Directors compensation as rent payment

Written by YRK Reddy | Updated: May 12 2007, 05:30am hrs
There was a caustic remark made the other day at a meet of institutional investors on corporate governancethat in India, rules get framed more by interests than principles. Thus, one will be hard put to find another country that deems nominees of financial institutions as independent directors. In most mature economies, they are indeed either prevented by convention or prohibited by regulation from joining the boards of their corporate clients. It is believed that providers of finance must invent their own ways of reporting, disclosure, rating and monitoring to safeguard their moniesit is unwise to sit on the boards and be party to potential defaults, omissions and commissions of the client. We now have a curious case of stock options and their exercise by nominee directors who are also full-time employees of financial institutions but deemed independent. The issue is in the courts.

The accepted international norm is to award stock options only to executive directors. Even in exceptions, the preference is to grant stock at market value than concessional options, and have them vested after some years on demitting office. The logic is to prevent potential self-dealing, manipulation and insider trading. In the rare cases of salaried nominees from institutions or government, the individuals are required to decline all directorship compensation or remit such income as directed by their employer. But then our in-landish practices have their own assertions, which will hopefully emerge as the case progresses in the courts.

The level of compensation for directors is another issue. In the case of managers, when the market gets distorted by competition for talent or irrational largesse, compensation could easily go beyond the economic value of outputor of the truly added competitive advantage. Theoretically, that becomes rent.

Many of our boards do not appoint directors on the basis of pre-set competence requirements and competition. Formal contracts and evaluation systems of performance are rare. In such conditions, most director compensation is indeed rent. This has adverse dynamics that destroy value. Rent conditions become noticeable, as I see it, if the compensation exceeds about one-tenths or so of the average income of the individual from other professional and non-directorial sources.

But then, the justification, mostly from well-compensated directors, is that low compensation creates conditions for adverse selection. Of course, this is very unfair to some eminent people on public enterprise boards who accept directorships mostly as a matter of duty to the country. That exception aside, the belief system and the oft-quoted saying is that if you pay peanuts, you get monkeys.

When the market gets distorted by competition for talent or irrational largesse, compensation could go beyond the economic value of outputor of the truly added competitive advantage. Theoretically, that becomes rent
That sounds right. But the answer does not lie in rents. Or, to stretch the satirical argument, if you offer caviar instead of peanuts, you might get the same monkeys (if not other carnivores), only more spoilt by privilege. Peanut-happy-monkeys addicted to caviar can be exceptionally troublesome, because they would never want to quit the board. How many times would one want them to sing paeans, giggle at the right moment, growl at a hint and clap loud One cannot shoo them away as they resent it muchand might bite hard.

In the end, the choice for the firm in choosing and compensating independent directorswhichever way definedis threefold. One is to select fit, proper and competent directors objectively from a wide range of upright people, and at an economically justifiable cost. Dedication to principle is the key, and this is a workable idea as long as the company is not up to mischief.

The second is to pay peanuts, and expect that they will be lured away for peanuts as well. The third is to pay caviar (that is, suffer rents) and bear the unjustifiable costs and attendant risks of entrenched interests. Having been a director for long, I know that being a peanut-eating-monkey (or a top dog or watchdog, if you will) was indeed very satisfyingbut many say caviar tastes better.