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What Is To Be Done?

Everyone complains about excessive executive compensation, but what do we do about it? Discussion below.

Kevin suggests: "Transparency of pay plans, stock option accounting, deductibility of perks, tax treatment of capital gains and dividends, and progressive taxation in general are obvious starting places." I'm all for making taxation more progressive, but I have my doubts that it's the solution to this problem in particular. The issue is excessive management control of the corporate resources they're supposed to be using in the interests of the corporation's owners. Insofar as the tax system makes abusing this control through the payment of high salaries infeasible/undesirable, it will be done in other ways. The system to too subject to gaming through shifting compensation away from salary toward various kinds of perks and other benefits. A more progressive tax code would raise additional revenue, which would be a good thing since the government needs more revenue, but it's not the way out of the trap.

Now I suppose you could make a rule that all non-salary benefits need to be offered to all employees and managers on equal terms. Or at least that the value of non-salary benefits offered to the most-compensated employee cannot exceed some relatively low multiple of the value of non-salary benefits offered to the least-compensated employee. That would push the vast majority of unequal compensation into the salary realm. Unequal compensation is, of course, perfectly appropriate. Some employees are more valuable than others. But when such inequality is dispensed largely through the mechanism of salary, it's highly transparent and subject to mitigation through progressive taxation.

Our current tax bracket system is actually a bit odd in light of the vast right-hand tail of the US income distribution curve. Everyone in the top bracket is making a lot of money. At the same time, some members of the top bracket are making orders of magnitude more than some other members. No other bracket has this feature. Additional tiers to capture some of the income of the super-wealthy, or to discourage corporations from investing their revenue in mega-compensation would be worthwhile steps if the bulk of mega-compensation could be pushed into this venue.

It's interesting to note in this regard that the actually existing tax code, combined with the actually existing compensation structure, manages to discriminate wildly within the class of extremely high earners. People pulling down huge compensation packages as, for example, movie stars or atheletes wind up getting screwed relative to people pulling down huge packages as CEOs. No one's crying for Tom Cruise, and rightly so, but it's still a strange way of doing business.

Underlying all of this is the question of corporate governance rules, about which I know little. If it were possible to create an actual system of capitalism in this country -- in which the means of production were effectively controlled by their owners -- we might well not have this problem. Instead, the means of production are effectively controlled by a tiny number of the capitalists employees, who seem to collude with each other on Boards of Directors to prevent a more efficient allocation of resources. Surely, some changes in the rules could alter this state of affairs.

December 12, 2004 | Permalink

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Comments

Means of production effectively controlled by their owners? That sounds, like, Communist or something!

Posted by: scarshapedstar | Dec 12, 2004 3:50:56 PM

Matt, I think the example to draw on here is how the so-called 'green' companies voluntarily incurred higher costs in order to be environmentally responsible. Before Bush let traditional industry off the hook, the greens were actually making headway in the market. The case here is different in that companies would not need to incur higher costs, but would have to write into the corporate by-laws such novel ideas as no executive should make more than five times the lowest paid employee, or something 'responsible' like that. A good branding label (similar to green) would help convey the social responsibility shown by such firms, where the general public would know that the focus of the executive team is on perpetuating the business, and not on self-enrichment.

By the way, the 'system of control' that you mention is the corprate by-laws. If socially responsible businesses can agree on a standard set of corporate governance rules, it stands to reason that the good companies should overtake those whose CEOs are merely transaction agents looking to cash in.

Posted by: poputonian | Dec 12, 2004 4:17:41 PM

Among people who actually study corporate governance and executive compensation, it is overwhelmingly agreed that the best way to hold executives accountable is a healthy market for corporate control. If a corporation is managed poorly, an opportunity exists for someone to buy the company, fire incumbent management, and make a huge profit.

The constituency most harmed by overpaid and unaccountable management is the shareholders. I think it says something that the corporate governance issue that tends to be most important to shareholders is reducing takeover protection measures. Most shareholders are far more interested in getting rid of poison pills and opting out of state anti-takeover laws than they are in constraining management salaries.

This is also one area where government is partially responsible for protecting incompetent managers. Virtually every government response to hostile takeovers has been to discourage them for the benefit of incumbent management. Generally, Democrats are at least as guilty of this as Republicans. Democrats like to keep inefficient, incompetent managers in charge because the most common sin committed by incompetent managers is their hesitation to lay off employees. So Democrats, in their attempt to avoid layoffs, bear some responsibility for the current environment of unaccountable executives and crony capitalism.

Your suggestion that government encourage corporations to compensate executives through salary instead of stock or options is kind of unusual and it's completely contrary to the existing tax code. The tax code allows corporations to deduct only up to $1 million for the compensation of its most highly paid employees, but there is an explicit exception for compensation that is tied to performance, like stock and options. The goal was to encourage that form of compensation and discourage base salaries. It seems that your only reason is that salaries are easier for shareholders to understand. I don't think it would as difficult as you seem to think that put a dollar figure on the value of options, especially in large publicly-traded corporations. I really don't see the benefit in encouraging salary over options.

Posted by: Xavier | Dec 12, 2004 5:11:14 PM

But Xavier, isn't the healthy market for corporate control you describe a theoretical textbook constuct which neither does, nor could, exist in any realistic human system. In free market thinking the idea is that all of the actual enterprises are bought and sold in a vast market of potential buyers, who will eagerly buy up any inefficient corporations if they can see a way to make them more profitable. But with corporations of a certain size, rather than small businesses, could there ever be enough potential buyers for this idealized free market mechanism to work? And since the most influential and wealthy owners are drawn from the same class as the people who benefit from the absence of ideal free market conditions - do they really have the incentive for efficiency that theory predicts?

And in the theory, we don't have to worry about the dislocations caused by takeovers, because workers (including managers) are just a kind of resource that should flow freely around the labor market with thir price set by supply and demand. We can make markets as efficient if we want, if we are willing to treat ourselves as just another tradable, priceable resource. But who would want to live in such a system, where their security, geographical location, conditions of work and way of life are under constat stress from efficiency-driven market pressures?.

Posted by: Dan Kervick | Dec 12, 2004 5:46:37 PM

Some people are suggesting a simple rewrite of Board voting rules. Now, all shareholders can do is withhold their votes of Board members, so 10,000 withholds and one yes gets someone in. It wouldn't take much -- especially if you did it in Delaware, to change state laws to allow direct Board elections. Whether that brings big money managers into the corporate governance fold is a separate questions, of course, but direct election would change something.

Posted by: david | Dec 12, 2004 6:06:07 PM

Dan: The market for corporate control works quite well even for large corporations. Leveraged buyouts have been used to dislodge management from many multi-billion dollar businesses. If opportunities exist, they can be used to dislodge management from corporations of any size. That's not just textbook theory. That actually happens.

I also completely disagree with your assertion that the wealthy will tend to act in ways to preserve the interests of the wealthy as a class rather than their individual interests. There may be a class of incompetent managers that try to protect themselves and each other by discouraging hostile takeovers. There are plenty of other wealthy individuals who are effective managers. If we allow the effective managers to prey on the ineffective ones, I have no doubt that they will do so, and I think the history of hostile takeovers clearly supports that position.

It might be true that the wealthy have an incentive to band together to prevent hostile takeovers through some collective action, but the only effective option for doing so would be pressure legislatures to pass laws discouraging them. If we remove that option, I don't see how such collective action would be possible.

I point out again that although shareholder activism is rarely effective, many of its biggests successes have been in reducing impediments to hostile takeovers. Since shareholders are generally wealthy, I think that cuts against your argument that the wealthy have some class interest in opposing the market for corporate control.

Your position isn't supported by either dominant economic theory or empirical observation, and I don't find your Marxist class consciousness argument terribly persuasive.

As for your second paragraph, what's the alternative to treating workers and managers like economic resources? When managers cease to make decisions based on pure economic efficiency and instead consider factors like loyalty and stability, we end up with a network of crony capitalism, which is precisely what liberals always claim to oppose.

Posted by: Xavier | Dec 12, 2004 6:07:42 PM

Xavier wrote:

"As for your second paragraph, what's the alternative to treating workers and managers like economic resources? When managers cease to make decisions based on pure economic efficiency and instead consider factors like loyalty and stability, we end up with a network of crony capitalism, which is precisely what liberals always claim to oppose."

Your previous arguments made sense and were very well-stated. This paragraph, on the other hand, pulled a rhetorical slight of hand, re-labelling "welfare capitalism" as "crony capitalism" and imputing an argument to your ideological opponents that they do not hold. Since I am impressed at the level of the discussion on this particular thread, especially since I disagree with you (but may be convinced), I would implore you to avoid this sort of argumentation in the future, especially since Dan did raise a valid issue about which group should bear most of the risk in a market economy, and whether mitigating that risk for workers is worth the economic cost.

I will go back to observing now.

Posted by: Noel | Dec 12, 2004 6:18:51 PM

There is a big difference between welfare capitalism and crony capitalism. Welfare capitialsm means that government provides a safety net for displaced workers. Crony capitalsim means that managers keep employees in economically inefficient positions to avoid laying them off. I think Dan's comment makes more sense as an endorsement of the latter.

I think most people don't have much sense of how top level corporate executives think and why they do what they do. When they provide for fellow executives who are their friends and protect them from being laid off after poor performance, I think they generally see that as an act of loyalty more than a self-interested attempt to encourage reciprocity.

Managers who show loyalty to lower level workers by refusing to lay them off when they become economically inefficient are no different. They are using corporate funds to indulge themselves in a personal sense of loyalty, which is wrong.

Crony capitalism might be a rather loaded word, and I guess some people might think of it more in terms of quid pro quo than I do, but I still say it's a more accurate term than welfare capitalism. Maybe I got a little too carried away with my theme of tying Democratic policies to crony capitalism. Sorry about that. I'm glad you appreciated my other comments.

Posted by: Xavier | Dec 12, 2004 6:45:21 PM

Xavier is the only one here who seems to understand that CEO and other senior executives are mostly compensated through stock, not salary. And there is a very good reason for this; it aligns the interests of the managers with that of the stockholders.

Which is all that counts. After all, it's the shareholders money, not yours. Here's a good short explanation of why:

http://www.econ.duke.edu/Journals/DJE/2003_DJE_regular_issue/jasonliebelDJE.pdf

Posted by: Patrick R. Sullivan | Dec 12, 2004 7:37:35 PM

But what if we lived in a world where the stock options were priced so that, even if the stock didn't go up, the options were still worth money. Or to be even more dastardly, they were repriced (for top executives) at lower prices if the stock price decline. That way, the elites could still profit from a decreasing stock price.

That dastardly world is the world in which we live in.

Not the world that RoseFeeder occasionally sends us messages from, of course.

Posted by: Barry | Dec 12, 2004 8:09:27 PM

Xavier has it dead on, and Yglesias really doesn't know what the hell he's talking about. Take a company like Disney. Suppose its poor management is causing a company to miss out on billions of dollars of revenue. If there are no protections from buyouts and takeovers, Giantmega Conglomerate comes in and buys Disney, running the company more efficiently and making a profit. There is a market for control of corporations, which ought to be made freer and not more regulated, which maintains inefficiency.

Stockholders are the owners but it makes no sense for them to invest time and energy to put in good managers. When a company is poorly managed you sell your stock, unless you think it's so undervalued its going ot be taken over and run more effectively.

I don't remember the arguments against the expensing of stock options, but I remember thinking when I studied it that it made more sense to expense them, as they really are an future liability to the company. Could be wrong though.

Posted by: Reg | Dec 12, 2004 8:34:47 PM

The empirical evidence for the market for corporate control isn't there. It sounds good, especially if you're a Thatcherite, but there's no real evidence that poorly managed companies tend to be takeover targets, or that the threat of takeover leads to better management.

Options can be and often are repriced so that management's interests are not aligned to shareholders via stock.

There is the dream world of it's working, and there's the world of grossly inflated executive pay packages.

Posted by: david | Dec 12, 2004 9:12:43 PM

This won't be solved, or even considered for change, under the Bush administration. No such animal as exess compensation for the wealthiest class in the US right now.

Of course, the solution is the Federal tax code...when the will is present to address excess compensation.

Posted by: Debi | Dec 12, 2004 9:42:44 PM

From a purely practical side, there's nothing wrong with the level of CEO compensation. It's a drop in the ocean, to be honest.

Most of the feelings on this issue, if you like it or not, come from a moral perspective. Like it or not, true morality is more than sex.

From a practical issue, the problem isn't the level of compensation, it's the FORM of compensation. By being mostly through stock options, it puts the value for the CEO in the stock price, not so much the long-term success, or even profitibility. It's all in the perception of profit, in the minds of a very poorly working market.

So you basically have slash and burn economics..and the race to the bottom.

Posted by: Karmakin | Dec 12, 2004 10:02:31 PM

The SEC should pass a regulation requiring that all publicly traded companies allow their shareholders to vote on the following (binding) resolution each year.


The total compensation of both the CEO and the CFO shall not exceed $1 million in the coming fiscal year.


Those who dislike government meddling in business have little to complain of here since the government isn't telling any business how to set salaries. The government is just requiring that business owners be allowed to vote on a specific option.

What would happen of such a regulation were in place? Senior executives would complain long and loudly. Many large shareholders --- especially pension funds --- would gladly vote for lower compensation. Many mutual funds would feel pressured to do so. My guess is that the resolution would pass at many companies.

There would then be significant (downward) pressure on executive salaries across the board. If you're the CEO/CFO of a big company, there are very few employees who you think should be paid more than you are. Of course, this won't allow you to pay people (much) less than they could get elsewhere, but the number of people for whose services the "market" is willing to pay more than $1 million per year is small. The very best baseball players, rock stars, entrepeneurs and Wall Street traders would still make millions, but only because any attempt to lower their pay would cause them to go elsewhere with their services.

Posted by: Dave Kane | Dec 12, 2004 10:03:51 PM

"there's no real evidence that poorly managed companies tend to be takeover targets, or that the threat of takeover leads to better management"

Do you read the Wall Street Journal?

Posted by: Reg | Dec 12, 2004 10:13:22 PM

Dave: One major problem with your suggestion is that shareholders are already free to do that with a shareholder proposal. Shareholders sometimes make proposals similar to the one you are suggesting. They are generally far less restrictive, but they still fail. The SEC actually enacted a rule very much like what you suggest in June 2003. It hasn't had much impact. Shareholders are now required to vote to authorize stock option compensation plans, but overwhelmingly, they approve them. Most of the attempts to restrict executive compensation through shareholder activism have come from unions and government-run pension plans. That tends to undercut your argument that there is no government coercion involved.

As I mentioned earlier, the biggest attempts at shareholder activism have been proposals to reduce takeover defenses. To the extent that incompetent and overpaid executives are a problem, it's the shareholders that suffer. Shareholders seem to think that their best protection is a healthy market for corporate control. Legal and business academics overwhelmingly agree. But although executive compensation has been a hot topic in the liberal blogosphere these past few days, I don't think anyone but me has mentioned it.

Posted by: Xavier | Dec 12, 2004 11:12:10 PM

Sorry, everybody:

Reg, do you read anything but the Wall Street Journal?

Xavier, that's a very limited reading of shareholder activism, one that seems conditioned to get the results you want. Especially if you think that pension plans aren't real owners, just the big bad government. Anyway, hostile takeovers don't happen all that often these days.

The issue of mergers and compensation, of course, is closely linked. One-off payments of very very large sums often go to executives who undertake mergers; those same executives argue vociferously that mergers have to be made to benefit shareholders. Lo and behold, lots and lots of mergers don't create shareholder value. Only faith lets you think that millions of dollars won't lead executives to screw shareholders.

Posted by: david | Dec 13, 2004 12:03:07 AM

Xavier,

First, thanks for taking the time to respond to my post. I'm not an economist and can easily get confused by economic matters. But here is my best shot for now at what I had in mind.

Regarding my comment about workers as resources, what I was actually thinking about is the self-interested use by workers of the power of democratic government to protect their own job security, wages and benefits. I was not suggesting that boards and managers should neglect their responsibilities and govern companies in a manner otherwise than that which most profits the companies' owners. Government, though, can adjust the ground rules under which boards and management are constrained to act, so that the range of decisions is contracted, and in furthering the rational self-interest of the owners, to the greatest extent it can be futhered within the constraints imposed by the rules, other social goals are automatically met.

So my point was not about how managers acting within the economic system should treat their workers, but how all of us should treat ourselves in using government to design an economic system. we have other values to consider besides efficient production.

This is the kind of government regulation with which we are all familiar. For example, companies could be legally required to offer certain health care benefits, or legally required to pay a sizeable penalty to the government every time it lays off a worker, or legally required to pay a minimum wage, or legally required to hold management salaries under a certain maximum wage, or legally required to pay a worker dislocation tax if they choose to move production facilities to a remote geographical locations, or legally required to pay workers a sizeable severance payment if they lay them off. Enacting such laws changes the outcome of the cost-benefit analysis for certain decisions, including board decisions over whether or not to sell the company.

Regarding my comment about the most influential and wealthy owners being drawn from the same class as the people who benefit from the absence of ideal free market conditions, I didn't mainly have in mind the possibility that those people cooperate out of "class consciousness" - although that might happen in some cases. But there are other ways in which the fact that these people are drawn from the same economic stratum might produce cooperation among them and keep them from behaving in the manner classical theory predicts.

First, there is a difference between class consciousness and class prejudice. Even a person who never thinks of himself as part of a class, or never gives any thought to protecting the interest of such a class, may share irrational prejudices that characterize members of that class. Human beings have limited rationality and knowledge, and their judgment may be distorted by arguments and theories that evolve in an environment in which wishful thinking, prejudice and mutual benefit drive acceptance of those theories, even when the theories are not well-supported by the evidence.

If, for example, a board member really does have a solid rational basis for thinking that the company would be more profitable if management instituted a pay scale in which the highest paid employees could not be paid more than some fixed multiple of the lowest-paid employee salaries, he may not respond to those reasons. He may be in the grip of a weak and poorly supported theory that is popular in his own set, one that falsely tells him that what common sense tells him will happen will in fact not happen.

Also, as one advances up the scale of wealth, the average 5 or 6 degrees of separation that connect randomly selected individuals contacts to 1 or 2 degrees of separation. The guy who manages the company you direct may be the son of a friend you went to school with. There are bonds of affection between players, and social ties and obligations that may prevent potential competitors from acting like the the self-interested predators of classical theory, who seem to live only in a market, and have no personal interests beyond their interests in that market.

I don't believe it is true, as you suggest, that when a group of wealthy people perceive mutual advantage in some cooperative scheme, their only effective option is legislation. My understanding is that behavioral research shows that groups of people who perceive mutual advantage in cooperation often spontaneously evolve conventions and cooperative strategies based on tit-for-tat signaling.

So, isn't this a plausible picture: Shareholders, not being managers themselves, may be ill-equipped to tell whether their company is being run as profitably as it could be, or hindered in various ways from doing anything about it. Meanwhile you have a collusive tit-for-tat scheme among board members and the elite managerial class to dupe shareholders, and to keep the gravy train rolling, rather than drive their own personal profits downward by competing with each other for the efficient management of enterprises.

Posted by: Dan Kervick | Dec 13, 2004 12:59:02 AM

Much like tort reform, this issue is such a red herring. Causing executives to make less isn't going to cause workers to make more or shareholders to earn more.

Now, you may want more progressive taxation. Fine, that's an issue that is apart from how much money CEOs make, since CEOs are probably not even a majority of the millionaire class. If you want to advocate progressive taxation, I don't see how bringing up CEO pay makes sense except as a way to stir up class envy.

Posted by: Adam Herman | Dec 13, 2004 3:04:50 AM

I would point out Matt is wrong in the first sentence - in fact, everyone does not complain about executive compensation, and many who do, like Matt, come from academia or other public/semi-public/non-profit entities where compensation has less room to be wildly disproportionate. Which is to say, that many people are appalled by something in which they do not participate. Which is part of the reason - along with inertia - that nothing gets done about the most egregious examples. Ultimately, it's actually not in a company's interest to allow an especially outrageous compensation package to remain in place, and a few years in professional life in the private sector have led me to the conclusion that the market does, in fact, try to police itself - badly, but it tries. Is there a need for more regulation? I suspect yes, but it'll be very hard to rein in the truly creative ways people get around rules and ceilings. Ultimately, I think, it's about what the middle level worker is willing to accept, and the reason communism fails - there's a group that believes the only problem with high executive pay is that it's not given to them, and someday it will be. And no one seems to be able to burst that bubble.

Posted by: weboy | Dec 13, 2004 7:02:29 AM

Good discussion...although it seems the yglesians are being overrun. A few things...I was under the impression that the argument for aligning interests in the form of stock options (which really took off in the nineties) was facing a lot of empirical evidence against -- perhaps later I will be able to find a cite.
It seems fairly clear that some way to incorporate stock options into expensing should be non-controversial - the devil is in the details. From there the 1M cap on expensing of executive compensation should start to have some real teeth. Couple that with giving more power to share-holders (I think the threat of takeover is diminished by the enormity of the undertaking -- if all the police had were nuclear weapons they would find it very difficult to stop theifs. The ability for shareholders to have more say in lowering salaries would be more effective.)
Some general guidelines on salaries would probably be a good idea, and salaries over a certain amount would need to be officially justified by an auditing company, or executive compensation consultation (which would need to be chosen not by the executive in question).
Stronger collective bargaining for non-executive employees would also place some pressure on pay.
Tangentially, removing healthcare from business would probably do a lot to allow companies to focus on what they do best, and removing an enormous amount of complexity from CEOs jobs, theoretically making the job worth less. And while we are talking about benefits, the idea of regulating special one person pension plans would be a good idea as well.
Any thoughts on whether this would push more companies into private ownership?

Posted by: theCoach | Dec 13, 2004 10:01:09 AM

Most of the mega-compensation comes in the form of capital gain, not ordinary income. Progressive income tax rates won't touch it.

The unfairness is on the lower end--not Tom Cruise, but the law partner finally making $1 million after eating shit for 12 years.

Posted by: Thomas | Dec 13, 2004 11:22:35 AM

Xavier, I'm sympathetic to your overall argument, but I do think your picture of governance theory is a decade out of date.

Your argument would have the following empirical implications, which are not generally true: i) takeovers of low-performing by high-performing firms would perform better on average, because they would represent the market for corporate control, ii) europe (and asia) would have the highest ratio of ceo to worker pay because they restrain hostile takeovers.

Your comment on crony capitalism gets to the heart of a debate we're only just beginning to have. From a descriptive standpoint, we know that social networks operate within and affect financial markets, but from a normative standpoint it's not clear if they could be engineered for better outcomes or if they should be reduced as much as possible.

Posted by: cw | Dec 13, 2004 12:15:42 PM

"I don't believe it is true, as you suggest, that when a group of wealthy people perceive mutual advantage in some cooperative scheme, their only effective option is legislation. My understanding is that behavioral research shows that groups of people who perceive mutual advantage in cooperation often spontaneously evolve conventions and cooperative strategies based on tit-for-tat signaling."

Avoiding hostile takeovers isn't a mutual cooperation scheme to do something, it's a mutual cooperation scheme not to do something. There's a big difference. It's definitely possible for a small group to develop some informal behavioral norms where they all act for each other's benefit. It's less possible for the entire class of wealthy individuals to collude to refrain from engaging in hostile takeovers. It only takes one person (out of thousands of people in the class) to defect, and the whole scheme falls apart. With the tremendous profit potential available, someone is bound to defect.

In fact, that's what has actually happened. Hostile takeovers used to be regarded as a fairly shady business. But the profits were so huge they took off anyway. The stigma against takeovers has long since disappeared.


"So, isn't this a plausible picture: Shareholders, not being managers themselves, may be ill-equipped to tell whether their company is being run as profitably as it could be, or hindered in various ways from doing anything about it."

I agree that shareholders are generally ineffective in policing management behavior. That's why I think shareholder proposals tend to be ineffective. Shareholders aren't competent to decide whether a CEO should make $20 million or $30 million, and they probably shouldn't be making that decision.

That's the beauty of tender offers. They don't require shareholders to evaluate incumbent management. Bidders, who specialize in this sort of thing, evaluate the potential profits from a change in management. Then they make an offer to shareholders at a certain price. If a stock is trading at $40 and a bidder offers $50, shareholders know to take it.

"Meanwhile you have a collusive tit-for-tat scheme among board members and the elite managerial class to dupe shareholders, and to keep the gravy train rolling, rather than drive their own personal profits downward by competing with each other for the efficient management of enterprises."

Hostile takeovers may or may not reduce average compensation for executives, but it certainly doesn't reduce compensation for successful takover artists. The guys at KKR have certainly not had their personal profits driven down by competition. Hostile takeovers are very good for the compensation of successful managers, and most individuals who engage in hostile takeovers tend to think of themselves (rightly or wrongly) as successful managers. Those people have pretty big egos.

Posted by: Xavier | Dec 13, 2004 12:33:09 PM

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