In board and compensation committee meetings today, we hear a lot of talk about what is intended by the Dodd-Frank Act. And, rightly so. Dodd-Frank gives us the broad strokes on what reforms the government is seeking. In the area of executive compensation, Dodd-Frank covers four primary areas:
- Non-binding vote on say on pay
- Clawbacks in the case of any material financial restatement
- Increased disclosure around the relationship between executive pay and performance, and pay equity; and
- Rules around compensation committee member independence and compensation consultant independence.
Now that the broad agenda has been set by Dodd-Frank, board members are wondering how the SEC will interpret this direction and what new rules they will set. For example, in the case of clawbacks, how will companies actually determine amounts to be clawed back and how will they go about collecting these amounts?
While we can spend our time wondering what rules the SEC will come up with, it seems equally if not more important that we keep our eye on the basic intent of Dodd-Frank, which is to encourage better communication between companies and their investors. After all, the role of the SEC is to ensure that investors receive the information they need in order to be able to make informed investment decisions, not to opine on the quality of the executive pay programs themselves. This role suggests that investors, not the SEC, should be on center stage. The ultimate question is not, “What will the SEC require?” but “What do investors want from our executive compensation system, and are we giving it to them?”
To be sure, investors don’t have a completely uniform voice. For example, some investors focus on absolute performance of their portfolio companies (i.e., increasing shareholder value in absolute terms), while others focus on relative performance (i.e., increasing shareholder value relative to peers). Some think say on pay is a good idea, while others think it’s perfunctory. Despite these differences, we are hearing some common themes among investors.
- First, investors have told us that they generally see executive compensation as a “window into the boardroom.” In other words, if the executive compensation programs are transparent, reasonable and sensitive to company performance, then investors feel as though other aspects of corporate governance and operations likely will have integrity as well.
- Second, there is a view that executive compensation needs to be uniquely tied to the company’s strategy, but not at the expense of transparency and simplicity. Companies often make the mistake of either adopting plans that follow the herd, or on the flip side, adopting plans that are so unique that they lack transparency and are difficult to understand. Neither extreme serves the interests of investors, who already are resource-constrained in understanding executive compensation in their portfolio companies.
- Third, investors, particularly those who are in it for the long run (like pension investors), desperately want executives to rise and fall with the long-term fortunes of the business. They want executives to realize generous paydays only when long-term gains in performance can be sustained, and conversely, they want executives to feel the pain when there is no long-term gain. Accordingly, investors take comfort in plan design features that measure performance over multi-year periods, strike the right balance between risks and rewards and encourage a real ownership stake.
- Fourth, investors want to see the whole picture. They don’t want compensation that is hidden or comes from a dozen places. Moreover, they want to understand how all of the pieces of compensation, as well as pay actions, work together to create the right result. And finally, they want companies to communicate “early and often.” They don’t want to feel as though the board and executives are “hiding out.”
In the coming months, we will learn more about what investors want. This knowledge will come from a number of sources, including SEC comment letters, say-on-pay votes and direct conversations with investors. In the meantime, investors have given companies some clear conversation starters.
Robin A. Ferracone is founder and executive chair of Farient Advisors, an executive compensation consulting firm and author of the recently published Fair Pay, Fair Play: Aligning Executive Pay and Performance. Contact her at Robin. Ferracone@farient.com.