Management Compensation
Our Best Practices View:
Management pay must serve to align the interests of the management and shareholders. It’s this simple, but most corporations, regulators or even fund managers do not get it.
So let us go point-by-point about compensation:
Compensation Advisors:
Pay consultants in their current form are useless at best.
Boards engage consultants mainly to provide comparisons with other companies’ compensation levels. The “thinking” behind this comparison is that the company needs to be competitive in attracting and retaining top talent. However, this is ridiculous because most top executives are promoted from within, and the competition for the positions is limited. What compensation consultants do not do well or at all is determine the appropriate incentive structure that will maximize shareholder value. While insiders scream, “one size does not fit all” in response to any kind of shareholder proposals, they do exactly that when it comes to pay. They focus mainly on comparisons, not what is appropriate for their business model. Keeping up with the Joneses is the name of the game, regardless of how thoughtless or irrelevant compensation structures are in other firms. And this is why everyone jumps off the cliff at the same time.
Still, there is an even more sinister part of all this. Compensation consultants are hired by the same people whose pay they purport to analyze. OK, the compensation committees often hire them. However, the members of these committees are directors who depend on the CEO for nomination. Frequently they are elected by plurality and without any choice. Even worse, sometimes several pay consultants are hired. Then the report from the “best one” is cherry-picked. Complete consultant reports and a list of all of the engaged pay advisors are usually not transparent. Bottom line: compensation consultants have conflicts of interest. They will be rehired if they justify the management’s wants. How useful is this for shareholders?
There are several proposed solutions to compensation consultant conflicts. One is for shareholders to just be dismissive and ignore pay consultant reports entirely. The other is to forbid the board to hire them because they are a waste of company resources.
We believe that there is a place for compensation consultants, but there have to be some changes:
- Their mandates must be to design management compensation that aligns management and shareholder interests.
- Compensation consultant appointments must be confirmed by a shareholder vote in the same way as auditor appointments are.
- We do not cherry pick auditor reports. The same should go for pay advice.
- Just as the case with auditor reports, complete compensation consultant reports must be publically available.
- Having board participation from shareholder-nominated directors will go a long way to properly select and contract with a compensation consultant.
That is now a bit more useful.
Option Backdating
Imagine buying a stock option – the right to buy Company X shares in the future at a fixed price set today (strike price). Now imagine that Company X share price crashes. Bummer! Your option becomes nearly worthless because it is “out of the money.” You would not want to exercise your right to buy shares at a strike price that is higher than the market price. That’s the rough and tumble world of finance.
Now imagine a magic fairy… with wings. It sprinkles some pixy dust and decreases the strike price of your option as much by as the stock crashed. Now we are talking!
Well, guess what: the magic fairies works for top executive of companies in your portfolio. When company value falls purportedly for reasons outside management control, management options are often “backdated” to reflect the lower starting valuation. The theory is that without backdating, the management no longer has enough incentives to stay on the job or to do a good job. There is legal and illegal option backdating. It is illegal when not properly disclosed. Backdating is legal if properly disclosed and recorded on company’s books. Yet, just because it is legal does not mean it is a good practice.
If option backdating could really be justified, then it would apply not only in cases of a fall in value that is outside the management control; it would also apply in cases of an increase in value outside of management control. However, no one has ever heard of the latter.
Option backdating is a result of a failed “ex-ante” (starting) compensation scheme, supposedly designed by the pay advisors. If compensation packages were structured with real long-term views, real vesting and golden handcuffs instead of parachutes, there would be no need for backdating. If long-term options are awarded over time, both high and low values of shares would be reflected in the long-term compensation. Tough conditions? Well, shed no tears for the poor executives. If your compensation is in the millions, at least ya gotta work for it.
Shareholder Advisory Vote
“Shareholder advisory vote” or “say on pay” is a common proposal to allow shareholders to express their view on the compensation package. Many corporate insiders argue (lamely) that it would be a distraction for the management to try to defend their pay. They claim that the compensation committee and the compensation advisors are the proper entities to decide on pay.
However, we already see what is going on with corporate compensation under the status quo. It is senseless and out of control. Members of the compensation committee are nominated to the board by the management. The management or the directors whom they nominate hire compensation advisors. Doesn’t that smell just a little fishy?
Finally, what exactly do they mean when they say that defending their compensation to shareholders is a distraction? Anyone who ever had a boss or a client knows all about this distracting, pesky thing of having to defend and report on your progress, activity, and achievement. Who wouldn’t like to be left alone to be a maverick? It is absolutely absurd, but also telling that titular managers and board members feel that defending their record is an unnecessary distraction.
Some shareholder activists argue that an advisory vote is too weak. They say it has no teeth, and that the resolution of the shareholders on compensation should be mandatory. Perhaps. However, we do not think the advisory vote has no teeth. If directors do not try to change compensation, they will receive majority against or withhold votes at the following election. Even in a plurality situation, this will invite a proxy fight.
A mandatory vote “NO” would be confusing and have even fewer teeth. It would be impractical for shareholders to instruct the board exactly how to change the compensation structure. The board could merely change the pay structure nominally and claim acquiescence to the shareholders’ vote.
Pay Caps
Some suggest that compensation caps imposed on TARP recipients by the Government should be the best practice in general. We do not believe that rigid limits make for the best practice. While compensation caps can be useful in some situation, generalizing this could undermine and limit commercial opportunities. For example, Citibank was forced to offload its Phibro arm, a very profitable energy trader, because its executive compensation was not politically palatable to the Government. The Phibro team could actually move anywhere, and their compensation reflected the business that they have built. This was Citibank’s loss and Occidental Petroleum’s gain. Compensation should be restructured to be more long-term. It has to emanate from long-term results and tough conditions on long-term shareholder value. Caps may come into play at times as a part of a well thought-out compensation scheme, but they should not be universal.
In Summary:
There is no free lunch or easy money. A huge pay package must come with strings attached.
We will treat compensation consultants with extreme cynicism. We will support resolutions, requiring the maximum disclosure of compensation consultant reports and shareholder approval of their engagements in the same way as auditor appointments are approved by shareholders.
We are cynical of option backdating. Barring a very compelling reason, we will seek to withhold votes from directors who approve backdating, even if it is legal.
We will support shareholder say on pay resolutions. We will also seek to withhold votes from (vote against the) directors who do not adequately respond to shareholder demands to change the management compensation.
Finally, we will not support shareholder resolutions calling for pay caps, barring a very compelling reason.
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