What links excessive CEO pay packages with the shabby (and sometimes illegal) way that some mutual-fund companies have treated investors? Answer: both involve flaws in the way boards of directors work, flaws that aren’t likely to be fixed by the much-hyped drive to clean up corporate America.
It’s the old problem of too many lawyers, too many rules, not enough common sense. Instead of simply making it clear that corporate and mutual-fund boards should do the right thing–reining in CEO compensation and policing fund-management practices–we’re focusing on whether board chairmen and a majority of directors are “independent,” meaning that they do little or no business with the company other than accepting directors’ fees and perks. The idea is that if we install enough independent directors, the market system will solve the problem.
But markets need good information–and the right structure–to function properly. And there are big information and structural problems when it comes to determining what CEOs get paid and explaining the process to shareholders.
Lots of companies, especially big ones, use compensation consultants. That makes sense; it’s a complicated business. Reforms now require that the consultant be hired by the board’s compensation committee rather than the CEO. But that doesn’t solve a fundamental problem: that consultants advising on the CEO’s pay often do (or hope to do) other, far more lucrative work for the company. Who hires the consulting firm for that? You got it, the CEO.
Hmmmm. See a problem here? It’s the same problem accounting firms used to have when they did tons of highly profitable consulting for audit clients. That problem, you may recall, was that accountants might give their blessing to financial shenanigans for fear of losing consulting business. (The fact that board audit committees rather than the CEO hired the auditors didn’t help much, did it?) We’ve now got strict rules to handle the auditing- consulting conflict.
I assume most consultants are upright, just as I assume most accountants are. But it’s asking an awful lot for someone to take a dispassionate look at the compensation of a CEO who can hand him big contracts. One obvious solution: let boards hire consultants who will do no business with the company other than determining the packages of the CEO and a few other top execs. Or else do what Dick Wagner of Strategic Compensation Research Associates suggests: let the board hire its own consultant for a second opinion on top execs’ packages. I’m not saying that we need a law requiring this–we’re already lawyered to the eyeballs. It’s something we should just expect. And disclose everything, simply and clearly, to investors. Let the market decide. It just seems common-sensical.
That brings us to the structure of mutual funds, which is anything but commonsensical. Funds have boards of directors whose major duties include hiring the company that manages the fund’s investment portfolio. Maybe this made sense when there were only a few funds around. But now you’ve got fund families with hundreds of funds and the same directors sit on almost all of them, knocking down a couple of hundred grand a year in total. These directors are picked by the fund-management companies, and almost never put the fund-management contract up for bids or force the management companies to charge the fund the same, lower rates they charge for managing portfolios for pension funds and other large investors.
The current fund scandal shows how virtually useless fund boards of directors are. When the news broke that some funds had been systematically abused by fund managers–the Strong and Putnam funds come to mind–I expected at least one board to promptly announce that it would begin hunting for alternative managers. It didn’t happen. I should have known better.
When I shop for a mutual fund, I shop for a manager, not a board. I can’t imagine anyone who shops for fund boards. Let’s eliminate the boards, end the charade and let managers deal with investors directly. That may not solve the problem of excessive fees and costs and bad managers–but they won’t have the fig leaf of board approval to hide behind.
So instead of worrying about what makes directors “independent,” I’d rather worry about what makes them effective. Granted, executive-pay season would be lots less fun that way, and I’d have fewer mutual-fund scandals to write about. But that’s a sacrifice I’m willing to make.
