How much is a CEO worth? These days the munificent compensation packages lavished on America's chief executives have about as many defenders as Slobodan Milosevic. The statistics are simply too obscene: In 1999, the average chief executive earned 419 times more than his or her coworkers, up from 25 times in 1981, while the 10 highest-paid executives have seen their income soar an astonishing 4,300 percent between 1981 and 2000. If factory workers' pay had grown at the same clip, their average annual earnings would now be $114,035 instead of $23,753. Yet throughout the uproar over what Fortune magazine dubbed "The Great CEO Pay Heist," one question has lingered unresolved: What's driving it all?
During the 1990s, a frequently proffered answer was "market forces." As an influential 1995 book told us, we had entered the age of "The Winner-Take-All Society," in which a few exceptionally talented performers -- athletes, entertainers, business executives -- could walk off with the lion's share of the total rewards. In the view of authors Phillip Cook and Robert Frank, a Michael Eisner-type (Eisner has raked in $1 billion at Disney since 1984) was nothing so much as an A-Rod in pinstripes: the beneficiary of an intensely competitive open market where talent was bid up to the price it deserved. We could fume all we wanted to about the inequality of it all, but then we might as well curse Adam Smith himself.
This supply-and-demand view had the ring of common sense and the backing of a vocal tribe of academics (including Sherwin Rosen, author of the classic 1981 essay "The Economics of Superstars," and Harvard Business School's Michael Jensen and University of Southern California's Kevin Murphy, who opined that "top executives are worth every nickel they get"). Yet it also ignored an inconvenient truth: that, in practice, the market for CEO talent isn't really a market at all.
A new study by Harvard Business School professor Rakesh Khurana, Searching for a Corporate Savior: The Irrational Quest for Charismatic CEOs, pulls back the curtain on how the system of CEO selection actually works -- and just how far it strays from the beau idéal of open competition. When companies are looking to hire a new CEO from outside, Khurana found, they seldom consider anyone who doesn't already hold the CEO job at a high-profile company, personally know one of the directors on the hiring company's board and look a lot like the directors themselves (usually tall and WASPy). Qualified but lesser-known internal candidates are routinely overlooked, largely because Wall Street prefers celebrity types. And what of the executive search firms that are supposedly hired to scour the country for candidates? They serve more like masters of ceremonies, Khurana found, conferring legitimacy on candidates that board members already had in their sights.
In other words, the much-lamented shortage of CEO talent -- a mantra repeated so often in corporate circles that it has achieved article-of-faith status -- is mostly a social construction of boards' own making. "The shortage of CEO talent is a myth," says Jeffrey Sonnenfeld, a professor at the Yale School of Management who studies CEOs. And no one benefits more from the persistence of that myth than the top dogs themselves.
If the market for CEO talent is based on artificial scarcity, it also suffers from a serious information problem. For a winner-take-all society to work, you need a reliable way of knowing who the winners are. In baseball that's easy: A player cannot claim to have hit 60 home runs last season when, in fact, he hit 16. In the movies, there's the incorruptible accountant of box-office returns. In business, however, it's remarkably difficult to assess how much an executive has contributed to an organization's success -- which, after all, depends on a host of external factors and the input of hundreds if not thousands of employees. A number of academic studies suggest that a company's performance depends far more on what industry it's in, general economic conditions and stock-market trends than on who occupies the executive suite. Hence Warren Buffett's dictum that when a good manager enters a bad industry, it's usually the industry's reputation that remains intact.
Yet impressions are easily manipulated. Take the case of Carly Fiorina, the former Lucent Technologies executive who was recruited to run Hewlett-Packard in 1999. At Lucent, she acquired a reputation as a superstar manager. But commentators have since questioned whether her track record there was as impressive as it seemed. Not only had she never had direct profit-and-loss responsibility as a Lucent sales chief -- thus making her efficacy hard to judge -- but Lucent's apparent high-flying success turned out to be based on creative accounting, making it one of the great business disaster stories of 2001. So where had Fiorina's sterling reputation come from? According to an account in Vanity Fair, it was her appearance on the cover of Fortune's "Most Powerful Women in Business" issue that brought her to the attention of Jeff Christian, the headhunter retained for the Hewlett-Packard search. She had become well-known, that is, for being well-known. (Whether her talents were worth every nickel of the $69.4 million she earned in her first year is, well, another question.)
As for the oft-made comparison between CEOs and star athletes, another difference is worth noting. When a big-league free agent sits down to negotiate a new multimillion dollar contract, he's sitting across the table from someone who wants to pay him less money. By contrast, when a company is courting a CEO candidate, the candidate is often sitting across the table from himself. As a precondition to accepting the job, Khurana found, most candidates insist on taking both the chairman and CEO titles as well as the right to stack the board with their cronies, thus ensuring that their future salary negotiations will be anything but adversarial. Boards usually bow obsequiously. "The reality is that when you get enough along in the [negotiation] process, you can ask for pretty much anything you want," one candidate told Khurana. "So you ask. And you get."
If all this sounds a bit like Napoleon crowning himself, it is. Not that all companies have abandoned the pretense of "market-driven" compensation entirely. Many hire compensation consultants to benchmark their CEO's pay against their industry peers. But these consultants' estimates (often inflated by a highly selective reading of who constitutes a CEO's "peer group") serve largely as political cover for boards of directors. In his testimony to the U.S. Senate, one Enron board member said he "did not worry" about high levels of compensation at Enron because he checked with a compensation consultant, Towers Perrin, which told him that Enron was "right on target" compared to other firms -- even though this meant Enron executives received $750 million in cash bonuses for a year in which the company's entire net income was $975 million.
It would be one thing if big-name CEOs produced returns commensurate with their pay packages. Do they? A company's stock often jumps on the announcement that a star CEO has been hired, leading to the inevitable remarks that he or she has already added so many billions of dollars to the company's value. But most studies find that, with few exceptions (the most notable being Lou Gerstner's resurrection of IBM), the onetime pop gives way to long-term fizzle. Michael Armstrong may have "added" $3.8 billion in value on the day of his hiring at AT&T, but he has since subtracted $30 billion.
In the meantime, many of those CEOs have transferred ungodly sums of money from shareholders to their own pockets. It's a reminder that, when it comes to CEO pay, the grasping hand usually trumps the invisible one. And it's cause for wondering: When, exactly, did the winner-take-all society become the winner-steal-all society?