By Sanjay Sanghoee
October 1, 2012

FORTUNE — Whenever the topic of CEO pay comes up in public debate, it quickly devolves into a battle between free market capitalism and pseudo-socialist morality. This is a mistake. If we are to address this issue meaningfully, we need to move away from ideological extremes and consider the causes of the wide discrepancy between the pay-scale of CEOs and average workers (which currently stands at 379 times).

The current system for deciding CEO compensation, especially at large corporations (where this problem is arguably the most egregious) involves a compensation committee consisting of board members who vote on the pay package. In theory, the system is fair, since the board of directors has a fiduciary obligation to shareholders and must compensate CEOs according to their performance and the value they add to the company. There is obviously some leeway since ‘value’ is a subjective term and can encompass anything from actual business ability to public relations skills and even political connections, but by and large the process is reasonable.

The problem arises when a CEO sits on the boards of other companies, whose directors or executives might themselves be a part of the CEO’s board, creating an interlocking and incestuous network of decision-makers that can lead to compensatory nepotism. As is to be expected, the members of this exclusive club vehemently deny any favoritism, and actual evidence is difficult to find since self-serving decisions are usually not documented, but that does not mean the problem does not exist.

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When you consider the fact that some CEOs are rewarded handsomely even when their companies fare poorly or when they take unconscionable risks, it stands to reason that there must be a subjective dynamic at play that makes such an irrational result possible. Lehman Brothers CEO Richard Fuld was paid more than $500 million from 1999 to 2007 and Countrywide Financial head Angelo Mozilo collected more than $400 million in the same period, both of whom drove their companies to ruin by betting on extremely risky subprime mortgages. More recently, Oracle (ORCL) CEO Larry Ellison received a $21 million pay raise even though the company’s stock fell by 23% during that time. Even shareholder activism, despite the “say on pay” provision of the Dodd-Frank law, is rare and more importantly, non-binding on boards. In April of 2012, Citigroup (C) shareholders rejected a $15 million pay day for CEO Vikram Pandit in a year when the bank’s share price fell by 44%, and filed a lawsuit against the board for breach of fiduciary duty, but it is unlikely that anything will change.

The other big weakness in our system is the propensity of companies and shareholders to accept the “divine right” of CEOs, which elevates them to monarch status and enables them to run their companies like private kingdoms rather than as trusts run for the sake of the owners. Nowhere was this phenomenon more clearly evident than in the case of Dick Grasso, the former head of the New York Stock Exchange, whose disproportionately large $190 million pay package became possible due at least in part to his personally handpicked board, absolute stranglehold over the NYSE’s activities, as well as his ability to regulate the very people who were tasked with deciding his compensation. More recently, questions have surfaced about Jamie Dimon’s leadership at JPMorgan Chase (JPM) after the bank’s staggering mismanagement of risk and $6 billion in losses. Most CEOs who oversaw the wipeout of billions from their company’s value would have been fired or at least severely penalized, but Dimon has survived the debacle unscathed, suggesting significant influence over the bank and its board.

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Over the years, many innovative structures have been suggested for rationalizing CEO pay, including outright caps on compensation, deferred pay, clawback provisions, and even the restriction of CEO pay to a multiple of the salary of the lowest paid worker in the organization. All these ideas have their merits and drawbacks, but whatever individual companies or government regulators decide to do in the future, one thing is certain: CEO compensation will never be genuinely “fair” until the flagrant conflicts of interest in the system are eliminated. As long as CEOs and boards remain in bed with each other through interlocking governance structures, and as long as CEOs continue to exert excessive control over the companies they are supposed to work for, no truly objective system to measure performance can exist, and without that our merit-based capitalist system will inevitably fail.

Sanjay Sanghoee has worked at leading investment banks Lazard Freres and Dresdner Kleinwort Wasserstein as well as at a multi-billion dollar hedge fund. He is the author of two financial thrillers, including “Merger,” and writes regularly about politics and corporate excess. 



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