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.
I just finished writing a special July-August issue of The Corporate Counsel entitled “Say-on-Pay Solicitation Playbook: Practical Guidance on Strategies and More.” You will need this issue to help you prepare for mandatory say-on-pay. It includes analysis on:
– A Wake-Up Call: The Big Three
– The Drill Down: Why Did Shareholders Reject Motorola, Occidental and KeyCorp?
– The Cry for Shareholder Engagement: What is “Shareholder Engagement”?
– The Roadmap: How (and When) to Engage Effectively
– Overcoming Reg FD Concerns about Engagement
– Peeking Under the ISS Hood
– How Proxy Advisors & Major Institutions (& Employees) Vote on Pay
– The Roadmap: “When” and “How” to Hire a Proxy Solicitor
– The Preliminary Vote Count Looks Close: What Can You Do?
– Confidential Voting Policies: Proper Implementation
– How to Calculate Voting Result Percentages: Read Your Bylaws (and Compare with Your Proxy)
– The Importance of Making Your Compensation Disclosure “Usable”
– How to Gear Up for Mandatory Say-on-Pay
Ahead of our package of two full-day Conferences on the executive pay provisions of the Act – coming up in less than two months, catch tomorrow’s special pre-conference webcast to help you start taking the actions you need to be taking now. Dave Lynn, Mark Borges and Mike Kesner headline this webcast: “The New Pay Legislation: Action Items.”
Last week, AFSCME and Shareowners.org released a report on how 25 large mutual fund families voted on compensation issues during the 2009 proxy season. Notwithstanding the title, “Compensation Complicity: Mutual Fund Proxy Voting and the Overpaid American CEO,” the report found that mutual funds overall have become more supportive of shareholder proposals seeking annual advisory votes and other pay reforms.
The average level of support for compensation-related proposals–which also included resolutions seeking compensation consultant reforms, votes on “golden coffin” benefits, equity retention periods, and performance-based equity and severance–was 56 percent in 2009, up from 45 percent in 2008. The report was based on 2009 Form N-PX filings by mutual funds that included their votes from July 1, 2008, through June 30, 2009. According to the report, “the increase in aggregate support appears to have been driven by a substantial increase in support of [“say on pay”] shareholder proposals–from 45 percent in 2008 to 60 percent in 2009.”
The report, which was co-sponsored by the Corporate Library, also reviewed voting on management-sponsored equity plans, management “say on pay” votes, and the election of certain compensation committee members at S&P 500 firms.
Overall, the 25 mutual fund families were slightly less willing to vote against directors over compensation issues. The average support for selected S&P 500 directors (those who received more than 30 percent opposition overall based on pay concerns) was 50 percent in 2009, as compared with 48 percent in 2008.
The average level of support for management proposals on compensation issues was unchanged in 2009 at 84 percent, the report found. However, the mutual funds were less likely to back management during advisory votes on compensation; the average support was 77 percent last year, according to the report. That was below the 89 percent approval rate by all investors, according to ISS data.
The report observed that fund families have different approaches to executive pay issues. “Some emphasize strict limits applicable to management-proposed pay plans; others favor more specific measures suggested in shareholder proposals; and others express discontent primarily through withholding support for the reelection of certain directors deemed responsible for pay decisions. Indeed, only two fund families ranked in the top 10 for all three types of voting (management, shareholder proposal, and director), and only seven fund families ranked in the top 10 for two or more types of voting,” the report said.
Everybody is kung fu fighting. Quirky I know, but I couldn’t shake that song in my head as I read this NY Times’ front-page article on Friday about Special Master Ken Feinberg’s report about how 17 financial companies paid a total of $1.58 billion in executive compensation during the heart of the economic crisis. I probably should have been singing “Rich Girl” instead. Looking at the Special Master’s web page, I guess this is all there is – a 3-page report.
For the most part, Feinberg didn’t “name names” and his power is fairly limited since 11 of the 17 companies have repaid their TARP funds. Feinberg had conference calls with each of the companies over the past few weeks to lay out his proposals about how their compensation structures could be “fixed” – but as this WSJ article notes: “None of the firms contacted Friday said they would adopt the proposal on its face, with most saying they needed to study it, receive more detail or declining to comment. Others pointed out that they have already instituted similar procedures designed to claw back undue compensation.”
This post is copied from what Lucian Bebchuk recently blogged on the “Harvard Corporate Governance Blog,” and is based on his, Martijn Cremers and Urs Peyer’s recent op-ed article for the international association of newspapers Project Syndicate. The op-ed article discusses the findings of Bebchuk, Cremers, and Peyer’s recent empirical study:
There is now intense debate about how the pay levels of top executives compare with the compensation given to rank-and-file employees. But, while such comparisons are important, the distribution of pay among top executives also deserves close attention.
In our recent research, we studied the distribution of pay among top executives in publicly traded companies in the United States. Such firms must disclose publicly the compensation packages of their five highest-paid executives. Our analysis focused on the CEO “pay slice” – that is, the CEO’s share of the aggregate compensation such firms award to their top five executives.
We found that the pay slice of CEOs has been increasing over time. Not only has compensation of the top five executives been increasing, but CEOs have been capturing an increasing proportion of it. The average CEO’s pay slice is about 35%, so that the CEO typically earns more than twice the average pay received by the other top four executives. Moreover, we found that the CEO’s pay slice is related to many aspects of firms’ performance and behavior.
To begin, firms with a higher CEO pay slice generate lower value for their investors. Relative to their industry peers, such firms have lower market capitalization for a given book value. The ratio of market value to book value, termed “Tobin’s Q” by financial economists, is a standard measure for evaluating how effectively firms use the capital they have.
Moreover, firms with a high CEO pay slice are associated with lower profitability. The operating income that such firms generate, relative to the value of their assets, tends to be lower.
What makes firms with a higher CEO pay slice generate lower value for investors? We found that the CEO pay slice is associated with several dimensions of company behavior and performance that are commonly viewed as reflecting governance problems.
First, firms with a high CEO pay slice tend to make worse acquisition decisions. When such firms make acquisition announcements, the stock-market returns accompanying the announcement, which reflect the market’s judgment of the acquisition, tend to be lower and are more likely to be negative.
Second, such firms are more likely to reward their CEOs for “luck.” They are more likely to increase CEO compensation when the industry’s prospects improve for reasons unrelated to the CEO’s own performance (for example, when oil companies benefit from a steep rise in world oil prices). Financial economists view such luck-based compensation as a sign of governance problems.
Third, a higher CEO pay slice is associated with weaker accountability for poor performance. In firms with a high CEO pay slice, the probability of a CEO turnover after bad performance (controlling for the CEO’s length of service) is lower. Lower sensitivity of turnover to performance reflects less willingness on the part of directors to discipline the CEO.
Finally, firms with a higher CEO pay slice are more likely to provide their CEO with option grants that turn out to be opportunistically timed. A high CEO pay slice is associated with an increased likelihood of the CEO receiving a “lucky” option grant with an exercise price equal to the lowest price in the month in which it was granted. Such “lucky” timing is likely to reflect the use of insider information or the backdating of option grants.
What explains this emerging pattern? Some CEOs take an especially large slice of the top five executives’ compensation because of their special abilities and opportunities relative to the other four. But the ability of some CEOs to capture an especially high slice might reflect undue power and influence over the company’s decision-making. As long as the latter factor plays a significant role, the CEO pay slice partly reflects governance problems.
We should stress that a positive correlation between a CEO’s pay slice and governance problems does not imply that every firm with a high CEO pay slice has governance problems, much less that such firms would necessarily be made better off by lowering it. In some such firms, the large pay slice captured by the CEO may be optimal, given the CEO’s talents and the firm’s environment, and reducing the CEO pay slice might thus make the firm and its shareholders worse off.
Still, our evidence indicates that, on average, a high CEO pay slice may signal governance problems that might not otherwise be readily visible. Investors and corporate boards would thus do well to pay close attention not only to the compensation captured by the firms’ top executives, but also to how this compensation is divided among them.
We recently wrapped up our latest report – “PM&P On Point: 2010 Executive Pay-for-Performance Survey” – which is a comprehensive survey that provides a wealth of detailed, actionable data about the selection and setting of long- and short-term performance standards among 630 employees and outside directors across a wide range of company sizes and industries. Benchmarking data provides the perspective needed to adapt your organization’s executive incentive programs to meet changing governance and regulatory standards. Here is the 22-page Executive Summary of the report.