Author Archives Jeff McCutcheon

“Pay For Performance” Made Simple

Posted by Jeff McCutcheon on August 12, 2016  /   Posted in Compensation Committees

With the introduction of shareholder “Say on Pay” votes, an entire industry formed to demonstrate the degree of alignment between executive pay and corporate performance or to challenge the result (the underlying assumption being that the two should be directly, causally, related).  Few Compensation Committees, however, really consider the definitions of what constitutes “pay” and “performance”.  Moreover, even assuming a perfect linear relationship between, for instance, SEC-reported total pay and total shareholder return (TSR), where your company’s pay is dead-on with performance, you still don’t know if that pay is appropriate or if any causality exits.  At best, all you can say is that you are no worse than anyone else – which fails to inspire anyone.  What is missing in this analysis is whether shareholders are getting a fair return on the value of the equity that they have granted to employees.

Our analysis of Fortune 1500 companies indicates that salaries and “target” cash incentives are generally predictable based on company size.  Level of salary is strongly linked to company size and the amount of the annual incentive (generally a percent of salary, with notable exceptions in certain industry sectors) is typically tied to annual financial performance.  In very basic terms, cash buys the talent.

Most of the disparity in the relationship between pay and performance arises from equity incentives.  Equity is powerful. It constitutes 60%-70% or more of the pay package in the largest companies.   Because it takes many forms, it is difficult to compare many types of equity in terms of the value delivered to management and in terms of direct comparison to any “market” standard.  The matter is further complicated by governance programs and a regulatory/reporting framework that often considers peer practice comparisons more important than any judgement regarding reasonable sharing-of-value creation.

For Compensation Committees and executives, it is beneficial to stand back from the process and think in more broad terms about what incentive equity in executive compensation should achieve.   In a start-up, equity incentives represents a trade-off for current compensation and a shared risk in the venture, with earlier employees (higher risk-takers) generally receiving the more lucrative terms.  As the existential threat of downside company risk declines, the relative ownership stake awarded to management as a percent of the company generally declines through successive funding rounds, IPO’s, etc.  In private equity situations (leveraged buyouts, going private), an up-front sharing of 10%-12% of the company in the form of an option is intended to align management to an expected time horizon (i.e. 4-6 years) and a new, focused strategy.  This dilution is explicitly built into investors’ expectations, and management’s potential gain is calculated based on the expected returns of the specific investment thesis.   However, in most public companies in corporate America, we see a different practice.  Executives are awarded “long-term” equity on an annual basis which is then valued, reported and viewed by executives as part of their annual compensation.  We effectively shift from a value-sharing arrangement to a competitive annual pay arrangement, where in most instances the competitive pay target is hypothetical and only loosely related to value sharing.

We think it is a better approach to think in terms of a competitive level of value to be shared with management based on the relative importance of capital and labor (knowledge) in the creation of that value.  Industries or situations where capital is the primary driver (e.g., utilities, heavy industry, etc.) require less value shared.  Industries where intellectual capital is paramount warrants proportionally larger ownership interest to attract the necessary talent.  Once a competitive ownership level is defined, Boards and their Compensation Committees should think about how quickly to allocate the equity.  If it is a potential breakthrough situation or a turnaround, a front-loaded award of equity makes sense.  If the strategy is more akin to hitting lots of singles and doubles (to use the baseball analogy), annual awards tied to incremental achievement might make more sense.  In either instance, the level of sharing is not in question, only the time required to realize the full allocation.

A shared-value approach to equity also addresses the “elephant in the room” – how much equity is enough?  By operating with a value sharing target, the conversation shifts to how quickly the target can be allocated.  Long-term vesting, distinct from the award, remains the key to retention and liquidity, and limits the company’s exposure from a premature executive exit.  More importantly, the value sharing approach automatically aligns executive and shareholder interests through shared expectations, without the need for elaborate charts and graphs.  At the end of the day it’s about value sharing – the more value you create, the more wealth you get.  Committees need to avoid distractions from excessive peer comparisons, proxy advisor edicts and SEC & accounting rules.  It is only through a shared, “mature” view of the executive relationship that we can quell the critics and clear the air on executive pay.

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Compensation Committees and Stock Buybacks

Posted by Jeff McCutcheon on June 02, 2015  /   Posted in Compensation Committees

Share repurchShare buybackase arrangements (stock buybacks) are expected to top $600 billion in 2015, up from an estimated $550 billion in 2014. In fact, at the current rate of growth, share buybacks will soon represent a return of capital twice the size of aggregate dividend payments. Critics (including Blackrock CEO Lawrence Fink) argue that this large return of capital is evidence of short-sighted management eating the seed corn rather than investing within the business. In contrast, companies (and many activists) view their stock repurchase arrangements as rational, tax-effective decisions in reaction to a lack of attractive internal investment alternatives. Regardless of the reasoning, given the magnitude of share buybacks, we believe it is worthwhile for compensation committees to review closely the relationship between buybacks and incentives and carefully consider the role of unintended consequences within the executive performance management process.

Share repurchases use cash (capital) to reduce the number of shares outstanding. This reduces the aggregate value of the company (market capitalization) in rough terms by the amount of the repurchase, net of any indirect increase in share price. By reducing the shares outstanding, earnings per share increase. By reducing the capital employed, return measures also increase (ROE, ROA, ROIC, etc.). If the share repurchase is reflected in the setting of goals, this may not be an issue. If the buyback is determined after annual goals are set, the repurchase has the potential to distort performance compared to goals.

The excess capital used to repurchase shares may be the result of performance, but the act of repurchasing shares does not create value. Short-term investors surely benefit from any bounce in share price, and proxy advisers may embrace the impact on total return to shareholders (again, calculated on a per-share basis), but it is a return of capital, not the creation of real operating value. For this reason, compensation committees are advised to consider whether the performance management process–in terms of defining individual executive success and in terms of determining incentive payout–is accurately discerning between intended performance (e.g., increased aggregate earnings) and unintended results (increase in EPS attributable to a decrease in shares outstanding).

In reviewing individual and corporate performance measurement and payout arrangements, compensation committees are advised to look at both cause and effect with respect to buybacks. Does the performance measurement process create an incentive for the company to repurchase shares rather than invest in the business at an acceptable rate of return? Do incentive payout formulae distort performance in the event of a repurchase? If the intent of the incentive is to reward performance, is an adjustment for the impact of share repurchases warranted? These are all questions that are best raised during the plan design and goal-setting discussions rather than waiting until year-end to address.

Compensation committees should also be mindful of the bias that may be created toward inadvertently rewarding the return of capital through buybacks compared to the return of capital through dividends or the investment of capital in the business. Directors and critics generally agree incentives should not create any bias–the use of capital should be based on expected returns, strategic plans, and opportunities, not maximizing compensation. Unfortunately, many plans have the unintended impact of rewarding the buyback. Some programs, such as EPS-based annual cash plans, may do this directly. Other programs, such as CEO scorecards that are based on simple, as-reported financial results, may achieve the same unintended bias in a more indirect manner.

Companies with both large buyback programs and EPS-based incentive arrangements are at risk, as are their compensation committee members, of adverse scrutiny when proxy disclosures indicate that the impact of a buyback has a greater influence on CEO incentive payout than actual changes in performance. As a result, a growing number of companies now disclose in their CD&As their policy toward adjusting incentive payout calculations for the impact of share repurchases. As buybacks continue to increase in size and frequency, statements to shareholders clarifying this communication will become increasingly important. It may only be a matter of time before incentive payments resulting from buybacks result in derivative litigation.

We find there is nothing wrong with earnings-based measures or per-share-based measures, just as there are many good reasons to execute a share repurchase. However, we caution compensation committees to take into consideration and control any unintended bias resulting from this increasingly popular capital program.

To download a pdf copy of this article, click here.

For additional insight into share buybacks, click here to see S.L. Mintz, Institutional Investor, February 2015.

Simple Incentives to Improve CEO Succession Planning and Results

Posted by Jeff McCutcheon on February 03, 2015  /   Posted in Compensation Committees


Board members have an obligation to protect the company from gaps in executive talent by ensuring leadership continuity, particularly during times of CEO succession. While we find numerous commentaries addressing best practices surrounding the planning for succession, we believe incentives should be considered that focus on the succession result.

Most boards recognize that they must rely on the CEO for much of the insight into potential internal and external successors and risks. Unfortunately, the CEO is perhaps the only individual who typically has no financial interest in the actual success of the succession effort.

Through our work with boards of directors, we have identified three types of obstacles to a CEO effectively planning for his or her own succession:

  • Socially, it may be difficult to discuss succession with a CEO who perceives that a ready and able successor diminishes the CEO’s relative power with the board;
  • Culturally, there may be a history within the organization whereby the CEO has controlled the pace and timing of succession based on the CEO’s own plans for retirement; and,
  • Economically, there may be incentive programs and employment terms that clearly exclude the CEO from accountability for the succession result.

While we do not believe these obstacles prohibit effective succession management, we do recommend boards and committees responsible for succession consider the impact these factors may have on their efforts to mitigate business risk related to CEO succession.

Board Advisory LLC reviewed 50 recently filed CEO employment agreements to identify current practices with respect to CEO succession. We were looking to identify contractual employment terms that support successful succession of the CEO role. What we found was that CEOs typically have little, if any, financial stake in the ongoing success of the company during the 12-18 month period immediately following their termination of employment. In almost all situations, executives were allowed to fully liquidate their ownership in the company upon leaving. Moreover, CEOs often negotiated accelerated vesting of time-based, and sometimes even performance-based, equity incentives in the event of terminations without cause or for good reason (i.e., a “good leaver”).

In evaluating contemporary pay practices in light of CEO succession, we have identified several interesting arrangements that can align interests between the outgoing CEO and the ongoing organization through the most critical portion of the succession process. The concepts may be far easier to implement when recruiting a new CEO than when renegotiating with a current CEO, but we believe they are worth discussing in both situations.

  1. Establish at the beginning of the relationship that the CEO is the leader of the organization and thus is obligated to ensure continuity in leadership under all circumstances. Whether as a result of voluntary or involuntary termination, the CEO is expected to have plans in place to protect the organization—and will be held accountable to some extent for the success or failure of these plans.
  2. Recognize the CEO’s obligation to the organization extends beyond the last day worked. We find that over 90% of CEOs already have post-employment covenants such as non-compete/non-solicit arrangements, but only one CEO in 50 had a stock ownership obligation that extended beyond the last day worked. Requiring CEOs to retain their target ownership for 12-24 months beyond the termination of employment helps maintain a real interest in leadership continuity and success.
  3. Do not accelerate equity vesting upon “good leaver” terminations. Construct 409A-qualified arrangements whereby shares continue to vest over time and are retained by the former CEO through the succession period, adding to the former CEO’s financial alignment with continued organization success.

We propose that compensation committees consider requiring CEOs to have “skin in the game” for a brief post-employment period to shift the focus from the process of succession planning to the actual succession result. After all, a principal responsibility of the board is to manage the succession risk, not the succession plan.

Jeff McCutcheon and Rich McGinley.    This article originally appeared in Corporate Board Member magazine, Q4 2014.

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Are You Paying for Performance or Just Paying for Results?

Posted by Jeff McCutcheon on February 08, 2014  /   Posted in Compensation Committees

Performance reportPaying for performance is assumed to be the objective of most executive and employee pay plans. A quick read of a handful of proxy statements will likely find the phrase “pay for performance” prominently used. The Dodd-Frank Act expressly instructs the SEC to require companies to describe their pay-for-performance program. However, we find many of these programs simply pay for results.

Let us explain. Paying for performance infers that the reward is somehow  linked to actual contribution, whether as individuals or as a team. It requires some level of cause and effect. In the context of a management long-term incentive arrangement (LTI), this might be achieved by linking the number of shares vesting to achievement of a key strategic objective, like successful diversification into a new business or developing a pipeline of new products to sustain a higher gross margin.

Paying for results is simply managing incentive payments to an outcome, whether the direct result of performance or not. For example, a company’s stock may rise for many reasons, including factors well outside the impact of management. This approach is typical of many total shareholder return (TSR)–based long-term incentive plans. The plans are defensible on the basis of their alignment with shareholder returns over the same period of time. However, let’s not lose the distinction here—paying for results is not the same as paying for performance.

Investors support long-term incentives primarily because they believe the incentive will both reduce the risk inherent in strategy execution and decrease the eventual investor cost to realize the strategy. The LTI should reward successful strategy execution and serve to complement and, at times, counterbalancethe short-term nature of the annual incentive. It’s about providing a financial incentive to create future value through execution of a strategy, which may require an extended period of time to achieve.

For these reasons we argue that performance—causality to results—is critical to maximize the valueof the incentive investment. If you simply pay for market-based returns using absolute or relative  TSR, the LTI may serve more as a lottery ticket than an incentive. By this we mean actual payout is viewed  more as chance than contribution. This hardly serves to motivate any change in behavior on the part of the executive or help guide the executive team in navigating tactics and priorities. While such programs are often lauded, they may in fact diminish or delay accountability for a poor strategy by rewarding (or punishing) for events reflected in stock price that are unrelated to changes in long-term franchise value.

The LTI should address two equally important objectives—deliver the strategy (paying for performance) and create value for investors (paying for results). The former is an often difficult, uncertain, and time-consuming effort. Yet, achieved thoughtfully, it produces a resilient and successful organization. The LTI should also reflect performance risk. A business-as-usual strategy (or lack of strategy) should provide no more than “caretaker” rewards, even if shareholder returns are exceptional. Similarly, an exceptional strategy that does not produce above-market returns for investors cannot be granted superior rewards. However, the exceptional strategy that is duly rewarded over time by the market should deliver superior rewards to the management team

As we saw in 2013, institutional investors are beginning to migrate from simple, standardized, and often poorly conceived metrics dictated by the proxy advisers (e.g., ISS and Glass Lewis) to a more nuanced dialogue with managers and board members regarding pay. As institutional investors trade the “pass/fail” approach for dialogue, it is critically important for managers and boards to speak clearly to their shareholders about how the LTI is integrated with both successful strategy execution and rewards to shareholders. By clearly articulating the detailed link between enterprise strategy and executive rewards, companies will benefit from not only more effective executive efforts, but also greater investor support.

Are You Paying for Performance or Just Paying for Results? from BoardMember Magazine, Q1, 2014

2014 Trends in Executive Compensation and Governance

Posted by Jeff McCutcheon on January 20, 2014  /   Posted in Compensation Committees

2014The following represents our assessment of executive pay, governance and how these factors impact the role of the board member in 2014.

Our Environment in 2013

Pay.  In 2013 the S&P 500 total return was 31.9%, the strongest since 1997.  The rapid climb in value resulted in substantial wealth gains by investors as well as many CEOs and directors.  The S&P gains also highlight two longstanding issues with executive pay that directors must confront.  First, that pay plans often fail to differentiate relative performance, where “all ships rise with the tide”, second, and related, that a single measure such as total return may measure results, but the results may be unrelated to management’s actual contribution and success in their roles.

In 2013 we saw generally conservative executive pay actions.  The average CEO salary increased by roughly 1%, with 2 of 3 CEO’s seeing no increase at all.  Option usage declined slightly, offset by a corresponding increase in the use of performance-based restricted stock or stock units.  Perhaps the result of modest economic growth and the maturity of the Say-on-Pay regulation, restraint was evident.  It will be interesting to see how this general trend is affected by the equity market escalation; I expect 2014 pay disclosures will reflect more aggressive pay actions.

Regulation.  Regulatory and pseudo-regulatory bodies were more reserved than prior years.  Heavyweight pay influencers such as ISS and Glass-Lewis refined benign issues such as peer group methodologies and danced around more volatile issues such as pay-for-performance standards.

The SEC, with 4 major regulations outstanding from the 2009 Dodd-Frank legislation, effectively told the market they would address the CEO pay ratio and punt on the remaining issues (i.e., pay-for-performance disclosure, hedging and claw-backs[1]).  SEC changes announced in 2012 becoming effective in 2013 and 2014 such as Compensation Committee member and advisor independence, were generally not disruptive to most companies.

The IRS established no new landmarks.  Taxation of carried interest plans as ordinary income (currently treated as capital gain) remains a target.  The IRS refine its thinking on the timing of deductibility of annual bonus plans.  Similarly, no new accounting changes impacting executive pay were implemented in 2013.

In all, it was a quiet year for the traditional players in executive pay.

Investors.  For many compensation committee members 2013 distinguished itself as a year of change in the role of the shareholder.  In 2013 we saw continued evolution of the role of shareholder litigation in executive pay, where the derivative litigation industry used failed Say-on-Pay votes, 162(m) disclosures, as well as minor pay reporting errors as grounds for derivative suits against the company and the board.  While very few of the fiduciary-based derivative lawsuits were successful, companies and Compensation Committees were often involved in prolonged, expensive and distracting efforts to defend themselves.

Takeaway from 2013.   In 2013 we saw what is likely the waning of relative influence of ISS and Glass-Lewis[2].  Several large institutional investors such as Vanguard, Fidelity and Blackrock developed their own proxy analysis/governance groups, with some explicitly stating they no longer followed ISS recommendations.  In addition, statements from both Canadian and US securities regulators indicate a willingness to regulate[3] the proxy advisor industry in reaction to what was perceived as heavy-handed practices by the industry leaders.

Also in 2013, as mainstream institutional investors proved they were willing to join, or sometimes lead, shareholder efforts to drive change in companies[4], compensation committee members found themselves much more involved in shareholder outreach programs.  For 2013 Georgeson reported 58% of large public companies undertook a formal outreach effort[5].  The single most “popular” reason for the effort was to explain CEO pay, followed by company strategy.

Looking Into 2014

At the macro level, it is reasonable to believe several trends will be of consequence to compensation committee members and their companies in 2014.

Pay.  Since 2008 we have seen a steady shift away from stock options, primarily to performance-vested RSU’s (at least for post-TARP organizations).  This aversion to stock options was driven by a number of sources, arguing that the asymmetric risk characteristics of an option were conducive to excessive risk taking and placed the executive in a market-timing conflict with other investors.  These arguments coincided with a major market correction which at least temporarily wiped out nearly all option gains held by executives, resulting in little desire to contest the conclusions of pay critics.  With the market now restored to pre-recession levels, a gradual return to stock options is likely.  We can expect a shareholder-endorsed “Stock Option 2.0” will be granted with share retention requirements as well as potential limitations on exercise timing, directly addressing prior investor and pay critic concerns.

In addition, we believe that companies will increasingly rely on some form of realized pay in addressing pay-for-performance concerns from investors.  Compensation committee members are reminded that we still generally define “competitive” executive pay in terms of SEC reporting standards, where pay opportunity (e.g., Black-Scholes), not value received (realized pay), is the comparator.  Committee members need to be mindful of the difference, and be certain this distinction is communicated to investors and other stakeholders.

Proxy Advisors.  There is a good chance the SEC will withdraw the original 2003 no-action letter that provided institutional investors with fiduciary “cover” when they relied upon a recommendation from a proxy advisor[6] for voting their shares.  Such a change, coupled with individual institutional investors fighting to directly establish their own agenda in the boardroom, may mean multiple standards for acceptance of pay actions and the end of what was previously an ISS “safe harbor”.

Institutional Investors.  We expect that “problematic pay practices” will remain a point of contention with institutional investors.  However, we should expect they will address the problem with companies directly – and expect compensation committees to respond personally.  Fortunately, the institutional investor approach is typically a negotiation, not a disruptive “no” campaign.

Regulation.  The SEC has clearly shifted to the recalcitrant regulator with respect to public company executive pay.  However, recent statements indicate the final three regulations dictated by Dodd-Frank will finally be introduced over the course of 2014, five years after the act was passed[7].  The pay-for-performance regulation (Section 953(b)) is potentially the most controversial of the three.  It is our belief the SEC will follow the emerging trend of describing pay in terms of company performance over an extended period of time, consistent with contemporary realizable pay methodologies[8].  Independent of the SEC’s eventual rule-making, we see an increasing number of companies embracing realized pay as a means of assessing long-term compensation committee effectiveness and as a tool for direct communication and justification of pay decisions with investors.

At this point there is little controversy surrounding the claw-back and hedging policies, particularly in light of the “problematic pay practice” standards of ISS, Glass-Lewis and certain institutional investors[9].  While we expect any additional regulations to be burdensome, we do not expect the eventual rules to reflect any change in the current evolutionary path of executive pay and employment terms.

Board Tenure and Board Refreshment.  While not new, discussion surrounding director independence is increasing, particularly relating to age and tenure.  A number of institutional investors have determined that an exceptionally long tenure of a director may jeopardize the independence of the director.  The EU recommends terms no longer that 9-12 years.  The UK considers directors with more than 9 years of board service no longer independent.

We do not expect any action on this subject in the US yet, but we believe continued discussion in governance circles will result in several leading companies reinvigorating prior retirement programs and considering new board refreshment programs.  Institutional investors appear to endorse the board refreshment concept[10], in conflict with the general view of companies.  However, it is unknown whether institutional investors will be willing to force a key director out or whether they will simply endorse the program as a tool to weed out lower-contributing directors.   Independent of the outcome of the board refreshment issue, we believe board succession and diversity will remain a visible issue for 2014.

Litigation.  We see no change in the pace of derivative shareholder litigation in 2013.  Despite the relative failure of plaintiffs to win judgments, the industry remains profitable for certain law firms to conduct a form of economic extortion on those companies failing Say-on-Pay voting, failing to adhere to disclosure standards, and failing to adhere to their own shareholder-approved plans and Committee charters.

What This Means for the Compensation Committee

Our principal concerns for Board compensation committees in 2014 are the following.

  • The relative economic weakness on Main Street and its contrast with the success of the equity markets highlights an economic divide within the economy and provides popular support for arguments to address perceived inequities and abuses arising from executive pay.  The level of discussion is now working its way into preliminary political statements as we prepare for mid-term elections, and will likely maintain social pressure on perceived executive pay abuses and potential future regulation.  Committee members are advised to remember that only executives like executive compensation.
  • Committees will come under increased scrutiny if realized executive pay over a 3-5 year period is not correlating with investor outcomes.  The data necessary for any analyst to perform the calculations is publicly available and is likely to become a vehicle for activists to tell their story.  Committees are advised to be prepared by understanding their CEO’s realized pay relationship to performance.
  • Boards will see increased scrutiny from institutional investors to explain company strategy, and compensation committees (and their advisors) must be prepared to explain precisely how the existing pay arrangements advance that strategy.  Quoting a “pay-for-performance” philosophy may be insufficient.  Compensation Committee members should be prepared as investors will be seeking clarification of strategy and how pay relates.
  • Good management of compensation committee processes will remain important as the derivative litigation industry continues to thrive.  Committees are advised to consider audits of plans and processes[11].

That said, we are optimistic about executive pay and its related governance in 2014 for a number of reasons.

  • The increased attention of institutional investors in understanding unique business strategies can support more rational pay decisions.  Perhaps we are seeing an end to “data slavery” and the disproportionate focus on pay comparisons based on present-value methodologies.
  • The decreased emphasis on homogenizing executive pay and elimination of the one-size-fits-all governance model can help companies who are willing to differentiate themselves.
  • Greater sophistication of institutional investors in understanding executive pay arrangements will support concepts such as realizable pay being used to support good committee decision-making, and to protect committee members who commit to longer-term pay strategies.
  • SEC recalcitrance to issue regulations has created a void that is being filled by institutional investors who have a direct interest in value creation rather than a shifting political agenda.

Jeff McCutcheon


[1] The outstanding claw-back regulation involved compensation erroneously earned, as opposed to the specific financial services industry regulations finalized in 2011 impacting claw back liability in the instance of failed financial institutions.

[2] For example, of the 261 “no” recommendations on Say-on-Pay from ISS, only 18% failed.  In general, 2013 ISS recommendations tended to correlate with votes, but by no means dictate voting (source: Wachtell, at

[3] There have been a number of statements, including statements by David Gallagher (SEC Commissioner)  indicating potential SEC action (at NASDAQ request) to withdraw a no-action letter from 2003 that provided a fiduciary safe harbor to investment companies relying on proxy advisor counsel for voting shares.  The Canadian Securities Administration has announced possible regulation of the industry.

[4] In 2013 Blackrock announced they are no longer following ISS recommendations regarding the voting of shares, and Fidelity’s governance group initiated discussions directly with companies as a result of sending letters to 350 companies asking for direct information regarding problematic pay practices.

[5] Georgeson 2013 study of client companies.

[6] There have been a number of statements, including statements by David Gallagher (SEC Commissioner)  indicating potential SEC action (at NASDAQ request) to withdraw a no-action letter from 2003 that provided a fiduciary safe harbor to investment companies relying on proxy advisor counsel for voting shares.  The Canadian Securities Administration has announced possible regulation of the industry.

[7] The Dodd-Frank legislation required agencies to establish 398 separate rules.  As of July 2013, over half remain unresolved with 29.4% in pending form (since then, the CEO pay ratio was finalized) or not yet issued (32.2%).  See DavisPolk, Dodd-Frank Progress Report (June 3, 2013),

[8] Voluntary disclosure of realizable pay calculations were presented by a minority of companies in 2013, including large cap companies.  ISS began using a variant of realizable pay in assessing companies where there is “high or medium concern” regarding the relationship of pay and performance.

[9] Over half of public companies already disclose policies prohibiting executives and directors from hedging.  SEC rules dating back to Sarbanes-Oxley (2002) require the SEC to pursue the claw back of compensation earned through fraud.  As a result, most companies also have claw-back policies within their various incentive plans.

[10] In 2013 ISS surveyed investors and companies regarding exceptional board tenure.  74% of investors viewed long tenure as problematic, whereas 84% of companies said it was not problematic.

[11] See BoardMember Magazine, Q4 2013, “See the Forrest and the Trees” P. McConnell and J. McCutcheon.

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Executive Compensation: See the Forest and the Trees

Posted by Jeff McCutcheon on January 20, 2014  /   Posted in Compensation Committees

forest and treesFor executive compensation, achievement of corporate strategy is the destination; pay levels, pay programs, and metrics provide the route. As inevitably as the Cubs missing the playoffs, the end of the year swiftly approaches and compensation committees must reflect on the year’s actions and re-check their route. With media scrutiny, regulatory oversight and the specter of derivative litigation ever-increasing, we all need to ask ourselves some pointed questions about our compensation strategy.

Consider the environment:
• Executive compensation represents one of the Board’s principle responsibilities in executing company strategy. Mistakes are costly. Pay-for-performance alone is insufficient for driving successful strategy. Investors expect more.

• Derivative litigation continues to plague companies. Even the most specious claims require extensive board time, distract management, and represent wasted profits in the form of direct and indirect legal expense. This growing litigation shark tank feeds on seemingly minor compliance errors, obliging committees to conduct their own independent audits. (If in doubt as to the potential scale of this problem, ask counsel to brief your committee on the Clorox1 case.)

• As executive pay regulation accumulates such as the expected 2016 CEO pay ratio disclosure, committees need to anticipate public and investor reactions to pay actions through the lens of current disclosure regimen. In 2013 we saw an increase in activism from historically quiet institutional investors. As many large institutional investors have brought their proxy analysis in-house the relative reach of ISS and Glass-Lewis have diminished, also diminishing the assumed “safe harbor” found with the proxy advisors’ formulaic approval process. Committees that overstep expectations may find themselves suddenly initiating investor outreach programs, directly explaining their actions to key institutional investors.

There are no clear-cut answers to every issue, and no one-size-fits-all approach that will automatically place a company beyond reproach. Instead, compensation committees must reflect on both the exigencies and opportunities facing their company, and act accordingly.
By following a methodical approach to committee compliance, compensation committees will equip themselves to make informed, careful, strategic decisions that will serve their companies well in 2014 and beyond.

We suggest an internal review along three major themes:

Pay Strategy.
(How the Compensation Committee uses pay and employment terms to advance the company’s strategy.)

• “The Compensation Story” – Is there a succinct narrative that can consistently and compellingly be used by each board member and affected management?

• Value Creation – Is it readily apparent to all that your executive pay plans promote shareholder value creation in a manner consistent with investor presentations and your investors’ expectations?

Pay Effectiveness.
(The degree to which the actual value delivered supports the strategy.)

• Simplicity – Are the various plans understood and embraced by executives? How do we know? (“I don’t understand all that stuff” = Low ROI.)

• Wise Risk – Does the overall program encourage appropriate risk? Discourage unwise risk?

• Impactful – Is it suitably motivational and does it promote retention?

• Defensible – When described in the media, are you proud or embarrassed?

(Safeguarding the company from nuisance litigation through disciplined compliance.)

• Achievement – Did the committee complete all responsibilities laid out in its charter?

• Compliance – Is the company in full regulatory and exchange compliance with plans and filings?

• Advice – Are external advisors competent? Do we have sufficient confidential contact with them?

1 Mancuso v. The Clorox Co., No. RG12-651653 (Cal. Super. Ct. Alameda Cnty.).

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Annual Executive Compensation Levels: Where We Veered Off the Road

Posted by Jeff McCutcheon on August 30, 2013  /   Posted in Compensation Committees

[Originally published in Board Member Magazine 2013 Q3.]

VeerIn our last article, we noted that somewhere along the way, executive compensation veered off the road.  Executive compensation plans became too complex, isolated from true performance and downside risk, and in many cases, total compensation was just too high.  While there is no shortage of blame to go around, we find one obvious flaw is the prevailing practice of treating executive equity as annual compensation.

Assume that you had money to invest in a business and I was going to run it for you.  I’d get a salary and bonus for my labor.  You might also give me shares of the company to align our interests and ensure I was fully “bought in” to the venture. It would be clear between us that the stock was my “share of the deal” and would remain invested with the company until we parted ways.

As an unintended consequence of the thirty-year effort by the SEC to improve the oversight of executive pay, we have effectively created a bias against the “share of the deal” approach to equity.  To provide greater transparency and comparability, the SEC requires companies to report all remuneration in annual terms – even if it is not an annual event.  Consequently, we stopped thinking about executive equity as a “share of the deal” and we fell into the mindset that it was all annual compensation.

Obviously, equity awards have a compensatory effect, and are a key part of an executive’s total pay.  The best talent will seek opportunities where they can share in the value they help create.  However, by seeing executive equity as a piecemeal annual reward rather than as one’s share of the deal we have created the perception that the equity is indeed a cash equivalent, to be exchanged for cash when needed.

From an owner’s perspective, the critical issue should not be the annual increment of equity, but the total equity commitment necessary for each key executive role to achieve the following investor objectives:

•        Providing an attractive package to recruit and retain the management talent needed;

•        Matching executive performance and wealth more closely to the company risk horizon; and,

•        Aligning executive wealth proportional to investor gains or losses.

Unfortunately, in the current “tail wagging the dog” scenario, we find companies think about equity in annual terms because we report it and compare it on annual terms.  This has the perverse impact of:

•        delaying the formation of a substantial equity position for several years in order to comply with annual compensation practices;

•        rewarding volatility by granting more equity (as a percent of outstanding stock) when the company does poorly and fewer shares when the company is highly successful; and,

•        thinking of equity as a cash equivalent that can be sold during the term of employment.

It makes far more sense to manage equity decisions using established target equity levels for each of the key executive roles.  Achieving the target ownership may be accomplished in one step (e.g., in a turnaround), or parsed out over time.  The key difference, however, is that executives and investors know the annual grant is not a bottomless pit of investor dilution.  Periodic grants would represent the execution of a strategy rather than an attempt to chase some market median practice.

With this approach companies, executives, and investors benefit three key ways:

•        We answer the question “how much is enough?” — the elephant in the room nobody currently wants to talk about;

•        We simplify pay by distinguishing an illiquid career investment from annual cash pay.  This change in perspective removes much of the concern driving the Dodd-Frank pay-ratio debate; and,

•        We assure all parties that executive management is a long-term investor in the company, with upside and downside risk, and full accountability for the economic consequences of risks through a sizeable stake held throughout their career.

It is time we begin to think and act like owners and treat equity as if we were making partners out of management – by granting them a piece of the enhanced value of the business over time, not doling out shares simply to reach a “competitive” amount of annual compensation.

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CEO and Executive Pay Plans: Help for a Broken System

Posted by Jeff McCutcheon on May 06, 2013  /   Posted in Compensation Committees

[Originally published in Board Member Magazine 2013 Q2.]

Broken Somewhere along the way, executive compensation veered off the road.  It became too complex, isolated from true performance and downside risk, and in many cases, too high.  The original idea of executive compensation was to pay an adequate and fair wage and good benefits.  Any additional pay was intended to place executives in the same position as owners.  However, with high base salaries, equally powerful short-term incentives, long-term incentives that are treated as income rather than investment and often protect against downside risk, and the potential for golden parachute payments that reward executives when they fail, something went wrong.  The good news is that it can be fixed.  The bad news is that it will require some bold new thinking on the part of boards and management.

Performance.  Before discussing pay, let’s examine performance.

  • More often than not we reward CEOs for luck and good timing rather than for leadership, stewardship and good strategy.  Research has shown that as much as 80% of total return may be based on macro-economic factors and industry trends unrelated to company behavior.
  • Performance against internally-developed goals is important, but may be unrelated to actions that build long-term value for investors.  If a CEO is truly operating at a strategic level, the real impact of their leadership may not be evident for 5-10 years, and in some industries with long development or capital cycles, perhaps 15 years.  Yet for the most part we define CEO performance in terms of annual financial results rather than on more broad indicators of long-term value creation.
  • Current year plan-based targets, ROIC (return on invested capital) and share price are all great dashboard measures, indicating directional progress, but these measures should not be confused with actual success of a strategy or long-term value creation within an organization.  Boards need to think long and broad when it comes to assessing performance.

If we are to improve the pay model, we must first be willing to commit to a longer-term view of performance and articulate exactly what success looks like.

Pay.  Much of the current executive compensation thinking is a product of the 1980’s and 1990’s.  Many of today’s practices are influenced by the SEC efforts to standardize disclosure in an effort to bring more transparency and comparability to executive pay.  Unfortunately, as with many things, there were unintended consequences.

  • We think about and communicate pay in annual terms rather than in long-term outcomes.  If in doubt, read the “compensation philosophy” section of the typical CD&A.
  • We emphasize annual bonuses that pit CEO’s self-interest against investors when negotiating performance targets.
  • We claim that equity is an incentive to create alignment and balance risk, but we allocate it on the basis of “competitive pay” like cash; we too rarely acknowledge an intended career allocation or a targeted ownership objective.
  • We rationalize equity programs as putting executives in the same position as owners, but, in our experience executives rarely lose money. Annual equity awards are typically based on dollar-denominated “target values”, protecting executives from stock price changes, and executive stock holdings are often sold to the extent they exceed minimal ownership requirements.
  • We use “competitive practice” as a synonym for minimum requirement, whether dealing with salary and incentives, terms of employment, or severance.  As a board we seldom exercise leadership in crafting employment arrangements directly supportive of the company’s mission.

To say that executive pay is “broken” may seem overly harsh, but we should at least acknowledge that executive pay often falls far short of delivering on its objective of rewarding executives for long-term value creation.  The first step in the cure is admitting you have a problem.

In later articles, we will examine several solutions to these problems.

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Pitfalls in Executive Loans: Stock Purchase and Loan Plans

Posted by Jeff McCutcheon on March 28, 2013  /   Posted in Compensation Committees

Stock CertificateLast week (March 20th, 2013) Baker & Hostetler, LLP[1] received guidance from the SEC regarding the use of arms-length loans within an executive stock-purchase-and-loan plan (SPLP) for a client company, RingEnds Partners[2].  Of significance here is not the design of the plan or the ability of employers to effectively arrange credit for executives, but that complicated executive pay arrangements are being developed to circumvent tax policy to the potential detriment of companies and investors – with limited positive effect for the executives.

The RingsEnd Partners executive compensation program consists of:

  • The company transfers stock award shares into an independent trust on behalf of the executive.
  • The executive elects to recognize the grant value of the shares upon receipt by electing 83(b) treatment
  • The trust immediately borrows money at arm’s length from a bank, securitized by (and only by) the shares it holds, distributing cash to the executive approximating the income taxes owed

At this point, the executive’s basis in the security is the grant value of the award, with all subsequent gains or losses subject to capital gains treatment.  The executive’s tax/vesting risk is effectively transferred to the trust and the company; if the shares do not vest, the executive is not liable for the loan used for tax payments or the interest on the loan.  Assuming the shares vest, the trust will withhold shares at the vested value to repay the loan and interest, transferring the remaining shares to the executive without any further taxation until sale of the stock.

  • The executive benefits from two features of the plan. Assuming the rate of appreciation exceeds the rate of interest on the loan obtained by the trust, the executive benefits from the spread between the tax-effected loan interest rate and the equity growth rate, plus,
  • The effective deferral of taxation on appreciation in shares from grant date through vesting date until eventual sale on the shares.

But for all the complexity of the arrangement, economic benefits are limited.  In contrast:

  • We believe there is a potential shareholder issue if, in fact, the employer is underwriting the financial risk associated with an executive’s 83(b) election.
  • We question whether an 83(b) election is even appropriate when an employer is effectively underwriting the risk.

And (notwithstanding this caveat), there is little the plan provides that an executive could not achieve under the existing tax and regulatory framework.  An 83(b) election to recognize income upon receipt of a stock award is already available.  The only unique feature with RingsEnd is that, through a rather complicated trust arrangement, the company is underwriting the risk that the shares will not vest, relieving the executive of paying taxes on shares never received.   Strangely, this effectively reduces the executive’s negative consequences of leaving the company prior to vesting.

We believe that encouraging executive shareholding, particularly with limited liquidity during the term of employment, is good public policy.  When executives hold a considerable portion of their total net worth in the form of illiquid shares of company stock, they are more inclined to have a balanced view of investor risk.  However, we find nothing in the RingsEnd plan to support an ownership objective and find it may undermine other incentive objectives such as retention, solely for the benefit of incremental executive tax efficiency.

Companies are advised to be wary of programs that are inordinately complex, and avoid falling into the trap of allowing design elegance to distract you from actual program effectiveness.

Jeff McCutcheon is a Managing Director at Board Advisory, LLC, an independent consulting firm exclusively serving boards of directors, their compensation committees, and investor groups.

[1] Prominent in the Baker & Hostetler, LLP request was Michael Oxley, the former Congressman and Chairman of the House Financial Services, and co-author of the Sarbanes-Oxley legislation, now Of Counsel with Baker & Hostetler, LLP.

Reconciling U.S. Tax Policy on Executive Equity with the Public Interest

Posted by Jeff McCutcheon on March 28, 2013  /   Posted in Compensation Committees

taxesThere is substantial agreement between academics, policy makers and behavioral experts that executive ownership of company shares, particularly when those shares are held for an entire career (e.g., retirement plus 2 years for successor transition), is good for investors and the public.  Long-term equity ownership on the part of executives is viewed as a mitigant for excessive risk taking, providing financial accountability for risks taken over the course of a career that may not be reflected in annual bonus or salary decisions.  However, current tax law does not effectively extend to executives the same tax treatment afforded investors, nor does it encourage the type of ownership that can retard events such as those leading up to the recent financial crisis.

Gaps and inconsistencies in tax policy have contributed to much of the complication, obfuscation and negative unintended consequences in current executive pay arrangements.  Companies seek, often through overly-complex arrangements, to provide executives with the same tax treatment afforded investors.

The IRS Code has provided some opportunity for alignment between tax policy and good governance dating back to 1964 through employee stock purchase plans (ESPP’s)[1] and since 1981 with Incentive Stock Options (ISO’s)[2].  These provisions allowed, in certain circumstances, for employee equity to be treated consistent with investors with respect to capital gains treatment.  An Incentive Stock Option (ISO), established in 1981, provides employees with capital gains treatment for the gain on any qualifying option award under certain exercise and holding period requirements.  Unfortunately, the original $100,000 award limitation remains unchanged from 1981.  On a pay-inflation-adjusted basis alone, this limit would need to be over $1M in 2013[3].

We propose that through minor modification to the existing tax code we can increase the transparency of executive equity/compensation arrangements, provide greater alignment of executive rewards with societal goals of balanced risk taking, and increase the actual net revenue to Treasury.  We propose the following simple changes to existing tax code:

  • Eliminate the $100,000 limit on Incentive Stock Option awards.  The definition of a qualified award would include full-value shares as well as stock options.
  • Where there is a discount element (e.g., restricted or performance shares), the discount at grant would be treated as ordinary income to the executive, taxed upon sale of the shares. The corresponding employer tax deduction would also be deferred until sale.
  • To qualify for capital gains treatment, shares must be held for the longer of ten years from the date of grant 2 years following termination of employment.  Shares sold prior to the time limit would be disqualified and subject to immediate ordinary income taxation of the entire amount.

These proposed tax rules create a strong incentive for executives and Boards to design equity plans utilizing hold–till-retirement provisions.  This will result in more net shares remaining in the hands of executives, presumably providing a more significant incentive for delivering long-term results for investors and the public at large.

Curiously, although the executive would receive favorable tax treatment, the tax revenue gains to the government would actually increase.  Currently, upon share vesting or option exercise, income tax paid by the executive is generally offset by the compensation deduction of the employer.  On a net basis, the only revenue received by Treasury now is the capital gains tax received upon sale of the shares.  Under our scenario, the employer loses the tax deduction for gains from grant through exercise/vesting (further delineating between income and investment), leaving the government with effective taxation, albeit at a lower rate, of a greater portion of the award.

Under our proposed approach[4], the executive’s capital gains would be measured from the grant date price – as is the case with an investor purchase – with no offsetting tax deduction by the corporation for subsequent gains. While this results in a lower tax rate for the executive, the effective Treasury revenue is increased by elimination of the employer’s tax deduction. Furthermore, the combination of hold-till-retirement covenants and supporting tax policy better aligns the executive performance incentive with the interests of investors and the public over time, rather than allowing an executive group to be rewarded for short term results.  With a broad definition of equity incentive plans (i.e., including nonpublic company equity and equity-like vehicles), this approach can successfully apply regardless of company size or ownership structure (e.g., small businesses, joint ventures, subsidiaries, private equity and start-ups).

The individual & corporate taxation, as well as federal revenue, can be summarized in the following example where an executive is granted 3,000 restricted shares at $10 per share, vesting in entirety at the end of three years, with the shares eventually sold at the end of 10 years, assuming a constant 10% CAGR in share price.


Treating executive pay consistent with investors is good public policy.  Creating an effective tax penalty for executives choosing to liquidate shares prior to retirement achieves a sensible balance for executive risk-taking and provides greater long-term skin-in-the-game that provides additional accountability for executives and corporations within our economy.  We believe this is an easily-achievable step toward aligning federal tax policy with public policy interests, and can immediately provide increased federal tax revenues through improved public policy.  Lastly, it would eliminate the need for complex plans, where any benefits to investors or the public are negligible at best.

Jeff McCutcheon is  a Managing Director of Board Advisory, LLC, an independent consulting firm exclusively serving boards of directors, their compensation committees, and investor groups.

[1] The Revenue Act of 1964 provided the tax treatment for options contained in ESPPs through IRC Section 421(a)(1), providing that “no income shall result at the time of the transfer of such share to the individual upon his exercise of the option with respect to such share.”

[2] The Economic Recovery Tax Act of 1981 established ISOs. P.L. 97-34. Senate Report 97-144 states the intended tax treatment for ISOs: The bill provides for “incentive stock options” where there are no tax consequences when an incentive stock option is granted or when the option is exercised, and the employee will be taxed at capital gains rates when the stock received on exercise of the option is sold. Similarly, no business expense deduction will be allowed to the employer with respect to an incentive stock option.

[3] IRC Section 422(d)(1).  The $100,000 limit on ISO value was established in 1981 and has not changed.  Based on compound growth rate of executive pay for S&P 500 CEOs from the period 1989 through 2011, the $100,000 limit established in 1981 would need to be over $1M for 2013 based on the average growth rate in S&P 500 CEO compensation of roughly 7.5% per year.

[4] See Aligning Tax Policy with Sound Executive Pay Practices, Board Advisory, LLC, (Issue 3, 2009).

© 2013 Board Advisory.
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