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"Too often, executive compensation in the U.S. is ridiculously out of line with performance," Warren Buffett stated in his 2006 annual report to Berkshire Hathaway shareholders.
Nell Minow, editor and co-founder of The Corporate Library, a research firm that focuses on corporate governance, would likely agree with Buffett. On a recent visit to Fool headquarters, Minow -- whom BusinessWeek once dubbed the "queen of good corporate governance" -- said she believes executive compensation is at the root of what's wrong with corporate governance today.
Minow's company grades corporate management teams on the job they're doing. Out of the 3,500 companies The Corporate Library rates, just 17 have As.
If companies want a good grade, Minow says, they must get compensation right. Minow weights compensation structures heavily because she has found that excessive compensation is the best predictor of investment risk, litigation risk, and liability risk. "Too many pay plans today are all upside and no downside," Minow says. "We find that when there is no downside to the pay plan, people don't try very hard."
The ideal CEO pay package
If good corporate governance comes down to executive compensation, then what is the most effective way to structure the compensation system? Minow believes there are three things a pay plan must have -- three things no single company has in combination, which is why she gives such bad grades.
1. Meaningful clawbacks
Minow argues that if executives underperform, the bonuses embedded into their pay packages should be revoked, or "clawed back." That means that if the numbers that supported a bonus are later proven to be wrong, the executive has to give the money back.
To put it in perspective, Minow approves of "pay czar" Ken Feinberg's institution of clawbacks at seven companies, including AIG (NYSE: AIG ) and Citigroup (NYSE: C ) , that took government bailout money. However, Minow says the problem with the Feinberg approach is that it includes language that is open to interpretation -- the clawback only occurs if the adjustment is "material," which can mean anything to anyone.
Minow also says that some clawbacks that other companies have adopted only occur in the case of fraud. "I don't care if it's fraud or mistake," she says. "We want executives to have an incentive to get the numbers right the first time, and the only way to do that is not reward them when they get it wrong.”
2. Low up-front payment with a payday when things work out
Restricted stock grants seem to be back in fashion. When the economy was strong, employees preferred options, which generated more compensation when share prices rose strongly. But whether it's a restricted stock grant or an option, it's still just money, Minow says.
Issuing such a grant at today's trading price without any kind of an adjustment doesn't really benefit shareholders, Minow argues, because as much as 70% of the gains from those rewards come from the overall stock market rather than the particular company. She says this amounts to rewarding people because the economy is good, rather than because their performance is good.
Unless the options or grants are attached to particular performance goals or to outperforming a company's peer group, Minow says, they really aren't very meaningful.
3. Restricted stock grants or realized options
Finally, Minow believes that executives should "never" be allowed to sell stock from restricted stock grants or realized options, or at least not until three years after leaving the company. "I want them to care about the decision the day before they leave as much as they do 10 years before they leave," she says.
Minow's CEO picks
On the basis of these desirable characteristics, Minow favors founder/CEOs like Buffett and Costco's (Nasdaq: COST ) Jim Sinegal. She also likes JPMorgan Chase's (NYSE: JPM ) Jamie Dimon.
On the flip side, Minow says that Tom Donohue, CEO of the Chamber of Commerce, should be ousted. She cited Donohue's role as a former director of Qwest Communications (NYSE: Q ) , which settled SEC allegations of accounting fraud without admitting liability, and as a current director of Sunrise Senior Living (NYSE: SRZ ) , which is currently under SEC investigation and has had to restate years of financial results.
In Minow's words, "[Donohue] has hijacked capitalism on behalf of executives rather than investors. He's a terrible director on all of the companies on which he serves. He's a director for Sunrise Senior Living, which had accounting fraud. He was a director for Qwest, which had accounting fraud. He's a director for Union Pacific (NYSE: UNP ) , where they supported the bonuses of the executives by attributing revenue from the IPO of a division as operating revenue. So three strikes and I think he should be out."
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