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Last year, Oracle (NYSE: ORCL ) CEO Larry Ellison got a $90.7 million payday despite significant shareholder disapproval. Was he paid for performance? Not necessarily. Research suggests that stocks of companies with the highest-paid CEOs underperform their industry peers.
So what explains their high pay? One place to look is the board's governance structures, which too often permit significant conflicts of interest among those who set executive compensation.
Do the companies you own allow these conflicts? Here are a few key places you can look.
Conflicts of interest can arise if the CEO is able to play a significant role in selecting and approving board member nominations, as this gives them some power to hand-pick rubber-stamp board members who are more likely to push through favorable compensation packages.
How can you determine if this is the case?
Take a look at the proxy sections discussing the company’s Nominating and Corporate Governance Committee. It provides valuable information about the procedure a company uses to select and approve board members, including members who will serve on the compensation committee.
For example, Chesapeake Energy's (NYSE: CHK ) 2011 proxy statement indicates that the entire board of directors had "the authority to accept, modify, or reject the slate of nominees recommended by the Committee." Since Aubrey McClendon was at that time serving as both the CEO and the board chairman, this means that he had a significant amount of power to choose the board members who would ultimately determine his compensation package and approve his management decisions.
According to some critics, McClendon used that power to hand-pick Chesapeake's board, which proceeded to offer generous compensation packages, and (according to some accounts) approved McClendon's decision to take out about $1.1 billion in loans against his stake in company-owned wells.
Investors should also worry when the CEO is able to play a significant role in creating and approving board compensation packages, which can create a temptation among directors to kowtow to the CEO to preserve cushy compensation and perks.
How can you determine when this is the case?
Take a look at the proxy's explanation of the responsibilities held by the compensation committee.
Chesapeake's 2011 proxy statement indicated that the compensation committee, which was entirely composed of independent members, was responsible for approving the amount of compensation directors achieve in equity. However, the proxy also indicated that the board of directors as a whole was "responsible for establishing and approving director cash compensation."
This put McClendon, who then served as both CEO and board chairman, in a position to guide decisions regarding cash compensation packages awarded to directors -- including those who set his pay.
Other questionable board connections
Suppose you're a member of the compensation committee at Corporation A, and also the CEO of Company B, and that you recognize that Company B could profit from doing business with Corporation A. Wouldn’t you want to stay in the good graces of A's executives to keep that opportunity open? Sure you would. And one way do to that would be to create generous compensation packages.
For this reason, investors should also be wary of any other situations in which compensation committee members' other corporate affiliations might create a temptation to form a quid-pro-quo relationship with those whose packages they help determine.
How can you determine this?
First, look for disclosures of related-party transactions, which indicate when your company has purchased goods or services from a board member's company.
Let's look at a related-party transaction that occurred at Oracle, which awarded Ellison a compensation package worth $90.7 million in 2012. This egregious package garnered such strong shareholder disapproval that 58.9% of shares voted against it, even as Ellison himself owned about 23% of shares at the time.
Oracle’s 2012 proxy statement discloses that at least two out of three of its compensation committee members are associated with companies that may profit from Oracle's decision to contract with them for goods and services. George Conrades and Naomi Seligman both serve as directors on the board of Akamai Technologies (NASDAQ: AKAM ) , and Conrades served as its CEO from 1999 until 2005. In 2011, Oracle purchased products and services from Akamai.
While Oracle's purchases were modest (they did not exceed $120,000), the case demonstrates the potential for conflicts of interest that may motivate directors to curry favor with the CEO against investors' best interests.
So how can investors discover these conflicts of interest before they manifest in ways that require disclosure under "related-party transactions"?
Investors should look closely at the biographies of compensation committee members and determine whether their other corporate affiliations may tempt them to offer quid-pro-quo exchanges that may not benefit the shareholders they're supposed to represent.
Compensation package creation process
In addition to looking at the people involved in executive compensation committees, we should also look at the process the committee uses to create executive pay packages.
Ideally, investors should look for a transparent process that provides clear, objective metrics indicating what counts as good performance for the CEO and other top executives. The existence of objective standards introduces accountability into the creation of executive compensation packages and limits directors' ability to approve exorbitant pay when executives fail to serve shareholders well.
How can investors determine if these conditions are met?
You should look closely at your company's section on executive compensation -- especially the section providing compensation discussion and analysis.
Chesapeake has made some progress in its performance metrics. Its 2012 proxy statement indicates its move from a fully subjective compensation approval process to one that includes predetermined performance metrics.
However, in the "Compensation Discussion and Analysis" section of its 2012 proxy, SandRidge Energy (NYSE: SD ) indicates that its officials "do not currently base executive officer compensation decisions on pre-established performance targets." Also worrisome is SandRidge's admission that CEO Tom Ward submits recommended executive salaries, including his own, to the Compensation Committee for approval, rather than allowing the committee to come up with its own recommendations.
The Foolish bottom line
While it is possible for compensation decisions to favor shareholders despite the presence of conflicts of interest, shareholders should look for governance structures that will foster accountability among decision-makers and eliminate conflicts of interest to ensure their boards reliably put them first.
Otherwise, you may be forced to pay through the nose for underperforming CEOs who kill your returns.