CEO Pay—Can We Get It Right?

Editor’s note: This is the second in a two-part series on the subject of CEO pay.

Last month’s column examined shareholder anger surrounding the dramatic rise in CEO pay and outlined how executive compensation reached the sorry state where it is today. We also discussed why many shareholders are clamoring that pay is too high, while a number of knowledgeable observers believe pay actually is appropriate.

That column identified several key questions about CEO compensation, with a promise to address them in next month’s column. Well, next month is here, and the answers are below.

Are boards letting chief executives set their own pay packages, or are the boards effectively negotiating in the best interests of shareholders?

That depends on which company you’re talking about. Yes, some boards are still mired in the past, where the Chairman/CEO has undue influence on the pay package. The too-cozy relationship between directors and the chief executive results in more of a rubber stamp than a true negotiation.

Experience shows, however, that many companies today—probably most, and definitely most large companies—no longer behave this way.

Their boards and compensation committees are largely (or almost entirely) comprised of independent directors, and while they work closely with the CEO, they have an independent mindset. They understand and embrace their duty of loyalty and indeed put the company’s and shareholders’ interests above all.

Setting CEO pay is a challenge, especially when trying to lure an accomplished, successful leader from another organization. That individual needs to be persuaded to walk away from what often is a large pay package (including options that may be vesting soon), and a track record of success providing a sound basis of job security. Directors know this fact of corporate life, and they need to deal with it on a very pragmatic basis. This likely requires agreeing to some type of change in control and other severance arrangement, should events fare poorly. How well boards have found the right balance is open for debate. But deal with it they must.

It’s significantly easier to negotiate pay when promoting an executive from within. Other than the relatively few instances where the executive has built a strong reputation outside the organization, the compensation committee can set pay somewhere above the executive’s current compensation, with appropriate incentives to align shareholder and CEO interests. The negotiation process usually is very much simplified and tends to work well for all.

Going back to the stated question: Yes, I believe that in today’s environment the vast majority of boards and compensation committees do negotiate pay with the CEO. They are not beholden to the CEO. It’s also fair to say that some do a much better job than others.

Where is shareholder “say on pay” going, and what will it accomplish?

This train has already left the station and there’s no turning back. One American company, Aflac, has already given shareholders a non-binding vote on executive compensation. It won’t be the last. Reports indicate that last year investors filed 60 resolutions asking for a say-on-pay, receiving an average of about 44 percent of the vote. This year, more than 90 resolutions have been filed and at least a half-dozen have received majority support.

Investors point to Britain and Australia, where say-on-pay has been common for years. Many believe those votes have helped keep CEO pay levels in check, although recent reports say CEO pay of the largest British companies rose 33 percent last year. In the United States, bills are circulating through Congress that would require shareholder advisory votes on compensation. The impetus is clearly in place, and there’s little doubt say-on-pay is coming on a broad basis.

One interesting hiccup has happened at several companies stung by the credit crisis, including Citigroup, Merrill Lynch, and Morgan Stanley, where shareholder proposals for say-on-pay got 37 percent of votes, down from 43 percent the prior year. I believe this is an aberration in the trend, and we will see more votes going for non-binding say on CEO pay.

Is this a good thing or a bad thing? Here again, as with most of these issues, the answer depends on one’s perspective. Shareholders fed up with escalating CEO pay are pleased to be able to vote, with some seeing it as a first step in actually participating in determining CEO pay.

But beyond appeasing investors and letting them speak their minds (which is a good thing), I and other governance experts see say-on-pay as a bad idea. The notion that shareholders can do a better job than boards at setting CEO pay, when shareholders have limited information and a weaker grasp of corporate strategy, is absurd. Yes, shareholders should have relevant information (discussed further below), but there’s no way they can (or should) be involved in making these decisions. This is the board’s job, and the board is best positioned to do it. If shareholders don’t like how the board is doing its job, they can act on that notion—which is a whole other issue to be addressed some other time.

Where do we see CEO pay going in the coming years, and does this make sense?

CEO compensation is likely to evolve in a number of ways. The spotlight on compensation committees is having an effect on how they operate, and further changes are forthcoming—or perhaps the same changes on a broader basis. Compensation committees of many boards are doing a better job of aligning the CEO’s interests with those of shareholders. They’re taking more care in developing pay packages with a better mix of components, such as restricted stock, performance options, and longer vesting periods. They’re hiring their own compensation consultants and also taking other actions outlined below in response to the next question.

No one can know whether compensation across a broad spectrum of companies will go up or down. My sense is that is will come down. But in any event we can expect to see better alignment of interests, with a closer correlation of the long-term fortunes of CEOs and shareholders. Importantly, we can expect to see much greater care with change-in-control and severance provisions, also discussed further below.

What can, and should, boards and compensation committees be doing to do their job right?

Here’s what boards and compensation committees should be focusing on:

Real negotiation. Compensation committees recognize that they set CEO pay, but in some cases there’s been a good deal of passivity (although less now than in the past). It is essential that pay be set through a meaningful negotiation. No one, certainly not the CEO, should be allowed to dictate his or her own pay. The compensation committee needs to have its own compensation consultant and be armed with information needed to act with authority. Of course these discussions should continue to be cordial—after all, the trust and working relationship between the CEO and board needs to be maintained. But negotiation it should be; and as we all know, you’re not negotiating if you’re not prepared to walk away from a bad deal. Discussions shouldn’t get to that point, certainly. But if push comes to shove, it needs to be an option.

True pay for performance. Many board compensation committees have been doing a much better job at paying for real results. For the reasons described last month, it’s not a matter of simply tying CEO pay to stock price, or totally ignoring how the marketplace values the company’s stock. Performance needs to be measured based on a number of factors, specific to each company. There should be clear alignment to the strategic plan, along with forward-looking metrics that drive long-term share value. And the pay package should have the right mix of components, typically including base salary and bonus but also elements such as restricted stock, performance options, and meaningful vesting schedules that truly align the CEO’s and shareholders’ interests, and provide the right motivations—and accountability—for outstanding performance. An area requiring particularly strong focus involves change-of-control and severance provisions, which must be carefully crafted to avoid some of the absurdly huge windfalls bestowed upon unsuccessful chief executives. These provisions need to undergo scenario analysis and stress testing to ensure they will appropriately fit any reasonable eventuality.

Transparency. Shareholders have a right to receive meaningful information about CEO pay, and the board and compensation committee have a responsibility to provide it. Securities and Exchange Commission rules mandate disclosure be reasonably comprehensive and in plain English. The rules accommodate a need to avoid disclosing matters that would provide advantage to competitors, and despite some false starts in such disclosures, there’s room to accomplish all objectives. Providing relevant and appropriate information to shareholders takes thought and care and should be done in a meaningful fashion.

Many boards right now are doing these things well. And it’s really not rocket science. It involves having in-depth knowledge of what the company is about, where it wants to go, and how it plans to get there; of sound compensation practices; and a desire to recruit or retain the right person to lead the company at a cost in line with the value that individual provides. Every company’s board needs to get this right.