Professor Richard Leblanc (@DrRLeblanc) teaches corporate governance and executive compensation in York University's master of financial accountability program. He also advises governments, investors and boards on leading governance practices.
"We have corporate governance that allows CEOs to pay themselves ungodly sums," U.S. President Barack Obama told a reporter the other day. Why should this be the case, and how might this problem be addressed?
Following "say-on-pay" protests at companies in the United States (and in Canada at CIBC, Barrick Gold and Yamana Gold), the U.S. Securities and Exchange Commission recently proposed rules linking pay to performance, six years after Congress passed the law directing them to so.
Will the new rules work? Regulators have a poor track record of getting executive pay right – indeed, some say the U.S. Congress has been the single greatest driver of increasing CEO pay.
If the executive pay model is broken, as many believe, here are three ways to fix it.
First, look at who is negotiating the pay
A CEO's pay contract is negotiated between the executive and a subset of company directors – the compensation committee. "I will outgun any compensation committee," a CEO once told me, and he was right. For any contract to work, there needs to be proper motivation and equality of bargaining power. Many directors on pay committees are former CEOs, have been on the board for over nine years or tend to have been recruited on the basis of prior relationships. These types of directors are not effective in negotiating a CEO pay contract.
Directors confide to me how they are compromised by perks, including gifts, vacations, jobs for acquaintances and so on. There is no free market for CEO pay if the people on the other side of the table are captured.
An effective bargaining party should be independent of management and selected directly by shareholders to represent investor interests. In other words, directors should be selected by shareholders – not directors and certainly not management.
I advise large investors to press for this right to select directors. Industry Canada is considering corporate reforms, and should give shareholders the right to select and remove directors without artificial barriers. In the Canadian companies above, not a single director on the compensation committees was forced to resign.
Second, be wary of 'peer benchmarking'
In this process, invented by pay consultants, a CEO's pay is compared with that of other CEOs, often at larger, more complex companies. Compensation committees, which purchase this comparative data, want to pay their own CEO not at the 50th percentile, but the 75th or 90th. Research confirms that this inflationary effect has resulted in structural increases to CEO pay. The process is worsened by rivalry, because CEOs see what other CEOs are earning and think they deserve more. This knowledge and mindset increases a CEO's leverage during negotiations.
One public sector organization that I recently advised has opted to disclose pay not by specific employees, but only by position title. This disclosure promotes good governance and accountability, but addresses peer rivalry, privacy and safety concerns. More regulators should exercise care over the inflationary results of disclosure. Compensation committees should focus less on comparisons and more on performance and value creation.
Link pay to sustained value creation over the longer term
This brings me to the final pay reform. Most performance metrics for executive pay are short term, financial and based on total shareholder return. Even the new SEC rules rely on TSR. Research shows, however, that much of this metric is outside management's control, reflective of exogenous market forces.
Most of a company's business model and market value is composed of broader, leading indicators that are non-financial in nature. By focusing only on financial results, boards lack the ability to track indicators that measure broader performance, such as customer and employee satisfaction, reputation, innovation, research and development, ethics, risk management, safety and so on. Many boards desire these metrics, but they are underdeveloped by management, which reflects board complacency.
Ninety per cent of pay is structured for the short term, under three years. This causes executives to swing for the fences for short-term gain because their pay motivates them to do so, rather than being aligned with the company's product cycle, which tends to be five to seven years.
International Monetary Fund chief Christine Lagarde has called for banks to change the culture of short-term risk taking, and the Institute of Corporate Directors is responding next month with a conference on short-termism. But opposition to such reform movements is so entrenched that these reforms are almost unachievable. CEO pay problems will continue.
To truly solve the problem, more leadership is needed from investors and directors. Models and best practices are needed to devise roles for shareholders in selecting directors and long-term pay principles. Thoughtful regulation and more industry leadership and co-operation are required.