The ethics of executive pay

THE ETHICS OF EXECUTIVE PAY

By Ben Teehankee

Green Light, Manila Standard Today

September 27, 2004

The recent debate about the level of executive pay in some government-owned and controlled corporations (GOCCs) and government financial institutions (GFIs) raises a number of important issues about public service, fairness in compensation, and the role of corporate governance in determining levels of executive pay, especially since these firms are exempted from the laws on government salaries.

Setting aside for the moment the polemics and moral indignation already expressed in many quarters, we can look more closely at the questions underlying the issues in search of some principles we can use to address them. For example: Is private sector practice a proper basis for determining executive pay in GOCCs and GFIs? Should the level of pay be based on financial performance? When is executive pay in a government firm excessive? How should executive pay be controlled in government firms?

Basis for compensation

Is private sector executive compensation practice a good basis? It depends on the practice being used as a pattern. In the first place, the issue of executive pay also arises in the private sector. In the US, where shareholder activism and compensation disclosures are highly developed, American business journalists and politicians have long lamented the widening gap between the pay of average workers in a company versus the pay at the very top. Unite for a Fair Economy (UFE) reports that the ratio of average CEO pay to average worker pay in the US has grown to 301 to 1, up from 42 to 1 in 1980. Negative public reactions to such high pay levels have been very strong. Richard Grasso of the New York Stock Exchange resigned after his $140 million package was discussed in the media. The Exchange is filing suit against Grasso to give some of it back.

But during bad times, there are occasionally good examples of private sector practice that should be emulated. While John Chambers has been CEO of Cisco Systems, the company increased its annual revenues from $1.2 billion in 1995 to $18.9 billion in 2003. In 2002, as Cisco was facing layoffs of 8,500 employees, Chambers volunteered to lower his annual salary to $1 with no bonus. He took the same $1 salary in 2003. The fact that Chambers holds about $200 million in stock options does not diminish the sensitivity of his no-pay gesture.

I like the Chambers example because it shows that even in a for –profit corporation which is doing very well financially, an executive can choose to take a pay cut out of sensitivity to difficulties faced by the company and its employees. Stated another way, an executive can understand that the strong financial results may have been gained at the expense of stakeholders such as employees, and act accordingly. It is not enough to argue that a pay level is acceptable because the market can bear it or that the firm is making money. A principled approach would be sensitive to the state of all stakeholders, especially the vulnerable.

Difference principle

When does executive pay become excessive? Ethical theory suggests a principle for guidance. Social justice philosopher John Rawls developed the “difference principle” which states that a structure that creates inequality among people is just if it is in the best interest of the least advantaged. This implies that it will be fine for executives to have greater pay as long as they bring their least compensated stakeholders up with them. For publicly listed corporations, the least advantaged would be rank-and-file employees and minority shareholders. The difference principle implies that they should be benefited by higher executive pay through higher pay and higher returns as well, respectively. For government firms, the stakeholders are the government employees and the Filipino people themselves. It can be argued, using the difference principle, that GOCC and GFI executives can have increased pay to the extent that this helps to raise the pay of their employees and to benefit the Filipino people in a demonstrable way. This is a matter of perception, of course, but pay beyond the level where it benefits the least advantaged is quickly seen as unconscionable or, in local parlance, garapal.

The proposal to legally cap GOCC and GFI executive pay tries to achieve the same purpose but I consider it more logical to aim for a ratio of executive pay to the lowest worker pay, following the difference principle. In the US, Congressman Martin Sabo of Minnesota is sponsoring a bill that would limit tax-deductible executive compensation to 25 times the pay of the lowest-paid worker. If passed, companies can still pay their executives as much as they want but amounts exceeding 25 times the lowest employee pay will not be considered an expense for tax purposes. Analogously, a possible application of the difference principle to government firms is to limit compensation to, say, 25 times the minimum wage. Based on the current P250 daily minimum wage, I would estimate this at around P170,000 a month. Although much lower than some of the pay levels we have been seeing, this will have the principled advantage of being anchored on the situation of the least advantaged Filipino worker.

Opportunity for patriotism

Ultimately, of course, the application of any principles for determining executive pay rests on the board of directors of the GOCCs and GFIs, as defined by law and designated by the President. Since the law gives the boards such wide latitude during these very trying times in our nation’s economic history, their leadership – nay, their stewardship – will have to come to the fore. I don’t think that presidential directives or new laws are necessary or even desirable because they rob the boards of an opportunity to truly govern. For both board directors and executives, this opportunity to be patriotic in aid of the common good is too important to miss. For such is the essence of corporate governance – the exercise of prudent judgement for the good of the stakeholders of the firm and society as a whole. I’m sure that executives who truly want to serve in government will not object to a reduction in their salaries given the national situation, lest they incur the people’s wrath. For, to quote the enduring words of John F. Kennedy, “If a free society cannot help the many who are poor, it cannot save the few who are rich.”

Ben Teehankee is the Senator Benigno Aquino associate professor of corporate social responsibility and governance and director of the Doctor of Business Administration program at the Graduate School of Business of De La Salle Professional Schools Inc. He may be emailed at teehankeeb@dlsu.edu.ph.