Economic turmoil and Congress’ financial-services bailout package (with compensation strings attached) have brought executive pay to the forefront, if that was even possible, given the attention executive compensation was already garnering. Boards face difficult questions about how to connect strategy to compensation and continue to provide incentives to executives during a steep economic downturn. James V. Hughes, senior managing director of Pearl Meyer & Partners’ Los Angeles office, and managing directors Michael T. Esser and Daniel M. Wetzel led a Directorship Roundtable on the daunting challenges faced by directors in such uncertain times.
The fallout from the credit crisis has caused higher volatility, lower stock prices, and overall business instability. Eighty percent of S&P 500 companies have a higher degree of stock volatility in 2008 than a year ago. With previous performance targets unreachable, stock options under water, and companies unable to accurately predict where the market is going in the long term, directors must recast their compensation strategies to meet objectives amid heightened scrutiny of executive pay.
Many executives are holding stock options that are hopelessly out of money, damaging the alignment with shareholder interests that these packages aim to achieve. In fact, said Hughes, companies are planning the process of issuing additional awards. “Based on stock price, companies will be increasing the number of awards by 15 to 20 percent,” he said. When stock prices are on the rise, shareholders are less likely to be disgruntled with the diluting effect of awarding stock options to executives. However, in the current economy, companies are doling out more options because prices are down this year, and they deliver less value as a result. “It’s a little counter-intuitive,” noted Hughes. “Stock prices are down, yet companies give out more stock options.” One possible solution, he said, is performance-based equity. “We are seeing greater movement from restricted stock to performance-based equity,” he added.
Another potential setback is that disclosure changes have also affected executive pay. A company might review compensation, but that does not mean its review is detailed. Instead, many companies limit themselves to a broad overview of the company’s compensation policies. “Two companies can have very different- looking charters,” said Otis Baskin, professor at Pepperdine University. “The difference between a charter being one page and another being 14 pages is simply whether one is a checklist.”
Going Beyond the CD&A
Regulatory requirements can also be seen as a hindrance to directors looking for solutions. Rajesh Shrotriya, chairman, president, and CEO of Spectrum Pharmaceuticals, believes boards spending excessive time meeting disclosure requirements. “The SEC mandates 400-plus pages of CD&A—we’re being very reactive,” said Shrotriya. He noted that because so much time must be devoted to regulatory concerns, boards are unable to focus on making the company successful.
Disclosures push shareholders to demand an overall harmony with the company philosophy and the associated risk factors. “There is much more rigor among shareholders,” said Mark Casner, president and CEO of Digirad. “You have to disclose everything and the board is very aware of the transparency—the company plane went away a long time ago.”
Management in the Trenches
Retention is less of a factor when laying out compensation needs. The economy has forced leadership roles onto perilous grounds. Battles in which CEOs and management are embarking often hold many challenges, resulting in increased expectations for combat pay. “Despite the pressures, boards need to batten down the hatches on compensation,” said Jeffrey M. Cunningham, chairman and CEO of Directorship.
“While it’s an enormously difficult time to manage, I don’t think boards are feeling very generous,” said Robert E. Gipson, attorney at Gipson Hoffman & Pancione and chairman of First California Financial Group. “But I can be sympathetic with that idea of [combat pay].”
In order to address compensation issues such as combat pay, directors need to focus on what strategy the compensation committee will choose to best motivate their employees. “It’s a core business issue,” added Elizabeth Harrington, CEO of Harrington Global. “You need to be strategic to set up the right objectives and motivate people.”
Discovering where to draw the line between providing the right incentives and ensuring pay for performance can be difficult. “You have a very delicate dance balancing the different interests, and this is where combat pay is right now,” said Larraine D. Segil, partner emeritus at Vantage Partners. Segil noted that a management team that turns around older operating companies is expecting its due. “If they don’t have the recognition…you don’t retain them very long,” said Segil. Being able to satisfy both long- and short-term compensation needs is key.
Planning for the Unexpected
In order to compile effective entry and exit packages, comp committees and management need to interface freely with one another. “There needs to be good communication between compensation committees and management—not just once a year when it’s time to approve the compensation,” said Suzy Papazian, corporate secretary and attorney with San Jose Water Co. “You really need to understand how to set performance and compensation goals.”
With the potential need to replace the CEO during difficult times, boards need to pay close attention to how termination payouts may look under the glare of public scrutiny. When devising a pay package, Hughes noted that the worst-case scenario is a termination provision. “When Fannie and Freddie went down, their exit packages for the company were not bad,” said Hughes. A company needs to prepare for retaining talent, as well as releasing an executive with a predetermined exit package.
A Harmonious Alliance
“What should comp committees be on the lookout for?” asked Cunningham. With numerous issues facing the chair and CEO, building a harmonious and cooperative alliance is imperative to a successful business. When the relationship is strained, it obstructs the efficiency and overall success of the process.
PM&P’s Wetzel points to an example where contention between the comp committee chair and CEO resulted in a change. “The chair was overly sanctimonious and reluctant to ‘throw money away,’ ” said Wetzel. “We ended up switching out the comp committee chair because there was too much bad blood between the two.” Another chair was elected to bridge the emotional gap, and a crisis was averted.
Differences between the chair and CEO are often inevitable, but both need to work toward aligning their views to serve the best interests of the company. “Try to be independent, try to be truthful,” said Hughes. “But at the end of the day, there’s got to be some kind of agreement there.” He noted that bringing in an advisor to help settle a conflict should be a last resort. “While [the advisor is often] able to overcome the challenge, it can take a long time,” said Hughes. When shareholders are unhappy, they will voice their concerns to their CEO and the board as a whole. With both the chair and CEO on the same page, their ability to address shareholder concerns is strengthened.