Executive compensation plays a central role in corporate governance, the agency theory, and the relationships between investors, Boards, and management:
Boards, by designing and approving the CEO’s pay, are able to ensure the CEO acts in line with the strategic orientations set by Boards. Effective Board oversight of executive remuneration should therefore contribute to address the information asymmetry between Boards and management.
Similarly, investors outside the Boardroom lack access to inside information, but have a financial interest to ensure that Boards and management teams act in the company’s long-term interest. Therefore, they can leverage on executive remuneration disclosure to anticipate potential future management behaviours (e.g. by looking at which performance metrics the Board is focusing on in the design of a variable plan), but also gauge the dynamics between Boards and management.
Because of the role played by executive compensation, the way it is set and structured may signal a potential imbalance of powers between the Board and the CEO, which could be the early sign of a governance issue. For instance:
Excessive remuneration: cases when remuneration is repeatedly and significantly increased year after year, one-off cash awards and other retention plans, or golden parachute and large severance agreements (making the CEO’s revocation costly), while sometimes justified and well explained, could also in some cases reflect the CEO’s high bargaining power and level of influence over the Board.
Insufficiently stringent performance targets: for instance, bonuses showing little variability over the years regardless of the company’s performance, minimum performance thresholds or targets set well below market guidance, can lead investors to question why Boards are accepting payouts to the CEO even when the targets they set are not achieved.
Poor Board accountability: repeated and significant shareholder dissent on remuneration proposals without any visible reaction from Boards, high turnover within the Remuneration Committee, or low tenure of non-executive directors compared to the CEO could affect the level of Board accountability on remuneration issues, and may be signs that Boards are not acting as stewards of shareholders’ interests, but rather are under the sway of the CEO.
These examples demonstrate how it can be beneficial for investors to closely examine how executive remuneration is set and structured, as it may reveal broader issues related to Board functioning and the Board’s ability to independently and effectively oversee management.
An in-depth analysis of the structure, process, and governance around executive compensation may actually help investors undercover the potential signs of a weak Board.