Keep on Strivin’

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Expert Perspective by Grahall’s OmniMedia Editorial board

In his article for GuruFocus.com “A Fix for Executive Compensation – The Reorientation of Director Intent” author, Karl (no last name) who “…is continually striving to learn more about investment”, says with regard to Director’s pay that:  “The directors are paid egregiously in many cases” – with the notable exception of Directors of Berkshire Hathaway. Karl continues: “Berkshire Hathaway board members were paid $2,700 or $6,700 for the year ended December 28, 2008 depending on their duties.” 

Karl suggests that “…director compensation to be stock only. And only stock that must be held for several years. Some sort of cap on this should be instituted. A maximum cash compensation should be extended to directors for expenses.” And he continues: “The proposed changes are not overly complicated or confusing.”

We agree with Karl in two regards:
1) He definitely needs to strive to learn more about investing and about the impact of director’s pay on shareholder value.
2) His proposed changes are not overly complicated; in fact, they are overly simplified.

Let’s start with how Warren Buffet and Berkshire Hathaway are lauded for their highly restrictive approach to Directors’ pay.  Frankly, there are a few companies in the US where individuals might be willing to serve on the Board for no pay at all.  Why? Because of the success of the company and the strength of management coupled with the prestige and contacts that the position offers.  The most notable of those companies is likely to be Berkshire Hathaway.

However, it doesn’t follow that every company could pay directors meager sums to sit on their boards.  Perhaps Karl has forgotten that there is a dearth of qualified candidates willing to take the personal risk of being a board member for little reward.  Over the past several years the risk/reward ratio has changed dramatically, and that might be part of the reason why director pay has doubled over that period of time.
Several years ago a blue ribbon panel convened in the UK to study director pay came to the following conclusion:  The only way the directors should be paid is straight cash because stock decreased objectivity.  Around the same time, another blue ribbon panel was convened in the US to study director pay; their conclusion: directors should be paid no less than 50% of their compensation in the form of stock to align their interests with shareholders. 

The real point of this discussion is that simplistic approaches to director pay — low pay, no pay, cash only, minimum of 50% stock, stock only, etc, etc . — does nothing to address the real issue.  That being companies should pay their directors based on their own specific situation.  Is the company large, small, mature, start-up, successful, trying to restore value?  All of these considerations should influence directors’ pay.  Additionally, individual directors should be paid based on their role, experience and expectations. 

The compensation level of reward for any individual on the Board should first reflect the organization’s environment, key stakeholders, and business strategy. Secondarily, it should reflect the role those board members play and the responsibilities they have. Finally it should reflect the total number of directors carrying the load.

No two organizations are the same, and no two organizations have the same relationship with—or expectations of— their Board of Directors. That fact alone demands that a Board’s role – and the way it is paid – will vary from company to company.

The relationship, responsibilities, and roles should be the starting point for Boards as they set the amount and form of compensation they receive for the Total Reward Strategy. New notions of corporate governance demand that director compensation be separate from that of operating management, and be treated differently. Directors who are elected by shareholders to serve as stewards of their investments should have broad reward components focusing on long‐term success factors consistent with the various shareholders interests, be it risk-adjusted returns or organizational sustainability for example. In this context, director total reward strategy should visibly reflect this distinct role.

One other area where we agree with Karl is that “gifting” is not without its potential to create conflicts.  Director “swag bags”, whether they are products or services of the companies on whose Boards they sit, may be influential in Director decisions, and in some cases are inappropriate. 

But it is important to point out other examples where influences and incentives are far more significant.   Let’s take drug companies.  For years they have practiced a form of influence peddling by giving physicians incentives to write prescriptions for their drugs.  One of the most egregious examples (and the most recent) is the case reported by AP in January of this year.  Federal prosecutors have charged that: “…healthcare giant Johnson & Johnson paid tens of millions of dollars in kickbacks so nursing homes would put more patients on its blockbuster schizophrenia medicine and other drugs… J&J paid rebates and other forms of kickbacks to Omnicare Inc., the country’s biggest dispenser of prescription drugs in nursing homes… the scheme went on from 1999 through 2004, a period when J&J’s sales of drugs through Omnicare jumped from about $100 million to more than $280 million.

There are many places where incentives, swag, bribes or whatever you care to call them should be outlawed or at a minimum penalized. The situation with Directors is far less serious than in some other areas.

We suggest that Karl read the book by Grahall partner Michael Graham, “Effective Executive Compensation” and especially Chapter 17: Board of Directors Compensation. If Karl will give us his last name and email address, we might even send him one.

Contact Grahall’s Editorial Board at edie.kingston@grahall.com

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