How you pay your board affects their motivation and mission
Over the past few years, due in part to corporate scandals, shareholder activism, media criticism, and recent legislation, there has been a major reexamination of the role and accountability of Boards of Directors. This has resulted in a number of healthy outcomes, perhaps the biggest being that Boards have come out of the boardroom and are becoming more active in their oversight of corporate activities.
The move to reign in excessive executive compensation has at the same time placed a renewed emphasis on the responsibilities of the compensation committee. As more eyes are focused on the Board, it has become correspondingly more difficult to recruit qualified, independent Directors, which has in turn resulted in changes in the compensation packages of paid Directors. Some of these changes are as a result of supply and demand; others are a reaction to changes in legislation, accounting rules and shareholder awareness.
Before we delve any deeper into these changes, it is important to segregate Boards and their compensation arrangements into three types so we can better understand the dynamics between Director pay and performance: Board members of public firms are elected by shareholders and serve distinct terms. They’re appointed to specific committees with the responsibility to oversee various corporate activities (audit, compensation, nomination, government, etc.), and those responsibilities are clearly delineated by charters or other formal documents. These Boards are governed by a variety of regulations and regulatory bodies(Sarbanes-Oxley, the Securities and Exchange Commission and the Internal Revenue Service), as well as having specific duties and responsibilities defined by those regulations.
These Board members are typically compensated for their services commensurate with similarly sized firms in their industry, and usually receive payment in cash and stock. This is the group of Directors that is most in the limelight, and for which compensation arrangements are most prevalent.
It’s interesting to note that although most Board members serve on a voluntary, unpaid basis, they’re subject to more stringent and punitive regulations relative to their compensation decisions that are compensated Board members serving public corporations.
The cash component of their compensation consists of an annual retainer for Board membership and participation in specific committees. Although they have historically received separate meeting fees for attendance at each Board or committee meeting, the recent trend has been to eliminate such payments and fold these fees into the retainer. With the inclusion of meeting fees, there has been a marked increase in the amount of compensation paid to Directors. The other cash component of the compensation package is for holding the Chairmanships of certain committees (audit and compensation, for example), and for acting as the independent head of the Board. These various cash components can easily total $150,000 or more for a large public company.
The second major component of the Board compensation at public companies consists of stock. In the past, this has consisted almost entirely of stock options, but there has been a recent shift to other-based programs – primarily restricted stock – because of FASB requirements to expense options, the desired reduction in amount of stock overhang and the inherent value associated with full-value plans. Many companies have also adopted stock ownership guidelines for their executive, and these guidelines have been extended to outside Directors. While options generally don’t count in calculating stock owned, restricted stock is included in determining the multiple of compensation used for establishing stock ownership.
These Boards are commonly comprised of the owner(s) of the company. There has typically been a more inclusive attitude in privately owned companies, which means the Board will also often include outside advisors such as the company’s accountant and/or legal counsel, other (non-working) family members, investors and, less frequently, outside independent parties.
Processes among these Boards tend to be much less formal. Board members are selected, not elected, and the compensation decisions are usually are more informal and tend to lack the arms-length dealings between corporate officers and outside Directors that are required in public companies. For example, compensation decisions are often made by the owner/Director with limited input from outside advisors. Regulations covering compensation arrangements (and the reasonableness of compensation) in privately owned firms are less extensive, but are still subject to the scrutiny of the IRS as well as other shareholders and investors.
Working family members who serve on the Board usually aren’t paid, they obtain thier compensation through salary and distributions of profits. However, outside Board members are typically paid for their services. In those instances where Directors are also outside formal advisors to the companies, their compensation may be an extension of their regular professional services (or a separate pre-established meeting fee). In virtually every case, the compensation paid for Board members at a privately-owned company is considerably less than at a comparable public corporation, and doesn’t contain an equity compensation component.
Not-For-Profit organizations (NFPs)
NFP Boards tend to be made up of individuals who serve on a volunteer basis and are selected because of their strong dedication and belief in the goals and humanitarian or religious mission of the organization. It is not unusual for Board members to be chosen for their philanthropy and ability to devote time to a cause rather than their business acumen and expertise. Often, these Boards have a number of standing committees to oversee organizational activities. While many NFP Boards are active in the affairs of the organization, the top executive and executive committee often hold considerable influence over Board decisions.
Very few NFP Boards provide any form of compensation to their members, although there doesn’t appear to be any prohibitions from doing so. NFPs are accountable to the IRS, lately through IRC §4958 (Intermediate Sanctions regulation) which requires officers to be compensated competitively. In addition, many state Attorneys General are monitoring NFPs, looking for excessive compensation. offices are similarly monitoring NFPs in matters of excessive compensation. It is interesting to note that although most Board members serve on a voluntary, unpaid basis, they are subject to more stringent and punitive regulations relative to their compensation decisions than are compensated Board members serving public corporations.
Proper governance is also an issue facing Boards. While privately owned firms are less concerned with governance vis-à-vis federal legislation, they’re shifting toward this concept, assuming that at some point they will face more definitive and restrictive regulations.
While these three these types of Boards differ in their compensation and background, they share many common issues. Overwhelmingly, public company and NFP Boards face the scrutiny of federal regulators looking into executive compensation practices. This puts a tremendous burden on their compensation committees to ensure that compensation package are competitive with similar jobs in the industry and that any above-average compensation is justified by above-average performance. Even privately-owned firms are more frequently coming under scrutiny by the IRS and minority shareholders with regard to excessive compensation, and many are seeking outside compensation consultants to assist in the design of a fair and equitable compensation packages. This requires a change in mindset among privately owned firms, whose owners often dictated the terms of their compensation without regard to the company’s financials or their own performance.
Proper governance is also an issue facing these Boards. While privately owned firms are less concerned with governance vis-à-vis federal legislation, they’re shifting towards this concept, assuming that at some point they will face more definitive and regulations.
How can you help your Board operate more effectively in today’s highly charged, high-visibility environment? Here are four steps that Boards and compensation committees can take to ensure their continued success and compliance:
· Establish a working, cooperative relationship with management. With the increased responsibility of the Board, management often feels territorial and may not be open to the Board’s involvement in the company’s affairs. The Board should only seek to become involved in those matters where they have clear accountability, leaving the day-to-day management of the company in the hands of the executive team. In other words, the Board should provide the direction and oversight, but should not micromanage things.
· Document all discussions, decisions, rationale, and provide appropriate supporting data. This includes clear and concise Board/Committee minutes, attendance records, resolutions, other decisions of the Board, and related matters. Changes in corporate policy, this should be clearly documented, and any documented, and any documentation that supported the change should be included. If outside advisors are used, their recommendations need not be adopted wholesale, but instead should be considered in light of the organization’s mission, direction, culture, and resources. If their recommendations aren’t adopted in whole or in part, provide a written explanation as to why not.
· Define the Compensation Philosophy for the company. The Compensation Philosophy serves as the baseline for establishing all compensation programs for the company. Therefore, it is essential that the concepts of the philosophy tie directly to the organization’s business strategy and future direction. The Philosophy should identify the marketplace in which the company operates, its relative position within that marketplace and the various elements of the compensation package. Also, the compensation philosophy will establish the mix of fixed pay and variable pay, including annual awards and long-term incentives.
· Establish compensation plans in writing.
Having clear plan documents, administrative guides, communication memos, etc., will assist the company in administering these programs with objectivity and consistency. This will also help avoid challenges in award calculations where performance metrics are utilized. Side deals, under-the-table plans and similar forms of undocumented compensation are prohibited by statute in most cases; even if they’re not, they leave the company open to criticism and censure.
Understand What Motivates Them
Bottom line: By understanding the way your Board is compensated and what motivates them, you can better address the operational issues and objectives they face. Help them be the best they can be, and that will ultimately translate to higher performance and greater profitability.
Paul R. Dorf, Ph.D., APD