Compensation Committees and Share Buybacks

Share repurchase arrangements (buybacks) are expected to top $600 billion in 2015, up from an estimated $550 billion in 2014. In fact, at the current rate of growth, share buybacks will soon represent a return of capital twice the size of aggregate dividend payments. Critics (including Blackrock CEO Lawrence Fink) argue that this large return of capital is evidence of short-sighted management eating the seed corn rather than investing within the business. In contrast, companies (and many activists) view their arrangements as rational, tax-effective decisions in reaction to a lack of attractive internal investment alternatives. Regardless of the reasoning, given the magnitude of buybacks, we believe it is worthwhile for compensation committees to review closely the relationship between buybacks and incentives and carefully consider the role of unintended consequences within the executive performance management process….

To read more and download a pdf copy of this article from Corporate Board Member magazine, Q2 2015, click here.

For additional insight into share buybacks, click here to see S.L. Mintz, Institutional Investor, February 2015.

Simple Incentives to Improve CEO Succession

The following article appears in the Q4 2014 BoardMember magazine. A pdf may be downloaded here.  (https://www.scribd.com/doc/242397608/Simple-Incentives-to-Improve-CEO-Succession)

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Board members have an obligation to protect the company from gaps in executive talent by ensuring leadership continuity, particularly during times of CEO succession. While we find numerous commentaries addressing best practices surrounding the planning for succession, we believe incentives should be considered that focus on the succession result.  Most boards recognize that they must rely on the CEO for much of the insight into potential internal and external successors and risks. Unfortunately, the CEO is perhaps the only individual who typically has no financial interest in the actual success of the succession effort.

Through our work with boards of directors, we have identified three types of obstacles to a CEO effectively
planning for his or her own succession:

• socially, it may be difficult to discuss succession with a CEO who perceives that a ready and able successor diminishes the CEO’s relative power with the board;
• culturally, there may be a history within the organization whereby the CEO has controlled the pace and timing of succession based on the CEO’s own plans for retirement; and,
• economically, there may be incentive programs and employment terms that clearly exclude the CEO
  from accountability for the succession result.

While we do not believe these obstacles prohibit effective succession management, we do recommend boards and committees responsible for succession consider the impact these factors may have on their efforts to mitigate business risk related to CEO succession. Board Advisory LLC reviewed 50 recently filed CEO employment agreements to identify current practices with respect to CEO succession. We were looking to identify contractual employment terms that support successful succession of the CEO role. What we found was that CEOs typically have little, if any, financial stake in the ongoing success of the company during the 12-18 month period immediately following their termination of employment. In almost all situations, executives were allowed to fully liquidate their ownership in the company upon leaving. Moreover, CEOs often negotiated accelerated vesting of time-based, and sometimes even performance-based, equity incentives in the event of terminations without cause or for good reason (i.e., a “good leaver”).

In evaluating contemporary pay practices in light of CEO succession, we have identified several interesting arrangements that can align interests between the outgoing CEO and the ongoing organization through the most critical portion of the succession process. The concepts may be far easier to implement when recruiting a new CEO than when renegotiating with a current CEO, but we believe they are worth discussing in both situations.

1. Establish at the beginning of the relationship that the CEO is the leader of the organization and thus is obligated to ensure continuity in leadership under all circumstances. Whether as a result of voluntary or involuntary termination, the CEO is expected to have plans in place to protect the organization—and will be held accountable to some extent for the success or failure of these plans.
2. Recognize the CEO’s obligation to the organization extends beyond the last day worked. We find that over 90% of CEOs already have post-employment covenants such as non-compete/non-solicit arrangements, but only one CEO in 50 had a stock ownership obligation that extended beyond the last day worked. Requiring CEOs to retain their target ownership for 12-24 months beyond the termination of employment helps maintain a real interest in leadership continuity and success.
3. Do not accelerate equity vesting upon “good leaver” terminations. Construct 409A-qualified arrangements whereby shares continue to vest over time and are retained by the former CEO through the succession period, adding to the former CEO’s financial alignment with continued organization success.

We propose that compensation committees consider requiring CEOs to have “skin in the game” for a brief post-employment period to shift the focus from the process of succession planning to the actual succession result. After all, a principal responsibility of the board is to manage the succession risk, not the succession plan.

Are you Paying for Performance or Just Paying for Results?

Paying for performance is assumed to be the objective of most pay plans.  However, we find many of these programs simply pay for results.    If you simply pay for market-based returns using absolute or relative TSR, the LTI may serve more as a lottery ticket than an incentive. This hardly serves to motivate any change in behavior on the part of the executive or  help guide the executive team in navigating tactics  and priorities. While such programs are often lauded, they may in fact diminish or delay accountability for a poor strategy by rewarding (or punishing) for events reflected in stock price that are unrelated to changes in long-term franchise value.  By clearly articulating the detailed link between enterprise strategy and executive rewards, companies will benefit from not only more effective executive efforts, but also greater investor support.   Click here for the full article:  Are You Paying for Performance or Just Paying for Results?

2014 Trends in Executive Compensation and Governance

I have attached a rather lengthy note highlighting 2013 events and 2014 trends as we expect those trends to impact board members serving on compensation committees.  Key to the findings:

1. The relative economic weakness on Main Street and its contrast with the success of the equity markets will create additional tension in 2014, with the discussion of income disparity already working its way into the mid-term election political statements.  Committee members are advised to remember that only executives like executive compensation.
2. 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.
3. 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.  Compensation Committee members should be prepared as investors will be seeking clarification of strategy and how pay relates.
4. 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[1].

On a brighter note, we are optimistic about 2014:

1. 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.
2. 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.
3. 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.
4. 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

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[1] See BoardMember Magazine, Q4 2013, “See the Forest and the Trees” P. McConnell and J. McCutcheon.

Compensation Committees: Keeping the Big Picture in Mind

See the Forest and the Trees, Board Member Magazine, Q4 2013 (Click for Article) For executive compensation, achievement of corporate strategy is the destination; pay levels, pay programs, and metrics provide the route.  Compensation committees must  reflect on the year’s actions and recheck their route.  With media scrutiny, regulatory oversight, and the specter of derivative litigation ever increasing, we all need to ask ourselves some pointed questions about
compensation strategy.

We suggest an internal review along three major themes:

Pay Strategy. How does the committee use pay and employment terms to advance the company’s strategy?  Can you articulate executive pay within the context of the 3-5 year business strategy?

Pay Effectiveness. To what degree does the actual value delivered supports the strategy? To what extent does your CEO’s realized or realizable pay correlate with investor outcomes?

Compliance. To what extent is the company safeguarded from nuisance litigation through a disciplined compliance program?  When was the last audit of programs and processes?

By following a methodical approach to committee compliance, compensation committees will   equip themselves to make informed, careful, strategic decisions that will serve their companies well in 2014 and beyond.

SEC Position on Post-Sarbox Loans: Does “RingsEnd” Accomplish Anything?

BA Blog Post-Sarbox Loans – Does RingsEnd Accomplish Anything?  (Click for Article)    Our analysis of the recent (March 2013) SEC guidance surrounding post-Sarbox executive loans. We find nothing in the RingsEnd design to support an ownership objective and find it may undermine other incentive objectives such as retention, solely for the benefit of incremental executive tax efficiency.

We find there is little the plan provides that an executive could not achieve under the existing tax and regulatory framework.  An 83(b) election to recognize income upon receipt of a stock award is already available.  The only unique feature with RingsEnd is that, through a rather complicated trust arrangement, the company is underwriting the risk that the shares will not vest, relieving the executive of paying taxes on shares never received.

Companies are advised to be wary of programs that are inordinately complex, and avoid falling into the trap of allowing design elegance to distract you from actual program effectiveness.

Tax Policy, Executive Equity and the Public Good

Tax Policy and Executive Equity  (Click for Article) Given the current public policy objective of making CEO’s accountable for long-term risks, and the US Treasury’s need for tax revenue, we propose a rather simply solution of updating the concept of the “Incentive Stock Option” to remove the existing $100,000 limit, but require all shares to be held until the later of retirement + 2 years or ten years from date of grant.  In exchange for the executive realizing capital gains treatment for the investment, the employer loses the compensation tax deduction and Treasury realizes greater net revenue from the transaction.  If only all problems were this simple.

Compensation Advisor Independence

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.

Paul McConnell                                 Jeff McCutcheon
(407) 876-7249                                  (904) 306-0907
pmcconnell@board-advisory.com        jmccutcheon@board-advisory.com

November 2010: Another Chance for the SEC to Get Pay for Performance Right

Read our recent article discussing potential disclosure under the Dodd-Frank bill as it relates to executive compensation and company performance.  The article, Another Chance for the SEC to Get Pay-for-Performance Right (click for link to pdf) is also available for download at our website at http://www.board-advisory.com

April 2010 Update

Boards of directors are under increased pressure from investors to manage risk.  One of the greatest risks directly within the responsibility of the board of directors is the leadership risk within the executive tier of management.  Whether as a result of performance failure, changing strategic requirements or executive defection, boards need to be actively mitigating the risk of loss of qualified and capable executive leadership within the organization.

See our recent articles and recent interviews at http://www.board-advisory.com