Red Flags for Say-on-Pay Voting
For investors, the advent of
advisory shareowner votes on executive compensation — at more than 300
companies in 2010 — is an opportunity and a challenge. These votes can be
catalysts for shareowner discussions with directors and management about
pay concerns, including the structure and size of executive compensation.
But they also oblige shareowners to analyze compensation in a thoughtful
Many investors, however, lack
the time and resources to do deep dives on compensation at each of the
hundreds of companies in their portfolios. They need rules of thumb to
identify executive pay programs that are ticking time bombs.
Poorly-designed incentives can promote excessive risk-taking and get-richquick
mentalities — key contributors to the financial crisis.
Accordingly, the Council has
developed the following list of red flags to help members target companies
where pay deserves careful scrutiny and where dialogue may be most urgent.
The list was crafted by Council staff after a thorough review of Council
policies and comment letters on executive compensation, checklists
developed by other organizations and the recommendations of 15 pay experts
who briefed members in a series of teleconferences in 2009.
The list is a guide to
problematic pay practices but is not meant to be exhaustive.
1. Stock Ownership
and Holding Policies
- Do top executives have
paltry holdings in the company’s common stock and can they sell most of
their company stock before they leave?
Senior managers who don’t own
much company stock may not be guided by what is in the best interest of
long-term shareowners. Executives who can cash their stock out quickly may
be emboldened to take excessive risks that pump up short-term gains at the
expense of long-term value creation. Compensation committees should ensure
that top executives own a meaningful position in the company’s common
stock, after a reasonable amount of time, and that they hold a significant
portion of their equity-based compensation for a period beyond their
- Does the company lack
provisions for recapturing unearned bonus and incentive payments to
Strong clawback policies may
discourage a CEO from taking questionable actions that temporarily lift
share prices or accounting numbers but ultimately result in a financial
- Is only a small portion of
the CEO’s pay performance-based?
- Is the company’s
disclosure of pay-related risk management controls and procedures
nonexistent, vague or suggestive of weak oversight by the board?
- Is the CEO’s annual bonus
based on a single metric?
- Is long-term incentive pay
also linked to the same target?
To promote long-term
shareowner value creation, a majority of senior executive compensation
should be based on performance, and pay-related risk should be properly
disclosed, managed and overseen by the company and the board. A mix of
metrics that support the business strategy makes it harder for a CEO to
game the result than if just one metric is used (and check your wallet if
EPS is the sole metric because it is relatively easy to manipulate).
Diverse metrics also discourage executives from focusing on one goal while
ignoring others. Using the same metrics for short- and long-term incentive
pay rewards executives twice for the same performance.
- Are executive perks
- Do they seem unrelated to
legitimate business purposes?
Lucrative special perks can
be a sign that the board is in the CEO’s pocket. They can also harm
5. Internal Pay
- Is there a wide pay chasm
between the CEO and those just below?
This can indicate poor
succession planning and a weak compensation committee. It can also
demoralize promising senior managers. Many compensation experts draw a
line at CEO pay that is more than three times that of the next layer of
6. Stock Option
- Did the company reprice
underwater options for executives, thereby shielding them from downside
- Did the CEO receive
options that vest after a period of time, with no performance
A rising market or sector can
lift the share prices of all players, even those performing poorly
relative to peers. To isolate management’s contribution to stock price
performance, stock options should be indexed to a peer group or should
have an exercise price higher than the market price of common stock on the
grant date and/or vest on achievement of specific performance targets that
are based on challenging quantitative goals.
7. Performance Goals
- Did the CEO get a bonus
even though the company’s performance was below that of peers? Incentive
pay is supposed to motivate executives to deliver superior, sustainable
returns exceeding those of peers. A company that rewards below-median
performance is likely to get it.
- Does the company disclose
performance goals? Investors cannot evaluate the rigor and payfor-
performance alignment of pay programs without knowing the targets that
the CEO was shooting for.
- Does the company guarantee
severance payments to executives who leave as a result of poor
performance—whether they are terminated, resign under pressure or the
board fails to renew their contract?
- Are change-in-control
payments (including a large slug of options that vest upon the control
change) so lucrative as to incent executives to sell the company even if
that is not in the best interests of shareowners?
- Do retired executives get
perquisites? That can be a sign of a board that is in thrall to the CEO;
top executives are usually paid well enough to cover the costs of their
- Does the company make
payments beyond earned or vested compensation upon the death of
- Do supplemental executive
retirement plans (SERPs) use guaranteed or above-market rates of return
or add phantom years of service or other sweeteners that are not
available to other employees?
compensation can hurt morale, the company and shareowners.
Policy and Philosophy
- Is the Compensation
Discussion & Analysis confusing, vague or incomplete?
- Does the narrative focus
on the whats and hows, with short shrift to the whys?
- Does the disclosure fail
to explain how the overall pay program ties compensation to strategic
goals and the creation of long term shareowner value?
- Does the company’s list of
pay peers leave you scratching your head, and does the company do a poor
job of explaining and justifying its process for selecting pay peers?
Investors need to understand
whether and how the executive pay program encourages superior,
sustainable, long-term shareowner value creation. A company that does not
make a cogent, convincing case may have a muddled pay program and a
compensation committee that is not doing its job. Also, a company’s choice
of pay peers can have a major impact on the size and structure of
compensation—investors must take care that the pool of peers is legitimate
and not designed to pump up pay for executives.
- Does the firm advising the
compensation committee earn much more from services provided to the
company’s management than from work done for the committee?
Consultants who count on
lucrative actuarial or employee benefits business from senior management
may be inclined to recommend overly-generous pay packages for those
executives. Helpfully, the SEC now requires proxy disclosure of all fees
paid to the compensation committee’s consultants if the consultant or its
affiliates earns more than $120,000 for work performed for the company
beyond executive and director compensation services. Disclosure must be
broken down between: (1) aggregate fees for executive and director pay
consulting; and (2) aggregate fees for other services.
© 2010 The
President and Fellows of Harvard College