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.
This presentation contains general information only and Deloitte is not, by means of this presentation, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This presentation is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this presentation.
Because board members set their own pay, director compensation is a wide-open opportunity for shareholder litigation. In this BoardVision interview–moderated by NACD’s Publisher and Director of Partner Relations Christopher Y. Clark—Marty Coyne, experienced director and chair of NACD’s New Jersey chapter, and Dan Laddin, partner at Compensation Advisory Partners, discuss ways boards can limit exposure to litigation when it comes to director compensation:
Both the compensation committee and the governance committee are involved in determining director pay.
Director compensation aligns with that of company peers.
Director compensation is based on the responsibility of directors—which may see little change from small to large companies.
Companies may consider adopting a shareholder-approved limit for director compensation.
Here are some highlights from the discussion.
Christopher Y. Clark: Do you think that the [nominating and governance] committee or the compensation committee should [have primary responsibility for setting director pay]?
Dan Laddin: Chris, if we look at the market, it’s pretty mixed—a little bit leaning towards [the] compensation committee versus [the] nom/gov [committee]. At the end of the day, I think it really comes down to the principles you use for compensation of your directors overall. One, you may want to make sure you have an objective committee, which obviously you would [with]…either. You also want to make sure that compensation for directors aligns with the philosophy of the directors, and so in that sense, maybe the compensation committee is a little closer to that. At the end of the day, there’s a lot of cross-pollination usually across those two committees, so either works fairly well. We do see a little bit [of] leaning towards the comp committee though.
Clark: Thanks, Dan. Marty, you’ve been on all types of boards. What is your take?
Marty Coyne: I prefer the compensation committee…mainly because the comp committee is much more familiar dealing with the compensation consultant and much more familiar with the peer group. And so when you look at all of the data inputs, the comp committee understands the source, where the weaknesses are, and the strengths. I think one of the key things, though, is the full board approves director compensation. So regardless of which committee brings it forth, and brings forth the recommendation, the full board has to vet it and approve it.
Clark: In many cases, for leading governance practices, company size does matter. [Companies] are affected by different policies and regulations. The boards are occasionally very different; occasionally they are not. But when it comes to director compensation, it is a hot button and it certainly affects that board’s reputation [and] the company’s reputation, but most importantly, that individual director’s reputation. So, Dan, again, let me start with you. Do you feel that there is a company size factor here when it comes to compensation and reputation?
Laddin: I think reputation risk exists regardless of the size of the company, and that’s somewhat borne out by the compensation data we would take a look at. … [T]here’s a basic responsibility of directors that doesn’t really change, regardless of company size, and that’s really reflected in the compensation data.
Coyne: There is a scale that the bigger the company [is], the more the directors are paid. The exposure potential for larger-company directors is far greater than the smaller-company directors because they just make better news than the smaller companies. There is a point though; it’s almost like a minimum size where, when you hit it,…the director workload is pretty much the same regardless of the size of the company. And, to attract and retain good directors, you’ve got to pay a fair compensation for those individuals.
Clark: Many companies have director compensation limits. My question would be why, and what is a fair compensation limit?
Laddin: Sure. So this concept of the limits really [has been] coming to play in the last few years, as there were a few lawsuits against companies that said directors are inherently conflicted when they are setting their own pay. And in those specific companies, the view was that they set it well above any credible norm… The attorneys came in and said, “We can basically put in a shareholder-approved limit on directors’ compensation,” which then gets us back within this business judgment rule.
Clark: For the shareholder-approved limit, what’s the status today?
Laddin: We’re seeing most companies, as they go back to shareholders to renew their plans in the normal course, that that’s when they go back and put in a limit. When they go back for new equity plans or just general approval from shareholders, that’s when it’s happening. I wouldn’t say there’s a mad rush to do it, but it is normal course.
Clark: Well, Marty, what has been your experience? You’ve been on public boards, [and] you’ve been on private boards.
Coyne: I think…having a limit is very, very valid—and it’s necessary. I don’t see any resistance to putting limits on directors’ compensation. If I were a shareholder, I would expect my compensation plan that I’m approving to have limitations for director compensation.
Clark: When we look at the umbrella of business judgment and compensation, I’ve got to ask you, is the litigation environment lukewarm or is it red hot?
Laddin: I would say it’s lukewarm at this point. The lawsuits have really been at the extremes where director compensation was well above the norm.
Coyne: I think…there’s been a quantum step forward on the nom/gov side in choosing the right directors sitting around the table. I think the next step is going to be how do you compensate your directors? What is your philosophy to attract and retain good directors? How does director compensation correlate with company performance? Is there potential pay at risk? I think there will be some…comparisons of director comp to the TSR. And if a company is not performing well, I think directors are going to have to answer a lot of tough questions about why are we paying you when the company performance is so poor? But I don’t see any dramatic changes in the next couple of years.
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.