Business at a Crossroads Leadership_3 pdf

76 Business aT a Crossroads
High levels of inequality cause serious social problems. In their
book, The Spirit Level, Richard Wilkinson and Kate Pickett marshal a
wealth of evidence showing that social ills, including rates of physical
and mental illness, teenage births, crime, obesity and violence, and rela-
tively low educational performance and social mobility, all correlate
much more closely with the degree of inequality within societies than
with absolute levels of income. Inequality is the curse of mature, liberal
capitalist societies, particularly of the U.S. and the U.K. Wilkinson and
Pickett argue that instead of addressing social ills on a piecemeal basis,
policymakers should focus on reducing inequality.
5
It’s not inevitable, of course, that all countries will follow the U.S.
and U.K. path toward growing inequality. In Europe, there seems to be
a divergence between the U.K. and southern European countries on
the one hand, and more egalitarian patterns in Scandinavia and Germany
on the other. Moreover, Ginis are influenced by traditions reflected in
tax rates, as well as by distributions of value added within companies.
It remains to be seen whether such national path dependencies
(the tendency for traditional distributions of income and wealth to be
maintained) will be strong enough to resist the upward pressure on
national Ginis exerted by large, global corporations, organized on
Anglo-Saxon lines.
This book focuses on the U.S. and the U.K., however, and for these
two countries, the danger is clear.
We are in uncharted territory. Mature liberal capitalist societies have
never been tested by such inequalities. No one knows how they will
react. Protests, certainly. Riots, very possibly. Revolts and civil wars,
unlikely. But there could well be a political lurch to the left, a return to
some form of socialism, and a loss of market freedoms. Those who fear
any such developments should be afraid.

According to the U.K. Institute for Fiscal Studies (IFS) the U.K.
Gini coefficient soared from 0.25 in 1979, to 0.34 in the early 1990s.
“The scale of this rise in inequality,” the IFS authors commented, “has
been shown elsewhere to be unparalleled both historically and compared
with the changes taking place at the same time in most other developed
countries.”
6
The proximate causes of riots in Brixton, London; Moss
Side, Manchester; and Toxteth, Liverpool in summer 1981 were said to
be racial tensions, and the heavy-handed use by the police of the “sus”
(suspicion) laws. But in his report on the causes of the Brixton riots
Lord Scarman suggested “complex political, social and economic
factors” had created a “disposition towards violent protest.” It seems
likely that among these factors was the erosion of the public’s percep-
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4 The deCadenT CorporaTion 77
tion of background fairness during a period in which inequality was
rising at an unprecedented rate.
The rapidly rising Gini during most of the Thatcher era (after the
cuts in marginal tax rates, inequality fell in the mid-1990s) may have
contributed to New Labour’s general election victory in 1997. People
sensed the rich were getting richer and the fat cats in the City were
coining it, resented the growing inequalities, and chose the party with
the stronger egalitarian tradition.
If this is what they thought, they were disappointed.
After falling slightly in the early to mid-1990s at the end of the
Thatcher era, the U.K.’s Gini rose again in Labour’s first term to a new
peak of 0.35 in 2000–01. During Labour’s second term, it fell slightly,
before resuming its growth and passing the previous peak in 2006–07.
Insofar as voting for Labour in 1997 was voting against the growth

of inequality during the Thatcher era, it was futile.
Although there was no recurrence of inner city riots following
New Labour’s signal lack of success in reducing inequality, there
were rumblings of discontent. In the first of a series of articles in the
Telegraph in early 2008 Judith Woods bemoaned the fate of what she
called “the coping classes,” who were not in fact, as the IFS later
pointed out, but felt impoverished. “While the working class is
topped up with family credits and hedge fund managers cream off
millions, it is Britain’s beleaguered middle earners who are under
siege” claimed Woods.
7
The IFS suggested this feeling of impoverishment among people
with rising and well above average incomes may have had something to
do with the rapid increase in the highest incomes. The authors looked
at the 99

:

50
income ratio; incomes at the 99th percentile (the top 1
percent) relative to incomes in the middle. The ratio rose by over 15
percent between 1997 and 2007 “suggesting that incomes at the very
top of the distribution have grown faster than incomes in the middle …
This also means, of course, that incomes at the very top have been
accelerating away from incomes at the 90th percentile [which had
grown at the same rate as the median income]. This may go some way
to explaining the sense of injustice allegedly felt by the outwardly
affluent ‘coping classes’.”
Since a consensus is sustained more by beliefs than by facts, what
people perceive to be the case is more important for the future of liber-

alism capitalism than the facts of the case. Judith Woods’ “coping
classes” are not actually impoverished, but the “millions” being
“creamed off

”
(interesting metaphor, see Chapter 5) by city fat cats and
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78 Business aT a Crossroads
senior executives make them feel impoverished. This sense of injustice
(the feeling that the background fairness that most people demand in
return for their compliance with the system, which is by no means
confined to the coping classes, of course) is deepened by the publicity
now given to what are widely regarded as the excessive sums paid to
company leaders.
Ordinary people seem to have got it into their heads that city fat cats
and company leaders are being paid not only hundreds of times more
than the average, but much more than their “fair share”; much more
than the Rawlsian difference principle allows; much more than the
economic value they add. They are coming to be seen as “robber
barons,” accumulating enormous wealth by means that are tantamount
to institutionalized theft from the savings of ordinary people.
More than fair shares
The financial crisis of 2007–08 is likely to be seen in retrospect as a
turning point in the evolution of liberal capitalism.
The consensus that sustained the system had been undermined by
the erosion of background fairness during the previous decade, but
had survived because the rising tide of stable economic growth had, as
promised, lifted all ships. The difference principle that required
inequalities to be in the interests of the disadvantaged seemed to be
working, more or less. Ordinary people may have grumbled a bit, but,

by and large they trusted the putatively extraordinary people who
were managing the system (the CEOs and fat-cat financiers) and toler-
ated their manifestly extraordinary pay levels. Executive pay was
certainly an irritant, but not a provocation. While the system was
delivering the goods, most people accepted these pay packets as the
going rates for the allegedly “rare skills” needed to do these vital
system management jobs.
It was natural that when the system crashed, the system’s managers
should be called to account. The irritation with executive and fat-cat
pay became indignation, bordering on outrage, when some of the fat
cats and CEOs walked away with bulging pockets from the disaster they
had helped to bring about.
Charles (“Chuck”) Prince resigned as CEO of Citigroup, the largest
U.S. bank, in November 2007, shortly before the company announced
a fourth quarter loss of almost $10 billion, after over $22 billion of
write-downs for subprime mortgages and consumer loans granted on
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4 The deCadenT CorporaTion 79
his watch. In a farewell statement Prince said: “given the size of the
recent losses in our mortgage-backed securities business, the only
honorable course for me to take … is to step down.”
8

Honorable, he may have been, but Prince was hardly destitute. His
severance package consisted of vested options, deferred stock and
restricted shares, and a pro rata slice of his 2006 bonus adjusted for
2007 shareholder returns. That added up to about $40 million.
9
Merrill Lynch, the “thundering herd” financial services group, was
forced into a rescue merger with Bank of America after making a $7.8

billion net loss in 2007. Chairman and CEO, Stanley O’Neal, retired in
October 2007 taking $161.5 million worth of securities and retirement
benefits with him.
10
It was “punishments” for mismanagement such as these that led
the U.S. Democrats to insist on the inclusion of restraints on execu-
tive pay in legislation giving effect to the government’s $700 billion
Troubled Asset Relief Program (TARP). These restrictions, which at
the time of writing in early 2009 were widely expected to become a
model for comprehensive federal legislation limiting executive pay in
general, and reducing tax reliefs associated with it, reflected the
nature of public concerns about the way senior executives were
being rewarded.
TARP restrictions on executive pay
Outgoing U.S. President George W. Bush signed into law the Emer-
gency Economic Stabilization Act of 2008 (EESA) on October 3, 2008.
EESA authorized the Department of the Treasury to use a “Troubled
Asset Relief Program” (TARP) to buy up to $700 billion of residential
or commercial mortgages, mortgage-related securities, obligations or
other instruments originated or issued on or before March 14, 2008
from financial institutions either directly or at auction.
11
In response to the concerns that taxpayers’ money might be used to
enrich the executives of firms taking advantage of the TARP, EESA
included provisions restricting compensation for “senior executive
officers” (the top five most highly paid executive officers) and reducing
associated tax deductions under the 1986 Internal Revenue Code, at
participating institutions.
When a financial institution sells assets directly to Treasury and
Treasury gains “a meaningful equity or debt position,” the company

has to meet “appropriate standards for executive compensation and
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80 Business aT a Crossroads
corporate governance” while Treasury holds the equity or debt. The
appropriate standards include:
■ No incentive arrangements that encourage senior executives to take
“unnecessary and excessive risks that threaten the value of the finan-
cial institution.”
■ The company must claw back any bonus or incentive payments to
senior executives based on financial reports that later prove to be
“materially inaccurate.”
■ No “golden parachute” payments to departing senior executives
while Treasury holds the equity or debt.
When a participating institution sells over $300 million of assets to
Treasury, it cannot sign new employment agreements with senior exec-
utives that include golden parachute arrangements in the event of an
involuntary termination, a bankruptcy filing, insolvency, or receiver-
ship, for as long as the TARP is in effect (until December 31, 2009
initially, but it can be extended until October 3, 2010).
The tax code’s $1 million a year limit on the deductibility of the pay
of top executives of public companies, introduced during Bill Clinton’s
presidency, is reduced by EESA to $500,000 for financial institutions
that sell over $300 million of assets to Treasury. The exception for
performance-based rewards, such as shareholder-approved, equity-
based incentive plans, is withdrawn; their income counts toward the
$500,000 cap. These lower caps remain in effect while the TARP
remains in effect.
The tax code imposes a deduction limit on parachute payments after
a change in control, and a 20 percent tax on any excess. The EESA
extends these provisions to payments to “covered executives” (CEO,

CFO, and the three other most highly paid officers) of companies
receiving $300 million or more from the TARP, in the event of invol-
untary termination of employment by the institution, bankruptcy filing,
insolvency or receivership, whether or not there is a change of control.
The EESA specifically states that the amounts treated as EESA golden
parachute payments cannot be reduced by amounts deemed reasonable
compensation in the change-in-control provisions. Here too, the provi-
sions apply while the TARP remains in effect.
These restrictions on executive compensation at TARP beneficiaries
have been criticized for not going nearly far enough, for going so far that
institutions affected will be unable to hire sufficiently talented executives,
for being unworkable or easily evaded and for not defining key terms,
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4 The deCadenT CorporaTion 81
such as “involuntary termination,” “golden parachute,” “meaningful
equity or debt position,” “unnecessary and excessive risks” and “appro-
priate standards” for executive pay and corporate governance.
Whether or not any of these criticisms have any merit, and whether
or not the TARP rules effectively rein in excessive executive pay, the
EESA conditions for TARP participation illuminate the concerns of
Americans about executive pay in the midst of a major financial crisis
and on the brink of what seemed at the end of 2008 to be an unavoid-
able recession, likely to be both deep and prolonged.
There were four major concerns.
The first was that the incentive plans for top executives designed to
reduce agency costs by identifying the interests of executives with those
of shareholders, were having the unintended consequence of encour-
aging executives to take “unnecessary and excessive risks that threaten
the value of the financial institution” or companies in general. This was
largely because the incentives were “up-side loaded” – there were

rewards for outperformance, but no penalties for underperformance.
Some senior Democrats, including Massachusetts congressman,
Barney Frank, chairman of the House of Representatives financial
services committee, want to outlaw such asymmetry. “If you take a
risk and it pays off, you get a bonus,” Frank told the Financial Times.
“If you take a risk and lose the company money you break even. That
is a bad incentive. I don’t care about bonuses going forward, as long
as we deal with deductions going backward. We have to find some way
to make that a law … They can have any bonus they want as long as
it’s a two-way street.”
12
The second concern was that, because incentive plans were based on
numbers in financial statements over which senior executives had a
considerable amount of influence, there was scope for “gaming” the
plans by fudging the figures. This was why the TARP rules required
participating companies to claw back incentive plan payments based on
figures that later proved to be “materially inaccurate.”
The third “concern,” if that’s not too mild a word to describe the
indignation of many Americans at the huge pay-offs to the likes of
Chuck Prince and Stan O’Neal (see above), is with the particularly
provocative manifestation of upside loading, known as the “golden
parachute.” Huge rewards for failure strike people struggling with the
consequences of such failures as outrageous affronts to normal stand-
ards of fairness. In Rawlsian terms they are gross violations of the differ-
ence principle’s implicit requirement that pay should be proportionate
to economic value added. TARP conditions ban new golden parachute
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82 Business aT a Crossroads
contracts with senior executives of participating institutions and, at the
time of writing, there’s pressure to make them generally illegal.

The fourth concern revealed by the TARP rules is that, quite apart
from the reckless risk-taking encouraged by the upside loading of incen-
tive plans and the unfairness of golden parachutes, senior U.S. execu-
tives are paid too much. This is reflected in the halving of the tax code’s
$1 million a year limit on the deductibility of the pay of some senior
executives of public companies participating in the TARP.
The gathering storm
A puzzling feature of the U.S. and to a lesser extent the U.K. debates
on executive compensation is that, so far at any rate, people seem less
concerned about the absolute levels of executive pay than the asym-
metry of incentives and rewards for failure. Despite high and growing
inequality in both countries (as indicated by their Gini coefficients),
there seems to be a wide public acceptance that it is reasonable to pay
“C-level” executives orders of magnitude more than ordinary employees.
Graef Crystal, doyen of American executive pay commentators, takes an
admirably hard line on CEO pay packets, but, as two articles on his excel-
lent website in late 2008 showed, he reserves most of his scorn for high pay
without high performance. He expressed disgust at the $21 million paid to
H. J. Heinz Co.’s CEO, William Johnson, for 2007–08, because Heinz’s
performance that year was average, but approved of the $27 million a year
paid to Hank Paulson, Secretary of the Treasury in George W. Bush’s
government, during his stint as CEO of Goldman Sachs, because the bank
handsomely out-performed during his stewardship.
13

Leaving aside, for the moment, doubts the reader may harbor about
assigning credit and blame for above and below average performance to
CEOs alone, public indignation about executive pay before the crash
was focused on high pay for average or below average company perform-
ance, rather than on high pay itself.

Possible explanations for the hitherto sanguine public attitude to
very high levels of executive pay include the belief that they are actually
worth what they are paid (this is less plausible and less prevalent since
the crash), good public relations (calling senior executive pay “compen-
sation” was a PR masterstroke), a lack of resolution in public percep-
tions (an extra million or so a year is neither here nor there) and the
distinctive American culture (the “American dream”) which idolizes
entrepreneurs and admires wealth itself.
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4 The deCadenT CorporaTion 83
But, as noted at the beginning of this chapter, wide acceptance of
the system and, in this case, executive pay, is not unconditional. The
consensus must be maintained. Another million here and another
million there and pretty soon you’re talking about serious money.
People will notice. If they begin to believe the inequalities they’ve toler-
ated hitherto are getting out of hand, or that the system is rigged, their
admiration for the wealthy and successful could turn to resentment.
Executive compensation was already an issue before the crash. When
the chairman of the U.S. Securities and Exchange Commission (SEC),
Christopher Cox, announced his review of executive pay disclosure
rules, the recommendations of which were implemented in 2006, the
SEC received a then record 30,000 letters from investors and other
interested parties.
12
The crash, and particularly the shower of golden
parachutes it ejected, heightened public sensitivity and reduced Ameri-
cans’ admiration for wealth. As former SEC chairman, Harvey Pitt,
said: “It is decidedly un-American to pay people when they don’t
perform and don’t do the job[s] they were hired to do. It’s a huge issue
that boards have not really addressed in the way they should be

addressing it.”
12
This is a critical period for the liberal capitalist consensus. If board
Remuneration Committees (RemCos) do not substantially rein-in
Anglo-Saxon senior executive pay levels in the next year or so, popular
demands for legislation imposing restrictions much tighter than those
contained in the EESA could become irresistible.
It will not be easy for RemCos, for political, legal and technical
reasons, to achieve such a reining-in.
Barriers to reform
A Democrat in the White House, and a Democrat majority in Congress
provide a more threatening political environment, which should, on
the face of it, make it easier for RemCo reformers to insist that, if
companies do not regulate executive pay themselves, legislators will
do it for them.
But there is still plenty of political support for, and opposition to,
changes in the status quo in executive pay.
Free marketeers have billed plans to reintroduce a so-called “say on
pay” law, similar to those in the U.K. and elsewhere, which would give
shareholders a non-binding vote on executive pay, as a left-wing bid for
power in company boardrooms, and the bill itself as a gross, unwar-
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84 Business aT a Crossroads
ranted intervention in the workings of the market. The original bill was
passed by Congress, but got stuck in the Senate, where its sponsor was
the then senator for Illinois, Barack Obama. The bill could be law by
the time you read this, but some suggest fund managers who vote
against pay packages designed to motivate executives to improve
performance could be in breach of their duty to fund beneficiaries to
maximize the value of their holdings.

Given the non-binding nature of the proposed “say on pay” vote
and the fairly relaxed attitude to executive pay of most institutional
shareholders, apart from union pension funds and a few “socially
responsible” investors, the bill was hardly a major threat, on its own, to
the status quo. The opposition of American liberals to the bill probably
stemmed more from philosophical, than from practical concerns. They
saw it as an ominous, if minor, withdrawal of hard-won freedoms; as a
small step on The Road to Serfdom (the title of an important libertarian
book by the liberal philosopher and Nobel laureate economist, Frie-
drich von Hayek).
The vigilance of American libertarians in protecting freedoms, and
opposing any developments or proposals that could be construed as
thin ends of wedges leading to more state control is admirable and
healthy, because it’s true that the road to neo-socialism is paved with
good intentions.
But better the thin end than the thick. A much more potent threat
to liberal capitalism than non-binding “say on pay” legislation is the
alarming possibility that, rather than moderating in the wake of the
crash, for technical reasons relating to options, executive pay could
explode again as equity markets recover.
When compensation consultants are asked to recommend pay deals
for top executives, their normal practice is to identify a “comparator
group” of companies of a similar size in the same industry, trade infor-
mation with the comparators on total pay, including the value at grant
of stock options (estimated with the Black-Scholes model) for the posi-
tions concerned, and make recommendations based on the RemCo’s
brief. This could be the average for the comparator group, or, if a client
wants a reputation for paying well, a higher point in the distribution,
such as the 75th percentile (the top quarter).
Options are important components of pay packages, because they

are seen by investors as identifying the interests of executives with
those of shareholders. But a key variable, when estimating Black-
Scholes present values, is recent share price performance. If the
company has performed well and its share price is high, the Black-
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4 The deCadenT CorporaTion 85
Scholes value of options will be high on date of grant. This leads to
the perverse result that, if the desired position within the comparator
group is to be maintained, fewer options can be granted when the
company’s share price is high.
Apart from making a mockery of the putative incentive effect (when
a share price is high, it’s likely to be harder for the CEO to get it
higher, so more options are needed to maintain the incentive), this has
alarming implications for executive pay rises in the next year or so. We
have seen why fewer options can be granted when the share price is
high. The reverse is also true. In the absence of agreement between
companies to moderate option grants, more would have to be granted
when the price was low, if the desired position within the comparator
group is to be maintained.
Since all share prices plummeted during the 2008 crash, the normal
practice for compensation directors and consultants, would be to
recommend grants of very large numbers of options in 2009. If, as
expected and fervently hoped, equity markets recover over the next few
years, these will become very valuable and cause executive pay to rocket.
As Crystal put it: “If you think ordinary Americans are pissed now over
high executive pay, fasten your seatbelt.”
13

The executive pay explosion may be even larger if RemCos decide
to compensate executives for the fact that so many of their pre-2008

options are “under water” (worthless), by granting them even more
options than Black-Scholes values may suggest. The same applies to
grants of restricted shares that “vest” after a specified period, which
have become popular recently for motivating and retaining executives.
Extra large grants of restricted shares to compensate for losses on
those granted before 2008 will also supercharge pay in recovering
equity markets.
There’s a ratchet at work here. When markets tumble, Black-
Scholes calculations and RemCos anxious to retain executives whose
options are worthless and whose restricted shares are worth much
less, sow the seeds of another executive pay explosion during the
subsequent upswing.
A dangerous decadence
Although to understand the calculus of executive compensation, is to
have some sympathy with the RemCo’s dilemma, it should be clear to
company directors, who in their executive roles are among the greatest
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86 Business aT a Crossroads
and most conspicuous beneficiaries of liberal capitalism, that the system
needs yet another executive pay explosion over the next few years like it
needs a hole in the head.
But they can’t see the wood for the trees. They are locked into a
comparative, rather than an absolute, way of looking at executive pay.
They do not want to be too generous relative to their peers because
investors would object, but neither do they want to appear penny-
pinching, or to break ranks and adopt pay policies that seem fair to
ordinary people. They don’t want even to think about that, because
they know, deep down, that a pay policy that seems fair to the man on
Main Street would require reductions in current levels of executive pay
of at least an order of magnitude; reductions, in other words, of at least

90 percent.
Directors hear the public outrage, but they don’t heed it. They’re
much too busy watching their peers and making sure that, according to
the benchmarks, they and their senior executives are overpaid enough.
They must heed the public outrage, try to see themselves as
others see them, and particularly as voters see them, and wean them-
selves from their addiction to already enormous and constantly rising
pay packets.
So persistent is the upward surge of executive pay, so egregious is its
level and so heedless are the executives themselves of popular objections
to it, that it is easy for ordinary people to see it as evidence of a fin de siècle
decadence and to see CEOs as sybaritic Bourbon monarchs, advised by
obsequious courtiers (including their compensation consultants), heed-
less of the breadless masses on the eve of the French Revolution.
But to suppose it’s all because of greed would be to miss the most
important point.
The argument so far
Companies, and the work they provide, are not as most people would
like them to be, because the company has not adapted sufficiently to
today’s business environment. Moreover, the power and pay large
companies assign to their CEOs has led to growing inequality and a
pervading sense of injustice, which threaten to erode the liberal capi-
talist consensus. The question we turn to in the next chapter is whether
this inequality and injustice are prices we have to pay for the system’s
economic efficiency.
9780230_230941_06_cha04.indd 86 09/09/2009 10:01
4 The deCadenT CorporaTion 87
References
1 A Theory of Justice, page 303, Oxford University Press, 1972.
2 Belknap Press, 2001.

3 Social Unrest in China, May 8, 2006, CRS.
4 “Distant Thunder,” August 18, Financial Times.
5 The Spirit Level: Why More Equal Societies Almost Always Do Better, Richard Wilkinson and
Kate Pickett, Allen Lane, 2009.
6 Poverty and Inequality in the U.K.: 2008, Mike Brewer, Alastair Muriel, David Phillips and
Luke Sibieta, Institute for Fiscal Studies, Commentary 105.
7 “The Coping Classes – Part 1: Why do we all feel so damn poor?” Telegraph, January 29,
2008.
8 Citigroup press release, November 4, 2007.
9 “Citigroup gives ex-CEO Prince $40 million severance package,” by Dan Wilchins, Inter-
national Business Times, November 10, 2007.
10 U.S. Securities and Exchange Commission filing, October 30, 2007.
11 U.S. Department of the Treasury, HP-1207, October 14, 2008.
12 “Fear of falling,” Francesco Guerrera and Joanna Chung, Financial Times, January 6,
2009.
13 The Crystal Report on Executive Compensation, GraefCrystal.com.
9780230_230941_06_cha04.indd 87 09/09/2009 10:01
88
5 Not so much greed
We saw in Chapter 4 how the high current levels of executive pay are
undermining the political consensus on which the survival of liberal
capitalism depends by increasing inequality to a dangerous level, and
eroding the public’s belief that, by and large, liberal capitalism produces
fair and reasonable distributions of wealth.
This chapter will focus on the questions of why, given its obvious
dangers for liberal capitalism in general and company executives in
particular, this unfairness arose in the first place and why, in the face of
the growing chorus of opposition, it persists.
Various answers to these two questions have been proposed over the
years, and I shall suggest some more later on. But I want to start with a

suggested answer that is widely subscribed to, and probably contains an
element of truth, but which is, in my view, inadequate at best, unhelpful
and distracts attention from far more important issues.
Greed
Many people who object strongly to what they see, quite rightly in my
view, as obscenely high levels of executive pay, attribute these annual
king’s ransoms to greed. It is an appropriately ugly word, which, with a
little practice and the addition of adjectives such as “sheer,” “breath-
taking” or “insatiable,” all of us can spit out with considerable venom
and indignation.
It is usually left at that. Today’s breathtakingly high levels of senior
executive pay are explained as the products of a character flaw that
afflicts the tiny fraction of the population who succeed in climbing to
the tops of corporate ziggurats.
There are three implied assumptions in this explanation – greed is
bad; greed is unnatural; if others with natural appetites ran our corpora-
tions they would not demand such huge pay packets, and the social
tensions they are beginning to cause, which make them in my view the
Achilles heel of modern capitalism, would be eased.
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5 NOT SO MUCH GREED 89
All three assumptions are open to question.
The word “greed” has many meanings. It is excessive consumption
of or a desire to consume excessively, food, as in “greedy guts”, and is
thus a synonym for gluttony. Through metaphorical extensions it has
come to mean excessive consumption of – or a desire to consume exces-
sively – more or less any thing or any sensation, and has in the process
acquired overtones of selfishness and rapacity. It is also used as a
synonym for avarice and acquisitiveness, and, more generally, for hunger
and desire, when a pejorative implication is intended.

In the context at hand, it means a hunger or desire for money, and
although a pejorative implication is most certainly intended, it’s argu-
able whether it’s warranted.
In the 1987 film, Wall Street, Gordon Gekko, the anti-hero played
by Michael Douglas, said in a speech at a general meeting of a company
he was planning to acquire that greed was good. In the film, this was
merely a disingenuous apologia for avarice, cobbled together for the
“good prevails over evil” plot. But, as is often the way with a parody, it
contained truth. It was also an eloquent articulation of the dynamic and
situational logic of free markets. Greed is hunger, without which free
markets would not keep moving resources to higher value uses.
Greed, in the sense it is used in the executive pay debate, is not good
or bad in my view, and nor is it “unnatural.” In the passage quoted in
Chapter 2, Max Weber made the same point:
The impulse to acquisition, pursuit of gain, of money … exists and
has existed among waiters, physicians, coachmen, artists, prostitutes,
dishonest officials, soldiers, nobles, crusaders, gamblers and beggars
… it has been common to all sorts … of men, at all times … wher-
ever the … possibil

ity of it is or has been given.
1
If greed, in Weber’s sense of “The impulse to acquisition, pursuit of
gain, of money” is natural, we can’t be sure that a change of personnel
at the top of our major companies would moderate senior executive pay
sufficiently to remove the deep sense of unfairness that is eroding the
liberal capitalist consensus. I do not believe it would. Given the oppor-
tunity, almost all of us are acquisitive. Those who rail against the greed
of company executives should ask themselves whether they would
behave any differently if they found their way into an orchard where

money grows on trees.
To explain the executive pay explosion as evidence of an unnatural
greed is to miss the point and divert attention away from the real and
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90 BUSINESS AT A CROSSROADS
serious problem; that there’s something wrong with the system. If
greed is the only explanation, if the political–economic system we have
chosen cannot help but allow a few people to indulge their impulse to
acquisition so extravagantly, liberal democracy and its economic system
of capitalism are in trouble, because it’s hard to imagine how any
political–economic system could survive such gross inequities in the
long term.
Those who rely entirely on greed to explain today’s extremely high
levels of executive pay must confront the logical implications of their
explanation; namely, that these rewards are the creatures of capitalism
itself, or rather, of the interactions of natural human impulses with the
capitalist system. Their proposition is that the freedom to indulge our
natural human impulses within a free market system leads, inevitably, to
huge disparities in income and wealth and such disparities, and the
sense of unfairness they foster, are the price we have to pay for the
superior allocative efficiency of the free market system.
I hope, we should all hope, this isn’t true and I don’t believe it to be
true for two reasons.
The first is that it is the growing sense of unfairness created by gross
disparities in income and wealth that is eroding the liberal capitalist
consensus, not the disparities themselves. People don’t begrudge entre-
preneurs their wealth. I don’t believe the wealth of very successful
entrepreneurs such as Bill Gates, Steve Jobs, Sir Richard Branson, James
Dyson and Anita Roddick, contributes to the public sense of unfairness,
and thus to the erosion of the liberal capitalist consensus.

Most people admire entrepreneurs and regard their wealth as a fair
reward for their creativity. Few people see it in these terms, but most
believe, in effect, that in making entrepreneurs wealthy, the system is
working efficiently and, therefore, fairly.
It is the greedy guts, those who seem to be taking more than their
fair shares, who cause resentment. The deep sense of unfairness is
generated entirely by the rewards being paid to executives, not to
those being earned by entrepreneurs. It stems from the widespread
belief that, when granting these rewards to executives, the system is
working inefficiently and therefore unfairly; that executives are paid
extremely well, not because they are (like entrepreneurs) extremely
creative, but because they have found a way to evade the system’s
automatic regulators and, in common parlance, “rip it and the rest of
us off.” They’re grabbing more than their fair shares. Their rewards
are out of all proportion to the economic value they create for the
shareholders who employ them.
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5 NOT SO MUCH GREED 91
This perception is basically sound. The system that sets executive pay
levels isn’t working properly. But there is no conspiracy. Top executives
aren’t all consumed by greed and cynically manipulating their reward
systems to line their own pockets.
Some might wish to. Some may try to. Some may even succeed to
some extent. But there are regulators, in the form of shareholders,
and corporate governances laws, rules and codes of practice. It’s true
they do not work well, but an unlawful manipulation of the system
can still lead to a jail sentence. That such corruption is rare is partly
because most executives are law-abiding, partly because it is risky and
partly because there’s no need. CEOs can do very well for themselves
without cheating.

The real problem lies, not so much in greed or in low standards of
compliance with executive reward systems, as in fundamental flaws in
the executive reward system itself. It produces “more than fair share”
rewards, because:
■ In the absence of any suitable performance measurement for CEOs,
their reward systems default to what I call “asset-skimming.”
■ The CEO “market” operates within an alliance (between companies
and capital markets) that is riddled with conflicts of interest and
conflicts of interest and duty.
■ The executive pay explosion in the 1980s was the consequence of
the arrival of shareholder value analysis and the deregulation of
financial services.
■ The transformation of the CEO from the most senior “manager” to
the superstar “leader” effectively closed the CEO market.
This is the second reason why I don’t believe that unfairness is a
price we must pay for the free markets. Enormous executive rewards are
the result of a “market inefficiency” the system has so far failed to
correct.
The market in question is the market in management and “leader-
ship skills.” Whatever else divides those who find today’s high levels of
executive pay acceptable, and those who see them as evidence of sheer
greed, they are united in believing that the market in these skills is effi-
cient. If it is not, then the actual pay rate is not the market clearing rate
(it may be higher or lower) and, on the far from heroic assumption that
it’s higher, sheer unnatural greed is not the only explanation for it.
It’s one thing to allege a market inefficiency, however, and quite
another to demonstrate and describe it.
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92 BUSINESS AT A CROSSROADS
Asset-skimming

Years ago when I was a young financial journalist I wrote a letter to an
estate agent who had just sold my mother’s house. I was very rude. I
told the agent that, for a deal in which an aggressive and unscrupulous
buyer had “reverse gazumped” my mother (unilaterally reduced the
agreed price) the day before she went on holiday, his fee for printing a
few brochures and attending a few viewings was much too high. I went
on to say that what irritated me most of all was that his professional
qualifications as a valuer and surveyor, the initials of which he proudly
displayed on his literature, were of no relevance at all to the business of
selling a house.
I received a rather sniffy reply, which conveyed (quite eloquently if I
recall) a nice blend of injured pride and mild reproof, and pointed out
that my mother had agreed his terms – 2.5 percent of the sale price –
before his engagement. The correspondence ended there. I had had my
say and was not involved in buying and selling houses often enough to
feel inclined to make an issue of it.
But I wasn’t alone in those days in thinking there was something a
bit “shady” (as my mother would have said) about the estate agency
business, and that agents were getting more than their fair share.
Estate agency fees have come down since. I paid 1.25 percent when I
sold my mother’s last house. But, in view of what had happened to
house prices in the intervening 30 years, it still seemed a bit of a
rip-off. My impression is that many people feel the same way today
about estate agents with their flashy cars, tailored suits and patron-
izing airs. They seem, or seemed until the house market stalled in
2008, like a bunch of spivs who were charging much more than the
services they provided were worth.

Most people are paid for the value they add, either directly, with
piece

rate or more usually nowadays through the “proxy” of time
worked or spent in the office. Estate agents, investment bankers, securi-
ties brokers and fund managers don’t get paid for the value they add or
the time they work. Their income takes the form of a levy on the assets
that pass through their hands, or are entrusted to their care.
It is the same for senior company executives. They do get paid for
time worked, in the form of a basic salary and of contributions to their
pension funds, but this is usually just pocket money. By far the largest
components of their pay are equity incentives, such as issues of options
and restricted stock, both of which skim a slice off the company’s value
by diluting the holdings of other owners.
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5 NOT SO MUCH GREED 93
Asset-skimming of this kind yields substantial rewards that have little
to do with the economic value executives add while markets are buoyant.
And, as we saw in Chapter 4, extra issues of options and stock are quite
common after markets take a dive. Bear markets are very useful for
executives, because they increase their gains in subsequent bull markets.
It works like a ratchet, or the jiggle siphon you use to drain your fuel
tank when you don’t want a mouth full of petrol. The more the market
jiggles, the more options and stock senior executives accumulate, and
thus the greater their pay packets over the whole cycle.
An unwholesome alliance
Partly because they are paid in the same “asset-skimming” way CEOs
and City and Wall Street investment bankers share similar outlooks and
have common interests.
They share, for example, an intense interest in balance sheets.
The influence of the CEO on a company’s profit and loss account is
more limited than is normally supposed, because any improvement in
operating profitability is the achievement of many employees, not, as is

implied by his or her pay packet, the personal achievement of the CEO.
The CEO’s real power base is the balance sheet. That’s where he or she
(almost invariably he) bets the farm by borrowing, making acquisitions,
launching new businesses or investing more in existing businesses, and,
by proxy (through putatively independent non-executive directors on
the RemCo) diverting value into his own pocket with issues of options
and restricted stock.
RemCos themselves have their own conflicts of interest and duty.
Those who support the status quo in executive pay usually cite the
huge pay packets of sport stars, such as David Beckham, and suggest it is
inconsistent to be sanguine about the latter, while opposing the former.
I will examine this argument in more depth in the next chapter. Suffice it
to say here that the rewards of sports stars are not decided by other sports
stars, whereas members of RemCos, although non-executive directors,
are usually executive directors of other companies, and thus have a clear
interest in ensuring the level of executive pay in general remains high.
Because investment bankers make most of their money from
corporate balance sheet operations, such as bond and share issues (on
which they earn large, asset-skimming underwriting fees) and mergers
and acquisitions (M&A), they encourage CEOs to exploit their balance
sheet powers to expand their businesses by these means. CEOs tend to
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94 BUSINESS AT A CROSSROADS
be favorably disposed toward such encouragement, because there is a
strong link between the size of a company and the size of its CEO’s pay
packet. Since there is no such link between company size and profita-
bility, insofar as CEOs seek higher rewards by pursuing growth oppor-
tunities that offer returns below the cost of capital, shareholders suffer.
In this case, the interests of the investment banker (who earns transac-
tion fees) and the CEO (who is paid more) coincide, but are in conflict

with the interests of shareholders. And the interests of the CEO are also
in conflict with his duty to shareholders to maximize shareholder value.
The quest for size at the expense of shareholder value is a common
agency cost that’s sometimes actually encouraged by those, or their
representatives, who incur it.
When U.K. retailer Kingfisher announced plans to sell its Superdrug
and Woolworths businesses in August 2001, a National Association of
Pension Funds (NAPF) spokesman took what in any other context
would have been a commendably tough line on the pay of Sir Geoff
Mulcahy, Kingfisher’s CEO, by arguing that, since the size of the
company would diminish, Sir Geoff’s pay should be reduced.
2
But this
was dangerous talk, because it appeared to endorse a link between size
and pay, and thus to encourage CEOs to overpay for acquisitions and to
refrain from making value-creating divestments.
Conflicts of interest, and conflicts of interest and duty were also
evident after U.K. cellphone operator Vodafone’s acquisition of the
German conglomerate Mannesmann (one of the largest takeovers on
record) in 2000. Top Mannesmann and Vodafone executives, including
Vodafone’s CEO Sir Christopher Gent who received a £10 million
“transaction bonus” in shares and cash, and the investment banks
involved, did extremely well out of the deal, but Vodafone’s shareholders
subsequently suffered a substantial fall in the value of their holdings.
Wealth itself is part of the bond between an investment banker and
his or her CEO client. Thanks to their asset-skimming success both are
extremely wealthy by normal standards. They feel comfortable in each
other’s company for that reason and see the world from the wealthy
person’s point of view. Most are honest, law-abiding and ethical, but
because of the balance-sheet power of CEOs and of the investment

bankers who have influence over them, the world is more manipulable
for them than it is for ordinary people. And nothing CEOs do is more
intense and exciting than exercising that power to manipulate by making
bold, industry restructuring acquisitions.
Imagine how the CEO feels at a meeting with his investment bankers
after a rival bidder has offered more for the target. The bid team is
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5 NOT SO MUCH GREED 95
discussing whether to withdraw or increase the offer. The deal is on a
knife-edge. Adrenalin surges through his body. To withdraw now is to
lose. His investment bankers, fearing the loss of their success bonuses and
the underwriting fees on the share issue that will finance the acquisition,
urge him to stick with it, bid again and “dare to be great.” It may be in
the interests of shareholders to withdraw from the auction, but it is in the
interests of no one in the room. Even for a CEO who is scrupulous about
acting in the interests of shareholders, the temptation to run the due
diligence numbers again with more optimistic assumptions on post-
merger cost savings, so that they justify a higher bid, can be irresistible.
An unhappy coincidence
One of the puzzling questions about senior executive pay is why it took
off so dramatically in the late 1980s.
According to a recent study by America’s Economic Policy Institute
(EPI) the CEOs of the 350 largest U.S. public companies were paid on
average 24 times the pay of a typical U.S. worker in 1965. The ratio
rose steadily, but not dramatically over the next decade or so, to reach
35 in 1978. Over the following decade, the ratio doubled, to 71 in
1989 and then rocketed to reach 298 in 2000. The bursting of the dot.
com bubble reduced the value of equity-based compensation and the
figure fell to 143 in 2002. But the ratio of CEO to worker pay quickly
resumed its rapid rate of growth and within five years was close to its

2000 peak at 275. “In other words,” the EPI study pointed out, “in
2007 a CEO earned more in one work day [there are 260 in a year]
than the typical worker earned all year.”
3
Executive pay packets aren’t as enormous in the U.K., but they’re in
the same ballpark. The Guardian newspaper’s 2008 annual survey of
executive pay found that 34 of the 956 directors of FTSE 100 index
companies were paid, including salary, bonuses and shares but not
pension contributions, more than £5 million in 2007, up from 20 in the
previous year. Eight directors were paid more than £10 million and
three took home more than £20 million.
4
The average CEO’s pay fell slightly, from £2.9 million in 2006, to
£2.8 million in 2007, compared to the average U.K. employee’s pay of
£24,000. That means the average FTSE 100 CEO was paid 117 times
more than the average employee.
You have to take care with the figures, because some analysts with
axes to grind count options when they’re granted (at Black-Scholes
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96 BUSINESS AT A CROSSROADS
values) and when they’re exercised, and so end up with much higher
ratios than the EPI’s. But all the time-series analyses of the CEO
pay : t
ypical worker’s pay show that sudden acceleration in the late 1980s.
I was a financial journalist at the time and preoccupied with two
major, long-running stories. The first was the run-up to and fall-out
from Big Bang – the deregulation of financial services – in 1986, which
led to the development of modern investment banks. The second major
story, less dramatic at the time, was the arrival of a new (to most CEOs
at the time, at any rate) and, it transpired, influential idea about how

companies should be managed. It came to be known as “shareholder
value” and was, initially, not so much a prescription for a company
leader, as a description of how markets valued companies. Jack Welch,
CEO of U.S. giant General Electric (GE), is usually said to have been
the first CEO of a major company to adopt shareholder value as a
fundamental strategic objective, but there were several precursors,
including James (later Lord) Hanson of Hanson Trust, who employed
shareholder value strategies before they became known as such. Alfred
Rappaport provided the intellectual basis for the shareholder value
revolution in his 1986 book Creating $hareholder Value: The New
Standard for Business Performance.
5
It became the bible for a new
generation of company leaders dedicated to the maximization of share-
holder value.
I found and still find the idea that the sole purpose of a company is
to maximize shareholder value, in the form of capital gains and divi-
dends (“total shareholder returns”), very appealing. It seems to me to
be true, in the sense that the share price of a company that has a purpose
other than shareholder value maximization (SVM) will be lower than it
would otherwise be and the company will be vulnerable to a takeover.
It is an evolutionary process. Companies that don’t maximize value
are consumed by those that do. The SVM prescription is little more
than an “exploration of the situational logic,” as Sir Karl Popper
described Darwin’s theory of evolution.
Others object strongly to the SVM imperative, and insist companies
should have higher purposes. Advocates of this “stakeholder” model of
the company argue that companies have responsibilities, which they
should acknowledge, to employees, customers, suppliers, local commu-
nities, society at large and the environment, as well as to their share-

holders. This is silly. The capitalist system does not, and would not work
that way. A non-owner stakeholder (I prefer the word “constituency”)
cannot (and should not be empowered to) hold a company to account
as can its shareholders. But a company that doesn’t take employees,
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5 NOT SO MUCH GREED 97
customers, suppliers, communities, society at large and the environ-
ment into account would find it hard to create value for anyone.
The SVM idea is valid and healthy, and its adoption by most listed
companies has probably led to the movement of a vast quantity of
productive resources to higher value uses. But its success has had an
unfortunate side effect.
The main benefit for shareholders when a company adopts SVM as
its principal objective is that, other things equal, the agency costs they
incur when their hired managers have other objectives will be reduced.
It followed from this that the best way to ensure senior executives
focused on shareholder value was to give them “skin in the game,” in
the form of equity-based incentives. Because of the market’s poor
performance during the 1970s executive stock options had been out of
fashion since the mid-1960s. They came back with a bang during the
shareholder value revolution and have since soared way past their peak
in the mid-1960s when, according to Rappaport, gains on options
accounted for roughly a third of senior executive compensation.
SVM evangelists, like Joel Stern, the co-founder, chairman and CEO
of Stern Stewart, an influential “managing for value” consultancy, say
that as far as equity-based incentives are concerned, the more the better.
I had lunch with Stern in London, when SVM was getting into its
stride. I liked him. He’s great company; a showman in the dry number-
crunching SVM world, who could talk the hind legs off a donkey. “If
the sky’s the limit” he told me, “people tend to reach for the sky.” Stern

Stewart’s concepts of Economic Value Added and the “bonus bank”
were healthy restraints on the indiscriminate use of stock options in
executive pay, but it was thanks to Joel Stern and others like him that it
became conventional wisdom in the U.S. and U.K. investment commu-
nities that, if shareholders wanted maximum value, they had to offer
CEOs the prospect of becoming seriously rich.
There was no suggestion that this was necessary to encourage others
as tournament theory suggests (see Chapter 2). The incentives were for
the CEOs themselves.
The puzzle is why the investment community accepted these huge
CEO rewards. It was in the interests of asset managers, and the savers
they act for, to deter CEOs from imposing agency costs associated with
non-SVM strategies, but it seems odd on the face of it that they were
so sanguine about exchanging one kind of agency cost for another;
namely huge CEO pay packets. Some institutional investors have been
quite aggressive in demanding more effective performance links and
shorter contract terms, but the investment community as a whole has
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