Fixing exorbitant CEO pay: All is not lost

September 30, 2013: 3:08 PM ET

Despite what has felt like relentless insanity, the prognosis for positive changes to executive pay looks better than it has for a decade.

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FORTUNE -- What would you think of a 10,000 square-foot house, with 1,000 square feet of living space and a 9,000 square-foot bonus room? It would defy the meaning of the word bonus.

Welcome to the crazy land of U.S. pay jargon, where boards dole out a $9 million "bonus" as part of a $10 million CEO paycheck -- and CEOs view the $9 million in extra greenbacks as obligatory.

Despite what has felt like relentless insanity, the prognosis for positive pay and leadership changes looks better than it has for a decade.

On September 18, the SEC proposed a Dodd-Frank rule that would require companies to report CEO-to-median-worker-pay ratios. The proposed calculation includes global employees, something Vineeta Anand, chief research analyst at the AFL-CIO Office of Investment, had advocated.

Some board members I've talked to complain that the averages currently available (like CEOs earning 350 times the average worker's pay) aren't all that helpful because the denominator doesn't use individual company data. The new proposed disclosure requirements correct that weakness. And companies that wish to provide additional information to make the measure even more meaningful will be free, of course, to do so.

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With more luck than may be possible, the ratio could become a new metric some CEOs follow and aspire to reduce. This would be particularly true for CEOs who seek to embody a flavor of leadership called servant leadership, promoted by Robert Greenleaf. In a 1970 essay, Greenleaf characterized servant leaders as those who put service to others first, as opposed to serving themselves first. "Leaders can use the resources they have to accomplish their own agendas, or to support the agendas and needs of those who follow them. If the leader's agenda is driven by the needs of the followers, that's servant leadership," says State Auto board member Paul Otte, who advocates Greenleaf's principles. Clearly, CEOs who are servant leaders in more than name only would want to know the ratio and narrow the pay gap.

In addition to the SEC's proposed rule, there's been action on the legislative front too. In August, Senators Richard Blumenthal and Jack Reed introduced the Stop Subsidizing Multimillion Dollar Corporate Bonuses Act, which would limit pay tax deductibility to $1 million. Public Citizen's financial policy advocate Bart Naylor, who supports the bill, wrote me in an email, "Congress decided in the '90s that tax breaks for pay beyond $1 million are as irrelevant to productive business as a three-martini lunch. This bill merely closes the loophole in that sensible policy." It also ends the pretense that outsize pay tied to stock or stock options is de facto performance-based.

This year, shareholders have won victories in addressing pay structure issues. At McKesson (MCK), shareholders approved a proposal by Amalgamated Bank LongView LargeCap 500 Index Fund to strengthen bonus clawback policies. Under the new approach, the board would disclose details of its deliberations and consider implementing clawbacks of executive pay even if misconduct wasn't intentional or financially material. "We've had constructive discussions with McKesson after the shareholder vote and are hopeful that the board will be responsive," Scott Zdrazil, Amalgamated Bank's director of corporate governance, wrote me in an email.

The New York City Funds worked this year with Capital One (COF) and Encore Capital (ECPG). The actions resulted in adoption of stronger clawback policies at both companies. And earlier this year, UAW Trust and Johnson and Johnson led efforts to forge new recoupment practices at six pharmaceutical companies, Zdrazil told me. Provisions to hold back compensation for payment until a future time do an especially good job of encouraging managers to focus on risk management. Along with Johnson & Johnson (JNJ), Amgen (AMGN), Bristol-Myers Squibb (BMY), Eli Lilly (LLY), Merck (MRK), and Pfizer (PFE) signed on to the better practices, Zdrazil says.

The New York City funds also sponsored a proposal that called on Abbott Labs to "adopt a policy that no financial performance metric [used for pay purposes] shall be adjusted to exclude Compliance Costs." In the proposal, compliance costs included legal expenses and costs from product recalls. Excluding litigation expenses from performance metrics gives an executive an unwarranted free pass. The measure earned nearly 40% approval (not a majority, but a strong vote of confidence from investors) -- and it's an issue that should be on every board's radar.

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Beyond the details in the Abbott (ABT) proposal, there are ways to satisfy both shareholder and board concerns over accountability for litigation and compliance risks. Abbott could assess ongoing risk charges against its profit and loss statements based on litigation experience, akin to the logic used in insurance underwriting, something I explain how to accomplish in my book, Economic Value Management. These risk charges penalize individuals who shirk efforts to improve operational risk management. The pay programs should also employ longer payout timeframes, so as risks emerge, the individual who is responsible for those risks takes the hit for them. Post-crisis, the Fed has strongly recommended that banks adopt these methods. Bank boards need to do much more in this arena.

We've been living with entrenched compensation approaches that have managed to frustrate both active shareholders -- and the corporate boards responsible for overseeing CEO pay. And it has taken tremendous effort to accomplish even the small steps forward that we've witnessed this year. It's probably too early to say whether there's enough momentum to spur transformation. But the progress and collaborative efforts are encouraging.

Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance (http://thevaluealliance.com), a board education and advisory firm.

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About This Author
Eleanor Bloxham
Eleanor Bloxham
Contributor, Fortune

Eleanor Bloxham, an authority on governance and valuation, is CEO of The Value Alliance and Corporate Governance Alliance, an independent board and executive educational and advisory firm she founded in 1999. She is author of the books Value Led Organizations and Economic Value Management: Applications and Techniques, and publisher of the Corporate Governance Alliance Digest and her blog The Bloxham Voice.

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