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Archive for the ‘CEO Succession Planning’ Category

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.

The Governance of Executive Compensation: A Counterpoint for Compensation Committees

For those compensation committees and their advisors who wish to get ahead of current and emerging requirements and meet best practices in this area, here are ten suggestions, independently and constructively offered:

1.         Independent Members

Committee independence should exceed black-letter requirements, i.e., members should be reasonably seen to be independent from the outside, and assessed anonymously by fellow directors from the inside. Interlocks, prolonged tenure, personal relations, service provider associations, perks and subtle conflicts should all be addressed.

2.         Compensation Literacy and Closed Shop Pay-Setting

A skills and diversity matrix should be used for the Committee. Compensation literacy, expertise and industry knowledge should be defined and met by members. The Committee should not be homogenous. At least one member should be a woman. Non-CEOs and first time directors should also sit on the Committee.

3.         Independent Advisors & Resources

The Committee should have explicit access to unconflicted qualified advisors who work for the Committee. If an advisor’s colleague seeks to do, or has done, work for the company, that advisor should not be retained. The consulting industry has not done an adequate job of addressing conflicts and professional standards and further regulation is coming. There should be no undue funneling by management in advisor retention.

4.         Risk-Adjusted Metrics

Compensation consultants, if used, should be instructed by the Committee to incorporate explicitly risk-adjustment into proposed metrics and adjustments ex post (after the fact) prior to vesting of deferred cash and instruments. The Committee should understand how to do this, consistent with best practice. If not, it should get independent advice, per item 3.

5.         Proper Clawbacks and Malus

If these clauses cannot be drafted by the Committee itself, they should not be drafted by management or internal or external counsel (who are conflicted by being self interested or assessing their own work), but by an independent advisor (see item 3) consistent with best practice and industry standards.

6.         Pay-for-performance Linkage

Management prefer short-term, quantitative, formulaic pay plans. Regulators explicitly want compensation committees now to incorporate qualitative, longer-term metrics, pay periods and discretion. More rules are forthcoming but compensation committees need to be able to understand the business model, the key strategic drivers and get this right so pay equals performance. This has not happened in several instances. Re-cutting pay plans is emotional and adverse so compensation committees need courage and resources at least equal to that of management.

7.         Meaningful Shareholder Engagement and Binding Votes

The Committee should meet directly with key shareholders without management present on a regular basis. Binding votes on pay are forthcoming. Conflicts of interest among institutional investors and asset managers and other barriers to engagement will likely be addressed. Boards should prepare for direct shareholder engagement and voting on a broad basis using technology in the future.

8.         Pay Equity and Disparity

The use of peer groups (vs. CEO rankings) and at the 50th, 75th or 90th percentile have resulted in a perpetual compounded 17% increase in CEO pay overall. This increase results in a significant disparity not only in the C-suite (depending) but also with the average worker. When ratios emerge, committees should scrutinize and act as appropriate. This disparity is part of public and regulatory parlance now. Inaction is resulting in regulation.

9.         Succession Beyond CEO

Boards increasingly should want to see a deep talent bench for key units and functions, beyond the CEO. CEOs resist, including in their own succession but boards should persist. Succession should be part of the pay package for intransigent CEOs. Proper CEO succession mitigates excessive executive compensation payouts.

10.       Director Pay

Management has an interest in paying directors beyond what is required for a part-time job, including for non-executive chairs. Committees need to push back on exorbitant pay that can be reasonably seen to compromise their own independence. In the US, for example, the NACD had recommended a 15-16% premium for Lead Directors, specifically to guard against compromising of independence. This premium is much lower than 2X or 3X seen for non-executive chairs, and the spirit of director pay overall.

CEO Succession Planning – The Number One Job of the Board, But Poorly Done

I received a call from a board chair the other day. He wanted to see pay arrangements for his company’s C-suite executives to confirm that potential CEO successors heading business units were properly compensated. He felt entitled to this information but wanted to check with me first.

I said that the board should see any compensation of any individual within the company, as the board deems appropriate, to ensure that individuals are not taking inappropriate risks, based on new regulations (PDF, at page 8093). I have written about implementing risk-adjusted compensation.

That the board had not seen, much less approved, the pay and leadership development of potential CEO successors is a risk. TSX boards are responsible for succession planning under the regulations. If potential CEO successors are not compensated properly, they may be retention risks. Leadership development blockages may exist, but the board has no way of knowing this without a viable plan.

CEO succession planning is poorly carried out in many boards because CEOs drag their feet and ineffective boards accept this. The choice of CEO is the most important decision a board makes. Leadership can make or break an organization.

The reasons for poor CEO succession planning are simple. The current CEO is conflicted and so is the board. CEOs are conflicted because they are planning to replace themselves, which no one wants to do. Boards are conflicted because they are assessing their own work, namely their decision to hire the CEO in the first place.

Problems and solutions for poor CEO succession planning

Here are some of the telltale problems, solutions and red flags for poor CEO succession planning:

Problem: Dominant CEOs refuse to plan or unduly influence the process

Solution:

The board should own CEO succession planning, not the CEO. The current CEO’s views are important but should not over-ride. If a CEO is not being helpful, CEO succession planning should form part of incentive compensation, with specific objectives. CEO succession planning should start the day the new CEO is hired.

Red flags:

  • Chair and CEO roles held by the same person (see my recent paper on separate chairs);
  • a CEO who is a founder;
  • large pay gaps between the CEO and direct reports;
  • limited board exposure to high potential talent;
  • limited management bench strength; and
  • other signs of CEO entrenchment.

Problem: Boards of directors do not make CEO succession planning a priority

Solution:

The board should have a private session without the CEO to discuss and assign the leadership and scope of CEO succession planning. A robust CEO and leadership development plan from management should be requested. A board committee of independent directors should oversee the identification of executives matched to paths and time-frames, and make recommendations to the board.

Red flags:

  • A board that is not independent;
  • low director turnover;
  • minimal external benchmarking; and
  • lack of knowledge and information.

Problem: CEO succession planning relies on informality rather than concrete plans

Solution:

The next CEO profile and development leadership ladders for near, mid and long-term high potential talent, both internal and external, should be documented. Boards should understand the availability, quality, action plans, and special compensation arrangements for candidates. The board should provide input on, approve, and regularly discuss the CEO succession plan.

Red flags:

  • Plans are seen as personal rather than good governance;
  • limited resources and advisors for the board;
  • limited proxy disclosure of CEO succession planning; and
  • lack of even immediate successors.

No one is irreplaceable or will live forever

Directors often tell me when I ask about their biggest mistake that they waited too long to replace a CEO. Poor succession planning can adversely affect the morale and performance of any organization.

Organizations change and strategies change. Generally, people don’t, so the skills of a CEO and even directors may be outdated or not suited for the organization as it evolves.

CEO tenures have gotten much shorter.

You can’t replace someone without a viable alternative.  It becomes a lot easier for a board to “pull the trigger” when proper succession planning is done.  If there is dissatisfaction with CEO succession planning, that is the fault of the board.


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