In this and the following two blogs I am going to take a look at the wacky world of corporate governance. Aside from Professor Bebchuk and his colleagues in the corporate governance program at Harvard Law, most other commentators on corporate governance have no idea of what they are talking about. They generally utter gibberish, much like Gaddafi at the UN.

Boards of public companies have five responsibilities:

1. Hiring the CEO and negotiating the employment contract;
2. Measuring the performance of the CEO and senior management team;
3. Firing poorly performing senior executives;
4. Supervising the strategic planning process and approving the plan: and
5. Preventing fraud.

Since executive compensation currently is getting the most attention, I start with my simple suggestions. Boards should not be allowed to retain compensation consultants, the smartest whores in the consulting business. They should assume the responsibility directly for setting the compensation package for their CEOs. Supposedly, directors are reasonably intelligent individuals who should be fully capable of performing this task. If they are not, and must rely on external advisors, then why are they directors in the first place? Well, we know the answer, and it is not satisfying.

The compensation packages of CEOs, regardless of the industry, should consist of a modest base salary (whatever happened to pride and the drive for success — surely they are not influenced by the base salary); annual bonuses paid entirely in cash; and stock options. The annual bonuses should be linked to stringent profit targets, preferably operating cash flows. Just meeting the target should not trigger any bonus. Meeting the target should save the CEO her/his job for at least another year. If the target is exceeded by a minimum of 10-20%, then a bonus should be payable. The more that target is exceeded, the larger should be the bonus. But the annual bonus should be paid out in equal installments over five years. Future year installments would only be paid if the profit targets for those years also are achieved and the CEO is still with the company.

Stock options should have their exercise prices indexed, either to a broad index such as the S&P, or perhaps to an index consisting of the companies the previous compensation consultants selected as the comparator group. The options would have value only if the CEO and the company outperformed the index. There is no reasons whatsoever for CEOs to be richly rewarded for mediocre performance and luck — the luck of being CEO when equity prices in general are rising. Indexing also would eliminate the current practice of re-pricing options which are underwater. Further, the options should be exercisable only at the later of five years after their being granted or the date of departure of the CEO from the company. This should focus a CEO’s attention towards a longer time horizon.

My suggestion to legislate that Boards cannot hire compensation consultants is part of a much broader recommendation. Boards should not be allowed to retain executive search firms, financial advisors and most other types of external advisors they currently use. The quid pro quo is thta Boards should be exempt from shareholder suits. Being a director is a full time job, and directors must be willing to put in the effort and make the key decisions as a result of collective discussions, not as a result of advice from external advisors who are retained primarily as a “cover my ass” stratgey in case there is a lawsuit.