Lead from the front

When it comes to moving targets in governance, few things are moving faster today than executive compensation. Here are 10 key areas to address to ensure your board stays ahead of the rules
By Richard Leblanc

The governance of executive compensation by boards continues to be in the headlines. Regulation has emphasized the independence of compensation committees and consultants, similar to what Sarbanes-Oxley did for audit committees and auditors. However, given the occupy movements and wealth disparity, more regulations emerge including potentially binding say-on-pay by shareholders and diversifying compensation committees and boards. Compensation committee chairs and advisers should key on the following to stay ahead of emerging regulations.

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 advisers and resources The committee should have explicit access to unconflicted qualified advisers who work for the committee. If an adviser’s colleague seeks to do, or has done, work for the company, that adviser should not be retained. There should be no undue funneling by management in adviser 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 adviser (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. Those 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 new technology.

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. Committees need to push back on exorbitant pay that can be reasonably seen to compromise their own independence. In the U.S., 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.

Richard Leblanc is an associate professor, governance, law & ethics, at York University’s Faculty of Liberal Arts and Professional Studies and a member of the Ontario Bar. E-mail: rleblanc@yorku.ca.

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