Why Boards Often Fail To Curb Executive Pay

Last fall, Richard Grasso, the chairman of the New York Stock Exchange, was forced to resign following disclosure that he had accepted a $187.5 million compensation package. The chairman didn’t set his own salary, however. The board of directors set it.

What was their rationale for approving a package of that magnitude? Was he being wooed by another company willing to offer him a similar package? Was it the result of the NYSE far exceeding some objective performance criteria that had been established in advance in a bonus plan for key executives?

None of those reasons applied. The head of the board’s compensation committee admitted he simply didn’t fully understand the compensation package.

It’s easy enough to treat the compensation practices at the NYSE and other companies making headlines as aberrations — products of greedy CEOs and overly compliant boards. The news reports make great fodder for the press to rail against corporate greed, academics to lecture about the need to reform corporate governance, and politicians to enact legislation regulating corporate conduct.

But those actions aren’t enough. Neither is replacing the handful of the CEOs and board members involved in the most egregious pay scandals.

Despite all the talk about reforming compensation practices in corporate America, little will change. CEOs, with the approval of their boards, will find new ways to ensure that they are exceedingly well-paid, whether or not they deliver results for shareholders.

The problem isn’t that salaries of key executives are necessarily too high, but rather that they’re determined too indiscriminately. To make lasting and meaningful changes, boards must acknowledge and deal with the reasons why they don’t adequately exercise their responsibility to oversee executive compensation.

Currently, compensation and the performance of key executives aren’t connected, for two reasons:

  1. Boards generally don’t select directors who have real expertise in negotiating executive compensation on behalf of corporations, even those asked to serve on the compensation committee; and
  2. Boards fail to view the process of setting the compensation of key executives as a negotiation.

Most directors take their responsibilities to a company and its shareholders very seriously. They are conscientious and seek to use compensation as a way to attract and retain the best talent and to drive company performance. Why then do boards of directors so frequently approve compensation packages for top executives that appear to be excessive in relation to the results they produce?

Many people think greed or excessive coziness with the CEO are the culprits. But the main reason is that boards have fewer resources and expertise available to them than does management. Not only do most boards lack even a single member with experience dealing with executive-compensation issues, but they also fail to recognize that the process of setting compensation for key executives is less an analytical exercise than it is a high-stakes negotiation with self-interested executives. Management isn’t only better suited to handle these negotiations but it also recognizes the process for what it is.

If, as The Wall Street Journal has suggested, “the board’s most important job is hiring, firing and setting compensation for the company’s chief executive,” why do boards rarely include a human-resources executive with expertise in executive compensation? Moreover, the current practice of populating boards almost exclusively with sitting and former CEOs virtually guarantees a bias in favor of overcompensating executives.

Most directors are current or former CEOs. As a result, arguments that tie compensation of key executives to strict performance measures would apply equally to their own compensation or, on a subconscious level, won’t influence them.

Board members who have been CEOs tend to see things from a CEO’s perspective. They are predisposed to accept arguments that favor higher compensation for CEOs. Without a sufficient number of board members with different perspectives (such as individuals with compensation and negotiating expertise) to provide a strong counterweight, there is inexorable pressure toward ever higher CEO compensation.

With few members with real expertise in negotiating executive compensation, the board must rely on management and its compensation experts for the information it needs to make compensation decisions. Not surprisingly, the recommendations they receive and the information supporting those recommendations result in overly generous compensation plans.

Equally problematic, boards typically fail to view those recommendations as part of a negotiating process. As a result, at many companies the “pay for performance” philosophy that results in large bonuses for executives in good times becomes “pay notwithstanding performance” when things aren’t going so well. Bonus plans seem to be designed to ensure that executives get their bonuses year in and year out, regardless of how the company does. When that doesn’t work, the performance targets in the bonus plans are set even lower.

For example, AT&T Wireless Services Inc. last year lowered the performance targets in its bonus plan at midyear, thereby enabling its top executives to pocket bonuses in amounts they wouldn’t have earned under the original plan. Until recently, General Electric Co. and Verizon Communications Inc. included pension-plan earnings, which are totally unrelated to how well the business is run, in determining earnings for purposes of calculating executive bonuses. Some companies have issued new stock options or repriced existing options for their executives when stock values have fallen dramatically. To the public, these actions are akin to a local referee moving the goal line forward and signaling a touchdown when the home team fails to get the football into the end zone.

Similarly, in granting stock options or restricted stock, boards too often treat a long-serving executive who already is a major shareholder in the company as if he or she were a newly hired executive with no equity stake. This is the inevitable result of relying on studies by consultants that look at the size and frequency of stock and option grants to executives at other companies without taking into account the specific reasons for the grants at those companies. The common practice of using compensation studies as the basis for compensation decisions creates a built-in bias toward ever-increasing compensation packages and almost always results in existing management receiving packages that are too generous and not linked closely enough to results.

Directors need to become assertive when making compensation decisions because of the significant impact of those decisions on the success or failure of a company. Ultimately, there’s no substitute for directors recognizing that the process of setting compensation is a negotiation between the company and its key executives.

To start, boards need more members with appropriate expertise in compensation and negotiating, especially to sit on the compensation committee. They must be better educated about the compensation issues facing the company and available alternatives. Most important, they must recognize that there’s no simple answer to how key executives should be compensated; merely commissioning a study of pay practices at other companies isn’t the solution. The board has to take into account the specific needs of the company plus key performance goals the executives must reach, and then ensure that the compensation package will provide rewards consistent with the company’s performance.

 

By Lee E. Miller

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