VARIABLE DEPENDIENTE

Given the performance related bent of Nozick’s thesis, it then becomes relevant to determine how the use of comparator averages in the setting of executive pay, factors within his justice perspective. Utilising comparator averages in the determination of executive pay, is a widely regarded practice amongst compensation committees of

some of the largest Anglo-American firms118_{. To determine whether the practice falls}

within Nozick’s postulation of a legitimate process, is to first understand the implication of basing executive pay on peer averages instead of performance, from a justice perspective.

Benchmarking involves the use of industry averages in the setting of executive compensation. Compensation packages are determined by the going rate within a select group of peers-usually firms with similar core characteristics-and to which the movement of the CEOs pay would be pegged. In practice, compensation is usually set at or above the median pay within a given peer group. Figures from the year 2015 show, that of the firms within the American S&P 500 index, 96% used peer groups in setting CEO pay, while over 56 per cent set pay based on the earnings of 80-100 per

cent of the firms within the same industries119_.

118 _{Charles Elson and Craig K. Ferrere “Executive Superstars, Peer Groups and Over Compensation–}

Cause, Effect and Solution” at p.105. Available at <http://ssrn.com/abstract=2125979> (accessed on 25/07/2018).

119 _{Mercedes Erickson ‘Peer Benchmarking and Trends in Executive Compensation’. Available at}

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Proponents of the standard view of compensation, would argue that the pay setting process is above reproach in the majority of cases, this argument fails to factor the exacerbating effect benchmarking has on pay levels. Benchmarking could ensure that compromised pay packets become frames of reference in the setting of pay, becoming a standard for executive compensation, known as the mimetic effect of

benchmarking120_{. Given the pervasiveness of the practice, it is important to a}

discussion on the purity of the process, to determine whether benchmarking in practice, meets Nozick’s standard of a legitimate process.

3.5.1. Does Benchmarking Meet the Standard of a Legitimate Process?

Shin critiqued the efficacy of basing the pay of CEOs on those of their more successful

peers121_{. While Ezzamel and Watson note, that the upward adjustment of CEO pay is}

the more common reaction to peer reports which show an inequity, when considering

his pay in relation to the industry average122_{. The fact that peer grouping}

predominantly leads to higher wages for the affected CEOs, could suggest some form of managerial interference in the pay setting process. Shin, notes that the ability of the CEO to restore equity-that is get his wages to match or better the peer average-is

120 _{Donald C. Hambrick and Sydney Finkelstein ‘the Effects of Ownership Structure on Conditions at the}

Top: The Case of CEO Pay Raises’ Strategic Management Journal, [March 1995] Vol. 16, No.3, pp. 175- 193 at 179.

121 _{Taekjin Shin ‘Fair Pay or Power Play? Pay Equity, Managerial Power, and Compensation}

Adjustments for CEOs’. Journal of Management, Vol.20, No.10, pp.1-30, 2.

122 _{Mahmoud Ezzamel and Robert Watson, ‘Market Comparison Earnings and the Bidding-Up of}

Executive Cash Compensation: Evidence from the United Kingdom’ The Academy of Management Journal [April 1998] Vol. 41, No.2, pp. 221-231.

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stronger when he wields greater influence over the board, and would be far less able

to do so, where he does not123_.

There are several reasons why firms would want to base pay on the going rate rather than performance: it could stem from a desire to make the CEO feel appreciated or valued, to retain his services or ensure the firm remains competitive on all fronts

including the compensation for its head124_{. It could also be argued that benchmarking}

CEO pay could help facilitate the equitable distribution of wealth amongst CEOs of a

similar standing125_{. As supported by evidence, which shows that CEOs who earn below}

the peer average, usually benefit from an upward revision of said pay in the following

year126_{. This assertion however ignores the balancing effect of the theory.}

Equity theory is based on the need to restore parity when inequity in distribution becomes evident. A restoration of this nature may require upward adjustments of the subject’s earnings as well as deductions to bring it in line with the stated average. Therefore, the use of equity theory to justify benchmarking is worrisome, the reason being that the practice is more frequently utilised for pay raises rather than contractions. On this point Ezzamel and Watson, using a sample of firms trading in the UK, show the prevalence of peer average inspired upward adjustments in executive

compensation as against the lowering of salaries for overpaid executives127_{. They do}

state however, that the trend should not be taken as evidence of “collusion between

compensation committee members and the executives whose pay they are setting, nor

123 _{Shin (n121) 9.}

124 _{ibid 4, Ezzamel and Watson (122) 223.} 125 _Ibid.

126 _{Shin (n121) 4.}

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does it necessarily imply indifference to shareholder demands to render pay more dependent upon firm performance measures”128_{. It however, remains difficult not to} draw such a conclusion. As Shin mentions, strict adherence to compensation benchmarking is as much determined by whether the CEO is overpaid or than the need to restore equity129_.

He draws a clear link between managerial influence and benchmarking inspired pay increases. Stating that upward adjustments are rarer in the case of overpaid CEOs, than when they are underpaid in comparison. Accordingly, when underpaid CEOs unduly influence the board, compensation committees are more willing to incorporate external evaluations of peer average in their pay considerations, than they perhaps would, where such deference does not exist. In the latter instance, pay considerations would take a more inward direction, in adherence to the pay for performance mantra. Similarly, powerful CEOs who are overpaid, might use said influence to limit the use of comparator groups in pay setting, while encouraging appraisals that are almost entirely performance based. While overpaid CEOs with little or no influence over the board may find themselves unable to prevent a downward adjustment to align pay

with the peer average130_{. The former is most pronounced when the CEO dually acts as}

chairman of the board131_.

Furthermore, Hambrick and Finkelstein, found mimicry of industry averages to be more likely in manager-controlled firms, than in firms controlled by a single majority

128 _Ibid.

129 _{Shin (n121) 9.} 130 _{Ibid, 3.} 131 _{Ibid, 23.}

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owner132_{. Common sense would suggest that the latter scenario would be the least}

frequent, calling to question the usefulness of benchmarking as practiced, if not to justify high or excessive CEO wages.

Even optimal contracting enthusiasts recurring contentions that current pay levels result from optimal and efficient processes, would concede that it would not be completely implausible to contemplate the possibility of managerial influence over the pay setting process, albeit in a limited number of instances. Whatever the nomenclature, basing compensation on peer performance does not evidence prudent contracting by company boards. The most important fact here, is not the frequency of such instances or how widespread the practice is, but rather the effect even a handful of manager influenced pay packages could have on overall pay levels.

For example, statistics from the U.S show that in 2013 the top ten most benchmarked companies within the S&P 1500, were referenced a total of 580 times, with the most being manufacturing conglomerate 3M, which had 62 companies reference its compensation policy in setting executive pay. It is worthy of note, that 3M paid its CEO

$16.4 million in total compensation for that year133_{. The least referenced company was}

food manufacturing giant Kellogg, which had 43 references to its name, along with

Illinois Tool Works and Colgate Palmolive134_{. If any of these firms had their}

compensation policies drafted by captive boards then you have a situation whereby a minimum of 43 other firm’s base compensation practices on flawed standards.

132 _{Hambrick and Finkelstein (n120) 179.}

133 _{James R. Haggerty ‘3M CEO's 2013 Pay Rose 11% to $16.4 Million’ March 26, 2014, WSJ.com}

(accessed on 25/04/2015).

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Having noted the above, it then becomes difficult to argue that benchmarked pay packages are the outcome of Nozick’s postulation of a legitimate process. The centrality of the concept of desert to his entitlement theory, requires that every pay package should have a direct correlation to the service provided. Only when pay is given in exchange for the CEO’s value proposition, can the requirement for justice in distribution be said to have been met.

It is fair to say, that even the most ardent proponent of peer averaging in compensation setting would struggle to defend the practice on the basis of Nozick’s theory. The already stated widespread use of peer averages, increases the potential for compromise pay packages, to be the basis upon which others may be set. Given the importance of the pay setting process to the question of the justice of high pay, this latter fact suggests that executive pay, in its current form, falls short of the justice standard upon which Nozick’s thesis is based.