The Institutional Investors' Point of View

Paul Hodgson is Senior Research Associate of The Corporate Library

The three issues that are most often cited to me as of concern are:

1. The link between pay and performance
2. Severance benefits
3. Dilution

There is a strong movement among investors at the moment to identify those companies that are both poor performers and high payers. This is the focal point of a big problem: companies with executives who are consistently receiving high bonuses, high stock option grants and high restricted stock awards, but where the returns to stockholders simply do not justify this level of reward. Investors are keen to target such companies and to get them to redesign their incentive schemes so that rewards are only earned when the company’s performance justifies it.

These focal point companies, however, are seen as extreme examples of a much wider problem. The inefficient link between pay and performance is perceived as much more widespread, with the perspective being that many – if not most – companies are not only measuring performance over much too short a time span but they are also using the wrong metrics.

This kind of point of view was confirmed only a week or so ago, when the Council of Institutional Investors said that companies should be measuring some kind of shareholder value added performance over at least three to five years. My figures show me that only around an eighth of US companies have any kind of real long-term pay/performance measurement plan in place. The rest are solely reliant on stock price as a long term measure.

This situation is changing, however. As stock options lose in popularity, companies are beginning to introduce other kinds of scheme that do measure performance.

One issue here, though, is that the design of current schemes is at fault. If companies introducing new performance share plans use current schemes as a template, this fault will be perpetuated.

Some 90 percent of the plans that I have looked at that measure performance against a peer group – typically using total stockholder return – allow for some level of reward for below median performance. Plans will pay out the maximum generally for upper quartile performance, at target for median performance, and at threshold for lower quartile performance. I can’t see any justification, and nor can the institutional investors I talk to, for paying managers for below median performance. A company underperforms 50 percent of its peers and management receives incentive pay for this? This is not what investors count as pay for performance.

While we are on the subject of long-term incentive plans, there are continuing issues with both dilution and run rates. There are several industries where, historically, dilution levels are so high that they can hardly be described as publicly-owned at all. Some effort at bringing these levels down, however, is now expected. But more importantly, and more generally, it is widely known what levels investors think are acceptable for dilution and run rates. Dilution is expected to max out at 15 percent of outstanding shares, while run rates – the proportion of shares doled out annually as equity awards, should be kept to between 1 and 2 percent of outstanding stock. It is heartening to see that some companies are making efforts to bring these problems under control – I’m thinking of Intuit, American Express and National Semiconductor in particular. But investors would like to see these kinds of initiatives much more widespread.

Severance benefits also continue to be a source of complaint, both from the point of view of how much is paid, as well as what happens on a change of control. There are several key issues here:

• Double triggers and what happens to equity awards on a change of control.
• The length of contracts.
• The concept of mitigation.

First of all, many investors feel that many golden parachutes already provide too much of a conflict of interest, and offering additional "merger incentives" just increases this problem. Merger bonuses of any kind – for example those seen in the recent WellPoint Anthem merger – are out of favour. This is what is meant by the need for a double trigger. Most investors see no reason why all equity awards should vest immediately on a change of control. If a termination of employment occurs, there is some justification for accelerating the vesting. But if no termination occurs, what is being put forward as best practice now is that equity awards are converted into awards in the new entity and continue on their normal vesting schedule. Performance awards may need to have targets adjusted, but otherwise it should be business as usual.

Secondly, the general length of contracts is seen as too long, leading to excessive benefits on termination. It is generally felt that three years of salary, bonus and benefits as a financial cushion is now too much. There are two areas of obvious improvement here, both of which are much favoured by investors. One is to reduce the length of contracts. There are some examples of this occurring across the board, as aggregate contract lengths are slowly falling. The other is to remove any guaranteed incentive awards from severance benefits altogether.

There are companies out there – maybe 20 or so out of the whole S&P 500 – that disclose actual year-end termination costs. If you take these figures and work out an average, it’s pretty low. But, I have parsed out termination benefits and the figure for these non-disclosed benefits is a lot higher. This is an obvious message, but it is quite apparent that those companies that feel able to disclose termination costs are obviously much more moderate payers than those who feel they cannot. If you think costs are too high, and you don’t want to disclose, maybe steps should be taken to reduce those costs.

The third issue is one of common sense. The vast majority of employment agreements contain a clause specifically exempting officers from having to seek further employment following termination. Most will also guarantee continued payment of salary and bonus even if further employment is found. The only element that is not fully guaranteed is the continuation of welfare benefits. There are many agreements out there that will cease provision of this benefit if benefits at a similar level are provided by the new employer. This seems logical enough. But if it is logical when applied to welfare benefits, why is this logic not also applied to the other typical elements of severance – pay and bonus. The classic example of this lack of mitigation, reduction of severance, was seen recently at HP and WorldCom. Michael Capellas received a parachute of some $30 million when he left his position at HP at the beginning of December 2002 and later that month landed the CEO position at WorldCom with a golden hello of over $15 million. This is not income security at all – the real purpose of golden parachutes – it is simply compensation. Institutional investors would like to see clauses inserted into contracts that 1. required executives to mitigate severance benefits by finding further employment and 2. ended severance when such employment was found.

On a final issue that was brought up in an earlier panel, I have heard from institutional investors that they will be watching for cited compensation consultants that crop up time and time again as being responsible for poorly-designed compensation packages. These are easy to track, or will be as disclosure improves, so as Jesse Brill, chairman of NASPP says, it’s a double-edged sword. The Corporate Library has an enormous database of information available to our subscribers, many of whom are institutional investors, and there is a field in it naming compensation consultants. If they see Excessive Compensation Consultants, Inc come up over and over at the worst offending companies, then they will soon track which companies are clients and start either interfering or selling stock short in those companies.