Published on November 30, 2009

At the end of next month, many investors will look back at a “lost decade” marked by multiple financial crises, poor overall stock market performance, and periodic revelations of serious incompetence reaching the highest levels of corporate America.  Investors can be forgiven for being cynical about prospects for reforming executive compensation but should also be aware that their own complacency has contributed significantly to the problem.

Take Proxy Statements Seriously

A relatively small number of individual investors bother to read annual and quarterly reports before committing funds.  Typically, investment advisors or publications such as Value Line or Morningstar are used as time saving “shortcuts”.  Even fewer investors read annual proxy statements which provide details regarding executive and director compensation practices.  While institutional investors such as mutual funds are more likely to pay attention to proxy statements, the ultimate owners of the funds are usually oblivious to what their managers are being paid.

The term “their managers” is emphasized for a reason:  Executives work for the shareholders and all too often, shareholders seem to forget this important fact.  The goal should be to provide compensation sufficient to attract talented managers and to align their incentives with long term shareholder interests.  Few executives should expect to join the ranks of the super-rich merely by managing an already established enterprise and without risking their own capital along with shareholders.

Compensation Structure Matters

The question of executive compensation levels has attracted a great deal of attention recently, but an equally important question pertains to the structure of the compensation.  Some observers, such as Henry Mintzberg writing in today’s Wall Street Journal, advocate eliminating bonus compensation entirely while others suggest a greater reliance on stock based compensation.

Mr. Mintzberg makes some valid points regarding the difficulty of measuring performance metrics and determining whether the CEO is actually responsible for the results or has simply inherited a business with momentum.  In addition, it can take a long period of time to determine whether a CEO has actually added value.

Typically, executives are paid a base salary along with yearly performance based cash bonuses and longer term stock option awards.  The question is what mix of compensation more closely aligns executives with the owners of the capital they are charged with managing.

True Stock Ownership vs. Option Grants

Earlier in the decade, there were heated debates over whether stock options actually represent a cost to the business that should be recognized in financial statements.  This debate eventually led the Financial Accounting Standards Board to implement policies related to stock option expensing.  However, the more important question is whether options actually align management interests with shareholder interests.

A stock option simply gives a manager the right to purchase stock at a pre-determined strike price over a set period of time (usually ten years).  In most cases, the strike price is not adjusted for retention or distribution of earnings which gives management an incentive to retain free cash flow rather than to pay it out as dividends.  Simply retaining free cash flow will make a company more valuable over time and result in the options building value regardless of whether investment opportunities exist for the retained cash at acceptable rates of return.

In addition, stock options only provide upside potential for managers and do not carry any downside risk.  If a manager makes decisions that harm shareholder interests resulting in a stock price decline, he or she will simply not exercise the option.

For these reasons, stock options are a poor substitute for true stock ownership and generally fail to provide incentives that align management with shareholders.  In addition, the “upside only” aspect of options may increase the risk profile of a business since managers can take “moon shots” in the hopes of making options more valuable, yet without bearing any downside risk.

Require Stock Ownership

Shareholders should require the CEO to purchase shares in the company directly on the open market.  Only by directly allocating capital on the same terms as ordinary shareholders can a CEO claim to be walking in their shoes.  It would be easy for boards to require CEO ownership at a certain multiple of yearly earnings or net worth.  For example, a CEO might be required to accumulate shares equal to two years of after-tax cash compensation within the first five years of employment in the CEO position. The shares would have to be retained until retirement.

In addition to aligning CEO incentives with shareholder interests, the timing of CEO purchases would be revealing.  A CEO who is truly bullish on company prospects and believes that the shares are undervalued would be likely to accumulate the required position early in his or her tenure while those with less confidence might be prone to procrastinate.

Stock ownership should continue to be a component of CEO compensation beyond the initial accumulation period.  Over time, a CEO would have a substantial percentage of net worth invested in the company.

No heavy handed government regulations or laws are required to implement this type of reform.  Shareholders must simply understand who the ultimate “boss” is and demand that their top managers are willing to walk in their shoes.  If a CEO candidate is not willing to do so, shareholders have probably dodged a bullet and can move on to the next candidate.

Investors Must Take Responsibility for Executive Compensation

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