COMPENSATION COMMITTEE

SPRING 2004 43

T is ruledafter a thorough investigation to be dueto pilot error and only pilot error. Howcan this be when the craft was flown byan experienced and competent crew?

The flight recorder indicates that the problem wasnot their level of experience and competence, butrather the poor communication and deficientprocess of interaction between the pilots.

In the same vein, how can the board membersof the New York Stock Exchange have voted suchoutsized compensation for their CEO? Even al-lowing for the press’s misreporting it as a singleyear’s paycheck when some of it was deferred com-pensation from earlier years — and allowing forthe general witch-hunt environment in which pre-viously laudable acts are now considered larceny— just how could a board pay so much money forthat job? Experience and competence were clear-ly not the problem; by any standard of accom-plishment and track record, the NYSE had one ofthe very best boards you could select. But some-thing in the communication and decision-makingprocesses of boards and their committees can

break down, and the NYSE board is not alone.In our work as management consultants and

board advisers — almost 60 years between the twoof us — we’ve seen other boards struggle withreaching good decisions and we’ve thought aboutthe reasons why. We think the struggles boil downto six different dynamics and six practical tools ofresolution.

1. The real or imagined domineering CEOSituation: After a hearty round of greetings and get-ting the coffee poured, the CEO opens the com-pensation committee meeting. “Shouldn’t we getstarted? We’ve got a bunch of items on the agendaand just an hour before the full board meeting.”The tone has been set: lots to cover, little time, don’ttake us off track. Motions and seconds are asked forin approving the minutes of the last meeting, andthe CEO leads onward as they go tab-by-tabthrough the three-ring binders that are full ofcharts, graphs, tables, and legal language. The CEOis crisp and decisive. He knows this material be-cause it is the staff work of his own team, andfrankly, some of it’s personal. Fifty-nine minutes

later, he brings the committee throughthe last tab, no further questions, and aquick adjournment. Few questions havebeen asked anyway, and the discussionhas been limited to clarification of tech-nical details more than anything.

How compensationgets manhandled Something in the way boards review and approve executive pay frequently goes awry.To avert these common breakdowns, here are six suggestions for sharpening compensation committee foresight. By Roger Brossy and John Balkcom

Roger Brossy (at left) is managing director of Semler BrossyConsulting Group, a compensation strategy firm. He was formerly thepresident of Sibson & Company before forming Semler Brossy in 2001.John Balkcom has been a management and board adviser throughouthis career. He was a longtime principal of Sibson & Company and forthe past three years served as president of St. John’s College in SantaFe, N.M. He is now a strategic partner of RNW Consulting LLC and adirector of IMCO Recycling Inc.

Resolution: The emergent “good governance”tenets put a tremendous burden on CEOs. We needmore than 10,000 CEOs to run the public compa-nies in this country, and we now ask not only thatthey be strong, decisive leaders capable of “takingthe hill” but also that they have the charm anddiplomacy to ask for and promote open-ended dis-cussion and the grace to acquiesce to the wisdomand tempered views of a board of directors. Somehave it and some don’t, but it is certain that manyCEOs who were successful in the old model willbe driven to distraction by the new one.

So what to do when a compensation committeeis intimidated by a controlling — or seemingly con-trolling — CEO? Our thoughts on what works:

• Schedule an annual committee discussion ofphilosophy and strategy, with no intention of ad-dressing plan design. Ask the unasked questions:Does the entire program pass the test of fairness,justice, and transparency? Would the committee beat all embarrassed to have the dollar results of its de-cisions posted on a bulletin board at the companyor a Web site subject to public review?

2. Dealing in piece partsSituation: It’s the June meeting and the committeeconvenes to review and approve annual optiongrants. The head of HR leads the discussion.“We arerecommending a similar number of shares as lastyear — no increases,” she indicates. “Of course, theamounts of shares we grant by individual have

changed as we reflect on theincumbents’ performance andour take on their potential.”

A committee member asks,“I see the number of shares,but what about the Black-Scholes value?” The HR headnods and replies, “Well, wedidn’t show those because thevalues are jumping all around,and we just don’t think theymake a lot of sense.” A feweyebrows are raised, but she

hastens to explain: “Our volatility is lower this yearthan in prior years, and that’s a key input into theBlack-Scholes value. We’ve also increased our divi-dend rate now with the favorable tax treatment ondividends ... and that’s another factor. But the stockprice is up since last year’s grant, too. And thatchanges the Black-Scholes number even more.”

The committee member doesn’t want to let itpass, so he asks that a subsequent analysis be pre-pared and distributed that shows the Black-Scholesvalue.“Okay,” replies management, “we’ll have that

for the September meeting when we do the re-stricted stock.”

The committee approves the motion to acceptmanagement’s proposal for stock option grants.Nowhere in their supporting materials have theyseen all the elements of pay assembled and addedtogether. In September they will convene to makerestricted stock grants. In November they will ap-prove merit increases and target bonus adjustments.In February they will approve bonus payments forthe preceding year. Their workload has beenthoughtfully spread out over the calendar ... but thebig picture eludes them.

Resolution: We’ve seen the good intentions of thisapproach and occasionally wondered about the less-than-good intentions. The solution is straightfor-ward:

• In the first section of the committee book hand-ed out at every meeting, include a table listing theestimated annual value of every element of com-pensation for the senior management and the roughtotal annual compensation value. The list of recip-ients could be as few as a half dozen or as many asthree dozen for the large, multi-divisional compa-ny. Supplement this table with a listing of the ter-minal value of compensation under all existingcommitments to each executive in the event of ter-mination.

3. Banding together against a hostile worldSituation: An unflattering article has hit the news-stands. The CEO has asked the compensation com-mittee to convene telephonically so the writer’s at-tack on the company’s executive pay can bediscussed.

“We’re really incensed over this,” he begins.“They’ve completely blown the facts. As you know,none of us made this kind of money last year.They’ve mixed up take-home pay with the theo-retical value of our option grants — which, ofcourse, may never make any of us a dime. Thenthey’ve got this so-called expert weighing in on oursupposed low levels of management ownership, andit’s clear he hasn’t even read our guidelines in theproxy!”

One of the committee members can truly feel theCEO’s pain. He’s on two other boards and used tobe a CEO himself. He well remembers the year be-fore his retirement when, after not having taken anyoption gains for his seven-year tenure, he finally ex-ercised a sizeable chunk of his vested options. Onemagazine put his picture on the cover and madehim a poster boy for excessive pay. “Don’t pay any

COMPENSATION COMMITTEE

44 DIRECTORS & BOARDS

Nowhere in the supporting

materials does the

committee see all the

elements of pay assembled

and added together.

attention to them,” he advises the CEO.“They can’tget it right, and they’re just looking to sell papers.Ignore it and move on.” The other members assent.

Resolution: With attacks or poor reporting fromactivist groups, proxy advisers, commentators, andthe media, there are many potential hostile forcesbashing away at a company’s pay practices. This in-vading force can create a natural banding togetherof board and management to face down the criticstogether. To be sure, the press often fails to reportpay accurately, activist groups such as the pensionfunds of some unions tend to pick on a specific issueto the detriment of the bigger picture, and the proxyadvisory groups in the big fund companies often userules of thumb that just don’t work (e.g.,“We don’tapprove new share authorizations if overhang is15% or greater”). Nonetheless, as board and man-agement circle the wagons a board member couldfeel far out of step asking a question like,“Yeah, butlet’s take that reporter’s points one at a time and seeif there is any merit to any of them.” Here’s what wesuggest:

• Have the company annually report to the com-mittee where the company stands or would be eval-uated by the relevant constituent groups relativeto those groups’ policies. These groups might in-clude the major institutional shareholders of record,unions with a stake in the company’s employmentpractices, broad-based proxy advisers such as theISS, and key political or regulatory agencies thatmight influence or control the company’s impor-tant contracts or potential revenue streams.

4. Lob the performance review over the wallSituation: The committee has convened to reviewthe bonus recommendations for the year just fin-ished. Each bonus is modified by the “performancefactor” assigned to each bonus recipient at the man-agement level. The committee starts with a binderthat leads them through the assessments one by one,starting with the lowest-level recipients. Out of re-spect for the committee’s purview on CEO pay, thereview factors are shown versus results, but the finalscore is left blank.

Resolution: It’s just plain awkward to reverse animplied performance rating. In this case, the scoresgiven to everyone else might all have to be re-ex-amined if their results roll up to something less, inthe eyes of the committee, than what is implied inthe binder for the CEO. In effect, managementmight think they are showing respect by not pro-viding the rating or the pay action that should fol-

low the rating, but in fact they are boxing in thecommittee by building the recommendations fromthe bottom up.

Boards and compensation committees are at a bigdisadvantage if the launching point for their assess-ment of CEO and top management performancestarts with an explicit or implicit answer providedby management. Companies can avoid this by:

• Establishing a process for the committee to re-view CEO performance before the CEO then eval-uates his or her direct re-ports. An annual calendarof CEO performance plan-ning and review, with reg-ular updates at board andcommittee meetings, takesthe element of surprise outof year-end evaluations, aswell as their associated payand stock actions. It alsogives the board the oppor-tunity to formulate a view of CEO performance in-dependent of the CEO’s evaluation of the manage-ment team at year end.

5. Setting our own compensation,then yoursSituation: The committee’s first piece of businesswas to review and finalize a decision on board com-pensation. Directors had put in considerable un-scheduled time during the past year in response toSOX (the latest board-level acronym for Sarbanes-Oxley), the changes in exchange rules, and an unan-ticipated number of shareholder proposals. Thewhole board, but especially the audit committee,had been consumed with first trying to chart a rea-sonable course of action as its long-time auditor,Arthur Andersen, came under intense fire, and thensecond, having no choice but to find a replacementas that firm crumbled.

Since much of that increased workload lookedcertain to remain the norm, the committee agreedthat its committee chair roles and committee mem-bership stipends needed to be increased.

Finally, with the increased sense of liability andno end in sight to the off-cycle meetings, the com-mittee decided to increase the annual restrictedstock grant for all directors. With that decisionmade, they turned to management’s proposal to adda restricted stock component for the executive team.

Resolution: Directors and executives are asked tomake numerous decisions in which some conflict ofinterest may be perceived or felt; such conflict is in-herent in the nature of leadership roles. Neverthe-

COMPENSATION COMMITTEE

SPRING 2004 45

What to do when a

compensation committee

is intimidated by a

controlling CEO?

less, we believe the potential conflict for compen-sation committees in setting their own director paywhile also setting their executive pay is increasinglyuntenable. We have come to support the idea of:

• Separating board pay from the duties of thecompensation committee. Nominating or gover-nance committees should pick up the director payresponsibility and leave the compensation com-mittee to deal exclusively with executive and otherequity-based plans.

6. ‘Just too complex’Situation: It’s the early ’80s, when times seemed somuch simpler — even quaint — compared to whatdirectors face today. The compensation commit-tee of a large industrial company convenes. Thedirectors to a person are renowned for their man-agerial and directorial capabilities. One of your au-thors is also in attendance.

At the start of the committee meeting, the com-mittee chairman calls the meeting to order and thenbegins reviewing several routine matters that requirecommittee notification or ratification: approval ofnew options for a few promotions and new hires; re-view of regular reports of options exercised in the

past quarter by senior officers ofthe company; updates on perfor-mance to date as defined underthe company’s bonus plan; con-firmation of the CEO’s havingsubmitted a self-appraisal to thecommittee for consideration at alater meeting; and so on.

At the end of his recap ofthese information-only items ofcommittee responsibility, thecommittee chair pauses, and inthe momentary silence another

member speaks up to say: “Is this the point in theagenda when we discuss the long-term incentiveplan?” No one speaks up, and the chair seems to nodin the affirmative. “Yes, then I have something Iwould like to say. I’ve given this matter considerablethought, and I have deep reservations about thisplan. Four years is hardly long-term; the measuresgive no weight to cash flow, instead focusing onearnings related measures that are subject to many,many exceptions under the terms of the plan; thelikelihood is that we’ll be asked to approve large pay-ments whether or not the shareholders have bene-fited in the same way over the period measured; andmost of all....” An awkward pause of about 45 sec-onds ensues, puzzling everyone in the room.

The chair looks quizzically at the speaker, whothen sits back in his chair and says with embarrass-

ment,“I’m so sorry. That’s the United Airlines plan.”The speaker has lost his place in the many meetingshe has attended of such compensation committees,perhaps including those of his own company, andhas given this committee his critical review of thewrong long-term incentive plan.

Resolution: Good governance guidelines now en-courage a limited number of directorships. Follow-ing these guidelines, the number of directors whomight get caught in an “If it’s Tuesday this must beXYZ Corp.” scenario are limited. Nonetheless, thefactors that must be considered in any one com-pany’s compensation programs have become morecomplex. Committee members today must beversed in the current and potential accounting rulesfor equity-based and long-term compensationforms. They must be sensitive to the balance sheetand dilution impact of equity vehicles. Option val-uation models and their limitations must be con-sidered. Changing laws and exchange rules compli-cate a board’s flexibility in making pay programdecisions.

While compensation programs should be biasedtoward simplicity, today’s complexities cannot bebrushed aside. Here is an action that can help man-age the complexities:

• Hold a committee executive session with thecompany’s compensation consultant to give direc-tors the opportunity to “ask the consultant” with-out management’s presence. This allows for clarify-ing questions that a director fears would soundchallenging or mistrustful if asked in front of man-agement as well as for frank assessments and give-and-take on the overall strategy, program designs,and levels of potential value.

Conclusion: Examine and estimateThe job of compensation committee member hasbecome both harder and riskier. It requires carefulstudy of the company’s compensation practices andpolicies, and it can threaten a director’s reputationfor integrity and judgment. Regularly examining theunderpinnings of the linkage between performanceand reward — as well as more accurately estimat-ing future events that may look unlikely (did everymember of the NYSE’s compensation committeeanticipate that the CEO’s “deferred compensationarrangements” would be fully calculated and dis-closed during their board tenure?) — will give com-mittees and their chairs a means of foreseeing theunanticipated financial outcomes and profession-al consequences of their decisions and ensure theirprocesses of communication and analysis are upto the task. ■

COMPENSATION COMMITTEE

46 DIRECTORS & BOARDS

Confusing his board

memberships, the committee

member gave a critical

review of the wrong

long-term incentive plan.