A reasonable and fair compensation system for executives and workers is fundamental to the creation of long-term corporate value. However, the past two decades have seen an unprecedented growth in compensation for top executives and a dramatic increase in the ratio between the compensation of executives and their employees.
Boards of directors are responsible for setting CEO pay. Too often, directors award compensation packages that go well beyond what is required to attract and retain executives and reward even poorly performing CEOs. These executive pay excesses come at the expense of shareholders as well as the company and its employees.
Excessive CEO pay takes dollars out of the pockets of shareholders—including the retirement savings of America’s working families. Moreover, a poorly designed executive compensation package can reward decisions that are not in the long-term interests of a company, its shareholders and employees.
Some CEOs may have far greater control over their pay than anybody previously suspected. The past year has witnessed a stock options backdating scandal that has resulted in U.S. Securities and Exchange Commission (SEC) investigations at as many as 160 companies and the departure of many CEOs, such as William McGuire of United Health Group.
Also in 2006, departing CEOs Henry McKinnell of Pfizer and Robert Nardelli of Home Depot both received exit packages of more than $200 million. Both companies underperformed during their tenures, although their excessive pay was an issue in itself.
In some cases, CEOs were entitled to receive generous exit packages, despite their involvement in the stock options backdating scandal. Former CEO Bruce Karatz departed because of options backdating at KB Home, but because he retired and was not fired for cause, the terms of his employment agreement entitled him to an exit package worth as much as $175 million.
Karatz’s compensation is frozen until an agreement is reached between him and KB Home on how much he will actually receive. Investors have urged the company not to pay Karatz. However, because of the legally binding employment agreement, KB Home has a weakened case if it decides not to pay him
Excessive CEO pay is fundamentally a corporate governance problem. The board of directors is supposed to protect shareholder interests and ensure that CEO pay reflects performance. However, at approximately two-thirds of companies, the CEO also chairs the board. When a single person serves as both chair and CEO, it is impossible to objectively monitor and evaluate his or her own performance.
CEOs also dominate the election of directors. The vast majority of directors are hand picked by incumbent management. Because of the proxy rules, it is prohibitively expensive for long-term shareholders to run their own director candidates. Moreover, even if a majority of shareholders withhold support from directors, they still are elected to the board at many companies.
Ultimately, shareholders have to be able to trust their boards of directors to set responsible CEO pay packages. For this reason, CEO pay will be reformed only when corporate boards become more accountable. Until then, CEOs will continue to influence the size and form of their own compensation, and CEO pay will continue to rise.
The good news is that investors may finally get the tools needed to make boards of directors more accountable. Last year, a historic court decision at American International Group ruled that shareholders have the right to reform the way that directors are nominated for election.
The business community has been pushing the SEC to undo this decision through regulatory action. Hopefully the SEC will resist this pressure and ensure the protection and expansion of long-term shareholders’ rights to participate in corporate board elections.1]The Corporate Library's Annual CEO Pay Survey 2007, The Corporate Library, December 2007.
 Remarks by Linda Chatman Thomsen, director, SEC Division of Enforcement, at the March 19, 2007 conference of the Council of Institutional Investors.
 Pfizer 8-K, Dec. 21, 2006; and Home Depot 8-K, Jan. 4, 2007.
 “Exiting Under a Cloud, with $175 Million,” Los Angeles Times, Nov. 20, 2006.
 “U.S. Prosecutors Examining Options Case at KB Home,” The New York Times, Feb. 24, 2007.