"Fred Cook Speaks to Directors
About Executive Compensation"
Summary of Remarks
by Frederic W. Cook, Chair, Frederic W. Cook & Co. [1]
CompensationStandards.com and
Stanford Directors' College - June 21, 2005
In connection with this speech, please review Reference Paper A: "How
Use - and Misuse - of Executive Compensation Surveys Leads to Upward
Escalation of CEO Compensation" and Reference Paper B: "A Different
Approach to Stock Option Grants - Stock Option/Pay Multiple Formula"
I speak to you, the directors of many of our major corporations, from the
vantage point of over 30 years of consulting to U.S. corporations on matters of
executive compensation.
There is much to report that is positive about executive compensation
practices and trends in corporate America – namely a focus on
pay-for-performance, equity incentives and ownership. And there is a new
dynamic taking place in board rooms across America. Power to influence
compensation practices is moving from the CEO to the Compensation Committee, and
from the HR and compensation staff to the committee's outside advisors and
consultants who are not beholden to management, but to the committee.
Problems will occur and there are kinks to be worked out. But whether you
view this transfer of power to be for good or for evil, it is occurring and not
likely to be stopped at least over the near term, which is likely to stretch
over the next decade or so.
Also, there is a new mood of conservatism, restraint and transparency in
board rooms when it comes to making decisions on executive pay. There is (1)
less concern with whether the proposed action is justified by competitive
surveys, and more concern with whether the proposed action has a strong business
rationale and makes sense for the company, (2) less focus on justifying the
proposed action just because is legally permissible, and more focus on whether
the action is reasonable, fair and appropriate to the circumstances, (3) less
inclination to favor actions that qualify for minimum or no disclosure, and more
inclination to favor actions that can be fully disclosed without embarrassment,
(4) less inclination to favor actions that put the executives' interests ahead
of the companies', and more inclination for a balancing of interests, even if it
means reducing or taking away a benefit that has previously been granted, and
(5) less inclination to push the rules to, or through, their limits and more
inclination to adhere to the spirit of the rules, regardless of the effect on
the bottom line.
This is all to the good. But we must be careful not to over do it in
responding to the hostile cries of outrageous indignation that arise from
certain groups purporting to represent "shareholders' interests" but who
actually are pursuing their own agendas.
We must continue to reward top talent in an extraordinary fashion when
deserved, as measured by company performance and shareholder returns. In doing
so, we also must be willing to pay less to weak management. Examples of
instances where poor performance and failure are rewarded with exorbitant
severance packages undercut public support for executive compensation and bring
into question whether high pay for strong performance is fairly balanced with
low pay for poor performance.
My presentation to you today will include discussions of: the cycle of
executive compensation; the problems with using compensation surveys to set
executive pay; the rise of stock options in executive compensation; a warning
about converting option values to outright grants of restricted stock; a new
approach to setting equity grant guidelines; using internal pay equity to set
target executive pay levels in the managerial hierarchy; traps compensation
committees should avoid; and evolving best practices in corporate governance of
executive compensation.
I hope you find these topics interesting and thought-provoking. Moreover, I
hope to give you a few key ideas that you can use in bringing value to your role
as a corporate director concerned with the long-term health of your company and
our overall economic system of public ownership and private management.
The Cycle of Executive Compensation
Executive compensation at a company is the result of a process that follows a
cycle. This cycle has a start point – which is the setting each year of
base salaries, annual and long-term incentive targets, the performance metrics
and payout schedules for earning incentive awards, and new stock option or other
equity-based grants.
And the cycle has an end point – which determines whether target,
above target or below target awards, or even nothing, will be earned and paid
out. Depending on the plan type, that performance may be company financial or
other internal performance (which usually determines the payout of annual and
longer-term incentives) or stock market performance (which determines the gain
from stock option awards and the value of other equity grants and ownership
holdings).
Executive compensation is not "out of control" as some alarmist critics
hold. The start point is totally under the control of the compensation
committee which exercises independent judgment and decision making, often
relying on independent experts, to set base salaries, target incentives,
performance goals and payout schedules and new stock option grants.
The compensation committee is not in control of the end point. There,
control is exercised by the performance of the company itself (which governs the
incentive amounts earned and paid) and the company's stock price growth (which
determines the gain from options and the value of other equity grants and
ownership holdings).
The cycle of start point and end point is typically an annual
cycle. More specifically, the start point is annual, with new grants made every
year. The end point may also be annual in the case of annual incentive payouts,
but may stretch over several years for long-term incentives or up to 10 years
for stock options.
The Problem with Surveys
So now let me come to my main point. From my vantage of almost 40 years of
executive compensation consulting, and attending countless compensation
committee meetings, I believe the major problem in executive compensation is
that we, all of us, have become too dependent on executive compensation
surveys to set target executive compensation pay levels and equity grants.
It is at the start point of the executive compensation cycle that
surveys create the problem, not the end point where performance and the market
take over to determine the outcomes.
In the paper accompanying this presentation, which has been posted on
Compensation Standards.com for easy access, I identify many of the problems
contributing to the misuse and abuse of surveys in setting the start point
of executive compensation. That this problem exists, I'm sure, is not a
surprise to you. All of you have a healthy suspicion of surveys. But some of
the points I make in the paper may add to your awareness and deepen your
suspicions.
A good friend, Ken West, known to many of you as a former CEO of Harris Bank,
chair of Motorola's compensation committee, and a respected consultant on
governance to TIAA-CREF, goes so far as to name the survey consulting firms as
"Ratchet, Ratchet & Ratchet."
No one doubts that the misuse and abuse of surveys has contributed to the
escalation of executive pay levels and the widening pay gap between CEOs and
other executives and salaried employees in large U.S. corporations, and to the
widespread public perception that something is fundamentally wrong in executive
compensation.
Why are we so dependent on surveys to set the start point of executive
compensation? The answer is that we do not know how to value the job of
management. In the absence of that knowledge, we rely on surveys to give us the
answer. But do the other companies in the survey know how to value the job of
management? I don't believe they know any more than you do. A survey of other
companies who do not know how to value something does not produce an answer to
the value of management. A collective lack of knowledge does not create
knowledge.
To recap, the sum of all these points is that surveys are a major contributing cause to what's happened in executive compensation over the last 30 to 40 years.
And as compensation committee members, and as outside advisors, we are too dependent on the use of surveys to make and take action that otherwise might not be justifiable or rationale on their merits. This problem particularly comes into play with long-term incentives and stock options, which make up the dominate portion of total executive compensation today.
How Did Stock Options Come to Dominate Executive Compensation?
How did we get to the point where stock options and other equity incentives
make up such a large portion of executive total compensation? Long-term
incentive grant values have been the fastest growing component of executive
compensation during the past 20-30 years, peaking in 2000/01, then declining
with the general market, and now climbing back up.
In a large company, it would not be unusual for new stock option and other
equity grants to the CEO to average 600% of salary a year in
Black-Scholes value. If salary were $1 million, and bonus another million,
total compensation might be $8 million a year, including options.
These numbers are Black-Scholes values at grant. If the Black-Scholes value
was 30% of option price, which is the typical value for a large industrial
company, then the face value of the option grant each year, if the entire
equity grant were in options, would be 20 times salary per year [I get to
a face value of 20 times salary by dividing the present value factor of six
times by the 30% Black Scholes value (6 ÷
0.3 = 20)]. And this might be repeated
year after year. This would lead to "equity carried interests" far beyond
anything necessary to inspire the executive to think and act like a shareholder.
What is an "equity carried interest"? For the avoidance of doubt as to
meaning, having a "carried interest" is having a right to the benefits of owning
an asset without actually owning the asset. A stock option is a
carried-interest instrument. If you have a stock option for 100,000 shares at
$50 a share when the market value is also $50, you have an equity carried
interest in $5 million in stock value. You do not own $5 million in
stock; you have a right to the appreciation on $5 million in stock as if
you owned the stock.
With a stock option for 100,000 shares, you have a paper gain of $100,000 for
every dollar appreciation in stock price. If the option exercise price is $50,
you have an equity carried interest in $5 million. For every 10% appreciation
in stock price from $50, you have a paper gain of $500,000.
Let's return to our example of a CEO with a $1 million salary and a $6
million present value stock option grant, which has a face value or equity
carried interest of $20 million ($6 million ÷ 0.3). If this grant were repeated
every year for five years, the executive would have total carried interest in
$100 million in stock value. If the stock price went up 5-10% year,
certainly a reasonable assumption, the executive would accrue a paper gain of
$5-10 million a year. This would be 5-10 times salary every year in option
gain. If the goal is to provide a sufficient equity carried interest so that
executives think and act like an owner, the goal has been met many times over.
In fact, the carried interest may be so high as to make executives risk averse.
What purpose is served by such a series of large grants? And how did it come
to pass that grants this size are average? Here, from my perspective of
almost 40 years, is what happened:
- Not Intended as Compensation – Stock options
were not intended originally to be compensation, but rather an ownership
incentive. There was no cutback in current compensation to make room for stock
options; they were on top. The whole premise of stock options, and other equity
incentives for that matter, was not to compensate people, but to make
non-founder executives and other key employees think and act like shareholders
in managing the business on behalf of the absentee shareowners.
- Could Not be Valued as Compensation – Since they
were not intended as compensation, and in the early years could not even be
valued, questions arose as to how grants should be administered. The typical
pattern then was to think of the grant size in terms of "face value," namely the
number of option shares granted times option price. This face value was then
ratioed as a multiple of salary for administrative purposes. For example, the
top people might get a grant of one to five times salary, with the multiples
decreasing at lower levels. The general idea was that, over time, executives
would accumulate a "carried interest" in their company's stock price
appreciation that would be motivational to them relative to their annual income
and other benefits from company employment. This, frankly, is a very simple and
logical approach, first espoused by Mr. Crawford Greenwalt, President of DuPont
in the 1950s.
- Consultants Regularized Practice – Consultants then
got involved in the process when companies and boards sought their advice for
how to administer option plans. So, consultants started surveys of other
companies' option grant practices, typically measuring grants in terms of the
face-value multiples of pay as described earlier. Consultants also annualized
option grants to include them in their annual surveys, even if the early
adopters of options never intended options to be granted regularly to the same
executives year after year. It was compensation professionals, with their
penchant for order, regularity, measurement and comparability, that made stock
option grants a regular part of the annual compensation cycle.
- Option Valuation Made Possible – In 1973, the
Black-Scholes formula for valuing traded options was first published. It took
several years before its possible application to executive compensation was
recognized and absorbed. Then it became possible, for the first time, to put a
present value dollar amount on stock options and to combine the results with
salary and bonus income, making option grants fungible with other compensation
elements. The survey professionals quickly adjusted their survey models to
accommodate stock option grant values in total compensation. They found that the
wide variety in practice, as one would expect, produced a large number of
companies (roughly half of any survey population) whose total compensation was
now below average, thereby creating a market for consulting assistance to
correct this competitive shortfall.
- New LTI Forms Developed – During this same period
of the '70s and early '80s, the stock market was in recession and stock options
were perceived as having little value. Various enterprising consultants and
strategic thinkers devised new forms of long-term incentives, both equity based
(like restricted stock and performance shares), and cash based (like long-term
performance units), to motivate and reward senior management for long-term
actions that would benefit company performance over the long run, even if not
recognized by the stock market. With Black-Scholes providing the key to valuing
stock options, and consultants providing the survey information to assess how
far behind one was in total compensation, it became a relatively easy matter to
either carve out of option values amounts that could be converted to these new
forms of long-term incentives, or just add the new forms on top, particularly if
one was low anyway.
- The Golden Years of Options – The mid '80s saw a
resurgent stock market, which continued with minor interruptions through early
2000. Stock options regained their supremacy as a long-term incentive. And
these other equity forms, such as restricted stock, performance shares and
long-term cash, treaded water. This was the same period when (1) corporate
raiders threatened to take over and break up companies whose stock prices did
not reflect their inherent values, (2) LBO firms emerged to make sweetheart
deals with managements of companies to take them private, and (3) institutional
investors and other shareholder advocates led an assault on corporate boards and
managements under the high-sounding mantra that shareholder-value creation
should be the overriding, if not sole, purpose of public companies.
- Shareholder-Value Creation Pre-eminent – Boards,
managements, compensation consultants, and academic theorists responded to these
both positive and negative pressures all throughout the 1990s by rapidly
increasing the size of stock option grants and total share usage for stock
options. Even conservative boards of directors, who did not want to get too far
ahead of market medians, were helped by a particular quirk in the Black-Scholes
formula, namely the higher the stock price at grant, the greater the option
grant values, all other things being equal. Thus, during a period of rising
market values, consultants were able to show that total compensation from
options was rising, even if the survey companies granted no more shares from one
year to the next. This created another reason for relying on consultants and
surveys. If your company lagged the growth in market values, then you had to
increase the size of your grants just to remain competitive.
- Mega Grants Made Regular – For a variety of reasons,
some valid and some less so, many companies made "mega grants" of stock options,
restricted stock, or performance shares during this period. These were very
large grants, for example, three or more times normal. They were designed for
special purposes, for example, to attract a new senior executive, recognize a
significant promotion, retain potential CEO replacements, signal a new strategic
direction, bring merged company managements together, transform performance to a
higher plateau, or just because others were doing it.
Whether for good purpose or not, the problem occurred when
consultants included the mega grants in their surveys, annualizing them as if
they were a regular, ongoing part of total compensation. This escalated
long-term incentive survey data significantly. While mega grants are rare today,
their residual effect remains in the survey numbers.
- Regulatory Requirements Favored Options – I would be
remiss in not mentioning the role that favorable accounting treatment, tax
consequences, and SEC reporting requirements for stock options had in
contributing to the upsurge in their usage.
- Converting to Real Compensation
-- Finally,
now that options are "expensive" under new accounting rules, companies are
shifting to other equity devices deemed more likely to deliver steady
compensation based on performance. The problem is that we are now shifting to
these newer forms of equity incentives from a position of very high stock option
grant values, which were created under totally different circumstances and
sustained by competitive surveys using the Black-Scholes formula, which
overvalues employee options versus traded options.
For example, our latest survey shows the mix of long-term
incentives for CEOs moving to 50% options and 50% restricted/performance stock
values, with options down from an 80/20 mix just two years ago.
What is the future likely to bring? I believe we are at a critical point in
executive compensation. What you do as directors–and we do as consultants–will
determine the outcome of this choice currently facing compensation committees.
It will either be continued high and expensive equity grant values, or it will
be more rational and reasonable, but still highly motivational, equity grants.
A Warning About Restricted Stock
The issue is as follows. Everyone, except FASB, believes the Black-Scholes and
binomial option pricing formulas overvalue employee options. They were
developed for publicly traded options. And employee options differ from traded
options in that they are not transferable. Once exercised, they die.
Wall Street firms estimate that nontransferable (and non-hedgible) employee
options are worth about 25% less than traded options. But none of the
consulting firms doing third-party surveys reflects this discount in their work.
Companies that use survey values to convert options into other grant forms on
a dollar-for-dollar basis will be making a mistake. They will be giving
executives a raise in risk-adjusted pay and embedding in compensation costs and
survey values something that never was meant to be compensation in the first
place.
What is the solution? I believe companies with high Black-Scholes values for
their options (such as 25% or more of option price), which are moving to other
forms of equity, should convert those option values to other forms of equity at
a discount of, say, 25%. For example:
|
Option-to-Restricted Stock Grant Ratio |
|
Option Value as
% Option Price |
$-for-$
Conversion |
Suggested Conversion
at 25% Discount |
| |
|
|
|
50% |
2:1 |
3:1 |
|
33% |
3:1 |
4:1 |
|
25% |
4:1 |
5:1 (really 5.33) |
Any option value below 20% can be safely converted without discount.
Further, companies considering a switch to a new form of equity incentive
may wish to make a clean break from the past and consider new approaches to
equity grant guidelines. Why use inflated option grant values from old surveys
of bubble-induced questionable practices to determine the new equity grant
amounts that are real compensation?
If management objects to any discounting of option values as unfair or
non-competitive, let them keep getting options.
What's Another Approach to Equity Grant Guidelines?
It is my belief that currently high stock option grant values for executives
have gone beyond any rational motivational value and are sustained only by
compensation surveys. To illustrate, what can be the possible purpose served in
granting a CEO who already has an equity carried interest of 150-200 times
salary, another option whose "face value" is 20 times salary? The CEO is likely
to be already so motivated by stock price performance that new grants add no
incremental motivational value. They only add cost. It is only done because
the surveys say that, without the new grant, the CEO's total compensation will
not be competitive. No survey, to my knowledge, considers what executives have
already received in options.
Jesse Brill challenged me to suggest an alternative way for a compensation
committee to deal with options if it wants to step off the survey treadmill. I
have tried to do so in Reference Paper B entitled "A Different Approach to Stock
Option Grants - Stock Option/Pay Multiple Formula" accompanying this
presentation. In summary, my idea is to consider the total equity carried
interest, which the executive has received from the company over the past 10
years, when granting new options. If the total is more than some logical
multiple of salary, say 30 times for the CEO, then throttle back on new grants
and let the multiple fall to a more reasonable level as older options run out.
Why 30 times? Because for good stock price performance over a sustained
period, 30 times salary in equity carried interest will produce a net future
gain after tax of 6-15 times salary. The prospect of earning this amount of net
equity through sustained good performance should be sufficient to optimize a
leader's alignment with shareholders and motivation for share price
appreciation.
Will this alternative approach work? Frankly, I'm not optimistic. A board
faced with an aggressive management that demands to be treated "competitively"
according to the surveys needs new tools to counter the pernicious effect of
surveys. One idea is to ask for a new survey of executives' equity carried
interest or shareholder value transfer that compares the cumulative effect of
stock option and other equity grants over the past 10 years.
What would it take to put surveys back into their proper place? It would take
a management and a board who are more internally focused than survey driven and
who come together to devise new ways to think about and administer equity grants
that is motivational to executives and fair to shareholders. The solution lies
in recognizing that an option is not part of current compensation. It is an
incentive for future performance whose motivational effect continues for a long
number of years.
Internal Pay Equity
During the last 30 years, compensation administration has moved from a
balanced approach considering both internal equity, based on job
evaluation, and external competitiveness, based on surveys, to an
approach that relies almost exclusively on surveys. Being competitive has
replaced being fair and equitable. This, among other factors, has caused CEO pay
to rise faster than the pay of other executives and employees, resulting in the
widening CEO pay gap.
Surveys now tell us that CEOs in large companies are paid 5-7.5 times
in total compensation the pay of the heads of their direct reports who run major
divisions. Is this pay gap reasonable? I have not heard of it existing at any
other reporting levels in a large public corporation.
Such a stalwart of American capitalism as J.P. Morgan is reputed to have had
a rule that he would not invest in a company whose CEO was paid more than 50%
above the executives at the next level. He reasoned that, if the CEO was paid
more, he wouldn't have a team but only courtiers.
I had the privilege, several years ago, of working with the CEO of a very
large company shortly after he took office. He realized that CEO pay was
rapidly out-pacing not only the pay of the average worker, but also that of his
direct reports. He also realized that global competition and the drive to
reduce costs would mean that his regular, mostly non-union people would not be
receiving much in the way of pay increases, and even would be experiencing
benefit cutbacks and takeaways. If his company was successful, he and his
executives would benefit the most because their pay was driven by performance
and options. He worried that the other employees would realize they were not
benefiting from their productivity improvements and sacrifices, which helped
create that performance, and that they might withdraw their support. He went to
his compensation committee with two proposals. First, that his own cash
compensation be capped at 150% of the average cash compensation of his major
division heads. Second, he proposed a one-time, all-employee option grant of
100 shares.
Unfortunately, very few large companies have followed this leadership
example. I would encourage those of you who are drawn to the idea of internal
pay equity to ask your HR heads or consultants to look at the CEO pay ratios
that existed in surveys five, ten or more years back, and then ask yourself
whether the current ratios are justifiable and sustainable, or whether some
other approach to setting CEO pay might be more reasonable.
What Are Some Traps Compensation Committees Should Avoid?
Here are some traps I have learned about over the years that compensation
committees should avoid in fulfilling their duties as directors and compensation
committee members:
- Internal Implications – Be as concerned with the
internal implications and repercussions of your decisions as you are with the
external reactions
– A major, but often overlooked, negative of poor executive compensation
decisions is the disaffection of other layers of management and employees. This
can impede the credibility and moral leadership of the CEO
- SERPs – Do not implement or approve changes in
top-hat Supplemental Executive Retirement Plans without understanding the costs
and other long-term implications
– If you do implement a SERP, make it for future pay and service only, not the past
–Better yet, never adopt a SERP unless it is a special way of hiring executives mid-career who will not be able to accumulate a reasonable retirement
income in their remaining years with the company
–SERPs are elitist, expensive and redundant with the large equity
holdings senior executives can expect to accumulate during their careers
- Being Rushed – Do not approve something if you do not fully understand the costs and long-term implications
–Always take two meetings to consider and decide upon major compensation changes
–Do not be afraid to say no; every recommendation does not have to be approved
- Long-Term Incentives – Do not let long-term
incentive grant values be included in the definition of pay for benefits,
retirement pay and severance purposes
- Retention Incentives – Do not automatically extend
special incentive grants to the CEO that exist for another purpose
–For example, selective restricted stock grants to lock in
high-potential management succession candidates need not be granted to the CEO
- Keeping the CEO "Happy" – While it is reasonable to
consider the CEO's views of his own pay situation, your prime responsibility is
to be fair and equitable, not to keep the CEO "happy"
What Are Evolving Best Practices in Executive Compensation Governance?
Now on the positive side, here is some of what I believe are evolving best
practices in compensation committee governance of executive compensation:
- Competitive Positioning
– Use surveys only for an
after-the-fact check on your executive pay levels, not as a driver of pay
decisions or actions
–Executive pay decisions should have an internal rationale other than
what others are doing
–Consider what pay levels would be today without the pernicious
effect of survey abuse and misuse that have occurred over a long number of years
(see Reference Paper A entitled "How Use - and Misuse - of Executive
Compensation Surveys Leads to Upward Escalation of CEO Compensation")
–This is particularly important in surveys of stock option grant
values, which are so inaccurate in identifying real compensation values, but so
heavily relied on in driving over half of the executive pay package
- Internal Pay Equity – Use common sense and good
judgment in deciding how—and how much—to compensate your key people in relation
to one another
–If your concept of individual worth and value is at odds with survey
values, go with your own judgment of what is right and fair
- Tallying Total Compensation – Develop dynamic "tally
sheets" of your top executives' total compensation packages so that (1) you know
what their all-in total compensation is worth, and (2) you can assess the effect
of changes you approve in one pay element on other elements and the total
package
–Other "tally sheets" being requested by forward-looking compensation
committees enumerate what senior executives would receive, by element and in
total, at various types of termination of employment, including a change in
control
–If you are surprised by what this reveals, solicit committee and CEO
support for making a change
- Leadership Example Setting – Some compensation
committees are stepping up and reexamining current practices in light of new and
more conservative standards of acceptable practices
–Examples include reexamining employment and severance agreements,
change-in-control benefits, special benefits and perquisites (including SERPs
and aircraft rights) and post-retirement stock option/long-term incentive
treatment and perquisites for retiring CEOs
–Managements are not likely to initiate these re-examinations. But
their cooperation can be obtained by explaining that what was done in the past
was not necessarily wrong. Times have changed, what was acceptable in the past
is not good practice now, and the company must reset its practices accordingly.
- Due Diligence – Spend the time understanding major
compensation proposals: understand the cost implications, near term and long
term; test the outcomes under alternative scenarios; retain your own counsel and
advisors, beholden to you, to review the proposals and related legal agreements;
document the due diligence process; and review the resulting committee minutes
carefully.
- More Than Compensation – Finally, compensation
committees want to move away from spending all their time on executive
compensation matters. They want to reset compensation programs and practices to
more reasonable and sustainable levels, and then move on to gain a deeper
understanding of the company's culture and its people and values, and to
encourage talent development so the company does not have to go outside to fill
open positions.
In Closing
Even if compensation surveys are scrupulously fair and accurate, and all
misuse and abuse are exorcized—which is a big if—is that enough? The surveys
are still measuring compensation levels that have been inappropriately escalated
by years of misuse. What to do? Can executive pay levels be reset? Should they?
Who will be first?
This is a tough one. I am not sure it is realistic. If I were asked to advise
on flattening the executive pay slope in a particular situation, I would say,
first, we would need the cooperation of a CEO who saw benefits to the company in
taking a leadership stand on executive compensation and who was not personally
selfish.
Second, the likely process would be to develop internal pay ratios for cash
compensation grounded on competitive pay at some management level, but then
escalated upward without reference to surveys. Then, we would set a long-term
equity objective and process that was logical and sustainable, but also not
driven by surveys. The switchover to the new system could be accompanied by a
one-time, career equity grant that would offer the potential for substantial
reward for long-term success.
My thoughts for you to take away may be summarized as follows:
First, set the right starting point each year and then let performance
drive the outcomes.
Second, be mindful of the pernicious effect of surveys when you set
that starting point.
Third, rely on logic, internal rationales and what makes sense to you
as representatives of shareholders' interests in your decision making. Don't
let surveys be the sole basis for the decision.
Fourth, set a strategy and game plan for the use of equity incentives
based on optimizing the executives' motivation to think and act like
shareholders, balancing—but not dominating—other competing interests. This
requires considering past grants when making new ones. Once the optimum point
has been reached, what is served by doing more? And be especially careful in
converting from stock options to some other form of equity incentives that you
do not inadvertently give executives a big raise in pay by converting
high-valued—but risky—options into another form of less risky pay like
restricted stock.
Fifth, give equal (if not greater) weight in setting executive pay
levels to relative internal equity and fairness, not just what some survey tells
you the job is worth.
Executive compensation is more than about paying executives properly. It is
an easily visible symbol of board performance to employees, shareholders and the
public at large—the support of all of whom is important to the continued
vitality of our American system of public ownership and private management.
Thank you for giving me the opportunity to share what I have learned over my
consulting career and to offer some ideas for possible actions to restore
executive compensation to respectable and fair levels.
[1] The views
expressed in this speech are strictly those of the author, and do not
necessarily represent the views of other members of the firm.
Please review these related materials:
Jesse Brill's Comments
Thank You, Fred. Fred said a lot of very important things today. And he chose
his words with care. He went through several drafts of the text of his speech
because he knew that people would refer to it and continue to use it as a
reference. In many ways what Fred has said today will be viewed just as
groundbreaking - and influential - as SEC Director Alan Beller's speech at our
Executive Compensation Conference last October, which people are still referring
to today.
I'd like to take just a few minutes now to underscore three or four things that
I hope everyone takes away from what Fred said today.
i. Surveys - What Fred said today about surveys is so important. You now
know how to respond the next time you are presented with survey numbers - no matter how
much the consultant who prepared the survey says that the numbers have been
scrubbed to eliminate bias and distortion.
As Fred has made clear, all the numbers now are inflated, in part because of
chasing the 75th percentile - so that what was yesterdays' 75th is today's 50th.
Today's surveys are all based on numbers resulting from the flaws of previous
surveys.
So what do you do after you show the consultant Fred's words in his speech today
and in Fred's paper on surveys: "How
Use - and Misuse - of Executive Compensation Surveys Leads to Upward Escalation
of CEO Compensation." What will you look to? That brings me to the second
point.
ii. Tools - Fred has given us four important tools that we should
each take back with us:
- Internal Pay Equity - Perhaps most important, is to go back and
task your in house HR people to do an internal pay equity check at your own
company. Have your HR people provide the compensation committee with a historical internal pay equity
audit within your own company going back several years - in some companies, going all
the way back within your own company to the early 1980s.
Separate out all the components: look at salary and bonus and then look at the
gaps that may have developed. Do this for each of the other components of compensation
from stock options and long term incentives, to retirement and SERPs and severance
arrangements, and perks etc. In this connection, I refer you to the excellent
piece just posted on CompensationStandards.com on "Why
Compensation Committees Should Ask Their Consultants or HR to Provide Them With
a Comprehensive Tally Sheet Showing All the Components of Their CEO's (and
NEO's) Compensation "
- Tally Sheets - This is a very important tool that many companies
are now beginning to implement. It prevents unwelcome surprises. It is a very
simple concept. You have your HR people and consultants put together in one
place a sheet showing the value of each of the components of the CEO's and top 5
executives’ compensation, tallying it all up. In this way, whenever you are
asked to make a decision about one aspect of
compensation, you are seeing it in the total context.
But, be cautious. In situations where there is a "Holy Cow" reaction by the
board, then corrective actions need to be taken. We have some nice examples of
tally sheets posted in "Tallying
Up Total Compensation."
- Hold Until Retirement - A solution that a number of savvy companies
have now implemented is a "hold ‘til retirement" requirement for CEOs and top
executives. What many banks and brokerage firms came to realize is that the
current values of options they had granted their top executives over the years
had now become so large that key
executives were now in a position to leave and retire early or go to a
competitor.
We've posted on the website what these companies are now doing, essentially
requiring that all past grants as well as future grants be held until you reach
retirement age - to keep skin in the game, so to speak. See our "Hold
Until Retirement Provisions" Practice Area.
- Fred’s New Approach to the Size of Equity Grants – Fred has stated
it so nicely, each of us will want to refer to "A
Different Approach to Stock Option Grants - Stock Option/Pay Multiple Formula."
We have posted very helpful materials on each of these tools on the website
and accompanying the written text of Fred's talk. And this actually brings me to
the third point.
iii. Resources - There are resources for Directors that you should know
about. For example, for the many of you out there who are tuned in on your
computers or watching this webcast in conference rooms, this may be the first
time you have gone to the Compensation Standards website. After this webcast,
take a few minutes
to look at the materials we have put together to accompany Fred's talk today.
If you are going to Compensation Standards.com for the first time, to get up to
speed, go to the home page and just look at the right hand column. Make sure to
read the 12 Steps to Responsible Compensation Practices set forth in these two
issues of The Corporate Counsel in the right hand column: the
May-June issue of The Corporate Counsel and the
Sept-Oct issue of The Corporate Counsel.
Your lawyers, HR staff and other advisors already have discovered the
website. But it is
really designed for YOU as a Director to use yourself. As you will see, we have
put together a wealth of very useful resources for directors. For example, we
have just posted an important piece on airplane perks that all directors should
read: "Disclosure
of Corporate Aircraft Use."
The other important resource for directors is the "2nd
Annual Executive Compensation Conference." Fred's talk today is actually
the first leg of that conference, the rest will follow on October 31. The video
archive of last year's Conference is up on the website. That is where SEC
Director Alan Beller delivered his famous talk before an audience that numbered
over 2000. This year's Conference should be even more important. It will
actually build on a number of the points and tools that Fred addressed today,
providing loads of practical guidance.
My parting request is actually to the two constituencies making up our
audience today.
First to the directors: My hope is that every director here in the audience and every director tuned in on the webcast will go back to your own boards and make sure they hear the video
archive of what Fred has said today. And, don’t overlook the materials
accompanying his talk that are posted on the website.
Now, to every lawyer, HR staffer and other advisor tuned in to the webcast.
First I am gratified by the huge audience of advisors out there - which outnumbers the
directors out there. But, that is also my concern. Still, too many of us
advisors are screening too much from our directors. So, my request is that the
advisors in the audience make sure that the directors at all your companies or
clients hear or read Fred's talk and the supporting materials.
And, please make arrangements now for your directors to take in first-hand the
webcast of the "2nd
Annual Executive Compensation Conference" in October.
Fred has challenged us to implement some important changes – please let us
know about the changes you implement so that we can share with each other and
build some momentum before regulators (and the plaintiffs) try to tell us how to
run our business.
Thank you. And now to the questions.
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