Is Finance Theory Responsible for the Rise in CEO-kleptocracy?

The unprecedented rise in the compensation of CEOs and other top executives in US listed companies began in the early 1980s. As documented in several studies, including that of Frydman and Saks (2007) from which we reproduce the following two charts. In the 1980s the average total compensation of the top three executives suddenly jumped from an historical multiple below 40 times the average worker compensation to a median multiple that is now close to a 120.

This trebling in relative compensation was achieved mostly by linking compensation to the stock performance during the strong bull market of the 1980s and 1990s. As shown in the next figure its contribution to total compensation now accounts for more than 50% of basic compensation (salary + performance bonus).

Since managers have little or no influence in the valuation of their companies, was their pay just a fortunate coincidence due to the exuberant valuations of the stock market during those two decades? Or, did finance theory legitimize in the eyes of the shareholders their hands in the till behavior? We can dismiss the first hypothesis by the fact that throughout the last seventy years managerial stock holdings remained always below 1% and by looking at Shiller's chart of the S&P Composite Real Price-Earnings Ratio.

Although the nine-fold rise in real valuations between 1980 and 2000 was unprecedented by historical standards we must notice that during the other two major bull periods ended in the crashes of 1929 and 1973 the median compensation multiple never exceeded 40 (despite a seven-fold valuation rise before 1929 and a four-fold rise before 1966).

Moreover, when valuations returned to their normal values after the stock market crash of 2001, executive compensation continued to rise instead of correcting downwards. For instance, in the period 2000-2005 the real value of total compensation of the three highest-paid officers in the 50th percentile almost doubled to 5.2 mllion while that of those in the 90th percentile more than doubled to 21.6 million dollars in today’s values.

So what led shareholders and the taxman to become so generous in overlooking this hands on the till behavior?

Until the 1950s the number of top executives holding share options was basically negligible. However, from 1965 to 1980 the fraction of those granted share options rose from less than 20% to more than 60% and by 2000 it had reached 100%.

Despite being traditionally indifferent to management issues, finance theory was seized by executives to demand and legitimize their new found wealth. The following is a short-list of the key developments in finance theory that played some role in this process:
1) The Modigliani and Miller theory on the neutrality of capital structures resuscitated the entity theory of the firm and provided the basis for a widespread belief that paying dividends was an inefficient way of making distributions (a view reinforced by the predatory tax regimes of the time);
2) It also created a tolerant attitude towards excessive leverage which was later used to drive buy-out strategies and risk arbitrage driven M&A transactions;
3) Modern portfolio theory, with its emphasis on diversification, promoted the wide dissemination o capital among minority institutional investors. This, in practice, left companies in the hands of their managers and investment bankers colluding on irresponsible corporate governance approaches sanctioned by ever obliging compensation consultants;
4) Financial innovation in the use of derivative instruments and the Black-Scholes formula to price stock options facilitated and ignited the recourse to dubious short-term market manipulations through earnings management and outright accounting fraud.

However, although finance theories were the facilitators of the process, what really ignited it was the replacement of previous values based on fairness and justice by the greed and no-taxes cultures promoted by the Reagan and Thatcher right wing revolutions. These were compounded by the subsequent corruptible nature of the regulated and regulatory industries brought in by subsequent left wing governments.

So, halting and reversing the hands on the till process will now require a change in political attitudes as well as a denouncement of the misuse of academic finance theories.