March 28, 2013 Executive Compensation Executive & Director Pay Design Articles

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Executive & Director Pay Design

Four Principles Guiding Discretion

All businesses are inherently uncertain, which complicates business planning and makes target-setting and year-end decision-making for incentives a challenging endeavor. In these times of volatile national and global markets, the calls for adjustments to formulaic awards are becoming increasingly pervasive.

Add to these market factor a variety of unforeseen events both man-made: the political gridlock in Washington and the resulting fiscal cliff, sequestration etc. and natural: the devastating and disrupting effects on businesses of Super Storm Sandy last year and the Mississippi flooding the year before — and the challenges facing compensation committees with respect to the application of discretion are truly daunting.

In an effort to provide compensation committees some guidelines for using discretion, we offer a series of four principles to help guide the committee’s deliberations. The principles in aggregate suggest that committees should not be too quick to accede to management’s requests, and if the decision is made to do so, to proceed in a deliberate manner.

The limited use of discretion is further affirmed by the fact that the forces responsible for uncertainty (e.g., macroeconomics, political actions, weather, technology, commodity prices) generally affect results both positively and negatively and tend to balance out over time.

Principle 1: Management should be accountable for the actual results delivered and adjustments should be made only in exceptional circumstances

Management should be accountable for the actual results delivered and adjustments should be made only in exceptional circumstances (i.e., they should be small in number). There are three key points that should be considered here:

  • Adjustments should generally only be made for non-recurring items that were unplanned, uncontrollable, and material in amount. The first two conditions are fairly straightforward. If the items or events were planned and controllable, there is likely little argument that management should be held accountable for them. The third is a caution against the compensation committee having to consider a myriad of small adjustments that would consume the committee’s time with little real effect. Further, for every small event with a negative impact, there is likely a positive one that would cancel it out (if there were full disclosure).
  • Adjustments for unplanned items should only be made to the extent that they could not have been reasonably anticipated and planned for (i.e., planning failures are not items for adjustment) and/or mitigated on a timely basis. The fact that something was not planned for does not argue for obvious relief. Management should have the burden of demonstrating that appropriate diligence was shown in the planning process for considering all likely scenarios. A plan built on the “best case” alone is not sufficient. Further, even if an event could not have been reasonably anticipated, management should also show that once the event became known they acted quickly to take actions that limited the consequences for the business — there is no excuse for “being asleep at the switch.”
  • Adjustments should be symmetrical — in some cases adjustments will be positive and in other cases they will be negative. A balanced approach is needed to ensure that adjustments are not just driven by unplanned factors that adversely affect payouts, although these are naturally the most likely raised. The compensation committee also needs to uncover any other factors that have material unplanned positive impacts. In our experience these generally exist with the consequent effect that if a fair balance is truly achieved, the need to make adjustments is minimized.

Principle 2: All adjustments should balance the interests of shareholders and management.

All adjustments should balance the interests of shareholders and management. Generally if shareholders are experiencing poor results, then management should share in the burden, and vice versa. This principle is especially true when applied to the senior leadership team. It is hard to explain to shareholders, even in the most compelling CD&A, why senior management pay should not be fairly closely aligned with both the gains and losses experienced by shareholders. Of course, this outcome can be mitigated somewhat by good relative performance, even if absolute results are not forthcoming. In such cases, shareholders can take some solace that things may have been much worse were it not for the efforts of management. Thus, in most cases, unless there are very compelling reasons, discretion should not be used.

Principle 3: Adjustments that forgive management for making “bad bets” should be avoided

Adjustments that forgive management for making “bad bets” should be avoided — frequent forgiveness can create “moral hazards.” If such moral hazards are created, management may be motivated to take imprudent risks to obtain upside, under the belief that they will not be held accountable if they fail. The experiences of the recent financial crisis make us all too aware of the concept that bailouts (a form of relief) can create moral hazards in which the freedom from consequences can set bad precedents for the future. If management teams are not held accountable for poor results, they may be tempted to make even bigger bets in the future and expose the firm to unnecessarily high levels of risk in hopes of getting a big payout. Most firms have processes to guard against such risk-taking, but the board should be careful not to encourage such actions with poor judgments with respect to the pay program by making frequent discretionary adjustments.

Principle 4: Adjustments are not needed if the factors under consideration are already adequately addressed by other elements of the design.

Adjustments are not needed if the factors under consideration are already adequately addressed by other elements of the design. Of course the need for most adjustments can be obviated by a well-designed plan. Features such as rolling cycles where goals are reset every year, metrics are defined to exclude elements for which the committee believes management should not be held accountable (e.g., extraordinary charges), and averaging base years and end years (or multiple quarters) if a plan is based on growth are examples of how to avoid triggering adjustments through sound plan design.

If the committee does decide that action is appropriate, then the committee needs to decide who should participate in any adjustments and how large the adjustments should be. For example, we believe the following approaches could be used to address these questions:

  • If retention is the primary concern and the other grounds for an adjustment are weak, then the committee should consider the use of targeted retention awards that are meaningful in amount and thoughtfully deployed using well-thought out criteria.
  • If the committee believes that senior management should bear a loss in line with the shareholders or because management has primary responsibility for what transpired, then consideration should be given to excluding senior management from the adjustment.
  • Finally, the size of the adjustment should be determined, where possible, based on thorough analysis. For example, for one client that benefited from an unplanned sale of a business, we estimated the incremental gain above what investment bankers estimated was the going-in value of the business. This incremental value was then used to determine the size of the positive adjustment for those who were directly or indirectly involved in the sale.

Similarly, if forgiveness is involved, management should be asked to provide details on the reasons for any shortfalls and the magnitude of the contribution of each. This principle is illustrated by another client case in which management requested an adjustment for a major earnings miss. We worked with management to decompose the loss into its key causes: (1) weather; (2) changes in commodity prices (which caused virtually all of the loss); and (3) advances in technology (that had not been expected). The committee then had to decide whether these factors would balance out over time; and in the case of #2, could have been better hedged; and in the case of #3, could have been better anticipated.

We understand the difficulties committees face when having to use discretion. Based on our experience, we believe the ideas outlined above can make the process easier and more thoughtful.

[Endnote: Care should be taken when using discretion to preserve the deductibility of the compensation for Named Executive Officers whose nonperformance-based compensation would exceed $1 million. Although negative discretion can be used without deductibility issues, to use positive discretion in cash-based annual and long-term plans, a so-called 162(m) umbrella plan would need to be used. Under such a plan, a formula would be established to initially fund the award at the maximum payout allowed by the plan, and then negative discretion employed to achieve the desired payout. Equity-based plans are more problematic.]

View the full article as it was originally published.

Seymour Burchman

This article was originally published in NACD/Directorship.

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