Participant Comments on Forum Objectives
Keith Johnson, who is currently coordinating the
International Roundtable on Executive Remuneration, has provided a very
thorough and thoughtful commentary on the Forum program. Copied below, it
the evaluation of options policies in the broader context of
executive compensation and the associated interests of shareholders in
long-term business performance, and
the need to tailor practices to individual companies, reflecting
particular strategies and competitive conditions.
The focus Mr. Johnson recommends is clearly consistent with the
Forum’s defined objectives and established direction. His carefully
organized observations therefore provide a very effective framework for
defining specific goals of the five projects we defined. We should make
good use of this to stimulate our thinking about what, specifically, each of
the projects should be presenting for review at the Forum’s open meeting in
As Mr. Johnson concludes, “success will depend on how boards,
shareholders and consultants implement their responsibilities on a
company-by-company basis.” Please let me know how you think the Forum
program can best address the information needs of these decision-makers.
GL – 1/19/07
Lutin & Company
575 Madison Avenue, 10th Floor
New York, New York 10022
Responses to December 2006 Options
Submitted by: Keith L. Johnson, Chairman
Reinhart Institutional Investor Services
After reflection on results of the Initial Open Meeting, the following
comments are submitted for consideration by participants in the Forum.
It would be most productive to evaluate stock option policies in the larger
context in which they fit. Failure to look at the bigger picture is one of
the problems that has contributed to unpleasant surprises and mismatched
executive compensation practices with shareholders. Option policies should
be tailored to each individual company and structured to fit each
company's strategic plans and competitive position. Where these are out
of alignment, either the compensation policies or the context in which they
exist must eventually change or company wealth and shareholder value will be
put at increasing risk.
Development of options and executive compensation policies also cannot be
evaluated outside the context of the board's fiduciary duties to
shareholders. The franchise granted to corporations by corporate law
contains a series of legal obligations. One of those is the overriding
obligation to manage the company in the best interests of shareholders.
This necessarily requires that, in the event of a conflict of interest
between management and the company's owners, the board cannot choose to
favor management at the expense of outside shareholder interests. Although
shareholders often have diverse goals and demands (e.g., active and passive
owners, short-term and long-term horizons, risk tolerance variations, use of
short sales and hedging versus long-only positions), boards are legally
obligated to do their best to make informed decisions about executive
compensation issues, identify shareholder interests, evaluate them, and
ensure that the company is managed in the overall best interests of
Options are a particularly challenging compensation vehicle because they
inherently involve dilution to future ownership of outside shareholders and
introduce potential divergence in interests with shareholders (e.g., from
vesting schedules and differences in downside risk and upside value).
Consequently, they usually need to be used with other compensation vehicles
that keep balance in the compensation scheme.
Policies on the use of options should only be considered in the context
of the entire compensation package within which they fit and the
circumstances of the particular company. From a shareholder perspective, a
one-size-fits-all approach to options could be very dangerous.
Effective Communication of Compensation Policies
Given that options are only one of many executive compensation tools, they
are best evaluated with a view toward the larger compensation plan context
in which they are used on a company-specific basis. However, in order for
shareholders to effectively perform their function (both as part of the
governance structure of the individual corporation and as decision makers on
allocation of capital in the marketplace), best practices on use of options
require a high degree of transparency in communications from directors to
shareholders. Conversely, direct and clear communications flow from
shareholders to directors also facilitates effective board performance of
Disciplined implementation of the recent SEC executive compensation
disclosure requirements will determine, to a large extent, whether more
effective options and compensation policies will develop. Fulfilling the
underlying transparency principles, rather than merely complying with the
new SEC rules, will be the key. Forum participants should commit to
encourage increased communication between boards and shareholders on the
full context in which options are being used at each company.
The following issues are among those that could be addressed by boards and
shareholders when evaluating option programs and the compensation plans
within which they are contained. To a large extent, what is measured and
evaluated will determine how options plans and compensation are managed.
Relevance and implementation would be expected to vary from company to
- Independence: Both compensation committee
members and the consultants they use should be free of conflicts and fully
able to function independently of influence by company management. That
does not mean that company management should not have input into the
process. However, it does mean that integrity of the process is crucial
to outside shareholders and the marketplace. If stakeholders do not trust
the players and the process, effective communication and acceptance of the
program will be undermined.
- Compensation Discussion and Analysis (CD&A):
The board's compensation philosophy and how use of options fit within the
overall company strategy should be communicated clearly. The CD&A is part
of a conversation with shareholders and the marketplace about how the
board approaches compensation practices. Shareholders should demand that
the CD&A meet their requirements and that it demonstrate how compensation
is aligned with their interests. Boards must ensure that shareholders
understand the company's compensation philosophy.
- Shareholder Base: Proactive board attention
to the company's shareholder base was a central recommendation of the
Conference Board's Commission on Public Trust and Private Enterprise. A
shareholder base of short-term investors is unlikely to support a
strategic or compensation plan that focuses only on long-term goals.
Companies that need a particular base of shareholders might need to
develop a plan to seek out those shareholders as part of the compensation
- Competitive Comparisons: Boards and
shareholders could be more careful in evaluating how option programs and
compensation plans use market comparisons. Pay delivery consultants have
not always focused on apples to apples comparisons in job matching.
Global companies with a global shareholder base may find it increasingly
difficult to limit themselves to local US market comparables. If
shareholders demand that boards fulfill their fiduciary responsibilities
and apply the same standards to locating qualified and competitively
priced executive personnel as they do to any other labor contract, global
companies will be increasingly forced to include executive compensation
comparables from outside the US. At underperforming companies, greater
attention to comparables might mean not using executives at outperforming
companies for current compensation award comparables. Companies with
single product lines might not compare their executives to others at
complex conglomerates (even in the same industry), where a higher skill
set is required. Executives with few strategic planning responsibilities
might not be compared to those at companies where executive strategic
planning duties are more closely associated with shareholder value.
- Total Holdings: Should option plan design
reflect how much an executive has already accumulated in company equity
exposure? The marginal increase in incentives associated with additional
equity awards might vary depending on size of existing holdings.
Shareholders and boards could question plans that fail to address this.
Tally sheets with total company career compensation received might be
enlightening in this regard.
- Pay for Performance: On an all-in basis, are
the shareholders obtaining a reasonable return on their investment for the
compensation paid to company management? If the board and shareholders
are not comfortable that pay is aligned with performance and that both
management and shareholders are receiving a fair split of company profits
and losses, the board has failed in performing its executive compensation
- Internal Pay Equity: Credit rating agencies
have begun to recognize increased investor risk is associated with CEO
compensation levels that are more than about three times greater than a
company's next level of executives. Should boards and shareholders begin
to view unexplained internal equity issues as indicative of "iconic CEO
risk" or an unrealistic CEO succession plan? Boards would be well-advised
to consider succession planning in conjunction with compensation.
- Integration with Strategic Plan: The board
and its consultants should be able to clearly articulate how option and
other compensation plan components are tied to the company's goals. For
example, will compensation reward sustained shareholder returns, reflect
the company's cost of capital or return on assets, include internal
operational goals and facilitate healthy relationships with the company's
other influential stakeholders. Shareholders could focus on evaluating
how incentive plan targets and metrics are integrated with the company's
strategic plan and whether the board is regularly reviewing the goals to
ensure their relevance and consistency. Distinctions between operational
duties and strategic responsibilities targeted to build future value
should be particular interest to shareholders. Information about ability
of the compensation consultant to provide services beyond mere pay survey
comparisons might also help shareholders determine whether the board has
been adequately advised.
- Company Specific Evaluation: Companies should
obtain regular feedback from their shareholders on how the market
evaluates the job they are doing on executive compensation. Directors
would benefit from both interaction with large, sophisticated shareholders
and from advisory shareholder votes that provide information from all
shareholders, including those not in direct communication with the board.
Shareholder advisory votes on compensation plan disclosures currently used
in the UK, Australia and several other countries have been effective in
providing boards with this information. These votes also ensure that
directors receive an unvarnished market reaction that is not filtered by
intermediaries (e.g., management, compensation consultants or politically
motivated shareholders) with potentially conflicting interests.
- Gratuitous Compensation: The underlying
fiduciary duty of directors precludes them from giving away compensation
without receipt of some benefit to the company. Compensation received
through option awards should be evaluated in combination with other
compensation (e.g., change in control payments, retirement awards, perks,
etc.) to ensure each form of compensation is procuring an added benefit
for the company that is consistent with shareholder interests. Complex
compensation schemes, duplicative awards under annual bonus and long-term
incentive plans and redundant rewards to different executives for the same
achievement are areas particularly ripe for evaluation in this regard.
Differentiating between operational and strategic goals could also help
identify redundancies in executives' responsibilities and flag related
compensation payment waste.
- Clawbacks: Failure to include provisions in
option plans to recover awards improperly made for meeting financial or
performance targets that are subsequently restated should be treated as a
red flag. Aversion to clawbacks raises questions about integrity and
whether the compensation plan is aligned with the interests of
Option policies cannot be designed or evaluated in a vacuum. They fit into
a broader context and should be viewed on a company specific basis as part
of an overall compensation plan. One way to improve option plans would be
to encourage clear communication about their design to the marketplace and
facilitate direct shareholder response at each company. The SEC disclosure
requirements and implementation of an advisory shareholder vote on executive
compensation would provide a market based process to help identify best
practices over time. However, success will depend on how boards,
shareholders and consultants implement their responsibilities on a
company-by-company basis. Attention to the issues set forth above would
help make the process more effective.