The Trouble With Stock Compensation

Using equity to compensate outside board members has become a popular practice. The theory goes that if directors are paid with stock, they will have a stronger incentive to protect the interests of shareholders. But does investor advocacy for a compensation scheme that aligns the interests of the board with those of shareholders usurp the interests of other constituencies — such as the environment or society at large — that may not have an obvious connection to shareholder value creation?

This question comes amid recent public outcry over business actions that have had a negative impact on societal and environmental interests — such as BP’s oil spill in the Gulf of Mexico in 2010 or the 2008 financial crisis. Surprisingly, despite the growing prevalence of corporate social responsibility (CSR) in business over the past decade, the question of whether compensating the board with stock has any adverse impact on such responsibility remains largely unanswered.

Our research set out to investigate the relationship between outside director compensation and corporate social performance. We looked at both social performance ratings and director compensation data for more than 1,100 U.S. public companies between the years 1998 and 2006. (A full description of the study was published online in August by the Journal of Business Ethics in an article titled “Compensating Outside Directors With Stock: The Impact on Non-Primary Stakeholders.”)

Our analysis produced some intriguing results. While companies in our sample with high levels of outside director stock compensation in a given year exhibited higher financial performance in later years, they also showed lower levels of responsibility to communities as measured by their charitable giving, relations with indigenous peoples, community employment and economic development, and support for basic public services. A similar effect was evident with environmental performance, where companies with higher rates of outside director stock compensation later exhibited higher pollution levels, higher use of toxic and ozone-depleting chemicals, higher instances of environmental fines, lower use of recycled materials and alternative fuels, and higher revenues from products with environmentally destructive outcomes. Finally, companies with higher outside director stock compensation tended to perform less well on human rights measures in subsequent years and demonstrated greater involvement in “sin” industries — alcohol, tobacco, gambling, nuclear power and firearms.

What These Findings Suggest

Paying outside directors with stock is an important and attractive tool to align outside directors’ goals with those of shareholders. Yet it also incentivizes them to ignore other stakeholders. What is more, history has shown that ignoring these seemingly irrelevant stakeholders can result in negative implications for the very interests of the shareholders these compensation arrangements were designed to protect. Nowhere has this lesson been more salient than at BP PLC, where negligence of the interests of the environment and communities surrounding its oil platforms led to one of the greatest environmental disasters in U.S. history and a $4.5 billion guilty plea to 14 criminal charges in 2012. In effect, BP’s negligence in protecting seemingly unimportant stakeholders ultimately had a negative impact on shareholder value.

Because directors are responsible for multiple tasks, it is difficult to design incentive schemes that will motivate them to produce an optimal outcome. Our findings suggest that there is a need to investigate more creative compensation arrangements that better reflect the complexity associated with addressing multiple and oftentimes contradictory interests simultaneously. Such arrangements require less focus on aligning directors’ goals to those of shareholders and greater attention to process-based dimensions that are more sensitive to multiple and, in some cases, incongruent forms of value creation; in other words, directors should be motivated to consider different forms of value creation at different times.

One approach may be to enhance the diversity of the board with stakeholders who represent non-shareholder constituents; such constituents can exert pressure on the board when decisions are made on behalf of shareholders exclusively. German law, for instance, requires employee representation on second-tier boards of directors, while the corporate governance models of Japan reflect the view that corporations exist in a network of stakeholders, all of whom need to be represented. Another related approach might be to extend incumbent board member roles to encompass social and ecological mandates; for example, Canadian oil giant Suncor Energy Inc. has appointed five of its 12 board members to a sustainable development committee. It is worth emphasizing that diversity in the boardroom and the creation of board committees for CSR-related endeavors should be coupled with a compensation scheme that motivates the directors to protect the interests of a broader range of stakeholders. Such an arrangement might tie outside director compensation to a balanced scorecard, so that performance evaluations reflect the extent to which non-shareholder constituents are considered in the company’s decision-making.

From a purely strategic point of view, another approach may be to more deliberately position a company as a leader in corporate social responsibility so that any divergence from such responsibility has a direct and adverse effect on the company’s competitive advantage. For instance, Interface Inc. has revolutionized the global carpet industry through its Mission Zero program, which aims to have no ecological footprint by 2020. The company has since reaped substantial customer loyalty and brand recognition benefits such that any board-level decisions that detract from this goal might undermine the company’s positioning among competitors and essentially erode shareholder value.

There is no doubt that to achieve improvement in social performance, careful examination of outside director compensation schemes will be required. At a time when public expectations for greater responsibility of business are at their peak, and more and more companies are at risk of being perceived negatively in the public eye, the growing use of stock compensation for outside directors may subvert business’s efforts to demonstrate leadership in corporate social responsibility. And with 93% of executives claiming that CSR issues will be critical for future success — according to a study by the United Nations Global Compact and Accenture — and many businesses reporting CSR information to the public, the competitive stakes couldn’t be higher.