The public is outraged these days over CEO compensation, with good reason. Far too many chief executive officers get paid large sums even when they don't perform. I believe that CEOs should be well-paid when they do perform, but there is no justification for paying for nonperformance.
As a result, shareholders are demanding the right to approve CEO pay packages. Following the tradition of British companies, "say on pay" proposals on proxy statements are gaining momentum in the U.S. But under U.S. corporate law, determining the compensation of CEOs is a fundamental responsibility of the board of directors. Directors are charged with the fiduciary duty to use their "business judgment" in these matters, and the courts have consistently backed them up.
However, by not paying CEOs based on company performance boards are failing to execute their responsibilities. Unless they step up to this issue they risk ceding their responsibilities if unhappy shareholders push through say on pay resolutions.
Home Depot, Hewlett-Packard Handouts
If this were to happen, who would determine these complex compensation packages? The courts? The Securities & Exchange Commission? External governance gurus, who have no responsibility for the corporation's performance? None of these alternatives makes sense. In fact, they threaten the very foundation of our system of governance.
I must emphasize that the real problem here is not that CEOs are paid too much money. You don't hear criticism of the compensation of top performers like A.G. Lafley of Procter & Gamble (PG) and Bob Ulrich of Target (TGT). The real problem is paying enormous sums to CEOs who fail to perform. Our system of capitalism is based on taking risks and being rewarded for success, not on guaranteeing huge payouts to CEOs who destroy shareholder value.
How can anyone justify Home Depot's (HD) former CEO Bob Nardelli receiving a $200 million termination settlement after declines in market share and shareholder value? Or the former CEOs of Morgan Stanley (MS) and Hewlett-Packard (HPQ) losing their jobs and walking away with tens of millions? Shareholders ought to be outraged by these inequities.
Taking a Toll on Employee Motivation
It is ironic that by guaranteeing CEO compensation, boards put their CEOs at minimal risk while putting employees at far greater risk. When CEOs in these firms fail, it is the employees who lose their jobs and their income, while CEOs pocket their guaranteed pay.
Is it surprising that outsized CEO pay packages destroy employees' trust? With loss of trust, employee motivation gives way to to cynicism and superior performance becomes mediocre.
The underlying cause of this problem is the failure of boards to develop their future CEOs internally. The board's most important job is to ensure long-term succession plans for the top leadership. But many boards don't take the time and expend the effort to develop seamless internal succession, and consequently they are forced to search outside the company, often yielding to investor pressures to hire a corporate savior.
No CEO Contracts at General Electric
In turn, these high-profile CEOs from outside the company who know little about the business, the company's culture, or its people, hire high-powered attorneys to negotiate multiyear contracts that guarantee their compensation, regardless of performance.
Why do CEOs need contracts in the first place? The CEOs of General Electric (GE), Goldman Sachs (GS), and Exxon (XOM) don't have them. They get paid to perform.
Executive compensation should be tied directly to the company's long-term objectives and based on building the firm's economic value, not its stock price. The best compensation programs tie up half of the executives' compensation for the duration of their tenure, so they cannot cash out when the company's stock peaks. These programs are based on a mix of short-term and long-term incentives so that no one objective can be pursued to the detriment of the firm's interests.
To ensure the CEOs' separation from the compensation process, boards should hire their own compensation consultants who do no work for management.
Finally, CEO compensation should not be based solely on a comparator group, which can be easily manipulated. Rather, internal equity should be given equal weighting so that gaps between CEOs and their subordinates are narrowed, and it is the team that is rewarded for the company's success.
To rebuild the confidence of shareholders and the public and to retain control over CEO compensation, boards of directors should put their CEOs wholly at risk, with no contracts, and pay them only for long-term performance.
That's the only way to restore trust in corporate leaders and in our system of corporate governance.