Executive pay: Don't blame the CEO

November 16, 2011: 9:15 AM ET

Yes, huge stock-based compensation packages have distorted the incentives for executives. But CEOs aren't to blame, their bosses are.

By Roger Martin and Jennifer Riel, contributors

occupy_wall_street_nycFORTUNE -- Just where the Occupy Wall Street protests are headed is unclear. Though New York police cleared out Zucotti Park and others cities quickly moved to follow suit, it is unlikely the movement will simply die away in the near term. Real anger remains, an anger that extends well beyond Wall Street. Yes, there is clear enmity towards the financial services sector for tipping the world into a lengthy and damaging recession, but the protests run much deeper than that. The much-referenced 1% -- the global elite that controls a disproportionate percentage of global wealth -- is not made up solely of hedge fund managers, investment advisors and traders. It is made up of executives and leaders of non-financial firms in every sector. The anger is directed here too. And it is just as important to make sense of this strand of criticism.

Per the AFL-CIO, CEOs of 299 top firms earned, on average, $11.4 million in total compensation in 2010. The disparity between that number and the average worker's salary -- just over $33,000 in 2009 -- is part of what gets the blood boiling. But it is more than just money. The salary argument obfuscates a legitimate point about executive behavior that is worth exploring.

The anger with our corporate executives is also rooted in a sense that corporate America has abdicated its moral responsibility. The notion that "with great power comes great responsibility" is not just a line from a Hollywood blockbuster. It contains a powerful and resonant truth: We want the most powerful among us to act with care and to wield that power responsibly. The sub-prime mortgage debacle, the Enron, WorldCom and options backdating scandals, and myriad other examples of corporate malfeasance suggest that our corporate leaders are capable of acting utterly irresponsibly. They suggest that profits now come before employees, before the environment, before customers, before society, before anything and everything. They suggest that CEOs have traded their ethics for a paycheck and led us down a greed-driven and corrupt path.

Defenders of the corporate world argue, as we have, that the problem is not so much with individual executives as with a system that creates an unwinnable game. Executives are asked to focus on increasing shareholder value. This is a profoundly difficult task. Shareholder value, as reflected in stock price is a measure of other people's expectations. And while these may be based in part on the fundamentals of the business, they are also fueled by macro-factors, systemic biases and, well, hype. It's hard for executives to influence share price in the short-term through the real, difficult work of improving the company. So, they work on investor expectations instead. They provide guidance, they hype the stock, they undertake foolhardy acquisitions and divestitures, all to spur upward momentum in the stock price.

It is easy to argue that they do all of this due to personal weakness and greed. After all, we've created a system wherein most of the compensation executives receive is in the form of stock-based incentive compensation. When the stock price goes up, so does their compensation. But the reasons for focusing on the short-term stock price rather than long-term real growth are not limited to personal greed. In fact, these executives are doing what we as shareholders have demanded that they do.

The board of directors, our representative as shareholders, provides all of that stock-based incentive compensation. And by providing that incentive, the board is explicitly telling the executives what matters above all else -- and that is the stock price. When boards provide stock-based incentive compensation, they issue a direct instruction to work first and foremost on raising the stock price from the current level. It is not about improving the company, not about thinking long-term, not about bettering the world. If an executive with considerable stock-based incentive compensation focuses on anything but raising the stock from its current level, he or she is being insubordinate to the board that provided that as the central incentive. It is not for the executive to say: "They gave me this big stock-based incentive but they really don't mean it. They don't really want me to attempt to do what would be necessary to reap the rewards of this incentive." It is not about being craven; it is about obeying your superiors. In short, we have built a system of incentives for executives focused on raising the stock price at the expense of all other goals. Why then should we be surprised when executives act in accordance with this system?

Does that mean we should excuse the behavior of individual executives and let them off the hook when ethical lapses occur and when greed runs rampant? No, absolutely not. We want and expect executives to behave well and live up to a high ethical standard. We want insiders to shine a light on illegality, as Sherrin Watkins did at Enron or Jeffrey Wigand did in the tobacco industry. But it is important to recognize just how hard a task we are setting for these individuals. It is a very high bar when we ask executives to be genuinely insubordinate in order to be moral. Would we not be better off to design a system in which the explicit incentives encourage long-term thinking, value creation and contribution to society? The challenge is to do away with our current incentives and create new and better ones.

Roger Martin is dean of the Rotman School of Management, University of Toronto. He has been named one of the top fifty management thinkers and ten most influential business professors in the world. He is the author of "Fixing the Game: Bubbles, Crashes, and What Capitalism Can Learn from the NFL." He serves on the Thomson Reuters and Research in Motion boards of directors. Jennifer Riel is Associate Director of the Desautels Centre for Integrative Thinking at the Rotman School and editor for Fixing the Game.

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