Activist investors in both Canada and the US recently proposed – for Hess Corporation and Agrium Inc. – that their nominees to serve as independent directors on the companies’ boards should receive incentive pay directly from the activist investors themselves, with the amount that tied to share price appreciation.
The rationale for this incentive pay – which has been termed “golden leashes” – was to encourage new directors to the board to maximize share price.
Most independent directors on public company boards are compensated in a blend of cash and company shares. The equity component is typically restricted or deferred until the director retires from the board, thus postponing taxes and enabling the director to amass a portion of equity in the company to align his or her interests with shareholders (it is believed). The equity can be a predetermined number of restricted shares, or a set monetary amount in the form of share “units.”
The problem with paying independent directors this way is that there is little incentive for personal performance or company performance. Directors get paid the cash and equity regardless. There is little if any downside, especially when directors can ride a stock market or Fed driven increase in overall share prices.
Not surprisingly, the activists noted this lack of incentive pay.
It is hardly surprising that boards do not focus on value creation, strategic planning, or maximizing company performance as much as they do on compliance. Their compensation structure does not incent them to.
Compensation incentives drive behavior, both for management and for directors.
Here is what is needed to align director pay with shareholder interests:
1. Directors should be required to issue cheques from their personal savings accounts to purchase shares in the company. Bill Ackman of Pershing Square stated that if Canadian Pacific directors were required to cut cheques for $100,000 each, the CEO would have been fired prior to Pershing Square being involved. Mr. Ackman is right. “Skin in the game” for a director does not mean shares are given to a director in lieu of service. The motivation to be attuned to shareholders is greater if directors are actual investors in the company. In private equity companies, non-management directors are encouraged to “buy into” the company and invest on the same terms as other investors.
2. For Directors’ equity to vest (the portion they did not purchase), hurdles would need to be achieved that reflect personal performance and long-term value creation of the company. Assuming you have the right directors, this sets up a situation in which Directors are forced to engage in value creation and be rewarded for doing so, similar to private equity directors. The hurdle rate provides the incentive. The vesting hurdle should be based on the underlying performance of the company, commensurate with its risk and product cycle, possibly peer based, and not simply on riding a bull market.
3. The long-term performance metrics for value creation should also apply to senior management, and the board should lead by example. The vast majority of performance incentives are short-term, financial and quantitative. We know that the majority of company value however is now based on intangibles. Long-term leading indicators such as innovation, reputation, talent, resilience and sustainability are being completely overlooked in compensation design. You get what you pay for.
Management has proposed “passive” pay for directors and short-term pay for themselves. Boards have acquiesced.
Where the activists went wrong in the Hess and Agrium examples is in proposing short-term incentives tied to stock price that applied to a sub-set of directors. However their point is excellent in that independent director compensation is flawed. The correct approach is long-term value creation and incentives that apply to all directors, and to managers, and to shareholders.
Only when this shareholder-director-manager alignment occurs will the compensation issue be solved. It makes little sense to award executives on a biased short-term basis when the effects of their actions can last for years, or to award directors on the basis of time – or, as one of my students put it, “showing up.”
Compensation consultants are using the same short-term metrics as before the financial crisis. They need to be directed by their client boards to do otherwise.
The need to establish long-term value-creation metrics, in the words of one American director, “is one of the greatest challenges in establishing long-term incentive compensation plans.”
Richard Leblanc is a corporate governance lawyer, speaker and independent advisor to leading boards of directors. He is currently teaching corporate governance at Harvard University. He can be reached at email@example.com.