Published: May 11, 2013
DIRECTORS of some high-profile public companies are coming under scrutiny this proxy season. Shareholder advocates say it’s about time.
The coming meeting of JPMorgan Chase shareholders, to be held in Tampa, Fla., on May 21, is a case in point. Directors on that board are under fire for not monitoring the bank’s risk management, a failure highlighted by last year’s $6 billion trading loss in the company’s chief investment office. Shareholder advisory firms have recommended voting against some of the directors on the risk policy committee and audit committee, so it will be interesting to see what kind of support those board members receive at the election.
The risk-management fiasco at JPMorgan was an obvious failing, but directors of public companies often let down their outside shareholders in ways that are more subtle, but equally important, say some experts on public company board practices. Directors commonly neglect chief executive succession planning and inadequately analyze company performance as it relates to managers’ pay.
Paul Hodgson, principal at BHJ Partners, a corporate governance consulting firm, said he believed chief executive succession planning was one of the signal tasks of a director and one at which most of them continued to fall short.
“J. C. Penney is the most recent example, but there are countless others,” said Mr. Hodgson, referring to the recent ouster of Ron Johnson, who came to Penney with great fanfare from Apple.
“Hiring an outside C.E.O. costs between three and five times the amount it does to promote an existing manager, so boards are failing in their fiduciary duty and wasting shareholders’ money by not having a properly functioning succession plan in place,” Mr. Hodgson said.
Another board duty that is basic but often badly executed involves how a company’s performance is measured for pay purposes. Mark Van Clieaf, managing director at MVC Associates International, an organization consulting firm, said he believed boards were stuck in a groove that was dangerous for shareholders. The measures most directors use to assess corporate performance, he contends, are too focused on earnings growth and often do not weigh a company’s return on assets, equity or invested capital.
Return on invested capital is a preferred method to measure the creation or destruction of shareholder value, Mr. Van Clieaf said, because it reveals how effective a company is using its money to generate returns. If boards ignore this measure when setting pay, executives could be rewarded even when their companies’ financing costs exceed the returns on their investments. No company can survive in that circumstance for long.
Equally troubling is the board practice of rewarding executives for short-term performance when the risks in their businesses take much longer to play out. The rewards handed over to senior bank executives in the years leading up to the financial crisis, for example, show how unbalanced many companies’ incentive plans are.
Consider the mortgage business. It typically takes as long as five years for problems, like payment defaults, to show up in home loans. Yet most financial companies paid those top executives for performance periods significantly shorter than that.
Back in 2009, responding to the credit debacle, the Financial Stability Board, a group of international regulators and standard setters, published a policy paper recommending principles for sound compensation practices among financial companies. The board said a “substantial portion of variable compensation, such as 40 to 60 percent,” should be deferred over a period of no less than three years. And in 2008, the Institute of International Finance, a global financial industry group, suggested that a sizable portion of executives’ bonuses be deferred over five years.
Both were good ideas, Mr. Van Clieaf said, that have gone largely unheeded. In 2010 he looked at compensation packages at the 18 largest United States banks. “For the 90 named officers of those banks,” he said, “the average performance period was 2.2 years.”
Mr. Van Clieaf has not analyzed these institutions since 2010, but said that other analyses indicated performance periods at most big banks might have stretched to three years, on average. Even that needs to be lengthened, he said.
This short-term orientation on executive pay extends well beyond the financial industry. Last year, Mr. Van Clieaf examined performance periods and metrics among roughly 250 large corporations. He found that less than 4 percent of these companies had both a balance-sheet oriented metric, like return on capital, equity or assets, and a performance period longer than four years.
Another analysis he did, of the 1,500 largest United States companies in 2012, showed that only 18 percent used a balance sheet metric and even fewer — 8 percent — employed performance periods of more than four years.
I ASKED which companies appeared to be taking the right approach. Mr. Van Clieaf pointed to the Eaton Corporation, a maker of engineered products, which bases its incentive pay in part on the cash flow return the company generates on its capital.
Eaton also uses a four-year performance period when setting pay for executives.
Abbott Laboratories, a provider of health care products and services, is another good example, Mr. Van Clieaf said. It uses five-year performance benchmarks and includes return on equity and return on net assets in those calculations.
These companies are in the minority, however. Mr. Van Clieaf blames not only corporate directors but also their advisers and the shareholders who rubber-stamp the misaligned pay practices.
Directors make good money. According to the most recent figures compiled by Equilar, an executive compensation data firm, median pay for outside directors at companies in the Standard & Poor’s 500-stock index was almost $239,000 in 2012. That’s up 11 percent from the median pay awarded in 2010. But that pay comes with a duty: ensuring shareholder interests come first.
“This is a failure to create metrics, performance periods and incentives that are truly strategic for long-term shareholders,” Mr. Van Clieaf said.
“Boards, pay advisers and investors,” he said, “all need a whack on the side of the head.”