As Firms Face CEO Pay Scandals, Directors Quit

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Expert Perspective by Grahall’s Garry Rogers

Two recent Wall Street Journal articles present a most interesting  contrast.  The first is an opinion piece dated December 4, 2008 titled “Since Enron, Little has Changed”; and the second is a news article dated November 21, 2008 titled “As Firms Founder, Directors Quit”, by Joann S. Lubin (journalist for The New York Times).  Let me summarize and quote from the articles.

· CEO compensation is screwed-up because too often Boards failed at the task of governance. Were these boards incompetent, uninformed, or simply intimidated by powerful CEOs? The answer is not entirely clear. Whatever the reason, the outcome was the same: they failed in their fiduciary duty to govern.

· Primarily because of excessive time demands, the number of Directors not standing for reelection is on the rise. So far this year, 46 outside directors who are CEOs or chief financial officers left the boards of 42 companies in three struggling industries — financial services, retail and residential construction. … During the same period three years ago, 31 directors with those titles left.

Based on our experience in consulting to Boards and Executive Management, we are in general agreement with the first observation, and we are seriously concerned about the second. As politicians and pundits finger-point their way through the economic crisis, we suggest that taking a fresh look at how Boards are paid will provide will provide a useful perspective.

Is Board pay based on contribution to sustainable value creation for shareholders? The answer is: No! So, are we surprised that Boards too often fail to pay CEOs and top executives for sustainable value creation? The answer also is: No! In fact, if this was school and we were teachers, we would grade typical Executive Compensation practices a “D” and typical Board Compensation practices an “F.”

Board pay is usually reviewed through the lens of competitive analysis, i.e., through a comparison of pay levels to a group of competitor companies and broader industry trends. As is the case with over-reliance on competitive analysis to set executive pay levels, we know the result is a predictable upward spiral, with variations predicated by stock price, not performance: In fact, since 2003 the median Total Direct Compensation for Board Members at the Top 200 U.S. Public Companies increased by 42%, with even larger increase trends for smaller companies (as reported by the National Association of Corporate Directors).

Why is Board compensation typically set through competitive analysis? We suggest two intertwined reasons: competitive analysis is the preferred methodology of compensation consultants, and Board members find the approach to be a convenient fig leaf, certainly much easier than addressing pay for performance and contribution to value creation. But isn’t this exactly what Boards are being criticized for not doing with executive pay?

We believe Boards should be paid primarily for their role and their contribution, within a framework of defined and articulated total rewards strategy for Board compensation. Basing Board pay on competitive analysis delivers the wrong message to Directors and to Executives.  We will have much more to say on this topic in the coming months. For starters, we suggest a review of our white paper on Board of Director Total Rewards Strategy

Will a fresh approach to Board compensation solve the critical governance and retention issues? No, or at least not on its own. But will it help? Undoubtedly, Yes!

To quote Warren Buffet: “Executive compensation is the acid test of corporate governance.”   Grahall believes typical Board compensation practices send the wrong message regarding executive compensation practices. Email Garry Rogers at garry.rogers@grahall.com

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