inside the boardroom

By DavID W. aNDErsoN, MBa, PhD, ICD.D The anderson Governance Group

Earning their pay:

How Directors Can Make Better Decisions in Compensating Executives

utrageous executive pay gets much attention. it foments shareholders distrust of boards and eats at the publics confidence in our economic model. But most executives are paid unremarkably and get correspondingly little media coverage. rarer still is a view into how boards of directors arrive at their pay decisions.

Paying a CEO to leave while promoting from within

Ownership structure: a publicly listed company with over $1 billion in revenue, with a private equity firm holding a controlling interest. Situation A: the board faced a challenging situation and a threat to its credibility. the company had posted two years of poor corporate performance, with no reasonable prospects for recovery in the short term. the share price was near historic lows and trending downward, as the market signalled a lack of confidence in managements recovery plan. Looking at these factors (and a recent ceo assessment), the board judged its long-serving chief executive incapable of turning the company around. Behaviour and judgement: the board decided it needed to act quickly; it fired the ceo, paying out the provisions of severance, which was three years salary. the board then appointed a successor from within the management ranks, signing the new ceo, for expediency, to the same contract as governed the employment of the former ceo.

in this article i offer three examples of specific executive-pay decisions, drawn from my experience with a range of organizations: 1. Paying a CEO to leave while promoting from within; 2. Hiring a CEO from outside with appropriate pension credit; 3. Setting incentive pay in volatile markets. in each case, i provide context by indicating the ownership structure and nature of the situation facing directors, followed by a description of the behaviour and judgement shown by the board, and the ensuing implications. i conclude each case with learnings and suggestions that directors may find useful in deciding pay for their own executives.

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inside the boardroom | Case studies

Implications: in its haste to install a new ceo and get the company back on track, the board failed to take proper note of all the aspects of the employment contract in particular, the three-year severance provision. this obliged the company to pay three years worth of salary to an executive who did not have the same lengthy tenure of the first ceo, for whom the provision had been considered reasonable. Situation B: the new ceo proved no more capable of putting the company on a prosperous path. the company continued to experience major problems trying to adapt to difficult market conditions. corporate performance did not recover, customers became increasingly concerned, and morale flagged within the organization. Behaviour and judgement: concluding it had made the wrong choice, the board acted to save the company by replacing the ceo less than two years into his term. Because of the severance provision in the contract, the ceo received a parting cheque for three years salary. amazed at how they had missed this detail in signing up this ceo (and being critical of the compensation consultants who had not advised changing it at the time), the board negotiated a two-year severance provision with the next ceo. Implications: after four years of overseeing poor corporate performance, the board was embarrassed when it learned and more so when it was disclosed that a two-year ceo was leaving with an extra three years pay, after having not delivered on expectations. analysts and shareholders were forthcoming in their criticisms, as pay for non-performance is the surest way to raise their ire. the newest ceo readily accepted the two-year severance provision, showing that it was not a necessary inducement to attract talent. the board understood that it is easier to get the terms right when an executive is eager to accept the top job than to get a sitting ceo to give up contract provisions in his or her favour, despite the reputational risk to the company. Learning and suggestions: as a consequence of this experience, the board made a point of reviewing in detail all executive employment contract provisions, asking itself what provisions were necessary to offer competitive pay packages, as well as how shareholders

would judge the economic efficiency of the terms. more important, the board insisted that future pay packages be subjected to rigorous scenario testing prior to approval (a requirement now codified in recent u.s. legislation1). this discipline ensures that the board knows in advance how a compensation plan would pay out under various terms and conditions. such information allows a board to negotiate firmly with executives, having explored and documented the risks inherent in the plan notably when facing poor performance and severance. all boards should adopt this practice, and boards of publicly listed companies should disclose the scenario tests and outcomes of approved senior-executive pay plans. this approach is the best way for a board to judge the appropriateness of its pay plans, and creates external pressure on boards to better balance executive and shareholder interests.

Hiring a CEO from outside with appropriate pension credit

Ownership structure: a widely held public company with market capitalization over $5 billion. Situation: With the company possessing an enviable track record of corporate performance, the ceo decided to retire. the board conducted a thorough search and settled on an external candidate with the right mix of experience and vision to offer sufficient leadership continuity while bringing a new perspective. this candidate had himself recently retired from an executive role in another company and had commenced receiving a pension based on over 20 years service and his (non-ceo) executive-level earnings. it would not be uncommon for a ceo candidate being recruited to a new company to negotiate full credit in the pension plan for the years served in the prior organization after all, the company is paying the executive for that experience. For this ceo, however, the higher earnings (above those received from his former executive position) would translate into a considerably higher pension outcome and represent a significant pension liability to the company if applied to his full, prior service. Behaviour and judgement: the board considered these factors carefully and strove to balance the need to recognize prior experience, precedent,

1 Dodd-Frank Wall street reform and consumer protection act, signed into law July 21, 2010.

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inside the boardroom | Case studies

the financial demands on the company should full prior service be credited, the fact that the new ceo was already receiving pension benefits, and stakeholder perceptions. the board decided, upon the recommendation of its internal compensation staff, to recognize five years of prior service in the pension calculations by doubling the pension benefit earned each year for five years. additionally, the former pension, prorated to reflect five years of service, would be subtracted from the ultimate pension benefit, requiring the company to pay the difference. Implications: this approach provided a built-in fiveyear retention component by stretching out the period over which prior credit would be given, and limited the financial impact on the company for supporting this new ceos pension, recognizing 10 years of pensionable service, rather than 25, after five years. the candidate agreed this was a reasonable compromise and accepted the role of ceo. Learning and suggestions: Boards have the challenging task of understanding and balancing competing interests, and applying their judgement to situations where standard practice does not return a fair result to the company. a board should take care to communicate its rationale in the negotiating phase and show resolve when it has determined a fair balance of demands against its objectives. Further, this example shows that boards can benefit from listening to their own internal compensation staff when that staff demonstrates competence, creativity, and dedication to corporate interests, and the good judgement the board expects of itself.

formula agreed with executives in prior years and using comparative data from 2007 the latest data upon which comparative analyses were based. Behaviour and judgement: realizing that the consultants recommendations would have resulted in unusually large financial gains for executives should the market recover as a function of both a relatively large number of options being granted and a highly favourable strike price the board rejected the recommendations. arguing that drastically changed economic conditions justified changing the formula agreed upon with management, and that the 2007 comparative data would not reflect the decisions of other boards in 2008 who, like themselves, were facing a different market reality, directors decided to apply their own judgement to those benchmarks in light of macroeconomic indicators. the board prospectively reduced by 25% the number of options that would otherwise have been granted. Implications: By changing the formula to grant fewer options than expected, the board upset the management team. however, this judgement turned out to be sound, when in 2009 it became apparent that other boards had taken similar actions, and that improved macroeconomic factors meant executives would indeed have gained significantly more financial advantage based on stock appreciation not attributable to their leadership. Learning and suggestions: Wildly oscillating market conditions make the directors job of setting executive pay more difficult. historical benchmarks become less reliable and thus cannot be given the same weight or applied mechanistically. past agreements with executives determining the number of options or strike prices may no longer be justified. Directors and their advisors should view benchmarks with reservations, revise pay formulas for which previous assumptions no longer hold, and apply judgement proactively in light of prevailing market conditions, so that the effect of their pay decisions returns the desired result: reasonable pay for performance that is directly attributable to executive leadership. David anderson is president of the anderson governance group. he can be reached at david.anderson@taggra.com or (416) 815-1212.

Setting incentive pay in volatile markets

Ownership structure: a public company with market capitalization over $750 million. Situation: toward the end of 2008, in the immediate aftermath of the global financial crisis, the board found itself looking at recommendations for options grants to senior executives. the crisis had resulted in a considerable reduction in the companys share price, as it did for most issuers. Following standard procedures, the companys compensation consultant devised these option grant recommendations based on a

This article originally appeared in the Director Journal, a publication of the Institute of Corporate Directors (ICD). Permission has been granted by the ICD to use this article for non-commercial purposes including research, educational materials and online resources. other uses, such as selling or licensing copies, are prohibited.

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