article:  The Sky-high Club

James Surowiecki, the author of The Wisdom of Crowds, wrote an article for the New Yorker on the finding that CEO connections lead to increased pay.  He begins the article by discussing the ex-CEO of Home Depot, who was given two hundred million dollars despite the fact that he did not do an exceptional job.  Surowiecki accounts this surprising severance to the fact that the independent board members are not truly independent.  He notes that the people on Home Depot’s board sit on an average of two other boards and these connections to other companies lead to a continuous increasing of CEO pay.  However, the downside of this happening is that increased compensation does not necessarily lead to better performance.

First, this article shows how information cascades can lead to bad decisions.  Surowiecki describes how the idea of high pay travels from one board to another through its well-connected members.  Thus, in the same way companies may adopt new strategies for competition, they adopt the idea of supporting high paid CEOs.  In short, if many boards seem to pay their executives well, you should too.  In fact, to keep a good CEO, you should pay them more.  As the board of a company gains connections (from sitting on other boards), there becomes an increased chance that they will become a “friend of a friend” to the executives.  Thus, the connections between independent board members and the executives become friendlier and more “you help me, I’ll help you”.  At the end of the article, Surowiecki notes that while people join boards to be more connected, this often leads to less valuable decisions.  In short, the wisdom of the crowd is lost when people are too connected.

Perhaps this can also be a literal example of the “rich-get-richer” model.  Since, in an ideal world, compensation would relate to how well someone performs, a high-paid CEO would be thought to do a very good job.  Thus, when trying to attract a new CEO or retain a good one, the board must take into consideration how much money the CEO currently makes.  Consequently, high-paid CEOs, who are thought to be good, would then be paid even more in an attempt to attract/retain their expertise.

if you’re interested in seeing the actual study Surowiecki talks about(it’s 62 pages): Director Networks, Executive Compensation and Firm Performance