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The Role of Luck in Pay-for-Performance

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May 12, 2015 | Barbara Baksa

The Role of Luck in Pay-for-Performance

Arguments in a recent divorce proceeding potentially cast doubt on the idea of pay-for-performance, i.e., that outsized executive compensation is justified by performance.

The Jed Clampett Defense

If this sounds familiar, it's because we highlighted an article ("Are C.E.O.s That Talented, or Just Lucky?," Robert Frank, Feb. 7, 2015) in the New York Times that discussed case in the Across Our Desk column in the March-April 2015 NASPP Advisor. Lawyers for the founder and CEO of Continental Resources argued that he should only have to pay a small portion of his overall wealth to his ex-wife because most of the growth in his wealth was attributable to factors outside his control.  Apparently under the applicable state laws (and in the laws of a number of states), the increase in value of an asset that you owned prior to marrying is not divisible in your divorce if the increased value is not due to your own efforts.

According to the article, the CEO's lawyers argued that "under 10 percent of his wealth was a result of skill and effort, and that mostly he rode the crest of oil prices and the slide."  The CEO's holdings included a 68% stake in Continental Resources, which has market capitalization of over $30 billion. Essentially the argument was that, although the CEO's wealth increased during his marriage and much of that wealth was attributable to his holdings in the company he founded and runs, the holdings increased in value through little effort of his own. He was just lucky enough to be CEO of a successful company (sort of like Jed Clampett of The Beverly Hillbillies striking it rich by finding oil in his backyard).

Pay-for-Performance?

This was interesting to me because there is so much emphasis these days on paying for performance.  This emphasis has lead to a surge in the use of performance awards, which often include multipliers when the company performs well, increasing payouts to execs.

I looked up what the Continental Resources proxy said about the CEO's compensation.  The 2014 proxy included statements like: "We rely upon our judgment in making compensation decisions, after...reviewing the performance of the Company, and evaluating an NEO’s contribution to that performance...and long-term potential to enhance shareholder value," and other statements that seemed to indicate that compensation is based, at least in part, on individual performance.  So while the CEO might not have thought he contributed to the company's success, management and the compensation committee didn't seem to share this view.

On the other hand, the Times article notes that academic research seems to indicate that individual executives don't necessarily have a lot of control over the success of a company:

“As we know from the research, the performance of a large firm is due primarily to things outside the control of the top executive,” said J. Scott Armstrong, a professor at the Wharton School at the University of Pennsylvania. “We call that luck. Executives freely admit this — when they encounter bad luck.”

The Ends Justify the Payouts, Even If They Aren't the Means?

Ultimately, do shareholders care about the reason for a company's success?  I suspect that if the company is doing well and increasing shareholder wealth, they are fine with large payouts to executives even if the company's success is not due to the efforts of executives.

-Barbara

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