Let boards do their job

Posted by Marc Hodak on March 12, 2007 under Executive compensation | Read the First Comment

For many governance critics, the level and growth of CEO pay suggests something is broken with the way boards oversee their companies. The idea that there is a problem, of course, attracts the idea that we need a political solution. Thus, a bill to allow shareholders a direct vote on executive compensation has been introduced by Barney Frank (D-MA). The proposal sounds sensible. The shareholders, after all, own the firm. In a perfect world, shareholders should decide exactly how their companies are run, including compensation policies.

In the real world, shareholder involvement in corporate operations, including human resource decisions, is simply infeasible. That’s why we have boards. Boards can study the issues in depth, consult with relevant experts, and bring their often-considerable operational experience and judgment to bear on key decisions affecting the value of the firm. Increased shareholder involvement would do little to address the underlying drivers of executive compensation. It would, however, create new agency costs of unpredictable magnitude regarding board oversight.

As I see it, the theory behind increasing investor input on CEO pay is based on two flawed assumptions: (1) investors are able to assess the quality of compensation plans at least as well as directors; (2) that even if they aren’t as competent, investor input is needed to overcome a corrupt relationship that exists between directors and the executives they supposedly oversee.

The first assumption falls under the general heading: “How hard could it be?” It’s hard. Even conscientious, diligent insiders must make tough trade-offs based on necessarily incomplete information. Compensation decisions must account for competitiveness, alignment, and cost, including the increasingly complex tax issues. Based on my extensive experience with both directors and institutional investors, no outsider, including large investors not on the board, should have any more say on setting pay for managers than they do on setting prices for products.

The second assumption–that boards can’t be trusted to watch over managers–is debatable, to say the least. In my experience, most directors, though not all, are quite conscientious. These days especially, directors are vigorously exercising their independence; if anything, most are wary about overpaying their CEO. Can directors distinguish compensation plans based on their shareholder-friendliness? Not well, as I have noted in my own research. Unfortunately, boards tend to adopt widely accepted practices rather than designs suggested by the most up-to-date financial and behavioral research. But this deficiency has little to do with venal motives. It has far more to do with the inherent conservatism of directors, a conservatism that, if anything, is strongly reinforced by the over-the-top scrutiny of executive compensation.

What is the likely consequence of introducing shareholder votes on executive compensation? The primary effect would be to further politicize corporate decision-making. Instead of the board relying on experts and their own judgment, they will have to account for various external factions with an opinion about executive pay. Some of those factions are, themselves, deeply conflicted with regards to their role in maximizing shareholder value. Union-run pension funds, especially, don’t assume that a market for labor needs to be heeded at any level of the organization, including that of the CEO. Based on the history of regulation, no one can anticipate all the consequences that such a proposal may create. However, the experience in the U.K., where a rule like this has been in place since 2002, clearly indicates that one thing this proposed rule would not do is slow the growth of CEO pay.