Director pay showing up as an issue

Posted by Marc Hodak on May 22, 2013 under Executive compensation, Governance, Reporting on pay | Read the First Comment

In yesterday’s WSJ, an article reported rising criticism of directors’ pay from institutional investors.  Many of the quotes came from one such investor, T. Rowe Price.

Current pay structures don’t give directors enough of a stake in making sure the company does well, and boards need to be more creative about tying their compensation to performance, said John Wakeman, a vice president and portfolio manager at mutual-fund giant T. Rowe Price Group Inc.

“If bad people are going to be on these boards, we’ve got to stop it,” said Mr. Wakeman. “We owe it to our fund holders.”

“When you’ve gone to restricted-stock world, basically directors get paid more or less for showing up,” Mr. Wakeman said.

If Wakeman were referring to the portion of director fees paid in cash, then he would have a point about directors being paid for just “showing up,” but even that ignores the value of getting good directors to show up.  Being a good director means working.  In the world that Mr. Wakeman and I share, very few people beyond commissioned salespeople are expected to show up with zero guaranteed pay.  Does he want directors compensated with purely variable pay?

But in alluding to “pay for showing up,” he is not referring to the fixed fees earned by directors, but to their restricted stock, which accounts for more than half of their total pay.  Calling this “pay for showing up” is a curious accusation.  To some extent, someone getting restricted stock compensation is almost certain of having something of value at the end of their tenure.  But the value of restricted stock goes up and down with the share price.  You don’t get any more performance-based than that.  In other words, given both its retention and incentive characteristics, restricted stock may be the perfect compensation instrument for directors.

The point of bad people on a board is not how we pay them, but how do we prevent them or get rid of them.  It may have been the writer instead of Mr. Wakeman who conflated these appointment versus compensation issues, but such a conflation does not help us determine the right way to either get good directors onto boards or to pay them.

The article also notes that some activist investors are experimenting with incentive pay programs for directors.  The clear premise is that directors don’t have enough incentive in their current pay programs, which raises the question:  what kind of pay package would be better than a program of fees plus restricted stock?

One can argue that the proportion of that pay mix ought to be more in favor of restricted stock than it is now, or that the stock restrictions should be more demanding, such as requiring that most of the stock be held to retirement.  But as someone who has designed these things for many boards, and thinks deeply about compensation design every day, I would caution against too much experimentation.  The three basic alternatives to restricted stock are:

1.  A restricted stock-equivalent, such as a cash-settled stock appreciation plan that pays off exactly the way restricted stock would.  I would favor such a plan only because it creates an income opportunity for those of us who design them.  Otherwise, the shareholders get the same retention and alignment benefit as if they award restricted stock.

2.  An alternative equity instrument, such as stock options.  This would likely create an asymmetrical risk/reward profile for directors versus shareholders–the kind of thing that contributed to Wall Street’s troubles during the financial crisis.

3.  A non-equity based incentive plan.  This would be asking for trouble, as the Coke example in the article showed.  The only body in a company than can certify achievement of performance results is the board of directors.  Asking the board of directors to certify performance relating to their own pay creates an inherent conflict of interest.  This is a fine recipe for either manipulation of corporate results, or the continual appearance of such manipulation.  I would never institute a directors’ non-equity incentive plan for any company I advise (and have actually lost business for my refusal to do so).

The real story, here, is that pay is becoming the magic elixir for fixing all governance problems.  We don’t have a significant problem with lack of alignment between directors and shareholders.  We just have some companies that don’t perform well, and some of that lack of performance reasonably attributable to lax oversight by the board.  Too much experimentation with director pay would only make the problems worse because it would be attacking the wrong problem.