As proxy advisors and shareholders continue to focus on improving the relationship between compensation and shareholder returns, and new pay for performance rules are finalized by the U.S. Securities and Exchange Commission, it is likely that more companies will consider adapting incentives based on Total Shareholder Return (TSR) principles. Ultimately, companies need to balance shareholder value creation with executive motivation and retention when deciding whether a TSR-based incentive plan is appropriate and aligns with the company’s compensation philosophy.
If TSR is utilized in a performance-based award package, companies need to consider the following three factors: whether TSR should be measured on an absolute or relative basis, the appropriate TSR performance hurdle, and whether there will be a cap on payouts based on absolute TSR performance.
1. Absolute versus Relative TSR. Absolute TSR requires the company to set stock price targets that must be achieved to earn a payout. Establishing an absolute stock price level at the beginning of a performance period can be challenging, as a declining stock market could make goal achievement difficult to achieve, while a “buoyant” stock market could make the absolute goal relatively easy to achieve. The challenge with relative TSR is that it requires the company to select a peer group or index that is appropriate for relative TSR performance comparisons. Identifying an appropriate comparator can be particularly challenging for companies in unique markets or industries with just a few competitors.
A well-designed TSR plan might provide that when a company achieves both low absolute TSR and relative TSR, little to no payouts would be allowed (Figure 1, box C); similarly, when absolute TSR and relative TSR performance are high, payouts would be sizable (Figure 1, box B).
In cases of high absolute TSR with low relative performance (Figure 1, box A), some type of reduction in payouts might be appropriate, as the company underperformed the stock market. Similarly, in cases of low absolute TSR and high relative TSR performance (Figure 1, box D), management could be rewarded for out-performing a down stock market.
Competitive practice, however, does not often combine these two concepts. Most plans are based on relative TSR, with no adjustment for absolute performance. The few companies that set absolute stock price (or TSR) goals do not consider relative performance. A few large companies have introduced payout caps when absolute performance is negative, a concept which is discussed below.
2.TSR Performance Hurdle. If absolute TSR is utilized, a company will need to decide a minimum stock price level that must be achieved to trigger a payout (e.g., the current stock price is $15, and a trigger price of $30 is established before a payout can be earned). Determining an absolute stock price, or TSR hurdle, should stretch the executive’s efforts, but should not be demotivating. That said, the performance of the overall stock market or the stock performance of the company’s industry sector can make the $30 target in the example either impossible or easy to achieve, which may not create the intended incentive.
For relative TSR, the company must decide the minimum level of relative performance compared to a peer group or market index that begins to provide a payout. This approach allows companies to avoid the need to set a specific stock price. However, it is important to remember that a relative TSR goal may not provide the intended motivation, as the goal is not as clear cut as the absolute stock price target (and, presumably, the underlying earnings or cash flow that must be achieved to support the target stock price).
A typical relative TSR performance curve for a US-based company is illustrated in Figure 2. The threshold level is often the most debated payout level on the performance curve, although competitive market practice suggests the 25th percentile is the most common threshold performance level. By way of contrast, a UK-based company would typically start payouts at 50thpercentile relative performance.
3. TSR Caps. In order to reward both relative and absolute performance, some companies with relative TSR plans have placed a cap on payouts when absolute TSR is negative. These caps often limit payouts to 100% of target despite the company’s ability to outperform in a down market, as shareholders lost value during the performance period.The obvious issue with this approach is the lack of symmetry. Specifically, if the share price increases significantly, but relative TSR is below the threshold level, no payouts will occur. Thus, shareholders will realize a significant increase in stock value and management does not receive a payout (contrast this result with stock options, where management would realize a significant amount of “intrinsic value”). The lack of symmetry and the general belief that out-performance in a down stock market should be rewarded has likely led companies to refrain from imposing caps on payouts.This may change as shareholders and the proxy advisory firms continue to apply pressure on companies to better align pay and performance. In addition, the SEC proposed rules required under Dodd Frank in July 2015 that when finalized will require disclosure of the relationship of pay and TSR (both relative and absolute). This disclosure could impact the design of incentive plans including TSR-based plans to further align realized compensation with shareholder returns (including the use of TSR caps).
Michael Kesner is principal and Jennifer Kwech is senior manager of Deloitte Consulting LLP’s Compensation Strategies Practice.
Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee (“DTTL”), its network of member firms, and their related entities. DTTL and each of its member firms are legally separate and independent entities. DTTL (also referred to as “Deloitte Global”) does not provide services to clients. Please see www.deloitte.com/about for a more detailed description of DTTL and its member firms.
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Litigation challenging director pay has made headlines over the past 18 months with shareholders alleging that pay is excessive pay or challenging the processes by which pay is set. The reality is, however, that a new norm of modest pay growth has settled in across American boardrooms, according to the Pearl Meyer/NACD 2015–2016 Director Compensation Report.
Elements of Board Pay Remain Steady
The report, co-produced by NACD and the executive compensation consulting firm Pearl Meyer, reveals that over the past five years, median director pay increased annually at a rate of 3 percent to 5 percent per company, while year-over-year pay increased between 1 percent to 5 percent. This steady but incremental trend is attributable to the typical board practice of only suggesting changes in pay every two to three years. Low- to mid-single-digit pay increases are expected to continue for the next several years unless a significant catalyst for change occurs.
In 2015, the numbers rose slightly from the average, save for micro companies, whose directors saw a compensation increase of 9 percent. Pearl Meyer attributes this jump to minor changes occurring in the constituent companies that are surveyed year over year, and to their volatility as high-growth oriented enterprises that quickly exceed the $500 million mark.
Jannice L. Koors, managing director at Pearl Meyer and head of the firm’s Chicago office, noted that pay practices appear to be reverting to those seen prior to the passage of the Sarbanes-Oxley Act of 2002 (SOX). “The pendulum is swinging back to director compensation in the pre–SOX days, when pretty much all director staff was paid the same,” she said. The concept underscores the board’s unity when, in Koors’ words, “something goes bump in the night.” “If all the board members’ feet are going to be equally held to the fire, then is it really appropriate to have differentiation in how the committee members were paid for that liability risk?” she asked.
Use of Cash Retainers Increases, While Pay for Committee Members Is Limited
Another element that has demonstrated statistical prevalence is the rate of cash retainers for directors across companies. Ninety-seven percent of companies offer cash retainers to their boards as compensation for their service. The cash retainer typically makes up 32 percent to 36 percent of total director compensation (TDC) packages. Equity grants also continue to comprise a large portion of a director’s pay package—93 percent of companies offered grants. Companies of all sizes offered equity grants at a fixed dollar value rather than a fixed number of shares. This practice is perceived to better align directors’ stewardship and oversight responsibilities. When these fixed-value equity awards are included in TDC, the number of shares is typically adjusted to each grant date based on the price of the stock to provide an equivalent value each year.
One standout figure in this year’s data emerged in the differentiation of compensation by committee role. Audit committee chairs received the highest level of compensation across company types at a median level of $20,000, with compensation and governance committee chairs receiving progressively less, at $15,000 and $10,000, respectively.
A similar trend is reflected in the median total compensation figures for all committee members, which includes both retainers and meeting fees. However, the prevalence of compensation for committee members decreases with the size of the company. Members of both the compensation and the nominating and governance committees at Top 200 companies—the largest 200 companies in the S&P 500 by revenue—are not compensated at more than half of the companies surveyed, which results in median compensation of zero dollars for these committees when averaged with those that do provide retainer or meeting fees for committee service.
“I don’t know that I would ever see the trends moving to a place where committee compensation goes away across the board for all companies in all situations, because there are some very legitimate reasons where committee pay actually makes sense and plays a role where the workload isn’t even,” Koors said.
Legal Implications Regarding Pay
Three recent court cases that have either been adjudicated or are in process open the door to potentially significant changes in director pay practices.
In an ongoing case being heard in the Delaware Court of Chancery, shareholders of Citrix Systems have accused directors of awarding themselves excessive equity compensation in a pay plan that was ratified by shareholders in 2005. Shareholders claim that directors failed to accurately and fully disclose several details during the process, specifically the amount or form of compensation to be rewarded to the non-employee directors. Additionally, shareholders allege that only five of the 14 peers selected for comparison in the ratified pay policy were true industry peers.
Directors argued the stockholder ratification defense when seeking to have their case heard under the business judgment rule. The court ruled, however, that the ratified Citrix payment plan was indeed not specific enough, hence disqualifying the Citrix board’s case from being heard under the more deferential business judgment standard.
A case against Goldman Sachs, brought by shareholders before the Delaware Court of Chancery in June, alleged that directors bear the burden of proving the entire fairness of a per-participant limit of 24.75 million shares, which was valued at $2.8 billion when the case was filed. While the same might not be true for Citrix, it appears as though Goldman Sachs based its compensation on a true peer group. A decision is pending.
At Facebook, Chair and CEO Mark Zuckerberg and the board came under fire in 2014 for the process used to ratify director pay. That case, which went to trial under the entire fairness standard, argued that Zuckerberg’s deposition and affidavit of approval of the director compensation plan put forth by his board was not valid, as Zuckerberg was acting for the directors as an interested party and violated the rule that such transactions must be approved by a vote at a stockholders meeting or by written consent. Facebook settled in late January after Zuckerberg’s ratification was deemed invalid by the Delaware Chancery Court, and the social media company agreed to stricter oversight of director compensation.
Koors suggests that all boards take the time to ensure their disclosures accurately and clearly reflect the rationale of the director compensation program, with full highlights of their skills, qualifications, demographic diversity, and details on the nomination and board re-evaluation processes. More robust communication regarding director selection and compensation could help mitigate proxy season disruption, as well as protect against the types of litigation described.
Pearl Meyer’s 17th annual survey of non-employee director compensation examines key director compensation elements as collected from 1,400 companies across 24 industries, and derives its findings from proxy and other financial statements that disclose director compensation information for the fiscal year ending between Feb. 1, 2014, and Jan. 21, 2015. Companies were assigned to one of the 24 industries based on their industry classification within Standard & Poor’s Global Industry Classification Standard (GICS). Data for the survey was collected in part by Equilar Inc. Comparisons are made to the Pearl Meyer/NACD 2014–2015 Director Compensation Report. All companies surveyed are publicly traded.
This blog is excerpted from an article originally published in NACD Directorship magazine’s March/April 2016 issue.
Executive compensation is a perpetual hot-button topic and one that activist investors frequently use to court shareholder support for their proposals. In a recent BoardVision video, Semler Brossy managing directors Roger Brossy and Blair Jones talk with Ken Bertsch, partner at CamberView Partners, about the following questions:
What compensation practices are red flags for activists?
What happens when an activist investor, or their representative, joins a board?
What are some practical considerations for boards and compensation committees?
Here are some highlights from that conversation.
Roger Brossy: [Activists have] $200 billion under management in various funds. We could see, at current pace, as many as 700 campaigns in corporate America led by activists. Blair, what does executive compensation have to do with this?
Blair Jones: It certainly is not the primary issue that an activist is using as they pursue a company, but it is a hook to engage other investors and also to engage the public at large if it’s a very public fight. The kind of thing they’re looking at is the magnitude of pay. So they would look at the “how much is too much?” question. They might look at certain elements of pay, like retirement or special supplemental retirement benefits, that only executives get. They love to look at pay and performance. Their favorite chart is a pay level that stays steady or even goes up, contrasted against a performance level that’s going down. That’s one of their key areas of focus and interest. They like to look at whether the metrics that they care about are included in the compensation programs, and they also look at say-on-pay votes. And if the company has a pattern of lower say-on-pay votes, it’s often an indication that there may be other governance problems underlying some of the decision-making at the company.
Brossy: Ken, we’ve engaged with activists who are very, very thoughtful about executive pay and have a very reasoned point of view about what the structure of programs ought to look like. But we’ve also been in situations where it felt like stagecraft, and we weren’t sure there was a lot of conviction. Maybe it was more just sort of a point to embarrass or try to curry favor with others. How do you see this fitting in?
Ken Bertsch: Well, I saw both things happen. This is a bit of a campaign—a political campaign—and people use things in campaigns that may make people look bad, which might not always be authentic to what’s going on. On the other hand, I wouldn’t want to overstate that, because I think executive pay does often get to, or is linked to, underlying strategy. Blair talked about discussion of metrics and what makes sense. If the investor has a view on what’s going wrong at the company and the pay strategy fits into that, that’s going to be a useful—and in some ways illuminating—piece of the campaign. So I think it’s both things, and it makes it hard to deal with.
Brossy: So what is your advice for boards?
Bertsch: Number one, be as clear as possible about executive pay. Disclosures have gotten a lot better in recent years, and I think that’s very important. Why are people being paid what they’re paid, and what’s the strategy behind it? How does it link to the company strategy? A lot of the investors who are not activists but [are] potentially voting on activism, that’s what they care about. So you want to be logical about what you’re doing. I think you want to avoid some of the practices that tend to get a lot of criticism. I think, also, you want to listen to the activists, to your shareholders, and try to hear if there is merit in the arguments being made.
Brossy: Blair, when we’ve had boards take activist slates into the board, obviously a very unusual and interesting environment ensues. People who might have been in sort of antagonistic public stand[off]s with each other are now looking to find a constructive way forward, and there may be a variety of points of views or degrees of willingness to have that happen. What should compensation committees do at that stage as they’re taking new members onto the board and potentially onto the compensation committee?
Jones: I think that’s a great question, and one of the most important things is to get a clear articulation of the philosophy of the compensation program. It’s important for the new board members to hear the history of how you got to where you did, but it’s also important for the whole board to talk about where the program is and to either affirm where they are or say there are some things that need to change. They do that as a group where they’re revisiting it. I think that’s job number one.
I think job number two is to … think about the people and the talent. Considering we’re in the situation we’re in, do we have any talent out there that we need to shore up and ask to stay and work with us through the process of taking this company into the next era? That may mean looking at things like severance arrangements so people feel like they have some protection. It may be selective retention or special programs that have new measures related to whatever the objectives of activists’ campaign were.