Nonprofit Business Advisor, Strategies to Survive and Grow in Tough Times

Executive Compensation: Cherchez la Board

When corporations stumble, why do directors get a free pass?

By John Carver November 21, 2012
The economic turmoil of the past year has left Americans startled and offended, once again, by corporate executive compensation. Criticizing greedy executives is pervasive in news reports, political commentary, and even standup comedy. There is nothing new about revelations of egregious payouts to CEOs and others in top management. But this time the issue comes up while many companies are on the receiving end of taxpayer largesse. Even President Obama has stated his disapproval of CEOs’ behavior in strong language—using words like “shameful” and “the height of irresponsibility.” In this article, John Carver demonstrates that established governance practices are at the root of the problem.

I WOULD NOT WISH to argue against high compensation for persons capable of successfully leading large and complex businesses. If salaries and bonuses are the result of free market forces and performance, it is folly to think that either legislators or economists will improve upon compensation thus established. But the history of compensation for CEOs is not one of a free market but of manipulation that recognizes a floor, but no ceiling. Executives will not be available below some market-determined amount, but no similar barrier sets an upper limit.

Corporations exist for their shareholders. It is popular and sounds benevolent to proclaim a commitment to “stakeholders,” but it would be hard to find an equity company actually created for the benefit of employees, neighbors, and vendors. In any event, the company’s obligations to nonowner stakeholders, while valid, are a matter of ethics rather than ownership. Corporate boards understand that a penny paid to an employee, vendor, or community charity is a penny that does not accrue to those who have invested their capital. That means a penny paid to a CEO is a penny removed from potential shareholder value. So, considered against the board’s primary obligation to shareholders, what justifies any compensation for a CEO? The justification, of course, is the probability of its causing a net increase in shareholder value—the same consideration of financial return that justifies all costs (other than the costs of fulfilling ethical obligations).

Therefore, any board action that exceeds the free market compensation of a CEO is board theft from the shareholders it exists to represent. Why would otherwise responsible directors allow that to happen? It is doubtless as a result of two overlapping influences.

First, reciprocal directorships: I’ll serve on your board if you’ll serve on mine. The resulting good-old-boyism has been able to countenance all but the most radical departure from the market. Happily, overlapping board membership appears to be on the wane as a result of counteractive forces like governance codes, greater transparency, and the expectation that directors put in more work and bear greater liability.

Second, CEO dominance: Many CEOs either obviously or subtly determine board membership, meeting fees, agendas, and meeting amenities. Further, CEOs frequently take on the chairmanship role, thereby making their implicit dominance explicit. This situation causes a bizarre inversion of authority that in some ways results in boards working for their employees! Inclusion on the board of “inside” (“executive”) directors who as executives work for the CEO exacerbates management’s influence. Extreme cases of outside (nonexecutive) directors’ being unaware of just what they are paying their CEO have recently come to light!

Is it any wonder that the setting of executive compensation has long been a far cry from boards’ going into the free market to obtain the best talent at the best price? These antimarket practices have been the case for decades. But the uninvitingly arcane nature of governance and the cloak of secrecy that shrouds boardrooms kept the defect under wraps. As a result, executive compensation over the years has risen bit by bit to its current stratospheric levels. The cumulative effect has predictably become the “new normal.” Whether artificially created or natural, however, the resulting market is still the market. If you were a director today, you might understand that this problem is a creation of your many predecessors, but what option do you have but to pay what is necessary to entice the skill your shareholders deserve? In a twist of cause and effect, all boards now can claim with some legitimacy to be victims rather than perpetrators.

No matter how much history has saddled corporate boards with an inflated market of their own making, however, it does not excuse today’s boards for continuing to contribute to the problem. At this point, the problem incites an unusual amount of public condemnation, for massive bonuses go out one portal while massive public support comes in another. CEOs rightly expect to benefit from their companies’ doing well, but why should they benefit from their companies’ failures? The public understandably focuses its wrath on the executives whose compensation seems not only astronomical but worse, undeserved.

And the elephant in the room wanders off unnoticed. It seems few people—other than those aware of Policy Governance—notice that in the public debate corporate boards are seldom mentioned. It is as if they are invisible or everyone has an enormous blind spot.

Any logical view of the board of directors is that it is the bridge between owners and operators, a link in the chain of command. But links in the chain of command are also necessarily links in the chain of accountability. Otherwise, authority has no moral underpinning. Accountability in its managerial use applies not only to the personal responsibility of an individual but also to the extended responsibility one with authority has for his or her total purview. Let me put that point in sharper relief:

It may be hyperbole to say that no one seems to recognize that simple fact. But those who do must be hiding, keeping very quiet, or being paid no attention, for if you look for either political voices or the fourth estate to come down hard on boards of directors, your search will not be quickly rewarded. It seems we look on boards as ornaments rather than accountable bodies. Worse, however, is that when things go off the rails, boards apparently look at themselves that way as well. After all, how many boards have come forward to claim their complete accountability for executives’ actions?

Perhaps we can dismiss officials and scribblers as simply ignorant. After all, they are rarely sophisticated about management. Moreover, although they may be brilliant about governance in its macro governmental use that addresses decision making in a nation state, they are certainly never sophisticated about governance in its board setting. But it is perverse to let boards themselves off the hook for knowing governance; failure to understand their own role is not carelessness but negligence. One might think such board abandonment of duty is due to a lack of moral courage in tough times, except that corporate boards treat their accountability loosely even when fortunes are going well. So the charitable conclusion is simply that corporate directors have a slipshod conception of their role despite the mechanical solutions offered by the Sarbanes-Oxley Act and dozens of governance codes around the world.

The world of corporate boards is not alone in this dereliction. Nonprofit and governmental boards commit the same error. How many school superintendents have lost their jobs for failing to keep their communities happy—as if their boards were not the intervening authority? How many times have the media blasted a social or medical service CEO for what his or her board caused or allowed? In our own city, we have watched this phenomenon occur with the transportation authority, school systems, poverty agency, and mental health facilities—and the parade goes on. And, just as with corporate governance, neither press, public, nor elected officials trace issues to inadequate board performance.

Much of that is old news. What gives it heightened value now in the private sector is that the U.S. federal government— not unlike other governments—is poised to pour massive amounts of borrowed money into organizations to stimulate the economy. That money will be entrusted to the stewardship of boards. In view of the current public uproar, it would not be surprising for legislative action to be taken to limit the executive salaries and bonuses for which those boards are accountable. To be sure, addressing compensation by law or regulation offers an angry public and Congress the satisfaction of a quick fix and may in these extreme times be the lesser of evils. But the unintended consequences of Congressional intrusion into corporate governance may well be worse than the disease.

Corporate boards can rightly be said to have brought a draconian solution upon themselves, but we all will suffer because of it. Corporate directors, had they been fulfilling their servant-leadership obligations all along, would clearly be the most informed parties to adjust compensation than a federal establishment not known for its managerial acumen. Wouldn’t it be refreshing if corporate boards would arouse in themselves the moral courage and intellectual leadership to address the lack of accountability that has been at the root of this disgrace for decades?

First Published in Board Leadership, June of 2009.