Corporate Governance

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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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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The Risks of Accelerating Executive Bonus Payments for Tax Benefit

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

accelerateWith 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.

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)

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.


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© 2012 Board Advisory.
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