The Handbook of Board Governance: Part 5

I continue my review of The Handbook of Board Governance: A CoThe Handbook of Board Governancemprehensive Guide for Public, Private, and Not-for-Profit Board Member. With the current post, I provide comments on Part 5 of the book, The Unsolved Governance Problem: Performance Measurement and Executive Pay. Talk to any of your acquaintances outside the corporate governance industrial complex and they will all have an opinion regarding CEO pay. This is a part of the book everyone can relate to. 

See prior introductory comments and those on Part 1Part 2Part 3 and Part 4. As I have indicated before, The Handbook of Board Governance will soon be the most popular collection of articles of current interest in the field of corporate governance.” It is already ranked 10 at Amazon (although ranking fluctuates daily, like a thinly traded stock).

The Handbook of Board Governance – Peer Groups: Understanding CEO Compensation and a Proposal for a New Approach

Charles-M. Elson

Charles-M. Elson

The work of Elson and Ferrere in this area is now classic, cited by many authors in the field, including on my own blog many times. This chapter or similar work by the authors should be ‘must’ reading for all directors. The competitive market for CEOs is largely illusionary, their empirical support is convincing, companies and shareholders would be better served if the board treated CEOs more like other employees of the company:

…his or her pay should be considered an extension of the infrastructure that governs the rest of the company’s wage structure. Internal consistency or pay equity throughout the organization, up to and including the CEO, is a natural and reasonable objective.

The authors seek balance, not a complete turning away from objectively constructed peer groups forming some basis for additional compensation:

If Pepsi’s performance far exceeds that of Coca-Cola, Pepsi’s CEO certainly may deserve relatively more generous compensation.

However, the current emphasis on peer group benchmarking has contributed to a disconnect between cause and effect, the problem of high and rising executive pay, wider income inequality and the rise of (this is coming from me) authoritarian thinking.

Will it happen? So far it looks like we are still headed in the wrong direction. It is so easy for boards to think their CEO is exceptional but all CEOs, by definition, cannot be above average. I am hoping new requirements to disclose CEO to median pay ratios will lead to a transition toward the type of approach advocated by Elson and Ferrere but I’m not holding my breath. (see CEO Pay Ratios: Do Employees Care?)

The Handbook of Board Governance: The Effective Compensation Committee

This is like a Nolo Press style step-by-step review (or introduction) for compensation committee members. What’s the committee’s role, role of the chair, relationship with management and outside advisors? How do you ensure effective meetings, align pay with performance, ensure succession planning and talent development, etc.? Its all there… well, of course, not everything… but a great template to build from.

Steven Hall, Nora McCord and Steven Hall Jr. even provide a valuable compensation committee calendar. What should the committee be doing at what time of year? I wouldn’t say there is anything revolutionary in the chapter but the authors provide a balanced approach on issues such as absolute versus relative performance metrics.

Executives are typically more comfortable with absolute-performance metrics, since achievements of these metrics is more squarely within their control. Shareholders and their advisory firms, on the other hand, are typically more interested in how the company has performed relative to peers.

They point out the up and downsides of each and advise appropriate measures. For example, relative performance metrics can produce unintended payouts when poor performance is simply less poor than that of comparators. Circuit breakers can help avoid embarrassing payouts. The authors also provide good advice on shareholder and proxy advisory firm engagement. It is a roadmap well worth reading for compensation committee members and shareholders alike.

The Handbook of Board Governance: Human Resource Management

Jay Conger and Edward Lawler begin with the old adage, “people are our greatest asset.” But given the amount of time most boards spend on workforce and talent management, they are “missing in action when it comes to monitoring human capital.” The chapter is mostly focused around closing the human resources (HR) effectiveness gap on boards… and they do an excellent job of that… they seem to write with an assumption that readers recognize how important HR and human capital management are. I’m not sure that is the case.

In 1997 I stopped by and interviewed Margaret Blair at the Brookings Institution. Although that was almost twenty years ago, the world is still catching up to Blair. Even back then, Blair recognized

[H]uman capital is different than physical capital. You can’t measure it easily and you can’t assign ownership to a third party. I haven’t done the numbers on this but what is being thrown out is that something like 75% of the value of the corporate sector cannot be accounted for in plant and equipment…tangible assets on the books. We need to revise our compensation systems to reward people with cash for their generic services and with a stake in the enterprise for contributions which are firm specific. [more on Blair on]

That said, Conger and Lawler do provide informative statistics and direction for HR capacity building within boards. What type of HR information do boards typically get? What HR expertise do boards usually have themselves? How frequently does the chief of HR (CHRO) attend board meetings? Readers may be surprised by the answers. I know I was.

If boards are so uninvolved in HR, how real can their succession planning efforts be? Many companies derive a substantial portion of revenue from abroad. Are they grooming top executives with global assignments? Recommended actions include the following:

  • Educate and coach the board
  • Ensure presence of CHRO or expert director at every board meeting
  • Establish a human capital management scorecard.

Conger and Lawler conclude by reinforcing the importance of human capital to organizational performance. Board involvement in HR can create a competitive advantage, but only if they are involved.

The Handbook of Board Governance: Designing Performance for Long-Term Value

Mark Van Clieaf, the author of this chapter is a frequent commentator on social media. Over the years, I’ve skimmed several of his pieces and have always been impressed. My main takeaway has been that companies and investors are too focused on share appreciation as a performance measure for the CEO and other executives. Performance Measurement and Executive Pay - Mark Van Clief

Creating value for customers and shareholders is best measured through operational excellence, five-year rolling revenue, profit growth, and levels of innovation that result in sustained returns on invested capital (ROIC) greater than the cost of capital…

70 percent of listed companies do not use capital efficiency metrics (I.e., ROIC, ROE, economic profit) in their disclosed long-term performance scorecard and incentive designs, and 87 percent of companies lack disclosures with direct line of sight performance metrics for innovation and capital reinvestment to drive future value.

Read and apply Van Clieaf’s chapter and your company is likely to do better over the coming years. Research from Credit Suisse Holt found the median shareholder return over four years increased by 21%. Take your eye off that share appreciation measure and focus on ROIC and appreciation will go up higher over time. Get executives focused on long-term capital efficiency, not day-to-day stock appreciation. That’s key to success.

It amazes me that over 43% of the S&P 500 between 2003 and 2012 actually had five-year cumulative returns on their invested capital that were lower than their cost of capital. You can only play that game so long before going bankrupt. Van Clieaf goes into detail about why earnings per share (EPS) is a poor measure of performance, even though it is the most popular measure.

  • Less than 15% of companies disclose return on capital as a performance measure. As mentioned above, that metric is key.
  • Less than 13% disclose measures around product development and other long-term metrics. Another key.
  • Most innovations take 3-7 years. Yet, most performance measures only go out 3 years. Your company’s performance measures should reflect your company’s innovation cycle.

Get all three right and your company will be in the forefront of measuring performance in a way that focuses on increasing value. It will also be more likely to attract long-term loyal shareholders.

The Handbook of Board Governance: Measuring and Improving Pay for Performance

Stephen F. O’Byrne has a different take than Van Clieaf but they are both trying to move companies past total shareholder return (TSR) as the primary measure. Key to the differences is the purpose of performance measures. For O’Byrne, the three basic objectives are:

  • Increase shareholder value
  • Retain key talent
  • Limit executive pay to levels that will maximize wealth of shareholders

O’Byrne shows directors why performance awards need to be adjusted for trailing relative performance. Vesting provisions need to take out the industry component of stock return.

Despite the fact that 21% of institutional investors surveyed said CEO pay is appropriate, only 2.7% of companies failed their say-on-pay vote. O’Byrne posits that institutional investors think such votes are “ineffectual and costly” because they are unlikely to change pay practices and they annoy company clients of the institutional investor.

Yes, companies won’t change because institutional investors won’t exert the necessary pressure. Why? Because it would cost them too much time and money to figure out what the right metrics should be at each company (time and money their competitors aren’t spending) and because they don’t want to aggravate potential customers. They want to run the company’s 401(k) plan.

O’Byrne goes on to explain how policies at NACD, ICGN, CalPERS and others compound the problems by prohibiting hedges that would factor out the industry component of stock return. ISS measures capture 21% of one performance measure but only 1% of the variation in the other two. Clearly, most companies and most investors could benefit by heeding the call of either or both Van Clieaf and O’Byrne, as well as the other authors in this section of The Handbook of Board Governance.

See also: The “Buy Side” View on CEO Pay by David F. Larcker, Brendan Sheehan, and Brian Tayan from The Stanford Closer Look series.

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