the line, the idea of being the highest paid CEO went from a scarlet letter to a badge of honor.

I think one of the most important things investors and boards need to do is begin to see high levels of compensation at firms as not a sign of success, but a sign of trouble.

There is a lot of research which highlights that excessive CEO compensation correlates with other problems, particularly weak governance and a short-sighted decisions such as cutting back R&D, and financial restatements.

The problem in the board room is that the power of the CEO rarely makes it possible to air these issues.


Anonymous: Historically, how much of American business genius has been "know how" versus market and system manipulation? Our great business pioneers were driven monopolists by any means necessary. Our modern business elite have appeared to manipulate short-term money gains by any and all means at the expense of long term. In some realms I do not see how they differ.

Rakesh Khurana: Again, I think a lot of things have been twisted around in recent decades. Again, no serious student of capitalism ever confused speculation (e.g. hedge funds, private equity) with entrepreneurship (e.g. Steve Jobs, Bill Gates, and Henry Ford). Yet, if you look at the press over the past two decades, we equated these two activities. If there is one message that needs to get out, it is that there is no economic or moral equivalence between dealing in the world of 'evaporated capital' (speculation) and hard capital (a sense of obligation and responsibility that comes with producing goods and services). And, lest anyone think that this is some type of 'radical' drivel, this distinction was made by Joseph Schumpeter, one of the champions of capitalism. He very much understood that we should never confuse the two activities. Indeed, he argued, that to confuse the two activities was not only dangerous to the economic system, but to democracy.


Washington D.C.: Great article yesterday. I went to the B School in the 70s and have been struck by the B school graduates (Skilling, Thain) who have been poster boys for executive greed. What would be the reaction at Harvard Business School these days on your article?

Rakesh Khurana: I think we need to re-think what we are teaching in business schools. Over the past two decades, fewer-and-fewer of our students are interested in managing and leading companies or building businesses. Two-thirds of graduates of leading business schools have been going into financial services and consulting. While these are important industries, the jobs they have been going into are individual contributor jobs, not leading individuals or teams. If there is a silver-lining in the crisis, I think all of us (myself included) will take greater pause in how we help our students think about their careers.


Evanston, Illinois: Shouldn't the shareholders have the right to a binding vote on management compensation?

Rakesh Khurana: I like a variation of this idea which is being tried in the UK. Advisory shareholder votes seem to be serving at constraining how much a board is willing to pay its CEOs. The other idea from the UK that might be useful here is the separation of the CEO position from the chairman position.

This creates an arms lengths distance between the structure and amounts of CEO pay and the CEO.


Washington D.C.: Compensation of other CEOs seems clearly not the right benchmark for a CEO's salary. What is the relevant benchmark for executive compensation? Is it average worker salary in the company, or something else?

Rakesh Khurana: It is not clear. Most scholars now agree that CEO pay is not set by 'market' processes. Markets are characterized by large numbers of buyers and sellers transacting anonymously. In a market, people are price takers, not price setters. Given the small numbers market of CEO pay as well as the plethora of conflicts of interest, pay tends to be set in a more arbitrary way than market theorists would predict.

The way CEO pay was once set was driven by the culture of the company. Firms would develop pay grades and pay scales that correlated with the levels below, geographic conditions, and the strategy they were pursuing. They did not outsource the decision of how to pay and how much to pay to the stock market. It seems that if boards were more involved with linking pay to the actual objectives of the firm, we'd be in a better place right now.


Princeton, N.J.: There was a column in the Times the other day ("Please Raise My Taxes") that was a good start, but he didn't provide enough justification. We can look at history to see why we need much higher marginal tax rates. During the period 1946-1973 taxes were much higher. Marginal rates averaged 70%; they were 93% under Eisenhower. The economy was better than what we now have. For example, median wages went up 3 times as fast as after 1973. Also I recently saw a graph of the national debt as a percentage of the GDP from 1946 to the present. It started high, went straight down until 1973, and then flatten out and in 1980 made a sharp turn and went straight up except for a wiggle during the Clinton administration. Since 1973, the percentage of the wealth and income of the US owned by the richest 10%, 1% or 0.1% has gone up at an ever increasing rate.

Have you ever wondered why US executives made bad decisions while others in Japan, say, made better ones as in autos, electronics, etc.? Could the reason be because our marginal tax rates are so low the our executives are motivated by the prospect of immense wealth to make short term decision that benefit themselves, but are bad for the country, the world, and indeed, even their own institutions? When we had much higher marginal rates, CEOs earned 50 times what their workers did (not 500 times) and they made better decisions.

Rakesh Khurana: I think in America we have adopted a different conception about the purpose of the corporation. There is no perfect system, but I think we have to start with the question. What is the purpose of the corporation? We know a couple of things. First, the corporation is one of the most innovative innovations ever created by mankind. It has the capacity to mobilize enormous resources and enable all of us to do something together that none of us could do alone. Yet, because of its power, the wrong type of leadership can use its power to manipulate the economy in a way that now threatens our well-being. We need to think about the relationship between corporate power and the governance of it.


NW D.C.: A few years back, leadership from the GE management tree was in vogue. They were heralded as great leaders and brought great return to companies. In fact, what several of them did was know how to please investors and Wall Street. Whatever happened to leaders developing quality products and gaining market share via better goods and services?

Rakesh Khurana: Interesting question. I think this model of outsourcing leadership development to another company has proven to be a bad idea. When I am asked by boards questions like: "Where is our great CEO?", I respond with the question, "What have you done to develop your great CEO?" We know there are lots of things excellent companies do to develop their leadership: they promote largely from within; they spend months matching people to positions; the boards are heavily involved in executive development. These things are actionable. Unfortunately, few boards take this duty with enough seriousness.


Marietta, Ga.: I think there is a big difference between regulating pay for companies taking bailout money, and regulating pay for private companies. If a CEO has done so much damage to a company that it needs bailout money from the taxpayers, he should consider himself lucky he still has a job, and expect that there will be strings attached to the bailout to make sure the taxpayers' money isn't wasted on things like $50 million planes or $1400.00 trash cans. If they don't like the strings, they don't have to take the bailout. They can try to find another way to save the company. (I'd personally recommend firing the people responsible, but I don't have an MBA.)

Rakesh Khurana: Agreed. I don't think the government is doing anything a private equity firm that took over a poorly firm wouldn't do. First, they would dramatically cut back pay of the executives. Second, they would align incentives toward long-term performance (which is what the government is doing with long-term incentives with the bank CEOs). Third, they would make sure that the preferred shareholders were paid back first.


Lusby, Maryland: What you are touching on is the redirection of the market from a place to invest and put your money to work and a place to gamble.

No one is talking or writing about the fact that the basic control of the market systems which were put in place in 1933 have, over time, been eroded allowing billions of banking dollars to be used to speculate/invest in securities. This flooding of the market with available dollars has caused the market to react not to the ability of a company to make profits from production but to react to the amount of dollars available at any given time to buy shares. Traders that perform no other service but to buy and sell using other stocks and assorted assets as leverage power then become a wheel within a wheel and bloat the money supply even more, odd infinitum, until something like the sub-prime loan mess comes along and affects the banks assets.

In short, the "market" is not a place to invest anymore. It is a casino where the tables are rigged by hedge-fund managers and banks.

Here are the bills I am talking about: Glass-Steagall Act of 1933, prohibited banks from owning stocks. The National Banking Accord of 1951, The Bank Holding Company Act of 1956, Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, and finally The Gramm-Leach-Bliley Act of 1999 which killed Glass-Steagall. The reinstatement of Glass-Steagall with language modernized to fit today's needs would be a great step toward establishment of banking control. The proper funding of control agencies would not be a bad idea either.

Rakesh Khurana: Interesting points. I think you are right. The institutional infrastructure we have for regulating and managing our economy was put in place during a very different era. It was designed for large, national or international companies, operating within relatively closed economies. Today, we have large multinational corporations operating across numerous geographies with a variety of complex services. The idea that 12 people sitting around a board table and meeting 4 times a year would be an effective governance system seems inadequate. The same is true for the regulatory structure. I think one of the challenges, to paraphrase Allen Greenspan, is that many of us were operating with a flawed model. Specifically, that markets didn't need institutions and institutional scaffolding to operate properly.


Herndon, Va.: What can your average citizen do to help stop this corporate greed?

Rakesh Khurana: Get involved. Too often our shareholders operate like absentee landlords. Additionally, the various stakeholders in society need to be more clear about the expectations they have for not only corporations, but those organizations charged with regulating them and educating corporate leaders. Without a strong, participative, system, we are likely to see the kinds of problems we are now seeing.


Rakesh Khurana: Wow! The time flew by. Thanks for all your thoughtful questions. I am deeply appreciative that you took some time today to interact with me.


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