September 2017

As a general rule, you probably won’t find too many CEOs that are particularly critical of high pay. Don’t bite from the hand that feeds you, right?

Well, Steven Clifford isn’t just biting the hand—he’s chomping at the whole arm. And I believe he has a good reason to do so.

Clifford, the former CEO of King Broadcasting, the Washington-based media conglomerate, recently authored THE CEO PAY MACHINE: How It Trashes America and How to Stop It. The book is both an investigation into obscene pay packages as well as a meditation on how excessive CEO compensation hurts average Americans in a multitude of ways. “This is a very corrupt system and it is based on assumptions that are indefensible,” Clifford tells me. “It stuns me that no corporate board has really taken this on.”

In my opinion, Clifford’s book is a must-read for anyone who cares about investing, finance, or the future of the American economy. In it, he shows, through both quantitative and qualitative analysis, that ultra-high CEO pay is not at all correlated to positive performance. In fact, he shows how it just might be the opposite: that huge pay packages result from hitting short-term milestones, but ultimately hurt the company—including shareholders, pension funds, and employees—in the long run. As one book reviewer wrote: Clifford “shatters the myths and explains the stupidity regarding astronomical salaries at the top of the business world.”

Now, I’m a money manager, so you might be asking — why do I care if the CEO of Discovery Communications made $224 million, right? What does Worm Capital stand to lose or gain from high CEO pay?

As it turns out, quite a bit. As I wrote in my previous column“What’s The Harm In Excessive CEO Pay? Answer: Long-Term Damage To Shareholders And Pension Funds,” flawed incentive structures cause CEOs to spend trillions of dollars in stock buybacks. They do this because their bonuses are tied to earnings per share (EPS) metrics, which are easily manipulated by buying back billions of dollars in stock. This is a great deal for CEOs who cash in for tens of millions of dollars, retire, and spend their retirement on giant yachts. But it’s terrible for pension funds, retirees, and unsophisticated investors who depend on a business’ longevity and health.

Simply put: As a long-term investor, I want to own healthy businesses for years to come—and CEO pay structures, which favor short-termism, are deeply flawed and need to be reformed.

After we published that column, Steven reached out to us to have a conversation. We are glad he did. While we’ve seen the problem of CEO pay in earnings reports, proxy statements and in the media—Steven actually lived it as a compensation consultant. He saw the absurdity of it up close. We spoke to him recently about high CEO pay and what to do it about it. Below is a lightly edited transcript of our conversation.

Arne Alsin: First of all, tell me about yourself and why you decided to write this book. You’re a successful CEO, but this is an issue you’re obviously passionate about. Why?

Steven Clifford: I was a CEO for 14 years. I retired in 2000. When I retired, I wanted to have some interesting work to do, so I got on some corporate boards. A couple of them asked me to chair the compensation committee. Now these weren’t fortune 500 companies like I write about in the book, but they use the same practices that the fortune 500 companies use; they use the system that I described in the book. And as I started to look at it, I said, ‘You know, this doesn’t make any sense, the system doesn’t make any sense.’ I mean it creates perverse incentives, and overpaying the CEO was hardly the worst of it.

The worst of was that it created very, very short-term and narrow focus for the CEO. So, I tried to convince my fellow board members that we really shouldn’t be using this. But no one did. So I started to do some research on my own, and the more I did the research the more I was convinced the system was lousy and was very bad for companies that use it. But it was also terrible for the American economy and for income inequality.

So I started off and I was going to write maybe an op-ed and then…maybe I was going write a magazine article…. and finally it turned into a book. (Laughs.)

It took me quite a while to do it because I’m a slow writer and I had to learn how to write narrative prose; all I’d written before were a memos. So that was the genesis of it.

Alsin: What were some of the more interesting or shocking things that you came across in the material you were researching?

Steven: The numbers that these guys are making are seemingly shocking, but people will say “Oh, well yeah but look how much actors get or how much athletes get!”

But it’s completely different, because CEO skills are largely company specific. To be a good CEO you have to know a whole lot about an individual company. You have to understand its culture, its history, strengths and weaknesses of the key personnel, its marketing, its product development, its finances etcetera, etcetera, etcetera. That knowledge is not worth much outside that one company.

So these guys aren’t like LeBron James. LeBron James can go to the highest bidder and he’ll improve that basketball team immediately because his skills are portable. It’s not the same for CEOs.

In the book, I use the example of the CEO of the United Health Care. His peer group, apparently, was Amazon, Apple, Bank of America, Goldman Sachs, Google. None of these companies would ever consider hiring this guy! This guy had worked for only two companies in his life—an accounting firm and the health care company. So it’s just insane to say “Well let’s base his salary on what those guys at Goldman and Google make.”

So that’s the first thing. But I would say probably the most shocking thing about it is the pure intellectual dishonesty of it. This is a very corrupt system and it is based on assumptions that are indefensible. It stuns me that no board has really taken this on.

I use this term in the book, that this is all “collectively delusional.” And delusional is simply holding beliefs that are demonstrably false. And this this seems to be rampant in corporate America—it’s stunning. It’s stunning that here are successful businesspeople on these boards who supposedly who pride themselves on using big data and quantifying everything and subjecting all key decisions to rigorous analysis and cost-benefit, etcetera. Then comes to paying their CEO and the board, you know, just rubber stamps it.

Alsin: You write in the book that corporate boards, which set the CEO pay structures, have very little incentive—personally, professionally—to change anything. Why is that?

Steven: Absolutely, there’s nothing to be gained by questioning the system. First of all, you’re not going be asked on many more boards if you question anything.

I was recently talking to a friend of mine who is the head of the Compensation Committee for one of the 25 biggest companies in America. He said, You know, the worst part about it is if you go and fight with a CEO—which he did—you can’t even claim credit. You can’t say ‘We saved the shareholders $25 million by not agreeing outrageous demands from our CEO. So there’s no incentive to do it and my view is that nothing will change until it becomes a political issue. There’s no reason for boards to reform themselves.

Alsin: Stock buybacks are obviously a big part of this equation, and a big part of your book. Can you talk a little bit about how buybacks affect CEO pay?

Steven: Well look, if I were a fortune 500 CEO and 85% of my pay is coming in equity that’s coming from the stock price—I’ve got plenty of reasons to want to see the price of the stock high.

Now, there’s two ways to do that. One—I could do the very hard work getting new products to market, beating the competition, reducing my cost, and having very creative marketing.

And two—I can manipulate my stock price. And why would I not want to manipulate my stock price? I can make a lot of money. I can make fifty million dollars this year if I do buybacks of a million dollar buybacks—which is nothing.

William Lazonick came out with another paper the healthcare industry. And he looks at the 18 pharmaceutical companies that are in the S&P 500; in the last ten years they basically haven’t reinvested a penny. Almost 50% of their income has gone for buybacks.

So here are these companies that say “We have to have high prices because we have to invest all this money you know for drug development.” And yet their net income is not reinvested at all. The whole thing is going to keep their stock price high.

In finance, you only want to buy your stock back is one when it’s cheap, when it’s below its intrinsic value. Well, they’re buying stock back when it’s very expensive—at all-time highs! I don’t care what they think the intrinsic value is; you can’t say the intrinsic value is today’s market price because that’s higher than it’s ever been.

And frankly, for any tech or health care CEO to say “We don’t have other investment opportunities,”…that CEO should be fired.  If you’re that unimaginative that you can’t figure out how to invest in the business or your community or employees, you could at least do a dividend. It’s so clear that this is about manipulating the stock price.

Alsin: So you think buybacks have gone too far?

Steven: Buybacks are out of control, they’re harming the American economy, they’re distorting capital flows, and economic historians 30 years from now are going to say, ‘How could America let its big major industry cannibalize itself? What were these people thinking?’

Well, the fact is they weren’t thinking at all. Shareholders don’t have a say on this. This is their money, but CEOs are only doing it because it rewards the CEO. That’s the only reason the CEOs are doing it. If you weren’t getting rewarded like this and you’re a CEO—it’s much more fun to invest for the future.

But if I had the opportunity to make $30 million next year, I’d be buying back my own stock. I mean you’d almost have to be a saint not to.

Alsin: Since the book has come out, have you heard from any of the CEOs that you single out?

Steven: Not at all. Assuming they’ve got some brains, they know the worst thing they can do at this point would be to make an issue of it. You know I was hoping one of them would sue me, I should be so lucky. (Laughs.) But basically I’m sure that somebody pointed it out to them to take this guy savaged you in this book and then their PR people said, leave it alone, don’t say a word.

Alsin: Sure, that makes sense. But how do you evangelize this issue? How do you make it an issue that gets real attention and gets big funds to criticize CEO pay structures?

Steven: The people who should be doing this would be the hedge funds. I think they should be doing it merely out of self-interest. They’re not bureaucracies—you take your average pension fund and you’ve got committees and it’s a big bureaucracy and they’ve got their outside experts and they’re pretty much wedded to the status quo. Everybody there is a is completely afraid to take a chance, because it could look bad.

I spent some time in politics, not a lot, but an issue has to ripen a before a politician’s going to pick it up. Politicians don’t go out on the street and say, ‘Hey I want to lead a parade on this.” They want to join the parade once it’s going on and then say—“I’m leading this parade!” So that’s where we are right now with CEO pay.

My book got a lot of reception in the left wing blogosphere. I didn’t even realize there was a left wing blogosphere, but there is. And for better for worse that’s where I see it started. I wish it would start with a responsible board saying ‘This is something we need to think about,’ but it’s not.

Alsin: So you think it has to come from the outside-in? That politics have to shape these rules, because corporate boards won’t change themselves?

Steven: Exactly. It’s got to become a political issue, because the boards have a very good defense. “We have the experts,” is what they say. They say “This is the American Way,” and you pay for performance, etcetera. I don’t know if you’ve read any of these proxies, but they’re filled with all this bullshit about, you know, ‘We have the cutting-edge best practices, pay for performance, alignment.’  There’s not a single proxy out there that doesn’t use “alignment” at least thirty times in its proxy.

So I think it’s got to be people like you that pick it up and say, look, ‘Yeah, these guys are making a lot of money and it’s a serious economic and political problem and the boards are not going to do a damn thing about it.’