Go Ahead, Vote Yourselves a Raise
from
September/October 2004
by Julie Connelly
Here’s a nifty notion for an agenda item at your next board meeting. If you and your fellow directors haven’t already done so, why not vote yourselves a raise? Ever since the Sarbanes-Oxley Act passed, you’ve been working like galley slaves—and take it from us, investors aren’t going to mind your giving yourselves a fatter paycheck. According to Patrick McGurn, senior vice president and special counsel at Institutional Shareholder Services, the proxy-voting-services firm and governance watchdog, shareholders’ attitude toward pay increases for directors is “Give them enough to do a decent job, and then demand that they do it.” McGurn adds, “For the first time, as far as shareholders are concerned, the expectation is that director pay will and should go up.”
That’s good, because 2003 was not a banner year for directors’ compensation. According to Mercer Human Resource Consulting, which surveyed director pay and benefits at 350 major industrial and service companies for Corporate Board Member, median total direct board-member compensation, which includes the value of all long-term incentive equity grants, was $129,712 last year, just about flat with 2002’s $128,530. Contrast that with the money paid CEOs, those real gas hogs, who enjoyed a 16.4% rise in their median total direct compensation last year, to $3.6 million, and you’ll see that director pay is still too paltry to concern many shareholders. As David F. Larcker, a professor of accounting at the Wharton School, points out, “The money you pay a board is a rounding error for big companies.”
The dwindling supply of experienced directors feeds the push for higher compensation. Directors with full-time jobs are cutting back on their boards, often at the behest of their employers. Or they have succumbed to what might be called the Wayne Huizenga effect. The founder of Waste Management and Blockbuster Video recently resigned from the boards of AutoNation and Republic Services, two other companies he helped start, telling the South Florida Sun-Sentinel, “Board meetings at public companies are not a lot of fun these days. You spend more time talking about Sarbanes-Oxley than about business.” Adds William E. Mayer, founder of Park Avenue Equity Partners and a director of four public companies, including Reader’s Digest: “Being a director used to be a privilege and an honor, but now it’s work and liability for real.”
While no one with a full deck would serve on a board only for the money, few would serve without it either. Board compensation typically consists of a cash retainer, a committee retainer, meeting and committee fees, and equity awards in varying combinations. The cash part is where compensation is starting to go up, in recognition that the job is not the victory lap it used to be and that its time demands are exploding. “There is a real notion that time needs to be compensated by either meeting fees or some other kind of fee,” says Holly Gregory, a partner in the corporate governance group at the New York City law firm Weil Gotshal & Manges.
Meanwhile, equity grant values are declining as part of the median total pay package, from 59% in 2001—the high-water mark—to 51% today, according to Mercer. This drop results from both the carnage in the stock market and decisions by many boards to replace option grants with fewer shares of restricted stock or deferred stock units. “There is a revulsion toward paying directors with stock options that has grown tremendously over the last 12 months,” McGurn says.
Directors can be overpaid, of course, as the governance scandals made clear; they compromise their independence if their comp aligns them too closely with managers rather than with shareholders. This is why governance experts argue about the appropriateness of incentive compensation like options for directors, and why there is a move to replace options with stock grants. You’ll look hard to find a director or governance guru who believes that board members should not own stock in their companies, though some want directors to use their retainers rather than their other resources to buy it so as not to have too much of their net worth tied up in a company’s shares. Says Lynn Stout, a law professor at UCLA who subscribes to this view: “The last thing we want is to encourage that behavior in directors that we got from CEOs.”
While hardly anyone is fretting that directors are overpaid, there is a small dark cloud on the edge of the emolument horizon: pay for performance. All directors used to receive the same $20 gold piece or bunch of $100 bills under the dinner plate for board service, but now there are differentials based on board and committee responsibilities.
The biggest bucks go to the independent chairman or lead director, and the next-biggest to the chair of the audit committee. Says Karen Horn, a director of Eli Lilly and Georgia Pacific: “You don’t give out committee assignments to be an implicit evaluation of a director, but it is implicit pay for performance.” If ambitious board members start bucking for promotion, as it were, to the well-paid and therefore prestigious committees, there could be some implications for the board’s ability to act as a team.
Directors are unique in business in that they set their own pay, usually benchmarking companies of a similar size or in a similar industry or ones they want their outfit to be like, and then targeting the median pay range. Board pay is not immune to the Lake Wobegon ratchet-up effect, of course, and some directors will always think they belong in the 75th percentile. But the problem is not nearly so acute as it is with CEOs, if only because the numbers are smaller. Thomas Wilson, a compensation consultant in Concord, Massachusetts, finds that most directors are cautious and have to be persuaded to go from, say, a $15,000 retainer to a $20,000 one. They fret about how it might look in the news media, a concern that Wilson says takes the form, “We’re laying off 30,000 people and we’re going to give ourselves a raise?”
Though both CEO pay and director pay rely on the same kind of benchmarking, “there is not a direct relationship,” says Bruce Ellig, author of The Complete Guide to Executive Compensation (McGraw-Hill, 2001). In his book, however, he argues that there should be. If the board as a whole has responsibilities equal to the CEO’s, he says, its pay should be proportionate to the CEO’s. Suppose the CEO’s salary plus incentives is $13 million annually for doing a full-time job, and there are 10 directors spending 10% of their time each on board matters. Shouldn’t they be paid $1.3 million apiece multiplied by 10%, or $130,000 a year, in cash and equity grants? “This is not a perfect formula,” Ellig says, “but it’s a starting point for figuring out what pay the board should receive.” Some directors, however, are leery, suspecting that board members could be motivated to jack up CEO pay even more so that the ratio would work out better for them.
What does correlate almost exactly with board pay—and usually with CEO pay as well—is the size of a company. The implication is that the bigger the company, the more complex it is, which in turn means more work for directors. For example, the Mercer study shows that total direct board compensation at outfits with median revenues of $1.5 billion was $91,000 last year, and at businesses with sales of $21 billion, $155,000.
The board starts with an overall dollar figure and works back to decide how much should be paid in cash and how much in stock. Meeting fees, long disdained as paying directors simply for showing up, are making a comeback. “They are a better way of compensating directors for the time they put in,” says Peter Oppermann, senior executive-compensation consultant at Mercer. The median board-meeting fee was $1,500 last year—the same as in 2002, according to the survey—but committee-meeting fees have gone up $200, to $1,200. “It’s just as important to encourage full attendance at committee meetings these days, because a lot of the work of the board is devolving on the committees,” says Donald Rice, CEO of the privately held biotech company Agensys and a director of four companies, including Amgen and Wells Fargo.
Increasing directors’ cash compensation got a big boost with Restoring Trust, former SEC commissioner Richard Breeden’s 2003 report on how corporate governance should be conducted at MCI, previously WorldCom, where he serves as the court-appointed corporate monitor. “It was pretty eye-popping when it got to director compensation,” says McGurn of Breeden’s report, “but shareholders wouldn’t disagree with his point that directors need to be paid more.”
Breeden recommended that MCI’s board members get no less than $150,000 and collect no other fees or equity awards. He said the non-executive chairman’s retainer should be twice as much as the other directors’. In addition, the chair of the audit committee would be entitled to an additional retainer of at least $75,000, and audit committee members $50,000; the retainer for the chair of the compensation and nominating committee would be at least $50,000, and for the committee members $35,000. The MCI board trimmed Breeden’s recommendation considerably. Its directors get $150,000 a year plus more for committee service, and chairman Nicholas Katzenbach, who served as U.S. attorney general during the Johnson administration, gets $275,000. Members of the audit committee collect an additional $12,500, and their chairman $18,750. Compensation and nominating committee members are paid $8,750 extra, and the chair $12,500.
Breeden also had ideas on where some of the money would go. “The amount of the cash retainer should be large enough to provide attractive compensation for high-quality board members . . . [and] large enough to fund a substantial mandatory stock-investment program,” he suggested. MCI’s board members went along with this and will invest a quarter of their total compensation in company stock.
The Mercer figures show that the appeal of options has cooled considerably. Once regarded as incentives to make board members more conscious of shareholder return, options are now viewed as vehicles for encouraging collusion with management to get stock prices up so the options can be exercised profitably. Furthermore, as early as 2005 option grants will probably have to be expensed.
“Stock options are still an integral part of long-term incentives for key employees, and they are still there for executives, but they are evaporating a bit more quickly for directors,” says J. Richard (“J.” is as familiar as he gets in public), who runs an eponymous governance and compensation advisory firm in Half Moon Bay, California, and served on the 1995 National Association of Corporate Directors blue-ribbon committee that studied director pay. The best compensation practice now tries to balance the short-term rewards given to the CEO with longer-term incentives for directors as the official watchdogs. So director compensation is starting to tilt toward stock grants, which are sometimes given in the form of restricted shares or deferred stock units with each unit equaling one share. The restrictions on the shares or units are many and varied, but their purpose is to prevent directors from selling the stock, often until after they leave the board—thus conditioning them like lab rats to see that the company operates for the long-term benefit of the shareholders.
Moreover, rather than give directors a predetermined number of options each year, which could turn into an unintended bonanza, boards are putting a dollar value on the stock or unit grants and converting that figure to a number of shares as of the day of a grant. That makes it easier for shareholders to figure out what they are actually paying their surrogates for overseeing the company’s performance. For example, members of the General Electric board, who are among the plutocrats of the governance world, received $250,000 in 2003, paid out as $100,000 in cash and $150,000 in deferred stock units. Each unit is the equivalent of a GE share and accrues dividends but carries no voting rights. One year after directors leave the board, they receive their units in cash—with each unit valued at the then-current stock price.
A downside of options is that they can end up far more valuable than originally intended. Recently Donald Rice was part of the committee determining pay for one of his boards, and the committee members realized that because the company’s directors had been given a fixed number of options every year—instead of a grant with a dollar value that was converted to options—and there had been stock splits, the value of the shares under option had grown enormously. That pushed the directors’ total pay way out of line with what peer companies were paying. “So we cut the option grant by two-thirds and introduced stock grants to make up for part of it,” Rice says. The stock component of their compensation came down from where it had been, and so did the total. Were any directors unhappy about that? “Some were,” says Rice, “but ultimately they accepted it.”
While directors continued to receive options at 70% of the companies in the Mercer survey last year, that figure was down from 77% in 2002. By contrast, 34% of companies paid directors with restricted stock, up from 28% the year before, and 27% made grants of deferred stock, up from 26% in 2002. Says Charles Elson, who directs the John L. Weinberg Center for Corporate Governance at the University of Delaware: “Restricted stock is the perfect alignment—if the shareholder’s stock goes down, so does yours. If the stock goes nowhere, you as a director have an opportunity cost of money, and so does the shareholder.”
The laudable desire to compensate directors in proportion to the increasing responsibilities and time demands of the job has a potential disadvantage, however. Paying them different amounts could lead to overvaluing the contributions of some at the expense of others. “The legal rules are that the board acts as a whole, making collective decisions,” says Margaret Blair, a law professor at Vanderbilt University. “And differential pay might undermine that.” According to Mercer, at companies where the audit or compensation chair gets more than other chairmen, the premium is often 100%.
Other distinctions, odious or not, are emerging from director evaluations. “This is the next big change in boardrooms, in the light of all the legislation,” says ISS’s Patrick McGurn. “We’ll move beyond simple board evaluation to director evaluation. And in just a couple of years, it will be common practice.” These reviews are kept confidential—until the time a judge decrees otherwise—and usually involve a form of self-assessment, but they could also be used to justify paying some board members more than others. It will not be to the shareholders’ advantage if showboating directors start angling for financially rewarding board activities.
Governance organizations like ISS and big investors like Calpers have been taking note of certain directors, such as Michael Eisner at Disney or Warren Buffett at Coca-Cola, and urging that they not be renominated at the annual shareholder meetings because of alleged conflicts of interest. Both men survived those votes, but Eisner was forced to give up the chairman’s title at Disney, even though he remains a director, and the publicity about Buffett highlighted the Coke board’s inept handling of the company’s management succession. When there is a big range in director pay, will directors’-and-officers’-insurance carriers and plaintiffs’ attorneys start asking whether certain board members are worth their premiums?
Because director compensation is not an issue of the moment, directors can work out a solution away from the glare of publicity and experiment to get the right mix of carrots and sticks. But that state of affairs won’t last forever. Chun-Keung Hoi, a finance professor at Rochester Institute of Technology, points out that 10 to 15 years ago investors were not particularly concerned with executive compensation either. “They didn’t complain about options, and now they are,” says Hoi, co-author of a 2002 paper that concluded that shareholders do not think there is any long-term benefit to them from equity incentive plans for board members. “Directors are the next wave. There’s a feeling that they are underpaid, but when you invite someone to raise his own salary . . .” In other words, if you think you’re worth it—and who doesn’t?—vote yourself a raise now.
