Advisor Independence

Board of Director Compensation Trends: “Follow That Bandwagon”

Posted by Paul McConnell on October 19, 2012  /   Posted in Compensation Committees

Originally published in Board Member Magazine (2012 Q4).

bandwagonBoard 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 Paul McConnell on July 12, 2012  /   Posted in Compensation Committees

IndependenceThe 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)

© 2012 Board Advisory.
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