By Edgar H McGaughey III
In 2010, CEOs face the third round of regulatory changes in six years. Some of these changes are subtle, but not insignificant. Others are moderate and have the potential to be far reaching. Each year, Pearl Meyer & Partners catalogues the top ten executive compensation issues for CEOs and Boards.
New Challenges and More Ahead
CEO compensation will remain in the limelight again this year. Media reports continue to adapt an all too typical perspective, blaming high CEO pay for a variety of economic and financial market woes. During 2009, the general bias against executive pay was further bolstered by a perfect storm of equity price declines, earnings shortfalls, financial institution failures and a very active Congress and White House committed to going after those at fault.
When it comes to CEO compensation, regulatory controls, tax changes and expanded reporting are still works in progress. From a shareholder perspective, say on pay is just around the corner. Yardsticks for voting guidelines have expanded among institutional shareholder services groups such as RiskMetrics Group (RMG) and major institutional investors and are increasingly focused on poor, and a new category of “egregious,” practices characteristic of some CEO pay packages.
What do these changes mean for the CEO of a public or private company who has or will form a Board for either ongoing oversight of the shareholders’ interests or preparing to take the company public? Is there an upside to focusing on governance if there’s no requirement to do so or if there is already a governance committee who has that responsibility?
In reality, the CEO is the point person, parting the grass, strategically looking over the next challenge and marshaling resources. Staying on top of regulatory and institutional challenges makes sailing smoother. Furthermore, good governance, like company growth and profitability, is as much of an outcome as it is a process. The old three-legged stool analogy works well for good governance: transparency, openness and frequent communications. Employing these principles is critical to building successful programs including compensation and benefits, succession, training and readiness.
Given that the large majority of CEOs have bigger issues to cope with in running a company, one must ask: What is the upside for the CEO in these times of increased shareholder activity, reporting and regulation? In short, the answer is “run a tight ship, review programs in light of stated pay philosophy, be honest and transparent in decisions and keep pay in line with performance.” The ramping up of the administrative and control systems and structures pertaining to executive compensation are not relegated to public companies.
The boards of private companies are focusing more on these areas because doing so results in better working relationships between ownership and management and a tighter link between owners, the board and management.
The CEO as the NEXUS
The CEO is in the center of the corporate sphere and must balance the interests of the shareholders, the board and the entire organization and all of its human and capital structures. Being fully aware of the perspectives and responsibilities of the board as the shareholders’ elected representatives (of which he or she often is as well), the CEO should be aware and take ownership of those emerging forces, specifically those that can better hone the organization’s culture and improve its image in the market and community.
Issues and relative importance vary by company. We invite you to review the listings that follow as an audit tool. While all the criteria in Pearl Meyer & Partner’s top ten lists have some tentacles to reporting and compliance, some will have more relevance than others as CEO challenges.
The CEO as the principal executive officer and signatory of the management discussion and analysis (MD&A) and now the compensation discussion and analysis (CD&A) is accountable for the accuracy of filings. Misstatements have serious and potentially criminal consequences. As the SEC ramps up the CD&A to the level of the MD&A with risk analysis, accounting tables and termination costs, the proxy is no longer an informational tool it is now like the MD&A – a “filed” report and the focus for the past two years has been to continue to ramp up its scope and level of disclosure.
The increase in reporting for the CEO as the principal executive officer and the CFO as the principal financial officer now takes a multiple of the time historically spent on the proxy. Furthermore the institutional services’ governance rating scores and ability to significantly sway voting outcomes via their recommendations have taken on a momentum of their own.
Based upon client input, client board agendas for 2009 and 2010 as well as our general experience in supporting CEOs, Chairmen and their boards, PM&P has updated the list for 2010. The new and previous lists amount to best practices for the CEO.as well as his or her Board. The new list for 2010 is more forward looking and hones in on a stronger linkage between pay and performance and being better prepared for the future increased involvement of owners and shareholders.
One thing is certain. The CEO will continue to face more regulatory issues that take time and require additional commitment of resources. Building more transparency into the reporting process (what the regulators want) should be looked at as a by-product of pursuing the optimum levels of measurement systems, controls and information systems you need as a CEO to better communicate with management, employees, boards, and shareholders.
1 Consider the Optics
Shareholder and institutional pressures focused in on excessive executive contracts, gross-ups for golden parachute arrangements, mega-grants of stock, high fixed compensation and evergreen contracts. SEC expanded disclosure rules of 2006 were implemented requiring not just tables but explanations of how and why payments were made.
2 Corporate Governance
Board member time commitments for the compensation committees started to approach that of the audit committee, independence of committee members, meetings without management increased and proxies lengthened by a factor of 4x.
3 Say on Pay
European exchanges and pension groups followed by U.S. pension fund administrators (followed by failed attempt in 2009 to be enacted by Congress) increased emphasis on the move to advisory shareholder votes and access to the ballot. Some elements of the effort were enacted into TARP legislation and other larger firms adopted advisory votes on executive compensation. Say on pay in some future form is a reality.
4. Assessing Risk in Compensation Plans
The impact of adverse risk taking borne out of the design of the company’s incentive plans or compensation arrangements increased rapidly in importance in 2009 to become a disclosure item for 2010.
5 Addressing Underwater Options
With the sharp declines in the market many firms found their workforce with options significantly under water. Remedies for addressing them are limited, require shareholder approval and most often for several reasons don’t work for the CEO.
6 Adapting the Pay Program to a Down Economy
Re-tooling for working out of an earnings decline, pricing pressure for goods and services required a re-think of executive and employee programs to encourage the right kind[s] of performance, to set realistic expectations and outcomes and to adapt programs to be more realistic while keeping key talent.
7 Selecting Measures and Setting Goals
The process of re-tooling involved and still involves a careful look at value drivers, achievement hurdles or thresholds that reflect meaningful performance. Being willing to look at relative performance in different perspectives; looking at operational and marketing goals that will or should be harbingers of increased efficiency and competitiveness; being flexible, willing to adjust midstream and not be overly punitive or generous, and using discretion when it is the right thing to do. Would an independent and objective analysis support the goals and rewards for the outcomes?
8 Managing Career Compensation
Boards and owners as well as CEOs most often look at the year’s performance, the executive’s performance, his or compensation and the holdings. Many boards are now looking at tally sheets or wealth accumulation pro formats that look forward in a way that helps structure and assess the current practices and shed light on different approaches regarding compensation mix, risk versus reward potential and performance over the same period as pay. Outcomes vary but a different perspective is provided to guide future pay.
9 Stock Ownership Guidelines
Stock ownership and retention programs became a check off item in the good governance list over the past three years and now is a common requirement for public companies whereby the CEO is required to hold 3-5 times his base salary in stock within 3-5 years from inception of the program. The requirement scales down with levels of the organization, most often going down through the management layers.
10 Peer Group Selection
The SEC’s expanded proxy disclosure rules of 2010, cover, among 18+ other items, one of which in the benchmarking discussion is the peer group. As companies compare their pay packages to their competitive industry, measure their stock usage against their peers and often structure incentive programs both long and short-term that are relative, the importance of selecting the right peer group (given the disclosure and discussion of relative outcomes) has taken an extra ordinary amount of time in the board room and in the CEO and his or her team’s analysis.
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