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Paying Directors in Equity
Directors remuneration can be quite a controversial issue. Many feel
that paying Directors large financial quantums is disproportionate to
their actual hands-on role. Whilst I agree with that concept, Directors
do contribute a significant amount to any business, and they must be
rewarded. The following article published in HBR examines the notion of
paying directors in equity - thus encouraging a win-win situation for
both company and director. Have a read on this, and drop us a note with
your thoughts on the matter.
When a corporate scandal breaks – like the recent one at Wells Fargo or earlier ones at Lehman, Enron, or Qwest – the question is always raised: what was the board of directors doing while the managers in these companies were involved in such unprofessional behavior? The answer is that, like most of us, directors respond to incentives. And my research suggests that those incentives need to change.
Director compensation typically consists of a cash component (retainer), smaller cash amounts paid for attendance at board and committee meetings, and incentive compensation in the form of stock and stock option grants which vest over a period of a few years. During the past decade, the prevalence and importance of stock ownership guidelines has increased significantly for the S&P 500 companies.
But the gradual evolution of director compensation doesn’t go far enough. I propose that compensation of corporate directors should consist only of restricted equity. By “equity” I mean stock and stock options. By “restricted” I mean that the director cannot sell the shares or exercise the options for one to two years after their last board meeting. I believe corporate directors should not be paid any retainer fees or other cash compensation. Of course, this change wouldn’t prevent every scandal or solve every problem with corporate governance. But it would help channel director attention toward longer-term profitability.
My research supports such a change. In two recent studies, my co-authors and I looked at the relation between director stock ownership and company performance for the largest U.S. companies. In one study, we looked at the performance of the 1,500 largest public U.S. companies during the period 1998-2012. We measured performance using the company’s return on assets, adjusted for the company’s industry and size. And we controlled for the company’s leverage, R&D intensity, board size, and its transparency to analysts. In the second study study, we considered the S&P 500 companies during the years 2003-2007, using the same controls. In both studies we found that companies in which directors owned more stock performed better in future years. We also found that directors who own more stock are more likely to discipline or fire the CEO when the stock price performance of their company has been sub-par in the previous two years.
There are drawbacks to this proposal, but they can be mitigated. If directors are required to hold restricted shares and options, they would most likely be under-diversified, and would be concerned with lack of liquidity. The proposal could also lead to early director departures, as directors seek to convert illiquid shares and options into more liquid assets (after the one- to two-year waiting period). To address these concerns, I recommend that directors be allowed to liquidate 10-15% of their awarded incentive restricted shares and options each year.
If we want directors to further the long-term health of the companies they serve rather than falling asleep at the wheel while malfeasance spreads, we need to provide them with the right incentives. If we pay directors solely in restricted equity, they’re more likely to do their job.
________________________________________
When a corporate scandal breaks – like the recent one at Wells Fargo or earlier ones at Lehman, Enron, or Qwest – the question is always raised: what was the board of directors doing while the managers in these companies were involved in such unprofessional behavior? The answer is that, like most of us, directors respond to incentives. And my research suggests that those incentives need to change.
Director compensation typically consists of a cash component (retainer), smaller cash amounts paid for attendance at board and committee meetings, and incentive compensation in the form of stock and stock option grants which vest over a period of a few years. During the past decade, the prevalence and importance of stock ownership guidelines has increased significantly for the S&P 500 companies.
But the gradual evolution of director compensation doesn’t go far enough. I propose that compensation of corporate directors should consist only of restricted equity. By “equity” I mean stock and stock options. By “restricted” I mean that the director cannot sell the shares or exercise the options for one to two years after their last board meeting. I believe corporate directors should not be paid any retainer fees or other cash compensation. Of course, this change wouldn’t prevent every scandal or solve every problem with corporate governance. But it would help channel director attention toward longer-term profitability.
My research supports such a change. In two recent studies, my co-authors and I looked at the relation between director stock ownership and company performance for the largest U.S. companies. In one study, we looked at the performance of the 1,500 largest public U.S. companies during the period 1998-2012. We measured performance using the company’s return on assets, adjusted for the company’s industry and size. And we controlled for the company’s leverage, R&D intensity, board size, and its transparency to analysts. In the second study study, we considered the S&P 500 companies during the years 2003-2007, using the same controls. In both studies we found that companies in which directors owned more stock performed better in future years. We also found that directors who own more stock are more likely to discipline or fire the CEO when the stock price performance of their company has been sub-par in the previous two years.
There are drawbacks to this proposal, but they can be mitigated. If directors are required to hold restricted shares and options, they would most likely be under-diversified, and would be concerned with lack of liquidity. The proposal could also lead to early director departures, as directors seek to convert illiquid shares and options into more liquid assets (after the one- to two-year waiting period). To address these concerns, I recommend that directors be allowed to liquidate 10-15% of their awarded incentive restricted shares and options each year.
If we want directors to further the long-term health of the companies they serve rather than falling asleep at the wheel while malfeasance spreads, we need to provide them with the right incentives. If we pay directors solely in restricted equity, they’re more likely to do their job.
Image Source: hbr.org
Craig J Selby | Craig is a long-time proponent of structured and measured change. His early career saw him teaching marketing and management at a variety of Universities and PTE’s in his native New Zealand, where he quickly climbed the management ladder to head several private sector institutes. Needing to do that little bit extra, Craig formed his own consultancy firm and was engaged by many in the sector as a trouble-shooter - responsible for internal auditing, restructuring and redevelopment of many departments and institutes in order to remain competitive in a highly contested market. This involvement motivated him to branch out and work with other industries - focussing on change and development as a core theme in business survival. When Craig moved to Malaysia, he went back into the Education sector to share his ideas with local private sector educational facilities. In 2009 Craig co-founded Orchan Consulting Asia, an award-winning Public Relations agency. His areas of specialisation are Crisis Management Communications and Change Management.
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