Disclosure rules now require directors to be philosophers. Every public company begins its Compensation Discussion & Analysis (CD&A) with a statement of the philosophy underlying its compensation programs, concluding with specific compensation goals or objectives. In our review of hundreds of proxy statements each year, we can see how clear, shareholder-friendly plans are more likely to arise from a clear, shareholder-friendly philosophy.
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Unfortunately, too many disclosures reveal the opposite—a philosophical muddle that underlies overly complicated compensation plans hidden behind nearly impenetrable disclosures. Such disclosures make investors uncomfortable, as if the board is hiding something, even when directors have no such intent.
First Principles
A good philosopher begins from first principles. In executive compensation, as with most governance matters, the overarching objective is (or should be) compensation plans that enhance shareholder value. The specific goals that satisfy this basic objective are essentially the same for every company:
- To attract and retain the talent needed by the company to create value;
- To reward, and thereby motivate, that talent for sustainable value creation; and
- To meet the company’s attraction and alignment objectives at the lowest reasonable cost to the shareholders.
This list satisfies another philosophical touchstone: that any set of objectives or goals be mutually distinct and collectively complete. Attraction, alignment and cost comprise all of the relevant points that a board ought to consider in the design, implementation and disclosure of compensation plans.
Compare this list to an actual 2010 disclosure:
- To attract and retain the highest possible caliber management team;
- To reward the achievement of predetermined company objectives;
- To reward superior performance;
- To provide management with incentives to build value; and
- To align the interests of management with those of our shareholders.
The last four items all describe alignment. What about the cost to shareholders? When you repeat two, three or four times the reasons that you would reward managers, and leave out any consideration of cost, your investors are bound to wonder what you really care about.
Schering-Plough’s list (from its 2009 proxy) shows a slightly subtler redundancy:
- To attract and retain a management team that will continue to deliver excellent performance;
- To motivate the management team to provide superior performance that would build long-term shareholder value; and
- To compensate the management team based on the level of corporate and individual performance, providing pay at or above the 75th percentile of the peer group if performance is superior and with compensation decreasing for lesser performance.
Stripped to its essence, one can see that the last objective is largely redundant, essentially saying that the company will reward its managers for superior performance (presumably motivating it) by paying them superior compensation for that performance (presumably enough to retain them). While pay for performance may hint at cost control, you can’t blame investors for wondering if cost was, in fact, a specific consideration.
No Principles
The opposite of reasoning from first principles is copying what everyone else seems to be doing. Too many compensation committees are stuck in a benchmarking mentality that inadvertently overrides their basic desire for shareholder value creation. A recent review of how a company’s statement of objectives had evolved over time showed that the list grew from five to eight objectives in 2009. The company said that it had hired a consultant to review its compensation philosophy, and had accepted their recommendations to revise them. The eight objectives included, as one might expect, six repetitive or irrelevant items, and was missing one relevant item—cost control. It was clear from looking at the disclosures of their peers that the consultant had benchmarked their peers’ objectives, making sure that they left nothing out.
A general review of CD&As reveals that nearly every company lists attraction or alignment in some fashion (often in multiple fashions) in their objectives. Many companies list other objectives that, under a good philosopher’s glare, would never really be traded off against attraction or alignment. Less than half include cost control.
From my experience, I know that very few directors are oblivious to cost. In fact, boards are highly conscious of compensation costs, and are wary of being perceived as overpaying their CEOs. Instead, I think the reason that cost control is missing is the same reason that relevant objectives get repeated, and irrelevant objectives slip in, i.e., many boards have not thought about their philosophy as a philosopher would, and instead benchmark their philosophy, creating something akin to everyone copying everyone else’s C paper.
The Mysterious Fourth Objective
Many directors have suggested to me that they could think of a fourth objective that should be added to my list of three. However, after discussing their suggestion, we almost invariably agree that (a) their proposed fourth objective is subsumed by one of the other three, or (b) that it is not directly relevant to shareholder value and therefore must be subordinated to the other three, or (c) that we disagree about shareholder value being the governing principle. (I understand that there are directors out there who believe that companies should focus on certain things that may run counter to shareholder value, but I don’t recall ever having seen such a sentiment expressed in a disclosure to investors.)
Multiple, distinct objectives invariably imply trade-offs. In other words, you can’t get more of everything— attraction, alignment and cost control—at the same time. Indeed, a critical role of the board is balancing those objectives, making those trade-offs against the ultimate standard of shareholder value. For example, the board must decide whether reducing the cost of compensation to the shareholders may be worth the risk of failing to retain key managers, or whether the higher cost of incentive payments is likely to result in the better performance that those incentives are designed to motivate. Given the importance of these trade-offs, it is surprising that this “balancing” role is not more widely mentioned in the CD&A, or the board actually addresses those trade-offs. Of course, you cannot make trade-offs if you are missing a key objective, like cost control.
The Cost of Poor Philosophy
Larry Ellison gets about $70 million per year, almost all of it in equity grants. This extraordinary sum is justified by an unbridled desire to align the interests of management and shareholders. It conforms pretty well to Oracle’s compensation objectives:
- To attract and retain highly talented and productive executives;
- To provide incentives for superior performance; and
- To align the interests of our executive officers with those of our stockholders.
The last two objectives are, of course, redundant; incentives for performance are the means of aligning interests. However, the real problem is the lack of a cost-control objective. The effects of that omission are particularly apparent in Ellison’s compensation plan. It’s a good bet that paying Ellison $70 million enables Oracle to retain his services as CEO. But what if the board asked themselves how much less than $70 million they could pay Ellison without risk of losing him? If they insisted on paying him $1, where would Ellison go? Would he say adios, and worry about how some other CEO might manage his $30 billion stake in the company?
Similarly, what if the board asked themselves how offering less than seven million options would affect Ellison’s incentive for performance or the alignment of his interests with the other shareholders? Given that Ellison already owns one billion shares, any number less than seven million additional shares would—my guess—probably not materially reduce his focus on shareholder value.
But Oracle doesn’t have cost control as an objective. The dominant shareholder—Larry Ellison—does not mind, so the board can act as if it has no constraint on what it pays to retain or motivate him. In Oracle’s case, the lack of a cost-control objective is quite visible, as it is for other firms whose CEO pay seems unmoored from the rest of Corporate America.
While the lack of a cost-control objective can be harmful for shareholders, inclusion of objectives that are irrelevant to shareholder value can be just as frustrating in other ways. Executive compensation is already complicated by the many elements available in meeting just those three basic objectives: fixed versus variable comp, cash versus equity comp, guaranteed versus contingent, in-service versus post-employment, and many more.
All of these trade-offs create an exponential number of permutations in how pay packages can be designed. This complexity can be more easily managed if the underlying philosophy guiding the trade-offs is clear and straightforward.
Investors are beginning to demand clarity. They crave simpler, clearer disclosures about executive compensation, especially now that they will have to vote on it every first, second or third year.
Marc Hodak is managing director of Hodak Value Advisors and teaches corporate governance at New York University’s Leonard N. Stern School of Business.