If nature abhors a vacuum, then it is probably fair to say that regulation loves one. And a vacuum is, in some ways, what we have in the world of executive compensation. While disclosure requirements for compensation of senior public company executives have dramatically increased in the recent past, many people outside the boardroom (and a handful inside it) feel there is a lack of genuine understanding about how executive pay is set and what role the board and the compensation committee really play.
Robin A. Ferracone
Speaking at the NACD’s Compensation Committee Advisory Council forum, Robin Ferracone, executive chair of Farient Advisors, an executive compensation and performance consulting firm, said that while the challenge of evaluating and setting CEO and executive compensation is becoming more of a lightning rod, companies that can pass the “red-face test” will have a relatively easy time with the new disclosure and say-on-pay rules. Those that cannot may be treated harshly.
Those attending the meeting highlighted several issues that need to be addressed, both in the fundamentals of setting pay and in the way those pay decisions are communicated to shareholders and to the wider community. Perhaps the most important questions to emerge from the discussion were: Why are some CEOs pilloried for their compensation while others—even those who may make more—are held up as heroes? There is little, if any, consequence for underperformance—in fact, CEO pay never seems to go down. How should directors really measure performance, and how can compensation structures and policies be best communicated to shareholders, the media and the general public? Until these issues are addressed, there can be no meaningful discussion of the role of the compensation committee.
Some participants questioned the premise that the compensation system is “broken,” and even the need to have the conversation. Why is such a dialogue important? they asked.
Ann Yerger (left), Arthur C. Martinez and Stephen L. Brown
Ken Daly, NACD president and CEO, answered succinctly: “If we don’t do something about this, then Congress will do it for us. If directors only do what is mandated [in terms of curtailing CEO pay], then we are going to get stronger regulation. Up to this point Congress has generally been happy changing behavior by increasing disclosure, but their patience has run out and they are starting to take a far more aggressive approach. If we don’t get ahead of issues and concerns around compensation—real or perceived—then we will lose control of the discussion.” In short, regulatory overtone is filling the gap in board leadership.
Shareowner advisory votes on executive compensation were the big story of proxy season 2011, the inaugural year for “say on pay” at most U.S. public companies. Dodd-Frank Section 951 provided that shareholders would have the right to cast three types of votes on executive compensation: an advisory vote to approve the compensation paid to named executive officers in the prior fiscal year (say on pay); a vote on how often this vote should be held (the “frequency vote,” sometimes referred to as the “say-when-on-pay vote”), and a vote to approve so-called “golden parachute payments” made in connection with an acquisition, merger or other specified corporate transaction.
Early attention of companies and executive compensation professionals was on the frequency vote and what frequency companies would recommend and shareholders would support. However, in recent months, focus has been on say-on-pay votes, proxy advisor recommendations, company responses and meeting results.
Against this backdrop, directors and governance experts engaged in several hours of sometimesheated conversation, which resulted in a handful of steps and resolutions that boards should take in order to take control of the issue and become leaders of compensation strategy.
1. The board must be the leader of the compensation process. While in theory it is the job of the compensation committee (and ultimately the entire board), in reality, many boards feel that the CEO dominates the conversation while the board is reduced to a reactionary role.
The board needs to regain primacy on compensation philosophy, metrics and planning. The compensation committee must set the tone and own the process. This may require the compensation committee to adopt a different tone or approach than other committees that provide oversight and work collaboratively with management. The compensation committee should be less collegial and realize that this is one of the few areas in which it has total responsibility. They shouldn’t act like dictators but, as one chairman pointed out, “You should remember that the CEO is really just an employee. This will assist greatly in setting the tone for compensation conversations.”
2. Tie pay to performance and define the metrics. Ferracone cautioned that assessing pay and performance is tricky. Perhaps the most common mistake is looking at the grant value of long-term incentives, rather than at the value of long-term incentives after performance has happened. To achieve the Holy Grail of pay—i.e., tying it to long-term performance—use forward-looking metrics rather than backward-looking responses to past performance. The board should conduct a robust discussion of how pay aligns with strategy. This should be a formal agenda item. Nonfinancial metrics should also be considered because they can have a tangible impact on both short- and long-term value. Broaden the scope of what is considered value creation and sustainable growth. Consider the impact the company has on the wider community. Some companies are including metrics such as workplace safety, reliability of service and customer satisfaction.
Stephen Brown, director of corporate governance at TIAA-CREF, suggested linking any increase in CEO pay to pay within all levels of the organization. “You could match the CEO compensation story with employees, shareholders and others,” he said. “If CEO pay goes up 20 percent but general employee pay only goes up 2 percent, you are likely to have a problem.” In other words, it can be very difficult to justify this type of increase, not just to the media but also to the workforce.
The board must also create a structure that outlines negative consequences for poor or nonperformance. Variability in executive pay is acceptable. The compensation committee should not be constrained by legacy metrics. It is easy to get trapped in a steady stream of upwardly ratcheting pay—CEO pay never really seems to go down.
Noted Arthur Martinez, director at AIG, Pepsi- Co, IAC/Interactive, Liz Claiborne and International Flavors & Fragrances, there is a “lack of true variability in pay at top levels. It is very hard to have the conversation that we can’t tell them their bonus will be 75 percent lower than last year. CEOs don’t always take that well. It’s the responsibility of those of us on committees to have that discussion and to introduce a real sense of variability.”
The Issue of Perception
Talent development is a critical part of the process. If the board is confident that the company has a robust and talented leadership team, then it will feel less beholden to the CEO when negotiating pay levels.
Perhaps most important, both for directors and those opining from the sidelines, is to consider reducing the complexity of the compensation program. The more layers or moving parts presented in a program, the more difficult it is for people to understand what the “total” amount of compensation is. What’s more, complicated programs make observers feel that something is being hidden or that confusion is intentional.
Of course, all of this is meaningless if no one is aware of it. Compensation is being played out in the public arena, and boards need to get better at articulating and communicating the compensation strategy, how it is genuinely linked to both financial and nonfinancial performance, and how it compares to others. Addressing the perception issue—that all CEOs and executives are overpaid—can only be done through clear, concise disclosure and an open approach to strategy and performance. Yes, there are competitive reasons to withhold certain strategy elements, but don’t hide behind these too much.
There is great danger in assuming the general public and outsiders do not know enough to understand the finer points of compensation strategy. The new reality is that these are the people who are driving regulation and lawmaking, and directors ignore them at their peril.
Of all the challenges in setting compensation, perhaps the most vexing is clarifying the perception of compensation among all those outside the boardroom. With that goal in mind, the NACD Compensation Committee Advisory Council will meet regularly to examine solutions, and plans to release proposals and practical advice for all compensation committee members.
Takeaways
The NACD Compensation Advisory Council recommends that compensation committee members consider the following key points when designing executive pay programs:
- More aspirational goals should be discussed, considered and disclosed.
- No pay for lack of performance. Create real up- and downside variability in pay.
- Equity: Is the CEO really worth it? Find a better, more accurate way of defining performance.
- Have more conversations with shareholders. Is there a problem with your pay program? Maybe the entire structure needs revisiting.
- Compensation committees need to take a greater oversight role in talent management.
- Make CD&A disclosures more readable for average shareholders.
Participants
Adam M. Aron: Director, Starwood Hotels, Prestige Cruise Holdings
Glenn H. Booraem: Fund Controller, Principal, Fund Financial Services, The Vanguard Group
James R. Boyd: Director, Arch Coal
Stephen L. Brown: Director of Corporate Governance and Assoc. General Counsel, TIAA-CREF
Dr. George Campbell Jr.: Director, Consolidated Edison, Institute for Internal Education
J. Kermit Campbell: Director, SPX Corp.
Betsy Z. Cohen: Director, Aetna
L. Dale Crandall: Director, Coventry Health Care
Ken Daly: President and CEO, NACD
Richard M. Donnelly: Director, Oshkosh Corp.
Kevin Edgar: Senior Counsel, Capital Markets/Securities U.S. House of Representatives, Financial Services Committee
Robin A. Ferracone: Executive Chair, Farient Advisors LLC
Barbara Hackman Franklin: Chairman, NACD
Brenda J. Gaines: Director, Fannie Mae, Nicor, Office Depot, Tenet Healthcare
Steven T. Halverson: Director, CSX, Blue Cross Blue Shield of Florida
Roy A. Herberger: Director, Apollo Group
Thomas Kim: Chief Counsel and Associate Director, Division of Corporation Finance, SEC
Linda H. Lamel: Director, Universal American Financial Corp.
Arthur C. Martinez: Director, AIG, IAC/Interactive Corp., PepsiCo, Liz Claiborne, International Flavors & Fragrances
Patrick S. McGurn: Executive Director, Institutional Shareholder Services
Ronald O. Mueller: Partner, Gibson, Dunn & Crutcher
Georgia Ricci Nelson: Director, Cummins
David S. Pottruck: Director, Intel
Gary L. Roubos: Director, Omnicom Group
Richard D. Shirk: Director, Amerigroup Corp.
Christopher A. Wightman: Senior Manager, The Vanguard Group
Edwina D. Woodbury: Director, Radioshack
Ann Yerger: Executive Director, Council of Institutional Investors