Compensation consultants, entrenched management and beholden boards have failed to link executive pay to corporate performance. Perhaps the only way to make the reward system work is through the back door — make boards more responsive to shareholders.

One of the hallmarks of a free-market meritocracy is that key players can earn what they are worth. As long as they are delivering for shareholders, no one is likely to make much fuss. But it often seems executive pay is less a function of rewarding performance and more about following the herd.

Many companies spell out the paradox in their proxy circulars — executive compensation is designed to attract top-notch talent by offering top-quartile or at least above-average remuneration. Of course, not everyone can be above-average. The result is that pay scales are ratcheted inexorably upward, with each package that aims to beat the average pushing the average a little higher — without requiring executives to give performances that merit these rewards.

And, of course, executives rarely suffer when their firms perform poorly. If a company has an off year or makes a major strategic blunder, executive pay hardly suffers.

But there are signs investors are increasingly fed up with the trajectory of executive compensation. This year, the Big Five banks faced shareholder proposals from long-time activist Yves Michaud calling for limits to executive compensation. In a statement supporting his proposal, Michaud calls the current levels of senior executive compensation “indecent” and “outrageous to shareholders who are powerlessly witnessing a veritable scramble for enrichment without cause.”

He also calls compensation experts “a con,” arguing that they and board compensation committees are interested in serving management’s interests, not those of shareholders.
Whether their votes represented merely dozens or thousands of shareholders, the idea of limiting executive pay proved popular with investors. According to data compiled by the Shareholder Association for Research and Education, the proposal received more than 9% support from shareholders at both Bank of Nova Scotia and Royal Bank of Canada.

While 9% support may not herald an imminent shareholder revolt, it proved to be the most popular proposal on both banks’ proxies. This suggests a significant number of shareholders are sufficiently outraged by the level of executive pay that they would support an anti-capitalist measure such as an arbitrary cap on compensation. They are clearly not buying the banks’ arguments that they must pay up for management talent, and that remuneration is closely aligned with performance.

And they are not alone. According to a fall 2004 survey conducted by McKinsey & Co.
and HRI Corp. for the Canadian Coalition for Good Governance, 65% of investors and 40% of corporate directors say CEO compensation is too high.

The critical issue appears to be an insufficiently strong link between pay and performance. One theory suggests this condition prevails because executive pay packages are typically not the result of arm’s length bargaining between the company and the executive. Lucian Bebchuk, professor of law, economics and finance at Harvard Law School, and Jesse Fried, acting professor of law, University of California at Berkeley, argue that managers wield significant influence over the setting of their own pay, and end up with excessive pay packages that are not tied to performance and, indeed, may create some incentives of their own.

More disclosure

The solution, Bebchuk and Fried argue, is for institutional investors to press for more and better disclosure, and for them to encourage firms to tie executive pay more closely to corporate performance. But that may be easier said than done.

The CCGG has published a working paper setting out its recommendations for improving executive compensation, including: enhancing disclosure (see story on page 10); pushing for independent compensation committees; ensuring these committees develop an independent view of compensation without management interference; establishing share-ownership guidelines; and, establishing and testing links between pay and performance.

Of the CCGG’s recommendations, linking pay and performance is probably the most
difficult to achieve. As the working paper notes, it requires filtering out market effects, picking the right performance measures, ensuring the pay package rewards exceptional performance (not just average or mediocre performance), forward-testing the structure to see how it should perform, then back-testing it to see how it actually did perform.

And even when a compensation committee comes up with a credible performance-based pay package, its size and structure can have other consequences. For one, it may motivate executives to game the system. A big reward tied to a profitability hurdle, for example, creates a powerful incentive for executives to exploit the flexibility of accounting rules to ensure the hurdle is reached, even at the expense of future earnings or long-term corporate health.

@page_break@There are also the effects on the other employees. According to one theory, firms that have a big difference between pay at the very top and the salaries of the rest of the staff enjoy better performance because managers are competing for the top job. A firm may not openly admit to inflating its CEO’s pay just to fuel competition, but compensation committees may have to consider this point in designing pay packages.

The CCGG recommends executive contracts include provisions requiring the return of performance-related compensation if the firm has to restate its earnings.

Others suggest chief financial officers should not have their compensation tied to corporate performance to lessen their incentive to cheat, and that CFOs should report to boards rather than to their CEOs.

Most routes to more effective executive compensation seem to require better boards of directors. If, as Bebchuk and Fried argue, one of the underlying problems with executive compensation is management’s influence over the board that sets its pay, the obvious solution is to lessen that grip. That means more shareholder democracy.

Shareholder activists have proposed a number of ways to enhance shareholder democracy and give minority shareholders more influence. These include allowing shareholders to vote for individual directors rather than slates of directors, allowing voting against directors, employing cumulative voting and adopting majority rather than plurality voting.

These ideas have met mixed reviews. The banks all received shareholder proposals to adopt cumulative voting this year. According to the SHARE report, National Bank of Canada’s shareholders gave the idea the most support, 7.1%. At other banks, only 2% of shareholders supported proposals requiring directors to have 75% of the vote in order to get elected.

A move to majority voting seems to be emerging as the reform of choice. The CCGG has come out in favour of majority voting (see Insight, page 50) and so has the Washington,
D.C.-based Council of Institutional Investors.

If the push for greater shareholder influence over boards continues and boards become more independent, executives may find their pay curtailed or at least more effectively related to performance. IE