Author Archives Paul McConnell

Jerry Jones Has a Point, But the Wrong One.

Posted by Paul McConnell on November 18, 2017  /   Posted in Compensation Committees

Much has been written about NFL Commissioner Roger Goodell’s contract extension and Dallas Cowboys President Jerry Jones’ objections to the amount he can earn and the lack of rigorous performance criteria.  While Jerry might be right, I think the bigger issue is a classic example of misalignment between owners and the executive.

Owners earn a healthy annual return on their investment.  But the serious money is made from the growth in the value of the franchise.  The franchise value grows tax-free over time from enhanced TV contracts, merchandising, stadium deals, operating management and keeping the stadiums filled.  When the franchise is sold, the gain is taxed at favorable long-term rates.

From press accounts, it appears that the contract being discussed is a collection of bonus arrangements designed to reward the commissioner for improvements in the various metrics that drive the franchise value.  One of the arguments is whether the performance goals are sufficiently difficult or if the bonuses are just disguised salary.  This is a typical “managerial” approach to compensation – pay me for the things I can control and I’ll “manage the hell out of them”.  Its not a contract compatible with the group of entrepreneurs that own the place.  In a public company this would be like paying the CEO huge annual bonuses, but no stock.

Here is an idea for a better approach.  Scrap the bonuses entirely.  Pay the Commissioner a nice high salary consistent with what the top players make – maybe an average of the top 5 players in each position or a fixed percentage of the cap.  The Commissioner represents the players too and he should have something in his package tied to their welfare.  But the true wealth from this contract should come in the form of something like a Stock Appreciation Right (SAR) tied to the increase in the aggregate franchise value.  Forbes Magazine, an objective third party, conducts a study each year.  The values they compute may not be 100% accurate, but the trend is consistent with the trend in the Owners’ value.  The SAR would only pay out at the end of the Commissioners term to ensure a long-term alignment with the Owners.  NFL Commissioners serve a long time – Rozelle served 30 years, Tagliabue 17 and Goodell has already served 11.  It’s a long-term job.  The pay should be too.

“Pay For Performance” Made Simple

Posted by Paul McConnell 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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Executive Pay Practices: The Road Not Taken

Posted by Paul McConnell on August 17, 2014  /   Posted in Compensation Committees

Two RoadsThe evolution of current executive pay practices may require more and more companies to take the “road less travelled by” in order to provide superior returns to shareholders. Pay practices continue to create heated debates among executives, boards, institutional investors and their proxy advisories (e.g., ISS and Glass Lewis). Underlying the debate are two contrasting views about executive pay and the economy in general – zero sum economics and expanding wealth.

Zero sum economics simply holds that one person’s gain, is another person’s loss. To wit, if the board pays their managers more, there is less for shareholders. The current metrics employed by ISS to assess pay-for-performance are really cost control measures that seem to reflect ISS’s view that executive pay is a zero sum game. While zero sum may capture the economics of trading pork bellies or oil futures, it does not describe how an economy creates wealth and how managers should share in the wealth they create.

The view of expanding wealth is embodied in the likes of Steven Jobs, Meg Whitman, Jack Welch and many others — business leaders who created substantial benefits for consumers and in the process created substantial wealth for themselves. In short, the pie got bigger and owners shared in the increasing size of the pie. It would be rare to find an investor who would begrudge the wealth these superstars have earned. Interestingly, among this illustrious group, some would likely fail today’s proxy advisor screens.

Rewarding managers for wealth creation is a “value sharing” approach to executive pay. The model dates back to the industrial giants who emerged prior to WW II. GM, JC Penny and others paid a share of the profits (after a fair return to investors) to the senior managers. After the War, public companies migrated to a “competitive pay” model that pays managers what other managers earned in the same sector and adjusted for size.

Unfortunately, with the exception of significant collapses in performance, competitive pay is often “memory less” — regardless of performance, the CEO gets what the CEO’s peers get. It should be noted that private equity has pretty much retained the “value sharing” approach to incentive pay, a potential source of competitive advantage in attracting talent.

While competitive pay addresses retention risk (if everyone’s paid the same, no one will leave for more money), it may not address performance. High leveraged plans pay out more as performance increases, but could run into the immoveable code of the proxy advisors. While no board member wants to be voted off the island, boards may unknowingly be taking the road to mediocrity by de-levering the compensation plan in order to assure favorable votes from investors.

Yet if ever there was a time to avoid mediocrity, this is it. Mediocrity, is what puts a company on the short list of potential takeover targets. In a world where the economy creates new wealth, “value sharing” compensation programs do matter. They matter not only to attract and retain talent, but also to encourage managers to pursue all value-adding investment opportunities. The biggest impact on shareholder wealth from the competitive pay approach may well be the opportunities foregone.

It’s time for boards to take a stand against mediocrity. Start with strategy – management must make a compelling case for their strategy and how it will create value for investors. The board must support the strategy (or change it). In supporting the strategy, the board must adopt a compensation program that is aligned with the strategy and allows managers to participate meaningfully in the value they create for shareholders. Finally, boards and managers will need to explain to institutional investors and their proxy advisors how they intend to create value (strategic intent) and how they will allow managers to “share” in the value created. In short, the road less travelled by may not be an easy road; but then it may make all the difference. BoardMember 2014 Q3 The Road Not Taken

Annual Executive Compensation Levels: Where We Veered Off the Road

Posted by Paul McConnell 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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Are Relative Total Shareholder Return (TSR) Plans “The Answer”?

Posted by Paul McConnell on May 06, 2013  /   Posted in Compensation Committees

[Originally published in Board Member Magazine 2013 Q1.]

stockThere has been a great deal of recent interest in performance share plans that use Total Shareholder Return (TSR) relative to a peer group as a measure of performance.  Clearly, these plans usually look good in a pay for performance comparison and can help secure favorable say-on-pay votes, but the additional questions Compensation Committees should be asking are:

  • Do they motivate executive performance?
  • Are they right for this particular company?
  • Does TSR reflect true executive performance?
  • Is this the only performance-linked program we should use?

Any discussion of total shareholder return must start with the understanding that TSR is a result of good management performance, not the performance itself.  The desired management performance is the production of great products/services, properly priced for consumer value, that deliver consistent financial returns commensurate with the riskiness of the required investment.  If the market sees this performance, share prices are bid up relative to peer companies and positive relative TSR results, assuming of course, other, exogenous events do not occur.

From a motivational perspective, the strongest incentives are those where a clear line of sight exists between the desired behaviors (performance) and the reward.  TSR plans may not provide as clear a linkage as plans tied to measures of operating performance.  Even though it may be very hard to do, executives know what it takes to raise net income by 10%; it is less clear what it takes to raise the stock price by 10%.  And the market is not necessarily rational, certainly not in the short term but also seemingly for the long term as well.  Thus plans tied to operating metrics more clearly convey performance expectations and behaviors.  However, executive pay is not just about incentives and motivation.  It’s also about sharing the risk and reward of ownership.  What then are the situations where risk sharing is more important than communicating performance expectations?  Although the following list is not exhaustive, it shows the areas where we think these plans have value.

Shareholder Relations Issues:  In cases where there have been historical issues with the pay for performance relationships, relative TSR plans alleviate that problem – in fact, better than outright share ownership.  By definition, the change in the value of executive shares owned has a 1 for 1 alignment with TSR.  TSR performance plans have a more exaggerated relationship, due to the fact that the value of the shares awarded as well as the number of shares themselves vary with TSR.  The value of these shares typically climbs faster and drops more quickly than total shareholder return itself does.

Change in Strategy/Turnarounds:  In these situations, it is difficult to set reasonable performance goals.  Success will likely be much different than current expectations.  But a successful turnaround will likely have a dramatic impact on TSR, as the market builds new expectations into the market price.  These kinds of awards are also useful in justifying the kind of above market grants that are typically required to attract new management required to effect the change in strategy/performance.

Technology/Life Sciences:  These industries are known for high risk/high reward – particularly in the pre-IPO stage, where large equity grants are the rule.  These grants are either very valuable or worthless.  (Executives that have worked in these industries often have enough worthless stock option certificates to wallpaper their office.)  Relative TSR plans can replicate this highly leveraged reward practice in the public company stage.  Very successful strategies produce high relative TSR, which these plans magnify into even larger reward.

In Conjunction with Other Plans:  When other long-term plans are in place that use other metrics, a TSR plan can be good for balancing the total plan so that a company doesn’t create negative perceptions that management gets very generously rewarded when shareholders don’t.

Are relative TSR plans “the answer”?  No, they are “an answer” that can be very appropriate in the right situations.

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CEO and Executive Pay Plans: Help for a Broken System

Posted by Paul McConnell 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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Facebook’s Multi-Billion Dollar Tax Break on Executive Stock Options

Posted by Paul McConnell on February 18, 2013  /   Posted in Compensation Committees

blue boxesThere has been a lot written recently about Facebook’s multi-billion dollar tax break from the tax deduction for the cost of executive stock options and share awards.  Stock awards such as these are taxed to executives as compensation based on their value at the time of exercise (options) or vesting (shares), and the employer gets a corresponding deduction for the compensation expense, even though no cash was expended.  Facebook’s phenomenal growth in value from its private company days (when most of these grants were made) makes the resulting deduction very large, particularly compared to its operating income.  The publicity regarding this little understood section of the tax code will likely lead to calls for limiting or eliminating these deductions.  In our opinion, this is treating the symptom, not the disease.

The fundamental problem is that in the eyes of the IRS, stock grants are treated as compensation by the employer rather than as an investment by the executive.    In the example below we contrast tax treatment of a warrant issued by a company as a “sweetener” in a stock offering to a identical situation where a stock option is issued by the same company to an executive.  In both instances, we assume the option is priced at $10 (strike price), exercised at $20, and with the underlying share sold after one year at $24.  For simplicity, we assume corporate tax of 35%, individual tax of 40% and capital gains of 20%.

Comparison of IRS Treatment: Investors vs. Employees

Employer Treatment

Investor/Executive

IRS

Deduction

Tax Impact

Ordinary Income

Capital Gains

Total Taxation

Net Taxation

Investor Model

$0

$0.00

$0

$14

$2.80

$2.80

Employee Model

$10

($3.50)

$10

$4

$4.80

$1.30

The company does not receive a deduction with warrants, and the warrant holder does not recognize any income.  Upon exercise of the warrant (share purchase), the capital gains holding period begins.  Upon sale of the share after completing the holding period for capital gains, their tax bill would be $2.80 per share (i.e., $14 gain x 20%).  In contrast, under the current IRS employee model, the employer realizes a $10 tax deduction for compensation expense (the gain at exercise), the employee recognizes the same amount as ordinary income.  Upon a later sale the employee qualifies for capital gains on the additional $4 gain. Thus the Treasury nets only $1.30 per share in revenue in the employee model compared to the investor model, where the IRS realizes $2.80 per share in revenue.

As we noted in an earlier blog entry treating corporate executives as shareholder/ investors for tax purposes would be beneficial to the Treasury by increasing revenue and simplifying taxation.  More importantly, it would align tax policy with social and economic objectives of encouraging long-term stock ownership as a deterrent to excessive risk taking and of making corporate and individual taxation more transparent.

Paul McConnell is a Managing Director of Board Advisory, LLC

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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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