Symptoms of a Social Disease

The nature of business has mutated, turning companies into navel-gazing monstrosities

"You could find a CEO to replace me for a quarter of the pay," the manager of one of Israel's 10 biggest companies told TheMarker last week, in a moment of candor. "He'd work just as well. My colleagues and I don't stand a chance of finding a job abroad. The prime minister's claims about an executive brain drain are a joke."

Why doesn't the board of directors that hired that CEO try to find a replacement at a quarter of the cost, or renegotiate this one's pay?

That's a stupid question, as anybody with a clue about the world of the biggest companies knows. The people who hired him and built his compensation package aren't concerned about his high salary. Most of them benefit from it indirectly. The chairman of that company earns about the same as the CEO, so the last thing he'd do is initiate a discussion on the board about executive pay. As for the directors, they know that if they want to stay in the loop they have to keep salaries as high as possible.

The company owners have their own reasons for giving big bucks to the people at the top: It's peanuts to them, compared to the impact of the regulator on the company. And anyway, they're not footing the bill. They have ways of milking the company without paying dividends to shareholders.

Bar graph of executive pay in various countries
Harvard Magazine

Prime Minister Benjamin Netanyahu and Finance Minister Yuval Steinitz may think the public is stupid, or apathetic. For two weeks now they've been peddling the story that the government mustn't intervene in executive pay because it would constitute an attack on one of the foundations of the free market (which is the engine driving the economy ) - the millions paid to managers.

If anything, the bleeding hearts are abetting the prime minister and finance minister. Their rhetoric perpetuates the illusion that executive pay is an ideological, or political, issue: socialism versus capitalism.

But all too often, executive pay has nothing to do with the good things underlying the free market: productivity, competition, initiative, talent. Inflated executive pay does not create value for companies, or for society. In Israel's case, in fact, it often destroys value.

If you want more information on executive compensation, read the latest edition of Harvard Magazine, a bastion of capitalism staffed by people who ardently believe in the free market. It contains an article called "The Pay Problem" by two Harvard Business School professors, Jay Lorsch and Rakesh Khurana.

Yes, in America they have realized that high executive compensation has morphed from a solution into a problem. Some are stuck in the past, still believing that it's a way to improve corporate performance and the overall economy. But this is increasingly a minority view, as more and more studies debunking that tenet are conducted.

Let's start with the facts. Lorsch and Khurana say that the most comprehensive survey ever done on the link between executive pay and corporate performance in the United States found that "changes in firm performance account for only 4% of the variance in CEO pay."

In other words, CEOs manipulate the system to extract maximum pay, irrespective of performance. Sometimes it's even worse: High pay creates dysfunction.

Lorsch and Khurana present a list of studies on U.S. executive pay over the years. They prove that pay levels do not correlate with performance; that many CEOs have no control over the results they "present"; that usually only the topmost people receive high remuneration even though many people are responsible for the results.

High pay, an end in itself

They show that there is no real market that sets executives' pay, and that wage advisers usually confine their services to advising CEOs on how to squeeze out the most. They show how the market mechanism results in pay only rising, never falling.

Mainly, they show that the system focuses the managers on creating wealth for themselves, not for the companies they lead.

In short, CEO pay rises not because it drives improved corporate performance, but as a consequence of the performance.

All that is very interesting, but even more interesting is the professors' main argument: CEO pay has ceased to be the means to improve a company and the economy as a whole. It has become an end in itself.

That applies not only to pay, but to the general conduct of CEOs and, some would say, of the leaders in many public frameworks as well.

In fact, the problems of executive compensation are symptomatic of larger societal questions," write the Harvard professors. The attitude toward executive pay has come to shape not only the market but American society as a whole, they argue.

Once big companies were seen as social institutions, not only businesses: they were measured not only by naked numbers but by the ethical and political implications of their moves. Today, nothing of that is left but financial criteria driven by contract law.

People have forgotten that companies are complex social institutions, and that relationships within the organization matter. They can't be boiled down to contracts, argue Lorsch and Khurana.

Reducing companies to contracts, and nothing more, conveniently ignores research results from a host of disciplines, and negates the company's responsibility toward the greater good.

The debate on companies must change, they argue, to revisit their role in society. They are part of society and can't simply pretend they aren't. They consume public services, albeit indirectly - education, publicly funded R&D, and basic infrastructure. In return, they are expected to behave in an ethical manner.

But they haven't been. Executive pay mutated the executive character, argue the professors. They view today's managers as free agents prepared to sacrifice the company's long-term good for their own short-term gain.

The present ethos legitimizes the idea that people need to be bribed in order to focus on creating value for shareholders, at the expense of commitment to workers, clients, the community or the environment, they sum up.

In their article, Lorsch and Khurana stress that they deeply believe in the power of business driven by profit. But, they say, "business is useful only if it serves as a means toward an end."

Ergo, high executive pay is a symptom of far worse social disorder. The debate shouldn't confine itself to technicalities: It should ask about the place of companies in society, in order to build an inclusive and sustainable economy in which managers don't need to be bribed into doing their jobs.

No. 2 at sheer piggishness

The members of Israel's executive-pay set are probably not enjoying this article. It reminds them, at least the more aware among them, that even the rich and successful belong to society and owe their success to it as well.

Some might argue that this article is relevant for the United States but not for Israel. Quite the opposite. It is hard to think of a more extreme example of the phenomena described by Lorsch and Khurana than what has been happening in Israeli society in the past decade.

Israel even gets a shout-out in the article. It's hiding in a bar graph at the bottom of a pages comparing CEO salaries in 27 countries. It turns out that when it comes to executive piggishness, Israel is exceeded by just one country: the United States. Compensation packages for CEOs in Israel, after controlling for company size and industry, are higher than in Switzerland, Ireland, Canada, the U.K., Australia, Italy, Germany, the Netherlands, Austria, Denmark, Singapore, Sweden, New Zealand, Finland, Norway, South Africa, Poland, Hong Kong, France, Belgium, Thailand, Spain, China, Malaysia and India - in descending order.

What also characterizes Israel, and some of the other backward economies in the graph, is that the highest salaries are paid at monopolies and cartels fed by government resolutions that are generally run by people who corporate America or Britain or Germany wouldn't touch with a barge pole.

The disease is not confined to the business sector. It's a disease of society, a swinish or corrupt ambience in which everyone is fixated on maximizing their own personal gain.

Millions of Israelis serve a tiny oligarchy of wealthy businessmen and well-connected people in the public sector. There is no real difference between the private and public sectors. The privatization process has turned public monopolies that disavowed responsibility to the public into private ones that did the same. Advanced economic structures meant to bring productivity, innovation, initiative and talent have become places in which few survive.

Executive pay is a symptom of the disease, serving sometimes as a tool of the oligarchy - and sometimes of Israel's leaders - to entrench the existing order. The weakness of the public domain serves them doubly: It enables them to rob taxpayers and consumers as well as to play the munificent benefactor who steps into the state's shoes and distributes largesse to their needy subjects through charities.

Anyone with eyes in their head sees these things. But the people in power don't want change, and just about everybody else is too busy trying to survive.