The implications of the New York Stock Exchange board’s handling of the Richard Grasso affair, reach much further than just settling chairman and chief executive Grasso’s enormous compensation package. As the chairman of the Securities and Exchange Commission William Donaldson reportedly said: “The pay package raises serious questions regarding the effectiveness of the NYSE’s current governance structure.”
In the current climate of questioning all aspects of corporate governance, the saga throws into high relief the issue of how boards deal with executive compensation and the role of the compensation committee in the overall corporate governance structure.
To recap the story, Grasso had worked for the NYSE for the whole of his career. When he was appointed chairman and CEO in 1995, his remuneration was just over $4 million year. It rose to nearly $62 million in 2001. The Compensation Committee of the board wanted to extend his employment contract from 2005 to 2007. As part of the negotiation, Grasso asked that his deferred compensation (a combination of performance bonuses and retirement benefits to which he was entitled, but which he had not yet taken), be released.
Given the huge liability, acceptance of this request was probably the only decision the NYSE board could take. But the ensuing negative publicity has been enormously damaging to the institution, even though (unlike Enron) there is no question of wrongdoing.
The disclosure of senior executive remuneration packages has only recently become the norm. Remuneration was previously seen as private, even sacrosanct, matter between the individual executives and their employer. Not surprisingly, investors and the general public now view the way organisations structure their pay as symptomatic of other practices. In five general areas of governance practice the Grasso affair offers some timely lessons:
*Establishing clear processes and accountabilities.
* Stipulating how consultants are used.
* Determining how the company est-ablishes the relationship between risk and reward.
* Ensuring that reward systems do not have compounding effect.
* Analysing fully the consequences of disclosure.
Formalised processes and accountabilities
It is essential that the roles of chairman and CEO are separated to ensure proper segregation of the governance and operational responsibilities. Unlike America, the fusion of these roles is uncommon in New Zealand. But even where the roles are separated, chairmen can be overshadowed by high-powered CEO. Grasso, for instance, was criticised as “having an undue influence on the board’s nominating and compensation committees”, by New York Times commentator. And according to the Washington Post’s Jerry Knight: “Grasso’s pay was set by board members and compensation committee members whom he personally picked for their jobs. No one is suggesting any quid pro quo – no kickbacks, no mutual back scratching – but the conflict of interest is no less obvious.”
In future, boards are likely to be required to prove that the members of the compensation committee are suitably independent. New York Times article suggested that “at the very least, the compensation committee ought to consist solely of outside directors”.
And boards should have written policies and procedures for the compensation committee on who will decide on executive pay, what will be their credentials, and the reporting and disclosure procedures to be put in place.
Consultants must also be able to demonstrate their personal independence in the process. Grasso had evidently been advised by lawyer who also acted as chief counsel to the board’s Corporate Governance Committee.
Our own professional experience shows that many boards do not consider the wider issues of independence and impartiality. We frequently receive instructions to review senior executive pay from the CEO or the general manager, human resources, rather than the chairman. This displays an admirable sense of trust by the board, and indeed that confidence in the senior executives’ impartiality may well be justified. But as matter of principle, the status of remuneration consultants should be similar to that of auditors, in that their responsibility is to report to the board alone. The chairman should, as matter of course, talk to the consultants during the process, even if only to ratify the information already passed through by the senior executive group.
Consultants must be able to arrive at their conclusions impartially and objectively. One of the most heavily criticised aspects of Grasso’s pay determination was the selection by the Compensation Committee of “a comparator group of financial firms” for the most senior roles in the NYSE. The basis for this selection was apparently not questioned, even though it became major source of contention once the details of the pay package became public. “Pay experts also criticise Vedder Price [one of the consulting firms used] for comparing CEOs at large, for-profit companies to Grasso, who is part regulator and part manager of much smaller, non-profit organisation,” said Gary Strauss writing in USA Today.
One of the essential elements influencing any CEO’s package is risk. With investors demanding ever-more-precise disclosure, boards must justify their decisions on pay in terms of the risk-reward equation for the company and for the senior executives. This is one of the most important aspects on which they should seek help from independent external consultants.
Analyse the risk
The function of the NYSE is, as The Economist put it, “more like regulator than private business”. Yet the board had apparently “focused largely on expanding its businesses and retaining its top executives and less on its performance as front-line regulator of the securities industry and enforcer of standards on its 2800 listed companies”. Grasso had been given the mandate to “expand the business” for NYSE, which it seems he did, very successfully.
However the risks attached to such strategy were not in any way akin to those borne by, for example, the CEOs of the large financial institutions to whom he was being compared. Those organisations are subject to the vagaries of market forces which influenced negatively the pay packages of many of their chief executives at period when the NYSE’s operations remained relatively unaffected. “[Mr Grasso’s] annual pay rose to peak of US$31 million in 2001 – including US$5 million bonus for his handling of the reopening of the market after September 11 – sum that was double what most of Wall Street chief executives received that year and large multiple of what regulators typically earn,” said the New York Times.
Not only was Grasso’s pay package structured so as to be relatively immune to external economic fluctuations, the elements of the package were also essentially risk-free. As The Economist reported: “… Mr Grasso’s pay does not seem to have had any element of risk attached to it. His pay was in cash, while many Wall Street executives are paid in stock.”
Matching stakeholder risk with CEO’s risk is the most important – and difficult – aspect of remuneration policy. It doesn’t, however, mean boards should encourage ultra-conservative behaviour. There is nothing wrong with incentives that encourage CEOs to take risks. senior executive recruiter, Peter Van de Velde, recently told the Australian Institute of Directors: “My concern is that the growing preoccupation of contracts and disclosure can have what is probably an unintended consequence of discouraging risk-taking by our corporate leaders.”
Executive compensation plans should align managers to the long-term interests of shareholders. Performance pay should reward executives for meeting specific, demanding targets set by the board and, conversely, should penalise executives for failing to meet those targets. But it is important to make the distinction between taking acceptable