The relationship between the compensation committee chair and the outside pay consultant has been reshaped both by the macro business environment and regulation. For an inside look at this changing dynamic, NACD Directorship asked a veteran compensation committee member to go one-on-one with a compensation consultant. Arthur C. Martinez is former CEO of Sears and today a public company director whose board service includes compensation committee chair of both PepsiCo and AIG, director of IAC Interactive, HSN and Liz Claiborne, and lead director of International Flavors and Fragrances. Robin A. Ferracone is the founder and executive chair of Farient Advisors.
Illustration by J. T. Morrow
Robin A. Ferracone: You’ve proven from your experience and track record that you don’t shy away from the hot seat. So given that we just finished our first proxy season with the partial implementation of Dodd-Frank, now is a particularly good time to reflect on executive compensation. What have you seen that has changed?
Arthur C. Martinez: The spotlight clearly has moved to the compensation committee, and that’s not unwarranted. There have been numerous—I would say serial—excesses in CEO and executive compensation, which have served to inflame regulators, the media and the general public. And while the regulation may feel and seem heavyhanded, there’s no question that the only thing that is rewarded in any meaningful way is performance. The early going on Dodd-Frank has been pretty benign, and demonstrates that most companies do act in a responsible way and most compensation committees do provide appropriate oversight. There are a number of implementing regulations still to come on areas like proxy access, which could be more problematic.
Ferracone: One of the things that didn’t happen this year was investors voting against compensation chairs. They did use their say-on-pay “no” votes to voice their opinion about whether they liked the compensation program, but they seemed to be reserving their director election “no” votes for next year, if needed. How are compensation committee chairs responding to the demands created by say on pay?
Martinez: There’s no question that the time demands have gone up pretty geometrically in terms of monitoring pay practices inside the company, taking a more active role with the management team, designing the programs that are relevant and appropriate for the company, and serving as the lead, if you will, for the rest of the committee and being able to distill complex matters into relatively straightforward proposals. I think you’re quite right that investors have given comp committee members and chairs a little breathing room here.
Ferracone: How does that differ from past practice?
Martinez: In the past, frankly, their only remedy was to vote against comp committee members when director elections were held. That’s still in the wings if problematic pay practices exist or companies that did not receive a large majority vote on say on pay don’t do something to reform their pay programs— that is the ultimate tool for investors. While everybody used to talk about financial liability for directors, I think the bigger liability is public humiliation.
Ferracone: I think that’s right. Now that we’ve talked about what’s changing, I think an equally important question is, what’s not changing?
Martinez: Mainly, the drift away from plain vanilla stock options. And that’s been in the making for two or three years, with more performance-based stock awards and performance cash awards coming into long-term compensation plans. Investors and proxy advisory services often feel that those at-themoney stock options are not as performance-driven. I think it’s an argument worth considering: an equivalent reward with straightforward and very measurable performance statistics to work against is preferable. Secondarily, I would say that there’s been a reasonable cap on the growth of the base salaries for CEOs in the current business environment.
Ferracone: Yes. Those things aren’t changing because they were trends that were happening before Dodd-Frank as well. Investors have told us that they’re very focused on pay and performance alignment, and that alignment factored heavily into their say-on-pay voting decisions. In addition, we’re waiting for new disclosure requirements around pay and performance from the SEC. So how do you think the pay and performance considerations are factored into the decision making for your compensation committees?
Martinez: There is a clearer link than there’s ever been. In the past, too much option-based compensation could be influenced by a rising tide and not the performance of the enterprise. Performance metrics need to be made clear whether it’s EBITDA growth, earnings-per-share growth, ROIC or cash flow—the metrics that seem right for the company in its market and its competitive situation. The awards can no longer be purely timevested, but must be delivered on the achievement of specific goals with a reasonable threshold and a very reasonable maximum. The rewards are no longer uncapped. It’s up to each comp committee to figure out exactly what are the right metrics, but it’s a relatively short list.
Ferracone: Comp committees also have to get clear philosophically on how they’re going to respond to unintended consequences. Are they going to play by the numbers? Are they going to use some discretion? How do you handle it when management does all the right things but the financial and stock price performance doesn’t reflect their performance?
In addition, I noticed that an interesting performance concept in PepsiCo’s CD&A is “performance with purpose.” Can you comment on this as a way to gauge executive performance and pay?
Martinez: “Performance with purpose” was the opening rallying cry for Indra Nooyi when she took over as the CEO, now almost five years ago. PepsiCo has always had very strong performance metrics and a long record of successful delivery of financial results. And Indra’s feeling was we certainly couldn’t—and shouldn’t—consider abandoning our focus on performance, but in a larger context there is more to running a business than financial results. Her belief is that talent sustainability is the bedrock of any enterprise—the quality of the people and how they are managed, treated, incentivized and developed. Then you also have to consider environmental sustainability, as we all live on this big ball they call Earth and we have a role in ensuring that it remains a healthy place for our families and future generations. Human sustainability—our communities require food, water, all of the things required to sustain life, if you take a true holistic view of a corporation’s role in the ecosystem of the world.
That rallying cry touched a nerve inside the company. It motivated and excited a younger generation of executives. What we have done at the comp committee is to integrate the purpose metrics into our evaluation and compensation decisions about our senior executives—as in the past with diversity, if it wasn’t built into your business objectives and into your rewards system it didn’t get a lot of attention. This has now become a set of strong internal beliefs that drive the organization. And we have taken all of that into account as we’ve made comp decisions.
Ferracone: Investors have communicated with us through our research that they feel the value of these types of measures should play a role in compensation programs. They help express the personality and the strategy of the organization while not necessarily giving up on the financial results.
Martinez: Make no mistake about it, PepsiCo has not lost its focus on financial performance as a key driver of shareholder wealth creation. It continues to have an admirable record in that regard.
Ferracone: Yes. And so that’s exactly why strategic measures don’t substitute for financial measures, but they can play an enhancement role. Let’s switch gears. One of the things that Dodd-Frank was intended to do was give the compensation committee the power to hire its own resources and to empower the compensation committee a little bit more in general. I was just wondering, in your view, whether the comp committee does have more power in the process.
Martinez: The comp committee has more powers, and the dynamics have reset the balance in some ways between management and the compensation committee. One of the key elements is the use of independent consultants. The mandate is that the consultants do no work for the company and that they are solely accountable to and hired by the compensation committee. Looking back over five or 10 years, it was more of a management-led process than a committee-led process. I think we’re in a much healthier balance right now.
Ferracone: Now we call that being collaborative, yet independent. We like to work in concert with our comp committees and management, but at the end of the day we still feel it’s our job to make sure that we’re providing an independent opinion. Comp consultants today need to come to the table with a number of skills that they may not have had in the past, because they need to understand not just the compensation subject matter in-depth but also their clients—that is, the company’s strategy, its culture and its people. There’s a sensitivity there that wasn’t required in the past. As a result, I feel that not only has the role of the comp committee changed, but the role of the compensation consultant has changed as well.
Martinez: I would add the word “trust” there, in the sense that the management team has to trust the objectivity and the good intentions of the comp consultant, and not treat them as an adversary.
Ferracone: I think trust on all sides is important, and consultants have to earn that trust by behaving in a transparent way. We hear stories that certain people will say one thing to management but something different to the committee, and that is exactly the way to destroy trust.
Martinez: It’s also a very good way for the comp consultant to get fired.
Ferracone: Agreed. What are the things you would advise a new compensation committee chair to do?
Martinez: Have a clear appreciation of the workload and commit to it. Then develop a clear understanding of the compensation culture at the company. Unless you’re a very new company, every company has built up a series of practices and expectations about what gets rewarded and measured, and there are nuances and quirks in the compensation culture of the company.
I would recommend to a new chair that he or she sit down with all of the executive officers and ask, “What do you think about our programs? What would you do if you were in my position to change those programs? What do people in the company think about these programs? What are the things that drive them crazy?” Understand the attitudes that are brought to the table by the other members of the committee. Everyone is a product of his or her own experience, and sometimes, frankly, you’re a prisoner of your own experience.
Finally, be very sure that you’re comfortable with your comp consultant. Make sure they understand what’s going on in the marketplace and in the company, its strategy, the business, the culture, and can respond or react appropriately to management’s proposals and that they’re there for the committee whenever they’re needed. It’s a daunting deep dive from day one.
Ferracone: What you’re saying is that someone really has to forge a partnership with external resources—the comp consultants in particular— but there are also the internal resources sitting down with management and discovering what’s on their minds and what’s on the minds of the other compensation committee members.
Martinez: We also need to recognize that we are in one of the more difficult and challenging macro situations that anyone has seen in the last several years, and so we must be sure that compensation programs take into account a dramatically changing and volatile environment.
I think the one thought I’d leave for compensation committee members and chairs at this point in time would be to be sensitive to the macro environment but not compromise principles.
Ferracone: What I will take away from our conversation today is that the comp committee chair is truly in the middle these days—between shareholders and management—and needs to be made of and do the hard work of steel to get so close to the flame without being burned.