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.
In a recent Harvard Business Review article, Graham Kenny posits that nonfinancial measures should be included alongside financial measures in incentive plans. He goes on to say that this is leading companies to use both hard and soft performance measures—where ‘soft’ measures can be more subjective in nature. We wholeheartedly agree with the premise—so much so that we wonder if Kenny goes far enough, particularly where subjectivity is concerned. For many, however, the element of subjectivity in this context implies an arbitrary assessment of performance against goals, based on the general sense of the board’s compensation committee. This interpretation rightly makes institutional investors and other investors uneasy. But, does this really need to be the case, especially given the abundance of data in today’s digital age?
We think there are ways to structure subjectivity such that the compensation committee’s performance assessments and incentive determinations make sense against the backdrop of company performance. Moreover, by bringing a clear structure and hard information to the more subjective elements of the incentive system, performance assessments and incentive determinations become more explainable, more powerful internally, and more defensible externally. We suggest an approach that would work as follows.
Define the performance to be measured as precisely as possible. We have used nonfinancial measures across a wide range of clients targeting a variety of strategic and operational areas. The goal in this step is to provide enough specificity at the board level so management can operationalize imperatives into specific, measurable key performance indicators (KPIs).
For example, one company was an end-to-end, integrated furniture manufacturer which covered product development, through the supply chain, manufacturing, retail sales, installation, and after-sales servicing. This company viewed the improvement of total customer experience as a critical strategic imperative in an increasingly competitive industry.
Consider potential sources of objective evidence and data. Preferably using a cross-functional team, determine KPIs to be tracked, sources of the KPI information, and favorable and unfavorable outcomes for each KPI. The KPI data could be sourced from: internal management information systems; Internet sources such as social media sites; sensors, which are becoming ever more prevalent in household goods, vehicles, industrial equipment; or tailored surveys conducted by or for the company.
For our furniture manufacturer, the board chose to use Net Promotor Score (NPS) as a key indicator. NPS could be benchmarked against key competitors and broader industry groups, and it tracked many of the key elements of total customer experience. The company then supplemented and validated this information with data collected from its own website and social media platforms as well as a few key Internet and social media sites that track customer satisfaction. It was recognized that the quality of data on these external sites can be open to question, so composite information and judgment are needed when using them. Favorable results were considered to be in the upper quartile vs. competitors, given the company’s premium pricing.
Build a scorecard. Use the evidence and data sources identified in the prior step to build a scorecard that can be measured quantitatively or with highly structured discretion. Such a scorecard is a useful tool for communicating with employee-participants, as well as external stakeholders (generally after the fact, to safeguard the company from competitive harm).
Put a range around the committee’s adjustments. Putting a fixed range around compensation adjustments makes the process more approachable and more doable versus using open-ended ranges. It also communicates to participants the importance of non-financial metrics by virtue of their potential impact on overall awards. In this case, the company allowed for a +/- 25 percent adjustment to the award.
By using this approach, executives have a better sense of focus areas and needed behaviors—as in, they know the rules of the game. And the compensation committee are more fully ‘in the seat’ when it comes time to judge performance. The committee also knows the rules of the game and, more pointedly, the committee knows the potential impact, or swing, its discretion can drive in the incentive outcome. Where discretion is left unstructured, we often see committees shying away from hard choices either out of concern for not having enough supporting information to make an informed decision or for fear of making too big an impact on the overall incentive outcome. Other important process points include: transparency, regular reporting on progress, careful consideration of unintended consequences, and openness to experimentation (e.g., implement the softer elements on a trial basis before including them in the formal incentive decision).
Consider the furniture manufacturer: the board and management built a program based on the principles outlined above that strikes the right balance of hard and soft performance measurement. And the softer, more subjective elements of the measurement system, by virtue of careful consideration and diligent information gathering, are anything but soft. Overall, the company’s incentive program is perceived as fair by employee-participants and investors, alike. And these key stakeholders also applaud how the system makes clear the company’s strategy and priorities for execution.
Barry Sullivan is a managing director at Semler Brossy. Sullivan supports boards and management teams on issues of executive pay and company performance. He may be contacted at email@example.com.
Seymour Burchman is a retired managing director at Semler Brossy. Burchman, who has been an executive compensation consultant for over 30 years, has consulted on executive pay and leadership performance for over 40 S&P 500 companies. He may be contacted at firstname.lastname@example.org.