AFairWage_CappingExecutiveCompensation.pdf

A Fair Wage? Capping Executive Compensation

Case

Author: Julian Friedland

Online Pub Date: January 02, 2019 | Original Pub. Date: 2010

Subject: Business Ethics, Compensation Management

Level: Intermediate | Type: Experience case | Length: 1871 words

Copyright: © 2010 NeilsonJournals Publishing

Organization: fictional/disguised | Organization size: Large

Region: Global | State:

Industry: Retail trade, except of motor vehicles and motorcycles

Originally Published in:

Friedland, J. (2010). A fair wage? Capping executive compensation. Journal of Business Ethics Education,

7(1), 129–140. JBEE7-0CS2.

Publisher: NeilsonJournals Publishing

DOI: http://dx.doi.org/10.4135/9781526460547 | Online ISBN: 9781526460547

© 2010 NeilsonJournals Publishing

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This content may only be distributed for use within Texas A.
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A Fair Wage? Capping Executive Compensation

Abstract

This case study highlights some of the latest research on setting executive compensation at eth-
ical levels. The board of directors of Spade’s, a mid-size U.S. hardware chain, considers altering
the pay package of its incoming CEO to best align his interests with those of shareholders and
stakeholders. Students are invited to consider various options on current trends, which seem at-
tractive and convincing on the surface, but might present certain risks over the longer term. Five
compensation components are analyzed, namely, salary capping, pay for performance, bonus
scales, stock option parameters, and severance package.

Case

Keywords: ethics, management practices, executive compensation, pay equity, productivity, loyalty, conflict
of interest, salary capping, pay for performance.

Spade’s Plant & Hardware, a successful chain of mid-sized hardware stores, was growing at a steady pace
despite the ubiquity of larger-scale hardware chains, namely Lowe’s and Home Depot. What set Spade’s
apart was its focus on quality and higher-end products, combined with an extensive greenhouse. Many of
Spade’s customers stopped going to the larger chains for their more common purchases, simply because
those stores were only slightly cheaper and often did not carry much that was a little out of the ordinary. After
several frustrating detours back to Spade’s for a screw, tool, or plant not carried by Lowe’s or Home Depot,
customers started simply going there first. Furthermore, shopping at Spade’s was a real pleasure, as it con-
veyed a feeling akin to shopping at Whole Foods, but from a plant and hardware perspective. The lighting was
pleasant, accentuating attractive displays of quality gardening tools around colorful plant and flower arrange-
ments. Employees were also extremely helpful and knowledgeable about the inventory, and management
strived to keep track of new and harder to find cutting edge products from smaller suppliers that its customers
would likely desire but had not yet discovered. The result was a trendy home store that developed strong
customer loyalty very rapidly.

After just twelve years in business, the company had gone public, with 170 stores nationally and 30 overseas.
Overall, Spade’s had gross revenues of $1.8 billion annually and employed roughly 20,000 employees. Mar-
ket projections showed that with the softening economy and housing market, Spade’s would continue to grow
but much more slowly, with an average of 5 new store openings per year over the next five years. In the face
of the downturn, it was crucial that the company retain its level of same-store sales and avoid closings. So
leadership was now more important than ever. But tragically, the founding CEO, Jane Goodwyn, had recently
died in a car accident. So the corporate board was now selecting a replacement and had narrowed its list to
two candidates, Paul York and Jordan Gallaway.

York was certainly the more experienced. He had already successfully led a top British plant and gardening
chain for over a decade, taking it from seventh place to what was now the third most successful British chain
in that category. However, as one of the highest-paid British CEOs in his category, he was very likely to ex-
pect a much higher compensation package than Jordan Gallaway, currently Chief Operating Officer (COO)
at Spade’s. Gallaway’s last position was HR director of Whole Foods, a company that, at the behest of its
CEO James Mackey, had successfully instituted a cap on executive compensation. This, according to ana-
lysts, was part of a corporate culture in which employee loyalty was uncommonly high. Gallaway had hoped
to institute a similar executive pay structure at Spade’s and had prepared a full proposal only a few weeks
before CEO Goodwyn’s passing. He included the proposal in his dossier of application for her job. It was thus
presumed that if Gallaway were the successful candidate, he would agree to his own recommendations.

This hiring decision therefore turned on a major philosophical question as to how the compensation package

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A Fair Wage? Capping Executive Compensation

should be determined. There was a growing debate across the U.S. about stratospheric executive pay, which
seemed to apply even to underperforming CEOs. At two major Spade’s competitors, for example—Sears and
Home Depot—CEOs recently resigned, after lackluster performance, with severance packages worth well
over $100 million. What’s more, numerous multinational investment banks nearing collapse after the mort-
gage crisis had generated outrage across the country at perceived executive greed and corruption. Legisla-
tors were thus considering a new law that would require shareholders to have an advisory “say on pay”. Such
a vote would be non-binding, but difficult to ignore if the board systematically chose to go against investor
wishes. Furthermore, globalization had attracted many new foreign investors who often balked at American
CEO salaries, which had mushroomed to an average of 180 times average employee pay (not counting
bonuses and stock options). That’s double what it was in 1990 (Hymowitz, 2008). In most European coun-
tries and Japan (England, where Paul York had been CEO, being a notable exception), average CEO salaries
tended to be much lower. To combat this trend, CEOs at several high-profile companies, such as Costco and
Whole Foods, had capped executive salaries (including their own) at 14 times that of their average full-time
employee. This usually did not include stock options. The result was that average employee wages would
have to rise before any executive salary increases could be approved.

So one of the questions weighing on the board of late was whether to embrace say on pay before any such
legislation were passed. As it stood, shareholders already had the right to protest if they disagreed with any
of the board’s actions. So it wasn’t clear that an official say-on-pay policy would add much, but it would sure-
ly create a bit more work for the board. Up to now, shareholders had been very happy with Spade’s stock
performance and had not objected to Goodwyn’s salary, which had been over 100 times the average employ-
ee salary, not including bonuses and options. But with the current increased scrutiny of CEO compensation
packages, together with slowing growth, the board could not be sure that shareholders would not protest in
the future and seek greater control over compensation packages.

Interestingly, Jordan Gallaway had given the board an attractive, if somewhat radical 5-year proposal without
say on pay. He argued that say on pay was too open-ended, and companies such as Whole Foods had suc-
cessfully capped executive compensation packages without it. Even under say on pay, he predicted stock-
holders were likely to continue rubber-stamping whatever the board suggested until the stock underperformed
and it was too late. His alternative proposal sought to cap CEO compensation in a more pre-emptive and
thoroughgoing way:

1. Yearly salary should be based on performance, with “clawback” provisions if earnings are
restated lower.

2. The salary should be capped at 20 times average employee salary.
3. End-year bonuses should be performance-based and made internally public but returned

into a general fund to be divided equally among all salaried employees.
4. Stock options should not be valued at more than 25% of the CEO’s combined yearly com-

pensation, with up to 50% exercisable on first exercise date and only 10% exercisable
annually over the subsequent 5 years.

5. Total severance package cannot exceed two years’ salary, based on yearly average.

He provided convincing arguments for each of these points (available in Appendix 1).

Gallaway’s proposal did seem compelling to at least a few on the board, especially as a way to prepare for
any impending belt-tightening from the slowing economy. It had the virtue of avoiding cumbersome share-
holder say-on-pay policy, while going much further to satisfy potential shareholder and employee concerns
about exorbitant executive compensation in a concrete way. What’s more, it would spare shareholders from
having to continue worrying about it. However, one board-member spoke up, to point out that there is still a
debate on whether capping executive compensation is really a good thing. He respectfully suggested that the
idea itself could be naïve and wrong-headed. He pointed out that under the previous CEO, who was making
100 times the average employee salary, the company was thriving and everyone seemed perfectly satisfied.
So why change the pay structure now? There was no indication that Goodwyn’s leadership had been overly
concerned with short-term gains. Therefore, although Paul York would presumably expect at least as much as

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A Fair Wage? Capping Executive Compensation

Goodwyn’s package, he was unquestionably the more experienced candidate. So why not simply hire him?

But at this point, it was time to adjourn the meeting until tomorrow morning, when the board would have to
come to some decision. One factor in the back of everyone’s mind was that the policy Gallaway was sug-
gesting might come at too great a risk, because he could fail as CEO. After all, he had never run an entire
multinational corporation. And even if he were to succeed, it might be difficult to replace him when he did step
down if Spade’s was no longer prepared to offer a compensation package anywhere near that of its competi-
tors. Suddenly raising the CEO’s pay to 100 or more times the average employee salary might significantly
lower morale.

Study Questions

1. Do you think executive compensation is generally appropriate or inflated in the U.S.? Can
it ever have a negative impact? If so, is this a potentially negative impact on society, the
firm or both? Does a company have an obligation not to have a negative impact on soci-
ety or just the firm? Provide examples.

2. Is Gallaway’s proposal for performance-based pay convincing? What do you see as some
of its likely benefits? Are there any other alternatives to keep from rewarding failure? If
so, are they preferable?

3. Are the long-term effects of CEO performance always clear at the end of each fiscal year?
Why or Why not?

4. Does Gallaway’s plan make it less likely for the CEO to artificially inflate stock value in
the short term? Why or Why not?

5. Do you find any of Gallaway’s reformist proposal at all convincing? Could capping CEO
compensation end up making the company less competitive for top talent, namely by
avoiding potentially more experienced candidates like Paul York?

6. What do you think about the idea of mandating that stockholders have a say on pay?
Could this be an acceptable middle ground between both sides of the capping debate?
Why or why not?

7. Do you think Spade’s should concern itself with boosting employee loyalty and morale via
postmaterialistic values and increased corporate social responsibility programs? If so,
how and why? Do you think Spade’s particular niche has any extra obligation to do so? If
so, how could it pay off in the longer term?

References
Balkin, D. (2008), “Explaining High U.S. CEO Pay in a Global Context: An Institutional Perspective”. Working
paper. Forthcoming in Werner, S. and Gomez-Mejia, L. , Global Compensation, New York: Routledge.
Bebchuk, L. and Fried, J. (2004), Pay without performance: The unfulfilled promise of executive compensa-
tion, Boston: Harvard University Press.
Bogle, J. C. (2008), “Reflections on CEO Compensation”, Academy of Management Perspectives, Vol. 22(2),
pp. 21–25.
Giacalone, R. A. (2008), “On ethics and social responsibility: The impact of materialism, postmaterialism, and
hope”, Human Relations, Vol. 61(4), pp. 483–514.
Hymowitz, C. (2008), “Pay gap fuels worker woes”, Wall Street Journal, April 28.
Kaplan, S. N. (2008), “Are U.S. CEOs Overpaid?”, Academy of Management Perspectives, Vol. 22(2), pp.
5–20.
Maremont, M. (2007), “Scholars link success of firms to lives of CEOs”, Wall Street Journal, Sept., A1.
Reich, R. B. (2007), Supercapitalism: The transformation of business, democracy, and everyday life, New
York: Knopf.
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A Fair Wage? Capping Executive Compensation