Thursday, July 16, 2009

The difficulties embedded in the Obama administrations Executive Compensation Principles

I sit on two public boards (JDSU and Rambus) and sit on the Compensation Committee on one, and chair it at the other - so executive compensation trends are very important to me. Add that I have been a public company executive several times (although I choose the private company world today) and I am watching the Obama administration's rhetoric with interest.

I was sent a briefing recently that outlines the Executive Compensation Principles the administration is espousing - see the description below.

While I am as disgusted as the next shareholder at obscene executive pay packages for failed executives I see two major difficulties with these principles.

The first is the implication that current compensation programs are not set up for the long term. Most good public companies absolutely require their executives (and board members) to hold stock minimums for the long term and many set up objectives to measure long term strategic program investment, not just short term performance.

It's easy to say "reward long term value-creation", but it's an incredibly hard thing to do in a measurable way - and compensation objectives have to be measurable or they are open to manipulation. Compensation tied to revenue is short term, when tied to strategic objectives it's very hard to know which objectives will really have impact in the long term - and yet they are easy to judge in hindsight. Using stock options as the reward works well because they vest over time and they only have value if the stock appreciates - but options have been under attack from the regulators and institutional shareholders for a while now which I think it very short sighted.

This leads to my second concern. Only the CEO and the executive team really know what the critical issues are in a company in depth. Boards do their absolute best to stay on top of the issues, to get briefed, to talk with customers and employees, but as a sitting CEO I know that only I have all the information being processed in one brain. My companies spend a great deal of time to keep me up to speed but it's a continuous, intense investment especially when things are changing fast.

This makes it a significant task for a board to set and review objectives and we spend a great deal of time on this at the compensation committee level. If it's hard for boards - who have all the information not just the publicly filed information, how much harder will it be for shareholders to make a realistic assessment of what are appropriate compensation measures?

Transparency is good. It's essential to build trust with shareholders. But while "Say on pay" is a great solution to the obscene packages, does it makes sense in 99% of the cases which are not obscene? Does it make sense in the cases of highly competitive industries where great CEOs are hard to find, and when you find them you need to pay them well to attract them and compensate them for the hard work and risk they take on as they strive to be a great company CEO?

It seems a crime to me that a handful of bad actors could cause regulatory changes which will hurt good companies ability to pay for performance - to pay significant pay packages for excellent performance. Institutional shareholders understand great CEOs earn their pay packages, and that bad ones should be fired. I worry that retail shareholders (that's you and me not the mutual funds) won't ever think a great CEO is worth $20M+ a year - and yet they may well be based on their future performance - but it can only be measured in hindsight (which means board judgment in advance) and not at the time the shareholders will be asked for approval.

Tough issue, and not one where I think more regulation is the answer. I think the answer is tougher board process and greater and greater transparency into board process in response to shareholder demands - but don't tell boards how to set compensation. Make compensation committees be very very transparent but let them do their jobs.

The Administration's executive compensation principles:

1. Long‐Term Pay for Performance Link
- compensation plans should be designed to reward long‐term value creation for investors, as
opposed to the short‐term focus that doomed financial institutions in the market meltdown. The
administration also emphasized that a broad range of external and internal metrics should be used beyond just stock price, which is not always the best indicator of the long‐term strength of the company.

2. Long‐Term Risk Time Horizon
- that executives maintain strong company ownership through the holding of equity‐based
compensation is one of the best methods to link executive pay with company performance. Compensation plans for both executives and other employees should be designed to match the risk outcomes of their performance.

3. Risk Management
- Committees should include risk‐management in the pay setting process, and conduct the
risk assessment in a public manner.

4. Appropriateness of Golden Parachutes and Supplemental Retirement Packages
- should reevaluate the necessity for golden parachutes and supplemental retirement packages,
and should determine whether their existence will result in pay for non‐performance.

5. Transparency and Accountability in Pay Setting
- Treasury Department plans to require more transparency and accountability for Compensation Committees by legislating Say on Pay and Compensation Committee independence standards.

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