Setting pay is part of the board's job and right now that means reinterpreting everything from bonuses to options
Financial difficulty and corporate strategy are on the front page of almost every major newspaper, but few issues get more attention than executive compensation. The pay of top business leaders is fast becoming a substitute measure for how well companies assess risk and for their ability to navigate the challenging future. So great is the public outrage that the president and Congress are implementing legislation in an attempt to control what companies are allowed to pay their executives.
The increased attention on executive compensation combined with an economy-wide reduction in share prices has greatly increased pressure on board directors to revisit compensation strategies. The overwhelming theme, as was discussed during the ‘Compensation committee evolving trends’ panel at this year’s National Directors Institute, is linking pay, in whatever form it may take, to performance.
As with most corporate governance topics, there are many different sides to the compensation debate and the panel represented most of the significant stakeholders. Jay Rothman, partner and chair of transactional and securities practice at Foley & Lardner, led discussions and was joined by Ted Buyniski, senior vice president, Radford Consulting; Evelyn Dilsaver, director, Longs Drug Stores, Aeropostale and Tamalpais Bank; Matthew Gorringe, partner, Eversheds; and Randy Harrison, director of human capital, Deloitte Consulting.
One of the most challenging aspects of executive compensation is assessing the role of the financial crisis in corporate performance. Most companies have a process in place to reward performance – some more effectively than others – but with so many companies suffering, often through no fault of their own, how can a compensation committee reconcile actual behavior with general market conditions? In some cases a board may wish to make bonus- and performance-related payments to executives for exceptional performance even though some performance targets may not have been achieved. In most cases the board will be in the best position to assess the true performance of executives, but given increased visibility and disclosure and the overwhelming dissatisfaction among investors, such a decision may be very hard to sell in the court of public opinion. The board may find itself caught between what is right for executives and what investors think is a fair reflection of performance.
The panel identified some alternatives if a board should choose to pay out bonuses. One option is to find alternatives to cash bonuses. This could include equity grants in lieu of cash with long-term vesting or holding restrictions.
Despite the potential for negative reaction, many companies intend to stick with bonus structures that were in place prior to the crisis, with some caveats. A recent Deloitte study finds that approximately 75 percent of participants were planning to adhere to the bonus arrangements they had established. According to the survey, a limited number of companies were establishing discretionary bonus pools that were significantly reduced from what the companies had originally targeted. Other changes in response to the current economic environment include implementing shorter performance periods and awarding restricted stock or options on an individual basis in lieu of bonuses, or granting off-cycle awards for purposes of retention.
Assessing your options
Another challenge, as highlighted by the panelists, are stock options. As a result of the widespread decline in equity markets, many options are now ‘underwater’, meaning they are fundamentally worthless at current prices. Revaluing options or replacing them is likely to upset shareholders although there are some ways alleviate the potential for negative attention.
As recommended by the panel, many companies that have substantial pools of equity available under existing plans are taking advantage of their situation to grant restricted stock or additional options to compensate for the lost opportunities. Some companies that do not have large equity pools available are considering or implementing stock option exchange programs that comply with the recommendations of institutional voting advisers: cost-neutrality, reset vesting periods and strike prices higher than the 52-week high of the underlying stock.
No conversation about executive compensation would be complete, explained Rothman, without talking about new regulatory restrictions and mandatory say-on-pay votes. First there were the restrictions placed on pay at companies accepting TARP funds. There has been some confusion about what the TARP restrictions actually mean but in short, employees at firms participating in the TARP are subject to a $500,000 ceiling on deductible compensation. Further, payments are subject to clawback in the event that payments were ‘based on materially inaccurate financial statements or any other materially inaccurate performance metric.’
Initially quite a narrow interpretation and only applicable to a relatively small number of companies, the TARP provisions were expanded by Congress under the American Recovery and Reinvestment Act (ARRA), which became law on February 17. Under one of the more controversial standards, some 400 companies are now required to provide shareholders with a non-binding advisory vote on executive compensation. While say on pay had been in existence for many years overseas, the big challenge here is the time frame. Getting the language prepared for the 2009 proxy season is a major problem. As the panel agreed, companies are scrambling and some are bound to get it wrong.
Off-season engagement
Say on pay is designed to provide shareholders with input into the compensation structure and strategy at a company. Many investors, and companies for that matter, are focusing on the vote itself, but this somewhat misses the point. Gorringe pointed to the example from the UK where these rules have been in place since 2003. ‘The real value of the rule is ongoing engagement throughout the year, which helps to foster a better understanding on both sides of the fence,’ he explained. At this early stage in the US, it is shaping up as more of a confrontation than a conversation. That doesn’t solve the immediate problem, said Buyniski, which is that directors need to come to terms with the rule, form language that they are comfortable with and also ensure that all the compensation practices are in line with shareholder expectations. ‘This is definitely not an easy feat,’ he remarked.
The reason this is so important now, concluded Rothman, is that, with increased shareholder activism and widespread majority voting for director elections, ‘Getting compensation wrong, at least in the eyes of investors, could quite possibly lead to a director being voted off the board.’
