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.”
