According to the King III report, which was released at the end of February 2009, companies’ boards are responsible for the development of remuneration policies. However, companies’ boards are now required to present the proposed remuneration policies to the companies’ shareholders for approval at a general meeting, which is in line with international best practice. As with King II, a Remuneration Committee is required to make recommendations to the board regarding remuneration policies.
Internationally, the need to revisit executive compensation practices was highlighted by the collapse of the United States (US) housing market in 2007 and the ensuing credit crisis, which wreaked havoc on global markets. The crisis manifested in, amongst other things, the erosion of shareholder value, high levels of market volatility and a lack of confidence among market participants. A very specific point of contention is the role that executive compensation played in incentivising risk-taking by executives, who jockeyed the creation and marketing of complex financial instruments, as was the case with the American International Group (AIG) in the US.
These incentive structures rewarded short-term risk taking without taking into account the potential long-term effects on the company, which may have contributed to the financial crisis. The root of the problem can be traced to greed. This is a sentiment that is shared by Charlie McGreevy, Internal Market Commissioner of the European Commission (EC): “Up to now there have been too many perverse incentives in place in the financial services industry. It is neither sensible nor sane that pay incentives encourage excessive risk-taking for short-term gain.”
The subsequent public outcry regarding executive compensation without due performance has highlighted serious concerns from various stakeholders in the international community. Shareholders, regulators, the media and the general public are now focusing closely on executive compensation. The challenge with executive compensation is to achieve goal congruence, i.e. aligning executive incentives with shareholder value creation, amidst the executive labour market’s war for talent. As Timothy Geithner, US treasury secretary, rightly pointed out: “Companies should seek to pay top executives in ways that are tightly aligned with the long-term value and soundness of the firm”.
However, no such alignment was visible within the AIG, whose executives, despite the company’s near collapse and subsequent bailout by the US government, even within the divisions responsible for the collapse, earned millions of dollars in bonuses. Although a confiscatory tax of 90% was subsequently imposed after a public outcry, many executives within the financial products division maintained that these bonuses were completely deserved.
In our own backyard, executives at Eskom were awarded bonuses to the amount of R10 million in March 2008, based on a year in which Eskom’s financial bottom line dropped by 85% to R974 million, down from R6.5 billion in 2006/2007, and the South African economy was brought to its knees by relentless power outages, hardly measures that to the educated mind warrant rewards for due performance. After a public outcry, Eskom CEO, Jacob Maroga, issued a statement saying that he would not be taking a bonus. The other executives, however, accepted 50% of their allotted bonuses.
As is often the case, the latitude of freedom needs to be reeled in after it has been abused. In business, this normally entails the re-examining of corporate governance. The purpose of this article is to explore which measures are currently in place or have been implemented internationally and locally to address these issues; and whether a framework exists that constitutes best practice?
Corporate governance measures
Following the collapse of the US housing market and the subsequent collapse of global stock markets, the EC released two recommendations on executive compensation in May 2009. This followed conclusions that were drawn from the Ecofin (Economic and Financial Affairs) Council meeting among the economic and finance ministers of the 27 member states of the European Union in December 2008.
Although existing initiatives focus on pay for performance through disclosure of remuneration policies, the EC now seeks to address structural flaws in remuneration policies. The first recommendation provides guidance to facilitate the structuring of executive compensation in line with performance by:
• focusing on the variable components of pay;
• suggesting that variable components of executive compensation should:
• be capped;
• be based on predetermined and measurable performance criteria;
• suggesting that severance payments should:
• not exceed two years’ fixed salary;
• not be paid if termination of employment is due to inadequate performance;
• focusing on a company’s long-term sustainability;
• advocating a minimum three-year vesting period for share options;
• requiring that a fixed number of shares are held until the end of employment;
• promoting the deferment of a major part of the variable component of pay; and by
• suggesting that claw back provisions should be included in contracts.
The recommendation, as with the King III report, also elaborates on the governance of remuneration policies with a specific focus on:
• strengthening the remuneration committee;
• ensuring the impartiality of remuneration consultants;
• the mitigation of conflicts of interest; and
• encouraging shareholders to use their votes at general meetings regarding director remuneration.
The second recommendation focuses on remuneration policies of companies in the financial services industry. The four major areas of concern are:
• remuneration policies of risk-taking staff should be consistent with, and foster, sound and effective risk management;
• remuneration policies should be transparent, clear and properly documented;
• remuneration policies and their features should be adequately disclosed to shareholders in a clear and understandable way that explains the main components of the policies, their design and operation; and
• the importance of supervision.
Although proper disclosure remains key to remuneration policies, these two new recommendations emphasise the importance of maintaining a balance between fixed and variable pay, identifying measurable performance criteria and the presence of sound supervision.
In a similar vein in the US, Geithner released a statement in June 2009, outlining five broad principles regarding executive compensation. According to his statement, remuneration policies should:
• properly measure and reward performance;
• be structured to account for the time horizon of risks;
• be aligned with sound risk management;
• be re-examined to establish whether golden parachutes and supplemental retirement packages align the interests of executives and shareholders; and should
• promote transparency and accountability in the process of setting compensation.
In a further effort to protect shareholder interests, the US Treasury Department released the “Say on Pay” bill in June 2009. Although the effective date is, as of yet, unknown, the bill gives shareholders the right to vote on the annual compensation for a company’s top five executives. The “Say on Pay” vote, which is already required or encouraged in the UK, Australia, Sweden and the Netherlands, was first piloted in England and demonstrated that it is an effective tool for shareholders to voice their discontent. The vote will be based on the pay as described in the Compensation Disclosure and Analysis sections of companies’ proxy statements, including salary, bonus, share awards, option awards, non-equity incentives, change in pension value, deferred compensation earnings, all other compensation and total compensation amount. Similarly, the King III report in South Africa requires shareholders to approve a company’s remuneration policy.
The US Securities Exchange Council (SEC) chair, Mary Schapiro, issued a statement in June 2009, outlining new disclosure rules that it plans to propose in the coming months for, amongst others, a company’s overall compensation approach and the potential conflicts of interest between compensation consultants and the company and its affiliates.
It seems that companies in general are rather reluctant to disclose their actual goals for executives on which bonuses are based. A Watson Wyatt-study in 2007 indicated that only 46% of public by traded American companies disclose the goals on which they base rewards, and only 55% disclose the goals for long-term incentive plans.
The SEC adopted new rules in 2006 in an attempt to furnish investors with enough information to enable them to understand how executives are compensated. According to SEC rules, companies must disclose such information in their proxy statements, unless it could result in “competitive harm”. Despite the fact that only half of the companies disclosed the information, even those that did failed to disclose specifics such as attaining earnings per share of US$4, for example.
According to Ira Kay, director of compensating consulting at Watson Wyatt, companies are experiencing increasing pressure from investors to be accountable for their executive pay programmes. Companies, however, should not do so grudgingly, but rather use this as an opportunity to demonstrate how their pay programmes are performance-based, which is the key requirement for executive compensation.
According to the King III report, which was released in February 2009, the board, assisted by the Remuneration Committee, should present a remuneration policy to the shareholders for their approval at a general meeting. The remuneration policy should reflect fair and responsible compensation, and focus on enhancing shareholder value in the longer term. Remuneration policies, the company’s strategic objectives and how they were implemented, the base fee policy, benchmarks, annual bonuses for targets achieved and pay above the median should be disclosed in the annual remuneration report. In order to avoid the manipulation of results, King III recommends that multiple performance incentive measures are used, including share incentives, and recommends that the vesting of share options and conditions of performance achievement should be linked to shareholder value.
The Remuneration Committee should, amongst other requirements, recommend a remuneration policy for executives, align the mix of fixed and variable pay with company needs, ensure that recorded performance measures are accurate, and regularly review incentive schemes such as share-based and long-term schemes for their contribution to the enhancement of shareholder value. Shareholder approval is required, in advance, for all new long-term share-based and other incentive schemes or major changes to the existing schemes.
A value framework for executive compensation
World-renowned leaders in the executive search industry, Heidrick & Struggles, emphasise three key principles of executive compensation: appropriateness, fairness and effectiveness. A strong strategic and operational skill set is required to run a business successfully, i.e. to sustain and increase shareholder wealth. Executive skills are applied in a certain corporate setting, of which certain generic parameters will render the executive compensation appropriate or not. According to Heidrick & Struggles, the appropriateness of executive compensation levels can be judged against the following parameters:
• Size – revenues, number of businesses, employees, etc;
• Complexity – number of products and services, technological content, extent of international, multicultural scope;
• Nature of the specific market – expanding, contracting, threatened by radical/ revolutionary competing businesses, chronic underperformance;
• Overall economic context – boom, bust, cost of capital; and
• Specific executive duties – scope, complexity, multiple versus single areas of responsibility.
Fairness is probably the most difficult of the three principles. According to Randy Jayne, managing partner at Heidrick & Struggles, the market will correct under- and over-paid executives. An executive whose pay is excessive when compared to poor company results will not be able to move to a similar position at another company with the same level of compensation. The executive’s compensation will either be adjusted downward or he/she will be dismissed. On the other hand, as executives become aware of the fact that their compensation does not offer a fair reward for their performance, they will move elsewhere.
The underlying principle that anchors effectiveness is pay-for-performance. The base pay should be set at a moderate level and topped up with variable performance bonus plans for both the short-term (current year) and the long-term (three to five years). The important link is how to connect improved company performance with a particular element of executive compensation.
An interesting alternative, which focuses on aligning executive’s efforts with the long-term performance of the company, is escrow accounts. According to research conducted at the University of Pennsylvania in the US, compensation structures based on long-term escrow accounts are a better alternative to cater for a company’s long-term future than the traditional method of rewarding short-term changes in the share price. The research indicates that linking executive compensation to the performance of the company over a number of years will prevent executives from taking short-term decisions that may enrich them vis-à-vis the company’s future profits.
The basic principle underlying this approach to executive compensation is that executives be allocated escrow accounts wherein a constant balance between cash and equity is maintained. These accounts are rebalanced on a monthly basis to maintain a “constant percentage” of shares and cash in each account. Applying this concept to a South African company where the percentage was set at a 70:30 share-to-cash ratio, for example, would mean that a CEO that earns R10 million, would have R7 million in the form of shares and R3 million in the form of cash. Should the share price fall, this would result in cash in the account being drawn to buy more shares in order to maintain the 70% share portion. If the share price increases, the CEO has the option of selling shares to increase his cash position. However, these gains cannot be cashed in immediately, but will vest gradually.
Apart from the fact that the escrow accounts manage to marry executive and shareholder goals, they also introduce a mechanism to avoid the short-term manipulation of the share price. Although companies such as Goldman Sachs and Morgan Stanley have implemented clawbacks for bonuses, Alex Edmans, finance professor at the University of Pennsylvania, holds that they are not as effective as escrow accounts: “If you have paid out bonuses and the company then tanks, trying to claw back the bonus seems like shutting the barn door after the horse has bolted”.
It is important to bear in mind that no single compensation model will suit all companies. The responsibility for implementing new executive compensation schemes resides with companies’ boards of directors. The board has the responsibility to ensure that executive compensation schemes are in the long-term interest of companies. How long “long-term” should be is up to a company’s board of directors, but one could argue that such a time frame should at least equate to the time it takes for the executive’s key actions to manifest in operations and the share price. In any event, a time frame of shorter than five years may carry with it an increased risk of actions taken to realise short-term earnings and share price spikes, but could hurt the company in the long run. Enron and Countrywide Financial are but two examples of the latter.
In terms of remuneration policies, the right mix of remuneration will ensure that the desired executives are attracted, retained and motivated. To this end, remuneration policies should embody three basic principles, i.e. appropriateness, fairness and effectiveness. The golden thread to the success of any remuneration policy is that it is appropriately linked to performance and ultimately enhances shareholder value over the long-term. To this end, the application of the concept of escrow accounts may be worth exploring.
Jayne, R. 2005. Leading practices in executive compensation. Working paper. Heidrick & Struggles Knowledge Management Centre. pp 1-9.
Riskmetrics. 2009. EC issues new pay guidelines. Published on Riskmetrics Group.: pp 1-3.
Riskmetrics. 2009. Treasury calls for annual advisory votes. Published on Riskmetrics Group.: pp 1-5.
Edmans, A., Gabaix, X., Sadzik, T. and Sannikov, Y. 2009. Dynamic incentive accounts.Working paper. Wharton School: University of Pennsylvania.pp1-46.
Jacobus van Zyl Smit CA(SA), BCom, LLB, is a non-Executive Director at PSG. Soon Nel CA(SA), MCom, HDE, is a lecturer in the Department of Accounting at the University of Stellenbosch.