There is one problem with all forms of variable pay—whether short term or long term, based on cash or on equity. There is always a fi nancial upside for executives (and sometimes that upside is quite high), but there is not an equivalent downside. To be sure, executives may not receive a bonus if they do not beat their targets in the company’s plan, or they may fi nd that their options are worthless if the company’s stock tanks. But in neither case is their own wealth genuinely at risk, as it is for the typical investor. This asymmetry of risk between executives and investors reinforces a short-term focus and encourages imprudent risk-taking.

It has been clear since the days of Adolf Berle and Gardiner Means - who published their breakthrough book, The Modern Corporation and Private Property, in 1932 - that business ownership is often separated from its most vital element, control. These [for-benefit business] designs go further by concentrating control in a deliberately chosen group, selected as stewards of the firm's living mission. Ownership shares can be bought and sold like property, but controlling shares represent a living essence that is not for sale - or for sale only under restricted conditions.

If most companies aren’t delivering demonstrably exceptional performance, what is the justification for granting demonstrably exceptional compensation to senior executives? Rare indeed is the pay-for-performance contract that seeks to pay only for performance by separating out the effects of luck from the contributions of the skill and effort of the executive.

Today the management, monitoring, and governance of a business are increasingly seen as separate functions to be done by separate bodies, even if some of the membership of those bodies overlaps. This is the corporate equivalent of the separation of powers. Management is the executive function, responsible for delivering the goods. Monitoring is the judicial function, responsible for seeing that the goods are delivered according to the laws of the land, that standards are met, and ethical principles observed. Governance is the legislative function, responsible for overseeing management and monitoring and, most important, for the corporation’s future, for strategy, policy, and direction.

When these three functions are combined in one body, the short-term tends to drive out the long, with month-to-month management and monitoring issues stealing the time and attention needed for governance. The big decisions then go wrong.

Transparency is often just as effective as a rigidly applied rule book and is usually more flexible and less expensive to administer.

In some ways, corporations are like liberal democracies. The shareholders of a company are like the people in whose interest the enterprise is run. The executive is like the government and the key to making it run successfully are the institutions that provide the checks and balances: the judiciary, the army, and bodies like the Federal Reserve Board in America have their counterparts in the board of governors, the auditors and bodies like the SEC.

Fareed Zakaria, in The Future of Freedom, pointed out how a democracy can only function well when these liberal institutions, independent of the executive, act as watchdogs and guardians of the public good. Otherwise, democracies tend towards failure. A similar conclusion can be drawn for corporations. The accountants, the boards, equity analysts et al have to be strong and independent, or the system is unbalanced.

You can’t do better than what Warren Buffett said to the people at Salomon Brothers many years ago: “If you lose money for us, we will be forgiving. If you lose reputation for us, we will be ruthless.” You make the situation clear by stating your intentions and you back them up in the design of your compensation program. If there’s any suggestion of bad behavior, the money goes back to the company. That’s the only fair and credible way. Any CEO who won’t come in on that basis is somebody you don’t want to bet on because he is not willing to bet on himself.

A board member primarily focuses on four things. First, strategy. Long-term strategy and execution are paramount. You need to have an aggressive goal and a plan on how to reach that. The second thing is performance management -- how you are doing against the goals and what resources you need to devote toward that. How do you achieve the objectives? The third is the talent discussion -- this is the cornerstone of all execution and is concerned with leadership and management and in some cases CEO succession. And the last is risk management as it relates to compliance and sound financial practice.

Put together a group of strong-minded people, arrange for them to meet six times a year, have no performance targets for them, and recruit a number of outsiders with no knowledge of the industry or the company into the group. Would they function as a team? We doubt it. Yet this is how we organize corporate boards. They are thrown together half a dozen times a year, with vague -- sometimes nonexistent -- performance objectives and expected to provide decisive leadership and deliver corporate performance to exacting governance standards. Then we wonder why it sometimes goes wrong.

Ordinarily, the US public attitude is generous and open minded toward profits and compensation. If somebody makes a lot of money the response is, "Great, someday it might happen to me." What drives people crazy is when you make a lot of money at people's expense. This is a powerful political form of resentment. It's resentment at being exploited. Americans want companies to make a profit but to make it by doing some good for others, not just themselves.

Ideally, business leaders ought to have three types of counselors who are prepared to speak truth to their power. First, they need a trusted adviser within the organization. Second, they need the counsel of someone completely outside the organization, preferably an old friend who is a peer. Third, they need a genuinely independent board.

Potentially, boards have three resources to use: power, information, and knowledge. When these three resources are present and effectively directed at, first, handling emergencies; second, making sure an effective strategy is in place; and, third, truly influencing the decisions of the chief executive officer (and who succeeds the CEO), then we can say that the board is acting in a high-performance way. But there's another key point that should be stressed. A board is a group, perhaps in some cases, a team. Boards need to be assessed by the same conditions and behaviors that lead groups to be effective.

Most boards believe that rewarding managers through stock options is an effective incentive leading to long term shareholder value. Equity ownership, by definition, aligns managers and shareholders. But effective incentive implies a motivation to do something, as opposed to a simple desire to see the share price go up. Most senior executives, right up to the CEO, will tell you that movement in the stock price over several years usually has more to do with exogenous factors than with the actions of management.

Management actions do matter, but they matter indirectly, over a long period of time and in often unpredictable ways, all of which tend to make equity ownership a weak motivator. While the alignment provided by equity ownership does motivate managers to seek out the drivers of shareholder value, equity by itself is inherently unable to provide a sufficiently detailed guide for value-creation to managers.

In purely top-down structures, key information and insights from below are often missed. Decisions take too long and are not as targeted and effective as they would be if information from front-line employees were taken into account.

But what governance system to use? Not a model based on consensus or democracy. Consensus often devolves into the least-common-denominator approach. People give in to what the largest egos or most insistent people in the room demand. And democracy tends to crush minority voices. Besides, the majority rarely knows best.

In most countries, the law gives the shareholder the power of hiring and firing the people who run the company. These powers were fine in the past, as long as the shareholder had a common purpose with the people who ran the company. But nowadays, in nine out of 10 cases the primary shareholders are managers of other corporate entities, with purposes and goals of their own. By their nature, the goals and targets of the shareholders are short-term and money-based, whereas the goals and targets of the company, in today's world, have to be people-based and long-term.

Businesses in the Western world are still governed by antiquated corporation laws. In the past, employees were regarded as an adjunct to business; they were simply the "hands" to operate the machines. Power was concentrated at the top. The law gave priority to the shareholders, based on the assumption that the human elements were mere extensions of the capital assets.

Most of today's corporations, however, have no or few capital assets. They are dependent on brain power; people are the critical success factor. But businesses are still ruled by 19th-century legislation. Managers are forced to optimise capital before all other concerns. Excessive power is given to shareholders and that power is being abused.

If you have a great idea, you want to set up your own firm, make a quick buck and a swift exit, then the limited liability structure makes sense. If, however, you want to grow a successful company over the long term, you should steer clear of the classical limited liability formula - it gives too much power to too few people.

There are a number of key questions board selection committees should be asking. The most important is: What risks does the company face? An understanding of a company's business environment and the potential risks it could face is essential to ensuring the board's ability to detect trouble sooner rather than later.

Following an assessment of a company's risks, the next question is an obvious one: Are there board members who understand the company's risks? The selection of new directors should be based in large measure on the extent to which the current board collectively understands the company's risks and opportunities. New director appointments should fill the gaps.

The final step is the first question that board selection committees should put to candidates: Does the candidate under review understand the industry risks that the current board members lack?

When directors who fill these risk gaps have been identified, only then is it possible to go back and add extra criteria, such as the ability to assist the CEO, exercise judgment, obtain regional and ethnic representation, and even a cultural fit. By doing so, directors may also contribute to identifying and growing market opportunities and sales.

While financial returns may be a good measure of how well executives are managing the company's existing assets, they do not accurately reflect executive performance in areas with deferred returns-for example, strategic planning, growth opportunities, business initiatives, or investments in the discovery and development of new products and technologies. It is clear, then, that incentive plans based solely on accounting measures can induce senior management to make short-term business decisions, and compromise investment opportunities with the promise of deferred or non-monetary returns.

The most important predictor of director effectiveness is not independence, but strategic experience that matches the company's needs. Â… Evidence that director experience is critical to board effectiveness is relatively new. However, evidence that board independence has neutral to negative effects on board effectiveness is not. The first research casting doubt on the value of board independence appeared in the late 1980s. Since then, not only have advocates of governance reform in the U.S. continued to focus on this issue, but the board independence mantra has spread to other countries.

America's Sarbanes-Oxley Act, UK's Higgs Review, and Ontario's Bill 198 do not promote good governance and, therefore shareholder value, as pointed out recently by Boardroom's Brian Lechem, so much as they protect investors from unseemly conduct. Like speed limits and stop signs they are useful to protect, but in no way do they constitute guidance for skillful, wise driving. One look at the unending stream of codes, particularly since Cadbury's 1990 report, is convincing evidence that there will continue to be more. While new prescriptions of practice are not without value, they have sharpened boards' interest in lawful compliance more than in better governance.

The board does not exist to advise or assist management, but to empower, charge, and evaluate management. A board might "ask good questions" or advise, but these do not constitute its job. They wouldn't for a CEO with respect to his or her subordinates and they don't for a board. A governancedestroying CEO-centrism quickly turns the board's commanding role into the feckless one of advisor. The board does not exist to react to CEO requests, to have its agenda management-driven, or to be either management's adversaries or its cheerleaders any more than the CEO's job exists for these reasons with respect to his or her subordinates.

In the end, managers are responsible to the institution they manage, the company, not to shareholders, not to employees, not to customers. They are required to protect the integrity of the institution. And I think that's the rule of management. It is responsible ultimately for protecting the integrity of the institution. And when I mean integrity, I mean it in all senses of the word. Integrity means it's holding together. Integrity is what lies at the core of the management profession. Now, integrity cannot be maintained unless shareholders are satisfied, because they will withdraw capital. Integrity cannot be maintained until the employees are satisfied, because they'll withdraw their labour, or customers or other "stakeholders," which is a word I don't like.

I would argue that managers are ultimately responsible for protecting and maintaining the integrity of the institution they manage, and that all the other responsibilities and obligations flow from this basic and primary responsibility. Then the directors become the referees that will ensure that the managers are indeed doing their job of protecting the integrity of the corporation.

New regulations could, and probably should, force companies to give shareholders more power over managers. But today's shareholders, individual and institutional alike, rarely exercise the rights they already have. Often, when managers let owners down and confidence in capitalism falters, investors are at least partly to blame. Even if they are not cheering the managers on to greater feats of daring, they are failing to demand probity and accountability.

Despite the overwhelming evidence to the contrary, boards tend to favor the "proven" talent, but often fail to ask "proven in what context?"