DATELINE: April 5, 2009, Chicago
Over the last eight months we have watched closely the developments that keep rocking our financial system and Corporate America. We have been fascinated by the one-sided debate over executive compensation. We were particularly impressed by the letter in the New York Times from Jake DeSantis, an AIG executive vice-president, who tendered his resignation and committed to give his bonus to charity. It wasn’t the gesture toward charity that impressed us. It was the fact that...
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this gentleman had nothing to do with the losses that brought AIG to its knees. Why should he have given up his bonus?
For weeks, we had been positing the following scenario: A company losses $20 billion, but one employee, who worked very hard, was responsible for generating $10 billion of profits, which kept the $20 billion loss from being a $30 billion loss. We would have happily paid that employee a bonus. In short, most of the criticism has come from people who believe everyone should make the same amount of money. We see that sort of stupid thinking all the time in the nonprofit sector.
Today Heather Landy of the Times finally raises the critical question: Where were the boards of directors? Executives Took, but Directors Gave. Unfortunately Landy continues to focus largely on the amount of the compensation paid to the executives at those companies that have taken TARP money. The issue is how compensation is structured, not the size of the compensation. This point was made abundantly clear by William D Cohan, in an interview we recently saw on a news program. Cohan, the author of House of Cards: A Tale of Hubris and Wretched Excess on Wall Street, argues persuasively that Bear Stearns collapsed because the interests of the employees were not properly aligned with the interests of the shareholders. By levering the company, senior management could generate the huge returns that would justify ever-higher compensation. Unfortunately, they were using the house’s (shareholders) money to finance the bet. If the bets turned out to be bad ones, there were no meaningful consequences to senior management. After all, they had contracts that provided them with lucrative compensation on the way out the door. In short, Bear Stearns was a heads I win, tails you lose situation.
The Bear Stearns board was supposed to be representing the shareholders’ interests. The failure of many corporate boards to do that is why the United States finds itself in the predicament that currently faces it. Landy points out how it is virtually impossible to successfully sue board members because of the business judgment. She also points out that boards are often too close to management. In many cases, management is responsible the list of board nominees. Finally, Landy talks about shareholder apathy and the failure to vote proxies. That is troubling, but to be expected given the ability of managements to put their hands on the scales.
Landy doesn’t, but her article calls for more tension in the relationship between the board and management. It also points out that setting compensation is about more than determining amount. Compensation must be structured so that the interests of management and the employees are aligned with the interest of the corporation’s shareholders. To do that properly, the board must understand organizational risks and the management of those risks. It is obvious to us that the AIG board had no idea about the incredible exposure that AIG’s London-based unit was creating by writing what were an unlimited number of credit default swap contracts. That is the iceberg that ripped a hole in the Titanic and sent AIG to the bottom of the sea.
At least in the case for-profits, the shareholders serve as the ultimate backstop. If things get bad enough, they can remove the board and reign in management. Although that is a solution, in fast-paced times, it may not be an effective one. Moreover, managements tend to lie to the marketplace, withholding the bad news for as long as the lawyers advise that management can hide information without violating the securities laws.
Now let’s consider nonprofits. The boards are even more important because there are no shareholders to backstop the board. The board is the sole check on management. If the board abdicates it duties or is captive to management, there is no oversight. Nobody is making sure that management’s interests are properly aligned with the organization’s mission. Nobody is examining organizational risks and making sure that they are properly controlled.
The naïve do-gooders who bemoan the size of nonprofit compensation packages have the wrong focus. If they truly believe compensation is too high and can make a rationale case that it is too high, the do-gooders should ask where is the board rather than why is compensation too high? The more pertinent question is whether the level of compensation and the payment terms properly align the recipient’s interests with the organization’s mission.
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