Boardrooms failing to deliver value for shareholders

Serious Money: Directors of some high-profile public companies are coming under scrutiny this proxy season. Shareholder advocates say it's about time.

The meeting of JPMorgan Chase shareholders next week is a case in point. Directors on that board are under fire for not monitoring the bank’s risk management, a failure highlighted by last year’s $6 billion trading loss in the company’s chief investment office. Shareholder advisory firms have recommended voting against some of the directors on the risk policy committee and audit committee, so it will be interesting to see what kind of support those board members have.

The risk-management fiasco at JPMorgan was an obvious failing, but directors of public companies often let down their outside shareholders in ways that are more subtle, but equally important, say some experts on public company board practices.

Directors commonly neglect chief executive succession planning and inadequately analyse company performance as it relates to managers’ pay.

Paul Hodgson, principal at BHJ Partners, a corporate governance consulting firm, said he believed chief executive succession planning was one of the signal tasks of a director and one at which most of them continued to fall short.

Badly executed
"JC Penney is the most recent example, but there are countless others," said Hodgson, referring to the recent ousting of Ron Johnson, who came to Penney with great fanfare from Apple.

“Hiring an outside CEO costs between three and five times the amount it does to promote an existing manager, so boards are failing in their fiduciary duty and wasting shareholders’ money by not having a properly functioning succession plan in place,” Hodgson said.

Another board duty that is basic but often badly executed involves how a company's performance is measured for pay purposes. Mark Van Clieaf, managing director at MVC Associates International, an organisation consulting firm, said he believed boards were stuck in a groove that was dangerous for shareholders. The measures most directors use to assess corporate performance, he contends, are too focused on earnings growth and often do not weigh a company's return on assets, equity or invested capital.

Return on invested capital is a preferred method to measure the creation or destruction of shareholder value, Van Clieaf said, because it reveals how effective a company is using its money to generate returns. If boards ignore this measure when setting pay, executives could be rewarded even when their companies’ financing costs exceed the returns on their investments. No company can survive in that circumstance for long.

Equally troubling is the board practice of rewarding executives for short-term performance when the risks in their businesses take much longer to play out. The rewards handed over to senior bank executives in the years leading up to the financial crisis, for example, show how unbalanced many companies’ incentive plans are.

Credit debacle
Consider the mortgage business. It typically takes as long as five years for problems, such as payment defaults, to show up in home loans. Yet most financial companies paid those top executives for performance periods significantly shorter than that.

Back in 2009, responding to the credit debacle, the Financial Stability Board, a group of international regulators and standard setters, published a policy paper recommending principles for sound compensation practices among financial companies. The board said a "substantial portion of variable compensation, such as 40 to 60 per cent," should be deferred over a period of no less than three years. And in 2008, the Institute of International Finance, a global financial industry group, suggested that a sizable portion of executives' bonuses be deferred over five years.

Both were good ideas, Van Clieaf said, that have gone largely unheeded. In 2010 he looked at compensation packages at the 18 largest US banks. “For the 90 named officers of those banks,” he said, “the average performance period was 2.2 years.”

Van Clieaf has not analysed these institutions since 2010, but said other analyses indicated performance periods at most big banks might have stretched to three years, on average. Even that needs to be lengthened, he said.

This short-term orientation on executive pay extends well beyond the financial industry. Last year, Van Clieaf examined performance periods and metrics among roughly 250 large corporations. He found that less than 4 per cent had both a balance-sheet oriented metric, like return on capital, equity or assets, and a performance period longer than four years.

He blames corporate directors but also their advisers and the shareholders who rubber-stamp the misaligned pay practices.“This is a failure to create metrics, performance periods and incentives that are truly strategic for long-term shareholders,” Van Clieaf said. – New York Times