Date: August 22, 1997 Source: The Economist, p. 49-50 Headline: "Management Pay -- Unintended Consequences" Summary A British perspective on US executive compensation practices is reflected in an overview of 3 papers presented at the annual meeting of the Academy of Management, held this month in Boston. The article cites 3 "reforms" that "discourage senior managers from feathering their nests at the expense of their shareholders." These are: recruiting more outside directors, linking pay to various performance measures, and giving executives ("bosses") stock options ("share options"). Based on the academic research presented to the Academy, the article concludes these measures have not achieved the desired result. Board Composition A study by James Westphal of the University of Texas at Austin found that "independent" boards of directors -- boards dominated by outsiders -- more often pursue strategies that are likely to favor senior managers rather than shareholders by diversifying their business, increasing executive pay, and weakening the link between pay and performance. Pay and Performance Professor Westphal joined Edward Zajac of Northwestern University to review performance measures used in determining management pay. While the measures varied greatly among the studied companies, these researchers uncovered a startling finding: executives "attend to measures that affect their own incomes and ignore or play down other factors that determine a company's overall success." The conclusion: these incentives promote "opportunism and tunnel vision." Pay and Performance Finally, William Gerard Sanders, of Brigham Young University, studied the effects of awarding a significant proportion of executive pay through stock options. He concluded the effect was to stimulate acquisitions and divestitures. Further, he believes these executives "relish such symbolic churning" as it creates an impression of strong leadership as they reshape their companies. He concludes such behavior is encouraged by the fact optionees have no downside risk from share price declines but benefit from price increases (a conclusion reached by many other studies of executive compensation). The article concludes with the thought that "any boss who cannot outmaneuver a system designed to keep him under control is probably not worth having." CPM Observations With the continued the globalization of the business environment, other nations' companies look to US practices as a model. Often -- and erroneously -- cited as having the highest-paid executives, the US compensation model is increasingly scrutinized. Now, 3 US academic studies again call into question the effectiveness of US corporate governance and executive compensation practices. While none of their findings or conclusions are surprising, we believe it is important to monitor the increasing international scrutiny of US compensation practices. The solutions to the issues identified in this research are known and, to a limited but increasing degree, implemented. They confirm our research and experience: Board Composition The "clubiness" of board composition will likely never be resolved, but increased disclosure requirements, shareholder activism, and media scrutiny are having a positive effect. While an independent board is often assumed the solution, the lack of ownership interest by most outsiders creates little alignment of interests. Pay and Performance Professor Westphal and Zajac's findings reassure us that incentives work -- and cause continued concern that companies continue to employ performance measures that do not measure true economic performance and support shareholder value creation. Until meaningless accounting measures such as EPS are abandoned as measures of success, research studies will replicate these findings. Pay and Performance Professor Sanders' findings reinforce the need for ownership rather than mere compensation at the executive level. US corporations have made feeble attempts at this through stock ownership requirements and guidelines and use of stock for short-term incentive payments. Yet the continued presence of seven-figure base salaries, cash bonuses, stock options, restricted stock, supplemental retirement plans, and insurance-funded deferred compensation arrangements to compensate US executives should cause us to expect more of the same behaviors identified in this research. Perhaps the US will demonstrate its global leadership position in coming years by finally resolving these issues which have been clearly defined, measured, and -- in concept -- resolved. Or, we can just wait to see how other countries implement solutions to our problems, before they become problems for their economies. Index: strategy.002 Recently in "Performance Bytes"... August 22, 1997 "Management Pay -- Unintended Consequences" The Economist, August 22, 1997 [strategy.002] March 7, 1997 "Performance Stock Options" Congressional Record, January 21, 1997 [alleeso.004] February 24, 1997 "Most EDS Employees To Get Stock Options..." Wall Street Journal, February 24, 1997 [alleeso.003] January 29, 1997 "American Air Pilots Asked to Agree to Arbitration" Wall Street Journal, January 29, 1997 [union.001] January 24, 1997 "A Tale of Two Compensation Strategies: (Eastman Kodak & AlliedSignal)" Fortune, January 13, 1997 [strategy.001] January 8, 1997 "Small Concerns Are More Likely to Pay Directors in Stock Than Large Firms" Wall Street Journal, January 8, 1997 [bdcomp.001] December 31, 1996 California Qualified Stock Options (CQSOs) State of California, Secretary of State (AB 3194) [alleeso.002] December 27, 1996 "All about EVA" CFO Magazine, November, 1996 [perfmeas.001] December 18, 1996 "Stock Options to Be Given to 69,000 Staff Members" (Chase Manhattan Corp.) Wall Street Journal, December 18, 1996 [alleeso.001]