The following is a Financial Timescolumn from yesterday, written by Roger Martin, Dean of the Rotman School of Management:
Answer the following question quickly: what incentive effect does stock-based compensation generate? The chances are that your answer will mirror the accepted wisdom: it causes executives to work harder to make their company perform better, whether that means growing faster, increasing profitability or increasing market share.
If that is your answer, however, you would be wrong. A stock price is simply the consensus of investor expectations about the future performance of the company, and linking compensation to it is an incentive for executives to focus more on raising investor expectations than improving actual performance. While we might imagine that real performance drives expectations of future performance, the link is exceedingly tenuous.
Just ask the executives of Microsoft. Last month, it reported a blow-out fourth quarter with sales up 22 per cent and profits up 45 per cent. The stock? It jumped a mere 2.9 per cent on the announcement. And that wasn’t because there had been a recent big run-up on the stock in expectation of a strong quarter. With a few brief exceptions, Microsoft has traded (adjusted for splits) in a narrow range between $20 and $30 per share for the past 10 years. During that decade, revenue and profit nearly tripled but the stock has remained flat. Had a dutiful executive been given a generous grant of 100,000 options on January 2 2001 at $21.69 and held on to them to today, the executive would be able to exercise those for a profit of a mere $440,000 (at the current price of about $26 per share) – after 10 years of hard slog to triple the company’s real performance.
Of course, this is one example and there are examples all over the map – including those in which expectations track real performance exactly. But that is precisely the point: the relationship between real performance and expectations is all over the map.
The only way an executive can be sure to realise a return from the incentive compensation provided is to work first, foremost and directly on raising expectations from the current level – the only thing that makes a stock price rise – often at the expense of improving the actual underlying value and performance of the company.
There are much easier ways to accomplish that objective than working for a decade to triple the revenue and bottom line. It is much easier to go to the City and hype your stock. Or change your accounting treatment to appear to produce a jump in performance. Or make stupid acquisitions to appear like a fast-growing company.
Stock-based compensation was originally conceived as a way to align the interests of senior executives with those of the shareholders. Interestingly, it has created a wonderful alignment between segments of each: bloody-minded executives and hedge fund investors. Both profit most from expectations volatility. A bloody-minded executive bent on doing whatever is necessary to maximise stock-based compensation earnings will happily drive down expectations in order to get more low-priced stock compensation (whether options, stock or phantom stock) and then drive expectations back up to realise huge gains, then repeat the process until fired. Hedge funds, meanwhile, make all their money from volatility – the rise and fall of expectations – so they are totally aligned with and actually help out the bloody-minded executives in producing and profiting from volatility.
One might ask, what is the harm in all of this: a little hyping, some accounting hanky-panky, a few acquisitions that might not have been needed, executive compensation going through the roof, hedge funds making extraordinary profits. The problem is that this is a short-term game. Expectations cannot be made to rise forever – Jack Welch was the last chief executive to master that ancient art form – so executives need to raise expectations as precipitously as possible, and then simultaneously get out and cash out.
More than anything else, stock-based incentive compensation is responsible for short-termism in the modern corporation and the shrinking average tenure of today’s chief executives. It is an incentive for manipulating expectations rather improving real performance.
The solution is to replace stock-based compensation with incentives that affect underlying value – whether that is increasing revenues, profitability, market share, customer service or, optimally, a combination of all of these. And for longer-term incentives based on the actual market not the expectations market, use royalties on real results, as are given to designers, inventors and musicians. The bottom line is that if you want to skew reality, use stock-based compensation. But if you want to build the real company, use incentive compensation anchored in reality-based measures.
The Investor Responsibility Research Center (IRRC) Institute and PROXY Governance Inc. (PGI) recently released a new study, “Compensation Peer Groups at Companies with High Pay,” that identifies a subset of S&P 500 companies with high pay that is not aligned with high performance. The data reveal that high executive pay companies self-select larger than appropriate peers – in terms of market capitalization and revenue – for compensation benchmarking purposes. The self-selected peer groups also are better performers. Then, not content with systemically skewing the comparables for the purpose of setting executive compensation, the boards of directors of the high pay companies basically ignore the peer groups to compensate chief executive officers (CEO) an average of more than double, or 103 percent, above the median of the self-selected peer group.
By contrast, the baseline, or non-high pay, companies paid CEOs an average of 15 percent lower than the median of benchmarking peers. The key research findings are as follows:
– While all companies in the study tended to select larger compensation peers, the differential was more dramatic for companies with high pay. Measured by market capitalization, companies with high pay were an average of 45 percent smaller than self-selected peers versus an average of 5 percent smaller among baseline companies. Measured by revenue, companies with high pay were an average of 25 percent smaller than self-selected peers, while baseline companies averaged only 17 smaller.
– Unlike baseline companies, companies with high pay tended to select higher-performing companies as compensation peers. On average, companies with high pay performed 7.7 points worse than self-selected peers, based on the studyʼs aggregate scoring metric. By contrast, baseline companies performed an average of 3.0 percentile points better than their self-selected peers.
* Companies with high pay were also more likely (21 percent) than baseline companies (17 percent) to select other companies with high pay as compensation peers. Conversely, however, the average company with high pay appeared in fewer S&P 500 compensation peer groups, at 8.5, than the average baseline company, at 10.3.
– Companies with high pay compensated their CEOs an average of 103 percent above peer group median despite being 25 percent smaller than those peers by revenue. Baseline companies, by contrast, paid their CEOs an average of 15 percent below peer group median – a discount roughly in line with approximately 17 percent smaller average revenue.
– Companies with high pay also structured their larger CEO pay packages with a disproportionately richer mix of equity awards (69 percent of total pay) than either their self-selected peers (62 percent) or baseline companies (61 percent). Full value equity awards at companies with high pay constituted 41.3 percent of total pay, versus 35.2 percent among self-selected peers and at baseline companies.
– Contrary to general perceptions, having an external CEO on the compensation committee appeared to act as a mild deterrent to high pay. Among the S&P 500 companies, 6.5 percent of companies with high pay had external CEOs on the compensation committee, versus 9.0 percent of baseline companies. Across the broader Russell 3000, only 1.7 percent of companies with high pay had external CEOs on the compensation committee, versus 10.5 percent of baseline companies.
– Nearly 65 percent of companies with high pay had a CEO who was also chairman, slightly higher than the 60 percent rate among baseline companies. Baseline companies, however, were moderately more likely to have a classified board (29 percent versus 24 percent) or have had a shareholder pay proposal on the ballot in the prior three years (29 percent versus 24 percent).
In my experience, companies that benchmark to larger than appropriate peers do so because they pick their peer group based on aspiration, rather than reality. Yeah, I’d like to play like Tracy McGrady. If my board pays me to match his $23,239,561, will that motivate me enough to play as well as McGrady?
Just as the Sarbanes-Oxley Act of 2002 reduced the ability of a private fund’s representative to serve on the audit committee of a U.S. public company (a “public portfolio company”), it appears that the Dodd-Frank Act will have a similar impact on the service of a private fund’s representative on a compensation committee.
The Act requires the SEC to adopt rules no later than July 16, 2011, directing NYSE and Nasdaq to prohibit listing any company not complying with enhanced independence requirements for compensation committee members. In determining compensation committee “independence,” the Dodd-Frank Act requires public companies to consider at least the following factors:
– the source of compensation received by a compensation committee member, including consulting, advisory, or other compensatory fees (apparently including management fees paid by the public portfolio company to the private fund), and
– whether the compensation committee member is an affiliate of the public portfolio company or any of its subsidiaries.
Although subject to SEC rulemaking, the SEC will likely base “affiliate” status on the SEC’s traditional definition, i.e., a person that directly or indirectly controls, or is controlled by, or is under common control with, the issuer, with a presumption that more than 10% direct or indirect ownership of a an issuer creates affiliate status. If so, a representative of a private fund owning more than 10% (or of a group of private funds acting in concert and owning in the aggregate more than 10%) of a public portfolio company would be precluded from serving on the company’s compensation committee, subject to the “controlled company” exception described below.
While the Dodd-Frank Act exempts a “controlled company”–i.e., a company with more than 50% of its voting power held by an individual, a group or another issuer–from this compensation committee independence test, the Act does not exempt a public portfolio company if the private fund owns between 10% and 50% of its stock.
This compensation committee independence provision is apparently inconsistent with other provisions of the Dodd-Frank Act. On the one hand, the Act seeks to expand stockholder powers by giving stockholders (including a private fund stockholder) both a “say on pay” and access to the company’s proxy statement for the election of directors. On the other hand, however, as discussed above, it would apparently deny a stockholder owning between 10% and 50% of the company’s stock (including a private fund) the right to have its representatives serve on the company’s compensation committee. Furthermore, the Act fails to address why is it acceptable for a private fund that owns more than 50% of the public portfolio company’s stock to serve on the compensation committee but not acceptable for one that owns between 10% and 50%.
It is particularly noteworthy that, in contrast to the Sarbanes-Oxley Act, the Dodd-Frank Act does not impose an absolute and inflexible definition of “independence” and thus leaves discretion to the SEC, NYSE and Nasdaq in this regard. The SEC should carefully consider this provision of the Dodd-Frank Act–especially the “affiliate” requirement–before implementing rules that potentially disenfranchise those stockholders with the greatest interest in ensuring that executive compensation is appropriate and properly balanced.
– Doug Friske, Paula Todd and Steve Seelig, Towers Watson
In addition to ushering in the say-on-pay era in the United States and making other significant changes in the legislative framework for executive compensation and corporate governance, the Dodd-Frank Act opens a new and more constructive chapter in the debate about the independence of advisors to compensation committees. Specifically, Dodd-Frank expands the recent focus on multiservice consulting firms to a broader range of executive compensation advisors (including lawyers retained by compensation committees) and a wider array of potential conflicts of interest.
The legislation requires compensation committees to closely examine all potential and actual conflicts of interest that could arise with any advisor that they hire. Such potential conflicts go well beyond the assessment as to whether the consulting firm that employs the compensation committee’s executive compensation consultant also provides other services to the corporation. These so-called “other service” conflicts are the only type of potential conflict that may require companies to disclose their consulting fees under the SEC proxy disclosure requirement that took effect earlier this year.
Under Dodd-Frank, no category of advisors to board compensation committees is automatically exempt from potential conflicts, nor are there any “safe harbors” for specific categories of advisors (e.g., boutique executive compensation consulting firms that, by definition, provide no other services to their clients). In fact, the legislation stipulates that future SEC requirements must be “competitively neutral among categories of consultants, legal counsel, or other advisors and preserve the ability of compensation committees to retain the services of members of any such category…”
With this broader focus, compensation committees should no longer be tempted to take a “one size fits all” approach to thinking about the potential conflicts of their executive compensation advisors. In selecting consultants, compensation committees should look for advisors that are most appropriate for their own particular needs. Such needs include the reputation and resources of the consulting firm (including data, global reach and other factors), as well as the qualifications, experience, personal chemistry and availability of individuals who will work directly with the committee. In short, committees should evaluate all conflicts that could potentially get in the way of the consultant providing fully objective advice – and then determine whether and how any such conflicts can be mitigated.
This memo has answers to some of the most common questions companies have been asking about the legislation’s implications for consultant independence and the selection of executive compensation advisors.