The Bear's Lair: The Guild of Greed


WASHINGTON, June 28 (UPI) -- Stock prices remain well below the peaks of 2000, yet top management compensation keeps rising. Since the overall economy's performance since 2000 has been at best mediocre, it's worth asking what fuels this inexorable climb.

It's certainly not good managerial performance. Jon Markham, in Thursday set out some of the more egregious examples of pay for non-performance, including that of AT&T's CEO, whose pay keeps rising, well into the double digit millions, while not only do earnings decline but even revenues shrivel by almost 50 percent -- the stock price in this case is down no less than 90 percent from its peak. California health insurer WellPoint Health Networks is selling out, triggering bonuses totaling $357 million to WellPoint executives. It's not just a U.S. disease; Roger Holmes and Luc Vandevelde, who had notably failed to turn around British retailer Marks & Spencer after they took over 2 years ago, were replaced by yet another turnaround artist Stuart Rose; the three of them split 10 million pounds ($18 million), which may not sound much by U.S. standards but in Britain represented unimaginable wealth just a few years ago.



The recession seems to be over -- in 2003 the median compensation for a chief executive officer of a Fortune 500 company rose 26 percent to $4.6 billion. The ratio of CEO compensation to that of the average U.S. worker is the highest it's ever been, considerably higher than at the peak of the 1929 boom.

It's the free market, right? Riiight!

Being a CEO, as distinct from getting the job in the first place and keeping it, is not all that difficult. Business schools graduate tens of thousands of MBA students every year, all of whom have by graduation acquired pretty well all the technical knowledge they will ever obtain to serve them in the business world. Designing a carburetor for a new Buick -- that's difficult and requires highly skilled engineering. Trading exotic derivatives -- that's difficult, complicated and stressful, and requires an unparalleled ability to keep your head in crazy situations. Performing open heart surgery -- that's difficult and requires a steady hand and superb observational skills to catch the first tiny signs of something going wrong. Being a CEO of a stable company -- not so tough; you attend lots of meetings, take about two strategic decisions a year and pick your subordinates with care. Even the people skills required (the lack of which is why I am not today an overpaid CEO!) are actually quite common.


So if the requirements of the job are relatively so modest, why are CEOs paid like rock stars or top baseball players? Rock stars and top baseball players, after all have skills for which there is clearly a more limited supply and probably a greater demand. What's changed since 1929, or more properly since about 1970, that's made CEO compensation increase so astronomically?

To answer that question, a little economics is in order. In a situation of perfect competition, prices and wages are set by what the market will bear, and any anomalies by which a particular group of people are very highly paid are ironed out over a few years by the appearance of greater numbers of that group of people. However, market participants don't like this, and therefore devote considerable attention to erecting barriers to entry, such as professional qualifications, by which the entry of new competitors can be barred or at least hindered.

The objective, of course, is to set up a closed guild, on the medieval pattern, which can then raise the prices charged to the public and achieve a "rent" over and above what they would get in a free market. As Adam Smith said "People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices." Guilds were and are the best such "contrivance" available.


In the case of top management, the guild is formed through the executive search business, known colloquially as "headhunters," which has existed in its modern form only since the 1960s -- of the top firms Heidrick and Struggles was founded in 1953, Spencer Stuart in 1956, Egon Zehnder in 1964 and Korn/Ferry and Russell Reynolds in 1969.

Before that time, top management mobility between companies was limited, and top managers were generally selected from the ranks of their subordinates. If a vacancy arose, the company advertised the job, recruited through a trade association, through personal contacts or through the college or business school that senior management had attended. It was a relatively open process, although naturally General Motors executives tended to be recruited from the social milieu of Grosse Pointe, Michigan. Certainly, there were many ways in which you could acquire the skills and experience that would qualify you for top management.

Of the famous and successful "outside hires" of the period, Alfred P. Sloan of General Motors had run a small supplier to the company, Thomas Watson Sr. of IBM had been a top salesman for a competitor, "Tex" Thornton and Robert McNamara of Ford had worked together for the army and were recommended to Henry Ford II by a personal contact and Sewell Avery of Montgomery Ward had managed his family's gypsum business. Only Watson fit the typical headhunter pattern of having been in top management at a competitor, but Watson had just pleaded guilty in a high profile antitrust case and was lucky not to be going to jail -- the headhunter "checks" would undoubtedly have blackballed him.


In the 1960s and 1970s there were a number of reasons why this changed. Equal opportunities legislation made it much more difficult to justify an informal recruitment process through personal contacts. Business life became more mobile, so the need to recruit senior management arose more frequently, lessening the chances of filling vacancies through personal contacts. The long bull market of the 1960s increased the vogue for celebrity managers; it became clear that you could increase your stock price by hiring a top manager with a gunslinger reputation. All these factors caused a demand for a service that would recruit top management from competitors, professionalizing the hiring process.

For the headhunters, once the deals started coming in, the motivation was clear. Headhunters made money (generally one third of the first year's salary and benefits) by executive transitions. Therefore it became in their interest to provoke executive transitions and to seek to drive up executive salary packages.

Initially, the normal willing buyer-willing seller relationship operated. The board of directors selecting the new CEO wanted to keep the cost down, the headhunter wanted to raise it; they were in an appropriate arms-length relationship.

However, as the market share of headhunters in top management searches increased, a new dynamic came into play. Top management had increasingly itself been put in place by headhunters, and was reliant on headhunters for possible future opportunities. The headhunter who hired you, of course, couldn't take you out of the company they'd put you in, but other headhunters could, and you in turn could cement your relationships with other headhunters by recommending your friends and thereby adding to their database of appropriate executives. The relationships became much closer.


The headhunters, in turn, began to act as gatekeepers. Instead of screening, as in a free market they should have, the universe of all possible candidates for a position, they screened only those who were already in similar positions, justifying their narrowing of the selection pool by the need to get the choice absolutely right.

After all, from the headhunter's point of view if they recommended somebody unconventional and he didn't work out, their reputation was damaged, whereas nobody (except the shareholders, who didn't matter) was damaged if sticking to a restrictive pool of conventional candidates meant their choice was far more expensive than he needed to be. The unconventional candidate might be unconventionally good at the job, but if he was, it was mostly the company that benefited and not the headhunter who found him.

From the board of directors' point of view, there was the "never get fired for buying IBM" factor -- you were unlikely to face a successful shareholder lawsuit if you hired someone recommended by Russell Reynolds.

Thus an open selection process became a closed one. The option of paying much less for a CEO outside the "magic circle" of those considered appropriate by headhunters disappeared, and top management, which had been a fairly open profession, where ability in a widely different job could qualify you for a post, became a closed profession, in which in order to be a big company CEO you had to have a top management track record with a competitor or a large company in a closely related industry.


The result, of course, has been a dramatic escalation in CEO and top management pay. Very satisfactory for top management, and even more satisfactory for the headhunters, charging a toll of a third of the first year's salary and benefits package every time someone changes jobs. The closed guild of top management, like the medieval guild of stonemasons, has been formed.

But it's nothing whatever to do with a free market, and like all market distortions it will severely damage the economy in the long run.

(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, June 2004) -- details can be found on the Web site


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