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Speaking at the NACD’s recent National Compensation Advisory Council, 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?

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.

Several hours of sometimes-heated conversation 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 made is looking at the grant value of long-term incentives rather than 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, PepsiCo, 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 NACD’s Governance Advisory Council, comprising directors who chair board nominating and governance committees at Fortune 200 companies, met recently with top decision-makers from the Securities and Exchange Commission (SEC), Institutional Shareholder Services (ISS), Vanguard, the California State Teachers’ Retirement System (CalSTRS) and the Council of Institutional Investors (CII) to candidly discuss perceived barriers and practical solutions to bolster shareholder confidence. In particular, the Council addressed the opportunities and challenges of board composition. The meeting was supported and co-hosted by Heidrick & Struggles International.

Directors, shareholders and regulatory representatives discussed the need for boards to apply maximum capacity to strategic issues in this environment. Directors expressed concern that responding to a bevy of rule making stemming from the Dodd- Frank Act will divert board time and attention away from strategic and risk oversight issues.

All constituencies concluded that relying on compliance and disclosure measures is not an effective way to bolster shareholder confidence and that more can be done to get ahead of the issues.

The Council suggested the following areas where both boards and shareholders can apply their energies and time:

Outcomes of the 2010 proxy season provide guidance for 2011
Patrick McGurn, special counsel for ISS, noted that ISS’ recommendations in favor of boards’ nominees and investors’ support for these candidates were actually higher during the 2010 season than they had been in 2009, despite the elimination of broker discretionary voting. “Big company boards have fixed the structural issues, such as independence and attendance, that shareholders view as the ‘chlorine in the government swimming pool,’” said McGurn. Instead, the 2010 bull’s-eye landed on mid-caps and smaller companies where structural flaws gave rise to the lion’s share of the season’s failed director elections. Because investor confidence remains shaky going into 2011, McGurn suggested that mid- and small-cap firms can expect an equal or greater level of scrutiny going forward.

Boards can increase oversight of the shareholder communications process
Both directors and stakeholders in attendance agreed that it was important for a board to know who the key shareholders are, understand their disparate concerns and gain a clear understanding of how the company and management have responded to their concerns. Establishing a benchmark of understanding will give the board context for any issues that may arise. “I like your IR people, they’re very nice, and I like your corporate secretaries. But I want to be sure that when I’m communicating to them, you all are getting that message,” said Anne Sheehan, director of corporate governance at CalSTRS. “I know we don’t all speak with one voice and you’re going to get some mixed signals,” she said, “but as you and/ or management have those discussions, you’ll pick up themes at the board level that can work in your advantage for considering long-term strategy.”

Boards that engage in dialogue with their shareholders are less likely to be targets of shareholder actions
Stakeholder representatives in attendance all agreed that good communication can help companies when and if proxy access becomes law. (In October, the SEC stayed proxy access, pending a ruling by the U.S. Court of Appeals for the District of Columbia Circuit on a lawsuit filed by the U.S. Chamber of Commerce and the Business Roundtable.)

CalSTRS’ Sheehan also emphasized that when companies engage in quality dialogue with shareholders, actions such as proxy access become unnecessary. “For example,” said Sheehan, “before the proxy access ruling was stayed (by the legal challenge), we were getting calls asking ‘Who are you going after?’ Everyone assumed we’d target companies where the concerns were most publicly glaring, like Massey and Chesapeake. But we’re not ‘going after them’ with proxy access,” said Sheehan, “because CALSTRS has a good dialogue going with those very companies in terms of those concerns.”

Thomas Kim, chief counsel of the SEC’s Division of Corporation Finance, echoed the need for dialogue. Referring to new “say-on-pay” provisions enacted this year as part of Dodd-Frank, Kim counseled that “while companies obviously should figure out for themselves what to do with the input they receive from shareholders, I think showing that you’re actually listening and are being responsive would be helpful in lessening shareholder frustration.”

Even if particular processes important to shareholders are not yet in place, just having an open dialogue can reduce the likelihood of proposals. “We (ISS) surveyed our institutional clientele during the off-season this year and asked, ‘Should we give boards credit for prospectively pledging to change particular behaviors if the company is responsive and promises in writing to improve its governing documents?’ Overwhelmingly, our client base said they would like to take that approach, looking forward rather than back,” said McGurn.

The concern over Regulation Fair Disclosure (Reg FD) is overdone
Boards can communicate with their shareholders without violating Reg FD, as long as they take certain precautions. This point was reinforced by the SEC’s Kim, who also previously served in the private sector as securities counsel at General Electric. “We recently issued staff guidance in which we said ‘Reg FD does not prevent directors from talking to you.’ We had to do this because investors were coming to us saying that they’d approached boards, but the corporate lawyers told them that the directors could not engage with them because of Reg FD. There is really only one regulatory barrier to speaking with shareholders, and that is that you cannot disclose material nonpublic information unless you have a confidentiality agreement in place,” said Kim.

The Council also agreed that boards can and should have the lead role in determining board composition, and that only the board can really ensure that composition is aligned with strategy
In response to director qualification disclosures mandated for this proxy season, one director participant said, “There have been all kinds of fads for director qualifications over the years. Operating and industry experience are very valuable. But for most of the boards I sit on, we’ve come to the conclusion that the most important qualifications for directors are judgment, pattern recognition and wisdom. We have to know a candidate to determine that.”

Theodore L. Dysart, managing director of board search for Heidrick & Struggles International, said, “That’s what I’m finding somewhat uncomfortable about the stage we’re getting into, where shareholders exercise judgment on director qualifications.” Dysart questions shareholder skills in this domain. “They know how to swing a bat, but can they hit a major league fast ball?”

However, participants also agreed that boards could provide more clarity on this process to shareowners, along with how the board is aligning board composition with strategy, and how it is working to maintain a high level of independent-mindedness. Recommendations from participating directors included:

• Look outside the box: “One of my toughest roles as a nominating and governance chair has been to broaden our board’s composition to include an individual with strong operating experience, particularly when the best candidates were not public company types,” said one director of a Fortune 100 company. “We chose someone from the non-profit sector with experience in very complex operations and she’s doing an excellent job.”
• Longevity is not always a good thing: Dysart noted that people are retiring younger; of the 225 new board members placed in the Fortune 500 last year, the average age was 57. “When someone who retired at 57 is on the board still at age 70, we need to be mindful of the greater distance between the active experience of that board member and the world that the management team lives in,” said one board member, who himself is a retired executive.
• Conduct a skills matrix: “On my board, we consider skills and strategy,” said another director. “If we’re expanding in Asia, we look for skills in that dimension. If we’re losing someone to retirement who is really knowledgeable about acquisitions, then we look for that experience.”
• Evaluations are a useful tool in developing a board skills matrix. “We used to pigeonhole our directors into what we thought they were good at,” said one nominating and governance committee chair. “Now, we’ve begun asking directors as part of the annual board evaluation process what they believe they bring to the table in terms of value. We found we had skills we weren’t leveraging, and that was great. But we also found that we had holes to fill in terms of aligning our composition with strategy.”
• Board member evaluations may also help directors understand how well they do or do not fit, noted several participants. Conducting annual director evaluations provides the lead director with a sound framework for having difficult conversations about resignation, if necessary.

Consider new technologies for better board-shareholder communications
Boards are encouraged to explore new options for actively monitoring the company’s level and quality of shareholder communication. “Everyone talks about transparency, but when you look at the regulations coming out, I don’t see anything that actually creates more of it,” said Richard Daly, president of Broadridge, the company whose technology plays a significant role in the proxy voting process. “It’s up to directors and shareholders to create a proactive and meaningful information flow.” New tools soon to be available may help directors screen shareholder comments by size of holdings. Sentiment recognition technology may soon even help directors see trends in shareholder views regarding key issues, providing advance notice of potential shareholder proposals.

Make sure the boardroom perspective is present in the regulatory process at the SEC
The SEC’s Kim also indicated that the Commission would like to hear from directors about the implementation of rules under Dodd-Frank, including disclosure requirements and say on pay: “It’s nice to hear your views in a private meeting like this, but for the Commission to take your perspective into account in developing the rules, your comments must be part of the official notice and comment rule-making file.”

The NACD has established several channels where directors can provide feedback, in part to inform comment letters to the SEC on behalf of the director consituency. See www.NACDonline.org for the NACD’s latest comment letter to the SEC.