Compensation: Common Sense Advice for New Directors

Compensation: Common Sense Advice for New Directors

Herbert S. Winokur explains the basic premises of compensation that every new director should consider before making important decisions.
May 20, 2010,
by Herbert S. Winokur

For a new director, participating in compensation decisions may seem daunting. Don’t worry–unless you are dealing with one of the global financial services firms, in which case this article won’t be any help. While there has been much discussion about the design of compensation systems and the size of bonus and equity awards, the conversation seems to have wandered far away from the basic premises which a new director should consider.

What is the board’s responsibility?
Directors represent shareholders. Hence, their responsibility, simply put, is to design a compensation system that meets the following criteria: (1) it aligns management’s interests with those of the shareholders as much as possible; (2) it can be relied on to attract, retain and motivate management to achieve the strategic objectives of the corporation as approved by the directors; and (3) it achieves these goals at the minimum possible cost to shareholders. These criteria are in conflict; a director’s job is to balance them appropriately.

With that in mind, a director should act as if he or she is the owner of the business, and therefore is paying from his or her own pocket. Directors should invest in the business and should encourage management to do so as well.

How should a compensation system work?
First, the director must be clear about the corporation’s strategic goals. Merely setting abstract financial targets, such as EPS growth, or relative standards, such as outperforming the S&P 500, is not adequate. The corporation’s strategy is substantially more complex, and a number of financial and non-financial indicators must be developed which tie to strategic goals, and allow for changes in these goals in response to changing markets and competitive conditions.

In addition, because shareholders provide capital for managers to oversee and deploy, financial measures should be designed to supply reasonable returns on capital to shareholders before significant compensation is available to management. Many studies suggest that share price is favorably influenced by earnings growth and increasing returns on capital. This makes sense – these are two of management’s most important responsibilities. Directors should begin by tying performance to achieving strategic goals and providing a minimum hurdle return for shareholders. Earning enough economic profit to exceed the company’s hurdle rate is a minimum standard; growing economic profit faster than one’s competitors is a better goal. Comparability of compensation for “comparable” positions across companies is not a goal. It is only one metric, and of limited value because companies are different from each other. Be aware that senior executives do compare their pay to that of supposed peers and will push hard to obtain or exceed “parity.”

Second, the compensation system can be considered in two dimensions: type of pay and time period over which it is received. Salary paid regularly during a year is not subject, except in extreme circumstances, to clawbacks and historically has been intended to permit management to maintain a reasonable standard of living.

While the annual bonus is traditionally paid to reward exceptional performance, it has become an entitlement in the compensation discussion; that trend should be reversed.

The bonus may represent 25 percent of salary for middle management and up to a multiple of salary for senior management. It has become common practice to pay the bonus partly in cash and partly in stock, and to permit clawbacks in certain circumstances. The director’s responsibility must include an intense focus on the criteria against which bonuses are awarded. Directors should remember one absolute fact: the circumstances that develop during a year will be quite different from those anticipated at the beginning of the year when the bonus criteria were designed. Hence, directors need to reserve the ability to modify bonus awards subjectively. Remember, management controls the flow of information, and even deeply engaged boards could be on the losing end of an asymmetry of knowledge.

Long-term incentives may involve restricted stock, stock options, cash, or more exotic forms of compensation that typically vest over many years and often are subject to clawbacks. In general, long-term incentive compensation is intended to mirror shareholder rewards over many years, and is typically fixed in advance, with little allowance for subjectivity. The tasks for a director are to determine how to value the various non-cash elements, and to consider the size of the payoffs under different scenarios such as the company’s operating performance, and its stock performance. Well-informed directors should see and disclose “payments” expected under these scenarios. A “best practice” should incorporate a presentation along the lines of the following hypothetical example:

If the company meets its revenue and margin targets as presented to investors, if dividend/share repurchase policies are unchanged, if the stock market increases at seven percent annually, and if the company’s relative valuation is unchanged, then the expected payouts to senior management in five years would be as follows…

The director should also ensure that long-term incentive compensation rewards are based on true absolute performance, not just the results of inflation, relative performance or market tracking. Shareholders and management should share upside appropriately. Restrictions on vesting of deferred compensation should be time and performance-based, to provide proper motivation.

Also consider that the common use of Black-Scholes methodology to value options for compensation purposes makes no sense. For example: a resource-rich company has $40 per share of natural resource reserves, and no net debt. If its stock fell to $20 per share, an option would seem many times more valuable than an option if the share price were $50. But Black-Scholes methodology produces the opposite result— the option on the higher priced stock is worth about $20 per share, approximately, while the option on the lower priced share is about $8 per share. This result is backwards.

Accounting rules that drove companies to use stock options with no performance hurdles were pathological, and continue to be so. For example, when an executive receives an option grant, the company earnings are charged, based on the Black-Scholes formula. If the executive leaves and the option is out of the money, the company has no way to reverse the earnings charge — another backwards result.

A director should review the percentage of payroll earned by the top five and top 100 employees versus the percentage earned by all employees, and/or the ratio of CEO compensation to that of the lowest level employee to ensure fairness and to be able to respond to stakeholder questions.

Compensation and audit committees should meet together at least once each year, preferably before awarding bonuses and long-term incentives. Audit committees need to understand the philosophy and valuation of management incentives. Compensation committees need to understand the assumptions underlying financial statements, such as mark-to-market accounting, off-balance sheet entities, contingent liabilities, pension funding assumptions, etc. This joint meeting should be a “best practice” to help save directors a lot of potential embarrassment.

Different compensation decisions should be made at different times of the year. Salary adjustments should be coupled with discussions of succession planning for a company with a calendar year reporting cycle; early fall is a good time. Bonuses for calendar year companies typically are awarded in March, as full-year financial results are completed. This offers a good opportunity to review company and individual performance. At least one compensation committee meeting should be devoted to a review of the compensation system in its entirety, and to an articulation of the program in a clear, summary fashion. Staggering these discussions allows directors to obtain continuing input from advisors and to provide clear and consistent guidance to management.

Reliance on Compensation Consultants
Compensation consultants provide data to permit comparisons of pay and pay practices across companies and industries. In general, all reputable firms worth retaining will provide roughly the same quality of data. Reliance on external consultants also provides cover for directors faced with shareholder unhappiness, litigation, etc. But these companies have only crude tools to make comparisons across companies; the misuse of Black-Scholes has been cited as an example. Resist by all means the pressure to pay everyone above the mean, and to reward upsides with no penalty for failure or with disregard for shareholders’ capital. And question the consultants carefully; they are seeking to retain a lucrative client.

Role of Executive Search Firms
It may become necessary from time to time to use an executive search firm to attract an external manager to the company. Hiring external candidates often throws compensation systems into disarray. The external candidate will seek to negotiate for what he or she hopes to deliver, while also being paid for what he or she is giving up at the prior position.

A better approach would be to establish the compensation parameters first (including limits on any guarantees for previous employment) and then allow the consultants to screen out people for whom the proposed amount and/or structure of compensation isn’t attractive

Other Compensation Issues
A significant perquisite worth directors’ focus is the use of the company plane. While the current tax rules are very much slanted in favor of the executive, the director has a responsibility to ensure that the policy for private plane use is sensible and subject to defense if attacked in the press or at a shareholder meeting. Use of a private plane for business travel often is extremely productive and even cost-effective. Misuse for personal benefit without adequate reimbursement is inexcusable.

Other “perks” should be eliminated. In general, management is sufficiently well compensated that they can pay for their own clubs, cars, and financial planning.

Treatment of unvested compensation and severance in the event of a corporate takeover or termination for non-performance also needs to be considered. In the former case, except for a small number of senior officers who will be involved in negotiating the transaction, vesting should require a “double trigger”—that is, a change of control and a loss of job or a significant downgrading of responsibility. Other issues such as company-paid life insurance, tax-deferred payouts, etc., should be addressed as they arise but in general, the simpler, the better. Many of these “gimmicks” have unintended consequences as interest and tax rates change, which reduces their usefulness.

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