A New Era in Corporate Governance

Directors and investors are demanding reform. Companies had better prepare for it.

Boards can probably best start by using basic evaluation tools that provide developmental and constructive rather than punitive feedback. Intel, for example, is said to require that all directors complete a structured questionnaire and discuss it with the (nonexecutive) chairman to identify how they can improve. This fairly unobtrusive approach has apparently raised the performance of individuals and of the board as a whole significantly.

Whatever evaluation tools may be adopted, directors must understand that over time their workload will increase, especially in view of the added work of complying with Sarbanes-Oxley and with the new NYSE and Nasdaq listing rules. These developments make it essential to have a clearer sense of the effectiveness of the board and its directors and to implement a process for improving both.

Money, Money, Money

Finally, there is the issue of executive compensation, which both the directors and the investors participating in our surveys regarded as an important element in the recent spate of corporate scandals. And with good reason: the transfer of wealth from owners to top management over the past decade has been astounding. In 1992, the top five executives at the 1,700 largest US companies cashed in options worth $2.4 billion; by 2000, that number had soared to $18 billion. (Joseph Blasi, Douglas Kruse, and Aaron Bernstein, In the Company of Owners: The Truth about Stock Options, New York: Basic Books, 2003.) In 2000, moreover, the annual income of US CEOs peaked at a multiple of 531 times the average production worker’s wage; in short, the combination of cash, bonuses, stock grants, benefits, and options has decoupled compensation from performance.

Investors and directors, upset with absolute levels of pay and with forms of compensation that have created risky management incentives, want concrete changes. In a few extreme cases, regulators and investors may ask CEOs to return some of the exorbitant sums they have been paid, as Richard Grasso (formerly of the NYSE) recently discovered. Institutional investors such as Vanguard have recently made it a policy to vote their proxies against directors who serve on compensation committees that continue to give CEOs excessive compensation. Influential investment advisers, such as Institutional Shareholder Services (ISS), have started advising clients to vote against members of compensation committees or against compensation plans that exceed certain competitive benchmarks or don’t have close enough ties to performance. Of course, a rising stock market in 2003 may have kept some of these tensions at bay. It’s one thing for management to claim a large chunk of the profits when the economy booms, but as returns settle down to historical averages—and some stock market forecasters predict returns below them—investors won’t remain idle if an executive team’s share of the pie gets larger.

As a result of these pressures, the day is drawing nearer when executive pay will be scaled back. Simpler, more transparent compensation will be more tightly linked not just to the stock price of a company but also to its overall health—as measured, for example, by market share, product quality, and customer satisfaction. Boards will have the unenviable task of balancing management’s inflated expectations with what investors think is fair.


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