The Advisors' Blog

– Don Delves, The Delves Group

Deeply concerned about the current state of executive compensation, more than 100 independent directors have been meeting in small groups to address the problem. These meetings have given rise to a growing effort known as the Independent Directors’ Executive Compensation Project (IDEC).

Some of those involved in the project held a meeting in September at Kellogg School of Management where they reached consensus that there is a dire need for a set of principles to guide boards. They agreed that it is imperative for corporate boards to voluntarily embrace and abide by a set of principles that would serve as a lodestone of responsibility for setting executive compensation. Several major companies have already indicated interest in adopting these principles as a basis for good governance and effective disclosure.

The goal would be to create a contagion of better and better practices – of companies voluntarily abiding by the principles and other companies following suit, lest they be left out of the positive limelight and look bad by comparison. Hence, positive compensation practices would edge out negative practices. And, as extensive research shows, effective compensation practices can translate into enhanced shareholder value as surely as negative practices can destroy it.

The need for principles-based compensation has become apparent. Repeated instances of high pay without performance have been eroding the faith of shareholders and engendering a call for public action. Adding insult to injury, Americans who have been hurt by the global economic crisis have ended up seeing their tax dollars spent on bailing out some of the same companies they hold responsible. Legislators, regulators and shareholder groups are lining up to propose a variety of rules intended to limit perceived and real excesses. Unfortunately, government efforts to limit the excesses of executive pay also limit the effectiveness of executive pay.

The idea behind IDEC is to help boards improve accountability and thereby restore the faith of the investing public and preclude emerging government intervention. At a recent meeting – and all prior meetings of these independent directors – there was agreement that:

– There are serious problems with executive compensation at publicly traded companies.
– Independent directors should a take leadership role to do something about the problems.
– An ongoing effort should be undertaken to continuously define, research, develop and communicate principles and best practices.
– Those principles and best practices should ensue primarily from a series of meetings of independent directors.

Thus far, five key principles have emerged from our discussions:

– Accountability
– Alignment
– Fairness
– Transparency
– Objectivity

These principles were discussed at length at the IDEC Project conference at Kellogg. The directors, academics and consultants gathered at that meeting suggested an initial set of illustrative factors for each principle. Here are the draft principles developed by those attending the meeting. Independent directors who have attended these meetings have expressed interest in fostering a voluntary peer-led process that would establish and expand these principles and encourage boards to incorporate them into their practices and proxy statements.

Something akin to this has been accomplished in Germany, where the corporate governance community took a direct approach. The German Corporate Governance Code (adopted in June, 2006) has three levels of guidelines: requirements that must be followed, recommendations that “should” be followed, and suggestions that “could” be followed. Companies that adopt the code agree to disclose the reasons behind any failures to follow recommendations or suggestions. This initiative has been successful as it has resulted in considerable peer pressure among companies to adopt and abide by the code while ensuring needed flexibility in applying it.

Corporate directors who attended the meeting concluded that the widespread adoption of key compensation principles would be an important step toward restoring public faith. They plan to hold conversations with their colleagues as well as with organizations which are working on developing principles such as the Conference Board and the Center on Executive Compensation. Independent directors who have joined the conversations over the past year express a sense of urgency that it is important that corporate boards take the lead in developing and implementing principles of compensation before those who little understand the power of compensation as an effective tool do it for them. The effect is to enable independent directors to employ compensation as the positive tool it can be to shape responsible corporate behavior that rewards both management and shareholders and builds a strong national economy.