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Since leaving Alcatel-Lucent as CEO in 2008, Patricia F. Russo has stepped up her board service. She is a member of the Alcoa, Merck & Co. and KKR boards; serves as lead director at General Motors; and chairs the human resources and compensation committee at Hewlett-Packard. In the days after the Securities and Exchange Commission issued rules that included a mandate on compensation consultant independence, and following year two of new say-on-pay rules, Russo joined Farient Advisors founder and CEO Robin A. Ferracone for a conversation about the issues currently facing compensation committee members.
Illustration by J. T. Morrow
Russo: I believe we have been evolving to a new normal with respect to corporate governance. The now-required say-on-pay vote has clearly brought more attention to the decisions of the compensation committees and the vote results. There is plenty of evidence that compensation committees and boards are considering what the outcome of the vote may be, and in some cases making modifications in order to gain advisory firm shareholder support that often require greater engagement and more communication than in the past. In that regard, certainly, things have changed.
Ferracone: When say on pay was introduced in 2010, there was a broad spectrum of thought ranging from, “Gee, it’s a nonbinding vote. It’s really not going to mean much,” to “The sky is falling because now shareholders will vote on things like our pay and they’re going to dictate what happens in the boardroom.” My take on it is that we have landed in the middle ground, and a much more positive outcome has occurred.
Russo: I agree that there are more positives than negatives. I do think we have to be careful that the say-on-pay process does not get out of control or balance, let’s say. It is important to remember that shareholders and proxy advisory firms, while knowledgeable, will not have the same depth and understanding as members of management and the board about the business, the industry, what it takes to keep people, and what the right metrics are to drive the operating performance that best aligns with shareholders’ interests. As long as we can continue to find that right balance in the center of the extremes you mentioned, I think say on pay can have a reasonably positive impact. I also think it is fair to say that the existence of say on pay has resulted in needed changes of the more problematic pay practices. In that regard, say on pay has been an enabler of needed change.
Ferracone: I think that’s right. One of the things that has struck me in talking with investors is that it’s really clear they’re not trying to do the job of the board. Rather, they want to make sure they’re holding the board accountable—and ensure that the board is doing the job for which they were elected and paid.
Russo: We’re only two years into say on pay, and one of the things I do worry about is too much influence by one or more proxy advisory firms where the shareholding institutions have policies to vote as advised by these firms. That puts a tremendous burden on ISS or Glass Lewis to get it right—or as close to right as possible. That is of concern.
Ferracone: What you’re talking about is concentration of power. My experience is that the investors are actually questioning the proxy advisors, and they’re using them for the most part as input and not as dispositive vote makers. And so what we end up with is the power of the proxy advisors being diminished, not increased.
Russo: Although the numbers suggest reasonably significant vote swings.
Ferracone: Approximately 25 percent of the vote appears to be attributable to an ISS recommendation, which is significant but, I think, less significant than last year.
Russo: I must say, to your point, I have found in interacting with some investors that they will consider the proxy firms’ advice but ultimately make their own independent judgment.
Ferracone: Doesn’t that mean, then, that the companies need to take some of the control here and initiate direct communication with the investors and not let the proxy advisors drive the vote? Doesn’t that mean that companies must disintermediate the proxy advisors from the investors—that is, eliminate the middleman, to some extent, by having direct communication?
Russo: Yes, obviously each company has to understand its shareholding base, including understanding their policies and philosophies relating to executive compensation. That includes, of course, how they may vote on say on pay, because the institutions have different views.
Ferracone: Investors are telling us that they want to hear from compensation committee chairs directly if ISS has recommended a “no” vote and there are material issues with the pay programs. Conversely, investors are telling us that they are willing to hear from management if the pay program is generally acceptable and there are only minor refinements that should be made. In the case of big issues, they want to hear from compensation committee chairs, and perhaps their advisors, because they think hearing from management is too self-serving.
Russo: I think that is understandable. One of the large companies on whose board I serve had a “no” vote on pay in the first year. We reached out to understand shareholders’ issues, we made changes, and as the new comp committee chair, I participated in a number of shareholder calls where we shared the changes that we had made, the logic and philosophy, and we took questions and got input. The feedback that we received from those sessions was very positive because, as you said, shareholders want the opportunity to be heard, and they want to hear directly from the committee when significant issues are involved.
Ferracone: One result of say on pay is that there is an increased focus on pay for performance. Until recently, pay for performance had been a pretty nebulous area. In fact, many companies think that they’re aligned with shareholders if they offer a lot of stock incentives. But this isn’t necessarily the case. At Farient, we have a two-part test for alignment: One, is pay reasonable for the size of the company, its industry or peer set, and the performance it’s delivering? And two, is pay sensitive to performance? If performance goes up, does actual pay go up with it, and if performance goes down, does actual pay also go down with it?
Russo: This comes back to how competent independent consultants can be helpful to committees. They can help look at the historical data and see how targets have been set and whether the payouts have been reasonable. There are some judgments that can be made about the degree of difficulty from a goal-setting standpoint. There is analysis that can be done around how pay has been linked to performance over time from a shareholder standpoint, and how the operating results of the company link ultimately to shareholder value creation. The underlying assumption has always been that if you produce operating results and you grow earnings and you grow cash and you provide a good return on invested capital, you are going to create value.
When you look at performance and pay, there must be a “realized pay” dimension because there is generally a very high-equity component, particularly in a CEO pay structure. The equity component could be 75 or 80 percent, right? You have a very high component tied to value creation. And when value is not created for shareholders, depending upon the structure, then the CEO doesn’t realize that value.
Ferracone: Using grant-date value for equity awards is flawed for assessing the relationship between pay and performance.
Russo: I agree it is flawed. So I believe that if you really want to assess pay for performance, you’ve got to look at realized pay and not target pay. Target pay is what you intend someone to get if they perform. Realized pay is what they actually get, which is intended to be related to performance.
Ferracone: Our model looks at performance-adjusted compensation, which values the equity granted over a given period of time and the value at the end of that period. This way, the time horizon of the compensation being assessed and the time horizon of the performance being assessed both match. In addition, no single equity vehicle is either advantaged or disadvantaged using this methodology.
Russo: That makes sense. One of the philosophic questions that committees have to address is around the notion of “target” and whether target pay should be adjusted downward in cases of underperformance. If the CEO continues to underperform, it is not just a pay issue—the board needs to determine whether to keep the CEO in the job. These are complex issues. What is going on in the economy? Is the CEO doing the best job possible in a very difficult environment? Or is the CEO just not up to the job?
Ferracone: We have this debate going on with one of our clients right now. We are biased as a firm toward setting target pay as the starting point, and then letting performance take care of whether actual pay is above or below market. So, if you give above-market equity because performance is good, then the value of that equity can spiral out of control, or even be above market for below-market performance. You’ve turbocharged the pay by virtue of targeting pay at above or below market levels in response to the prior year’s performance.
Russo: That’s how pay got ratcheted up during more prosperous times.
Ferracone: In general, a median pay positioning should be your starting point. Then let performance take care of whether the actual pay is high or low in response to actual performance. I also think doing diligence around what measures are eventually going to link to value in the long run is useful. It’s folly to look at one-year TSR [total shareholder return]. You need to look at TSR over three or five years or even longer depending upon the industry. And looking at rolling periods over time is actually good practice to see whether pay and performance have linked in that regard.
Russo: I agree with that. I think thoughtful deliberation around which companies are the right comparators is also important. So, for pay, committees have to think through, Are we only looking at industry peers? Or are we going to focus on companies of similar size with similar characteristics and across the general industry? Are we looking at large, global, integrated companies or companies that look more like holding companies? Those are just some examples. Also, for performance, what’s the context within which we’re going to look at total shareholder return? Is it industry peers, other like companies across industry, the S&P, the Dow, or is it an industry index? I think those are very important discussions, and the answers will vary depending upon the circumstances.
Ferracone: If you don’t have good analysis around the peer group, you may just be paying for volatility and not for real performance. Paying for volatility is not something that committees really want to do, but they might do it inadvertently if they don’t take a careful look at that. When you’re looking at peers, it’s important to think not only about what peers make sense for pay comparisons, but also what peers make sense for performance comparisons. Remember, performance is part of what we’re trying to assess here. We’re trying to calibrate both sides of the pay-for-performance equation, and so the peer group for various reasons may not be exactly the same for both purposes, but hopefully there will be some overlap. That’s the kind of sophistication and thought that companies need to put into the process of peer group selection.
Russo: To your point, the company is in the best position to define or recommend to the compensation committee which companies should be used to compare performance and why. Then the committee should have a thoughtful review and discussion with the help of the independent comp consultant. The peer group for performance will likely be a subset of the companies used to benchmark pay. I do not think this is best done by proxy advisory firms, as they can’t possibly have the level of knowledge about peers that the company has. Then, of course, that should be fully disclosed and understood by investors as they evaluate relative performance.
Ferracone: Yes, and this gets to disclosure issues. In the disclosures, companies should talk clearly about the criteria of how they thought about the peer group and how the selection process worked. Disclosing the thought process is as important as disclosing the peer companies.
Russo: But to me, you need to compare people who are managing like kinds of challenges and issues as opposed to, you know, “Well, this company is $5 billion and that company is $5 billion,” but their business models are completely different.
Ferracone: A good example is the issues in comparing an online retailer to a brick-and-mortar retailer. The business models are different.
Russo: Right. It’s totally different, and I don’t think that level of sophistication is captured by proxy advisory firms’ methodology, at least not yet, and that’s a disservice to the company and to investors.
Ferracone: We had spoken a bit earlier about the CD&A and how companies can make additional improvements in their disclosures. First, executive summaries have become popular for pointing out important changes and explaining the philosophical grounding of the pay system. Second, a Q&A section can be very effective. One of our clients used a Q&A section in this year’s proxy to respond directly to the issues that the proxy advisors had raised about their pay system. In response, their say-on-pay vote, while already good, rose even higher. Third, I think a clear pay-for-performance section is critical. The SEC hasn’t come out yet with their rules, but some companies, in anticipation of the rules, are including a pay-for-performance section in their CD&A, which is extremely helpful to investors because it’s such a core issue. Finally, investors report to us that graphics are extremely helpful.
Russo: I would say that the executive summaries are the most important section—written in layperson language that answers the most fundamental questions that shareholders have. I also believe there’s a push to disclose, disclose, disclose, and we lose sight of what the real purpose of the disclosure is. Here is another case for balance.
Ferracone: So more is not necessarily better.
Russo: Right. Let’s go back to the problem we are solving. The problem we’re solving is that investors need to understand how pay is targeted, what the metrics are and why, how are people performing, and are you really paying for performance. Obviously, there is interest in what other forms of compensation the CEO and most senior people are receiving, and those must be disclosed with full transparency. I distinguish that from the debates about what level of specific metrics should be disclosed, especially when you get into potential competitive issues. So, I say again, having the right balance is important.
Ferracone: I would say that investors are really appreciative when you put the “What did you do?” in the proxy, and also the “Why did you do it?”
Russo: I agree.