Inevitable Consequence of Soviet-Style Democracy in Corporate Board Selection?

Much has been made of the recent gargantuan pay days of many American CEOs. Depending upon your point of view it is either

1) a magnificent example of the free enterprise system at work, richly rewarding those super achievers who create extraordinary value, OR

2) a discouraging example of the excesses of human greed.

A recent New York Times column (Stephen Kotkin, Dangers of a Turbocharged Economy, 9/2/07) advocated, in passing, legislation that would link CEO salaries to a multiple of their own workers’ salaries, the theory being that it would simultaneously serve as a cap and as motivation to pay their lowest workers more. While I applaud the share the pie/social compact orientation of the proposal (I am a Populist Capitalist through and through) I do not find the solution workable. The Law of UnIntended Consequences would quickly kick in and bright legal minds would go to work searching for loopholes, the most obvious one which is simply to outsource all your low wage workers. Attempting to legislate and regulate around market forces is a full-time job, a never ending Sisyphusian task.

Fortunately, a simpler solution exists: use the free market, not legislation, to reduce runaway CEO pay.

The problem is not too much free enterprise, but not enough. The solution is to free shareholders to properly oversee corporations. Today, it is a myth that the shareholders own major corporations. Major corporations are run for the benefit of upper management, the CEO and the Board of Directors, not the shareholders. Shareholders are an afterthought, simply a more expensive form of capital, accorded none of the respect and stewardship that should accrue to true owners.

Shareholders typically face a reprehensible form of Soviet-style democracy: only one candidate. The slate of directors for the board is generally picked by the existing board and shareholders are usually presented with no alternative but yea or abstention. There exists a clubby atmosphere in the board rooms of most corporations where it is considered bad form to rock the boat or to call attention to unpleasant facts. Most major American corporations use a relatively small number of executive search firms to select both directors and C-level officers. To become known as a maverick, as someone who does not play the game, someone who is a shareholder advocate, is to jeopardize your future career opportunities and most certainly guarantee that someone will return the favor as and object lesson if ever it comes your turn to feed at the trough. To get along, play along. The heck with the shareholders (the titled owners in theory only), the widows and orphans, the great mass of American 401k holders.

This situation exists through a combination of restrictive state regulations and a company’s articles of incorporation and bylaws. The theory is that shareholders are incompetent to direct the affairs of the corporation and cannot be trusted to choose wisely. It has been under the paternalistic guise of the shareholders’ own good that state legislature have been lobbied to restrict (or to allow corporate organizational documents to do so) shareholder voting rights to the level of virtual nonexistence. While shareholders may not individually have MBAs, collectively they might. ”The Wisdom of Crowds, Why the Many Are Smarter Than the Few” by James Surowiecki raises some interesting issues in that regard. In any case, it is hard to imagine how shareholders could do worse than, say, the disastrous AOL-Time Warner merger or the current sub-prime mess.

If shareholders’ rights were restored, if shareholders were allowed to freely nominate and elect directors who truly represented shareholders and were not beholden to management or other directors for their selection, I suspect that CEO pay would gain a lot more scrutiny.

In general, to achieve a desired outcome, it is better to remove restraining forces (restrictions on shareholder oversight) than to increase driving forces (more legislation/regulation).