You object: “But without equity, they won’t think like owners.” To me, that’s a feature, not a bug. Managers should think like managers. Owners should think like owners. Things get confused when we expect our managers to think like owners and like managers.

But what about incentives? With equity, a manager’s main incentive is to increase the stock price. The problem is, the stock price depends on a lot of variables, many of which are out of the manager’s control. At best, the stock price is just an indirect and distorted reflection of what the manager actually did. At worst, the stock price will have nothing to do with the manager’s efforts, as we’ve seen when market bubbles rewarded the incompetent and market crashes punished the competent. Might as well pay our managers with lottery tickets.

A cash-only compensation system requires us to set incentives the old fashioned way: Figure out what we want our managers to accomplish, and pay them based on what they actually accomplish. This isn’t easy to do well. It requires a good understanding of the business, where it is going, what needs fixing, which achievements are probable, possible and nearly impossible, and how much it’s worth to the company to accomplish these goals. This is the sort of finely-tuned understanding we’d expect a knowledgeable board of directors to have. But many don’t. And others do but aren’t sufficiently  independent of the manager to implement it. And it’s a lot of work. It’s so much easier to load up on the equity and let the stock market sort it out.

Imagine if a CEO paid the heads of his subsidiaries this way. Instead of figuring out what they needed to accomplish and how much that would be worth, and then monitoring their performance throughout the year and adjusting as needed, the CEO just handed them shares in their subsidiary and left them alone, figuring they’d act like owners so everything would work out. I doubt anyone would view that CEO as managing effectively. So why is it okay to manage our CEOs that way?

Equity brings complexity. Complexity brings compensation consultants. That alone should be enough to scare us away from equity. But even worse, equity brings obfuscation. We all know what a dollar’s worth. We never know what equity is worth. This leads to crazy results. Every year there’s a new poster boy for over-compensation, some lucky dog we read about pulling down a nine-figure pay-day. In every one of those cases, I’ll bet, no one actually thought they’d be paying out nine-figures for a year’s work. No, they thought they’d be allocating a mix of X options, Y restricted shares and Z performance units based on some ostensibly scientific formula that, once run through the requisite black box, will magically spit out the right value. Who knew it would all add up like that? If they’d been dealing exclusively in dollars, they would have known. I guarantee that none of them would ever have agreed to write a check for those amounts if they’d been denominated all along in dollars.

Similarly, I feel for the managers who have a great year when the stock market happens to be having a bad year. All their hard work wiped out by the vagaries of the market. That makes no sense. If the manager did valuable work, accomplished what we asked of him, we should pay him for it.

But shouldn’t we pay in equity because it is tax-advantaged? Any tax advantage of equity only matters if it exceeds equity’s other costs. I expect those other costs – distorted incentives, unintended payouts, shareholder dilution – are substantial but rarely factored into the analysis. In any event, tax is subordinate. The goal is to build a sensible incentive structure, not a tax-avoidance scheme.

And we shouldn’t require a cash-compensated manager to invest in our stock, either. The manager is already heavily invested in the company just by being its manager. It is only prudent for him to diversify his holdings away from the company. No one should be forced to put all his eggs in one basket. I expect that forcing our managers to do this is what led some to take irrational, all-or-nothing bets. Which manager do you think is more likely to throw the dice with the company assets: the manager with everything in company stock or the manager who keeps his assets in index funds?

Equity is too often the currency of choice for executive compensation. Last I checked, cash was still legal tender for all debts, public and private, even executive compensation.

     1. The term. The term “golden parachute” is intended to convey a certain cushy lavishness. In fact, it makes no sense. A parachute made of gold will drop like a lead balloon. With a golden parachute, you won’t get a soft landing, you’ll plummet to a bone-crushing death. A parachute made of silk, canvas or sail-cloth works much better, but you never hear anyone calling an executive termination arrangement a “silk parachute.”

     2. The kitchen sink lump sum. When an executive gets a golden parachute payment, it is usually reported as one lump sum amount. Outrage ensues. What isn’t reported is that the lump sum invariably includes benefits the executive has already earned, such as deferred compensation and payouts on previously-vested compensation. I’ve even seen an executive’s 401(k) balance included in his publicly-reported golden parachute. Getting paid what you previously earned might be copper or bronze, but it’s not golden. So when we get outraged over golden parachutes, let’s be sure we’re not getting outraged over the golden part, not the fool’s gold.

     3. The ex post view. Golden parachutes are, by definition, paid when an executive leaves. Executives sometimes leave for good reasons, such as selling the company for a good price, but the departures that get our attention are those that are for bad reasons, such as poor performance. So viewed ex post, golden parachutes usually look bad.

     There is an assumption that it is always inappropriate to pay an executive who leaves for poor performance. This is, in fact, something that the newly-proposed Shareholder Empowerment Act of 2009 would ban.

     But when viewed ex ante, sometimes these payments make sense, even for poor performers. For instance, if to lure an executive to our company we need to pay her for benefits she is forfeiting at her old company, we can either reimburse her for them now or, instead, we can offer to pay them only if we terminate her early, even if that termination is because things didn’t work out. We might win that concession from her by convincing her that if things do work out at our company, she’ll make a lot more than she would have at her old company and therefore will still be ahead. But if things don’t work out, and we end up having to pay her for the forfeited benefits, outrage will ensue. And we’ll learn our lesson from the bad PR: Pay her successor up-front, even if it costs us more.

     4. Tax trumps all. I’ve seen golden parachutes attacked because they are not tax-deductible or because an executive’s benefits were grossed-up. There is nothing inherently wrong with doing things that are not tax-deductible or that require a tax gross-up. Just because the government decides something is or is not taxable doesn’t mean we should or should not do it. (Look what happened when we mindlessly piled into tax-advantaged stock options. The civilization may never recover.) So in deciding whether to enter into a golden parachute arrangement, a company should consider all the relevant factors, including the tax costs. If on balance the golden parachute still makes sense, the company should do it.

     5. We’re not tenured professors. A golden parachute may be needed to protect a specific deal, as in the example above. And a golden parachute can be fair when executives, well on their way to achieving a multi-year performance target, have their company sold out from under them. In situations like that it is hard to begrudge the payment (though we often do). What is easy to begrudge is the automatic golden parachute built on the presumption that by reaching the executive suite you’ve somehow earned tenure, especially when your company treats other employees as terminable at-will. It’s as if the executive suite moved to a northern European welfare state, leaving the rest of the company to toil away in Bangladeshi sweat-shops. There are situations in which golden parachutes make good sense, but these sorts of parachutes give them all a bad name.

Whether say on pay should be the law of the land is an interesting issue that, I am sure, I will not be able to resist discussing here in the future.

However, because today I am assuming that say on pay will be the law of the land, and because today I am wearing the corporate lawyer’s uniform, a uniform that, when donned, magically transforms its wearer from a philosophical but Quixotic idealist into a hard-nosed, pragmatic and adaptive realist, today I am only concerned with one issue: How will this new reality affect corporate clients?

Say on pay is all about stigma. Initially, shareholder activists identified companies whose combination of high pay and low performance left them vulnerable, and targeted them with say on pay proposals. These proposals drew unwanted attention to these companies, putting them on the defensive. Even when the proposals didn’t pass, and most didn’t, the say on pay campaigns left the targeted companies stigmatized.

So, in the beginning, the mere threat of a say on pay proposal was a potent weapon for the activists.

However, the activists recently overplayed their hand, proposing say on pay at numerous companies, many with decent pay practices. With so many proposals floating around, a say on pay campaign no longer carried the old stigma. The activists had ceded some control over the issue to the other shareholders, because now the stigma would only attach to a company if its proposal passed. This was proving difficult for the activists to achieve.

The activists may have eventually succeeded in getting more say on pay proposals passed, which would have re-sharpened their stigma weapon.  On its face, a say on pay proposal sounds so reasonable (shareholder thinks: “hey, why shouldn’t I have a say on pay?”) that there was a chance these proposals would start passing in large numbers, even at companies with decent pay practices. Such a cascade of approvals might have boosted the activists’ movement. Or, if enough “good corporate citizens” were saddled with say on pay, perhaps the cascade would have diluted the stigma, even for the bad citizens. The stigma game would shift away from the say on pay proposals to each year’s say on pay votes.

However, now that Congress is intervening, there will never be a cascade of approvals for the proposals, so we will never know how that would have played out. The stigma game will change. Neither the activist’s threat of a say on pay proposal, nor the fact that a company is forced to give its shareholders a say on pay, will carry any stigma. That stigma will instead attach only when shareholders actually say “no.”

If shareholders say “no” all the time, their “no” votes won’t carry much of a stigma. Companies with the worst pay practices will be better off than they were before, as indiscriminate “no” votes will just lump them together with companies with decent pay practices. They will find safety in numbers. And those companies with decent pay practices will have “no” votes that carry little, if any, stigma, so those companies will be no worse off than before.

If, on the other hand, shareholders say “no” rarely, their “no” votes will stigmatize. When no votes are rare, I assume companies with the highest pay and lowest performance are most likely to get the “no” votes, so these companies will bear the brunt of this stigma. However, I doubt these companies will be much worse off than they were before because these were the same companies initially targeted with say on pay proposals. For these companies, it will feel like déjà vu all over again.

Meanwhile, I expect the rest of our public companies will find themselves better off than they were before. With mandatory say on pay, their compensation will now be publicly blessed by their shareholders each year, making it harder to challenge. And, over time, as more and more companies see their compensation approved, it will be that much harder for activists to make a case that executive compensation, whether at those companies or in general, is broken and needs to be fixed.

These days, professional historians shun the Great Man Theory of history. Instead, they focus on the social, political, economic, geographic, technological and other forces that shaped historical developments. They believe this offers a deeper explanation for human events. They would agree with Herbert Spencer’s observation on Carlyle’s Great Man: “Before he can remake his society, his society must make him.”

While the Great Man Theory has disappeared from academia, it continues to thrive in popular histories. To the extent people read history at all, they tend to read it in biographical form. We’d rather read stories about people than analyses of abstract concepts, even if that means we’re getting a shallower explanation.

Our preference for people over concepts runs deep in our psyche, influencing our perception of all sorts of events. When faced with something complex and abstract like the “economy,” our brains could try to grapple with the immensely complex global web of interrelated exchanges that comprise our modern economy, but it’s so much more intuitive and comforting to fall back on visions of President Obama pulling levers and twisting dials as he steers the economy. Similarly, when things go wrong, our first instinct isn’t to examine the systemic underpinnings of the crisis, it’s to find us some villains.

So what does all this have to do with executive compensation?

In executive compensation, the CEO is the Great Man. If the company does well, or the stock price increases, we give the CEO the credit and lavish him with the lucre. If the company doesn’t do well, or its stock price decreases, we blame the CEO and organize a lynch mob.

In each case, our instinct to personalize complex and abstract concepts leads us into attribution errors. A company’s performance depends on many factors, only some of which are in the CEO’s control. If commodity prices fall, or if a large customer goes out of business, or if a large competitor stumbles, or if interest rates decline, giving the CEO the credit or the blame probably isn’t analytically correct, but it is so easy, intuitive and satisfying to do so that we do it anyways.

These Great Man attribution errors can be costly, causing us to overpay bad CEOs in good times and underpay good CEOs in bad times. They distort incentives, making it less likely that a compensation program will function as a useful tool. They also distract – after all, investors ultimately want great companies, not great CEOs. A great company should not need a great CEO; its business should be so strong that it should do well even with a mediocre CEO.

Warren Buffett supposedly once described a particular company’s business as being so good that even a ham sandwich could run it. This suggests a different approach to executive compensation: the Great Ham Theory. Under this theory, we’d reward CEOs who made themselves superfluous and punish those who persisted in making themselves essential.