The Golden Passport

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The Golden Passport Page 62

by Duff McDonald


  In May 2014, Nohira emailed Lynton to thank him for hosting a June 11 HBS Los Angeles Regional Campaign Event at Sony Pictures Studios, as well as a private reception beforehand for “Campaign Leadership, Board of Dean’s Advisors members, and other key HBS alumni” beforehand. He invited Lynton to speak at the event.

  Whether it was due to crossed wires or impatience, just three days later, HBS professor Robert Kaplan (’83)—the senior associate dean for external relations—emailed Lynton, asking him to make a “special effort” to attend the campaign dinner being held at his own studio, and promised “an informative, interactive, and fun gathering.” He also invited Lynton to attend the private reception beforehand. Kaplan’s email prompted a reply from Lynton less than twenty minutes later, although like all good CEOs, Lynton didn’t respond to the little guy—Kaplan—but to Nohria, and told him that he would be happy to speak at the event. He also managed to squeeze in a lunch with Nohria and Ralph James (’82), executive director of external relations at HBS.

  In June 2014, Harvard president Drew Faust emailed Lynton to say, “Michael—I based my Baccalaureate talk this year on Breaking Bad. Thought you might be amused.”

  That same month, Lynton sent a note to fellow HBS alum Ratan Tata. “Dear Ratan,” Lynton wrote. “A belated thank you for the wonderful mangoes you sent! They have already been consumed with great gusto. And many congratulations on the Tata building at Harvard Business School. I just had lunch with Nitin Nohria and I gather we will be sitting on the advisory board together.”

  But how much advice would Lynton be giving Nohria? Perhaps not too much. Because, by July 2014, he had apparently overdosed on both Harvard and HBS. In an email to Andrew Farkas, the founder of Island Capital Group, Lynton unloaded:

  The thing is, as in your case, the university has asked a lot of me in addition to money.

  1.Hosting 500 people at the studio for Harvard ReConnect

  2.Hosting 400 people for HBS kick off campaign

  3.Hosting dinners for Drew to meet the creative community here

  4.Getting Matt Damon to do a video for the admissions web site

  5.Getting Vince Gilligan [creator of Breaking Bad] to come and do a talk with Drew

  6.Endlessly introducing Mike Smith at events

  7.Endlessly taking calls from professors who need help with issues in Hollywood

  The list goes on and on. And then all the time for the Overseers. I think they really have to be careful about what they ask of me and what kind of money they are asking.

  I think that I should take a break from the whole thing. I will go to some of the Overseers’ meetings this year but not engage in any of the other activities. Let me recharge my batteries and see if I am up for a big gift in a year’s time.

  Five months later, with hackers threatening to level the company, Lynton was surely wishing for the calmer days of July. When it was all over, and Fortune magazine ran a scathing two-part investigation into the company’s utter lack of preparedness for such an attack, he turned to the Harvard Business Review, which in a softball interview allowed him to tell readers how he was able to “sustain [Sony’s] culture” throughout the madness. It served as a reminder to the HBS network that even if the whole world is gunning for you, you can always return to the warm embrace of HBR.

  58

  The CEO Pay Gap

  Do you want to know why CEOs make such obscene amounts of money these days? Here’s why: In 1951, General Motors hired McKinsey consultant Arch Patton to conduct a multi-industry study of executive compensation. The results appeared in Harvard Business Review, with the specific finding that from 1939 to 1950, the pay of hourly employees had more than doubled, while that of “policy level” management had risen only 35 percent. If you adjusted that for inflation, top management’s spendable income had actually dropped 59 percent during the period, whereas hourly employees had improved their purchasing power. Management, of course, took special note of this finding, and demand for Patton’s “research” went through the roof. Juan Trippe, then CEO of Pan American World Airways, engaged Patton to work on a study of stock options for his management team. Once started, this demand to “justify” executive compensation became a perpetual motion machine.

  The imprimatur of HBS’s house organ gave the work credibility and the study was suddenly an annual affair, appearing in HBR for more than a decade thereafter, at which point it moved into McKinsey Quarterly. (In total, Patton wrote more than sixty articles on the subject over the years.) Between 1948 and 1951, HBR had published just one article a year on executive compensation. A few years later, the journal was running five times that amount. It was actually a perfect moment for the new “field of study.” In the post–World War II years, a shortage of executive talent meant that companies had begun poaching executives not just from the competition but also from entirely different sectors. And they had to know how much to offer, did they not? Moreover, in the post-Depression years, no one had wanted to talk out loud about compensation. But after the war, they were ready to raise the volume.

  At some point, of course, things got out of hand. Blame Michael Jensen. (Seriously.) Fifty years ago, CEOs were paid roughly 20 times as much as their employees. Today, that ratio stands at a staggering 354-to-1. Asked in the 1980s how he felt about the effect of his work, Patton’s reply was “Guilty.”1 The people of HBS do not feel the same way. Nor would they give Patton the same amount of credit that he receives above. In 1939, Wallace Donham claimed that the School “was among the first to undertake objective studies of the long-neglected question of executive compensation.”2 But it was all in the interest of science, of course. “Bonus plans, pension plans, and profit-sharing plans have recently been subjected to new and critical appraisals,” he wrote, “frequently by the very executives who were responsible for their adoption.” What bravery.

  Instead of attacking today’s problem head-on—how to finally put a halt to excessive increases in CEO pay—HBS flits around the margins, with efforts such as 2014’s “How Much (More) Should CEOs Make? A Universal Desire for More Equal Pay.” The study, which cited “indirect evidence that at least some people wish for smaller pay gaps,” marveled at the fact that even though most people think the pay gap should be smaller, the fascinating thing is that most people also vastly underestimate the size of the gap itself. Americans, for example, guessed that CEOs outearned factory workers by a margin of 30-to-1, exponentially below the actual gap of 354-to-1. The consensus ideal ratio? Just 7-to-1.3 Likewise, Americans have no idea just how concentrated the country’s wealth actually is. In “Building a Better America—One Wealth Quintile at a Time,” HBS researchers found that Americans estimated that the top 20 percent of U.S. households owned about 59 percent of the country’s net worth, when the proportion is actually 84 percent.4 The ideal amount was considered 32 percent. Americans aren’t socialists, but they do have a clear sense of what constitutes excess.

  “There’s no doubt that business schools are complicit in this whole capitalist conspiracy of paying top executives outrageous sums of money,” says Julian Birkinshaw, professor of strategy and entrepreneurship at the London Business School. “Why? Because we benefit financially from it as well. Clearly, the fees we can charge MBA students are correlated with the salaries they can get when they go get jobs.” He’s right: HBS has explicitly compared the rate of median salary increase of its graduates to the rate of tuition increase when it has sought to justify increases in tuition, in the process reducing an education to nothing more than a return-on-investment calculation.

  Thomas Piketty, author of the surprise 2014 bestseller, Capital in the Twenty-First Century, is arguably the world’s top expert on income inequality—not from a “what to do about it perspective,” but the mere fact of it, as represented by his unrivaled analysis of data, across both geographies and time. In a 2003 paper cowritten with Emmanuel Saez, “Income Inequality in the United States, 1913–1998,” he encapsulated the dynamics of increasing inequality
in the United States in just two sentences: “The marginal product of top executives in large corporations is notoriously difficult to estimate, and executive pay is probably determined to a significant extent by herd behavior. Changing social norms regarding inequality and the acceptability of very high wages might partly explain the rise in U.S. top wage shares observed since the 1970s.”5 In other words, executives have seen their compensation rise not because of their contribution to corporate performance, but because of a surprising cultural acceptance of exploding executive compensation regardless of whether it was deserved or not. What Piketty is saying, observes Liam Murphy, a philosophy professor at NYU, is that “the real reason for the explosion in supermanagers’ pay . . . is that supermanagers set supermanagers’ pay.”6

  Among the responses from the executive suite to accusations of excessive pay: We’re not the ones making crazy money—take a look at hedge fund managers! There is some truth to the point: “While CEO salaries in the U.S. appear unconstrained by any sense of modesty,” writes Michigan’s Jerry Davis, “the more extreme sources of inequality come from outside of the corporate ambit. In 2004, the 25 best-paid hedge fund managers collectively earned more than every CEO in the S&P 500 combined. The U.S. has attained a level of income inequality higher than every country in Europe—including Russia. Yet it is not so much those at the top of bureaucracies that contribute to our current Bolivian level of income inequality, but those outside of corporate hierarchies.”7 But that’s merely a deflection, not a justification of excessive executive compensation, particularly considering that hedge fund compensation is largely determined in advance, generally as some percentage of assets under management plus a performance kicker. They eat what they kill, whereas the majority of corporate executives eat what they want.

  More to the point, they eat what they think they deserve, which is more than they do. While the majority of corporate boards have compensation committees that determine executive pay, those boards all tend to use compensation consultants, and those consultants base their estimates on prevailing compensation, which is set by boards with a heavy presence of current or former CEOs of other firms. In other words, it’s one of the most intricately designed circle jerks in business history. CEOs are paid what other CEOs think they should be paid, which is based on what other CEOs have been paid. That’s a problem that even HBS dean Kim Clark found worthy of mention in a 2003 speech to the National Press Club about the wave of corporate scandals at the time. “[Executive compensation] is an area that has not had the kind of in-depth look it deserves,” he said, “yet it is at the core of a number of the problems we’ve seen.”8 HBS claims influence when it wants to; it proclaims helpless-bystander status when it does not.

  And it’s never HBS’s fault. “There has been a lot of discussion about stock options and expensing them through regulatory action and through passing new additions to our GAAP standards,” Clark continued. “But this is just part of a much larger problem, as I’ve tried to suggest, and will require new thinking about the design of compensation systems and processes within the boards through which compensation is determined. Yet if you look at the discussions going on in the press, there’s very little attention paid to compensation committees.” So it was the media’s fault. (Isn’t is always?) Also: What press had he been reading? The issue had been given more than enough attention for more than a decade.

  In 2008, the Aspen Institute published “Long Term Value Creation Principles,” which included a section on the “appropriate structure” of compensation. It all made perfect sense, including the ideas that executives be forced to hold their equity compensation for a period beyond their tenure (thus seeking to avoid the juicing of short-term results at the expense of long-term value), the use of “clawbacks,” and transparency in the timing of equity awards. The report also recommended that boards remain “sensitive to the practical reality that compensation packages can create reputation risk and reduce trust among key constituencies and the investing public.”9 Well-intentioned it might have been, the effort lacked any teeth, given that the principles were merely “aspirational guidelines for good business practice.”

  In her 2015 paper “From Pioneer Egalitarianism to the Reign of the Superrich: How the U.S. Political System Has Promoted Equality and Inequality over Time,” Cornell professor Suzanne Mettler asks how a country so dedicated to equality has managed to experience such a dramatic increase in inequality since the 1970s. Her central point is that whereas business executives will argue until they’re blue in the face that it is business that lifted our collective boat in the middle of the twentieth century, it was actually the country’s progressive tax regime that did so. Since the 1980s, however, that dynamic has been reversed, and in an increasingly polarized political environment, lawmakers increasingly act only in response to the demands of the wealthiest Americans and powerful industries. That’s for a variety of reasons, including the dominance of special interest lobbying by conservative and business groups, but also the decline in the influence of American civic organizations. At the same time, rising tuition at schools such as HBS, combined with a declining commitment on the part of both states and the federal government to higher education, has resulted in marked decline in opportunity for all but the wealthiest Americans.

  “[What] was once an American innovation—a diverse and widespread array of colleges and universities that combined access and affordability with excellence—has gradually evolved into a system that perpetuates social and economic inequalities,”10 Mettler writes. But she saves her most pointed criticism for the “submerged state,” that panoply of recently introduced tax benefits—such as preferential treatment of capital gains and dividends—enjoyed by affluent households to the tune of $1 trillion in lost revenues to the federal government. When HBS professors Michael Porter and Jan Rivkin argue that the “path” to reducing inequality must focus on increasing the probusiness tilt of U.S. federal policy, including with respect to taxes, they’re hilariously off the mark. That’s the path we took to get us where we are today.

  It’s not that HBS is unaware of this fact. “In 1993 the U.S. Congress changed the tax code to encourage the grant of stock options as executive compensation,” writes Walter Kiechel in “The Management Century,” which appeared in HBR in 2012. “[By] the end of the decade more than half the payout to the typical Fortune 500 executive took that form. So what if the ratio of CEO pay to that of the humble cubicle worker was climbing to Olympian heights? Think of all the value the CEO was creating. OK, perhaps this wasn’t the kind of moral leadership that Wallace Donham had had in mind for the managerial class, but he was long dead, his voice largely forgotten.”11

  What’s more, the increasing disparity is a perfect example of market failure, not market perfection: It costs only about $80,000 a year to get yourself a battalion commander in the Marines, someone who has a lot more responsibility than the average CEO. Why should it cost more than, say, $1 million, to obtain competent managerial ability? Especially in light of the fact that hundreds of thousands of MBAs are awarded each year? One would think that battalion commander’s salary would fall if West Point increased to 100 times its current size, no? So why hasn’t the same thing happened to corporate pay? Because the system has been fixed.

  “[Leaders] are not only less important than they imagine, but also less important than we imagine,” writes Barbara Kellerman in The End of Leadership. “[Although] we have ‘this almost blind belief that the manager at the top changes everything,’ in fact he or she generally does not. This is not to argue that CEOs are insignificant. It is to argue that since ‘changes in leadership account for [only] roughly 10 percent of the variance in corporate profitability on average,’ they are not omnipotent. Of course my own view on this is that we, particularly those of us in the leadership industry, tend over and over again to make the leader attribution error: to assume the leader is where the action is. Though in exceptional cases—the iconic Steve Jobs again comes to mind—this hold
s true, more often than not it doesn’t.”12

  In a 2014 article in HBR, “How Boards Can Rein in CEO Pay,” consultant Graham Kenny makes clear that some executive compensation policies have simply lost all connection to reality. Pointing to the 2013 annual report of mining giant Rio Tinto, he observes that it “allocates a mind-blowing 41 pages (out of 244) to executive compensation.” Nearly 20 percent of their report to shareholders, in other words, is dedicated to themselves, not their company. “It’s an exercise in justification,” he writes, “and the logic is off-base. Showing how pay aligns with a narrow set of key performance indicators . . . has become a higher priority than making sure the metrics are relevant to the organization’s health. . . . Many companies . . . devote almost as much space to explaining their hellishly complex remuneration schemes for senior executives as they do to accounting for performance.”13

  “Complex” may be too generous a characterization. An alternative: “rigged.” “CEOs are frequently rewarded for good outcomes that are not the result of their own effort (such as a booming stock-market) and are not symmetrically punished for unlucky events,” wrote Piketty, Saez, and Stefanie Stantcheva in 2011. “[There] is [also] widespread malpractice in compensation setting which seems to indicate rent-extraction. For example, 30 percent of firms from 1996 to 2005 seem to have used ‘options backdating’ (which consists in choosing the ‘grant dates’ ex-post to allow for the minimal strike price of at-the-money options). [Evidence] for rent-seeking among CEOs is substantial.”14 More recently, a February 2016 study by three professors at the University of Michigan’s Stephen M. Ross School of Business concluded that between 2008 and 2014, executives continued to use manipulative devices, including backdating, to increase their compensation by some 6 percent.15

 

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