The Advisors' Blog

This blog features wisdom from respected compensation consultants and lawyers

January 3, 2018

How Directors Aren’t Stewards of Their Own Capital (Leading to Poor CEO Pay Practices)

Broc Romanek

In this paper, Stephen O’Byrne & David Young provide analysis that highlights a major roadblock to better governance and better pay practices. Here’s a note that Stephen sent about it:

One major “roadblock” is that the modern director is not a steward of his own capital, but a paid labor provider, just like management. Directors and management have a strong common interest in pay practices that protect labor providers at the expense of capital providers, e.g., providing competitive pay regardless of past performance. Their common interest is the governance problem, not “managerial power” as Bebchuk & Fried would have us believe. And the problem is hidden because the governance discussion focuses on director independence, not director incentives to increase shareholder value.

Earlier this year, we published a paper on the “Evolution of Executive Pay Policies at General Motors 1919-2008.” The paper chronicles the demise of management incentives based on fixed sharing in economic profit. From 1918 to 1977, the GM incentive pool was 10% of profit in excess of a 7% return on capital (with some minor variations over time in the sharing percentage and capital charge). This pool covered all management incentive compensation at GM, both cash and stock. In 1977, GM directors dropped fixed sharing and switched to competitive pay concepts (i.e., target dollar compensation).

One remarkable thing about the fixed sharing period is the lengths to which GM directors went to achieve compensation objectives without sacrificing the fixed sharing. To strengthen management ownership, they set up two eight-year long leveraged stock purchase plans when they could have easily increased the sharing percentage or made stock grants outside the incentive pool. To realize the post-WW II tax benefits of stock options, they developed an elaborate system of “contingent credits” to charge the stock option expected value against the incentive pool.

A second remarkable thing about this period is the magnitude of the directors’ stock interest relative to their director fees. In 1947, in the middle of the fixed sharing years, the median director owned $1.65 million in stock and received a director fee of $900. Assuming a 10% expected return, this means that the directors fee only made up for the loss of two days of expected stock return (one day = $1,650,000 x 10% / 365 days = $452). In 1977, when the directors dropped the fixing sharing plan in favor of competitive pay concepts, the median director owned $34,000 in stock and received a director fee of $47,000. This means that the directors fee made up for the loss of almost 14 years of expected stock return. The GM director in 1947 was a steward of his own capital, while the GM director in 1977 was a paid labor provider, just like management.

In a recent analysis, I looked at S&P 1500 directors to compare their expected stock return with their directors fee. For this analysis, I used an 8% expected return and classified a director as a “steward of his own capital” if his expected stock return was 10x or more his directors fee (vs 183x for the 1947 GM director). With this definition, only 3% of S&P 1500 directors are stewards of their own capital, while 97% are paid labor providers like management.