Things the U.S. Can Learn from Japan: How to Regulate “Say on Pay” is One of Them (the article that no one would publish)

Many observers around the world seem to think that “U.S. Investor ‘Say on Pay’ Is a Bust” (a failure), which was the title of a recent article in Business Week.  The article made the perfectly logical and factual point that after all the hoopla, the bottom line was that shareholders this year for the first time could vote on executive pay…but a majority voted against pay plans at only 32 of 1,998 companies.

I can’t say that I am at all surprised. Back in early 2009 I wrote an article on this topic, suggesting that mere advisory votes would not be sufficient, and that the U.S. should emulate Japan’s Company Law by requiring outright shareholder approval for aggregate pay to senior executives. However, try as I might, I could not get any major newspaper to publish the article.

I concluded that most likely, the thought that the U.S. has things that it can learn from Japan (of all people!) on matters of corporate governance was considered to be just too much for most potential U.S. readers’ egos to bear. Either that, and/or the topic was simply not one considered likely to sit well with corporate readers who, after all, are a major source of advertising revenues.

In the end, I sent the draft article to Senator Elizabeth Warren, who was at the time the head of the TARP Congressional Oversight Panel that reviewed misbehavior by financial institutions leading up to the financial crisis and oversaw the use of public funds to restore markets to stability.  She immediately sent it to all the congresspersons on her committee.  So in the end, I was able to reach the exact audience I most wanted to reach, on a pin-point basis.

Here is the article, two years later, in case anyone is interested to read it. The title is: Regulation of U.S. Executive Compensation Should Emulate Japan:

Maybe it will be useful in another 10 years !

Regulation of U.S. Executive Compensation Should Emulate Japan

June, 2009
(Never accepted for publication by any major news organization.)

Over the last 20 years, many U.S. boards seem to have evolved from being clubby, to being irresponsible. A relatively small number of “famous name” external board members sitting on multiple boards benefited from mutual favors – and invitations to return – by ingratiating themselves with each other and powerful “imperial CEOs”.

For these so-called “independent” board directors – ahem, who were nominated by the CEO and others just like themselves, not shareholders – the best way to keep feeding from the corrupt gravy train was to: a) assure the directors who chose the CEO that they had done a fine job; b) approve compensation arrangements that were pre-negotiated with the executives themselves (implicit message: “otherwise, we will quit”); and c) justify their approval by referring to thick reports by compensation consultants. Despite persistent public complaints, in fact the incredible complexity of compensation arrangements and personal employment contracts handily camouflaged many flaws and excesses that would, if known, have attracted even greater criticism.

The results are unsurprising and sickening: a) executive compensation that only ratchets up, at an alarmingly rapid rate; b) the decoupling of total compensation with long-term performance indicators or shareholder goals; and c) severance packages that make things worse, because they are so huge that “nothing succeeds like failure” (Warren Buffett’s conclusion).

Smart consultants that they are, the compensation “experts” know how to generate future business: sell the proposed CEO to the board and land him his package. All boards like to claim that they have found a “top quartile” CEO, and that is the reason they have to pay him “top-quartile” compensation”. But as investor Michael Stark has pointed out, only 25% of CEOs can make it into the top quartile. See the problem?

These practices have become most offensive and out of control in large banks and investment banks. The major reason for this is the increased complexity of the business, which has magnified a problem that is unique to financial businesses: executives can claim they and their teams deserve to be paid on a “present value” basis as of the time deals are closed but before all of the money is made or all the risks eliminated. The executives then threaten that if they are not paid enough, there will be a huge exodus of their completely fungible banker talent to high-paying competitors.

Just before the Latin American debt crisis, bonuses at Citibank reflected not only the fees that Citibank received from leading syndicated loans to Brazil, but also the interest spread the bank would receive in the future. But just a few years later much of that spread income was never received, and losses on the loans that remained on Citibank’s books made the syndication fees look like a rounding error. Similarly, when I was arranging large cross-currency swap transactions in the 1980s, each of us would carefully count the “present value” of future spreads that would be earned on each swap or structured bond we sold…even if we were discounting cash flows 20 years or more into the future. If our hedging assumptions turned out to be wrong, or if the counterparty went bankrupt, these “present value” profits might morph into losses. But that did not stop any of us from asking for, and getting, larger bonuses.

It is absolutely essential that regulators understand that the excessive origination, securitization and derivative transactions that created the sub-prime mess were largely caused by this fallacious dynamic, by which banker compensation has become an “entitlement” with no penalty or claw-backs for future blowups of the deals one has closed. There is no mechanism to get prior compensation back when all those securitization residual interests are only worth 10 cents on the dollar. Until we fix this obvious problem, financial bubbles will always be far more intense than they could have been, because bankers will have an intense incentive to crank out risky transactions at the top of the market.

The most basic, common-sense principle of regulating modern financial institutions should be and extension of Harvard Law professor Lucian Bebchuk’s line: “if it was not earned, it must returned”. Until all expected profits have finally been earned and risks are zero, part must be kept in reserve, withheld in trust, or compensated via long-term

Remember the furor about the massive $140 million deferred pay package for Richard Grasso that NYSE’s board approved? That board had for years included many of the top CEOs at Wall Street’s leading investment banks, including Philip Purcell of Morgan Stanley, his successor John Mack, James Cayne of Bear Stearns, Merrill’s David Komansky, and William Harrison from JP Morgan. If such men or their predecessors expected special cooperation from the NYSE when they approved Mr. Grasso’s compensation package, that would have been a contemptible and potentially legally actionable conflict of interest for a director of a non-profit SRO (“self-regulating organization”), even if nearly impossible to prove. And in fact, there was a lawsuit. But if they were simply trying to ingratiate themselves with potential future members of their own boards, while maintaining the convenient illusion that they themselves also deserved exorbitant pay, what does our regulatory system do to prevent those motives? At present, nothing.

Speaking of illusions, the reader may recall that Mr. Purcell himself was ousted, receiving a $114 million exit package. He was replaced by Mr. Mack, who over the next two years was paid roughly $80 million – for cranking out deals vigorously at the top of the market, just as he was incentivized to do. The compensation negotiations with Mr. Mack were described as “’an ice cream war’ between children, where one wants as much as much as the other.” But to confirm the existence of a compensation “ratchet” based on entitlement, all one really need do is read page 22 of Morgan Stanley’s 2008 proxy statement, where it says that Mr. Mack’s employment contract “provides that his annual base salary cannot be less than $775,000, the base salary of our CEO who immediately preceded him.” (I.e., Mr. Purcell.). Is this a performance-based compensation policy, or an upwards-only, ego-fed entitlement?

An ex-investment banker friend of mine says, “I call the U.S. system organized corruption. Just look at the investment banks. What business in the world can pay bonuses equal to 50% of top line revenue, without being corrupt?”

Indeed. But actually, there is a simple answer to my friend’s rhetorical question: “a business whose owners (shareholders) cannot nominate and elect truly independent directors to design and approve individual compensation, and cannot impose sane compensation limits in advance”.

I propose that U.S. regulation of executive compensation for public companies should emulate Japanese Company Law by adopting the following system:

  1. Shareholders will have “access to the ballot”, which they do not have at present, in order to nominate directors. All shareholders holding more than either 1% or about $1 million value in shares, will have the legal right to submit shareholder proposals to: a) nominate desirable candidates for truly independent directors, rather than just the famous acquaintances of existing board members or names introduced by conflicted headhunters hungry for future business; and b) propose changes to the Articles of Incorporation that affect election of directors, such as the use of cumulative voting or the elimination or staggered voting.
  2. The company will be required by law to include proposals on these subjects in the proxy materials, together with detailed explanations and supporting information.
  3. If approved by shareholders, proposals on these topics will be binding on the board. Moreover, this rule cannot be eliminated by changing the Articles of Incorporation. (Note: most shareholder proposals in the U.S., even when they can be made, are only “advisory” (precatory) in nature, meaning that the board can ignore them.)
  4. Each year, a total “cap” on the maximum aggregate value of all significant incentive compensation (that of all persons who will receive more than $X) during the next year must be approved by shareholders. To gain approval, management will be forced to transparently propose the coming year’s top priorities and goals, and to define what will constitute “excellent” performance, what bonuses will be paid for, and any proposed linkage. The economic value of any options or other non-monetary compensation at the time of payment must be included in the aggregate compensation limit, which the board will need to carefully allocate at year-end so as to fairly incentivize all important managers, not just the CEO and CFO. (This is, after all, what distinguishes actual management from mere individual greed: “managing” within a known limit.)
  5. At he end of the year, the board must disclose how much of the “cap” has been allocated, to whom, and why.  If the board determines that superlative performance or retention requires an increase in the cap amount, it is free to explain the circumstances and ask shareholders for approval at that time.

For financial institutions, helpful modifications would include:

  1. The definition of “excellent” performance and incentive compensation linkage must be based on risk-adjusted profits, i.e., those that have actually been earned with acceptable finality so far. In essence, this is simply the accounting “matching” principle applied in reverse to compensation.
  2. There should be two separate bonus pools with advance caps: one for the all senior executives, whose individual compensation amounts will be disclosed for transparency and to provide a shame-brake; and one for mid-level bankers, for whom only the aggregate amount must be disclosed and approved.

In Japan’s shame-based culture, the Company Law’s “advance limit” function operates a bit too effectively, holding down total executive pay to 5-10% of the U.S. level. As a result, the fixed component is high and the proportion of incentive from performance linkage is far too low. Since investors are meek and reputation concerns or cross-shareholding relationships hinder their use of shareholder proposals, what Japan needs is for the Company Law to require independent directors to sit on boards so that they can approve paying Japanese executives more, in performance-linked form.

But in the U.S., the power of public shame is weaker, shareholders are not meek, and the law already requires independent external directors on boards. In this environment, mixing Japanese corporate law features into the U.S. system to breath life into our moribund “shareholder democracy” would restore public trust in boards and compensation practices, and facilitate constructive and innovative dialogue with shareholders about managerial goals and optimal incentive structures. Both are badly needed.

It is important to note that the purpose of the “cap” is not to limit compensation at a low level. Rather, it is to use the simplifying device of a single aggregate number to: a) make monitoring and approvals easier, thus preventing windfalls and overpayments, b) facilitate dialogue that can fine-tune compensation so it is robust only when shareholders have been well served, and c) encourage management board and management to improve morale and performance by being more egalitarian.

I would expect that the American ingenuity and market participants would respond vigorously and positively to rules like these, by linking cash or restricted stock bonuses to explicit financial performance goals that shareholders themselves have approved, and by designing new, more effective forms of options.

 * Nicholas Benes is Representative Director of The Board Director Training Institute of Japan, a nonprofit organization recently certified as a “public interest corporation” by the Japanese Cabinet Office for purposes of offering corporate governance-related training ( and ).  Mr. Benes is also President of JTP Corporation, which provides mergers and acquisitions advice in the Japanese market. He has served as an external director on a number of Japanese companies, and on committees advising the Japanese Cabinet on FDI policy. 



The Board Director Training Institute (BDTI) is a "public interest" nonprofit in Japan dedicated to training about directorship, corporate governance, and related management techniques. It is certified by the Japanese government to conduct these activities as a regulated nonprofit. Read a summary about BDTI here, and see a menu of its services for both corporations and investors here.

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