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August 12, 2013

Board Governance Series

Third Quarter 2013 
Corporate Board Member
by Laura J. Finn 

This edition of the Board Governance Series features articles taken from Corporate Board Member’s quarterly webcast series, including thought leadership on many of the issues boards of private companies should consider before an initial public offering, the ways in which the compensation committee should be evaluating total shareholder return as a tool to align compensation with performance, and the risks and opportunities associated with “bring your own device” to work or the boardroom.

Each of our presenters–PwC’s Center for Board Governance, Meridian Compensation Partners, and BoardVantage–offers recommendations and practical, hands-on guidance to board members who may be in the midst of these situations within their own company.

To help round out your board’s information and education needs, Corporate Board Member brings you this special section and posts the corresponding Board Governance Series webcasts at www.boardmember.com as well as at each of our contributors’ websites.

Governance Considerations for the IPO Process
with Catherine Bromilow, PwC

Catherine, we understand you’ve written two new governance books. Tell us about those.
That’s right. We were getting a number of questions from companies that were planning to go public, asking us to talk with them about various governance requirements they’d face. And when we looked around, there were no publications that concisely summarized this information, so we decided to develop them. We worked closely with our colleagues who provide IPO services to companies that are going public. They had concerns that often companies were leaving their governance decisions to too late in the process and also that company executives didn’t understand all of the governance choices they had to make and the implications of those choices. 

The book, Governance for Companies Going Public—What Works Best, is a comprehensive description of the various governance requirements, from the SEC, as well as the New York Stock Exchange and NASDAQ. In addition to covering all of those governance responsibilities and requirements, it also describes the other governance choices that companies have, outlines the shareholder environment, and discusses the other parties who are influencing governance and what they are looking for. It also provides information on how to protect your directors and some tips for looking at your first year as a public company. Finally, the book has the results of a study we did of 50 IPOs that charted how the companies’ governance evolved over time, from before the IPO to their most recent proxy. Plus, it reflects insights from
directors, executives, and investors. 

That sounds like a useful book, especially with the research and the anecdotes sprinkled in there. What about the second book?
The second book is a concise companion to the first book. It’s called Going Public? Five Governance Factors to Focus On. It takes companies at a very high level through the five key areas they need to think about. First: Do you understand the governance requirements you’re going to face? Second: Have you thought about the changes you’re going to have to make to your board composition, or at least  consider for your board composition? Third: Do you understand who your potential shareholders are, what they want, and also what other groups have an influence on governance at companies? Fourth: Do you understand and are you going to be able to properly make some of the other governance decisions you’ll encounter? And fifth: Are you getting the resources and support you need so that your governance processes will work well for your company?

Let’s talk about board composition for a minute, because I think that is an imperative area, and it sounds like one that requires more homework from pre-IPO companies.

Board composition is definitely a fairly major item that companies need to think about. First, you need to understand the requirements from the stock exchanges. Both the New York Stock Exchange and NASDAQ provide definitions of director independence. They are largely consistent, but there are some subtle differences, so you should make sure to understand the rules
of the exchange you want to list on. The independence rules are important because both stock exchanges generally require that a majority of the directors on your board be independent, and that you have entirely independent audit and compensation committees. Also, if you do have a nominating/governance committee, that committee generally also needs to be entirely independent. Now, having said that, there are two items to note: One is that both of the exchanges give new companies a transition timeline to meet all of the independence requirements; within a year after your IPO, you need to have a majority of independents on your board and completely independent key committees. The other item is that there are exceptions to certain independence requirements for controlled companies.

That covers board independence. What are some other factors of board composition that need to be considered? 
If you haven’t been a public company executive in the past, you might not realize that the SEC requires companies to describe directors’ experience, skills, and background in their proxy statements and in their registration statements. So when you’re building a board for your public company, consider which skills and experience your current directors have, and then think through what your future shareholders are going to expect to see on your board. They’ll want to be comfortable that your directors will be able to ask management the right questions and add value to the company. If you find there are any skills or experiences missing, that can help you figure out where you may have gaps.

Beyond skills and experience, there’s also the question of diversity. We are seeing shareholders becoming interested in looking at the diversity of opinions on boards, as well as basic gender and racial diversity. Just under half of the new public companies in our IPO study had at least one woman director on the board when they went public. Gender diversity is something to keep in mind when you’re considering board composition, particularly if you are in a consumer-focused organization and your various stakeholders might have expectations about board diversity.   

Probably the last issue we have time to discuss is to think through board dynamics. Your existing directors and your new directors not only have to work with the management team, but they’ve also go to be able to work well together. This is a factor that’s difficult to get a handle on, but it is an important one to consider as you’re thinking through reshaping your board composition.

When do you think companies that are preparing to go public should start thinking about these and other governance issues?
Our key message is to think about these issues sooner rather than later. We understand that if you are preparing to go public, you have a lot on your plate. You’re trying to get your financials right. You’re trying to get the audits in place that you need. You are dealing with new regulation. You’re drafting your registration statement–and more. But we do think that making key governance decisions—particularly around changing board composition—sufficiently in advance of going public can be a good thing. Some of the directors we interviewed said your audit committee members ideally should be in place at least six months before you go public; others said a year. One of the directors used a great phrase: A board needs time to season. New boards have to address many factors, so the better new directors get to know each other and the company, the more value they can provide going forward.

Where can board members go to get these books?
They’re available on our website, under the Research and Insight tab.


How TSR Is Used in Compensation Packages
with Tom Ramagnano, Meridian Compensation Partners

Before we talk about TSR specifically, could you give a little background on the increased use of performance plans?
Over the last several years, the use of performance plans really has increased significantly in the marketplace. However, this has not impacted the use of traditional long-term incentive (LTI) vehicles like stock options and restricted stock. Those are still used, albeit less predominantly.

The important part here is the fact that the weighting of performance plans as part of the overall mix in long-term incentives has risen over the last few years to the point where it’s at about 50% of the value that’s delivered to executives on an annual basis through long-term incentives. I think the reason that has occurred is that there’s still an intense focus on pay for performance.

What that does is dictate that pay outcomes, or the amounts that are paid to executives or earned through incentive plans, must be linked to company performance.  Also, Institutional Shareholder Services (ISS) has policies that basically say vanilla stock options and time-based restricted stock are not considered to be performance-based. So in an effort to comply with ISS policy, companies are moving more toward performance-based plans, and I think that’s an additional factor as to why there has been this increase in use and in the weighting within the overall mix of LTI. 

I want to talk, too, about the design of performance plans. More often than not, they are designed as performance share plans, which means they’re paid out in company stock and there is built-in leverage, meaning that executives can earn either above the target level of shares or below the target level of shares down to zero based on performance achievement over time, usually measured over a three-year period.

Why does the use of TSR continue to grow in prevalence?
I think there are a number of factors as to why companies are using TSR more frequently. I think first and foremost, it’s about optics. Companies are able to put in their proxy that they use total shareholder return, and some level of shareholder value creation is required in order for executives to be paid out. And it is something that the media and shareholders are looking for—some level of shareholder value creation for payouts to be made. 

Second, setting three-year goals for absolute financial metrics like net income or revenue is very difficult these days. As I sit in on committee meetings, I can tell you that one of the more complex areas of executive compensation every year is coming up with financial goals and metrics, and companies struggle with setting one-year goals, let alone three-year goals. So I think TSR affords committees and management a way to lessen that complexity by focusing more on stock price. 

A third reason why TSR is becoming more prevalent is that it really is the focus of ISS. When ISS does its quantitative analysis of CEO pay versus performance, it’s really looking at TSR over one-, three-, and five-year periods. So I think companies will utilize TSR to try to gauge where ISS might come out, as well as linking pay for performance in their own programs. 

What are some of the key issues related to TSR that compensation committee members need to be aware of?
There are several factors committees should consider as they begin to contemplate using TSR as a primary financial matrix in their long-term plans. I think most wouldagree that TSR over the long term is a really good measure of shareholder value creation. However, there are some that would argue that over the short term to midterm, there’s not necessarily that direct link between the actions that executives need to take and decisions they need to make to drive stock price performance and resulting total shareholder return. So what I think is missing is the potential for the line of sight to be direct and strong with the actions of the executive team and the resulting TSR. 

Are there other alternative uses for TSR?
Yes. They’re not as popular, but we are seeing some use of them. The first is using TSR as a modifier. In those types of plans, you still have a three-year performance period, and the performance is measured by internally set, absolute metrics like net income or revenue. Whatever those metrics determine to be the payout, committees can then use TSR as a modifier to adjust the number of shares that are actually paid out. So, for instance, if TSR comes in at the bottom quartile of the peer group, committees can adjust the actual payout by a certain percentage, say from 15%-25%. It’s just a way to modify the actual payout based on a total shareholder return metric. 

A second alternative use of TSR is to use it as a hurdle or a cap. In those instances, a primary absolute metric, like return on invested capital, is used to determine the payouts. However, committees can use the resulting TSR as a cap. For instance, if TSR performance is in the bottom quartile, the plan might dictate that participants cannot earn more than the target number of shares, even though the plan would have paid out well in excess of the target. So it’s used more as a cap or a hurdle to make sure there is alignment with shareholder value creation as well.

Is TSR the wave of the future for compensation?
As I look at the data, the use of TSR as a performance metric has increased in prevalence year over year. I tend to feel that we’re kind of getting to a point where it’s reaching its limit. I think it has its purpose, but I think it has its shortcomings as well. I do hear that quite a bit in committee meetings. Many companies have reviewed TSR as a potential metric and have decided against it. So I think the prevalence of TSR is probably near its peak.

I still think it’s going to be an important metric because ISS utilizes it from a pay-for-performance perspective, so I think committees will still consider it and continue to monitor it. 

So if comp committees are not looking at it right now, they need to make sure it’s something they consider. 
Absolutely.


IT Risk: Making BYOD Work for Employees and Boards
with Scott Mallery, BoardVantage

A very popular acronym right now is BYOD, which is “bring your own device,” something employees across organizations are participating in nowadays. 
Yes. A lot of companies over the last few years have been adopting emerging technologies and the bring-your-own-device initiative is one example.

It is where the workplace is allowing employees to bring in their own personal mobile devices to access privileged information and applications. One of the benefits these companies are realizing is increased production, because with personal devices, employees aren’t needing any training. They can access their information and have everything they need. Also, there’s reduced cost for hardware and software. Traditionally, if you have a company-owned device, there would be associated training costs but with BYOD, that is eliminated. The game changer was a few years ago—the iPad has really allowed businesses to go paperless. They can centralize their process and monitor all users when it comes to accessing information or removing permissions to have access to certain information.

What are some of the ways companies can utilize BYOD?
There are two different types of solutions. One is point solutions. These are solutions for mobile device management such that if someone in the IT group wants to remove or purge information from a device, they can do so. There are also some software applications that are point solutions. For example, if you want to alleviate a pain, like sharing documents. Second, there are platforms that provide an end-to-end solution where you can control processes from user provisioning all the way down to controlling if a device is lost or stolen. You can wipe that permission or even lock a user out. 

So a company’s documents and applications are accessible on the employee’s personal cell phone, but the company has the kind of control you mentioned.
Correct. With the platform, the administrator or legal department will have complete access to upload content, remove content, and they can also wipe content from those devices remotely.

Well that sounds like something that would alleviate fear of a security threat, but what are some of the risks associated with employees using their own devices for work?
Some of the risks you have include someone losing a device. For example, if an employee is traveling and leaves behind her iPad or phone, she would need to call the company, as there could be a potential data breach. The ability to remotely wipe information with the click of a button in a platform makes it very compelling to allow employees to use their own devices. 

How about for board members themselves, are they ready to embrace bringing their own devices to the boardroom?
Definitely, and what we’ve seen are really five key elements that folks will use. The first is to protect against discoverability. Board members are very sensitive to company information and note taking. So what we do here is ensure there’s no tracking of any information on those devices. The administrator is able to go in after a meeting and remotely purge the content, as well as ensure there is no note left behind. 

Second is online and offline syncing. So for users, it’s very important as they travel to be able to work both online and offline. This works well for folks that travel by plane or by train, where they don’t have access to the Internet. They can write their notes as they’re traveling to the meeting and then, when they get to the meeting and go back online, all those notes will come back up and be online automatically, so they have the same user experience. 

The third is to provide a similar process as the paper environment, which allows varying levels of access for users. For example, permissions can be set so members of the governance committee only see their committee-related materials and audit committee members see only their committee-specific information. 

The fourth element is to deliver a better experience than paper, and now this doesn’t just apply to iPads. Board work has evolved to iPhone usage, so in between meetings, directors can access board information in a much better way. 

And then the fifth element is to embrace better communications. In the paper world, there’s really one-way communication. You get the materials, and rarely does the general counsel’s office get any response back. With bring your own device, board members can access information, respond, and use secure messaging to ask questions, so it’s a better experience. They can use this method for approvals and e-signatures as well. 

What should board members ask the tech team that is evaluating BYOD to minimize risks to the organization?
The No. 1 priority is, of course, security. It’s all about the company data, so you need to ask how that data is being encrypted. Is that data being encrypted at rest, in transport, and offline? And then in regard to a lost or stolen device, what is the process? Is there a policy in place to be able to lock out that user as well as completely wipe out the information that would be on that device?

How is BYOD impacted when somebody from a company is traveling abroad, using his device and accessing programs on his own mobile?
It really is a decision that’s made by each individual company. Some companies will allow folks to use their own personal devices, but maybe with content segregation that only gives them access to specific information for their travels. There are some companies that prefer to provide a separate device for travel abroad, so that way there’s no access to company information but rather, just access to exact materials that they’ll need to use in their travels.

Topic tags: board of directors, corporate governance