What the HR function can do to facilitate good governance.
If there was such a job called whistleblower, no one would apply because being a whistleblower is an awfully difficult thing. Unfortunately, though, this job has needed to be self-created when people have chosen to stand up to shocking activities. In 2002, Time magazine portrayed three salaried employees on its cover, employees who had withstood corporate and peer pressures and who had dared to challenge the ways in which their organisations were run.
Yet, despite their efforts, these organisations malfunctioned or imploded because there were no systems in place to either prevent or to act the fraud or deceit quickly enough. Lives were lost, careers were ruined and the fabric of the rule of law that is necessary for a fair and free market was deeply torn. Sadly, we have still not learnt our lessons. Seven years later, numerous events — global and in India — have thrown the spotlight back on the need for far more robust corporate governance processes and capabilities than we currently have.
The current governance debate is focusing not only on the changes and enhancements that need to be made, but also on the different players who need to have a role in either driving or monitoring governance. Within a company, focus is required from all functions; and we would like to explore here is what the HR function can do to facilitate good governance. We suggest three main areas of focus for HR. First, HR specialists can set and implement a framework for executive pay. Second, they can drive performance evaluation beyond the corporation and into the board room. Third, they can ensure that there are good systems for succession planning.
Top management pay
Salaries in India have grown at 12-15 per cent a year over the last few years, and at much higher levels in some of the high-growth sectors. In addition, due to years of superlative performance in many sectors, we have seen sizeable payouts in the form of annual bonuses and incentives; a burgeoning stock market also saw significant wealth creation for a sizeable segment through generous equity grants. Adjusted for purchasing power parity, Indian senior executives have been among the highest paid in the world. A large part of the growth in remuneration has been accompanied by, or rather has been, in the wake of significant growth and increase in shareholder value delivered.
Has all of this growth in remuneration been warranted, and done within a framework of good governance? A recent analysis of global pay trends highlighted that the worst performing quartile of the FTSE1000 had salaries that were 18 per cent more, and bonuses that were 29 per cent more than the average for the remaining better performing companies — the suggestion being that they had bailed out non-vesting of the long-term incentive schemes. Practices where “success is rewarded and failure compensated” are not consistent with good practice or shareholder interest. Indian companies and HR functions could do well to learn from this and prevent similar happenings.
We had conducted an analysis of how India CEO pay has grown in India between 2005 and 2008. Of the 45 companies surveyed, median CEO pay grew significantly faster than revenue growth or earnings growth in their companies. The correlation between revenue growth and CEO pay was stronger among professionally-managed companies as compared to promoter-managed ones.
It would be justifiably odd if we did not recognise that talented CEOs and senior staff are absolutely crucial for companies to grow and so companies need to ensure that they are appropriately compensated and motivated. It is clearly in shareholders interest to do so. What then, is a meaningful framework to guide how executive pay is set, and ensure that there is strong correlation with performance, the appropriate proportion of “pay at risk”, and the necessary levels of ownership and accountability driven? The four-quadrant framework presented below provides a context to look at this.
Appropriate remuneration strategies require development of the appropriate peer group to benchmark with, and determining of philosophies around positioning with respect to comparator group. While identification of the peer group seems a simple enough task to do, this is an area where there is a lot that can be done to drive governance. Peers need to be of similar scale and scope of operation, and need to have similar business characteristics. CEOs of start ups and smaller firms all too often draw comparisons with salaries drawn by peers in much larger organisations; HR professionals need to be able to take a firm stand here.
Another aspect of remuneration is determining appropriate terms of employment including entitlements in the event of separation, mergers or sell offs, extreme non performance and similar conditions. Arrangements such as clawbacks allow for bonuses and equity awards to be clawed back where they were earned on illusory performance. One such example is accounting-based performance that subsequently evaporates or was restated.
Having focus on performance requires selection of the appropriate measure (economic value added, topline growth, free cash flows, profits and so on), and calibrating the remuneration levels at different levels of performance on these metrics. Changing performance targets on a retrospective basis to factor in a difficult economic situation or adverse business conditions is unacceptable from the perspective of good governance in executive pay.
Effective governance begins with a clear understanding of roles and responsibilities, of the board of directors, the compensation committee, management and outside advisors. The board of directors delegate authority to the compensation committee (with some exceptions), and the committee in turn monitors executive pay from a shareholder perspective, approves pay philosophy and programmes, and approves executive pay decisions. CEOs need to provide the strategic context that drives pay philosophy and programmes, and the HR function is the facilitator and custodian of all of this. Outside advisors make recommendations the compensation committee on all of this, with an emphasis on opinion, objectivity and advice, not just data.
The current environment is being cited by a lot of companies for exceptional treatment of executive pay and stock awards; however, good governance requires recognition of the fact that this environment is the other side of the coin that has underpinned some of the extraordinary executive pay inflation seen over the last few years. The current context does not create a case or justification for increasing share scheme dilution limits. Compensation committees need to adopt a balanced approach and recognise that just because they can, they don’t necessarily have to use the extensive scope of discretion that they have.
Who will guard the guardians?
Boards have a dual role, on monitoring and ratification. Globally, there is evidence that more external representation on the board results in improved equity returns for the firm. A study conducted by the Marshall School of Business at the University of Southern California showed that while 95 per cent of directors interviewed rate their boards as being effective or very effective, only 59 per cent felt they were effective in shaping long-term strategy and only 63 per cent felt they were doing a good job in CEO succession planning. Clearly, setting expectations from board members and independent directors is critical and needs to be done in advance; at the same time we very often see that there is a hesitation to apply performance standards to this “exalted” level. This appears hypocritical.
A performance framework for independent director evaluation needs to cover three aspects — the outcomes expected from each, the skills and behaviours expected to achieve these outcomes, and activities that need to be focused on to achieve the outcomes. Outcomes are typically at a fairly broad level and need to be fostered over a long period of time; for instance, outcomes such as corporate performance oversight, ethics and compliance oversight, long-term shareholder value, organisation brand image, and so on. Hence, specific activities expected to drive these outcomes are worthwhile to spell out, including aspects such as articulating a clear understanding of trends, asking appropriate questions, providing ideas for retention and growth, and so on. Competencies and behaviours expected should be classified across three dimensions — functional expertise, strategic skills and personal attributes.
The leadership pipeline
Ultimately the biggest risk to a company and to shareholders is a weak leadership pipeline and a lacuna in the capability levels required to build the organisation and deliver robust shareholder returns. The HR function can play a very strong role here, in helping define the appropriate leadership competencies for the organisation, designing selection and assessment methods around these competencies and creating frameworks or mechanisms wherein high potential talent can be identified and nurtured and a healthy pipeline created. We strongly recommend that companies follow processes of both individual and team development when focusing on succession planning: this will help ensure that the company builds not just one leader but a portfolio of leaders, and that key abilities reside in a number of people and teams simultaneously.
Tough choices? Tough
These tasks are not easy to execute. Laws can be circumvented and the HR function can be subjected to a lot of function to conform. But without these efforts at governance, issues like director and CEO performance and pay will be overlooked till the next scandal. Until then, or even after companies have imploded, many top executives will continue to receive hefty departure deals that are, as one scholar put it, nothing but a continuation of warm, self-congratulatory gestures to themselves, leaving stakeholder devastation in their wake. There is no choice really.
Padmaja Alaganandan is India business leader, human capital, Mercer Consulting (India)