Few chief executives would concede, at least publicly, that they are overpaid.
Yet the issue of CEO and executive compensation has been simmering away for some time. It is now threatening to boil over following the US sub-prime crisis and its disastrous aftermath around the world. It is a sensitive issue for many CEOs and for the boards of the companies that employ them.
With executive pay a readymade excuse for grandstanding of all kinds, many CEOs will quite sensibly take the view that the issue will eventually run out of steam. They may feel (with considerable justification, it must be said) that in the present overheated climate it has become difficult, and perhaps impossible, to engage in a rational and informed discussion of the subject.
Australian executives might also feel that they are being blamed unfairly for the sins of their American counterparts. As columnist Robert H. Frank noted in the New York Times recently, voter outrage in the US over exorbitant executive pay has been mounting. “After all,” Frank wrote, “the government has just had to bail out financial firms that paid big bonuses last year to many of the same executives who helped precipitate the current financial crisis.”
It is hard to level the same criticism at Australian executives. For a start, few local executives have ever enjoyed the absolute pay scales and large bonuses as those routinely received by their US cousins, particularly in the financial services sector.
Still, it would be unwise of Australian CEOs to ignore concerns about these matters.
Investors and media concerns focus on the salaries, short-term incentives and, in particular, the long-term incentives paid to the C-level executives of listed public companies.
Amounts earned by private company executives and the bosses of hedge funds, private equity houses and the like, have generally remained below the horizon largely because such information is not public knowledge. By way of contrast, when an executive is among the highest paid in a public company, all details of their remuneration must be disclosed to investors.
The history of this disclosure shows that, on average, increases in public company CEO and senior executive pay over the past 20 years have consistently outstripped rises in average wages, growth in company profitability, and total shareholder returns. Various commentators have said that CEOs of public companies have substantially increased their incomes and wealth relative to most other groups in the community and, in many cases, relative to the owners of the companies they manage.
These cries, however, are generally made in the absence of remuneration information about all of those organisations and sectors that do not disclose such data and there are many of them including private equity groups, private companies, professional services firms, small business owners and more.
Public company CEOs, (and, in reality, it’s probably less than 100 of them) have been singled out as the cause of the economic problems in Australia and at the same time, the beneficiaries of so-called ‘excessive’ reward to the exclusion of everyone else.
Perhaps that would not matter if the executives concerned could be said to not have earned their rewards. Executive compensation should reflect corporate performance and shareholder returns. There are instances in which executive pay appears to have increased in the face of diminished shareholder returns and declining corporate performance. This phenomenon has been seen in stark reality in the past twelve months as corporate performance has deteriorated far quicker than might ever have been the case. In practice, the relationship between corporate performance and executive reward can be quite complex. It needs to be carefully and accurately summarised in a few lines in an annual report and often deserves a better analysis by media and investors.
The remuneration reports subject to shareholder vote in the last year disclosed executives’ fixed salary, short and long term incentives that were determined by their boards more than 12 months previously. Those pay arrangements were, generally, determined during times of corporate performance that met shareholder demands. The unravelling of global commodity and consumer markets has had consequential implications for the current corporate performance. These implications will be reflected in the pay deliberations of boards at present and will be disclosed in the next round of remuneration reporting.
Significantly, much of the negative reporting focussed on the value of long-term incentives granted to executives. It is now a harsh reality for many of the executives that they will have to accept that a large proportion of their pay was truly ‘at risk’ as many long-term incentives granted in 2005, 2006, 2007 and 2008 are unlikely to crystallise into reward for the executives.
The so-called ‘excessive’ value of long-term incentives seen in annual reports is often no more than the amortisation of the fair value of options and performance rights granted two, three and four years ago. For example, an executive may be attributed $500,000 in the 2008 annual report as amortisation of options granted two years ago but which are currently well out of the money.
Some commentators have proposed that the idea of linking executive compensation to a measure of company performance is inherently flawed. They argue that some incentives can actually distort executive judgement and suggest that the way some pay packets are structured could encourage CEOs to act in ways that could produce unforseen consequences or short term gains at the expense of long term growth.
Thus various groups are floating well meaning, but questionable, proposals to cap or otherwise control the size and composition of executive compensation packages.
- Capping the amount of executive remuneration that can be deducted for tax purposes. An amount of $1 million per individual per annum is often mentioned, reflecting American practice in this area. It was the introduction of this rule in the US that led to the excessive use of options without any performance hurdles, which were first visible in corporate failures like Enron and Worldcom in early 2000.
- Changing the non-binding shareholder vote on executive remuneration to a binding vote. It is difficult to envisage how a company could ensure all its shareholders are fully or sufficiently informed on all aspects of the remuneration and company objectives to make a binding vote worthwhile. In any event, such a vote would need to be on prospective remuneration.
- Making CEO employment contracts conditional on subsequent shareholder ratification. Like the previous point, this begs the question of the need for the board. It is difficult to see how companies could be successfully managed under such tenuous arrangements.
- Introducing ‘clawback’ mechanisms for excessively generous incentive and termination payments. This raises the question of who will decide what is excessive and, of course, how it will be clawed back.
- Amending the Corporations Act 2001 to make it easier for shareholders to sue boards for engaging in irresponsible or negligent remuneration practices. It is rare to find a board that does not exercise comprehensive and responsible diligence in determining executive pay. This may mean there would be fewer quality people interested in such board roles.
- Limiting the value and nature of non-cash incentives offered to executives could potentially reduce the quality of the executive pool interested in managing public companies.
- Compelling banks and other financial institutions to set aside additional capital if they engage in remuneration practices considered to encourage excessive risk taking and an undue emphasis on short-term results. There is no doubt this will increase the costs of operating the business.
It is not hard to detect the flaws in most of these proposals. However, the real problem is the assumption that underlies them, which is that boards cannot be trusted to make responsible and informed decisions on executive compensation matters. It is difficult to see how restricting board discretion in these areas could lead to better decision making. Would handing over board pay-setting powers to someone else result in better outcomes for companies and their shareholders? It is difficult to feel confident about either proposition.
I believe that, in the case of public companies, boards should remain the final arbiters of CEO and executive pay. They are in the best position to decide what is ‘reasonable’, competitive and fair in all the circumstances. Importantly, they are ultimately accountable to shareholders and other stakeholders in the business for their decisions in these matters. They can be challenged to explain and justify their policies. While some people might say they will not always get it right, that is an inherent characteristic of a market-based system which itself is subject to checks and balances. The non-binding vote, for example, has been used by shareholders to deliver strong messages to boards.
So, given all this, how should individual CEOs respond to concerns about their remuneration levels?
There is no simple answer to this question — CEOs must be guided by their individual circumstances. Nevertheless, the employment status of CEOs and other senior executives will fall into one of three categories.
- There will be those working under existing employment contracts that are essentially unaffected by recent adverse economic and commercial developments. In most instances, the individuals concerned will be perfectly entitled to sit tight. At the time of contract review, they will be subject to all of the prevailing market arguments. Nevertheless, the negotiation should proceed by reference to the usual factors of corporate performance, competition and personal performance.
- Others working under existing arrangements are likely to suffer actual or potential financial pain because of changes in business conditions and company performance. Incentive payments linked to such measures as the company’s level of profitability or total shareholder return, are not likely to crystallise.
For many, they will be told by their board that these outcomes are the reason why there are annual reviews and annual grants of deferred long-term incentives. It will be a case of ‘grin and bear it’. The type of equity and performance hurdles for this year’s grant will need to be carefully negotiated.
- Those who will be shortly renegotiating their contract of employment, or who will be taking up a new management appointment, should seek ‘at risk’ pay that can be expected to crystallise into reward. This means that shares rather than options may be preferred, and performance hurdles that are readily able to be managed and controlled by the executive. There is likely to be a greater use of internal hurdles, rather than measures like TSR.
Regardless of existing arrangements, many public company CEOs and their boards should recognise that recent events offer a legitimate reason for reviewing compensation arrangements and the difficult subject of measuring and evaluating executive performance.
Many executives whose long term incentives are well out of the money, may be inclined to negotiate for a resetting of the exercise price of options, a revision of the performance hurdles, or cancellation of their existing equity grant for a new grant. Pursuing these strategies is likely to create adverse accounting implications for the company, adverse tax implications for the executive and will create significant concerns for shareholders. These strategies can well be canvassed but executives should not be expecting a simple resolution. Executives can expect that they will be told their current experience is part of the reason why the company makes annual grants of equity. The different implications of each of these strategies can be the subject of a separate discussion.
It is also reasonable to expect that many executives whose long-term incentives have not crystallised into reward in the last year or two may want less equity and more cash, and want it delivered through short-term structures rather than long-term incentives. However, the message from shareholders to boards is that investors, now more than ever, want more of the senior executive’s pay to be at risk, delivered in a form that closely aligns their reward with shareholder return and delivered over the long-term.
This means the fixed salary component of total reward should be negotiated to be fair, competitive and at an appropriate amount for the role. This is the ’come to work’ money.
Executives have been used to their short-term incentive (STI) being paid out as cash. Boards will now be insisting that a proportion of the short term incentive be deferred for one, two and three years and delivered as restricted or deferred shares. Deferred shares means the executive will get the shares at the end of the deferral period and restricted shares are delivered at the end of the performance year but cannot be sold for the restricted period and may be subject to forfeiture.
The executive will need to be prepared to negotiate his or her remuneration structure within this context. At the same time, the executive will want to push for performance hurdles over the long term that reflect the company’s objectives and that can be controlled, managed and achieved by the executive, taking in to account that there needs to be a level of ‘stretch’ in those hurdles.
Linking executive pay and incentives to easily understood measures of company performance like total shareholder return, supposedly aligns executive reward with shareholder interests. However, in markets like that of the present, well structured businesses can still find themselves suffering a negative total shareholder return (TSR) for reasons beyond their control.
Business performance and company share prices can be subject to forces over which CEOs and their executive teams have little or no control, including interest rates, financial system liquidity, market sentiment, commodity prices, natural disasters and political upheavals to mention just a few. Trying to link executive performance to such measures as reported revenues, net profit, Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA), Earnings Per Share (EPS), or Return on Equity (RoE) can be at risk of ignoring the impact of external influences. These traditional performance measures work well when conditions are good, but break down when the business cycle moves into its downswing, notwithstanding that the underlying business may be well structured and able to work through the downcycle.
It is when conditions turn down that good CEOs and their executive teams can show what they are really made of. They are more likely to follow their own instincts rather than seeking the security of the broader view. They will pick up on changed conditions quickly, make the appropriate responses (including the unpleasant ones), guide the organisation through the worst of the situation, and position it to make the most of opportunities. They will not be overly concerned about reduced revenues and profits, but will be tenacious and uncompromising in defending the firm’s core markets and competencies and in preserving its solvency. They will understand that it is just as important to know when to sell as it is to know when to buy. They will have the courage to tell their board what they need to know, not just what they want to hear.
None of these qualities is easy to measure, but they are the competencies that will be deserving of recognition and reward.
CEOs now enjoy a rare opportunity to take the initiative in talking to their board about more holistic ways of measuring, evaluating and rewarding executive performance. Perhaps it could be likened to a ‘balanced scorecard’ approach that rewards executives for those things that they can control and influence.
Make no mistake, times are hard. Yet it is in such periods that men and women of vision can lay the foundations for future success and prosperity.
The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG, an Australian partnership.
