06/14/2012 05:21 pm ET Updated Aug 14, 2012

Executive Pay: Audit Needed

Like many before it, this spring has seen a high level of outrage over the executive compensation payouts in some large corporations. Among companies that have been the target of corporate governance activists this spring are Citigroup, Barclays, and Chesapeake Energy.

The debate over what to do about excessive and inappropriate executive compensation has been going on for decades. A few steps have been taken to correct the inappropriate compensation levels that are revealed every spring. The most visible recent step is the mandating of shareholder votes on executive compensation packages. In the United States, they are required, but the result is not binding. Only in a few European countries -- the Netherlands, Norway, and Sweden -- are they binding. EU regulators are now pushing for binding investor votes on executive pay.

The expectation is that binding votes will cause corporations to be more conservative with respect to the total amount they pay their executives and that their pay will be more driven by corporate performance. There is some reason to believe that this is true, but binding votes will not make fundamental changes in compensation practice unless shareholders make active, informed use of their votes. In other words, shareholders must actively consider the compensation plans of their companies and cast informed votes on them.

Executive compensation is an extremely technical and complex issue. To say the least, it is hard for shareholders to cast informed votes based on the information they typically get. Although most large investment funds have the knowledge to evaluate executive pay plans, many shareholders do not. All they see is the total compensation of executives and the financial performance of the company. Based on this, they are outraged, delighted, or as is most commonly true, oblivious to the executive compensation practices and policies of their company. This leads me to the point that even instituting binding votes will not be necessarily effective in improving executive compensation. Something more is needed.

I believe a mandatory audit program is the best way to improve the quality of executive compensation pay practices. The annual audit program should include a report to the shareholders on whether they should or should not vote in favor of the executive compensation amounts and practices of their company.

The compensation audit would be conducted by independent firms that have the same type of role that public accounting firms have with respect to the reporting of corporate financial results. Their audit would be based on an analysis of the executive compensation programs, policies, and amounts that corporations report. It would require corporations to develop a statement of objectives for their executive compensation program. The statement would include the types of performance it is expected to motivate and the market position it is trying to achieve for executive pay. The audit firm would then look at the actual plan and determine how well it fits the objectives laid out for it by the Board.

If the audit firm determines that the plan does not have a structure and payouts that are consistent with the objectives stated by the Board, they would issue a noncompliance report to be distributed to the shareholders. In addition to providing boards with expert guidance, the audit process will be a powerful motivator of restraint with respect to compensation amounts. It will also put pressure on the Board to analyze the impact of their company's executive compensation practices. It should force Boards to think through the objectives and the positioning of their company's executive compensation plan. Further knowing that the opinion of the audit firm will go to the shareholders, it should motivate the Board to pay particular attention to the credibility of the plan. An audit will also provide the shareholders with the information they need to make an informed vote on the executive compensation programs of their company.

At the present time, I am not aware of any group calling for executive compensation audits to occur and, of course, they are only likely to become a much needed addition to the corporate governance framework and practices if shareholders begin to call for them. This year's executive compensation Arab Spring has shown that there is a need for change and that shareholders are increasingly unhappy with executive compensation practices. Hopefully this will lead to shareholder groups looking beyond binding votes for ways to improve executive compensation.

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