Archive for the ‘CEO, Organizational Performance and Compensation’ Category

Executive Compensation is “Corrosive” and “Undermines Trust”: Connecting the Occupy Movements

I remember when US pay czar Ken Feinberg told a group of academics gathered at Wharton business school for a corporate governance conference to discuss the aftermath of the Global Financial Crisis that he was looking for independent compensation consultants and, to quote Mr. Feinberg, “there are no independent compensation consultants.” So he turned to academics. He wanted to study the claim by consultants that executives need to be paid extraordinarily high compensation or else they would migrate to other companies and jurisdictions, which – as it turned out – did not happen, Feinberg said, or is a “myth” as was stated in the UK this week. Addressing conflicts of interest by compensation consultants is only one of twelve reforms being urged by the “Final report of the High Pay Commission” in a scathing report released this week in the UK.

Reforms to the way executive compensation is set in the UK are forthcoming that may include significant and unprecedented changes – well beyond the structural Dodd-Frank reforms in the US. Changes that may be termed “radical” by some include: binding and forward-looking voting on compensation by all shareholders; having women and worker representation on compensation committees of boards; regulating remuneration consultants; regulating the disclosure, unnecessarily complexity and format of “fair pay” compensation; and having board of director positions advertised and applied for publicly.

A central theme throughout the compensation debate has been that boards and compensation committees – particularly in the US and UK but also elsewhere – have been incapable or unwilling to address the uncontrolled disparity between pay of CEOs compared to that of other senior management and, in particular, the pay of average workers, even throughout the financial crisis. The market is not really “free,” proponents maintain, but is in reality a “closed shop” (words of the Chairwoman Hargreaves of the High Pay Commission) (video). That is to say that pay is set by a small, heterogeneous, interlocked and self-selected group of management and directors. University of Delaware professor Charles Elson and his graduate student, Craig Ferrere, have documented an annual, compounded structural 17% increase in CEO pay over decades as a result of the way CEOs are paid at or above median and the marketing of peer group data by consultants. In some cases, exit pay packages for CEOs have been the hundreds of millions of dollars. The public outrage seemingly falls on some or many (but by no means all) tone-deaf boards and senior management teams.

All reforms are now on the table and the UK Prime Minister and Business Secretary Vince Cable have weighed in, including Mr. Cable expressing sympathy with the “Occupy” movement and calling the current system “dysfunctional” and a failure of corporate governance.

What the Occupy movements have done, it can be argued, is focus the discourse on the consequences of wealth disparity. Ted Talk by British researcher Richard Wilkinson, for example, talks about the harm to society that results from economic inequality, notably the gaps within (not between) societies, which include harms such as life expectancy, literacy, infant mortality, crime, teenage births, obesity and mental illness. (Credit goes to former York University student, Cliff Davidson, for showing me this link.) The link between wealth disparity and social harm is an “extraordinarily close correlation,” Professor Wilkinson states.

What the UK experience also shows is that regulators are prepared to step in and bridge gaps if industry proves incapable or unable to do so itself. In a speech I gave a year ago, I recommended that North American compensation consultants devise a code of conduct for consultants – independently developed and enforced – that includes consequences for breach, similar to regimes that lawyers and accountants have, or governments eventually would do so for them. John Tory was in the audience and endorsed my notion of industry leadership before government regulation. Regulation tends to have unintended consequences, and industry leadership is far superior to the former. Industry leadership unfortunately is not happening and is unlikely given vested interests. We have seen the consequences of inaction in the UK.

Why CEOs earn 400 Times Average Employee Salaries

I attended an American Bar Association seminar last week by telephone that was very informative. It was a presentation by an American colleague, Professor Charles Elson, and his graduate student, Craig Ferrere, on executive pay and the use of peer groups.

Background to Executive Compensation Reforms

Dodd-Frank (which is a significant piece of legislation in the US) is requiring that compensation committees that approve executive pay be composed of independent directors and that compensation consultants, when retained, also be independent. Sarbanes-Oxley (a similar piece of legislation enacted after WorldCom and Enron) adopted a similar approach mandating independent audit committee members and independent external auditors.

Dodd-Frank also will require (in regulation yet to come by the Securities and Exchange Commission in Washington) the disclosure, for each listed US company, of a ratio comparing CEO pay to that of the median (meaning, middle) pay of an employee of the company, and greater demonstration of pay-to-performance linkages. Dodd-Frank has also mandated that pay plans be put up for an advisory (meaning, non-mandatory) shareholder vote at least once every three years, otherwise known as “say-on-pay” votes.  The vast majority of say-on-pay votes have been approved.

Skeptics argue, however, that making compensation committees more independent, and mandating greater pay disclosure for shareholder approval, will not constrain pay, but may actually compound the problem, otherwise known as “the law of unintended consequences.” This means that with greater and greater pay disclosure, CEOs become competitive and greedy, saying to compensation committees, in effect, that they are worth more than another CEO, for example, and exert greater upward negotiating pressure on the committee.

Having a more independent compensation committee members may not, in and of itself, be adequate to respond to this pressure in the competition for executive talent. Nor will say-on-pay votes, as shareholders want the best CEO leading the company so that they will maximize their investment.

The skeptics may have been largely correct over the years, given that even with many of the above reforms beginning to be enacted and the global recession, CEO pay has continued to rise, at a 10-20 percent level.

The Structural Reason CEO Pay Continues To Rise Despite Reforms

A very important reason CEO pay continues to rise in spite of all these reforms over the years is related to the “Lake Wobegon” effect, which is a natural human tendency to overestimate one’s capabilities, and this means that the water continues to rise for all CEOs.

A problem is the way pay is actually calculated and compared.

Executive pay is calculated by comparing executive pay within similar companies, otherwise known as “peer groups.”  When the pay is compared, compensation committees decide whether they should pay their CEO at 50th, 75th or 90th %’ile when compared to the peer group. The peer group is a basket of companies that is very important, and executives will cherry-pick or favor certain companies that may not entirely compare to their company in terms of size, complexity or industry. Companies are compared using peer groups of similar companies, in other words, not individuals.

In addition, the vast majority of compensation committees will select either the 50th, 75th or 90th percentile for their CEO, for the simple reason that they do not want to signal to the market that their CEO, whom they have chosen, ranks in the 25th percentile, for example, or even below the 50th.

The implication of peer groups and percentile selection, combined, which constitute the primary tool of comparing and setting pay, therefore means that CEOs have a “built-in” increase of between 10 and 20% every year (or an average of 17%), which is compounded each year. This increase results from repeatedly choosing 50th, 75th or 90th percentile comparison of peer groups of companies rather than individuals.

The difficulty with peer groups is that they are predicated on the characteristics of the company, rather than the individual. Performance metrics of companies are compared and then the individual pay is “back-doored” based on the company’s performance. In addition, if a company within a peer group has a very successful year, all CEOs who use that company within their peer groupings will benefit regardless of their performance, which is unjust enrichment.

There are no widely accepted individual performance metrics, to complement or counter-act the systemic bias of peer groups and percentile rankings.  Imagine if you will that there was a CEO ranking based on a metric that was shown to correlate to corporate performance, and among individual CEOs so CEOs could be compared, such as “stewardship of assets,” for example.  CEOs could be ranked within an index, say Fortune 500, for Fortune 50, much the same way that mutual fund managers or even hockey players are (the number of goals, assists, etc.) are compared, over a 5 year period to counter act the effect of an anomalously good or bad year.

Professor Elson and his graduate student are working on a such a metric and index.  If they successful, this will begin to address the structural bias inherent in setting CEO pay.

Ten Suggestions to Reform Executive Compensation Oversight

I recently served as a compensation consultant asked by board and compensation committee chairs to recommend changes to a CEO’s compensation package. I was clear with the CEO that my client was the chairs, not the CEO, and my task was to embed best practices into the CEO’s compensation plan.

Here are the principles and touch points I employed. They do not necessarily flow from the above example, but also incorporate lessons learned over the years. The requirements for compensation committees are changing now, with guidance and codes arising from the BCBS, the FSB, the SEC (pdf) and the CSA (pdf).

1. Engage in CEO succession planning

Nothing handcuffs a compensation committee more, and gives an incumbent CEO greater bargaining power during pay negotiations, than the lack of immediate successors, internal or external. CEOs resist succession planning because it is not in their interest. The board should insist on regular, robust reporting on CEO succession plans, and do market checks. The board should own this process, not the CEO.

2. Ensure committee members understand the business.

The compensation committee is vulnerable to self-interested CEOs favoring certain metrics, or adjustments that result in enhanced bonus and equity. Members therefore must adequately understand the business and performance metrics that drive strategy and affect behavior to be the counter point.  Many compensation committees are not up to this task, in my view.

4. Have backbone and ensure no undue influence by the CEO.

A CEO may subtly co-opt and manage a compensation committee so it is composed of “friendlies,” who are sympathetic to the CEO, and resist full board involvement. Committee members need to have independence of mind, no personal relations with the CEO, and not be long serving. In two separate stock-option backdating cases I advised on, I recommended that the CEO not be in the room when compensation is discussed, and that a female director be recruited to sit on the committee.

5. Recruit a female director to sit on or chair the compensation committee.

If you think your compensation committee needs greater independence and expertise, bring on a female compensation consultant with 20 years experience who has done 50 compensation plans, including ones in your industry, with no ties to management, and then watch how things change for the better.

6. Use balanced performance metrics and stretch goals to drive behavior.

If a CEO is not listening to the board, or emphasizing certain things at the expense of others, change the compensation package. In my example, I recommended, modified and defined metrics in leadership, strategy, risk and financial, and customer, shareholder and board relations. The weightings, threshold and targets should be challenging and documented. There should be a balance between quantitative, formulaic, short-term metrics and qualitative, judgmental and longer-term ones.

7. Implement risk-adjusted compensation.

Compensation consultants are still promulgating the metrics that got us into the financial disaster. Risk-adjusted metrics and after the fact adjustments are however being requested by regulators. See my recent article (pdf) on this. Insist on tailored, adjustments to account for risk and compensation materializing before bonuses are awarded and equity vests. Compensation committees should have approval over pay of each risk-taker in the organization.

8. When hiring a consultant, ensure independence and knowledge of best practices.

Similar to non-audit related services, I would not hire a compensation consultant who works for a firm that provides non-committee related services to management. If a compensation consultant is doing his or her job properly, the CEO and senior management is likely not their biggest fan. Interests could even be adverse. Negotiation of terms, etc., should occur between the consultant and chairs. Chairs need to step up and inform CEOs of this new normal.

9. In linking performance and pay, document the “hows” and “whys”.

Regulators, shareholders and other stakeholders want to see how and why the committee and board made the decisions it did, in clear non-legal language. This does two things. It forces organizations to be transparent and accountable externally. Second, internally, it imposes rigor and diligence on the committee’s deliberations, reporting and assurance processes.

10. Involve key shareholders and chairs in compensation dialogue, without the CEO.

It used to be that CEOs did not want to leave the room during executive sessions. Now they are reluctant to leave the room during dialogue with shareholders. There should be a mechanism for the chair of the board and/or chair of the compensation committee to have direct exposure to, and hear views from, significant shareholders. The CEO should not interfere.


If a compensation committee does all or most of the above, there should be likelihood that shareholders will endorse a pay-for-performance plan.

Ken Feinberg on Independence of Compensation Consultants

Former Special Master for TARP Executive Compensation Kenneth Feinberg gave a key note address to a full room of 112 corporate governance academics from 27 countries being held at The Wharton School yesterday.

Mr Feinberg said he “remained dubious” of the argument that not paying executives what they believe they are worth risks that they will leave “to Europe or China.” 85% of the 175 people whose compensation fell under Mr Feinberg’s jurisdiction still are with the 7 companies that were under his purview, and he had not checked why the 15% had left.

In a humorous moment, he indicated the need to “get his own data” and finding an “independent compensation consultant,” at which point he deadpanned “There are none! So I went to the next best thing ~ academia.”

In a Q and A session to follow, in response to his view on the causes to the global financial crisis, Mr Feinberg remarked that “I do think, in a Washington / lay opinion, from someone who was a former chief of staff to Senator Kennedy, that the financial crisis had more to do with external absence of governmental regulation… The Reagan revolution went too far,” he said.

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