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Compensation Plans for Directors on Public Corporate Boards are Outmoded, Out Of Touch and Ought To Be Reformed

May 27th, 2013 · 4 Comments · Building Better Business Managers, Business Management, Improving Your Business Leadership

In the public corporate world, nothing is more conflicting and confusing than the purpose and worth of a board of directors

State and federal laws require that every corporation must have a board of directors with its legal responsibilities delineated in bylaws, but there is little agreement anywhere about the proper role and appropriate compensation for the board of directors.

Corporate-BoardsIn simplest of terms, the corporate board of directors is elected by the owners (shareholders) of a company to represent their interests. In turn, the board is legally responsible for hiring the executives who manage the company, reviewing and approving the strategy and plans of management and then supervising adherence to the strategy and the implementation of the approved plans. All of this activity is dedicated to the proposition that the interests of shareholders are paramount.

This is all straightforward and seems simple and easy, except in the real world – especially with publicly traded companies – it falls apart. There is constant deliberation, confusion and frustration as to how a board of directors should function and perform its duties. And there is an even more rancor and never-ending debate on how much and in what form directors should be compensated.

It’s Time for a Change 

All of this confusion and conflict arises because the traditional concept of a board of directors has become outmoded. It is no longer sufficient or appropriate for the board of directors of a public company to exclusively represent the interests of shareholders, which is universally translated into focus and preoccupation on the current stock price.

But this singular objective raises questions: Which shareholder’s interest should come first? Should it be long-term shareholders or those shareholders seeking short-term gain? Should the interests of banks and other institutional investors who often own millions of a corporation’s shares take preference over an individual who owns a few hundred shares in an IRA? Even more to the point, is the value of a corporation only to be measured by the stock price at the end of each quarter?


The point is, or should be, that there is more to the ultimate value of a company than can be measured simply by the current stock price; and to do so may be detrimental to the long-term vitality and value of the company. And because this is true,  the “charter” of a modern public corporate board of directors should be changed from singularly representing the “shareholders,” to a duty to represent all “stake-holders” of the company.

This refashioned board would not only be responsive to the best interests of shareholders, but also the best interests of management, employees, vendors, customers and even the communities in which the company does business. This revitalized board of directors should function to assure that the interests of all stakeholders are in parallel. The reason for this is simple: It is in the ultimate best interests of all shareholders when the interests of all stakeholders are aligned in parallel, because the potential for long-term success and survival of a company is significantly enhanced.

The idea that the board of a public company should represent broader interests than those of just the shareholder is not as farfetched as one might believe. The Wall Street Journal reported (May 23, 2013) that as a condition to approving Japan’s SoftBank Corp’s acquisition of Sprint Nextel Corp. the Justice Department and Homeland Security will have the right to approve a director of the Sprint board who will be responsible for “overseeing national security issues.” With that in mind, why shouldn’t the board also be charged with looking out for the best interests of employees, customers and the communities in which the company operates?

The (Pay) Envelope, Please . . .

The often heard cry is that director compensation should be tied directly to benefits received by the shareholder; and the way to do this is for directors to have “skin in the game.” This past week (May 21, 2013) another WSJ article reported that “Funds Get Active Over Director Pay.” The article pointed to an increasing number of large mutual fund groups calling for director compensation to be tied directly – if not exclusively – to the performance of a company’s stock.

There is no surprise here. When CEO of LifeUSA, I vividly remember meeting with a mutual fund manager at Fidelity, the multinational financial services company. He already held a big position in LifeUSA shares, so I asked him why he had purchased the stock. His response was likened to that of a stock day trader: “I don’t even know what your company does, but the numbers looked good, so I purchased the stock.” I later noted that when the stock reached a certain level, he dumped his position. So the question is: Why should compensation of corporate directors be based on the singular focus of guys like him, institutional investors whose interest in owning the corporation’s stock is measured by quarters of profit rather than decades of broad corporate performance?

The answer is, it shouldn’t. Interests that are tied to only one segment of many stakeholders can and will be detrimental to  Compensationthe interests of others. The most important responsibility for a director should be attentivenes to the overall long-term value and performance of the entire company, for all stakeholders. There is no argument that stock price is an important indicator of corporate value, but it is rarely the only indicator. There may be times when stock price needs to take a back seat to long-term growth and value. A director of a company should not be in a position to anti-select against the best long-term interests of a company in order to enhance his personal compensation.

There is also the inherent problem and fallacy of attempting to tie compensation to a benchmark that can’t be controlled by the individual being compensated, i.e. current stock price.  The truth is that actions taken to directly influence a current stock price are either very short-term in nature or illegal.

When a director’s compensation is heavily weighted only in the direction of stock performance, thinking can be narrowed to only those actions – good or bad – that impact short-term stock performance. That could – and has – resulted in directors taking actions that may increase their own compensation, but be damaging to customers, employees and ultimately, the long-term well-being of the company.

Changes That Should be a Comin’

It may be as irrepressibly optimistic as a Pollyanna to believe it will ever happen, but the best long-term interests of all stakeholders in a company will result only when director’s compensation is tied to multiple factors. Director compensationStakeholders should follow the pattern set by many compensation plans for senior executives. For example, it is not unusual for the total compensation of senior executives to be calculated based on a number of corporate performance benchmarks; with stock price playing a minor, if any role at all.

For example, a senior executive is compensated with a base salary and a bonus based on benchmarks such as increase in revenue, control of expenses, growth in profits, increase in shareholder equity and return on investment. Underpinning these benchmarks, of course, are related corporate functions, including labor relations, corporate responsibility, product development and customer satisfaction, and so on.  It is assumed that if management is successful moving these benchmarks in a favorable direction, then the stock price will naturally follow.

For the long-term benefit of all stakeholders and the company, director compensation should be determined by the same type of formula approach. However, in order to implement such a compensation philosophy for directors, the corporate world must disabuse itself of a number of myths and outdated rules. These include: all directors should receive the same base compensation, director pay should be tied to “peer-group” comparisons and directors will make better decisions if their compensation is based on stock performance.

Director Selection Revisited

Instead, directors should receive base compensation predicated on the experience and value they bring to the board. Other than the ego of existing directors, there is no reason why a company should have to raise the compensation of all directors to attract a new director who can add unique value, experience and perspective. Then, additional director compensation should be based on a set of benchmarks that are critical to the overall value, development and long-term growth of the company.

For example, a pool of compensation could be developed for the board members based on results such as increase in profits, growth in revenues, reduced expense ratios, employee turnover, increased market share and stock performance. These critical measurements may not be the same for all companies – nor should they be – but the idea would be to establish a compensation plan for board members that focuses their interest, attention and actions on the key performance measures that benefit all stakeholders in the company and not just those who may happen to be stockholders at the time.

This may be nothing but a pipe-dream, but should a company take this approach with its board of directors it will benefit from having directors who care about to overall growth and value of a company, not just one group. And in the long run, that will be better.

And the Moral of the Story …

For the most part, boards of directors for public corporations are mired in an outmoded paradigm of the past. There may have been a time when the sole purpose for the existence of these companies was to enrich powerful shareholders, at the expense of all else. In this environment it was reasonable to base director compensation exclusively in relation to the performance of the stock price. Unfortunately, while this approach did enrich some, it also lead to abuse – both to other stakeholders in the company and the long-term growth of the company. There is a litany of inappropriate and often illegal actions taken by boards that were focused only on one element of a company’s value.

There should be a more enlightened and broader approach to the function and responsibility of a board of directors and how the directors should be compensated. Directors should be rewarded for their ability to represent the interests of all stakeholders, not just shareholders. Directors should be rewarded for their ability to monitor and encourage actions that will lead to the long-term development, success and viability of the organization. The good news is that ultimately this approach will be in the best interests of all shareholders.

 

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