How should corporate directors be compensated?

• Author: Carey, Dennis C.
• Position: Special Report

Early in this century, a director of a company could expect, at most, to collect a gold coin (worth maybe $20) for fulfilling his board duties. Just 90 or so years later, his modern counterpart likely earns anywhere from $40,000 or $70,000 annually in cash, supplemented, typically, by a package of retirement and other employee-type benefits.

This dramatic shift in compensation for boards of directors has less to do with eight decades of inflation than with changes in the focus of the director's job. Historically, directors served on boards for very compelling personal reasons: to protect their own, typically large, financial investment in the company. Modern-day directors, by contrast, serve for other reasons, as we will discuss, and usually don't have a large personal financial stake in the company.

The contrast is instructive because it goes to the core of the current debate about directors' compensation: Can directors adequately protect the interests of a group to which they don't have a strong economic connection? Can they make appropriate financial decisions on behalf of shareholders when their own financial package has little, if any, relation to company performance? Would they be more zealous in their efforts if they had more of their own money at stake - as their forebears did?

Whatever directors themselves may feel about these questions, most institutional shareholders, among others, have few doubts about the importance of equity ownership for directors. Increasingly, in fact, major shareholders and shareholder groups are questioning the whole structure of directors' pay - much as they earlier questioned the "how" of executive pay. In both cases, they want to be sure that compensation is driving appropriate decisions and actions; that their not inconsiderable "investment" in pay yields a clear return in the form of increasing stock value.

The subject has already generated much controversy as the various interested parties debate the particulars. Should directors receive retirement income? Should benefits of any kind be part of the package? Should shareholders essentially "fund" donations to directors' favored charities? How much stock should directors own?

Important as these questions are, they are ultimately offshoots of a broader, more critical issue: What is the most appropriate mix of compensation for outside directors, given their unique role and obligations? Or, put another way, what kind of actions and behavior do shareholders want, and what is the best way to encourage that behavior?

Zeroing in on specifics - like retirement benefits, for instance - before addressing the larger issue is like choosing a window style for a house before it has been designed. It is necessary to first define the shape and function of the director's role, and then determine the combination of pay delivery mechanisms that best fit the role. The place to begin, appropriately enough, is with a bit of historical perspective.

Back to the Future

There is some irony in the fact that the future of directors' pay will no doubt look a lot more like the past: universally high equity ownership. In the earliest days of the industrial age, when virtually all companies were closely held by a small or extended family, directors were major stockholders. They took the "job" not to earn a paycheck, but to protect and enhance the value of their investment. As an 1846 book entitled A Treatise on the Law of Private Corporations Aggregate noted, "Directors of corporations...are not usually compensated for their ordinary services as directors." This was because directors were not "servants of the company" (i.e., employees) and, hence, not entitled to remuneration for services in that capacity. This view was firmly entrenched in eighteenth century common law, which clearly presumed that directors could not legally compensate themselves. The only monetary nod to the time that directors spent in this role was the placement of that aforementioned coin - generally, a gold double eagle - in front of their seats at board meetings.

This state of affairs continued throughout the first few decades of this century. In a 1926 case, Lofland v. Caball, for instance, the court held that directors had no right to compensation for services provided in the course of their duties as directors, unless authorized by the company's stockholders or bylaws. But the case also opened the door a crack in noting that services provided outside the scope of those regular duties might be compensable.

The first major shift in thinking about pay for directors occurred in the 1930s and 1940s when the large, modern public corporation came into being. As ownership of corporations moved outside family circles, there was a clear schism between ownership and control. Ownership broadened out to include a vast public and with that, control was given over to professional managers and professional directors. These individuals no longer represented only their own personal interests. In fact, as noted, many had no personal financial interest in the company. Consequently, they had to be paid for their time and effort, as well as the risk they bore in serving in a fiduciary role.

Modern Times

The so-called "professional" board had a clear, if loosely defined, mandate under state corporate laws: to "manage the business and affairs of a corporation" (Model Business Corporation Act, 1969 revision). Generally, of course, "management" in this context referred to oversight, not active, day-to-day involvement in the business. Nonetheless, director responsibilities typically included (and still include) such significant and varied activities as:

* reviewing and approving, and sometimes developing, objectives, strategies and plans

* counselling senior management

* ensuring compliance with applicable laws and regulations

* selecting and compensating the CEO and other senior executives

* evaluating board processes and performance (in other words, self monitoring).

While directors, like other fiduciaries of a corporation (e.g., trustees), are liable to shareholders for their actions, corporate law gives them significant latitude in deciding how best to meet their oversight duties. As a practical matter, outside directors generally are protected from liability as long as they can demonstrate that their actions meet the following two obligations:

Duty of Loyalty, which prohibits directors from making decisions that benefit them a the expense of the corporation; and

Duty of Care, which requires directors to make business judgments prudently, in good faith and in the honest belief that a decision is in the corporation's best interests.

As corporations grew more complex and directors' professional duties broadened, the law brought affirmation of directors' right to compensation. The Model Business Corporation Act, first promulgated in 1950 and revised many times since, not only explicitly sanctioned pay for directors in its earlier version, but gave them the right to set their own pay. As stated in the 1969 version of the Act, for instance, "The board of directors shall have authority to fix the compensation of directors unless otherwise provided in the articles of incorporation." This explicit right to set their own pay was necessary to address the issue of "self-dealing," which prohibits corporate officers or fiduciaries from giving themselves a benefit not available to other shareholders.

Throughout the 1960s, virtually all states changed their laws to follow these guidelines, thus making it common practice for directors to determine their own pay. The possible conflict of interest implicit in this arrangement was thought to be mitigated by the duty of care, requiring, among other things, good faith decisionmaking in the best interests of the company. Compensation deemed excessive could be seen as in conflict with that legal obligation, exposing a director to a possible lawsuit.

Paying directors became the norm during the 1960s, and typically took the form of cash payments of $10,000 a year or less. This was deemed sufficient to recruit and retain qualified professional directors. During the 1970s, however, director liability became more of an issue, with shareholders bringing suit in a number of instances where they believed directors had not acted in their best interests. The upshot not only was the creation of director and officer (D&O) insurance, but also somewhat larger pay packages to compensate for the increased risk of legal challenge.

Still, even as recently as 15 years ago, directors generally received only a cash retainer and meeting fees. In 1981, according to Towers Perrin data, the median retainer for outside directors at America's largest companies - in the Fortune 100 - was $15,000, and the median payment for attending board or committee meetings was $500. More interestingly, only a very small number of these companies provided employee,type benefits such as retirement arrangements or life insurance. In fact, the only non-cash arrangement offered with any frequency was the opportunity to defer compensation on a tax-favored basis (reported by 38% of Fortune 100 companies in 1981). And given the high marginal tax rates at the time, this was far more likely a move to provide tax-effective compensation than to allow directors to accumulate retirement income.

The Roaring '80s

The 1980s brought the first really significant shifts in pay for outside directors. The reason, largely, was that the job got tougher - and riskier - and companies perceived they needed a more attractive package of inducements to bring the best people on board.

Until the mid '80s, there had been few successful challenges to director decisionmaking that alleged violations of the duty of care requirement. The standard proved relatively easy to satisfy, and since bad decisions made in "good faith" did not appear to be legally actionable, few...