Henry Mintzberg On Executive Bonuses

It's rare that I read a Wall Street Journal article that is almost completely wrong-headed, but recently, I found one. It was in the November 30th edition's special section, entitled "No More Executive Bonuses!" by Henry Mintzberg. Mr. Mintzberg is a professor at McGill University in Montreal, Canada.

Here's how Mintzberg begins his half-page-plus rant,

"These days, it seems, there is no shortage of recommendations for fixing the way bonuses are paid to executives at big public companies.

Well, I have my own recommendation: Scrap the whole thing. Don't pay any bonuses. Nothing.

This may sound extreme. But when you look at the way the compensation game is played—and the assumptions that are made by those who want to reform it—you can come to no other conclusion. The system simply can't be fixed. Executive bonuses—especially in the form of stock and option grants—represent the most prominent form of legal corruption that has been undermining our large corporations and bringing down the global economy. Get rid of them and we will all be better off for it."

I have a lot of problems with large cash or even equity bonuses awarded for short term performances and, if equity, vesting for sale in only a year or two. But I'd hardly go so far as to eliminate bonuses entirely. And Mintzberg never provides evidence for his claim. None. There's no empirical evidence anywhere in his screed.

His next interesting passage reads,

"First, they play with other people's money—the stockholders', not to mention the livelihoods of their employees and the sustainability of their institutions.

Second, they collect not when they win so much as when it appears that they are winning—because their company's stock price has gone up and their bonuses have kicked in. In such a game, you make sure to have your best cards on the table, while you keep the rest hidden in your hand.

Third, they also collect when they lose—it's called a "golden parachute." Some gamblers.

Fourth, some even collect just for drawing cards—for example, receiving a special bonus when they have signed a merger, before anyone can know if it will work out. Most mergers don't.

And fifth, on top of all this, there are chief executives who collect merely for not leaving the table. This little trick is called a "retention bonus"—being paid for staying in the game."

Mintzberg does a tricky thing here, which is to mix performance bonuses with other types of special payments, such as for exits, mergers, or merely staying. I am with him on eliminating these types of bonuses. But, frankly, that's not what I believe is the major concern of most observers. And retention bonuses are really a non-performance version of performance bonuses, i.e., they are normal annual occurrences.

As for the performance bonuses, the first comment is irrelevant. I honestly don't know what it means for bonuses. But on the second point, I have argued since 1997, in an article I wrote for Russ Reynolds' Directorship Magazine, that the appropriate manner of paying executive bonuses is for them to include the following:

1. Cover a five year period.
2. Be measured as total return.
3. Performance for the period must be above the S&P500 total return.
4. If performance is for a year, then the bonus is to be paid in equity which can't be sold for five more years.
5. If performance is measured for the trailing five years, it may be paid in cash.

By these guidelines, a CEO can't pump the company's performance for just a year or two, collect cash or sell the bonus stock shares, and watch as shareholders experience subsequent negative absolute or, relative to the S&P, total returns as the after effects of his actions become clear.

Mintzberg then lists what he believes are "faulty assumptions" surrounding performance measurement and bonuses,

"But I believe that all these efforts are doomed to fail as well. That's because the system, and any proposals to fix it, must inevitably rest on several faulty assumptions. Specifically:

• A company's health is represented by its financial measures alone—even better, by just the price of its stock.

Come on. Companies are a lot more complicated than that. Their health is significantly represented by what accountants call goodwill, which in its basic sense means a company's intrinsic value beyond its tangible assets: the quality of its brands, its overall reputation in the marketplace, the depth of its culture, the commitment of its people, and so on.

But how to measure such things? Accountants have always had trouble when they have tried, as have stock-market analysts, investors and even potential purchasers of the company. (That's one of the reasons so many mergers fail.) No board of directors is going to have much luck finding that elusive measure, either."

This is just silly. We know that the market value of equity represents the value of a share of a company, as determined by both those wishing to buy or sell the equity. Mintzberg obsesses about book value and accounting issues, but simply ignores the fact that market values just is the current value, in consideration of expectations of future value. And it does, indeed, represent intangibles, in an accounting sense, but valued in dollar terms by the market.

"• Performance measures, whether short or long term, represent the true strength of the company.
For years, the idea was that a company's short-term performance represented its long-term health. The banks and insurance companies have pretty much laid that assumption to rest.

So now there is focus on trying to link bonuses with longer-term measures. Well, I defy anyone to pinpoint and measure such performance in any serious way and attribute it to one or a few executives.

How do you assess the long-term performance of a chief executive? Some proposals look at three years, others as many as 10 years. But can we even be sure of 10 years? Is a decade long enough in the life of a large company, with all its natural momentum? How many years of questionable management did it take to bring General Motors to its knees?"

Again, Mintzberg misses the larger point. CEOs are responsible, accountable and have the authority for resource allocation and performance of the firms they lead. Different boards may choose different timeframes, depending upon their products and markets, over which to measure performance and grant bonuses. But just because Mintzberg can't conclude there is one best timeframe doesn't mean each board can't arrive at a suitable one for their situation.

The best may be the enemy of the good in Mintzberg's eyes, but it need not be for board members.

"• The CEO, with a few other senior executives, is primarily responsible for the company's performance.

What if the CEO was lucky enough to have been in the right place at the right time? When it comes to a company's current performance, history matters, culture matters, markets matter, even weather can matter. How many chief executives have succeeded simply by maneuvering themselves into favorable situations and then hanging on while taking credit for all the success? In something as complex as the contemporary large corporation, how can success over three or even 10 years possibly be attributed to a single individual? Where is teamwork and all that talk about people being "our most important asset?"

More important, should any company even try to attribute success to one person? A robust enterprise is not a collection of "human resources"; it's a community of human beings. All kinds of people are responsible for its performance. Focusing on a few—indeed, only one, who may have parachuted into the most senior post from the outside—just discourages everyone else in the company. "

Nobody said a company can't give bonuses to each worker. Some smaller firms do precisely that. It is argued by those CEOs that it's only fair that every worker be similarly motivated along with senior executives.

So, again, Mintzberg sets up a straw man argument, but overlooks an obviously better, actually workable one.

On that topic, later, he writes,

"One alternative, of course, is to pay bonuses to everyone, perhaps according to their base pay. That solves one problem but not another: how to ensure that the goodwill is not being cashed in by everyone, collectively. Once again, who is to come up with the measures that assess performance correctly?

So, again, there is but one solution: Eliminate bonuses. Period. Pay people, including the CEO, fairly. As an executive, if you want a bonus, buy the stock, like everyone else. Bet on your company for real, personally."

Again, there is a solution- set an appropriately lengthy timeframe over which performance is measured. It's really very simple. Also, the board can adjust these measures as they observe how the performance bonus calculations are working.

He does, however, mention one thing which is hardly new, but is sensible. It's the only paragraph in the entire editorial with which I agree.

"People pursue the job of chief executive for all kinds of reasons: the prestige of the position, the sheer pleasure of heading up a major company, the chance to make a real difference to an institution they cherish, and, of course, remuneration. When push comes to shove, do you think pay is more consequential to these people than the other factors? All this compensation madness is not about markets or talents or incentives, but rather about insiders hijacking established institutions for their personal benefit."

It's no secret that boards are often composed of CEOs of other companies. Thus, when a board hires a compensation consultant, and that consultant recommends all manner of higher compensation to "attract" CEO talent, these higher levels of CEO compensation bleed into the other companies over time. Voting for higher pay for a CEO by a sitting board member who is also CEO of another firm is almost like voting her/himself a similarly higher compensation level.

This is one area in which all shareholders are injured by the nature of boards. The fact is that most CEOs would gladly take their job at 2/3 or 1/2 the total compensation they now receive. They just don't talk about it publicly.

On a related note, yesterday, on CNBC, I heard a debate considering some recent speech on senior executive compensation, bonuses, and greedy behavior allegedly given by inept, underperforming GE CEO Jeff Immelt.

One of the program's guests accurately fired off a remark to the effect that Immelt has already hauled down enough from GE's overly generous board (see my posts labeled "Immelt") to be able to speak sanctimoniously. And he hasn't offered to give back the overcompensation for actually reducing his shareholders' wealth.

For the record, I believe CEOs should be paid no more than about $350,000 in cash. Period. No special bonuses in cash.

Then, their incentive compensation should follow some variant of my recommendations in the early part of this post. That is, equity in some percentage of the difference between their 5-year average total return for shareholders and that of the S&P for the same period. If the measurement period is annually, then the equity should only vest after five years. If the measurement period is five years, then the bonus may be ex post, in cash.

The important elements are a smaller absolute cash amount than is typically paid now, and an incentive bonus which is tied to multi-year performance, measured by total return, in excess of what a shareholder could have received from merely holding the S&P. The difference might even be increased to adjust for the risk of holding the company's equity in isolation.