North America’s CEO-pay model is “fundamentally broken”

In case you hadn’t heard, Sears Canada is on a death spiral. The once-prominent retailer is now in the midst of a “restructuring” — this summer it sold off 59 of its stores, laid off almost 3,000 employees, and filed for creditor protection, a move that gives it $450 million in loans to fund the restructuring process.

Sears’ financials were apparently in such shambles (the stock has lost more than 80 percent of its value on the TSX since the beginning of this year) that the 2,900 laid-off employees did not receive the severance they were entitled to, and retirees of the company still stand to lose their pensions altogether.

But here’s the clincher: when this whole restructuring process is over, Sears Canada executives will end up receiving $9.2 million in “retention bonuses” under the Key Employee Retention Plan (KERP), that was in fact approved by the Ontario Superior Court in July.

Sears Canada’s Executive Chairman, Brandon Stranzl will apparently be paid a bonus of $50,000 for two months, in addition to his base salary of roughly $1 million.

[The chairman and CEO of Sears Holdings, the parent company of Sears Canada, by the way, is hedge fund manager Eddie Lampert, whose net worth is estimated to be $2.2 billion].

There’s so much that’s wrong with this picture, it’s almost laughable, except of course if you’re a 66-year-old former Sears employee whose pension has been suspended indefinitely, due, essentially, to the gross miscalculation of a series of Sears executives as to the slow demise of the departmental store model in favour of online shopping.

But the rot in the North American executive compensation model runs so deep that even in times of financial turmoil, the prevailing ethos of modern corporate governance holds strong — company executives are indispensable, so heaven forbid they operate on the same salary plain as the rest of us.

“The system is fundamentally broken and out of control,” says Hugh Mackenzie, an economist who runs his own public finance consulting business. “What’s clear is that boards of directors are not going to do anything meaningful to reign in these excesses.”

One could argue that executives at Sears Canada would not have remained at the company during the restructuring process if they had not been promised a hefty bonus. That is most probably true — if you’re taking home millions of dollars, what incentive do you have to remain at a company that will reduce your salary by at least 50 percent, just to maintain some semblance of pay equity?

The real question, then, is how did executive compensation get this way?

“One of the problems at the root of soaring and uncontrolled CEO pay packages is the role played by stock-based forms of compensation, such as stock options and grants of shares,” says Mackenzie, whose research for the Canadian Centre for Policy Alternatives lays bare the structural problems plaguing the C-suite pay system.

In 1976, William Meckling and Michael Jensen, two prominent finance professors, published one of the most-cited papers in financial history on the ownership structure of a firm. The paper argued that in order for a company to maximize its performance, the personal interests of company executives should be aligned with those of the corporation and more importantly, its shareholders. Paying executives in stock options and grants of shares implies that if a company’s stock goes down, your future payout goes down as well.

But according to Mackenzie, the greatest problem with stock-based compensation is there’s no real maximum salary cap. The incentive of the executive then becomes to continually increase the stock price, instead of actually generating real value in the form of tangible products.

In his book “Fixing the Game”, Roger Martin, former Dean of the Rotman School of Management calls stock-based compensation “naive and wrongheaded” because it rewards executives for “something they cannot influence or control”. Stock markets are “expectations markets”, says Martin — the price of a company’s shares is essentially based on how investors think the company is going to perform in the future, instead of how the company is actually performing in the present.

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The outcry over Sears Canada’s failure to deliver a fair severance to its employees while continuing to reward its executives recently culminated in the creation of a “hardship fund” — $500,000 will be pulled from the $9.2 million in retention bonuses promised to executives. That adds up to a measly $200 per employee, a far cry from the two years in salary that many employees were set to receive if only the company had not filed for creditor protection.

The Sears Canada example might be an exception, but it doesn’t change the fact that in Canada, the average CEO earns 159 times more than the average worker.

“One of the things governments could do is change the tax system or institute some way in which board of directors would have to set a maximum compensation for executives, regardless of how well the shares of the company perform,” says Mackenzie.

“That’s the only way in which this abuse will stop.”

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