The “bottoms up” approach is indeed a useful starting point for assessing directors’ pay at small and large organizations. But the potential liability and exposure fall virtually all on the outside professional advisors, who always run some risk of being sued successfully for malpractice and who therefore build the costs of that risk into their hourly rates.
The potential liability and exposure of directors have been badly overexagerated. As long as directors do these four things – (i) make decisions on a rational basis, (ii) use a rational process for making these decisions, (iii)act in good faith, and (iv) have no conflicts of interest – the business judgment rule will insulate them from liability. Of course, anyone can sue anyone for anything – and that’s why directors need D&O insurance to cover the costs of litigation.
But I do not know of a court decision where the court found that the directors met this four-part test and still were found liable. The business judgment rule gives directors the right to be wrong. Outside professional advisors do not have this right.
Our recently released study of 2006 performance metrics at the top 300 public companies – now being updated for 2007 data – revealed that 37% of companies with long-term incentive plans used total shareholder return (TSR), a market measure. All but five of these companies based their payouts on TSR relative to a peer group. On the other hand, for the majority of plans using a performance-based or internal financial measure, relative designs were the exception. Indeed, of the performance-based long term incentive plans, less than 20% used relative measures. To be compliant with Item 402(e)(1)(iii), disclosure of the measures, including threshold, target and maximum values, would be required.
Short-term incentive plans rarely use relative measures. This same study estimated just 8% of companies with short-term incentive plans used relative measures as part of these plans. Moreover, the reporting of metrics in 2006 was woefully short of expectations with just 16% of these top companies providing complete information on short-term goals and accomplishments. Clearly, there was great hesitation in disclosing this information.
For companies that would prefer not to disclose this information for competitive reasons, an easy solution would be to base payouts on performance relative to a set of peer companies. As with a TSR design, payouts could be based on percentile performance over a multi-year period. Reporting would consist of listing the applicable measure(s) and the percentile performance that triggers vesting/payouts. Equity-based plans would retain all the features of any other performance-based plan such as fixed expense per share and reversible expense for sub-threshold performance.
Using a relative design is also a better way to measure performance. With a relative measure, changes in the economy and industry are reflected in the performance of comparator companies. Consequently, if a company is falling short of its EPS goal, it is possible that the company can outperform its competitors and be rewarded accordingly. Alternatively, if the company goal is more easily achieved as a result of external factors rather than astute management, a relative goal can prevent an unwarranted windfall.
Of course, one downside to relative measures is the potential payout of incentives in cases of poor company performance but strong relative performance. Having minimum financial hurdles can be designed to prevent ill-timed payments.
One of the beauties of having so many experts participating on one blog is the dialouge it will create among them, as well as with their audience. For example, George Ince of Davis Polk & Wardwell notes: Peter Hursh’s blog on the “bottom’s up” technique of establishing director pay is a useful starting point – but I would suggest that it undervalues the director’s services since I think there should be some additional pay for directors to account for their fiduciary duties and potential liability and exposure in performing the role of a
director, which are not present for the other types of advisors he uses for the fee measurement.
More Performance Target Disclosure Stats
Back in early April, Equilar released a study regarding how many of the Fortune 100 disclosure their performance targets (compare the stats in Watson Wyatt’s survey, noted on April 10th in this blog):
– From 2006 to 2007, the prevalence of Fortune 100 companies disclosing actual performance targets for their executives under all types of compensation plans increased from 55.8% to 66.4%.
– Among Fortune 100 companies with annual bonus plans for executives, 68.3% disclosed the actual performance targets which must be achieved to generate payouts. Last year, 44.4% of Fortune 100 companies with such plans provided a comparable level of detail.
– The study also finds that 81.0% of awards which measure short-term performance, benchmark results solely against internal company goals. Conversely, 60.9% of long-term performance awards use relative measures as a component in determining payouts.
I’m often asked by directors of smaller publicly-traded, or even private companies whether I think their pay for board service is competitive. Most directors, like your boss and your spouse, are of course overworked and underpaid.
I respond by taking them through what I call the “bottom’s up approach” to setting pay for directors. I ask the director to estimate the number of hours he or she spends each year on different board activities – – mosty, participating at board meetings, at committee meetings, at a board retreat, on conference calls, and in individual meetings, as well as in preparing for these sessions (although I tell them to exclude travel time). Say that serving as a director of ABC Company takes about 100 hours per year. Then I ask the individual: what is the average hourly rate of the senior outside advisors to the Company and its Board – – that is, its attorneys, accountants, business consultants, marketing specialists, etc.
The answer is often, for smaller companies, about $350-$400/hour. Then I say, “Well, for you that’s 100 hours times $350-$400/hour, or $35,000 – $40,000 per year as an independent contractor – – i.e., as a non-employee director of ABC. How does that compare to the sum of your retainer, meeting fees and annualized stock opportunity?” The answer, in every case I’ve had so far, is that what the inquiring director is getting paid – – usually about half in cash retainers and meeting fees, and half in stock – – is very close to the bottoms-up answer. My experience is that (i) this reassures the director that his or her pay is fair and (ii) once an individual thinks that the pay for his or her job is fair – – and this is especially true for outside directors – – then that person does the job for other reasons.
Recently, we issued this “Early 50 Filers” report, which analyzes executive compensation disclosures by 50 companies that filed proxy statements early in 2008 and that had two years of experience under the SEC’s expanded reporting rules. The data covers disclosures related to: corporate performance metrics; benchmarking practices; consultant independence; corporate governance; readability; and length.
For purposes of having a little fun – and putting aside the fact that NBA players are paid based due to business decisions just like any other decision to invest in an asset to earn more (which is very different from the process by which CEO pay is set – check out my recent article that imagines if NBA players were paid like high-performing executives. I use the article to make some points about how properly designed pay packages would result in more pay-for-performance.
Interesting article from the Washington Post last week speculating on what the future may hold for “Say on Pay” votes in light of a fairly low success rate this season. Some pundits speculate having a simple “yes” or “no” vote on pay packages is too much of a blunt instrument – and suggest these votes may need to be retooled to focus more clearly on the elements of the pay package.
From our perspective, when advising clients to do a better job in their CD&A explaining how their program accomplishes their goal of “pay for performance,” we suggest they be mindful of a future that could involve “Say on Pay.” Our point to them is: Why wait until the vote is pending to make your arguments to shareholders? Why not be doing the analysis every year to prove the point?
Of course, performing an analysis of how the pay your executives ultimately earn stacks up to that of your peers – and then comparing what your executive’s earn versus how the company performed versus peers – is time-consuming and may yield an answer the client might not like. But without doing the analysis, in our view, it is impossible to make a statement that your plan pays for performance.
In a recent symposium we attended on the issue of “Say on Pay,” each of the proxy advisory firms who spoke on this issue acknowledged their “yes” or “no” recommendations would be based on many different factors, the most predominant of which will be . . . wait for it . . . pay for performance. There is still time for companies themselves to help define what this means, and by doing so in their CD&As, perhaps Corporate America can drive the definitions rather than the advisory services.
Let’s not forget, both Barack Obama and Hillary Clinton have proposed legislation to mandate a non-binding “Say on Pay” vote, so this issue will continue to be debated throughout the upcoming election season – and perhaps beyond that.
A recent consulting assignment highlighted the need to push back when faulty thinking threatens not only outcome but the process of executive pay determination. A CEO pushing for a renewal of his expiring 3-year contract felt ‘under-optioned” due to an odd history of Board decisions. He was requesting a 3-year front-loaded option grant and a fixed 3-year deal with all options vesting during that period. He hit a stalemate with the CC who felt something wasn’t right about his request and needed an independent viewpoint.
The outcome was one that satisfied all parties: an option grant 3x the normal number of shares in annual grant but with a 25% premium price and vesting consistent with a series of three annual grants (11-22-33-22-11%) rather than the company’s standard 3 x 33% vesting. He gets the advantage of the front-loaded grant only if the company outperforms.
The process of getting to this point was difficult. We emphasized a scenario-based tally sheet and analysis to refocus the CC and the CEO from the new option grant potential gains to the total gains from previous options plus the new one. This changed both parties’ thinking from the vesting-date based analysis to the post-vesting “tail” value of the options.
We all face the inertia of the old-school notion that “pay is annual” (reinforced by the SEC and financial reporting cycles) and that “value ends at vesting or expected life” (reinforced by FAS123R). I frequently emphasize the idea of “checkerboard pay” – every year looks different – and the cumulative uneven value of those patterns must be understood. Even more important now that the mix of SO, RS, Cash LTI, etc changes year to year and the pressure to retain options and/or shares has become an element of the pay package. The only way to understand the cumulative effects of decisions is looking back multi-year and looking forward multi-year.
With this client, I had to politely ignore both the Committee’s and CEO’s instructions to omit the previous option grants on the tally sheet because they were “irrelevant” – I guess that’s a little compensation consultant civil disobedience. When they saw the numbers with stock price projections, however, it changed everyone’s attitude and they requested that we show additional future years in the projection. Suddenly we weren’t talking about $2mm vs. $4mm but about $16mm vs. $18mm, and then $26mm vs. $30mm.
We had to emphasize a number of concepts to the Compensation Committee including:
– Truncation of option value is voluntary, not built into the option other than the term itself which is rarely a constraint. Vesting doesn’t end value accumulation, exercise only ends the tax-withheld part of value accumulation, and employment termination only affects the unvested AND unprotected (unaccelerated) part of value accumulation.
– Stock price projections are estimates, but better estimates than Black-Scholes values, and emphasize the “shareholder value commission” aspect of equity-based pay. If the projections are wrong the pay is self-correcting. The dollar value projections have to be accompanied by percent-of-outstanding analyses.
– We never, ever, ever, use accounting numbers in pay analysis. Options aren’t worth less because you paid an actuary to reduce your BS assumptions (pardon my acronym). RSUs are not worth face value at grant, they’re worth more. Conversely, performance shares are not worth the maximum payout just because you’re accruing that so you can reverse some of the expense later when EPS needs a boost. The complexity of LTI numbers require some thoughtful analysis, not FAS123R adherence.
– Despite the best efforts of “free agent” negotiators’ mentality, executive work is not professional sports and no one ever had to retire early from a knee injury sustained on a conference call with analysts. Let the sports analogy go. Shareholders should expect, and reward, continued performance-positive employment. And someone quitting at age 50 is not “retiring” they are quitting.
And yes, I’m still their consultant. Neither the CEO nor the CC fired me because I said “no”. But if they do, that’s fine too.
I recently wrote an article – “Long-Term Compensation Planning for High-Potential Employees” – whose theme is that a longer term view of rewards, focused on wealth accumulation, will be the competitive advantage companies need in competing for key or high potential talent for the future. In other words, simply providing competitive pay will not provide a sufficient advantage, and companies cannot continue to bid up wages for skills in short supply. I also observe and read that the talent management strategy of most big companies is shifting back to an internal strategy (make vs. buy). With this shift comes the opportunity to again look at levels of pay, and especially wealth accumulation, longer term. Let me know what you think.
With Aflac’s annual meeting results now in, “say on pay” is in the news. Here are five items to consider:
1. Aflac’s Pay Package Gets 93% Support – As noted in this NY Times article, Aflac’s meeting on Monday was uneventful with the company’s executive pay package getting overwhelming support.
2. RiskMetrics’ Aflac Report – ISS kindly has given us permission to post its analysis of Aflac’s “say on proposal.” It is interesting comparing that to the PIRC report that I posted last week.
3. Shareholders Not Supporting “Say on Pay” As Much This Year – As noted in this Washington Post article, the level of support for “say on pay” proposals is down this year compared to last year (bearing in mind that last year’s levels were remarkable for a “first year” type of proposal). So far, only proposals at Apple and Lexmark have garnered majority support.
Compare the Washington Post’s conclusions with those of ISS from this article. Here is an excerpt: “This year, pay vote proposals have averaged 42.1 percent support at 21 companies so far. That is in line with results for calendar 2007, when 52 such proposals received 42.5 percent average support. Surprisingly, however, the measure received less support at a number of financial companies this season, including Citigroup, Morgan Stanley, Wachovia and Merrill Lynch, where many observers expected the measure would fare better than last year given investor anger over subprime-related losses.”
As noted in the ISS piece, I’m also hearing that levels of support for proposals generally are down. I’m not sure of the reason, although some claim it’s partly due to the lower level of retail holders voting under e-proxy (I’m not sure I buy that given that relatively few companies are doing e-proxy).
4. Two More Companies Agree to “Say on Pay” – Littlefield and MBIA have joined the group of companies that have agreed to allow their shareholders to vote on executive pay, bringing the total number to seven. MBIA’s vote will occur in 2009 and Littlefield’s vote is in a few weeks, where its shareholders will vote on two management resolutions that ask shareholders whether the total compensation received by the CEO, president, and directors in 2007 “is within 20 percent of an acceptable amount,” according to its proxy statement. Hat tip to this ISS article for uncovering these two!
5. RiskMetrics’ Own “Say on Pay” Proposals – A few weeks ago, RiskMetrics Group filed its first proxy statement and it includes three separate resolutions for shareholder approval, which may become the model for future “say on pay” proposals. These three proposals are: (1) the company’s overall executive compensation philosophy; (2) whether the board executed these principles appropriately in making its 2007 compensation decisions; and (3) the board’s application of its compensation philosophy and policies to the company’s 2008 performance objectives.
Canada Revises Its Executive Compensation Proposals
Recently, the Canadian Securities Adminstrators re-published their executive compensation disclosure proposals. The original proposals were made a year ago – and interestingly, many Canadian companies have already voluntarily changed their disclosures to match the proposals. Here is a memo explaining how the proposals have changed.