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Here's Why Efforts To Curb Out-Of-Control Executive Pay Keep Failing

Not only are boards complicit in the executive compensation rip-off, but the government kicks in a significant share as well.

Compensation for public company executives is out of control. A number of factors have led to huge increases in executive compensation over the past 20 years and they all have had an impact.

When public companies were first required to reveal annual compensation for their top five highest paid executives, it was seen as a victory for shareholders. Now, finally there could be real shareholder oversight of executive compensation. In actuality, it has enabled executives to use those disclosures to negotiate ever increasing pay packages for themselves based on "comparables" of other public company pay packages for similar positions.

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Executives have been aided in this by a combination of a small group of highly influential executive compensation consultants (who are often paid a fee based on the level of compensation), weak board oversight and widely dispersed shareholdings that make it difficult to put pressure on boards of directors to control executive compensation.

However, there is one factor that more than any other has led to obscene public company executive compensation — stock options.

Stock options have been the golden goose that keeps on giving to executives. A stock option is a contract that allows the executive to purchase a fixed amount of the company's common shares for a fixed price, for a fixed period of time (sometimes as much as 10 years). The executive puts up no money and, once vested, will only exercise the option if she can buy the shares from the company at a lower price than they are trading at on the stock market.

Not only are boards complicit in the executive compensation rip-off, but the government kicks in a significant share as well.

It is like going to the casino and the casino says to you, "We will give you $1,000 to use in our casino, no strings attached. If you lose, you do not owe us any money, however; if you win, you can keep your winnings and just pay us our $1,000 back."

Not a bad deal — virtually risk-free for the executive. And like the casino, much of whatever value is created is based on luck and timing. Several studies have shown that there is no correlation between executive pay and stock performance. In Capital in the Twenty-First Century, Thomas Piketty and Arthur Goldhammer write:

"If executive pay were determined by marginal productivity, one would expect its variance to have little to do with external variances and to depend solely or primarily on nonexternal variances. In fact, we observe just the opposite: it is when sales and profits increase for external reasons that executive pay rises most rapidly. This is particularly clear in the case of U.S. corporations: Bertrand and Mullainhatan refer to this phenomenon as 'pay for luck.'"

The other major benefit of stock options for executives is that they are taxed as capital gains, which means they pay half as much tax on the proceeds from a stock option as they do on their salary. So, not only are boards complicit in the executive compensation rip-off, but the government kicks in a significant share as well.

Stock options have a legitimate purpose. They were originally designed as a useful tool for very early stage companies that had limited cash to pay their key people. In order to be able to get talented individuals to work at a highly risky start-up company, these companies were able to pay them with stock options. Most technology companies that started small used this form of compensation, and there are many examples of everyone from the CEO to the executive assistant becoming overnight millionaires (or in the case of the CEO, probably billionaires) when the company goes public through stock options granted when the company was struggling.

What is not so widely reported is that there are many more people at unsuccessful startups who made no money on their stock options and were probably paid very little in cash. So, they could have been working for several years for almost no compensation. This is the risk that these people take and the lucky ones are well rewarded.

The easiest and quickest way to begin to correct this egregious behaviour is to disallow public company stock options to be treated as capital gains. If the executives are required to pay tax at the top marginal rates, it will go a step towards making stock options less attractive. However, this will not correct the significant inequity of public company stock options as a no-lose proposition. Public company shareholders have to put more pressure on boards of directors to get off this merry-go-round, and the public needs to pressure the government to disallow the tax break.

So, the next time you are outraged at executive compensation, let your MP know.

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