A New Era in Corporate Governance

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

In the past, the board’s compensation committee would typically benchmark executive pay against a broad industry average and then, as a show of support and goodwill, peg total compensation to the top quartile. With every company trying to pay its executives above-average salaries, the average inevitably spiraled upward. The solution is for a board to index its CEO’s compensation to the average of a more narrowly drawn peer group. Higher compensation would then be awarded only for beating it, over two or three years, in total returns to shareholders. Few CEOs will do so consistently.

While CEO compensation will probably never get back to the levels of 1982, when it was a mere 42 times the average worker’s pay, it is equally clear that shareholders will resist compensation levels anywhere near those seen in 2000. (Executive Excess 2003: CEOs Win, Workers and Taxpayers Lose, Boston: Institute for Policy Studies and United for a Fair Economy, 2003.) Boards will have to understand what groups such as ISS and investors such as Vanguard think about compensation and then balance their views against the realities of the marketplace for managerial talent. If boards scale back compensation too fast they risk losing their best managers, but if they don’t go fast enough they could remain targets for reform. In any case, shareholders expect a significant—not an incremental—recalibration of executive pay.

In addition, the structure of compensation packages must change. Cash should become a much larger proportion of the total, and special elements, such as forgivable loans and termination bonuses, ought to be scaled back or eliminated. Many companies have already replaced stock options with cash bonuses or with restricted equity, both of which can improve transparency and better align incentives with performance. To prevent the kind of “pump and dump” timing of equity sales that was common in the recent past, some restrictions now being placed on equity awards actually stretch well past an executive’s retirement. Restricted equity also gives management more of an incentive to leave companies in the strongest long-term competitive position.

An Uncertain Path

Boards and management teams will find it hard to avoid addressing these three issues: separating the roles of CEO and chairman, increasing the independence and accountability of boards, and controlling executive pay. Investor outrage at corporate scandals drove the passage of Sarbanes-Oxley and the changes at the NYSE and Nasdaq. During the most recent annual director election cycle, investors kept up the pressure by submitting an unprecedented number of shareholder proposals. Investors have also forced companies to drop two antitakeover provisions they have long resisted eliminating: poison pills and staggered boards. (In 2003, investors passed 34 of 46 shareholder proposals to abolish staggered boards, and leading companies, such as Bristol-Myers Squibb, Coca-Cola, and Hasbro, adopted annual director elections.) The investors’ success in pushing through these reforms will only fuel enthusiasm for more change.

This new assertiveness will undoubtedly meet with headlong resistance from directors and management teams, especially CEOs. But unless the prevailing mood changes, the investors—with help from regulators and the courts—will likely prevail. Boards should thus prepare for reform. Those that don’t will run the risk of being singled out, unfairly or not, by the media or overzealous prosecutors looking to make them the latest examples of corporate malfeasance.


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