Executive pay has long been a key focus for shareholders, activists, directors, and the media—and there are no signs of that changing. Increased attention on income inequality, corporate social responsibility, and incentive plans that encourage risky behavior has further increased scrutiny of executive pay, making it a critical oversight area for boards of directors.
Compensation committee members should address the following questions to assist in exercising sufficient oversight:
What is the board’s required level of oversight on executive pay? Emerging best practices are pushing compensation committees to go beyond the technical requirements for approving and disclosing CEO pay set by the U.S. Securities and Exchange Committee and stock exchanges. It is now becoming a best practice also to include a broader view of human resources-related issues, including how a company allocates resources toward compensation and benefits, how incentive plan metrics interact with desired behaviors, and the board’s involvement in proactive succession planning.
How can compensation committees operate with the greatest efficiency? Compensation committee agendas tend to follow a similar pattern from year to year across companies, but certain practices can ensure meetings run more efficiently. For example, following an established cadence of pre-calls in advance of meetings between management and the committee chair, the committee chair and the advisors, and among other committee members can help them run smoothly. Many committees also reference the agenda at the end of each meeting to ensure that all parties’ expectations are aligned. Selecting and working effectively with outside advisors can further enhance efficiency and keep the committee as a whole up to speed on potential pitfalls and implications of pay and governance decisions.
How do compensation committees evaluate incentive plan designs and set performance goals? Incentive compensation is an important lever to encourage behavior and align management with shareholders. Recently, goal setting has received increased scrutiny from shareholders and proxy advisors who have raised concerns about significant payouts to management when performance did not yield a sufficient return for investors. Whether goals are set on an absolute basis or relative to peers, compensation committees often review models that stress-test payouts under various growth and return scenarios to avoid windfalls to executives. In defining acceptable target performance levels, compensation committees may consider multiple perspectives of the company’s expected future performance, such as past performance, peer performance, analyst expectations, internal budgeting and planning, financial modeling, and correlation between the company’s share price and the general market.
What are shareholders really looking for in compensation plans? Institutional investors and proxy advisory firms have views on compensation levels and design that are generally well documented. Committees should consider how compensation design features and pay decisions will be perceived by the company’s major shareholders and the proxy advisory firms. Typically their voting guidelines stem from the principal of pay for performance, but subtle changes to a compensation plan design can make it more acceptable to particular stakeholders. For example, investors have different views on acceptable levels of dilution from stock-based compensation. Knowing those levels may steer a company toward cash-based phantom shares for certain levels of employees to avoid triggering a dilution concern from a major shareholder. In addition, directors should be aware of trends in shareholder proposals, litigation risks, and how and when to engage directly with shareholders on issues related to compensation.
What keeps compensation committee members up at night? Succession planning, risk mitigation, environmental and social goals, gender pay equity, board diversity, director pay, and executive employment agreements are just some of the areas that have bubbled up to the compensation committee agenda recently. US tax reform is also affecting compensation plans and processes. Most notably, the elimination of the performance-based exception to Internal Revenue Code Section 162(m) means that compensation above $1 million paid to certain executives cannot be deducted by a public company, even if it met the former Internal Revenue Service definition of “performance-based.” The elimination of the performance-based pay exception gives companies more flexibility in how plans are designed (e.g., goals can be set later in the year and subjective judgement can be used to set and evaluate performance against goals). However, companies may not want to abandon the best practices dictated by the performance-based exception since shareholders and proxy advisors may object.
To help directors with their oversight responsibility, Mercer has partnered with NACD to publish the Director Essentials Guide to Board Oversight of Executive Pay. The goal of the publication is to provide directors with a clear and concise reference guide to basic principles that affect design and governance of executive compensation programs. Mercer and NACD are committed to helping directors stay ahead of the curve and aware of evolving trends. We hope you find the guide a useful reference and welcome your feedback in the comments section below.
Teresa Bayewitz is a principal in Mercer’s rewards consulting practice based out of New York City.
Take a look at the business section of any publication today and it’s clear: discussions of corporate culture have leaped from the pages of academic commentary to the agendas of directors across the world. Between the coverage of misdeeds at Wells Fargo & Co. to reported gender bias and workplace toxicity in the technology sector, the issue of a company’s culture is front and center. Investors, boards, and management teams are seeing direct impacts to shareholder value, which is leading companies to pay attention to their culture without any regulatory mechanism in place encouraging them to do so. They are trying to understand the common current that runs through their organization and whether it creates an environment for value creation or an environment that hinders it.
How companies evolve beliefs and procedures around hiring, retaining, developing, and rewarding a workforce—and how they implement them practically—is what defines a corporate culture at its core.
Thinking about culture in this way does require expanding one’s perspective on the topic. Similarly, when it comes to aligning compensation with that culture, we have to think broadly. Constructing executive pay programs so they support the organization’s long-term business strategy has become a fairly steady drumbeat, but is that executive pay program also in line with company-wide recognition and rewards systems? Ideally, it should be. A productive compensation philosophy is one that is well-known and well-understood at all levels and meets the achievement and recognition needs (both financial and non-financial) of its workforce and management team.
There are two straightforward questions a board can ask to uncover the firm’s true philosophy when it comes to talent development, career progression, and compensation:
how do people move up within the organization; and
what can stall or derail a career?
The answers will point directly to the culture and have tremendous influence on the company’s success.
Operating under the assumption that a “good” culture is the goal, in a positive environment there is always a high level of transparency. Employees up and down the command chain understand the system, believe it is fair, and have a clear idea about how they can advance their careers. There is consistency at all levels in the kinds of behaviors that are compensated in some way and it is clear that actions which run counter to the company’s values are not rewarded.
Accountability is a key part of the system. Personal performance and team and/or business unit achievements are evaluated on the basis of well-established goals and metrics. And finally, a degree of flexibility offers room to evolve strategy or take into account changing business needs or circumstances.
Perhaps what’s most important for boards and management to know is that this scenario is not mythical or unattainable. There are companies well known for their vibrant, performance-based cultures and the long-term value creation that follows. What they share is a company-wide compensation philosophy that carefully tracks to their business and talent strategies. They implement programs that appropriately incentivize, but also more holistically develop talent, understanding that people are at the heart of the company’s success.
As readers of this blog can attest, the role of the board is going to evolve. Today, we are seeing a demonstrated need for greater stewardship over corporate culture. As this and other “soft” issues become increasingly important to investors and impactful to the bottom line, the compensation committee will continue to find itself in a unique and powerful position to effect change and build value for the organizations they serve.
David Swinford is president and CEO of Pearl Meyer.
It remains appropriate for the boards of companies to prioritize discussion of the application of executive clawbacks in their compliance and compensation agendas, regardless of the initiatives in Congress to reform the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Michael W. Peregrine
Indeed, a series of public developments this year should be prompting boards to consider expanding the scope of existing “clawback” provisions listed in executive compensation agreements. When well-crafted, they can help prevent fraud, malfeasance, or damage to the corporate reputation.
A Short History
The concept of compensation recoupment as an executive sanction has its roots in the corporate responsibility provisions of the Sarbanes Oxley Act of 2002 and related enforcement actions by the Securities and Exchange Commission (SEC). Section 304 of the Sarbanes-Oxley Act empowered the SEC to compel public company CEOs and CFOs to reimburse the company for certain bonus and incentive-styled compensation that would not have otherwise been paid for misconduct.
The limited scope of Section 304 led Congress to include broader clawback rules for listed companies under Dodd-Frank. Generally speaking, Dodd-Frank provides for the exchanges to require companies to have a clawback policy as a listing condition. Pursuant to Dodd-Frank, proposed rules call for clawback policies to cover all executive officers, applied without respect to whether there has been any misconduct by the executive officer and extend to a longer look-back period. Proposed rules would also extend the clawback rule to more types of incentive compensation.
While these proposed clawback rules have not been adopted by the exchanges, shareholder advisory services like Institutional Shareholder Services and Glass-Lewis & Co. have taken a lack of a clawback policy into account when evaluating a public company’s corporate governance practices and making voting recommendations on directors. As a result, financial restatement-based clawback provisions are now accepted as a common public company practice, and increasingly so within large, financially sophisticated nonprofit organizations.
The utility of clawbacks as a corporate responsibility measure has attracted renewed attention because of a series of corporate, legislative, and regulatory-related developments.
One of the most prominent of these was the decision by the board of a prominent financial services company to claw back in excess of $60 million in compensation benefits from two senior executives following a major corporate controversy involving certain sales practices. Yet in another development, the board of United Continental Holdings took a different position when it decided not to seek compensation clawback from a CEO who had been terminated in connection with a federal investigation of the company’s conduct, in which he had been tangentially implicated.
Additionally, the Department of Justice weighed in on clawbacks when it issued new guidelines for compliance program effectiveness. Under these guidelines, the use of financial incentives (such as clawbacks) to motivate compliant behavior is considered to be an important element of program effectiveness.
Also notable was a recent governance survey suggesting an increased willingness of boards to terminate CEOs for unethical conduct. Another development was the 15th anniversary of the Sarbanes-Oxley Act earlier this summer, which is prompting many boards to renew awareness of the tenets of corporate responsibility.
A Possible Response
These developments combine to keep clawbacks in the mainstream of current governance discourse, not only from the perspective of corporate responsibility, but also from that of effective corporate compliance—notwithstanding legislative efforts to repeal Dodd-Frank and questions on the related enforcement focus of the SEC.
Matters of clawback review could be delegated jointly to the executive compensation and audit/compliance committees, as matters of executive compensation recoupment fall within both of their respective committee charters.
The focus of the joint committee review would likely be on the expansion of clawbacks, from incidents of restatement of corporate financials, to executive misconduct which is implicated in such matters as a fraud-based governmental or internal investigation, material ethical misconduct, and damage to the corporate reputation.
In their deliberations, those committees may wish to consider two additional, important factors. One is the fact that expanded clawback provisions cannot fairly be considered a corporate best practice at this point. Enhanced media and shareholder attention to the concept of clawbacks is not the equivalent of a broadly accepted governance conduct. It may be, however, that these recent developments could accelerate the movement towards clawbacks as a best practice.
The second consideration is the effect that any expanded clawback coverage could have on board-management relationships, executive team morale, and on broader issues of talent development and retention. The board should anticipate some amount of resistance from executive leaders to the concept of expanded clawbacks, especially if it cannot yet be promoted as a best practice.
The Timing is Right
There may be no best practice available yet to guide the board or committee discussion about expanded clawbacks. And there may be no single right answer about how any one company should address the issue. But the need for reasonable methods to incentivize appropriate executive behavior suggests that the timing is right for such a discussion. Indeed, the wrong answer might be to simply ignore it.
Michael W. Peregrine, a partner in McDermott Will & Emery, advises corporations, officers, and directors on matters relating to corporate governance, fiduciary duties, and officer/director liability issues.