Global Perspectives

The Battle over Executive Pay: Why Investors are Right while still
being Wrong
David W. Anderson PhD ICD.D, President, The Anderson Governance Group

Executive pay is too high. It’s a verdict
many support around the world.
The lure of equity compensation
focused the attention of executives and
contributed to the surge in productivity
and stock appreciation in the last 20
years. At the same time, the single-
minded pursuit of that wealth misaligned
personal and professional interests and exacerbated the current
financial crisis. It is also true that chasing ever-higher returns on
their capital, investors and their investment managers pressured
corporations to deliver unsustainable profits, and fuelled a market
for products with unsupportable leverage. These are not unrelated
stories. In their collective gamble, the ‘high risk’ side of the
coin finally landed top-side after a lucky string of ‘high reward’
outcomes. Yes, many intermediaries facilitated the binge, but
ultimately those were investment decisions and investors must
take responsibility.
bargaining partner and the quality of its judgments. Consequently,
resources are misallocated and investors believe they are paying
too much for their management. In any market, the buyer’s
judgement as to the amount that is ‘too much’ must be taken into
account. Directors should take note.
Second is the contingency view. Examples abound of
executives destroying wealth while still reaping huge pay. In
some cases, contingency does not exist by design; it has been
bargained away as guaranteed ‘bonuses’. Where contingency
is supposed to exist, executives sometimes describe the
conditions as a lottery. Payout is not clearly connected to
their behaviour. Thus, transfers of shareowner wealth are not
justified on economic grounds, and may lead to greater cost
in the future, as executives demand more to incentivise their
behaviour. More troubling is the effect on those executives
who can directly influence the reporting of performance metrics
to which pay is tied. The ‘results’ may be artificially created to
justify the reward.

Why is executive pay unfairly high? I offer three criteria against Even when contingency is present and clear, it may be a flawed
which the fairness of pay may be judged. First, the market view construct. From a psychological perspective, contingent pay
argues that, in the market for executive talent, supply is rare works best as a motivator for rote, concrete tasks, not the
and demand is almost unquenchable. It is easy to see why pay innovative, highly abstract work of executive leadership.
is high – but why is it unfairly so? It is because the market does
not function perfectly due to constraints that shift the power Third, the reasonableness view suggests that pay can be
advantage to executives, including: judged in light of its opportunity costs and ancillary effects. As
a motivator, pay offers a decreasing marginal benefit. At high
• information asymmetries; levels, it represents poor capital allocation of a scarce resource
• the perception that talent is scarce; within and across firms. From a leadership perspective, high
• duress as directors feel the need to act quickly; pay exalts personal gain above common goals. As a model, it
• flaws within board bargaining and assessment promotes immodesty and arrogance and fosters an unhealthy
processes; culture, dismissive of social accountability. It degrades the
• inappropriate company comparator groups (usually for motivation of others whose contribution one infers must
aspirational purposes); be vastly less meaningful. From a governance oversight
• complex pay plans and contingencies that are not well perspective, high pay distorts executive judgment because it
understood; motivates self-serving – sometimes even criminal – behaviour
• an emphasis on share price as the arbiter of and unsustainable performance and increases volatility. High
performance; pay for executives also distorts the judgment of the board itself,
• a regulatory requirement for disclosure of executive as it creates decision commitment toward the chief executive
pay, creating specific targets for executives to ‘beat’; on the part of directors.
• premature commitment to a candidate before
negotiating financial terms; and Excessively high executive pay also reduces the public’s support
• a belief that previous pay is an indicator of current value for corporations and capitalism itself – and that is unfair to the
to a different company. many businesspeople who are paid reasonably. Reinforcing
fairness in business enhances the legitimacy of corporate
These constraints distort the perception of supply and demand, leadership and encourages society’s acceptance of pay differences
and taken together they reduce both the power of the board as a earned through merit.

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Investors are right to pursue accountability
If executive pay is too high – and has broad, deleterious
consequence – then investors have ample reason to seek change.
Not only did investors lose money, but they have risked the
support of people and governments for the very system that
creates their wealth. Investors can and should closely examine
their own role in encouraging excessive pay. More broadly,
investors are recognising their legitimate role and responsibility as
shareowners in the system of corporate leadership. The work of
the ICGN and that of national investor associations is instrumental
to this cause.
A profound shift is occurring in investors’ sense of their proper role
– both in collaboration with each other and alongside directors and
executives – and their ownership power. Investor perspectives,
goals and behaviour are changing quickly. Just as boards reclaimed
their power by retracting previous delegation from management,
so too are investors seeking to assume the power to control
corporate agendas they once left to boards. A reform of capitalist
enterprise is well underway.
As a result of massive value destruction investors suffered earlier
this decade and again in the financial collapse, investors decided
to change their approach to share ownership. All at once, their
losses made clear the relevance of governance, which investors
had largely ignored, and their own impotence to protect their
interests – either directly or indirectly. Investor activism became
the norm and, with it, a zeal for accountability.
To exercise this new sense of power and desire for accountability,
investors first looked at indirect methods of control and found
one area over which they had obvious responsibility: the election
of directors. Finding the means of electing directors in many
jurisdictions oddly archaic and undemocratic (uncontested slates
of directors requiring only a plurality of votes), and directors
seemingly deaf to investors concerns, electoral reform became a
central focus of investors. Two prominent examples are majority
voting (requiring directors to achieve 50% endorsement by
shareowners) and access to the proxy (allowing shareowners to
bypass the board in nominating director candidates).
Director election is an indirect means of controlling a
corporation, as it is the decisions made by directors once
elected that constitute actual control. Although reform in
governance as exercised by directors has been significant, the
depth and speed of this change have been regarded with some
uncertainty by investors. This is most particularly seen in the
International Corporate Governance Network • 2009 Yearbook
Global Perspectives
matter of executive pay, where investor and director opinions
show important differences1.
‘Say on Pay’ – a shareowner vote on the executive pay policy
approved by the board – represents a move toward direct control
of corporate decisions. Investors have well established voting
rights in most jurisdictions that permit direct control over major
decisions such as proposed change of control transactions.
However, voting on matters like pay (while even advisory) that
have been exclusively within the domain of the board represents a
directional move toward more granular control and influence over
corporate behaviour.
Consistent with the rise in consciousness of investors and their
managers as to their ownership rights, investors would seem
to be on a course that sees them pursuing more direct means
of control over corporations – further retracting the historical
delegation of responsibility to directors. Investors must ask
themselves if indeed such direct means of control is their best
option, and whether they have given up too soon on indirect
means of influence. Investor agents are right to take responsibility
for share ownership in the interest of the ultimate owners. How
much responsibility are they equipped to handle – even if there is
the motivation to do so?
Investors are wrong to seek direct control
The growing sense of investor accountability and conviction
that ownership brings with it responsibilities as well as rights
are strong steps in the right direction for shareowners. Trying
to control executive pay through increasingly direct means of
corporate control is not. Investors and their managers do not
have the credibility, expertise, information and the means to
make informed pay decisions. The problem is they do not seem
to realise it.
In terms of credibility, it is true that investor influence has a track
record of success with boards: after all, directors began issuing
stock options to executives in an attempt to align executive and
shareowner interests. However, investors and their managers
should not fool themselves: they may talk a long game, but many
play a short one.
1
Anderson, D.W., Maly, J., and Melanson, S.J. (2008).
Directors, executives and investors are refashioning
governance: Practical research tracks governance evolution.
ICD Director, 138 (Jun), 28-32.
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 Global Perspectives
Regarding expertise, information and means, investors and
their managers do not have the experience and are simply
not close enough to the action to know how to construct,
administer or adjudicate executive pay plans. Unless they
pursue further avenues of direct control, investors manifestly
do not have the means to take a fully ‘hands-on’ approach.
To help investors understand this, here are ten things2 I
believe must be done to make good pay decisions – ones
that recognise that the long-term value of their owners’
capital is at stake.
Investors should ask themselves which of these ought to
be the responsibility of directors and which of investors.
Importantly, investors should also ask which of these they
are willing and able to influence the board to do better:
1. Articulate a fair pay philosophy in which pay
decisions will be made:
• c learly establish the purpose, principles and criteria of
fairness, as well as the metrics, magnitude, contingencies
and intended performance consequences of pay;
• d
 istinguish among the various uses of pay (e.g.
attracting, incentivising, rewarding and retaining talent)
and the appropriate means to achieve them (e.g. salary,
incentives, vesting and hold criteria);
• d
 ecide both the forms and proportions of pay available
for use;
• s pecify the percentage of total stock set aside for
performance incentives; and
• learn what other stakeholders think of this philosophy.
2. Use pay to efficiently allocate scare capital in line
with the corporate strategy and risk profile:
• c alibrate the magnitude of pay to shape constructive
behaviour and not distort judgment; and
• d
 etermine a sufficient incentive to signal long-term
performance expectations, but not tempt executives to
Anderson, David W. (2009). Executive pay: Help wanted. ICD
2
Director, 142 (Feb), 31-38.
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adopt a narrow short-term focus.
3. Make pay performance contingent, focusing on
long-term value creation:
• m
 ake pay clearly contingent upon business
performance as derived from strategy and risk
assessments, if not share price, to encourage value
creation and reduce the likelihood of its destruction;
• d
 ecide the degree to which executives have control
over key business outcomes (so as not to pay for other
factors affecting performance); and
• c hoose a suitable time period for risk-adjusted pay
plans with delayed incentive pay (to gauge sustainability
of the performance results), based on the business
model and business cycle.
4. Simplify pay plans and stress test them:
• m
 ake the link between what an executive does and
the pay consequence clear, or the power to incentivise
behaviour is lost; and
• s tress test at various levels of performance to ensure
directors are aware of the full range of pay outcomes
embedded in the pay formulae.
5. Monitor executive behaviour and performance
closely and consistently:
• e
 valuate CEO performance objectively, with rigour and
discipline, so as to have the means of holding them
accountable; and
• m
 anage the paradox of performance accountability:
monitor short-term performance while diligently
rewarding long-term performance.
6. Learn to attract, retain and incentivise executives
with tools other than pay:
• c hallenge the premise that high compensation is the
most valid tool for attraction and retention; and
• c reate ambitious business goals for executives who
delight in solving business challenges.

7. Improve executive selection and promotion
procedures:
• m
 anage a thorough selection process with valid selection
tools to emphasise performance driven by motivation
beyond pay; and
• c hoose a pay strategy that manages succession risks,
then choose the type of leaders required, and only then
decide what pay profile is needed to attract those leaders.
8. Increase the supply of talent, through diligent
succession planning and leadership development:3
• d
 evelop a well equipped, committed, and productive talent
base to increase the internal supply of executive talent,
giving boards more leeway in selection and subsequent
negotiation decisions, thus increasing the bargaining
power of boards.
9. Ensure directors are educated in the business and in
compensation:
• d
 evelop a thorough understanding of the business to be
able to direct the affairs of the corporation and guide its
executives with the powerful tools of pay;
• learn the language of pay, study complex pay plans and
understand human psychology in order to use the tools of
pay with precision; and
• g
 uard against biases regarding personal wealth when
making pay decisions, testing judgements from multiple
perspectives.
10. Leverage investor perspectives on pay:
• o
 wners have only the blunt instrument of director election
and in some cases advisory votes on pay as formal means
of registering their opinion. Directors should engage
investors in dialogue about pay philosophy; and
• d
 irectors have a difficult task working closely with
executives and making the biggest decisions affecting
3
Anderson, D.W. (2007). Do you know your next CEO? What
directors can do to succeed at succession. ICD Director, 135
(Dec), 24-28.
International Corporate Governance Network • 2009 Yearbook
Global Perspectives
their lives. When it is useful to lean on external support
to make the right decision, directors should know how to
leverage their relationship with investors.
Recommendations for investors
In general, investors should focus on influencing the corporate
behaviour of public companies through indirect means: targeting
directors, not controlling corporations directly.
In respect of executive pay, investors must articulate the criteria
they use to judge its fairness – and communicate these criteria
to directors. For example, in terms of the market, does pay
reflect the price to acquire, retain and incentivise talent in a
well-functioning market? When it comes to contingency, is pay
related meaningfully to performance? In terms of reasonableness,
is aggregate pay consistent with the overall integrity of the
corporation and its values?
Having organised, claimed and asserted their authority, investors
must find ways to engage with directors. Such direct contact
with directors – and the collaboration it may bring – will enhance
investor influence over corporate decisions and provide a more
productive means of protecting shareowner assets. There is no
substitute to forming human relationships for the purpose of
understanding, influencing and judging the people involved, in order
to get better insights into the quality of effort and results produced.
Investors need to consider deeply the most effective role
for shareowners in our system of corporate leadership, and
communicate their thinking with directors, executives, regulators
and politicians. Investors must decide how they will use their
power as shareowners to influence – or direct – changes in
corporate governance and potentially corporate decisions.
Investors must take responsibility for the short-term pressure
directors and executives experience coming from the market.
Investors need a holistic strategy based on a coherent philosophy
of corporate governance for public companies.
To get there, investors must ask themselves what they want
from their corporations and directors, what are the appropriate
tools to get it, and what behaviour on their part would constitute
the responsible exercise of their ownership prerogative? In other
words, investors must choose an appropriate line of delegation
between owners and directors that will create a stable, efficient
and productive system of corporate governance.
David can be contacted on david.anderson@taggra.com
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