Paul Hodgson in Agenda: Why Outsiders Should Let Boards Fix Executive Pay

The following opinion piece, written by The Corporate Library Senior Research Associate Paul Hodgson, was published in Agenda today.

Opinion: Why Outsiders Should Let Boards Fix Executive Pay

As the corporate governance world attempts to resolve the crisis in confidence in executive compensation, it might help to turn to a page from the past. Circle back to the U.K. in 1991, when a financial accounting scandal, focused on the now defunct Maxwell Communications, rocked the economy and led to the formation of the Cadbury Committee on Corporate Governance. The committee’s assignment was to restore accounting confidence, but as with the Greenbury Committee in 1995, its attention soon became hijacked by executive compensation and the need for solutions to excessive practices.

What came of the best practice principles the committees advocated? Well, to start with: One-year employment contracts, performance-related stock options, shareholder approval of equity pay plans, pensionable pay that excluded all bonuses, and deferred vesting of stock options.

Sounds like a wish list put together by an activist investor. So, who actually recommended these “best practices” to British industry?

The Cadbury Committee was set up by the London Stock Exchange, The Financial Reporting Council and the auditing profession. Further, the Greenbury Committee was staffed by the chairmen of major British corporations. There were more knights on it than at King Arthur’s Round Table.

The point I’m trying to make with this history lesson is that when corporations develop best practices themselves, they are far more likely to adopt them than they are to adopt any amount of recommendations from outside bodies. This is the case whether policies are advocated by the Business Roundtable or the AFL-CIO, Congress or the Treasury Department, or even, sadly, The Corporate Library.

With this in mind, it is cause for cautious optimism that several organizations that represent the employer side have gotten together to try and work out some best practice principles from inside corporations rather than imposing them from the outside. These include The Conference Board and the Independent Directors Executive Compensation Project (IDEC), which both released sets of compensation best practice principles earlier this fall. The two sets of principles are reassuringly similar. The news that the Center on Executive Compensation (CEC) is also working on a code of best practice is also heartening, despite its continued opposition to say on pay. Now we have management (The Conference Board), independent directors (IDEC) and senior HR professionals (CEC) all working on the same initiative.

Consider that an impetus behind the formation of IDEC was that there are no “Generally Accepted Compensation Principles” for the compensation consultancy profession. However, like auditors in the 1960s when the Generally Accepted Accounting Principles (GAAP) first began to be devised in the U.S., there was a feeling among many consultants that it was time there should be. And while we would never want, or could never get, a full GAAP for compensation, the fact that these groups, and others, are likely to try and formulate a common set of principles is good news.

Much of what has been devised so far has been devised before, with obvious references to the U.K.’s Combined Code and other European governance codes. However, it is not the originality of the principles that is important, it is the origin of the effort.

The cynic might be forgiven for asking, since we’ve been waiting so long for the problem to correct itself with little or no progress, why is now so different?

I believe it is because possibly directors and companies have already signed on to the principles put forth by IDEC and The Conference Board. Possibly because, if say on pay becomes law, it might be apposite for compensation committees to outline in their compensation discussion and analysis (CD&A) how they have implemented the principles. That way shareholders can examine the discussion and analysis and determine whether the route taken is one they agree with, and then cast their vote. Incidentally, this is also, perhaps, a process by which compensation committees can begin to wrest control of the CD&A away from the lawyers and back into the hands of the people actually making the decisions.

There are a number of provisions to be remembered during this process. First this is a principles-based approach. While the SEC’s principles-based approach might have caused nightmares for the authors of CD&As, in this case a principles-based approach gives freedom, while a policy-based approach would cause constraints. For example, although the compensation committee could explain its “compliance” with best practices in the CD&A, its implementation of those principles will not. Indeed, it should not take the same route as other companies and other industries.

Secondly, it must be remembered that once the principles are set out, they are not set in stone. Just as accounting standards have evolved and continue to evolve to take account of new initiatives, so must compensation principles. The code should be revisited regularly. Standard principles must not be mistaken for stand-still principles.

Finally, there is another reason why now might also be different. Government is currently wielding a pretty big stick, and if corporations want to stay out of its reach they might just make the decision that it would be better to exercise a little self-discipline. This could be much more favorable than some corporal punishment administered by Congress.