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Aligning Pay to Value Creation and Performance

Compensation is a very emotional subject for executives. And it is personal, sometimes inspiring competition, greed, wrongdoing, or even feelings of self worth. The legacy of the financial crisis will not be as much the quantum of compensation, but rather ensuring that boards and shareholders are more involved, and that pay is more tied to performance and risk-taking. Regulators have stepped in to ensure that shareholders have a vote; compensation committees and consultants are independent; and that, in expected regulations to come, pay is more linked to performance and compared to the compensation of the average worker.  The intent of compensation reform should not be a compliance exercise dominated by consultants and lawyers, but rather a re-thinking by the compensation committee of linking compensation to value creation for shareholders, and listening to their concerns. This is the heart of the issue.

In my review of the evidence and work with investors, boards and compensation committees, here is a list of opportunities for linking pay to performance and shareholder value:

  1. According to a study by an advisory firm, 95% of equity vesting in the US top 250 firms are time-based rather than performance-based. If this is the case, this is a serious lapse in oversight and alignment with shareholder value by boards. Non-executive directors should receive performance-based restricted stock also.
  2. University of Delaware researchers claim there is a 17% structural annual increase in CEO compensation simply by virtue of peer groups being used that are based on size rather than value creation, coupled with CEO compensation being awarded at the 50th, 75th or 90th percentile. This structural increase occurs irrespective of performance. As long as the current system of awarding pay continues, this ratcheting will continue.
  3. Increased disclosure of compensation has resulted in compensation consultants devising multiple vehicles, methodologies and time periods that are complex for investors to understand. There is a case to be made for the simplification of key value drivers associated with shareholder value, coupled with high wealth maximization for executives. Private equity firms do this very well.
  4. An independent advisor to a compensation committee should be one who has not done, nor is doing, nor seeks to do in the future, any non-committee related work for management. This restriction should apply to the firm as well as the person. If an advisor’s colleague has a relationship with management, then he or she does as well.
  5. There are examples of equity vesting when ethical transgressions have occurred. This should not be the case. Malus clauses should be used rather than clawbacks. The compensation committee or an independent advisor who has no relationship to management should draft the clause and the conditions. A clause properly drafted will be adverse to the interests of management.
  6. The periods covering pay and performance should be aligned and simplified. Right now there is overlap among intended, earned and realized compensation. This causes confusion in assessing compensation. Companies should do this on their own, and if they are incapable or refuse, regulators should clarify.
  7. Research studies suggest bonuses are not based on stretch goals in many companies, but are forms of disguised salaries. Bonuses should be discretionary and awarded by the committee over time as performance effects are realized and risk tails assessed.
  8. Despite the high say-on-pay approval rate, the controversy over executive compensation is not a blanket “CEOs are overpaid,” but is based primarily on two factors: examples of pay for non-performance, and the internal pay inequity (both officers and the average worker). Boards should take a look at these two issues specifically.
  9. Researchers have found no causal relationship between stock ownership by executives and firm performance. This should be kept in mind for target ownership plans. Large equity positions could promote entrenchment, asset misuse, and accounting and grant manipulation.
  10. Compensation committees need to make greater progress on adjusting compensation for risk, including incorporating risk into performance metrics and allowing equity to vest after risk has been assessed. There is much progress to be made here and regulations are emphasizing this.
  11. Greater progress needs to be made by boards on CEO succession planning, which affects compensation and firm performance. Survey data according to Stanford researchers have found that the board spends only two hours a year discussing CEO succession, and that 39% of boards do not have an internal successor. Outside successors cost more and there is considerable evidence they perform worse than internal successors.
  12. Proxy advisory firms should not be overly influential as they are now. Weak governance systems are associated with excessive compensation, research suggests. However, in considering recommendations of proxy advisory firms, they neither assess governance quality nor predict shareholder performance, the research also suggests. Compensation committees and boards should not necessarily amend practices to suit proxy advisory firms if their reliability cannot be established.

Conclusion: The compensation landscape for 2012 and 2013 will include all of the above touchpoints. They will require most importantly compensation committees with courage and expertise, particularly if there are systemic problems or questionable linkages to performance and value creation for shareholders.

Should Barclays’ Former CEO receive £17M in Compensation After the Libor Rate-Rigging Scandal?

Compensation drives behavior. As reported in The Telegraph, the Barclays’ board of directors intends to “ask” former CEO Bob Diamond to “cut” part of his £17M pay package in the aftermath of Diamond’s role in artificially suppressing the rate at which banks lend money to each other (otherwise known as the London Interbank Offered Rate, or “Libor”). There is an ensuing parliamentary inquiry into conspiracy by other banks to rig the Libor rate. Sky News reports, in “Lawyers In Barclays Bonus Battle,” that “investors have been warned that the bank faces a battle to fully withhold bonuses owed to Bob Diamond and Jerry del Missier, two top executives who quit the bank last week.”

There should be no “battle” and no need for the board to “ask” the CEO to relinquish compensation, given what happened, if the board is doing its job. The compensation (cash and stock) should not have been awarded or vested to Bob Diamond in the first place, if the Barclays’ board (and other bank boards) is complying with the Basel Committee on Banking Supervision’s guidance.

Boards have wide leverage to align ethical conduct and internal controls with executive compensation far more aggressively than they appear to be.

There are two main tools: “clawbacks” and “malus.” Clawbacks, mandated by Dodd-Frank in the US, are more popular, but are inferior to malus. Clawbacks means the cash and equity vests to the executive, and depending on risk and performance factors, the compensation committee has an uphill battle to recover (or ‘claw back’) the compensation it already awarded to the executive. The executive no doubt will contest such efforts.

In contrast, “malus,” which is recommended by the Basel Committee on Banking Supervision (“Basel”) (see the May 2011 report here at pages 37-39), means that the awarding of cash and vesting of stock in the hands of the executive does not occur until and unless the compensation committee says it does. This type of discretion is exactly what management does not want, which is discretion in the compensation committee’s hands. Basel however maintains that malus clauses are more feasible to implement or enforce than are clawbacks. And they are right. Basically, with clawbacks (e.g., Barclays), the board has to pursue the executive for compensation already paid, whereas malus means the board has discretion to make the award in the first place. The board can wait to see if there are any “hidden” risks (e.g., Barclays’ Libor scandal, JP Morgan’s derivative loss) or performance effects that have yet to be fully realized.

Barclays is reported to have a clawback provision, as to many of the major banks, but it is unclear whether banks also have malus clauses. If not, they should.

The clawback and malus clauses should not be drafted by an internal or external legal or compensation firm or person who serves, or has or intends to serve, management. (Otherwise there is no independence and the clause will have a low bar and be management friendly.) The malus and clawback provisions should be drafted by an independent, expert service provider retained by and accountable to the board.

Basel offers guidance on provisions that leading banks have used within malus clauses, including: (i) breach of the code of conduct (this occurred with SNC Lavalin’s former CEO) and other internal rules; (ii) compliance with risk protocols and a qualitative assessment of risk by the compensation committee; and (iii) a violation of internal rules or external regulations.

If the board doesn’t have a proper clawback and malus clause, there will be no shared understanding and alignment of behavior with compensation.

In short, if the board wants an executive to focus on ethics and commit the resources necessary to have proper internal controls and prevent management override, tie his or her compensation to these outcomes – before the fact, and retain discretion at all times. Doing this – which executives will resist – will focus executives’ minds to do what is right as their money is on the line. This is exactly what regulators want in the aftermath of the financial crisis. And clawbacks and malus clauses for banks will likely migrate to non-banks as all companies will be expected to have risk-adjusted compensation in the future.

The Battle for CP ~ Welcome to the Great (and Cozy) White North, Mr. Ackman

By now, you may have heard that Canadian Pacific CEO Fred Green, Chairman John Cleghorn, and four other CP directors have resigned or will not stand for re-election, to make way for Pershing Square’s Bill Ackman and a new slate of CP directors – and a new approach to corporate governance in Canada.

The Pershing Square bid is the perfect storm for what is wrong with Canadian corporate governance: (i) the lack of attention to strategy; (ii) the lack of shareholder accountability; and (iii) the lack of directors with domain expertise. It represents a tipping point for any board in the way it does – or should do – business in Canada.

Lack of Attention to Strategy

The “Dey” Guidelines are now almost 20 years old. They are outdated. Much has changed in corporate governance. Canada needs revised and updated guidelines to the 2005 National Policy, which incorporated many of the Dey guidelines. The Dey guidelines from 1994 contain six words on strategy: “adoption of a strategic planning process,” which is inherently ambiguous. The 2005 National Policy is not much better, adding that the board must approve a strategic plan at least annually. (Emphasis added).

This approach to strategy is wholly inadequate, and the consequences are obvious. In an Institute of Corporate Directors session I facilitated of ninety-four directors last week, when a question on the board’s role in strategy was asked, two panelists deadpanned “we do it in a superficial way” and “it doesn’t happen.” Boards have become obsessed with compliance at the expense of value creation for the company and shareholders.

The research – from Ernst and Young, Egon Zehnder and McKinsey for example – confirm that a more engaged board under a private equity governance model will outperform their public company peers, by a factor of three to one. This outperformance under a Bill Ackman model cannot be ignored by public companies. For academics who desire to show a more causal link between governance and performance, as do I, it should not be ignored either.

The deep dives and due diligence conducted by Pershing Square – over 100 pages in total – should be conducted by boards if they are doing their job, and wish to keep hedge funds from knocking at their door. But there is code like “nose in fingers out” or “micro management” used by Canadian CEOs and directors themselves that keeps directors from performing their strategic role.

The evidence of CP is a case example: Seven COOs and CFOs were replaced in the last five years; CP has consistently underperformed across its peers, including its Operating Ratio; and yet CEO Fred Green met 17 of 18 objectives set by the CP board. And the board moved those targets, resulting in the cost of management as a percentage doubling.

Public company boards need to be much more engaged in strategy, and demanding of management. As reported in the Journal of Applied Corporate Finance, value may be “left on the table” ~ which would invite sophisticated investors like Bill Ackman to come in.

I have reviewed public and private plans by activist shareholders and private equity firms and there is no comparison to the often “superficial” (to use a word from above) approach to strategy typically taken by public company boards. There is absolute clarity under private equity what management is held responsible for, and variances to be reported in advance to – and understood by – the board. Boards of this caliber are much more engaged and focused on shareholder value. No stone is left unturned.

Lack of Attention to Shareholders

Second, many public boards in Canada do not meet directly with shareholders, or if they do, it is behind closed doors – the “cozy” Canadian way. Bill Ackman did not accept this and was unwilling to compromise or go away. This cozy environment has to change, including shareholders asserting themselves much more. And lawyers cannot unduly influence this communication.

Most importantly, Canadian shareholders should have proxy access, or the right to nominate directors of their choosing and put those directors on to the proxy circular, which is another American development that makes sense. It should not take Pershing Square, a 14% shareholder of CP, CP’s largest, a long, protracted, expensive proxy battle to implement governance change. Vote counting, majority voting, plurality voting, etc., are window dressing. Shareholders should have the right to nominate directors to boards and fire directors who do not perform, with ease and transparency. The threshold should be low, or even based on the company’s largest shareholders.

In addition, Canadian directors need to have a % of their net wealth at stake in the boards on which they sit, for true shareholder accountability and alignment. This does not mean directors receiving shares for board service, but actually issuing a check from their savings. The CP board owned 0.2% of stock and it was given to them, not bought. If one director, had $100M of his or her own wealth invested, the CEO would be replaced, Pershing Square said.

Lack of Attention to Domain Expertise

Lastly, the entire board of CP, other than the CEO, did not have rail experience prior to Pershing Square’s involvement. This is a direct consequence of the Dey guidelines from 1994, even though the research does not support independent directors and firm performance. The reason is that if directors do not understand the business, or industry, they are under-engaged in strategy and even their ability to monitor is compromised. They don’t understand. Look at the board of JPMorgan, which lost $2B last week. Other than the CEO, not even a single director has banking experience. If a director does not have experience in the sector, they cannot identify the risks.

Pershing Square’s directors have been selected on the basis of railroad expertise, restructuring expertise, shareholder representation, entrepreneurial culture and a culture of equity ownership and shareholder value creation. What a breath of fresh air. Boards would be wise to take a page from the Bill Ackman playbook, or shareholders should themselves.

And, most of the above Pershing Square directors are from Canada. The notion that we have a talent shortage is a myth. If the board’s desire is for a “CEO,” then there may be a shortage, but the evidence from Stanford University is that CEOs do not make better directors. There is plenty of talent in Canada, and boards need to reach into the C-suite and into shareholder communities. And they need to diversify to mitigate groupthink. The directors exist. My own database contains hundreds.

The Need For New Guidelines

Shareholder accountability, strategic engagement, and director experience and skills, all point to shortcomings that are non-existent or short-changed in the Canadian corporate governance landscape. This is exactly what Bill Ackman brings to the table. Welcome to Canada, Mr. Ackman.

Compensation Consultants Need to Professionalize

Charlie Munger, Vice-Chairman of Warren Buffett’s Berkshire Hathaway, once said “As for corporate consultants who advise [boards of directors] on salary, all I can say is that prostitution would be a step up for them.”

Compensation consultants are widely regarded as not being independent and beholden to management for the bulk of their professional services. Therein lies the problem.

Boards need professional advisors who are accountable to boards and not management. They need auditors, lawyers, compensation consultants and search firms. However, these advisors have varying degrees of professionalism and oversight of conflicts of interest. Lawyers and accountants, for example, have very detailed rules of professional conduct. So do management consultants. See here, here and here. North American compensation consultants do not appear to have an industry code of conduct or performance standards.

Enron and WorldCom – and its legislative aftermath known as “Sarbanes Oxley” – fundamentally changed the relationship between auditors and audit committees. Auditors are now accountable directly to audit committees, not management or the CFO, to recommend to shareholders approval of financial statements of the company. Auditors may not engage in what is known as “non-audit” services to management, without permission, as doing so compromises integrity of the audit and accountability by the auditor to the audit committee.

The global financial crisis – and its legislative aftermath known as “Dodd Frank” – is similarly changing the relationship between compensation consultants and compensation committees. Consultants are now accountable directly to compensation committees, not the CEO, to recommend to shareholders the approval of executive compensation. Similarly, compensation consultants should not engage in “non-compensation” services to management, without permission, as doing so compromises their accountability to the compensation committee. But many consultants do. Their firms perform services for both management and the board, and doing so compromises the ability to do the best job for both.

Lawyers and accountants cannot act for two parties whose interests have the capacity to become adverse. A husband and a wife in a divorce; a vendor and a purchaser in a sale; and yes a CEO and a board in pay negotiations – all have potentially adverse interests, particularly if the professional is doing his or her job properly.

Respecting confidentiality, managing conflicts of interests, and the ability to advocate for one’s client, are the hallmarks of a profession.

Compensation committees and boards should insist on an industry-wide rigorous code of conduct for compensation consultants ~ that is independently drafted and enforced; that is publicly accessible; and to which all compensation consultants who advise these compensation committees subscribe.

The “Code of Conduct for Compensation Consultants” should be detailed, as are codes for lawyers and auditors. It should address specifically the following areas: the organization of a professional practice; relations with other firms and members; duties and obligations to your client; conflicts of interest; confidentiality (including privacy walls); competency and quality assurance; fees and retainers; monitoring and discipline; and, most importantly, objectivity, independence and integrity.

Compensation consulting firms and the industry as a whole have a choice – indeed they have a leadership and business development opportunity. They can professionalize themselves, collectively, collegially and independently, or governments eventually may do it for them. They may not like the unintended consequences of the latter.


Executive Compensation is “Corrosive” and “Undermines Trust”: Connecting the Occupy Movements

I remember when US pay czar Ken Feinberg told a group of academics gathered at Wharton business school for a corporate governance conference to discuss the aftermath of the Global Financial Crisis that he was looking for independent compensation consultants and, to quote Mr. Feinberg, “there are no independent compensation consultants.” So he turned to academics. He wanted to study the claim by consultants that executives need to be paid extraordinarily high compensation or else they would migrate to other companies and jurisdictions, which – as it turned out – did not happen, Feinberg said, or is a “myth” as was stated in the UK this week. Addressing conflicts of interest by compensation consultants is only one of twelve reforms being urged by the “Final report of the High Pay Commission” in a scathing report released this week in the UK.

Reforms to the way executive compensation is set in the UK are forthcoming that may include significant and unprecedented changes – well beyond the structural Dodd-Frank reforms in the US. Changes that may be termed “radical” by some include: binding and forward-looking voting on compensation by all shareholders; having women and worker representation on compensation committees of boards; regulating remuneration consultants; regulating the disclosure, unnecessarily complexity and format of “fair pay” compensation; and having board of director positions advertised and applied for publicly.

A central theme throughout the compensation debate has been that boards and compensation committees – particularly in the US and UK but also elsewhere – have been incapable or unwilling to address the uncontrolled disparity between pay of CEOs compared to that of other senior management and, in particular, the pay of average workers, even throughout the financial crisis. The market is not really “free,” proponents maintain, but is in reality a “closed shop” (words of the Chairwoman Hargreaves of the High Pay Commission) (video). That is to say that pay is set by a small, heterogeneous, interlocked and self-selected group of management and directors. University of Delaware professor Charles Elson and his graduate student, Craig Ferrere, have documented an annual, compounded structural 17% increase in CEO pay over decades as a result of the way CEOs are paid at or above median and the marketing of peer group data by consultants. In some cases, exit pay packages for CEOs have been the hundreds of millions of dollars. The public outrage seemingly falls on some or many (but by no means all) tone-deaf boards and senior management teams.

All reforms are now on the table and the UK Prime Minister and Business Secretary Vince Cable have weighed in, including Mr. Cable expressing sympathy with the “Occupy” movement and calling the current system “dysfunctional” and a failure of corporate governance.

What the Occupy movements have done, it can be argued, is focus the discourse on the consequences of wealth disparity. Ted Talk by British researcher Richard Wilkinson, for example, talks about the harm to society that results from economic inequality, notably the gaps within (not between) societies, which include harms such as life expectancy, literacy, infant mortality, crime, teenage births, obesity and mental illness. (Credit goes to former York University student, Cliff Davidson, for showing me this link.) The link between wealth disparity and social harm is an “extraordinarily close correlation,” Professor Wilkinson states.

What the UK experience also shows is that regulators are prepared to step in and bridge gaps if industry proves incapable or unable to do so itself. In a speech I gave a year ago, I recommended that North American compensation consultants devise a code of conduct for consultants – independently developed and enforced – that includes consequences for breach, similar to regimes that lawyers and accountants have, or governments eventually would do so for them. John Tory was in the audience and endorsed my notion of industry leadership before government regulation. Regulation tends to have unintended consequences, and industry leadership is far superior to the former. Industry leadership unfortunately is not happening and is unlikely given vested interests. We have seen the consequences of inaction in the UK.