While Oracle Corporation (NASDAQ:ORCL)’s purchases were modest (they did not exceed $120,000), the case demonstrates the potential for conflicts of interest that may motivate directors to curry favor with the CEO against investors’ best interests.
So how can investors discover these conflicts of interest before they manifest in ways that require disclosure under “related-party transactions”?
Investors should look closely at the biographies of compensation committee members and determine whether their other corporate affiliations may tempt them to offer quid-pro-quo exchanges that may not benefit the shareholders they’re supposed to represent.
Compensation package creation process
In addition to looking at the people involved in executive compensation committees, we should also look at the process the committee uses to create executive pay packages.
Ideally, investors should look for a transparent process that provides clear, objective metrics indicating what counts as good performance for the CEO and other top executives. The existence of objective standards introduces accountability into the creation of executive compensation packages and limits directors’ ability to approve exorbitant pay when executives fail to serve shareholders well.
How can investors determine if these conditions are met?
You should look closely at your company’s section on executive compensation — especially the section providing compensation discussion and analysis.
Chesapeake Energy Corporation (NYSE:CHK) has made some progress in its performance metrics. Its 2012 proxy statement indicates its move from a fully subjective compensation approval process to one that includes predetermined performance metrics.
However, in the “Compensation Discussion and Analysis” section of its 2012 proxy, SandRidge Energy, Inc. (NYSE:SD) indicates that its officials “do not currently base executive officer compensation decisions on pre-established performance targets.” Also worrisome is SandRidge’s admission that CEO Tom Ward submits recommended executive salaries, including his own, to the Compensation Committee for approval, rather than allowing the committee to come up with its own recommendations.
The Foolish bottom line
While it is possible for compensation decisions to favor shareholders despite the presence of conflicts of interest, shareholders should look for governance structures that will foster accountability among decision-makers and eliminate conflicts of interest to ensure their boards reliably put them first.
Otherwise, you may be forced to pay through the nose for underperforming CEOs who kill your returns.
The article Why Do Underperforming CEOs Make So Much? originally appeared on Fool.com.
Fool contributor M. Joy Hayes has no position in any stocks mentioned. The Motley Fool owns shares of Oracle. and has options on Chesapeake Energy.
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