Richard Leblanc: Ten reasons that pay governance is broken

Executive pay is always in the news. Just last week an executive of Yahoo walked away with what was said to be a 100M parachute. I was interviewed by CBC radio on upcoming sunshine laws that are going to be enacted in Alberta. Last month, Ontario Power Generation fired three executives after an auditor general’s report on excessive compensation. The Premier of Ontario has vowed to crack down on excessive public sector executive compensation.

Do politicians have a track record of properly addressing compensation? I don’t believe so. Here are ten reasons that the governance of executive pay is broken, starting with politicians.

Politicians. Politicians have been the single greatest driver of increasing executive pay. Transparency or “sunshine” laws that politicians enact enable executives to utilize the pay of other executives to exert upwards pressure and threaten to leave, which is difficult to counteract. Transparency is good, but transparency without any guidance towards pay setting results in pay spiraling upwards. There is not a single jurisdiction that introduced pay transparency where pay has gone down. There was a time where executive pay was written within an envelope in a top desk drawer, and the focus in pay negotiations was on what the executive can do for the company, not what everyone else was earning.

Pay consultants. Pay consultants use this pay data and sell it back to the company in the form of “peer benchmarking,” which consultants have cleverly invented, which is now the predominant way to set pay. This means executive pay is driven by cherry-picked larger companies at the 75th or 90th percentile, resulting in a baked-in pay increase to the executive irrespective of performance.

Lack of professional standards. Lawyers and accountants can lose their license if they breach their fiduciary duty to their clients. They (we) have professional standards and rule-books addressing the duty of care, conflicts of interest, fee arrangements, continuing education, and just about everything you can think of to ensure the client is well served. Compensation consultants have no such obligations. Anyone can put out a shingle and call him or herself a pay consultant, and they do. You can sit on a compensation committee without any compensation expertise whatsoever. The requirement to be a director is shockingly low. In many cases, you need only to be over 18, not bankrupt and not insane. Maybe it is time to raise the bar for compensation consultants and compensation committee members. When advisors have standards, and pay-settors have expertise, they will make better decision.

Unnecessary complexity. Ask any director how much did his or her CEO “earn” last year, and see if you get a consistent answer. You likely won’t. It’s a simple question that deserves a simple answer. Pay depends on whom you ask and can’t even be defined. Is it “intended,” “realized” or “realizable”? We now have multiple “vehicles” for getting all types of pay to executives, with multiple valuations and performance periods. It becomes impossible to understand, value, and compare pay to performance. Therefore, mistakes and self-interest are possible. Pay needs to be radically simplified. Complexity deliberately frustrates and obfuscates basic analysis.

Captured pay-settors. Even if a compensation committee has formally independent directors, this does not reflect social relationships, the use of company resources by the directors, interlocks, excessive tenure, over-boardedness, reciprocity, favors, exorbitant pay to directors, vacations, gifts, donations, jobs for directors’ children, and a host of other factors that my research and work with boards uncovers. The compensation committee is then an arm of management.

Short termism. Most pay metrics are short term and financial. This means the executive is being unduly enriched and is trading on the effects of his actions that materialize years down the road, or not. Pay metrics should be matched to the actual effects of performance over time, and the value chain of the company. It is impossible to align pay to performance with only short-term financial metrics. Long term, non-financial metrics must be used, and pay-settors should have the spine and competency to insist on it. (Or regulators eventually will.)

Heads I win, tails you lose, or no downside for risky behaviour. Pay needs to incorporate risk-taking. We know that risk management in many companies is immature, so how can the downside of a decision possibly be incorporated into pay? If it is not, there is no or limited downside for executives to swing for the fences. Pay metrics and awards should account explicitly for risk. Most do not. This is not an insignificant point, as risk-taking compensation fueled the financial crisis. Regulators are addressing compensation and risk, but not fast enough.

Undue influence of Management. One highly paid CEO said to me once, “I will outgun any compensation committee.” If pay is truly a free market decision between owners and executives, the power, expertise and participation of shareholders must equal that of executives. Pay committees will need surgery for this to occur, starting with shareholders determining who is on their pay committee. That way, pay committees are the agents of their owners, not management.

Directors not listening to Shareholders. Directors assume that they know what shareholders want but this is folly. Surveys reveal a wide divide between shareholders and directors on executive pay. Directors need to meet directly with shareholders without executives present. Most don’t.

Lack of oversight and accountability. In the public sector in Ontario, there have been several governance scandals, including Ontario Power Generation, eHealth, Ontario Lottery and Gaming Corporation, and Ornge, that have included compensation and spending. What this reveals is defective oversight. Governance is not government. Ministers oversee 100s of agencies, boards and commissions operating in major sectors of the economy. Without independently assured oversight, and directors chosen exclusively on merit and not pre-existing relationships, often to the Minister or party in power, these scandals will continue. Premier Kathleen Wynne would be well served to address this lack of accountability and good governance. Saskatchewan has an excellent upward reporting model involving corporate secretaries and use of governance tools I helped create that apply to all crown companies.

One of my colleagues recently said to me, on the outlook of corporate governance in 2014: “Seems like a stand pat year with lots of tinkering but nothing profound happening.” With pay governance to improve, we might need some profoundness and not as much tinkering.

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