Compensation Committees

Recommended Business Books : October “Board Break”

Posted by board-advisory on October 19, 2012 / Posted in Compensation Committees

The Power of Habit: Why We Do What We Do in Life and Business by Charles Duhigg

Duhigg divides the book into three sections: The Habits of Individuals, The Habits of Successful Organizations, and The Habits of Societies. This is a very, very informative and entertaining book. It reminds me a great deal of The Checklist Manifesto: How to Get Things Right by Atul Guwande, in that the ideas contained in both are “duh, why didn’t I think of that?” simple but profound. He uses hundreds of examples of how we develop good and bad habits and how we can improve by simply understanding the science behind our habitual behavior.

George F. Kennan: An American Life by John Lewis Gaddis

This is the best biography of 2012 and perhaps of the last several years. Kennan was, of course, known as the architect of the Cold War, through his “long telegram,” autonomous letter from X, and other writings that influenced policy makers and gave the blueprint for the containment of the Soviet Union. Gaddis, the author of several books about the Cold War, tells us about the human side of Kennan but also brilliantly covers an important and challenging time for the U.S. You will enjoy this book even if you are either already versed in 20th century foreign relations or simply don’t think you would want to know this much about it. It is that well-done.

The Risks of Accelerating Executive Bonus Payments for Tax Benefit

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

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

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

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

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

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

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

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

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

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

– Jeff McCutcheon

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

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

Board of Director Compensation Trends: “Follow That Bandwagon”

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

Originally published in Board Member Magazine (2012 Q4).

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

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

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

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

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

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

In summary, we believe boards should:

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

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

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

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

Download this article in the PDF format.

Independent Compensation Advisors & Compensation Committees

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

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

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

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

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

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

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

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

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

“Say on Pay”: Paul McConnell interviewed by Marketplace Morning Report

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

“Citigroup Investors Push Back on Exec Pay Packages”

Board Advisory’s own Paul McConnell, Managing Director, was interviewed by Marketplace Morning Report on April 18, 2012.

For Full Story & Audio/Video see the Marketplace website: https://www.marketplace.org/topics/business/citigroup-investors-push-back-exec-pay-packages

Transcript:

Bob Moon: Citigroup investors just pushed back on outsized executive pay. Fifty-five percent of the bank’s shareholders voted against pay packages for top execs, including $15 million in compensation for CEO Vikram Pandit. The vote is advisory only, though, and thus doesn’t actually force a change in Citi’s pay practices. So what will it accomplish?

Executive compensation expert Paul McConnell is on the line with his take on the message it sends. He’s managing director at Board Advisory LLC. Glad to have you join us.

Paul McConnell: Thank you.

Moon: I’ve seen stories that Citigroup can go ahead and stay with its pay practices in spite of this vote. If this doesn’t change things, what might?

McConnell: Well, it is an advisory vote, which means it’s non-binding on the board. But it’s non-binding in the sense that the pay is not going to be taken away as a result of this. The board will react to this; no board is going to take a “no” vote from shareholders and ignore it. If they were — which is, I think, first of all not going to happen –but if they were, the next step with shareholders would be to vote the board members out.

Moon: Do you think the attention this is getting might touch off some kind of shareholder revolt at other companies over these pay packages?

McConnell: I mean, first of all, you’ve got to understand — the Citi corp. pay package is not outrageous in terms of the amount of pay. I think the issue at Citi corp. is more, shareholders are questioning the relationship between pay and performance.

Moon: So these Citi shareholders are basically saying: You want this, you’ve got to earn it?

McConnell: They’re unhappy with that subjective approach. They think the standards are probably not high enough for the amount of compensations earned.

Moon: But you don’t think this reflects general angst among shareholders in general — not just at Citi?

McConnell: No I do not. As a matter of fact, the reason for that is that corporate America has done a pretty good job over the last two or three years in removing most of what are known as “problematic pay practices,” that were really making shareholders irate.

And also you’ve got to understand with Citi, there could be a lot of other things rattling around here. Citi is an organization that’s had its share of troubles over the last few years. And they’re basically telling the board that something is wrong and they want it fixed. And the board will probably make some changes in the pay programs in reaction to this.

Moon: Paul McConnell at Board Advisory LLC. Thanks for your insights.

McConnell: You’re welcome.

Corporate Governance and Board Behavior : The Highs & Lows of 2011

Posted by Paul McConnell on January 03, 2012 / Posted in Compensation Committees

Paul McConnell of Board Advisory was quoted in Agenda Week Online’s newsletter on corporate governance.

Original Article By: Amanda Gerut (January 3, 2012)

Last year’s hot corporate governance stories tended to describe how boards led the way — or withered — in the face of challenge. Herewith, based on Agenda’s reader statistics, the high and low points of boardroom behavior in 2011.

Hall of Fame:

1. After ISS recommended that shareholders vote against executive compensation plans at Alcoa, Assured Guaranty, General Electric, Lockheed Martin and The Walt Disney Company, their boards regrouped and altered elements of executives’ comp to gain the proxy advisor’s support — and shareholder votes. As Agenda reported in May, Alcoa, GE and Lockheed Martin amended the terms of equity awards previously granted to executives, while Assured Guaranty and Disney eliminated some promised benefits.“Listening to shareholders is always an example of good governance,” says Paul McConnell, a partner with executive compensation and governance firm Board Advisory — although he points out that it’s not clear whether ISS actually represents shareholders or just assumes what they think.

Continue reading the article on Agenda Week Online

Designing Long-Term Incentive Plans in Joint Ventures

Posted by Paul McConnell on August 24, 2011 / Posted in Compensation Committees

Originally published in The Joint Venture Exchange in April 2011

The CEO of a relatively new joint venture (JV) was struggling with his long-term incentive program (LTIP). His problem? The JV didn’t have one – and some of his best senior managers were now ready to leave for opportunities with a richer upside. Unfortunately, establishing an LTIP required the CEO to overcome some high hurdles.

Unlike a public company, his venture lacked a stock to use as cheap currency for the plan. Likewise, the CEO had to convince six parent companies, each with a separate corporate culture and approach to incentive design, to agree on a model. And he had to come up with a design that reflected the oddities of life in a joint venture – including whether and how parent company benefits not seen on the JV P&L should be included in the plan targets, and how to deal with parent-company imposed restrictions on the venture’s product and market scope that limited the JV’s earnings potential.

Such compensation struggles are typical for joint ventures.

And our work with dozens of JV Boards and CEOs shows that many JVs with LTIP programs find the current design sub-optimal in important ways. In some cases, the program has unintended limitations in its likely value to employees. In other cases, the program does not sufficiently target the outcomes that the shareholders want to incentivize. This might include pursuing synergies with the parent companies, or maintaining plant up-time rather than profitability.

Continue reading article in PDF Format

– Joshua Kwicinski and Paul McConnell (Managing Director of Board Advisory, LLC)

Interim CEOs Make Sense For Unexpected CEO Departures & Succession

Posted by board-advisory on May 27, 2011 / Posted in Compensation Committees

In response to Equilar Article “CEO Succession in Bunches – An In-Depth Look at S&P 1500 Companies with Multiple CEO Turnovers between 2007 and 2010“

On the topic of using Interim CEOs for unexpected CEO succession: For a company to have an immediate and well-thought-out leadership answer in the case of sudden CEO departure, I believe it’s a strong sign of responsible thinking and preparation rather than an indictment of a firm’s succession planning, particularly when the current (departed) CEO had plenty of runway expected. Like other significant organizational risks, you want to be prepared for unexpected, even tragic scenarios. Not having an immediate solution to those circumstances is irresponsible. The succession solution doesn’t necessarily have to be a permanent CEO (which ties into my next comments), but there must be a solid solution.

Indeed, an existing Board member is a typical source for interim CEOs, but it can also make good sense to go with another person from the Executive Team. Sudden CEO departure can shock an organizational culture, which in turn has negative ripple effects. What the organization needs is an instant stabilizing influence, including and interim CEO that the troops know, trust, and want to follow. Often times, there is a such a highly credible person who has been there a long time, has many deep relationships, clearly cares about the company and its people, and has a proven track record of success. Bingo. That person can be the parental influence that helps the family know that everything is going to be all right.

Why, you ask, isn’t the previously-described person just anointed permanent CEO. Couple of reasons. First, this person is typically on the tail-end of their own career, very likely planning to retire in a couple of years. They’re honored to take the reins on an interim basis, but have no desire (or ability) to significantly alter their retirement projection. Second, the CEO of the future might require skills and experience the interim CEO doesn’t have. This interim CEO can adequately manage the current business challenges for a relatively short period of time, and as importantly will serve a crucial emotional role for the organization. But they don’t have the right stuff to take the company to the next level and/or to handle what’s coming down the pike.

In short, interim CEO succession planning makes sense. It’s like a life insurance policy—you’d rather not have to use it, but are glad you have it if you do.

As for the piece of the article that covers the unexpected short tenure of new CEOs, these finding are consistent with previous research we’ve cited that shows that senior-level transitions fail more often than they succeed. The primary reasons for this trend include (a) a solid blueprint for success wasn’t really nailed down before the search, so the search was misguided, (b) assessment of the degree of fit between candidates and the role requirements was less-than-rigorous, essentially allowing a mis-hire, and/or (c) inadequate onboarding or assimilation was provided, which otherwise could have accelerated traction and value addition. These mistakes can be minimized, but that’s probably another blog discussion.

– Kevin Hummel, Ph.D. is a Managing Director of Board Advisory, LLC

ISS Urges Vote Against Exxon Executive Pay Plan

Posted by Paul McConnell on May 11, 2011 / Posted in Compensation Committees

A recent WSJ article noted that Institutional Shareholder Services (ISS) has recommended a vote against Exxon’s executive pay plan. Their key objections were that Exxon’s pay is not suitably correlated with Total Shareholder Return (TSR) on a 1 and 3-year basis and places too much emphasis on time-vested stock instead of performance vested stock. Exxon is a massive organization that makes very large and long-term capital investments all over the world that are subject to economic and geopolitical risk on a scale that few other companies can appreciate. The Company makes an excellent defense of their plan in a supplemental proxy filing and the description of their plan from their original proxy filing. There is no need to repeat the arguments here.

But this incident points out the obvious issues with using a one size fits all set of “objective” criteria to assess executive pay. Objective garbage is still garbage. No Compensation Committee wants to see its executive pay program criticized by a proxy advisory firm. But if your company is different in a significant way than the norm (as is Exxon), it is better to get that “No” recommendation for designing a program that is right for your company, than it is to get a “yes” by going with the flow and instituting a plan that doesn’t address your issues but passes the “objective” tests. In my experience as an executive compensation consultant, having designed plans for a broad range of industries and company sizes, there is always something unique about each company that must become the lynchpin of their executive compensation program. The art in this business is finding that unique element and designing accordingly. Even if it breaks the rules.

CEO Pay Trends in the S&P 500 – 2011 Update & Reactions

Posted by Paul McConnell on May 03, 2011 / Posted in Compensation Committees

Equilar has just released their latest report, on CEO pay trends in the S&P 500 in 2010… and with the report the findings quoted below.

“After pay declines in 2008 and 2009, CEOs saw their total compensation rise 28.2% from 2009 to 2010, to a median of $9 million. A few other findings:

Bonuses were the component of compensation that saw the most growth in 2010, with a 43.3% rise. The median bonus was $2.15 million. 85.1% of CEOs received an annual bonus payout in 2010, compared to 73.6% in 2009.
Options are still the most common equity vehicle, but performance shares and restricted stock are on the rise.
Both stock-based awards and bonus payouts became a larger part of the pay mix, at 38.2% and 27.2%, respectively, of total 2010 pay.”

Statistics like this are misleading without proper context. In 2007, the year before the recession/stock market crash, the median S&P 500 CEO had reported total compensation of $8.7 million (i.e., with equity awards reported at expected value, not actual value). That median declined to $8.0 million in 2008 as the recession began in many industries and $7.0 million in 2009 as the full force of the poor economy hit executive bonuses and stock grants. The $9.0 million reported for 2010 does represent a 28% increase from the low, but only a 3% increase over 3 years from the pre-recession value.

In order to properly understand trends, you need to look what is happening with each component over time. What actually happened was that 2008 equity grants were made in early 2008, before the recessions impact was felt – thus the median change was rather small and positive. The big change in 2008 was cash bonuses, which were down significantly (22%), although the impact varied by industry. In 2009, bonuses were up slightly (8.5%) reflecting largely performance versus diminished expectations. Equity awards for 2009 were made at or near the trough of the market – down 18% for options and about flat for stock awards. But this too needs to be considered in context. Many companies replaced option grants with full value share awards (i.e., restricted
stock or performance shares), thus the declining price was offset by increased prevalence producing a flat median award. The decline in the stock market value (40% – 50%) was somewhat masked by the fact that interest rates declined in 2009 and volatility increased. These factors increase the value of option awards as a percentage of market price, so that the reported decline in option values did not fall as fast as stock prices. The decline in both types of awards was also somewhat masked by the prevalent practice of granting a fixed value of LTI award (e.g., 300% of salary) despite the nonsensical effect this has of increasing share awards when stock prices decline and decreasing them when stock prices go up. In 2010, we saw the biggest change in pay in cash bonuses as profits recovered to 2007 levels. Stock and option awards were up sharply (39% and 16% respectively) as stock prices improved 40% to 50% over awards made at the same time in 2009.

The bottom line is that executive pay performed exactly as it should over this period – flat from peak to peak with significant declines in the trough of the recession.