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How to Succeed in Regulating Business

If you think executives who drive their companies to the brink of ruin don’t deserve lavish bonuses, you probably feel pretty good right now. After all, the current storm of public outrage against executive excess--whose signature moment was the tongue-lashing Representative Barney Frank bestowed on the titans of finance who appeared before his congressional committee last month--has finally resulted in real legislative action on pay-for-performance. The stimulus law signed by President Obama imposes stringent limitations on the compensation of bank executives whose companies receive TARP funds, restricting the bonuses of executives and banning their use of golden parachutes. But don’t break out the champagne just yet. In the struggle over executive pay, CEOs have lost a few battles lately. But these losses are likely to prove fleeting.

The enactment of any cap on executive pay is a remarkable achievement in and of itself. Frank himself has tried repeatedly for several years to pass legislation that allows shareholders to control managerial pay, encountering little success before the extraordinary circumstances of the current financial crisis. Even in 2002, as Congress hastily adopted the Sarbanes-Oxley law to tighten the reins on corporate boards in the wake of the Enron scandal, it was unwilling to broach the subject of pay caps for top execs. And when then-Senator Barack Obama joined Frank to sponsor legislation on executive pay in the spring of 2007, their bill fell to fierce opposition from business groups and the Bush White House, passing the House but never even making it to a floor vote in the Senate.

This difficulty underscores a political truth that bedevils efforts at both passage and enforcement of pay caps. Lawmakers do not want to take on CEOs unless there is a political payoff. And executive remuneration seldom offers such an electoral return. Politicians care about overpaid underperformers in the corner office only when the American public cares. But the public does not care about high pay for its own sake. It cares only when gross discrepancies between excessive pay and poor performance are highlighted--immediately following accounting scandals, for example.

In fact, the steepest rises in executive pay in recent years merited little public or journalistic attention. Between 1996 and 2000, CEO pay jumped from 100 to almost 300 times that of the average American worker, according to the Economic Policy Institute. Yet press coverage of the issue in three major national newspapers increased only slightly. Only the scandal at Enron brought the issue new prominence in 2002. And, though you might not know it from the last few weeks, overall press coverage of executive remuneration has leveled off since then, even declining slightly over the past two years. In The New York Times and the Los Angeles Times alone there were more than 100 fewer articles dealing with the topic in 2008 than in 2002, despite a presidential election whose winner strongly supported linking executive pay to firm performance.

Executive pay is a boring political issue unless it is attached to a juicy scandal. This year the financial crisis has provided many such scandals--John Thain’s $35,000 toilet and Citigroup’s $50 million jet prominent among them--fueling the push to include pay caps in the stimulus law. But there’s good reason to believe that push won’t last. In 1993, President Bill Clinton tried to restrain executive compensation by setting a $1 million limit on the amount of direct executive pay that companies could deduct from their taxes, unless their companies met certain performance standards. Clinton’s effort spurred compensation committees to move from direct pay towards stock options and restricted stock grants to ensure their CEOs were handsomely paid. Compensation consultant Graef Crystal told BusinessWeek that Clinton’s bill had so many potential escape clauses that “in 10 minutes even Forrest Gump could think up five ways around it.” Speaking of the current cap in the Los Angeles Times, Crystal recently echoed that sentiment: “It’s a lot easier to find ways around things like this than to invent them in the first place.” CEOs and the boards who set their salaries have more resources and more lawyers to throw at the problem than do the officials tasked with enforcement of the pay caps.

Here’s a better idea: the Financial Services Committee could annually identify the top two executives whose compensation is most out of line with company performance. In recognition of their monstrous pay and of Congressman Frank’s past legislative efforts, these could be called the Frankenpay awards. Winners of the awards would be required to testify before the committee about the details of their pay packages. Boards of directors will think twice before approving a pay package likely to land a CEO in front of Congress, and they would not be able to avoid the cap on direct pay by choosing alternative payments, such as stock options, because the awards would target the whole compensation package. If, as many current executives claim, the race for talent simply demands rich terms, then they will be able to state that case directly to the public. And if the press agrees that the worst of the pay deals seem reasonable, there will be no story to report. If not, the press gets a guaranteed field day.

The policy challenge around executive pay is not to set effective limits—government probably cannot do that—but to convince boards to limit themselves. That requires the fear of public outrage. And, given his performance over the last few months, Barney Frank’s involvement wouldn’t hurt either.

Pepper D. Culpepper is Associate Professor of Public Policy at the Harvard Kennedy School. He is completing a book on the politics of corporate governance reform.

By Pepper D. Culpepper