Commentary - Stephen Bainbridge: No need for federal regulations limiting executive compensation

The pending legislation raises two key questions: First, is executive compensation a problem needing repair? Second, assuming a fix is needed, should the fix be implemented at the state or federal level?

Executive compensation admittedly has grown significantly over the last two decades. According to the House report accompanying Frank’s bill, in 2005, the median CEO among 1,400 large companies “received $13.51 million in total compensation, up 16 percent over FY 2004.”

Yet, we live in an era in which many occupations carry such vast rewards. Lead actors routinely earn $20 million per film. The NBA’s average salary is more than $4 million per year. Top investment bankers can earn annual bonuses of $5 million to $15 million. Unless one’s objection to the amounts received by corporate executives is based solely on the size of those amounts, one must be able to distinguish corporate managers from these other highly paid occupations.

Many critics of executive compensation find just such a distinction in the argument that actors and sports stars bargain at arms’ length of their employers, while managers supposedly determine their own compensation.

To be sure, top executive pay is typically set by the board of directors, but the critics argue that boards are pawns of management who routinely approve pay greatly exceeding the level that would prevail if directors loyal to shareholder interests actually bargained with managers at arms’ length. As a result, they claim, executive compensation arrangements often fail adequately to link pay with performance. This is the problem Franks’ bill purports to solve.

In fact, however, the evidence does not support the critics’ arguments. Economists Xavier Gabaix and Augustin Landier, for example, found that “the six-fold increase of CEO pay between 1980 and 2003 can be fully attributed to the six-fold increase in market capitalization of large U.S. companies.”

In other words, CEOs got richer because their shareholders got richer. Indeed, much additional evidence suggests that executive pay in fact is closely linked to performance. As a result, Frank’s measure is attacking a problem that does not exist.

Let us suppose, however, that the system of executive compensation in fact is broken. Should the purported problem be addressed at the federal level?

In our federal system, issues of corporate governance, including both executive compensation and the substance of shareholder voting rights, traditionally have been the province of state corporation law rather than federal securities law.

As the Supreme Court explained in its 1987 CTS Corporation. v. Dynamics Corporation decision, “state regulation of corporate governance is regulation of entities whose very existence and attributes are a product of state law.”

Accordingly, it “is an accepted part of the business landscape in this country for states to create corporations, to prescribe their powers, and to define the rights that are acquired by purchasing their shares.”

Of particular relevance to Frank’s bill is the Supreme Court’s reminder that it is state law that determines the rights of shareholders, “including … the voting rights of shareholders.”

State law thus determines such questions as which matters may be authorized by the board of directors acting alone and which must be authorized by the shareholders. State law, for example, establishes the vote required to elect directors.

State law determines whether shareholders have the right to cumulative voting in the election of directors, whether the corporation’s directors may have staggered terms of office, and whether shareholders have the right to remove directors prior to the expiration of their term of office.

Frank’s bill thus would constitute a substantial federal intrusion into the state sphere and a substantial violation of the longstanding federalism principles in this area.

Legislation that “fixes” a nonexistent problem by upsetting basic principles of federalism ought to be a nonstarter. Unfortunately, the executive compensation debate has become so thoroughly bollixed up with issues of class warfare and financial populism that rational arguments seem to fall on deaf ears.

UCLA law professor Stephen Bainbridge is a member of The Examiner’s Blog Board of Contributors and blogs at ProfessorBainbridge.com.