In the search for culprits in the global financial meltdown, bloated executive pay and the excessive risk-taking behavior it fueled stand out as prime suspects. Of the two, pay dominates the headlines and provokes the most public and political outrage.

Pitchfork populism over the issue reached a crescendo last March when insurance conglomerate AIG, kept on life support with up to $183 billion in taxpayers’ cash, dished out bonuses totaling $165 million to 400 employees in the London office whose derivatives trading nearly destroyed the company. Lavish pay for poor performance wasn’t just an AIG phenomenon. On Wall Street, it was endemic. Bankers gave themselves nearly $20 billion in 2008 bonuses, even as the economy was spiraling downward and the government was spending billions on bailouts.

Politicians pounced. President Obama called Wall Street’s outsize pay packages “shameful,” especially for companies in need of federal bailouts. Such pay, he said, is “exactly the kind of disregard for the costs and consequences of their actions that brought about this crisis — a culture of narrow self-interest and short-term gain at the expense of everything else.”

That culture, critics maintain, spawned executive compensation plans with incentives that encouraged the excessive risk-taking that led to the financial crisis. And while the intricate details of pay plans don’t evoke the outrage of multimillion-dollar paydays, curbing the risk-taking incentives embedded in those plans is key to resolving the current crisis and preventing another. That task falls, by law, to corporate boards, clubby groups that are widely criticized as the handpicked “captives” of self-serving management.

With White House support, congressional leaders are intent on shifting the balance of power in the boardroom away from management. Senator Chuck Schumer’s (D-NY) Shareholder Bill of Rights Act, introduced May 19, casts shareholders as the antidote to runaway executive compensation and excessive risk-taking. The bill requires public companies to conduct annual, nonbinding votes by shareholders on executive compensation — so-called say on pay; grants substantial shareholders a new right to have their director candidates’ names included on the ballots sent out by the company (dissident shareholders now must send out their own ballots); puts an end to staggered boards at all companies (boards traditionally elect one-third of their members each year); requires that all directors receive a majority of votes cast to be elected; mandates the creation of a board risk committee; and forces companies to split the CEO and board chairman positions.

“The leadership at some of the nation’s most renowned companies took too many risks and too much in salary, while their shareholders had too little say,” said Schumer. “This legislation will give stockholders the ability to apply the emergency brakes the next time the company management appears to be heading off a cliff.”

Concurrent with Schumer’s bill, the SEC voted on May 20 to seek public comment on a proposal to give shareholders the right to place board nominees on the company’s proxy ballot. Said SEC chairman Mary Schapiro: “This would turn what would otherwise be a somewhat illusory shareholder right to nominate directors into something that is real — and has a real chance of holding boards of directors accountable to company owners.”

Major business groups lost no time denouncing the reform measures as vehicles for ceding enormous power to a small number of special-interest investors, namely, unions and public employee pension funds that, not surprisingly, favor the reform measures. “Big labor unions are trying to achieve at the board table what they cannot achieve at the negotiating table, under the guise of shareholder protection,” said David Hirschmann, president and CEO of the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness. The Business Roundtable was no less emphatic. “This is an unprecedented preemption of state corporate law… that will turn boards of more than 15,000 publicly traded companies into political bodies and threaten their ability to function,” said Roundtable president John Castellani.

Skeptics of government intervention are quick to point out that more than two decades of well-meaning attempts to constrain ever-soaring corporate pay and to reform governance through legislation, regulation, and shareholder pressure have, for the most part, failed or even backfired (see chart on facing page).

Nonetheless, the reform debate is fully engaged, and not just inside the Beltway. At HBS, a group of MBAs last spring crafted and sent to Washington a bold proposal to create an nonprofit, public-private Corporate Governance College to employ and train a cadre of professional directors to serve on corporate boards (see sidebar, page 35). And HBS professors, drawing on their areas of expertise, have attempted to influence the debate through opinion pieces in major newspapers.

Writing in the Wall Street Journal, HBS professor Jay Lorsch and coauthors Martin Lipton and Theodore Mirvis — partners of the New York law firm Wachtell, Lipton, Rosen & Katz — characterized Schumer’s bill as a misguided attempt at reform and blamed stockholders, not management, for the fixation on short-term financial results:

“Excessive stockholder power is precisely what caused the short-term fixation that led to the current financial crisis. As stockholder power increased over the last twenty years, our stock markets also became increasingly institutionalized. The real investors are mostly professional money managers who are focused on the short term.

“It is these shareholders who pushed companies to generate returns at levels that were not sustainable. They also made sure high returns were tied to management compensation. The pressure to produce unrealistic profit fueled increased risk-taking. And as the government relaxed checks on excessive risk-taking (or, at a minimum, didn’t respond with increased prudential regulation), stockholder demands for ever higher returns grew still further. It was a vicious cycle....

“The stockholder-centric view of the current Schumer bill simply cannot be the cure for the disease it spawned.”

Rather than address specific policy proposals, HBS professor Rakesh Khurana, who has written extensively on leadership, sees a problem with the larger system within which boards and executives function. Writing in the Washington Post, he and Andy Zelleke (PhDOB ’03), a lecturer in public policy at Harvard’s Kennedy School, argue for serious corporate soul-searching:

“As a society, we have bought into a system in which we ask little of corporate leaders beyond the aggressive pursuit of short-term self-interest. For two decades, this model has formed the core paradigm taught to our business school students. ‘Shareholder value’ was of utmost importance. Notions of obligation to the society in which the corporation is embedded have been set aside, even mocked. CEOs loved this model, as it provided cover for their pursuit of kingly riches. And the rest of us have accepted it because it appeared, through the workings of the ‘invisible hand,’ to be consistent with a globally competitive economy.

“This system — and the predictably reckless choices made by some of its most powerful players — has brought our economy to the brink of collapse. To scold business may feel good and may even help move legislation along. But we need much more than a good scolding and limits on sky-high paydays. We need to rethink how American business ought to be run, including changes to fiduciary duties, legal liability, takeover rules, and business education, among many other areas.”

Lorsch and Khurana will air their views in more detail to an academic audience this month when they and Professor Brian Hall, a sought-after expert in executive pay packages, convene a one-day, on-campus conference, “Executive Compensation: Broadening the Debate.” As co-organizers, each brings a different perspective to the search for answers about the past and future of executive compensation and corporate governance. In recent conversations, they reflected on key issues. Edited excerpts follow.

Brian Hall focuses his teaching and research on performance management and incentive systems. He has provided expert testimony on performance pay before the U.S. Senate and served as a consultant to many international companies.

The issue of to what extent the financial crisis was driven by misaligned pay incentives is one of the major concerns that spurred us to organize the conference. I don’t think it’s a given that executive pay practices really had a role in creating the financial crisis. In some ways, executive compensation practices were supposed to be a remedy for what happened. Long-term stockholding is something that really should cause executives to have a longer horizon, not a shorter one.

Having said that, we need to unpack pay issues to understand why, for example, many of the executives on Wall Street were given such large bonuses for one year’s performance. That’s a practice that needs to be examined.

Creating a rule in 1993 that limited the tax deductibility of executive pay to $1 million, unless the pay is perfor-mance-related, did more harm than good. It caused companies to come up with sham performance criteria that work on paper but really are not pay for performance.

I automatically advise any board I work with to make clawbacks a part of their compensation plan. Why wouldn’t you want clawbacks if it turns out that you’ve paid for performance based on faulty financial information? Why wouldn’t you want the right to go after that money? This doesn’t mean you don’t trust your top executives. It’s just good sound governance, good sound executive pay practice. It’s not personal.

Expensing options created a level playing field. Before, if you paid somebody in stock options, there was no accounting expense. But if you paid them in stock or anything else, there was an expense. That’s sort of silly. Now all forms of compensation are expensed. And sure enough, just as I predicted, there’s not been a cutback in the amount of equity-based pay, but there’s been a dramatic change in the form of that pay.

The increasing use of restricted stock is a sea change. It’s really dramatic, and it has been happening since 2005 or so when the accounting rules on expensing options changed. Some people predicted that expensing stock options would really cause a huge problem because options were the lifeblood of companies. But if stock options are a good idea, then companies will continue to grant them even if they create an accounting expense. And if they’re a bad idea, well, then they should stop granting them.

Jay Lorsch has written extensively about boards of directors. His book, Pawns or Potentates: The Reality of America’s Corporate Boards, with Elizabeth MacIver (1989), is regarded as a landmark work in the discussion of corporate governance.

I’m not convinced that CEOs are paid too much. That’s part of the reason I want to hold this conference. But I am convinced that most shareholders think CEOs are not paid too much.

In corporate America there is a battle going on for control and power. Over the last two decades or so you’ve seen boards of directors gain more power vis-à-vis managers. The situation has changed in pretty fundamental ways. I know people who are still beating up on boards, saying boards aren’t doing enough. But the reality is that in general boards have gotten a better handle on their companies now than they did when I first started looking at them twenty years ago.

If you look at the typical board of a major public company, you will find that only one or maybe two directors are members of management, and everybody else is “independent.” To argue against independent directors is like arguing against patriotism and apple pie. On the other hand, more and more people are becoming aware that director independence has a downside, something that I’ve been preaching for a long time. Boards look for independent people who by definition are likely to know very little about the company. Nobody is going to stand up and say, “We don’t want independent directors.” Another way to think about it is to ask, do we have the right legal definition of independence? My short answer is no.

Several HBS colleagues and I recently did interviews with 35 directors who are leaders on their boards. We asked, “Tell us what you think needs to happen differently in the boardroom.” One of the things they were most concerned about is their lack of understanding of their company’s business. They cited two reasons. First, there are too many independent directors in the boardroom, and it takes them too long to figure out what the business is all about. Second, there’s a flaw in getting information from management, or maybe management doesn’t understand what’s going on. As a consequence, if management doesn’t understand, the board doesn’t understand.

Rakesh Khurana teaches The Board of Directors and Corporate Governance elective in the MBA Program and is the author of Searching for a Corporate Savior: The Irrational Quest for Charismatic CEOs (2002).

While boards have improved in recent years, the speed at which they were improving lagged behind the speed at which solutions should have been implemented. I’m much more of the view that we need to rethink our corporate governance structure in fundamental ways for the 21st century.

There are three things we have to think about during the conference. First, when did executive pay become unmoored from internal labor market considerations? Executive pay in the postwar period was often based on what the people below you were paid. One consequence of the trend in going outside the company to hire a new CEO was that pay became set across a horizontal spectrum, decoupling it from the internal labor market as well as the specific culture of the firm. Maybe that went out of balance.

Second, we need to reconsider the idea that the CEO is somebody who simply leads an economic entity. We have to think about what it means in the 21st century for businesspeople to see themselves as part of the stewardship and leadership of our society. That’s built into the mission of HBS. It’s not something you do as an afterthought. And it’s not something you do after you retire. It’s part of the job description.

Third, it’s not clear that the current system has produced the type of society that we want. We’ve had dramatic increases in inequality. We’ve had an economic meltdown caused, some people argue, at least in part by faulty pay systems. The fact that we had an economic crisis that brought capitalism to its knees raises fundamental questions about the viability of the system.

Part of a definition of a good society is one in which those who are charged with running its most important institutions are fairly compensated, but in a way that doesn’t reduce the legitimacy and the respect of the institutions they are charged with running. One of the consequences of executive compensation has been a dramatic loss of trust in business. As somebody who loves the free enterprise system, I believe excessive compensation has contributed to lowering the legitimacy of the free market system because it ends up making the system look more like a game than an institution producing goods and services that advance the general social welfare.


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