CHRISTOPH NIEMANN

Even the most jaded observer of American corporate culture had to blink when, earlier this month, Home Depot’s board of directors handed the company’s C.E.O., Bob Nardelli, more than two hundred million dollars after pushing him out of his job. Nardelli had not delivered for shareholders: Home Depot’s stock price went down about six per cent during his tenure. And, while his operating performance was actually quite good, he would have made a lot of money even if it hadn’t been: most of his contract was guaranteed, and, when he had a hard time meeting a particular target for his bonus, the board generously substituted an easier one.

The size of Nardelli’s severance was startling, but his “heads I win, tails you lose” arrangement is far from unusual in corporate America these days. For all the talk of restraining C.E.O. pay, most compensation committees remain what Warren Buffett once called them—“tail-wagging puppy dogs.” At some companies, this is simply because the C.E.O. has packed the board with cronies. But at Home Depot Nardelli did not pick the board members, and most of them were what are usually called independent directors—ones who don’t work for the company or do any business with it. Even when an independent board negotiates a C.E.O.’s contract, however, the directors are often, in a sense, negotiating with themselves. Of the ten independent members of Home Depot’s board, for instance, eight are or have been C.E.O.s. Since C.E.O. pay is often driven by comparisons between companies, directors have a certain interest in keeping executive pay high. Furthermore, the salaries keep escalating because, board members argue, there just aren’t enough good C.E.O. candidates out there. There’s no evidence that this is actually the case, but who is more likely to feel that good C.E.O.s are indispensable and rare than other C.E.O.s?

A more complex problem lies in the nature of the social networks that bind directors and executives together. Home Depot has an exceptionally well-connected board. On average, its directors sit on two other outside boards, and the compensation-committee chairman sits on four. Connections are often beneficial—they insure that people are well informed, creating opportunities for new business. Unfortunately, the more connected board members are, the likelier they are to overpay for executive talent. In some cases, which economists call “interlocking” directorates, this is straightforward: I sit on your board and you sit on mine, and we both have an incentive to be generous. Sure enough, several studies have found that companies with interlocking directors pay C.E.O.s significantly more. Surprisingly, though, connectedness remains important even when the links are not direct. A study of S. & P. 500 companies, by Amir Barnea and Ilan Guedj, finance professors at the University of Texas, found that, even after other factors were accounted for, C.E.O.s at companies whose directors sat on a number of other boards were paid thirteen per cent more than C.E.O.s at companies whose directors were not.

Why? One reason is that the more connections board members have, the more likely they are to end up with what you could call “friend of a friend” links to the company’s C.E.O. A recent study by a team of business-school professors mapped the social networks of twenty-two thousand directors at more than three thousand companies, charting the degrees of separation between directors and C.E.O.s, and found that at companies where there are what the study’s authors termed “short, friendly” links between directors and executives C.E.O.s are paid significantly more. But even in the absence of this kind of explicit back-scratching the tight connections between board members insure that, once an idea takes hold at a few companies, it’s easier for it to spread, in a viral fashion. A host of studies have found that network ties affect how likely companies are to adopt anti-takeover strategies, to embark on specific types of acquisitions, and even to change their organizational structures. The same effect is observable in the matter of C.E.O. pay: Barnea and Guedj found that board members at companies where C.E.O. pay was high were more likely to support high pay when they sat on other companies’ boards as well. And, as with any virus, some people are more potent transmitters: Kenneth Langone, the board member who engineered Nardelli’s hiring at Home Depot, was also the head of the compensation committee that approved Dick Grasso’s extravagant payday at the New York Stock Exchange, and was on the G.E. board’s compensation committee that approved Jack Welch’s luxurious retirement package. Langone is what an epidemiologist might call a supercarrier of the executive-pay virus.

It’s tempting to wonder if the sheer prevalence of enormous C.E.O. compensation packages means that they have some beneficial effect. But academics have found little evidence that higher executive pay leads to better company performance, and the recent study of three thousand companies actually found that the firms whose directors were the most well connected—and which paid their C.E.O.s most lavishly—in fact underperformed the market. Markets work best when people make independent decisions about how much a commodity—in this case, the C.E.O.—is worth. They stop working well when people simply imitate what others are doing, or when non-market factors (like how well you get along with the boss) intrude. In the end, the very things that make people likely to join a board—connections, business experience, sociability—are also the things that make them less effective once they do. ♦