This Is How to Change Corporate Governance

"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."

For related Foolishness:

Fool contributor Jennifer Schonberger does not own shares of any of the companies mentioned in this article. The Fool owns shares of Costco and Berkshire Hathaway, which are both Motley Fool Stock Advisor and Motley Fool Inside Value picks. The Motley Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (17)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 12, 2009, at 6:20 PM, xetn wrote:

    We don't need a wage czar any more that we need a drug czar. As a matter of fact, we don't need any czars.

    The US constitution does not give the federal government any rights to meddle in the affairs of private business, except in the area of interstate commerce.

    The pay of any executive is the responsibility of the board of directors and the stockholders. If, as a stockholder, you disagree with an executive's pay package, you can voice your opinion at stockholder meetings by voting against these executives or you can sell your shares and go elsewhere.

    If you have read a company's reports, they list the incomes of various executives. If you dislike what you see, don't buy in the first place.

  • Report this Comment On November 13, 2009, at 1:59 PM, epber wrote:

    Don't add comments when you give out wrong info. A stockholder has NO binding input to a corporation. You can make and file a written proposal, you can speak up at the annual meeting and nothing you say is binding no the percentage of support you get from other stockholders. The gov't/SEC MUST make changes as indicate by Neil Minnow or nothing will change to corporations in goverance/exec salaries/ rights of stockholders, etc.If there are no changes, another disaster will occur to the economy.

  • Report this Comment On November 13, 2009, at 2:14 PM, corpgov wrote:

    Great commentary from Nell Minow. Contrary to "xetn," I don't see Minow advocating a general pay czar. She simply points to Ken Feinberg's clawbacks as a good idea that need improvement. Why should pay that wasn't earned (because it didn't meet the performance measures of a contract) be clawed back only in the case of fraud but not poor accounting or other mistakes?

    Institutional investors and high wealth individuals can't get better advice than the Corporate Library (http://www.thecorporatelibrary.com). It has no conflicts of interest and provides a great service. I've seen many of their reports.

    However, for most of us that can't afford more than an occasional report from TCL, ProxyDemocracy (http://proxydemocracy.org) is a great source. There you can see how respected institutional investors, many of whom subscribe to TCL services, are voting on important issues like pay proposals and directors.

    Build your social capital network to sites you trust, like http://proxydemocracy.org , http://transparentdemocracy.org , and http://isuffrage.org . Developing networks you trust can dramatically reduce your transaction costs, make you a better investor, and make the companies you invest in more responsible.

    Great article by Ms. Schonberger. I'd like to see more Motley Fool articles on corporate governance. Let's push investors to be shareOWNERS, not just shareHOLDERS.

  • Report this Comment On December 10, 2009, at 11:41 PM, 2humble2fool wrote:

    Jeez, 3500 companies and only 17 A's. I think this lady must be a clone of an English teacher I had in college. Can anybody say unrealistic expectations lead to useless information. Maybe someone should be grading TCL's performance?

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