November 2007 – Executives-paying for failure

You are chairing the board of a big company and, for whatever reason you need to go outside to fill the role of chief executive.

The headhunters have done their job, you are down to a shortlist of one and there is not much left to do other than settle the package with the candidate’s lawyers. Is there an argument, at this stage, for considering the consequences of failure?

This hardly ever happens. By the time a headhunted individual has reached the finishing straight for the role of chief executive in a big company, the psychological state of the recruiting board has shifted.

This is the stage that the prospective chief executive’s lawyers can lay down their demands and ask for the Earth. One of the first things they do is attempt to secure a lucrative exit package because, even if the recruiting board is naïve enough to ignore the possibility of failure, the contract lawyers would be in dereliction of their duty in making the same omission.

When corporate horizons are as short as they are, clauses dealing with “tomorrow money” are easily inserted. The chairman, indeed, may be looking to retirement just a year or two down the line. Besides, few of those present within the recruiting company will want to present themselves as killjoys or doom-mongers. Companies rarely welcome pessimism.

It is only when the unthinkable happens that those cleverly-inserted severance clauses will come back to haunt a company. These are the sort of arrangements that allowed Bob Nardelli to leave his chief executive job at Home Depot in January – after failing to live up to shareholder expectations - with a pay-off worth $210m.

More recently we have witnessed the departure of Stan O’Neal as head of Merrill Lynch, after the bank lost nearly 8$bn in mortgage-related losses. Merrill Lynch provided Mr O’Neal with a leaving package of $160m, dressing up his removal as a retirement. In doing so the company avoided a legal tussle over his severance entitlements.

It might be right, when the stakes are so high for those taking top jobs, that there should be some compensation for failure, but should there be limits on such payouts?

I raised the issue last week with Mark Hoble, a specialist in senior executive pay at Mercer, the human resources consultants. Mr Hoble was speaking at Mercer’s European member conference in Lisbon.

He suggested that it might not be a bad thing for companies to contemplate the possible downside of an appointment at the time of recruitment. “In reality people don’t want to think about the possibility of failure at that stage. But the lawyers do,” he said.

One possibility may be for companies to look at introducing private-equity style arrangements when recruiting top executives. The packages in these ventures are often weighted heavily towards share options that can bring big rewards if value is added for a profitable sale two or three years later. An executive who grows the equity value is rewarded by sharing the winnings with the other investors.

Some of these packages, says Mr Hoble, require a co-investment in equity by the appointed executive to encourage owner-like behaviour with the accompanying downside risk.

My own feeling is that the potential of high rewards should be accompanied by some element of risk. Too many executive packages in the past have resembled a one-way bet.

It is almost as if elevation to the senior executive cadre is the equivalent to winning the game of life, after which you gain membership to an exclusive club where failure constitutes bad luck and success, a reflection of your talents (rather than good fortune).

The media is sometimes criticised for highlighting so-called “fat cat” pay deals enjoyed by some top executives. Often, however, such headlines are in response to complaints among shareholders and, in some of the most recent cases, they have been generated by concerns over what appeared to be rewards for failure.

The pay and retirement package prepared for Hank McKinnell, chairman and chief executive of Pfizer, for example, came under close shareholder scrutiny ahead of his premature departure in July 2006. Some shareholders thought the package – worth about $6.5m a year for life – did not reflect the company’s unspectacular performance under his stewardship.

Whatever the sentiments of the a shareholders, complaining after the horse has bolted or is half-way to the knacker’s yard, is not going to alter a tightly-worded executive pay contract. The only way to exert any realistic pressure is to make representations ahead of the next appointment and it is difficult to do so when you are not a party to the arrangements.

The board of Chrysler, however, does appear to have been alert to the possibility of failure in its appointment of Mr Nardelli as chief executive and chairman in August. It set his base pay at $1. Mr Nardelli - who hardly needs the cash - would not disclose details except to say that his success was “rooted in the success of the company.”

This points to a package that is wholly incentive-led where Mr Nardelli has bet his talents on raising the fortunes of the company and its share price.

It’s difficult to quibble with this. Even though his pay off at Home Depot might have been interpreted by the company’s shareholders as a reward for failure, in that case the company’s investors did seem to have an unrealistic view of the company’s growth prospects.

A period of consolidation for Home Depot seemed prudent but prudence does not count for much among investors who have grown accustomed to annual double-digit growth. Neither did it count for much among those banks that allowed themselves to become heavily exposed to sub-prime mortgage lending.

But prudence might well be a quality worth nurturing in boardroom recruitment. It will not rid the market of compensation payments for failure but it might bring some transparency to the long term risks.

Football clubs live with this all the time. Managers are hired in the knowledge that their tenure might be cut short by a string of poor results. The sensible ones have the cushion of a lucrative contract and a good prospect of another job in an industry that takes a realistic view of failure. It happens to some of the best of them.

One other thing mentioned during the Mercer conference that could be worth considering, is the role of corporate governance guidelines in shaping executive pay arrangements. Just as governance codes influenced the length of executive contracts, perhaps also they could be brought to influence the size of severance packages for those who have presided over a corporate debacle.

Maybe I could be accused of old fashioned thinking here, but shouldn’t losers lose?

See also: A case for paying chief executives less