Investors now see corporate governance as a hallmark of the board’s effectiveness and one of the best sources of insight into the way companies operate. In response to this trend, Farient Advisors LLC, in partnership with the Global Governance and Executive Compensation Group, produced the report 2017—Global Trends in Corporate Governance, an analysis of corporate governance practices in the areas of executive compensation, board structure and composition, and shareholder rights covering 17 countries across six continents.
NACD, Farient Advisors LLC, and Katten Muchin Rosenman LLP cohosted a meeting of the NACD Compensation Committee Chair Advisory Council on April 4, 2017, during which Fortune 500 compensation committee chairs discussed the report’s findings in the context of the current proxy season. The discussion was held using a modified version of the Chatham House Rule, under which participants’ quotes (italicized below) are not attributed to those individuals or their organizations, with the exception of cohosts. A list of attendees’ names are available here.
Global Governance Trends
2017—Global Trends in Corporate Governance finds that governance standards around the world have strengthened in response to financial crises and breakdowns in corporate ethics and compliance. Those crises and breakdowns have led to greater pressure from governments and investors, who are demanding economic stability and safe capital markets. In regard to executive compensation, the report notes a number of global governance trends:
Source: Farient Advisors, 2017—Global Trends in Corporate Governance, p. 18.
Most of the 17 countries surveyed (94%) require executive compensation disclosure, although the disclosures made and the quality of these disclosures varies from country to country. Surveyed countries that had the least developed disclosures are South Africa, China, Brazil, and Mexico.
Say-on-pay voting is mandatory in most developed countries, although there is variance on whether the votes are binding or not. For developed countries where the vote is voluntary (e.g., Canada, Belgium, Germany, and Ireland), it still remains a leading practice.
Common leading practices are to use competitive benchmarks, such as peer groups to establish rationales for pay, and to provide investors with information on components of pay packages and performance goals.
2017 Proxy Season Developments
Meeting participants shared a number of observations and practices from the current proxy season:
Continuous improvement on disclosures Council participants indicated they are sharing more information with shareholders, in a more consumable way. “We want to be in the front ranks as far as providing information to shareholders,” said one director. “Instead of asking ‘why should we share that?’ we’re starting to ask ‘why not?’” Another director added, “Over the last few years we’ve moved from a very dense legalistic document to something that’s much more readable. Our board set up a process to do a deep-dive review every two years; this fall is our next review. It’s a way to ensure our disclosures keep pace with current practices and also reflect where we are as a company and board.”
Council members also discussed the status of Dodd-Frank rulemaking, given the new presidential administration and SEC commission. S. Ward Atterbury, partner at Katten Muchin Rosenmann LLP, said, “While it’s unclear exactly what the SEC will do with Dodd-Frank requirements in the future, investors have spoken on some of the issues, especially on things like say on pay and pay for performance. There may be less formal regulation, but the expectations on companies and boards are still there [to provide pay-for-performance disclosure].”
Growing interest in board processes According to one director, “We’re hearing more interest about CEO succession as it relates to strategy. Investors are asking us to describe our process—they understand we can’t discuss specifics.”
Director Pay Dayna Harris, partner at Farient Advisors LLC, discussed the increased focus on director pay: “Given the recent law suits regarding excessive director compensation and an increase in director pay proposals in 2016, Institutional Shareholder Services (ISS) created a new framework for shareholder ratification of director pay programs and equity plans.” ISS’ framework evaluates director pay programs based on stock ownership guidelines and holding requirements, equity vesting, mix of cash and equity, meaningful limits on director pay, and quality of director pay disclosure. ISS’ updated factors for evaluating director equity plans include relative pay magnitude and meaningful pay limits.
Environmental, social, and governance (ESG) issues Meeting participants agreed that social issues, such as ESG and gender pay equity, are increasing in popularity among investors. In particular, nonbinding shareholder proposals on climate change received majority support this year at Exxon Mobil Corp., Occidental Petroleum Corp., and PPL Corp.
Refining approaches to outreach and engagement with investors Meeting participants discussed leading practices for engaging shareholders. Some directors indicated that investors have turned down their offers to speak on a regular basis because of time constraints. One delegate emphasized that just making the offer to meet with shareholders is appreciated, even if that offer is turned down. One director said, “We invited one of our major long-term shareholders to speak at one of our off-site [meetings] as part of a board-education session. It was a different type of engagement and very valuable.”
The following blog post is one installment in a series related to board oversight of corporate culture. The National Association of Corporate Directors (NACD) announced in March that its 2017 Blue Ribbon Commission—a roster of distinguished corporate leaders and governance experts—would explore the role of the board in overseeing corporate culture. The commission will produce a report that will launch during NACD’s Global Board Leaders’ Summit Oct. 1–4.
Incentives can reward performance—and create tension and unintentional risks.
One element that helps define an organization’s culture is the set of incentives motivating employees to act. While incentives can effectively reward performance that benefits the enterprise, the compensation committee—and the board more generally—must factor in the tension and unintentional risks that incentives can create.
NACD, along with Farient Advisors, Katten Muchin Rosenman, PwC, and Sidley Austin, last fall cohosted the first-ever joint meeting between the NACD Compensation Committee Chair Advisory Council and the NACD Advisory Council on Risk Oversight. Committee chairs from Fortune 500 corporations joined governance stakeholders for an open dialogue on incentives and risk taking.
The discussion was held under a modified version of the Chatham House Rule, under which participants’ quotes are not attributed to those individuals or their organizations, excepting cohosts.
Six questions emerged that boards and compensation committees should consider:
Do we have an appropriate balance of metrics?
Are we calibrating goals and upside opportunity appropriately?
Are we considering the quality of performance?
How robust are the controls on data that is used as inputs to the compensation plan?
How are our board’s committees collaborating on developing and monitoring incentive plans?
Are we actively exercising discretion?
Below are details for three of those questions. More information is available for download in NACD’s complimentary brief, Incentives and Risk Taking.
Do we have an appropriate balance of metrics?
The Report of the NACD Blue Ribbon Commission on Performance Metrics states, “Corporate leaders must select metrics that encapsulate the company’s strategy, the balance of risk and reward, and the milestones along the way.” Management chooses appropriate metrics for the company. The board’s role is to decide if those metrics help create long-term value for shareholders—and also to ask management the right questions to ensure that risks associated with compensation plan incentives are being mitigated.
“Our responsibility is to understand the business and the industry,” said one director at the meeting. “The more we understand the business, the more [any] red flags will become apparent.” Meeting participants added that just as there is no silver bullet or single perfect metric to use when developing incentive plans, there is no one-size-fits-all approach to finding a satisfactory balance of metrics.
“There’s no perfect performance measure because every one of them can be gamed either deliberately or not deliberately,” said Dayna Harris, vice president at Farient Advisors. “In addition, it’s important to factor in trade-offs—for example, between metrics related to earnings and those related to revenue or returns—in order to get a combination that works.”
Thomas J. Kim, partner at Sidley Austin, said, “Performance metrics for compensation should be consistent with how management and the board think and talk about the business, both internally and externally. Qualitative metrics are generally more appropriate for, and tailored to, specific individuals, rather than for management as a whole.”
Are we calibrating goals and upside opportunity appropriately?
In addition to selecting performance measures, compensation committees must ensure the pay plan keeps the firm’s risk appetite in mind. The goal is to avoid unintended consequences that might compromise the enterprise’s reputation or its long-term viability. At one council delegate’s company, “the chief risk officer does a risk analysis of the executive compensation plans and shares it with the board. We can assess where it nets out on the risk spectrum. The analysis is repeated at the end of the year to look at incentive payouts and whether any business area took undue risks.”
Participants highlighted two areas for compensation committees and boards to consider:
Incentive thresholds. “Stretch goals are great and often important to strategy execution. But the board needs to ask whether high incentive thresholds may encourage bad behavior,” one participant said.
Slope-of-the-payout curve. Harris advised, “Make sure the upside [payout] opportunity is not excessive, especially for annual incentives. Three hundred to four hundred percent payout ranges can be dangerous.”
Are we considering the quality of performance?
Council delegates also emphasized that it is essential for compensation committees—and, indeed, for all board members—to ask probing questions about the way in which management achieves results, not just whether or not a particular performance target has been met: “How you get there makes all the difference: we have to look at the quality of earnings,” one delegate said. “If our incentive plan is heavily weighted toward rewarding revenue, did we end up with a bunch of low-margin or bad deals?”
One compensation committee chair reported, “To make sure that our results are sustainable, we’ve introduced strong metrics around employee satisfaction and engagement, along with customer satisfaction. These can count for as much as 25 percent of the CEO’s annual bonus.”
Questions about the quality of performance have risen to the top of many boards’ agendas in the wake of criticism over the consequences of aggressive incentive plans at companies such as Wells Fargo and Mylan. Reflecting on what has been publicly reported about these two situations, participants identified the following takeaways for directors:
Exercising skepticism is essential in times of good performance—when it is often most difficult to do. “It can be hard for directors to push back when they’re in the boardroom of a high-functioning organization and hearing lots of great stories from management,” observed one participant. Several delegates pointed out that executive sessions can be particularly useful in this regard.
Question over-performance as closely as underperformance. “If it looks too good to be true, it probably is,” a director said. “Wells Fargo’s cross-selling numbers were significantly above industry standard. As directors, we need to look very closely at outlier-level performance—it might be a red flag.”
Reputation risk can be material, even when financial losses are relatively small.
By incorporating into board discussions the above-listed questions, directors can strengthen responsible oversight of incentives. “It’s our responsibility as directors to understand the business and the industry in depth—trends, competitors, pricing models,” one director said. “That gives us a much deeper understanding about what is possible and what we’re asking management to do when we set goals and targets. It will also help us see potential risks and red flags much earlier.”
While the essentials of director pay remain steady, interesting changes are happening at the margins. Review the findings of the forthcoming Pearl Meyer/NACD 2016–2017 Director Compensation Report in this condensed article from the March/April edition of NACD Directorship magazine. Members may read the full article, including charts, here.
Continued slow growth in what boards pay their members suggests that “director compensation is evolutionary, not revolutionary,” said Jannice L. Koors, managing director at compensation consulting firm Pearl Meyer and head of the firm’s Chicago office. Director pay has, in other words, changed little over time.
Data from the Pearl Meyer/NACD 2016-2017 Director Compensation Report show that median director pay at public companies increased by 3 percent over the previous year. That brings median total compensation for individual directors to $191,440 for all firms, from micro-sized to the top 200 public companies. Median pay across all companies studied in the previous year’s report was $186,610.
While the report found no about-faces or surprises in overall median director compensation, a closer look at what is happening in the margins reveals continued evolution.
Pay Growth Aligns With the Stock Market
Directors have seen steady increases in pay in recent years as the stock market has continued to recover from the 2008 global financial crisis. The link between director pay and the stock market has strengthened as boards have offered directors less cash and more equity.
When Pearl Meyer published its inaugural director compensation report with the NACD in 1999, less than 25 percent of the largest 200 public companies in the United States included stock in their director compensation plans. That percentage had grown to 50 percent by 2002. In this year’s survey, 93 percent of the companies indicated they include some type of equity in their mix of director pay.
Changes in the Political and Regulatory Environments
The political and regulatory environments can stimulate strong performance among companies traded on the U.S. stock exchanges. Attempts to forecast what the next few years will look like for corporations prove difficult.
The director compensation report notes that President Trump’s administration and a Republican-controlled Congress could adopt protectionist policies that would likely refocus business activity on the United States and away from some international trading partners.
The president’s promises to help businesses by deregulating, however, have produced some level of optimism in corporate America. JPMorgan Chase & Co. in February published results of an online survey showing that more than 75 percent of middle-market business executives expect the policies of the Trump administration and the Republican-controlled Congress to positively affect their businesses because of expected tax reform and fewer regulations.
Koors noted that the current administration feeds the populist sentiment. That environment could call into question how year-over-year growth in director pay aligns with—or outpaces—employee pay increases. “There will continue to be a focus on income inequality and pay gaps,” said Koors. “Even if there’s not regulation around it, boards will continue to have to be sensitive to the broader stakeholder groups, not just the shareholders.”
Committee Pay and Workload
Seventy percent of companies surveyed for the report provide retainers or meeting fees to directors serving as members of a standing committee. However, pay differs depending on which committee the director serves.
Koors said that committees whose workload grew as a result of more regulation have tended to see increases in pay for members. When Enron’s corporate failure led Congress to pass the Sarbanes-Oxley Act of 2002, for example, the law’s regulations to protect shareholders from fraudulent accounting by corporate leaders meant greater oversight responsibilities for the audit committee.
This year’s director compensation report shows that, across all firms, audit committee members earn a median of $7,500 above their base pay for board service, while audit committee chairs drew $20,000.
Similarly, passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act took aim at executive compensation, and subsequent rules, such as say on pay, led to greater responsibilities for—and attention on—the compensation committee. Increased attention on high CEO pay and disclosures meant to improve pay transparency have also translated into more work for compensation committees, and more work should mean higher pay.
Median retainers and meeting fees for compensation committee members, above their standard director pay, totaled $5,000 across all firms, according to the report. Compensation committee chairs earned $15,000 for their service.
Koors added that heightened attention on issues such as increasing board diversity and improving succession planning could presage a workload increase for nominating and governance committees. Members of that committee received a median of $2,500 above their standard pay for board service across all firms, while chairs received $10,500, the report noted.
“Have we reached the point where every committee has an increased workload? Do we go back to pre–Sarbanes-Oxley [when all committee service resulted in the same level of extra pay]? We started to see a little of that in the data, but the most prevalent practice is still differentiation in pay,” Koors said.
Connecting Director Pay to Board Turnover
In addition to director compensation adapting to the political and regulatory environment, the report notes that director pay could be used as a mechanism to spur board turnover.
The 2016–2017 NACD Public Company Governance Surveyfinds that board turnover slowed last year, with just 67 percent of respondents indicating that their boards had added at least one new director in the past 12 months. That was down from the prior year.
Most boards deliver the biggest portion of pay to directors as equity. But many boards model their director compensation plans on those of executives, which seek to retain senior managers.
Many director compensation plans are similarly set up so that a director forfeits any unvested equity if he or she retires earlier than expected. Common practice is for directors’ equity grants to vest immediately or after one year, the director compensation report states, but companies with vesting periods longer than one year could inadvertently encourage directors to stay on a board for which their skills are no longer applicable in order to avoid forfeiting unvested equity.
“Make sure your director-award provisions allow the director to divest equity at the time of retirement,” Koors said. Doing so could help the company adapt to changing expectations around board turnover.