Determining executive compensation

March 2017  |  COVER STORY  |  BOARDROOM INTELLIGENCE

Financier Worldwide Magazine

Executive compensation has always been a delicate and contentious issue, but it has come under more intense scrutiny in the years following the financial crisis.

Wealth inequality is growing at a rapid pace. According to the Economic Policy Institute, CEO pay climbed 997 percent between 1978 and 2014, while worker compensation increased by just 11 percent. Furthermore, in 2015, CEOs in the US were paid 276 times more than the typical worker. Shareholders and the general public are often critical of executive compensation packages and feel there is a disconnect between executives and the rest of the workforce. Issues are brought into even sharper focus when executives are seemingly ‘rewarded’ for company underperformance or failures.

However, it is important to note that while executive pay may seem astronomical compared to the average worker, these packages are not analogous. While employees will be paid almost exclusively in cash, the same cannot be said for senior executives. In terms of basic salary for executives, many companies are limited in what they can offer. According to Professor Raghavendra Rau, the Sir Evelyn de Rothschild Professor of Finance at Cambridge Judge Business School, regulations in the US, for example, dictate that those companies that pay their executives more than $1m a year in cash will face additional tax implications. As a result, many companies choose to reward their executives via stock options. Although this method is popular with many organisations, it does pose problems, such as a conflict of interest. Arguably, stock grants and stock options can lead some executives to make decisions that reward them in the short term, rather than maximise value for the company and its shareholders in the long term.

Proxy season

Compensation packages vary from company to company, and it is important for each to find its own way. To strike the right balance, myriad factors must be considered. Shareholder activism and industry peer group benchmarking are two major concerns. In the ongoing battle to attract and retain talent, companies must position their compensation packages accordingly. These are all key issues companies face heading into the 2017 proxy season.

In the guidelines handed down by both Glass, Lewis & Co and the International Shareholder Service (ISS) both firms have focused on director overboarding in the 2017 proxy season, establishing a limit of five public board appointments for directors who are not company executives.

Glass Lewis addressed issues such as governance for newly public companies, board self-assessment and gender pay disclosure. In turn, the ISS guidance highlighted other issues, including undue restrictions, unilateral governance changes and shareholder ratification of non-employee director pay programmes.

These new guidance issues notwithstanding, companies must learn from past experiences. They should consider recent annual ‘say on pay’ votes and disclosure best practices, not only when designing their compensation schemes, but also when communicating them to shareholders. Say on pay votes have assumed greater importance in the six years since they were introduced, and cannot be taken lightly. They are having an important impact in helping to limit excesses, as Joel Shapiro, Associate Professor of Finance at Saïd Business School, University of Oxford, explains. “Say on pay provisions allowing shareholders to cast nonbinding votes on executive pay are now ubiquitous, with regulators strongly considering making the votes binding. There is evidence that even nonbinding votes exert discipline on executives,” he says

However, critics of say on pay suggest that voting may not be that influential, particularly given that results are merely advisory in the US. Companies are free to ignore them, and frequently do. The UK, though, has adopted a form of binding say on pay voting, which is mandatory every three years. If the policy is rejected, the company must continue to follow the prior policy or have a new vote. From recent say on pay voting in the UK, it is becoming clear that companies need to create a solid link between performance and compensation if they are to placate shareholders and legitimise compensation schemes.

Regulatory pressures

Obviously, companies must be aware of the ISS and Glass Lewis guidance entering the 2017 proxy season, but they must also be compliant with various regulatory developments which have emerged over the last 12 months.

In November 2016, the UK government announced a consultative report which outlined a number of potential corporate governance reforms that will bring the country’s executive compensation programme in line with the US. While things are clearly changing in the UK, the status of executive compensation in the US, like many other issues, has been cast into doubt by the election of Donald Trump. The potential repeal or amendment of certain elements of the controversial Dodd-Frank Act has allowed the Financial Choice Act (FCA) to emerge as a possible replacement. The FCA, should it be approved, will impact the Securities and Exchange Commission’s (SEC) final and proposed rules to implement the executive compensation provisions of Dodd-Frank in a number of areas, including pay ratios, say on pay provisions, incentive-based compensation, clawback provisions, hedging and pay vs. performance. President Trump’s campaign proposals, if implemented fully, could be transformative. Companies may be given more flexibility to structure their compensation arrangements. Furthermore, a reversal of the Department of Labour’s conflict of interest regulations – the much maligned DOL fiduciary rule – has also been floated by the Trump campaign.

The SEC also approved NASDAQ’s ‘Golden Leash Rule’ in mid 2016. This rule requires listed companies to disclose material terms of any agreement between a director, or director nominee, and any entity or person other than the company, regarding any amount of compensation or payment related to the director’s service on the board or the director nominee’s candidacy. The rule, which came into effect on 1 August 2016, requires annual disclosure in a companies’ proxy or on its website.

Changes at the SEC will likely have an impact on compensation packages in the coming years. There are, at the time of writing, two vacancies, and following chair Mary Jo White’s departure in early 2017, the makeup of the regulator could be very different.

Recent director compensation litigation will also have an impact on the structure of executive compensation schemes. Lately there has been a rise in the number of cases filed against company boards alleging breach of fiduciary duty in connection with excessive director compensation schemes. In light of these cases, companies would be wise to consider introducing director-specific compensation limitations in new equity plans or plans that are being amended. Companies should also take into account peer compensation practices and forecast their own short- and long-term compensation requirements. Alternatively, companies may consider adopting, and seeking shareholder approval of, a standalone director compensation plan, in order to limit any potential shareholder discord down the line.

One of the many challenges associated with executive compensation is that it is a hard concept to define. As Professor Rau notes, much of the consternation can be attributed to the fact that nobody really knows the right amount to pay a chief executive. Companies often determine their compensation schemes by studying their industry peers and adjusting their packages accordingly, aiming for parity. “There are two reasons for this: the first is that it gives you a benchmark for what to set and the second is that no one wants to look like an idiot. You do not want to say to your shareholders: ‘Look, we have a brilliant CEO, and as proof of his brilliance he accepted peanuts to come and work for us.’ So that means if anyone in the peer group gets a pay increase, so too will your CEO,” says Professor Rau.

Choosing the right peer group is an important step. The majority of companies now target their salary and options offered at the median of their carefully selected peer group. Organisations set their benchmarks by selecting a peer group which reflects their own breadth of operation and comparable size. This process enables firms to align long-term shareholder interests with compensation practices, which should help them to offer competitive packages at a level in keeping with the company’s risk appetite, profitability and shareholder expectations. For many organisations, current performance is less of a factor in modelling their executive compensation schemes than their peer group’s stock prices. Furthermore, many companies are using metrics such as total shareholder return and return on invested capital to help determine their policies.

According to Audit Analytics, the typical peer group, including performance and secondary groups, consists of around 19 peers. Other companies opt for larger peer groups as they reduce the impact of a single anomalous entity that may disrupt the overall data set and provide an inconsistent view of the industry.

Regulators have frequently tried to influence the shape of compensation programmes, yet they often encounter difficulty keeping companies in check. “Regulatory changes have been quite substantial over the last 15 years. The problem is, every time a regulation is put into place, people change their compensation structure in a slightly different way. The industry and the structure of compensation schemes change every time there is a regulatory change,” says Professor Rau.

With potential regulatory change on the way, companies will need to reconsider the design of their compensation programmes and related disclosures in the months ahead. For example, rules requiring pay ratio disclosure, which compare the CEO’s compensation to that of a company’s ‘median’ employee, are scheduled to take effect in 2018 but may be cancelled under the Trump administration.

Compensation consultants

Compensation consultants are experts in tailoring and implementing an appropriate and effective incentive scheme for an executive. Many companies are utilising these consultants as they offer numerous advantages. Notably, they can offer an objective and balanced view of compensation structures and help deliver a scheme appropriate to the company’s size. They also bring a wealth of experience from which the company can draw, and will allow companies to focus on other issues. However, there is a suggestion that companies end up paying more to their executives when a consultant has been engaged.

With increased expectation comes intense scrutiny, and when companies and their executives fail to live up to those expectations there are often consequences. One of the most controversial is the use of clawback provisions. Existing regulations in Europe require companies and financial institutions to have effective clawback policies in place, and there are similar proposals in the US. Companies that plan to use clawbacks must ensure that the provision is established in the executive’s contract from the outset; failure to do so could derail an attempt to trigger a clawback down the line. There must also be clear and well constructed channels of communication around clawback provisions. Staff and executives must be told that the clawback provision will only be applied in extraordinary and appropriate circumstances.

Though clawbacks have become more common in Europe, there are still doubts about their effectiveness, particularly in the US. “Clawback provisions have had little impact, mostly due to the perceived willingness to use them,” says Professor Shapiro. “Nevertheless, in the US, there were two cases in 2016 that signalled that clawbacks may be triggered more in coming years. First, the SEC won a court case allowing it to use clawbacks on a CEO and CFO in the case of financial misconduct, even if they were not directly involved in the misconduct. Second, the account opening scandal at Wells Fargo made the board trigger clawbacks for $60m on the top two executives there.”

The Wells Fargo case was an interesting study into the use of clawback provisions in the US. Though Wells Fargo was able to utilise a clawback provision, the company initially did not take any further action against the executive in question. Forcing a clawback with no further consequences for the executive raises a number of questions about the future conduct of that executive, suggests Professor Rau. “They did not fire him, they just clawed back the money. If you are the CEO of a firm that has clawed back a significant portion of your salary and you do not think this is your fault, how does this encourage you to behave going forward? Does it encourage you to be more careful? More ethical? Or does it lead you to think, ‘These guys screwed me, I’m justified in whatever I do to increase my salary’.”

With unethical behaviour a possibility, companies should also focus on whistleblower protections. The SEC has been more inclined to examine confidentiality provisions, severance and release agreements and other employee-related agreements which could potentially deter employees from reporting legal violations. As a result of this focus, companies should review their company policies and handbooks, as well as their employment and severance arrangements, in order to ensure that they do not prohibit employees from whistleblowing, cooperating or communicating with a government agency on any level.

Delicate and divisive

Executive compensation should not just be about the numbers. The process must be considered alongside the company’s wider strategic goals. It should consider factors such as short-term profits or sustainable, long-term innovation, and how an executive compensation scheme will complement those targets. Rewards for executives must be in line with the company’s stated business goals.

Executive compensation is a delicate and divisive matter, particularly when the gap between the world’s top earners and the rest is so wide. Companies must be mindful of this expanding gap, but they must also offer appropriate and attractive compensation packages. Keeping both executives and shareholders happy is not an easy task.

© Financier Worldwide

BY

Richard Summerfield