The latest developments in the hotly-contested area of corporate compensation
If there's one issue in the battle between companies and investors that just won't seem to lie down, it has to be that of executive and director compensation. Some try to discount the importance of high salaries and benefits packages by attributing the hostility they generate to the politics of envy: complaints from those vociferous retail shareholders are all based merely on jealousy, not on rational analyses of their impact on bottom lines. But despite the worldly ways of institutional asset managers - and their often equally worldly salaries - they, too, often join the fray when corporate captains are deemed to be overpaid for underperformance.
Recent contributions to the debate have come from both the SEC and the National Association of Corporate Directors. These take the form of considered offerings rather than knee-jerk reactions, but are no less interesting for that.
The SEC revisited the question of disclosure of compensation data at a meeting in June which focused on ways of improving presentation of this information; and it subsequently produced a release outlining proposals covering this and other matters (Streamlining and Consolidation of Executive and Director Compensation Disclosure, Securities Act No. 33-7184). The comment period closes on September 8.
The proposals would change certain elements of the system adopted back in 1992 and would probably come into effect for next year's proxy round. Amongst other things, the Commission is considering - and wants comments on - the possibility of allowing some of the information about executive pay to be moved from the proxy statement to the annual report - such as the stock performance graph. It also suggests moving some items to Form 10-K, such as the long-term incentive plan awards table; defined benefit or actuarial plan disclosure; aggregated option/SAR exercises and fiscal year-end option tables; employment contracts and employment termination and change in control tables; and the reports of repricing of options/SARs.
According to a response to these suggestions put forward by law firm Jones Day Reavis & Pogue, some of these notions to relocate bits of the published compensation data represent 'a departure from some of the objectives articulated by the SEC' back in 1992. In particular, Jones Day says, the proposals to take the performance graph out of the proxy statement and separate the options grant table from the option exercises and value tables seem inconsistent with the SEC's mandate to provide shareholders with the 'full picture framework' for analysis of compensation levels in relation to company performance.
Institutional Shareholder Services (ISS), the Bethesda, Maryland-based advisers to institutional investors on corporate governance issues, has many strong reservations about the Commission's proposed changes. It believes the current rules already by and large serve the purpose of giving adequate information, on the basis of which investors can assess the relationship between pay and performance. 'The changes seem trivial on the surface,' ISS says, 'but they could in fact introduce the very confusion that the SEC says it wants to remedy.'
The Commission is certainly insisting that its aim is merely to streamline the proxy, by getting rid of the current practice of providing the data in a piecemeal fashion throughout the document. Commissioner Wallman says this makes it too difficult to understand, and that it may even appear to exaggerate the size of benefits paid.
That must sound like music to the ears of the average embattled CEO, even if some shareholder groups have their doubts. But one area of proposed change that seems to be meeting with relatively widespread approval is the SEC's plan for changes on director compensation disclosure. According to the SEC's proposals, companies could choose whether to report the actual amount of fees paid to the directors named or to describe any standard compensation arrangements in roughly the same way, in the narrative form, as they do under the current system. But the SEC specifically wants comments about whether this choice should be removed. It wants to know whether the companies should have to start disclosing the grant date market value of any stock provided to directors, for instance; or the exercise price and other terms under which options are granted.
The Commission also wants to introduce a new table (reproduced below) in the proxy, which would set out data on director pay that currently has to be disclosed in narrative form. If this comes into existence, along with the recommendations in the NACD's latest Blue Ribbon Commission Report, current practice in the area of director compensation should start to come closer to that of executive compensation.
The NACD report, entitled Director Compensation: Purposes, Principles, and Best Practices, argues that many of the formerly unpublished benefits accruing to outside directors should now be brought into the open, thereby increasing the pressure on them to show that they are earning their keep.
Although the two organisations' documents were published within a week or two of each other, the SEC points out that its proposals on director compensation disclosure are not in response to the NACD report. The Commission said it would look at the NACD's contribution to the subject and consider whether it should be suggesting more change in the light of its recommendations.
The NACD Commission's scope is far wider than the SEC's, covering far more than disclosure. It looks at the whole issue of director compensation, recommending sweeping changes which it summarises in five recommended principles and in six statements of best practice (see box over), which are aimed at ensuring that compensation really does help to align the interests of shareholders and directors while providing 'value to directors for value received'.
The report, which follows two earlier Blue Ribbon Commission reports - one on CEO compensation, the other on CEO and board performance - represents the next stage in the NACD's programme to represent directors' own interests by encouraging them to fulfil their widest responsibilities. 'We aim to keep directors apprised of their duties and of the changing corporate governance environment,' says John Nash, president of the organisation. The NACD's underlying goal, according to Nash, is to ensure that directors, by following best practice and undertaking their own self-regulation, avoid intervention from the federal government.
Nash notes that after all the pressure on executive compensation, and the increased disclosure requirements for CEOs, the spotlight was bound to move to outside directors. 'There hasn't been full disclosure of true director compensation,' he says. Nor has there been enough effort to incentivise boards by relating their pay to the performance of the company and its stock. But since directors are there to represent the shareholders' interests, 'They should share the same risks and rewards as shareholders,' says Nash.
That implies ensuring that directors have a real interest in shareholder value and the NACD wants to see at least half of directors' pay being in the form of equity. 'Over time, that should rise to nearer 100 per cent,' says Nash. 'And directors invited onto the board should be required to buy a certain number of shares - not 100, but maybe 1,000,' he suggests, so that they have an additional incentive to scrutinise all aspects of management - rather than just take the money and run.
The counter argument to the idea of insisting that directors buy stock is that this can militate against diversity on boards, by excluding the less than well-off. Gary Hourihan, president of Strategic Compensation Associates in California, agrees that there should be an effective way of linking directors' rewards to shareholder value but is wary of insisting that all directors buy stock in the companies on whose boards they serve. 'The end result is that you get board members who can afford to be board members,' he says, noting that this will preclude, for example, certain academics who can often make useful contributions to companies, even if they cannot necessarily afford to buy sizeable chunks of their stock.
Hourihan is more sympathetic on certain other issues discussed by the NACD commission, however. He understands the disquiet about the explosion in retirement programmes for outside directors, which often see them continuing to receive the equivalent of their retainers and attendance fees for protracted periods after retirement. This issue was high on the agenda during this year's proxy season, with organisations like Institutional Shareholder Services advising clients to vote against director retirement plans wherever the opportunity arose.
The NACD is now recommending that such retirement plans for directors be dismantled and that no new ones be created. But Nash is also concerned that these and other perks should have to be disclosed. 'There's full disclosure now for CEO pay and it should be the same for directors,' he says. This would apply to services supplied by a director or a director's affiliates to the company on whose board he serves, for example, which has been a hugely contentious area with shareholders. 'And say a director of an airline gets free airline tickets, or an automobile company director gets a car, without having to pay taxes because it's 'for product testing'. These things should be disclosed if the concerns of institutional investors are to be satisfied,' says Nash.
Of course, the real virtue of disclosure is that it tends to reduce excesses simply because their perpetrators know what the result of spelling them out will be. And Robert Stobaugh, the Harvard Business School professor who chaired the NACD's 19-strong commission of governance experts, has no doubt that there are excesses. 'The level of director pay has increased dramatically over the past decade,' he says. 'Payment of stock and stock options can link the interests of directors and shareholders. It's difficult, however, to justify the increase in benefits,' he argues. 'Pensions, charitable contributions, life insurance and health insurance may have little connection to the performance of the individual director or the company.'
Given the impact that past NACD Blue Ribbon Commission reports have had, and the recommendations in this latest one, the writing may seem to be on the wall for some US directors who have enjoyed such handsome rewards of late. On the other hand, despite the extensive publicity attending overpaid, underperforming company executives in recent years, the amount of real change is not always clear to their envious retail shareholders and employees, struggling to get by on relatively minimal incomes.
After all, Graef 'Bud' Crystal, well-known monitor of executive compensation in the US, says CEO pay went up by an average 12.8 per cent from 1993 to 1994, while the S&P 500 rose by just 1.8 per cent. Over the same period, the equivalent figure for 'workers' (don't CEOs class as workers, too?) was just 3 per cent.
Maybe that's why the grass always looks so much greener on the other side of the (board) fence.
Principles and Practice
The NACD report on director compensation says that the following Five Principles should be used by all companies:
1. Director compensation should be determined by the board and disclosed completely to shareholders.
2. Director compensation should be aligned with the long-term interest of shareholders.
3. Compensation should be used to motivate director behaviour.
4. Directors should be adequately compensated for their time and effort.
5. Director compensation should be approached on an overall basis, rather than as an array of separate elements.
On the basis of these, the commission recommends the following Best Practices.
Boards should:
1. Establish a process by which directors can determine the compensation programme in a deliberative and objective way.
2. Set a substantial target for stock ownership by each director and a time period during which this target is to be met.
3. Define the desirable total value of all forms of director compensation.
4. Pay directors solely in the form of equity and cash - with equity representing a substantial proportion of the total up to 100 per cent; dismantle existing benefit programmes and avoid creating new ones.
5. Adopt a policy stating that a company should not hire a director or a director's firm to provide professional or financial services to the corporation.
6. Disclose fully in the proxy statement the philosophy and process used in determining director compensation and the value of all elements of compensation.
Source: NACD