Director Pay: In Search Of Rationale

Written by YRK Reddy | Updated: May 17 2004, 05:30am hrs
The assumption behind a good compensation design is that it attracts, retains and motivates appropriate talent to yield cost-effective and competitive performance. There are broad principles such as internal and external equity and scientifically structured variable pay that are important in designing compensation. These principles which are important for managers cannot be practised in the case of directors, as there are infirmities in their structures and motivational dynamics.

Unlike managers who come as one class with a similar type of employment contract, directors are a portfolio. They may be a bunch of non-executive directors (NEDs) representing the financial institutions, promoters or strategic equity holders; whole time directors; NEDs representing special interest groups either in compliance with law such as in the case of banking, or by convention; or independent directors. Each is a class that is not comparable with the rest.

To the NEDs representing financial institutions, directorship is less material than their contracts of employment, thus making director compensation inconsequential. In any case, most such institutions insist on direct payment to them or decline director compensation. This aggravates the loyalty issue. Though the principle of corporate governance states that directors owe their first duty to the company, in practice they bear upper most in mind, the interests of their constituency or powerful individuals. No wonder that representatives of institutional investors and venture capitalists would be more worried about valuations of their stock and exit strategies than the long-term interests of the company.

A similar situation applies to full-time directors who have employment contracts with the company. The pay, including bonus and incentives, is related to their performance as executives and not as directors. In the process, most working directors do not make a distinction between their duties and responsibilities as directors and their role as executives. This makes the full-time director full of management and little of board.

In the case of NEDs representing promoters, it is assumed that their performance will be guided by enlightened self-interest, of increasing shareholder wealth, which may indeed be convergent with those of all the shareholders. Contrarily, there is a pronounced distortion in the motivational pact of the directors representing special interest groups such as trade unions, small investors or borrowers. While the principle of corporate governance exhorts them to think of the company first, the very motivation behind sectional or special representation is to protect the interest of the constituency.

Thus, eventually, it is left to the independent directors to balance the diversities and bring forth board independence. However, there are increasing doubts on how independent directors can be, especially in view of the dynamics associated with their appointment and compensation. The diversity among independent directors in their background and market worth creates distortions in internal and external equity. While some may be high profile industry leaders, others may be from NGOs or academia. The market worth of such directors would be different from one another. Yet, the compensation in the form of sitting fee, commission on profits, director fee, or stock grants as provided under the law or on obtaining necessary approvals of the shareholders and the Central government, where necessary is invariably the same.

The unstated principle appears to be same class same pay. Unlike most managers, directors dont have any pay for performance. Variance in pay is only in sitting fee, where applicable, as it is linked to attendance. Commission on profits, which in any case is considered free-riding by many, does not differentiate between ones single meeting from anothers eight in the year. Hence, the highest pay becomes the common factor for the members of the Board.

One reason for not varying director remuneration amongst the independent directors is the fear of enhanced liability commensurate with higher fee. Consequently, the international practice also is to make the fee common to all NEDs and compensate additionally the independent Chair or Chairs of committees and other committee work.

Because of the need for parity, some directors may end up getting paid more than what they are worth in terms of their market value or contribution in the board. If an independent director is overpaid, the conditions would be right for cronyism. Also, as most companies do not undertake director and chairman evaluation, linking compensation with performance will never arise. Thus, the principles of internal equity, external equity as well as pay for performance get undermined in many ways.

Compensation under these circumstances is no different from cattle grazing. One has to be on the right spot to graze well such grazing has little to do with ones size or the amount of milk one can produce!

The author can be reached at yrk@yagaconsulting.com