Compensating Executives in a "Challenging" World

The rationale has always gone something like this: if you don't compensate your executives at least equal to their peers and if you don't reward their performance, you will never have a top tier executive group and your company will not succeed.

Is that statement true? Is part of it true?

We're getting much closer to finding out. The big news this proxy season is from shareholder proposals on executive compensation. That's right -- since Say-on-Pay votes are non-binding, shareholder groups are looking to force companies to put components of executive compensation to a binding shareholder vote.

Before getting into a few details, let's understand how most companies are reacting. It's not surprising, but as a group, large corporations do not think their shareholders understand executive compensation. They are seeking to keep these votes off of their proxies. As a precursor to doing so, they request what is known as a "no-action letter" from the Securities and Exchange Commission (SEC). In brief, when a government agency issues a no-action letter, it assures the requestor that it will not take action on a given issue. So, when a company seeks such a letter from the SEC, the company is asking the SEC to confirm that it will not take action, for example, for a failure to place a particular item in its definitive proxy.

One of the most ardent submitters of executive compensation proposals is the largest American labor union, the AFL-CIO. In a statement, the AFL-CIO said, "We opposed compensation plans that provide windfalls to executives that are unrelated to their performance."

On its surface, that seems very prudent. But, it may be a bit trickier in practice.

What makes compensation related to performance? How does one define performance? Is compensation as expressed in the Summary Compensation Table? Is it cash only? Does it include equity? Does it include the (proxy-includable) value of deferred compensation?

Here is how it would strike me.

• Base pay is not related to performance. But, generally, to the extent that such pay is deductible to the employer under Section 162(m) ($1 million pay cap), some observers will not consider it to be egregious. On the other hand, in today's world of pay ratios and calls for increases in rank and file wages, other observers will ask that it be capped at some multiple of either the median pay for the entire company or even that of the lowest-paid employees of the company.
• Bonuses are theoretically related to performance. To the extent that the criteria used to evaluate executive performance and by extension, executive bonuses, are appropriate, so should those bonuses be. To play devil's advocate, however, if an executive knows how her bonus will be calculated, she may take inappropriate risks (for the company) in order to maximize the expected value of her bonus. Similarly, she may find ways to accelerate certain items into the fiscal year in question while deferring others until the next year. 
• Long-term incentives are [nearly] always performance based. In today's world, it is expected that those incentive payouts will be based on the achievement of a set of goals related to metrics deemed appropriate for that executive. Often, there are circuit breakers (elements that if the executive fails to meet a pre-established minimum level of performance, he will not receive a payout or that part of a payout at all). But, long-term incentives are often paid in company equity. This means that compensation will, to a large extent, be tied to share price. As we know, however, share price is not always tied to corporate performance. On any given day, share price may be influenced by such as the state of peace or war in the Middle East, a speech given by the President of the United States, or the rise or fall of housing starts during the last month. 
• What about deferred compensation (here I am referring to traditional deferred compensation plans, either defined benefit or defined contribution)? It's rarely performance based. Theoretically, the company is paying an executive less today for a promise to give them some of that pay in the future. What sorts of plans should be challenged? If an executive voluntarily defers some of their compensation and it grows at a rate tied to some broadly investable index, is that okay? Suppose she has a DB SERP that looks just like the broad-based plan (qualified plan), but without limitations applicable to qualified plans. Institutional Shareholder Services (ISS) is generally fine with this, but major labor unions may not be. And, if that SERP looks very different from qualified plans, even if there is a good reason for it, this may be a situation where no institutional shareholders are satisfied.

What should Boards of Directors and their Compensation Committees do about all of this? ConocoPhillips shareholders are asking that the Compensation Committee develop a program to determine which portions of a bonus should be paid immediately, which portions should be deferred, and what adjustments should be made to those deferrals based on performance.

Perhaps this has some merit. If it does, however, it's a bit of a nightmare for people who need to figure out how to make such a plan 409A-compliant and for those who need to administer FICA tax payments.

On the other hand, if adjustments are to be made based on performance, can't the same executive who is able to manipulate performance metrics in the LTI scenario described above also find a way to manipulate them here? Where there are objective formulas, there are smart people who can figure out how to game the system. Where there are subjective evaluations, Boards will be accused of pandering to the executives of the companies.

More than ever, the Compensation Discussion and Analysis (CD&A) will be very key. Explaining why the mix of objective and subjective factors was chosen can go a long way to appeasing large shareholders. Explaining how levels of compensation were chosen is a must. And, for the first time, we may see companies rationalizing their levels of executive pay as compared to rank and file pay.

With all of these challenges to executive compensation, these are challenging times for Compensation Committees.