How Dodd-Frank has changed compensation practices

Executive and board compensation used to be determined behind closed doors, far from the influence of shareholders. Disclosure of compensation plans was routinely summarized by a straightforward table showing the cash and equity compensation of the five most highly paid executive officers and board members, followed by a few very dry paragraphs describing equity compensation plans. Underlying policies and practices were withheld from public scrutiny, veiled behind confidential treatment requests granted by the SEC.

The enactment in 2010 of the Dodd–Frank Wall Street Reform and Consumer Protection Act brought the compensation practices of public companies into the bright light of day – but while some may view the mandated transparency as intrusive, Dodd-Frank’s provisions provide an opportunity for forward-looking companies to reveal key aspects of their organizational strategy that translate to competitive advantage. Widespread compliance with these new provisions reveals how competing firms set tones of reasonableness, fairness, accountability and alignment with shareholders’ interests.

So, what long-standing compensation practices can actually be improved by embracing the spirit of Dodd-Frank? Given my experience as a corporate director, I would submit that there are at least four. These are: creating reasonable, quantifiable and measurable goals; developing a thoughtful list (or lists) of comparable companies for benchmarking purposes; committing to clear, transparent and ongoing communication of compensation practices with shareholders; and embracing a culture of continuous improvement in the face of changing times. If implemented in a cohesive and rational manner, these principles can help buttress competitive advantage and better align companies with their shareholders.

Finding the right metrics

Most directors would agree that well-crafted compensation plans must address multiple objectives: recruiting and retaining key employees and rewarding the achievement of short and long-term business goals, while also encouraging appropriate risk-taking. But setting out clear, fair and relevant metrics for keeping score is no small feat. These metrics should be carefully selected to capture key, quantifiable measurements of a company’s success, as well as line and staff management’s contributions to individual and shared objectives.

Financial metrics are unambiguous, but one size does not fit all. For some companies, goals such as growing divisional or corporate-wide sales, increasing EBITDA margins or minimizing the cost of capital may be relevant. Other companies may find that measuring return on assets, contribution margins on key product lines or growth in earnings per share provides a better financial barometer of strategic and competitive success. Even tougher metrics to measure that are still very important include competitive measures (such as shifts in market share and key customer wins) and organizational issues (such as limiting employee turnover and developing viable succession plans).

Thought must also be given to the motivational power of such metrics, balancing corporate and individual initiatives through weighting so that the end result rewards behaviors and achievements that benefit the enterprise both in the short and long term. In addition, compensation committees should carefully consider how to encourage appropriate levels of risk-taking that benefit shareholders on the upside, while at the same time providing avenues that allow management teams to implement reasonably swift reversals of strategic course if downside scenarios begin to unfold.

Setting benchmarks to determine appropriate compensation levels is often easier said than done. The authors of Dodd-Frank (and those charged with promulgating rules for its implementation) have frequently suggested a default benchmarking approach, using the North American Industry Classification System (NAICS), which was released in 1997 as an improvement to the Standard Industrial Classification (SIC) system in use since the Depression. Again, however, one size doesn’t fit all. While notionally appropriate, reliance on NAICS can lead to a list of comparable companies having little in common competitively with each reporting company, particularly those operating in multiple segments.

Best practice in benchmarking may well be to start with a list of companies with common NAICS codes, but then to aggressively add and subtract from it based on such measures as financial performance, size and geographic or business sector focus. Better yet, it may be entirely appropriate to construct one set of comparable companies for line management and another for staff positions that may require less industry-specific skills or knowledge, but deeper functional expertise. For example, the comparable companies used to determine fair compensation for a CEO of a life sciences company, where deep industry and scientific knowledge is essential to competitive success, might be very different from the comparable companies used to gauge appropriate compensation for a general counsel or chief financial officer of the same company. This is because competition for such talent may well come not from sectors that are dependent on scientific knowledge, but rather from companies regarded as being well managed in relevant functional areas.

Communicating to shareholders

Once measures are set and benchmarking has been completed, the task of explaining a company’s compensation philosophy, practice and relevance to total shareholder return falls to those charged with composing disclosure in the compensation discussion and analysis (CD&A) section of a company’s proxy. The principles behind best practice in disclosure are straightforward:

1. Be as transparent as possible and use plain English, augmented by charts and diagrams if needed

2. Consider issues of competitive sensitivity to limit the value of disclosure to competitors

3. In complex organizations, opt for ‘segment reporting’ within the CD&A section, calling out differences in approach between divisions or functions

4. Clearly describe the circumstances in which compensation is subject to board or committee discretion (rather than dictated strictly by formula)

5. Remember that the CD&A section in the proxy statement is the introductory piece to ongoing communication and dialogue with shareholders.

At its best, the CD&A disclosure can be an opportunity to clearly differentiate a company from its competitors, demonstrating enlightened compensation practices, adaptability to evolving business dynamics and attentiveness to the correlation between compensation and shareholder return.

So, are there overarching concepts that embody best practices? I would offer four key suggestions. First, scan the horizon constantly and vigilantly in order to stay informed of changes in compensation practices both within and outside your company’s narrow industry group. Second, take a hard and detailed look at others’ practices. Constantly seek to improve existing plans and test their effectiveness frequently, making corrections to metrics or benchmarks to stay on course over the intermediate and long term. Third, adapt and adopt approaches when appropriate, not because they may be in fashion, but because they better capture the fundamental principles of reasonableness, fairness, accountability and shareholder alignment. And finally, always be mindful that every company should construct a compensation plan appropriate to its business objectives, challenges and opportunities.