“Anger”, more so than “fear”, is perhaps the most often expressed emotion by U.S. citizens, Congressmen, and media analysts when discussing the proposed $700B federal bailout of the U.S. financial system. “Anger” is the primary emotion because the $700B will be put at risk by the American taxpayer to bailout the very same financial institutions that have become increasingly reckless and greedy regarding their investing and borrowing practices.

In America, especially over the last two weeks, the discussion of a bailout to save our financial system and economy from ruin has become logically intertwined with a concurrent discussion of Chief Executive Officer (CEO) compensation packages. Many are outrgaged, especially in light of the horrendous financial results and excessive risk taking, when finding out about the lucrative CEO compensation packages consisting of base pay, bonuses, stock options, and termination (severence) pay.

Let’s analyze this topic by comparing the compensation packages of basketball superstar Kobe Bryant and recently fired AIG CEO Martin Sullivan.

In 2007, Kobe Bryant earned $20 million dollars playing basketball for the Los Angeles Lakers while Martin Sullivan earned $14 million dollars in 2007 running AIG, one of the largest insurance companies in the world.

In 2006, Bryant also earned $20 million for the year, whereas Sullivan earned $27 million as AIG’s financial performance was much stronger in 2006 versus 2007, causing Sullivan’s 2006 incentive-based compensation to be higher than 2007.

Now the big one: Sullivan’s 2008 termination or severence pay upon his firing as AIG CEO was $47 million dollars (two years pay)! Pretty nice “goodbye present” for Sullivan given the fact that AIG failed causing its owners (the stockholders) and potentially our country (taxpayers via bailout) to be crushed! Although Bryant has no termination or severence bonus built into his contract, his contract is guaranteed through 2011 which is somewhat similar to Sullivan’s “severence deal” in that Bryant is guaranteed payment should he be injured.

Thus, both compensation packages (Bryant and Sullivan) are somewhat similar in dollar amount, but beg the question: Is anyone worth that much money?

So the primary question of this blog is to discuss whether private market compensation, should be somewhat controlled or limited by governmental law, and if so, how.

Let’s start with Bryant.

If we passed a law taking the position that Bryant’s salary could not exceed $5 million per year, he would likely go play in Europe where European contracts are becoming more competitive and similar to U.S. contracts. Even if Bryant did stay with the Lakers, despite the new law, at $5 million per year, the $5 million savings (reduced salary) would go to the Lakers owner, Jerry Buss, so Buss would be making $5 million more at Bryant’s expense. In summary, we would have passed a compensation limiting law taking money from Bryant and giving it to the owner! Through the study of economics we ultimately understand that Bryant is, in essence, being paid by you and I whenever we see him at the arena (ticket prices) or watch him on TV (ad revenues). Ultimately, Bryant gets $20 million because we, not Buss, pay him $20 million! This is the private market at work, where voluntarily owners (Buss) pay their employees (Bryant) what they believe they are worth. Said one last way, Buss pays Bryant $20 Million per year because Buss thinks he can make more profit than if he doesn’t and loses Bryant to another team.

Let’s go to Sullivan now.

If we passed a law limiting executive salaries to some arbitrary number, say $5 million per year, the same thing would happen that happened to Bryant. The Harvard & Yale MBAs would not pursue American companies but would go to work at Canadian, European and Asian companies whose compensation would be “free market”. The U.S. would lose its best talent and our companies would become mediocre, fail at an increasing rate, and our standard of living would deteriorate as our leadership quality would deteriorate. It is the CEO that is at the helm of companies helping American businesses to produce an average 10.4% return for their owners (stockholders).

Now we get to the toughest question which is “should CEOs be paid a multi-million dollar severence payment after they have failed and been fired?” The obvious answer seems to be no! But sometimes, what appears to seem to be the obvious answer becomes less obvious in a free market. Any smart, Harvard or Yale MBA knows that they have a 50/50 chance of failing and being fired within their first 3 years as CEO. Statistics bear this out as CEOs are fired all the time as it is easier to fire the CEO than all of the employees. Large firms need the best talent and a talented CEO knows that sometimes their companies fail quickly often for reasons beyond their control no matter how talented they are. Thus, CEOs demand an “insurance payment” called severence pay to compensate them for their high risk and rate of failure. Once the CEO fails it becomes increasingly difficult to get that next CEO job as their reputation in the market place sours. Thus, a CEO looks at the entire compensation package (salary, incentives, and severence) when deciding where to work. If the risk is too high (dedicating their life to their business in lieu of their families) relative to the reward, they will take their talents elsewhere or to a new career.

What is my suggested government solution regarding trying to protect shareholders from excessive executive compensation? I suggest that our government only pass new law to increase ”disclosure requirements” on executive compensation to provide a better ”check and balance” on the Board of Directors who set the pay and severence amounts for the CEOs. The Government (SEC) should not get involved, in my opinion, with compensation limits or restrictions on severence pay, but they should pass a new law to provide greater visibility for the owners (stockholders) on their CEO’s (and other key management) compensation. For example, even though today all executive compensation is publicly accessible by the owners by examining publicly filed documents, the Government could pass new legislation making it mandatory for companies to send an annual letter directly to its owners (stockholders) outlining only their CEO’s and Board’s compensation.

But , please Government, be careful and don’t do anything stupid like setting maximums for CEO compensation.

Discussion Questions:

1. In your opinion, should the Government limit CEO salaries to some maximum? What about their severence payments, should they be limited? If so, how would you set the maximum amount?
2. Is it fair that Kobe Bryant makes more than a police offer? Why or why not?
3. What specific action should the Government take, if any, regarding executive compensation?

Related posts:

1. Will limiting exectutive pay send American business leaders packing for Europe? Probably not…
2. Obama’s carbon market: an introduction the market-based approaches to pollution reduction
3. From public to private – what’s next, lighthouses?

Managing Globalization: To reduce poverty, money isn’t everything – International Herald Tribune

Two developing countries: Venezuela and Brazil. Two ideologies underpinning economic growth and development: command in Venezuela versus free market in Brazil. Which system has worked better for the people of these two large South American countries?

How much can governments do to fight poverty? In South America, a couple of answers are emerging in the growing economies of Venezuela and Brazil. Both governments have publicly pledged billions of dollars to raise living standards – but have they succeeded?

Overall income is moving upward in both countries, if for different reasons. Venezuela is riding the black tide of high-priced oil, while Brazil’s relatively firm economic policies have built confidence in its business prospects among both locals and foreigners.

The president of Venezuela, Hugo Chávez, has portrayed himself as an ardent socialist and a disciple of Fidel Castro. Reducing inequality is fundamental to his agenda, whether by dividing up Venezuela’s oil wealth or, as he has obliquely suggested this month, through land reform. His consolidation of executive power has brought Venezuela closer to a centrally planned economy and, as such, has given him the opportunity to invest heavily in social programs.

But identifying the results isn’t easy. The poverty rate in Venezuela was about 50 percent when Chávez’s presidency began in 1999, according to the government’s own figures. Since then, roughly equal numbers of people have fallen into and out of poverty at various times, with a spike to more than 60 percent in 2003 and a drop below 40 percent in 2005…

Rodríguez also questioned whether Chávez’s programs could be completely effective because of the way they were managed. Some of the world’s most successful initiatives for improving the well-being of the poor, he said, linked families’ benefit payments to useful actions like their children’s attendance in school or visits to the doctor. In Venezuela, he said, the link is to political loyalty instead.

“The level of political polarization has become so high that not only is loyalty to the regime the key determinant of your access to benefits, it is also the key determinant of your capacity to be involved in the administration of those benefits to others,” Rodríguez said.

One example of this problem was a program intended to improve literacy. “The government had no system of accountability to monitor performance other than the reports of its own administrators,” Rodríguez said. “When program administrators learned that it was more important to show loyalty to the regime than to effectively run the program, any incentives that they had to administer resources efficiently, from a social point of view, disappeared.”

In Venezuela, president Chavez’s socialist inspired, command policies, paid for by the sale of expensive oil to the rest of the world have led to benefits primarily for those citizens willing to show political loyalty to Chavez and his party. Hard work and productivity is not rewarded as much as loyalty and support for the government. This system of incentives leads to some poor outcomes. The result? Only mediocre improvements in poverty rates, literacy, employment and health of the people.

In Brazil, where free market principles underlie much of the economic development policies, monetary benefits for development workers and the families they serve are linked not to political affiliation but to actual behavior of households and government employees. The result, not surprisingly, has been real improvements in education, health, and poverty levels amongst Brazilians.

Meanwhile, in Brazil, progress appears to have been more widespread. Figures compiled last year by Rômulo Paes de Sousa of the Ministry of Social Development and Fight Against Hunger, covering the period from 1999 through 2004, painted a rosy picture: School attendance was up, while illiteracy was down. Life expectancy was up, but hospital visits were down. Employment was up, and child labor was down.

Again, however, it’s difficult to say with certainty where the credit should go… [perhaps] to the simple fact that Brazil’s monetary benefits for families are indeed linked to actions like attendance in school, prenatal care and childhood vaccinations?

The lesson here? In a command economy like Venezuela’s, in which the government decides how resources are to be allocated, it appears that real improvements in people’s lives are not as important as political loyalty. Because most people involved in economic development work for the government, they focus on making themselves appear more dedicated and loyal to president Chavez, in order to make sure they get paid more and promoted up the ladder.

In Brazil’s free market economy, on the other hand, rewards are based on performance, not political loyalty. Brazilians have enjoyed access to a wider variety of efficiently run development programs than Venezuelans, despite Hugo Chavez’s pledge to alleviate poverty. Correct incentives explain why the market system is more efficient and effective than a command system, and the examples of Venezuela and Brazil illustrate this observation quite nicely

Discussion Questions:

1. Why do command economies fail efficiently allocate resources to where they are needed the most?
2. What does Brazil do that Venezuela does not that has led to real improvements in people’s lives?

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