Author Archives Jeff McCutcheon

Keeping Dodd-Frank in Perspective: Lame Duck Session for the SEC

Posted by Jeff McCutcheon on October 31, 2012 / Posted in Compensation Committees

As the election approaches and candidates swap jibes at each other, we’re curious to see how the results affect executive compensation regulations. Up to now, the SEC has been sluggish—to the point of inertia—to adopt final rules for the “gang of four” regulations outlined in the Dodd-Frank act. Troubling though it is, their inaction has not slowed us down a bit.

Some background: Enacted in July 2010, Dodd-Frank is a behemoth of a law, registering at a whopping 2319 pages. The table of contents alone sprawls to fifteen pages. As you can imagine, the thicket of financial regulations are dizzying in number and complexity. And yet…the devil is in the details. Congress left it to the Security and Exchange Commission to sort out the nitty-gritty, including the more controversial issues. As of July, only a third of the rulings had been issued.

With respect to executive compensation, the act provided for a number of executive pay “reforms” of clawbacks, independence standards and increased company disclosure. The SEC has adopted final rules for “say-on-pay,” golden parachutes, and compensation committee independence standards. But the SEC appears to have run out of steam. Specifically, the whole “gang of four” is still up in the air (pay-for-performance, hedging policy, clawbacks and internal pay ratio.)

In a presentation to the NACD in July, Commissioner Troy A. Paredes said he was “troubled” that the Dodd-Frank regulatory regime went “too far.” His comments recognize that the legislation, if acted upon by the SEC, could have regrettable consequences not envisioned by the drafters. We agree with the Commissioner’s conclusions and share his concern regarding the executive pay regulation. However, we are less comfortable with the executive branch’s passive resistance to legislative action.

In our view, the SEC is playing “wait-and-see” until the election results come in, reticent to sift through the remaining Dodd-Frank executive pay issues in case a change in the political winds means a repeal (unlikely) or incremental reform of the problematic legislation (hopefully).

Still, we’re not holding our breath. Though we’re more than ready to help our clients navigate the murky waters of Dodd-Frank whether the political tides change in November or not, we hardly need to wait around to act on our experience and knowledge to devise winning compensation strategies. Politics aside, we’re on firm ground as far as that’s concerned. When all is said and done, we believe that executive compensation should be driven by the needs of the company and the desire to enhance shareholder interest, not what is coming out of Washington.

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The Risks of Accelerating Executive Bonus Payments for Tax Benefit

Posted by Jeff McCutcheon on October 19, 2012 / Posted in Compensation Committees

With continuing uncertainty regarding the nation’s finances fueled by current 2012 election banter, executives are faced with the temptation to accelerate executive bonus payments to be paid in 2012 to avoid increasing income tax liabilities. If Congress does not act, the typical executive could save in excess of 5%[1] of the amount of the bonus payments. In reviewing these requests, board members are advised to consider the old adage, “There is no such thing as a free lunch.”

Companies have accelerated compensation payments to executives in the past to avoid tax rate changes. Most notably, in late 1993 a significant minority of companies accelerated executive bonus awards that otherwise would have been paid in 1994, to avoid the uncapping of the 1.45% Medicare tax. Unfortunately, tax increases under presidents George H.W. Bush and Bill Clinton did not provide the same opportunity for tax planning.

With the risk of Bush-era tax cuts expiring, board members could be asked to consider acceleration of incentive payments for their organizations. Should your board be asked to weigh in on this issue, we suggest you consider the following.

While the request is typically for the benefit of senior executives, the benefit of accelerating income may go well beyond the executive ranks. Nearly all full-time wage earners could face a tax increase of at least 3%. Given the public concern over exceptional treatment of executives, particularly the CEO, we suggest boards discuss whether a limited action only benefiting senior management is appropriate, or whether an all-or-none approach may be warranted.

While the executive may save 5% in taxes, the acceleration has an economic cost to shareholders. It is objectively fair to assess the economic cost of the accelerated payment at the company’s cost of incremental debt. While some companies are currently experiencing very low borrowing costs, for others, the 2 ½ month advance payment will likely have an economic cost to shareholders of 2-3% or more. While this economic cost is not an expense reported on the summary compensation table it is a cost incurred by the company and should be part of an informed discussion.

There are consequences of accelerating payment in terms of making individual or organization performance assessments and in terms of protecting the company in the event of and termination of employment prior to the end of the performance period. Board members should consider whether contractual protections are warranted to clawback or adjust any award made in error or made prior to a having a full appreciation of company and individual performance over the entire performance period. Further, an advance payment that is contingent upon later results could conceivably constitute a loan specifically prohibited by Sarbanes-Oxley[2].

There may be risks to the company’s public image and brand. Given the level of public scrutiny currently provided executive compensation, it is not inconceivable that the act of taking exceptional action to avoid taxation for executives may draw the company and the board into a public debate they cannot win. Keep in mind that the rationale for the acceleration would likely require some narrative in the Compensation Disclosure and Analysis section of the proxy statement.

Lastly, there could be tax consequence with accelerated payment. Most companies’ 162(m)-qualified plans require compensation committee certification of results and prohibit “positive discretion. Any acceleration could potentially jeopardize the company’s tax deduction for the award.

Clearly, we do not consider the acceleration of payments to be a “slam dunk” decision. While it may be appropriate and non-controversial under many circumstances, such a decision can only be made by a board when benefitting from a full appreciation of each organization’s unique facts and underlying economics.

– Jeff McCutcheon

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[1] i.e., Reversion of the top tax bracket from 35% back to 39.6%, plus the impact of reinstatement of the phase out of itemized deductions.

[2] Section 402 of Sarbanes-Oxley prohibits companies from making loans or arranging credit for named executive officers. Public companies should seek legal advice prior to accelerating payments to executive officers.

Board of Director Compensation Trends: “Follow That Bandwagon”

Posted by Jeff McCutcheon on October 19, 2012 / Posted in Compensation Committees

Originally published in Board Member Magazine (2012 Q4).

Board Director compensation continues to evolve. We have seen director pension arrangements arrive and depart (1980s), board compensation using stock options have had their time in the spotlight (1990s through the mid-2000s), and now board meeting fees are waning. The clear trend and dictate of proxy advisory firms is to eliminate board meeting fees, set board pay at median, and pay at least 50% of the total in the form of shares held until retirement from the board. However, before we jump onto that bandwagon headed down the path of least resistance, perhaps we should consider for a moment reasons for paying directors in a specific form or amount.

Annual comparisons of director pay levels have led to a focus on an elusive “median director compensation level.” As one-half of companies find they are below median, they increase director pay and find a corresponding increase in the new average pay level. Unlike the fictional Lake Wobegon, we can’t all be above average. Rather, since the required level of reputation risk, personal energy, and talent commitment varies dramatically between boards, so too should remuneration.

The trend in form of pay, from options (incentive) to shares (investment), is easily understood in the context of the director’s role. An unintended consequence of options is that they can pit directors against all other investors with respect to the timing of exercise. While options may reward equity growth, they are inherently biased against dividends and can, under certain circumstances, provide an imbalanced reward for risk since the investment downside is limited to any embedded gains. More important, as a reward for price appreciation, the concept of any incentive may work directly against the director’s role—to provide risk oversight on behalf of investors.

Executive management is tasked with developing long-term strategies, executing those strategies, and managing the day-to-day enterprise. With the separation of capital and management inherent in our modern capitalist environment, the role of the board should be focused on ensuring the risks taken and strategies employed by management are reasonable, that controls are in place to avoid misuse of investors’ assets, and that the best executive talent is in place to lead the effort.

By establishing incentives for directors, we are distorting the balance in their assessment of risks by encouraging results without a corresponding risk offset. Incenting directors to improve performance may also unintentionally encourage boards to interject themselves into areas rightfully in management’s domain, at the expense of the board fulfilling its core responsibilities. On another front, what most analyses of director pay seem to avoid is any consideration of a director’s role in light of the value proposition companies communicate to their investors. Clearly, the board of a company held by a private equity fund will have a different role than a board of a company held primarily by retail investors. Similarly, an investor in early-stage pharma will have dramatically different expectations of the board than the same investor viewing a commercial real estate REIT investment. Just as the role of the board member should reflect these investor expectations, so should the pay.

Without belaboring the point any further, we have to ask, “How should directors be paid in the modern environment?” Clearly, each board is unique and must refine its objectives and define its role vis-à-vis investors and management. The role of a board of an immature, fast-growing company will clearly be different than that of a mature company. Chances are that the management team and the investors will look quite different as well. However, the concept of how to pay the board remains unchanged.

In summary, we believe boards should:

1. Pay an amount that reflects the board’s talent needs, as well as the level of reputation risk and commitment asked of the directors; this may involve paying well above or below industry standards when appropriate.

2. Pay in a form that reflects the board’s mission and does not create an imbalance with respect to risk oversight.

3. Implement ownership and shareholding guidelines that are consistent with the company’s message to investors.

This simply suggests the use of common sense, taking a fresh look at intent prior to racing to the trend. After all, it was Albert Einstein who observed, “The man who follows the crowd will normally go no further than the crowd.”

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Independent Compensation Advisors & Compensation Committees

Posted by Jeff McCutcheon on July 12, 2012 / Posted in Compensation Committees

The SEC recently published new rules on Compensation Committee Independence and Outside Advisers (17 CFR Parts 229 and 240), including specific factors to be used by the national exchanges in determining compensation advisor independence. The intent of this evolving regulation is to establish standards for compensation committees and their advisors that are comparable to the standards established over a decade ago for the audit committees and external auditors. However, after three years in the making, the resulting rules fail to establish any real test for independence. Worse, the resulting “factors” are inconsistent with existing audit committee standards and compensation committee member (director) independence standards. Regrettably, the resulting rules are more the inevitable outcome of successful lobbying efforts on the part of the compensation consulting industry than reflective of any rising standard for conduct by compensation committees and their advisors.

The Act and the subsequent SEC rules ignore the most likely conflict of interest facing compensation committees; that firms will derive the lion’s share revenue from any single client engagement serving management, and therefore be hesitant to upset management when completing an assignment with the compensation committee or the board. This is perfectly analogous to the situation in the 1990’s with audit firms conducting large-scale consulting assignments for management in the same firms they were supposedly auditing. We get it — independence means you can serve only one party.

The legislature erred in establishing two of the factors in their drafting of 10C (b)(2).

First, the rules establish as a factor the “provision of other services to the issuer” by the consulting firm, and do not consider the magnitude of the total fees attributable to the “other services” provided. This fails to differentiate minor services that may be provided to management by a board consultant that do not pose a threat to advisor independence. Using the audit analogy, it is not uncommon for external auditors to still provide services to management; it simply requires advance approval by the audit committee and disclosure to investors.
Second, the rules establish as a factor fees paid by the issuer as a percent of total consulting firm revenue, without considering the nature of the fees (i.e., management vs. board services). Clearly, if 100% of the fees are derived from the board relationship, interests are aligned and there is no conflict, independent of any concentration of consulting firm revenue derived from the relationship. In auditing, we find no consideration of audit income as a percent of firm income being relevant to the independence standard (nor is director concentration of income from the issuer a factor in establishing director independence). This factor is at best a red herring, at worst, a triumph of lobbying over shareholder interests.

It is our opinion the only amount of fees that are relevant are the fees earned for advising the Board versus the fees earned by advising management. When proxies report fees of $200,000 for advising the Compensation Committee and $2,000,000 for advising management on pension and welfare matters, it is difficult to see any independence.

Clearly the legislative staff was concerned about disrupting this industry. The Dodd-Frank legislative process considered input from a number of sources, including several of the large multi-service consulting firms, and includes a preamble to specifically establish that the independence factors be “competitively neutral among categories of consultants…”. Unlike auditor independence, where Sarbanes-Oxley created a bright line that clearly disadvantaged firms with conflicts of interest, this Act attempts to protect even those situations where a conflict exists, to “preserve the ability of compensation committees to retain…” advisors even when obvious conflicts exist.

Fortunately, we do believe that in spite of Dodd-Frank, boards are migrating to conflict-free committee members and conflict-free committee advisors. As a result, we find multi-service consulting firms continuing to spin off their executive pay consulting units. Market share for the multi-service firms has continued to erode since the late 90’s, indicating that most boards – independent of regulation – are mindful of both the potential for conflict of interest and the appearance of conflict of interest, and choose firms specializing in board-level consulting services. We clearly are on a trajectory to end up with the same model as with audit firms, albeit at a more confused pace.

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– Paul McConnell & Jeff McCutcheon (Managing Directors of Board Advisory, LLC)

Dodd Frank: Another Chance for the SEC to Get Pay For Performance Right

Posted by Jeff McCutcheon on October 21, 2010 / Posted in Compensation Committees

The Dodd-Frank bill contains two new disclosure requirements regarding executive pay: the ratio between the CEO’s compensation and that of the median employee, and the relationship between compensation actually “paid” to executives and company stock performance.

The new pay ratio is flawed on many fronts: it ignores organizational scope and size, it can be biased by outsourcing lower-paid work, it ignores the inordinately large role of benefits in the pay of lower level employees, and most importantly, it ignores the differences between guaranteed compensation and the risk inherent in equity based pay.

In contrast, the disclosure of pay in relation to performance has the potential to present a true picture of executive pay from which shareholders and the public can draw meaningful comparisons. The key is how the SEC eventually defines “pay”.

The Amounts Shown In The Summary Compensation Table Are Not Pay. Disclosure of executive pay has vastly improved over the last two decades. We now have accurate data on all the relevant components of compensation. While this data is extremely useful in designing competitive pay opportunities, the current required format does not show what executives actually earn — or how that pay might relate to company performance.

Cash bonuses are typically paid for financial performance versus targets, rather than for shareholder gain. Presumably, the cash payment relates to drivers ultimately reflected in stock price, but not necessarily reflected in the current year stock price.

For most executives, the largest portion of their reported pay is the disclosed value of stock awards. For performance based stock, the disclosed value is a “target” value on the date awarded. It does not reflect the actual number of shares earned or the realized value of the stock over the requisite holding period. Similarly, options awards are shown as the expected value from a probability distribution, not the actual realized gains.

These valuations were never intended to represent the actual value the executive would receive, and were only intended to satisfy the accounting world. Consequently, using current proxy data to explain the link between pay and performance is like using a baseball slugger’s “at bat” statistics to explain the team’s won/loss percentage.

The Best Comparison Comes From a Multi-Year View of Realizable Pay. To best evaluate board decisions regarding pay and to test the overall alignment of executive pay to investor gains, one must compare the value actually realized by the executive to the returns of investors. For this purpose we look at the cumulative salary and cash bonuses received over a multi-year period (e.g., five years) plus the ending-period value of actual stock awards granted, stock acquired from previous awards, and embedded option gains (e.g., the paper profits).

Such pay comparisons are extremely important when evaluating the relative wisdom of a board and their executive pay decisions. By looking at the cumulative effect of decisions over a 5 year period – perhaps the shortest time period when executive effectiveness can be reasonably assessed – management and the Board can more effectively establish for investors the degree of alignment between executive rewards, business strategy and shareholder gains.

The data required to perform these calculations are readily available through existing public company disclosure in proxy statements, related SEC filings, and commercial data sources. The general public could produce these calculations; however, use of multiple data sources and obscure reporting rules makes it difficult and time consuming.

Our investor and board clients have found this longer-term pay comparison to be an extremely effective tool for understanding the compounding effect of compensation decisions over time, and as an aid in calibrating prospective equity and cash incentive decisions. Perhaps more importantly, the analysis serves to bridge the communications gap between investors, the board and executive management by simplifying pay arrangements in terms everyone can easily grasp.

Conclusion. Much of the public’s understanding (or misunderstanding) of executive pay is driven by the annualized and hypothetical values disclosed in proxies. Regrettably, the format of the SEC disclosure also shapes how many boards make annual executive compensation decisions. The SEC will not release new rules until the second quarter of 2011, but regardless of the reporting form eventually chosen by the SEC, forward thinking Boards should supplement their CD&A disclosure with a true pay for performance analysis such as that presented above. For most boards this can convey a critical story line for investors wanting to understand how and why executives are rewarded.

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— Paul McConnell and Jeff McCutcheon are Managing Directors of Board Advisory, LLC

CEO Succession: An Interview with Board Advisory & Bank Director Magazine

Posted by Jeff McCutcheon on March 09, 2010 / Posted in Compensation Committees

Originially Published in Board Member Magazine

BD: Jack Milligan, associate publisher, Bank Director magazine
McCutcheon: Jeff McCutcheon, managing director and founder, Board Advisory LLC
McConnell: Paul McConnell, managing director and founder, Board Advisory LLC

BD: Federal banking regulators are beginning to focus more attention on executive pay. How will this impact the compensation committee?

McCutcheon: I don’t believe it will substantially change actual pay levels. Historically the government has been extremely ineffective at regulating pay — particularly executive pay. One could even argue that prior attempts to slow executive pay growth have had the opposite effect. However, regulations have been very successful in changing the vehicles used for pay delivery, as well as the form of pay and the governance process around pay. One would expect to see a transition from salary, stock options and annual bonuses to longer term less liquid stock grants. In addition, all the current attention that’s being paid to unnecessary risk taking will likely result in greater focus on relative goals rather than only absolute performance targets, particularly in community banking where a peer institutions with similar business models exists. This has also affected how boards go about managing pay. In the past it has been a management-directed process, where management would look at its strategy and develop pay plans in support of that strategy. This analysis and decision making is very quickly shifting over to boards. Compensation committees are quickly becoming responsible for interpreting strategy and thinking about what pay tools are going to be most effective in executing those strategies.

McConnell: We’ve also seen rampant growth in independent pay advisors like our firm, that work only for the board. It’s our sense that the independent firm is quickly replacing the older model of the multi-line consulting firm, where executive compensation was one of many services that were provided. For large, public companies, the market share held by the traditional large consulting firms has dropped from 73% to 58% in 2010 alone. This is a dramatic shift that recognizes the actual board advisor and the board advisor’s relationship rather than the geographic footprint or sheer size of the specific firm.

Boards of directors are now more focused on advisor independence. One of the first questions we are asked by boards is “How independent are you?” The challenge for boards and advisors is to strike the right balance between working with management as opposed to for management. I think one of the things you’re going to see as a result of the increased federal oversight is much more board independence. In the current environment boards cannot afford not to engage their own advisors.

BD: Will increased scrutiny of executive pay mean that bank compensation committees will have to look at pay practices for the entire organization rather than just the CEO and his or her senior team?

McCutcheon: In well-run banks the compensation committee has always been involved in compensation strategy down through the organization. Under current regulation this practice will need to become a standard process of the committee. In a lot of ways it’s a good thing, because that’s where a lot of the problems occurred that led to the financial meltdown in 2008. The problems were not necessarily originating at the top of the house. The excessive risk taking was occurring further down in the organization. However, I think the board’s primary focus will remain with executive management pay. The board’s charter is largely to hire the CEO, who in turn hires the rest of the management. And I don’t think anyone wants the board involved in the day-to-day operations of banks, least of all, boards.

BD: Is the role of the compensation committee is changing? And if so, does that mean that firms like yours will also have to change?

McCutcheon: The role of the committee advisor is changing very quickly, just as the role of the compensation committee is changing. Compensation committees are now held far more accountable for managing the executive leadership risk – whether we are talking about succession, new CEO selection criteria, or the choice of performance measures used to link strategy execution and value creation with executive performance and wealth accumulation. Each decision requires fairly active management of business risks involving executive leadership.
At our firm, and I imagine this also applies to our peers, we are far more involved in working with committees to develop their executive leadership strategy. Our client committees are spending far more time defining performance, managing succession risk and understanding investor expectations. We no longer see committees spending the majority of their time interpreting market median compensation practices or implementing the most tax or accounting-efficient incentive arrangement. Instead, committees are investing their time in the actions that move the needle – both in terms of improving management’s underlying performance results and in terms of clarifying the message to investors, influencing market valuations.

BD: In today’s environment, where profitability is under pressure and stock prices are low for most organizations, what’s the best way to compensate the executive management team?

McConnell: One thing they shouldn’t do is emulate the large banks, where in my opinion the basic compensation process is flawed. They don’t have any long-term incentives. Let me explain. What they currently have is a series of one-year plans that have a portion paid out in restrictive stock or options — and that’s the root of the problem. Most of the fixes the federal regulators have talked about would essentially space out the payment to create a “long term orientation,” but a well-designed executive pay plan involves balancing long-term and short-term objectives. There’s no balance in these plans. By focusing so much on the annual bonus pool they’ve created a what-have-you-done-for-me-today mentality that encourages the kind of excessive risk taking we have seen. In a well designed plan, top management – and top management in a large money center bank might extend down to a couple hundred people — would be paid primarily through large equity grants that are earned over time through sustained performance on a couple of contrasting measures that are not easy to achieve simultaneously. It could be growth and profitability, growth and safety or profitability and safety. Achieving sustained performance on those two dimensions in a manner consistent with the strategy, and doing so over a period of time, would be the primary basis for stock rewards. That’s how you create a long-term compensation orientation. Then your annual plan can be much more tactical in nature: It can be a reward for a good year. It can be a reward for achieving certain key objectives. In a small organization it might be a reward for achieving a key component of that long-term strategy such as installing new operating systems or completing a merger. But the executive focus should be first with the long-term piece and then secondarily with the annual bonuses.

BD: Will there be a role for stock options in the dawning era of increased government scrutiny, or are we going to seem them becoming increasingly unpopular with a shift towards restricted stock grants?

McCutcheon: I think there’s an absolute role for options but we will have to rethink how options are used. Historically, options have been extremely liquid and they provide the holder with both the opportunity and incentive to time the market. When an executive times the market, they liquidate their holdings when the stock is at a peak — and their gain is essentially financed by all other investors in the form of dilution. If options are going to continue to be used in the future as executive rewards, I think to a very great extent that ability to time the market will be limited, not so much as to the date of exercise, but specifically to the date of sale. It’s my sense that future use of stock options will be restricted through a specific holding requirement, where net shares would have to be held for something like 10 years from exercise. This allows the company to reap the benefit of the compensation leverage of the option without pitting the executive against other investors.

McConnell: The real problem with options as a long-term incentive vehicle is the heads-I-win-tails-I-don’t-lose kind of mentality that can lead to excessive risk in building a company because option holders don’t lose anything if the company fails. There is no cash value in the options when granted and holders don’t lose anything if they fail. That leads to a swing-for-the-fences mentality. Used alone, and particularly in large quantities, options can lead to excessive risk taking. I think where options will have a role in compensation plans going forward is as a balancing mechanism. If you have a sound annual bonus plan and a good long-term performance plan that’s focused on sound metrics, an option can still be used to sweeten the deal on the up side, making the overall program more lucrative and responsive to gains in stock prices.

BD: Is the skill set for a successful bank CEO any different today given the difficult environment that we’re in?

McConnell: Well, first they need a tougher hide. The underlying skill set required to run a bank is essentially unchanged. However, if we look a decade into the future bank CEOs are going to be operating in a far more complex regulatory environment and the required skill set may be -influenced by that. There is also the question of scale. A large and complex banking organization requires a fundamentally different skill set than a smaller community bank. As banks plan for their next CEO they should be mindful that some of these institutions are more than five times larger than they were 10 years ago.

BD: What’s the biggest mistake that boards make in terms of managing the CEO succession process?

McConnell: In a nutshell, it’s delegating the responsibility for doing it to the CEO.

McCutcheon: CEO succession is the most important single task that boards have, but it’s one that has been really delegated away in many instances. If we look at just the large banks, Equilar (an executive compensation and board research firm) found 28% of the CEOs at the beginning of 2009 weren’t there at the end of 2009. Certainly 28% of those people didn’t have planned retirements with carefully chosen successors in place. Perhaps Bank of America might come to mind. CEO succession is a known and very real risk that directly impacts investors. Simply put, boards cannot assume any CEO will want to undermine his or her own personal negotiating power by developing a stable of competent successors to take the reins the first time he or she stumbles. Succession is something that boards have to own and manage as part of their risk management obligations.

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Aligning Executive Pay with Risk Management in Banking

Posted by Jeff McCutcheon on November 01, 2009 / Posted in Compensation Committees

Originally published in Bank Director magazine.

Recent board director surveys indicate bank directors find current legislative and regulatory actions unwarranted, and that existing bank executive compensation plans do not encourage imprudent behavior or excessive risk. These opinions are diametrically opposed to global public perceptions that a serious problem exists with bank pay practices, and that substantial regulation is required. With governments racing to shape policy around public perceptions, bank directors will soon be left scrambling to retain talent if they do not use this current turmoil as an opportunity for proactive re-evaluation of the entire bank executive pay process.

Let us start by clarifying: executive pay practices did not cause the current crisis. In fact, our research indicates business unit incentives (e.g., trading, mortgage origination) were far more influential in the crisis than executive pay. Regardless, public perception is the board’s reality and, upon closer review, there are some changes that could be made to bank executive compensation programs that would better align pay with sound risk management.

As we have been reminded, banks have an exceptional obligation to operate for the long-term benefit of all stakeholders, not just maximizing shareholder return. Capital safety is the cornerstone of bank performance and the bank’s executive officers are uniquely positioned to manage the balance between risk and reward. These are the individuals (e.g., the CEO, CFO & Chief Risk/Credit Officer, etc.) that develop strategies and monitor risks, and are who the Board counts on to “see around the corner” in balancing current initiatives with long-term financial security.

To reassure the bank’s various stakeholders, executive pay should be revisited starting with a blank sheet of paper. For most of line management, use of salary, bonus and stock pay arrangements are likely still appropriate. But for the limited group of senior executive officers described above, who are directly responsible for managing to the long-term interests of investors and the public, we believe there is a very simple and powerful approach to employment, compensation and incentives that will provide a stronger incentive to deliver results for all stakeholders.

Remove key executive officers from the annual bonus plan, adjusting salaries to provide competitive total cash compensation. Free executives to more objectively set tough but prudent goals for the operating officers that appropriately balance risk and eliminate any perceived moral hazard associated with executives developing their own performance hurdles.

Establish an immediate, one-time equity stake for key executive officers upon accepting their role. Award this one-time grant in an amount comparable to the present value of awards an executive might receive for the role for remainder of their careers (e.g., for a CEO, perhaps 1% of the company in full-value shares), with vesting over the remainder of their careers based on time and relative company performance.

This one-time grant would provide an immediate, substantial financial incentive to operate for the long-term benefit of stakeholders. This approach reflects the investor-perspective, consistent with the practices of many private equity and venture capital investors. By establishing an ownership interest rather than an annual “pay” opportunity, banks can also eliminate the need for supplemental retirement, severance, life insurance and related income protection schemes. Critical to this approach, even vested portions of the award would remain non-transferable until a year or two after the executive’s employment ends, eliminating any opportunity to benefit from market timing or short-term appreciation in company equity.

By eliminating annual bonuses and annual incremental equity awards, and instead offering the executive officer fixed cash salary and an immediate investment stake, boards will recognize the unique role bank CEOs and other key executive officers play in managing toward the long-term health of the organization. Boards will also eliminate a number of performance and ethical obstacles created by existing arrangements. Executives would no longer “earn” their equity based upon annual assessments of short-term performance, the bias in goal-setting and selection of performance measures will be minimized, and the CEO would now evaluate risks and rewards in light of long-term value creation–without the added bias of personal short-term performance payoffs.

Properly communicated, this pay approach–simple, transparent and aligned with investors and public interest–will take an important step in changing the negative public perception of executive pay in financial institutions and signal that the CEO and the leadership team are committed to managing risk and reward for long-term value. While this may not be the perfect solution for any one bank, it provides directional guidance in responding to the justifiable public concerns and investor sentiments regarding managing bank risk.

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Executive Compensation: “Heads We Win, Tails You Lose”

Posted by Jeff McCutcheon on August 27, 2009 / Posted in Compensation Committees

[Originally published in Board Member Magazine.]

It is not surprising the public perceives that executive compensation is a “heads we win, tails you lose” proposition. For the past three decades, executive pay plans have grown like kudzu in a muddy Georgia field. In an attempt to balance performance, competitiveness, risk and rewards we have also increased the complexity of pay. Given our lack of success to date, it may be time we fundamentally rethought this process.

Each year, compensation committees spend a great deal of time determining appropriate levels and establishing incentives to provide executives wealth consistent with expected future investor gains. But the reality is that much of the eventual executive gain is determined by business cycles and the timing of option exercises and stock sales — items essentially independent of the long-term investors’ gains.

Recently, there has been a movement to reduce the impact of the timing of sales on executive pay by requiring that executives hold stock received until retirement. This is a powerful tool for aligning executive and shareholder interests, but it only solves part of the problem. In too many cases, the size of annual awards is largely driven by competitive considerations where a specific dollar amount of expected value is used to determine the number of shares or options granted annually. This produces the nonsensical result of increasing the number of shares granted when stock prices decline or decreasing them in response to superior performance.

A better and simpler approach would follow the lead of private equity and venture capital firms, where executive compensation is largely dictated by individuals with substantial personal capital at risk. In this approach executives would receive a one-time competitively sized grant of full-value shares when hired or promoted. This grant would vest over a long-period of time like a typical career (10 years) or until retirement – based on time vesting and/or by achieving performance goals. No further grants would be contemplated unless a promotion or significant business combination occurred. Thus, we introduce two concepts not frequently used by most companies: 1) one-time grant of full-value shares based on a percent of the outstanding shares of the company (rather than projected value), and 2) long term vesting and holding requirements that ensure management has an ongoing stake in the company.

This one-time grant approach to equity compensation, by definition, has a perfect correlation with shareholder wealth over the same period. In contrast, the competitive annual award process mutes the relationship by annually adjusting poor performers up and strong performers down. For example, looking back at the 10-year performance of companies that are currently still in the S&P 500, we find that a one-time grant would produce total wealth for executives in companies that perform at the 75th percentile that is about 3x that earned by the 25th percentile. With competitive annual awards, that ratio is about two times.

This one-time grant of full value shares approach has a number of other advantages:

Executive would have an appropriate level of “skin in the game” from day one instead of waiting 5-10 years until cumulative equity awards provided adequate net shares.
Illiquid full value shares balance risk and reward consistent with long-term investor, TARP and emerging Obama administration pay objectives. Options and other leveraged grants don’t have the same element of “loss” to balance risk-taking.
It would eliminate the need to provide severance if terminated without cause or following a change in control. Contractual vesting of a portion of the shares would provide executives with adequate security in a more shareholder friendly manner.
When tough economic conditions occur (like we are currently experiencing) reported compensation would be limited to base salary and bonus earned (if any). This would likely show a much clearer link between pay for executives and employees – particularly if companies annually reported the change in the market value of executive holdings.

By eliminating the concept of an annual “competitive” equity award, we will take an important step in changing the public perception that executive pay is a “heads we win, tails you lose” proposition. We believe that by isolating the ownership interest of management as a discrete, contractual incentive, boards of directors can better manage the cash incentives and salary of executives, providing a more coherent and transparent oversight process. If we want executive management to think and act like owners, we should pay them like owners – long-term owners.

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Reconsidering Executive Rewards: Separating Equity from Annual Compensation

Posted by Jeff McCutcheon on April 26, 2009 / Posted in Compensation Committees

For the past three decades CEOs, Boards of Directors and compensation committees have allocated stock options and numerous other equity-based incentive rewards to executives based primarily on the annual competitive practice of peer companies. In an effort to ensure equity rewards were appropriately appreciated by the executives, companies went to great efforts to communicate the value of their annual equity award in present value terms, as part of a total annual pay package. By treating equity as annual compensation, however, companies have created three significant disconnects between investor and executive interests.

First, when boards adopt a policy of providing executives with competitive, annual equity grants based solely upon the present value of the equity, they create the perverse phenomenon where stock price decreases (investor losses) result in granting more shares to management to maintain “competitive pay.” When the stock price appreciates, the opposite result is found, as fewer shares are necessary to create the same “competitive” annual award value. This contributed to the prevalent perception of a reward for failure, particularly evident in 2009. Due to depressed equity values, boards were faced with the prospect of granting 60%-70% more shares just to maintain comparable equity “values” to 2008 [1].

Second, most compensation policies strive to provide competitive equity awards in terms of annual equity grants, but not in terms of aggregate equity ownership. Thus, a new CEO and a very senior CEO, all other things being equal, would be provided comparable equity awards. As a result, we find ourselves in the somewhat irrational position of delaying 5-7 years before a significant level of cumulative incentive is delivered to the executive. Keep in mind the median tenure of a CEO today is 5.5 years.

Lastly, executive stock holding guidelines typically allow the executive to sell vested shares to the extent the executives’ holdings exceed a nominal ownership requirement. This reduces the executive’s wealth ratio (the ratio between a change in company value and the change in the executive’s total wealth), diminishing the overall strength of the incentive and diminishing the alignment with investors. Perhaps more importantly, the ability to sell shares allows the executive to effectively time the markets, potentially capitalizing on excessive risk taking and minimizing losses. In addition, by allowing executives to divest shares prior to retirement, companies reduce or eliminate the shared interest in the orderly succession of management within the company.

One solution for resolving these disconnects can be found by changing our fundamental view of long-term incentives. As an alternative to treating equity as part of a competitive annual reward package, companies can treat equity as a distinct, non-compensation investment incentive. In this sense, annual compensation (salary and annual cash bonuses) is liquid and driven by individual skills and responsibilities and annual results achieved. It is generally managed within the range of easily-established competitive practice at peer firms. In contrast, executive equity is a career-based investment made on behalf of investors for the benefit of the executive, to align executives’ wealth creation goals with the long-term interest of the investor and payable only when investors realize their investment objectives.

To distinguish equity from annual compensation companies can:

Manage cash compensation (base salary, annual incentives and other annual cash value) consistent with the practices of peer companies, adjusted for individual performance. This takes advantage of excellent peer data that is easily compared on the basis of company size, complexity and performance.
Establish a competitive ownership percentage for each key executive officer position based upon the percentage of beneficial ownership attributable to fully tenured peer executives at similar companies, balancing the level of incentive needed to achieve performance with the additional performance burden caused by the incremental dilution. Define ownership percentages in terms of percent of total shares outstanding rather than specific present value, which is prone to dramatic short-term fluctuations.
Create a substantial equity position for executive officers early in their tenure through aggressive grants, but set actual vesting based upon performance outcomes realized by investors. Suspend or limit awards once the competitive ownership/incentive level is achieved.
Treat long-term equity as a career investment on behalf of the executive, no longer subject to liquidation in order to buy the vacation home. Specifically, limit the transferability of all equity granted until two years following retirement, eliminating any appearance of market timing and require the executive to also have a shared interest in the near-term success of the succession program [2].

This alternative approach to executive pay can correct for the misalignment of actual equity grant practices with investor outcomes – eliminating what is perceived by some as a reward for failure. While this approach may be too aggressive for many organizations, it rightfully places the focus of boards and compensation committees’ attention on determining the appropriate level or strength of incentive necessary to achieve objectives rather than focusing on simply emulating peer behavior. Lastly, by separating equity from the annual “competitive” compensation program, boards can take an important step in changing the public perception that executive pay is a “heads we win, tails you lose” proposition.

– Jeff McCutcheon

Jeff McCutcheon works with a number of public and private Board Advisory clients on executive compensation, succession and performance issues. You can view Mr. McCutcheon’s bio here. If you have any question or comments on this article, or want to speak with Jeff about any executive rewards, performance, or succession issue, he can be reached at jmccutcheon@board-advisory.com, or at (904) 306-0907.

[1] Based upon a 40% reduction in equity values of 40% across the S&P 500, companies had to grant 67% more shares to maintain the same grant value as the prior year.
[2] See Board Advisory, LLC website for “Current Issues for Compensation Committees” for an analysis of proposed tax policy changes in support of “hold-till-retirement” equity programs.