CEO reward: Cash or stock?

The issue of chief executive officer compensation is such a headline grabber globally. Every year financial journalists across the globe publish a list of top-earning CEOs. And Kenya is not spared.

But often the missing conversation is whether they deserve those hefty compensation packages. The answer, usually, lies in measuring whether the compensation is commensurate with overall company performance. Take Kenya Airways, for instance.

Between 2007 and 2017, the national carrier cumulative executive compensation amounted to Sh896 million (about $10 million); while, in the same period, the company delivered a cumulative net operating loss of Sh7 billion ($80 million) and the value of its share shrunk by 96 percent.

This then begs the question: Shouldn’t public company executives be made to dip their skin into the game? Essentially, compensated by way of company stock, which then means the performance of the company stock dictates their compensation levels.

A Harvard Business School study by Michael C. Jensen and Kevin J. Murphy in 1990 found that the most powerful link between shareholder wealth and executive wealth is direct stock ownership by the CEO.

This incentivised pay structure dictates that a CEO's fortunes should rise and fall with the company's fortunes. In the case of Kenya Airways, executives should not have walked home with nearly $10 million in compensation while the company delivered nothing to shareholders.

In yet another classic case, Atlas Mara, the special purpose acquisition company (SPAC) founded by former Barclays CEO Bob Diamond, paid, as compensation, both its executive and non-executive directors a total of $25 million in cash between 2014 and 2019.

This happened even as Atlas Mara struggled to meet its debt obligations and its share price became nearly worthless. It was only in 2017, that some shake up happened in directors’ compensation and the company opted to pay its directors partly cash and partly shares.

But how much of an input does the characteristics of a company board have in the determination of executive compensation practices?

Broadly, boards have a fiduciary duty to shareholders and are responsible for several things including – approving dividend policies and establishing compensation for executives. And there is a good amount of literature on the relationship between board structure and CEO compensation.

One literature authored in 2008 found that CEO compensation decreased in the order of 17 percent among public companies that had not complied with the rules of the major exchanges in the United States that were issued in 2002 to govern the structure and operations of boards in the period after the rules went into effect, compared to the complying firms.

The 2008 research also investigated three other board mechanisms: (i) the concentration of institutional holdings; (ii) the existence of non-employee block holder on the board (defined as a shareholder who own at least 5 percent of a company's common shares); and (iii) director independence.

The research found that non-complying firms that already had a block holder, as well as non-complying firms that had large concentrations of institutional investors, were less affected by the rules. The findings on director independence were, however, non-conclusive.

The findings notwithstanding, the 2002 rules on the structure and operations of boards can generally be viewed as global best practice.

Specifically, provisions that placed demands on (i) a majority of board members on a single board be independent; and (ii) specific written procedures, so-called charters, be used to evaluate CEOs and elect new board members, can be quite useful among public companies in Kenya in providing monitoring mechanisms.

For instance, a quick study on the boards of top 15 public companies with high concentration of institutional holdings in Kenya shows that only a third of board members were independent.

Additionally, a high number of companies do not have written procedures used to elect new board members (other than the fact that new board members are generally handpicked within networks and friends).

For Kenya Airways, the subject matter of this instalment, out of a board membership of 13 in 2020, only three were independent. Anectodally, the presence of high institutional ownership concentration could have played a role in the high executive compensation (the so-called managerial power hypothesis, which states that non-independent directors allow CEOs to extract rents in the form of higher pay).

Undoubtedly, there is a disconnect between executives and shareholders and compensating public company executives through equity (dip their skin in the game) rather than base salary can help cut this disconnect. To achieve this, the board structure must also align.