MVC Associates International
Sept 4, 2003
Mr. Jonathan G. Katz
Re: Proposed Amendments to NYSE Rules Relating to Corporate Governance
I am writing to express our strong concerns regarding the proposed changes to compensation committee responsibilities in Amendment No 1 to the NYSE's Corporate Governance Rules Proposal (Amendment No. 1 ).
The SEC and the NYSE have made progress to improve corporate governance.
However, our emerging research regarding problems with CEO Pay for Performance, compels us to share recent findings. Our credentials include numerous appointments and publications on organization and executive work design, executive search, leadership assessment, performance management and shareholder value. i Our research identifies a crisis in competence related to executive compensation and pay for performance.
I will specifically address the responsibilities of the compensation committee and the required skills and knowledge to effectively carry out its charter, and add value to the governance process.
Our recent research has identified that:
The Role of the Compensation Committee & Proxy Statement Disclosure
Too many Compensation Committees are asking the wrong question. They have been asking
"How Much" and have not been asking " For What". Thus Pay for Performance is not working.
The proposed NYSE amendment to subsection 5 of new section 303A of the Listed Company Manual mandates that the board's compensation committee:
This is a good start, but does not go far enough.
Missing First Step
Forty years of research on organization design and accountability iii as well as current statutes and legal case precedent show a first and required process step has been omitted by the NYSE.
Employment laws and case precedents established by the EEOC and Equal Pay Act define that, to effectively address employment issues related to selection or pay, a rigorous job analysis is required to define and clarify what is the work. Should not the principles and spirit of these laws apply equally in the boardroom to the benefit of shareholders?
The Level of Complexity of the CEO role at Johnson and Johnson versus at El Lilly, is exponentially more complex, as it is at Procter and Gamble versus Kimberly Clark. Yet Eli Lilly and Kimberly Clark have chosen these peer group companies and CEO roles to benchmark against that are far more complex than their own CEO roles. J&J and P&G due to the higher complexity of their CEO roles should have a CEO compensation band exponentially higher than Eli Lilly and Kimberly Clark. iv However, faulty benchmarking is contributing to excessive executive compensation for the less complex CEO roles. This example represents much of current practice.
Boards appear to function as if all CEO jobs are created fairly equal. This is far from reality. Key factors used to evaluate executive work and the link to comparable compensation seem either to be missing or based on job evaluation factors that are not applicable at the executive level nor legally defensible. This same 40 years of research v has determined that titles (CEO, President, EVP), thumb nail job descriptions, layers / reporting lines, or size of business are inadequate indicators of comparable jobs at the same Level of Work Complexity. Yet this is accepted as common practice for CEO compensation benchmarking and succession planning. vi
Too many CEOs are being overpaid for the Level of Work and unique contribution they are being held accountable for by their Boards. This is based on the fact that 32 % of the S&P 500 had failed over 5 years, ending in 2000, to provide a Return on Invested Capital (ROIC) great than their Weighted Average Cost of Capital (WACC). If we recalculated these numbers for the 5 years ending in 2002, the number of companies not returning back their cost of capital could easily exceed 50 % of the S&P 500 vii Thus the business model and strategies of these poorly performing companies, based on Economic Profit and ROIC as measures, are not working. Nor is CEO Pay for Performance and related board governance.
The courts have established that without a clear and defensible understanding about the true nature of the work, identified through a rigorous job analysis, there is no basis to defend decisions related to pay or selection (please interpret as CEO compensation, selection and succession).
Thus we recommend that the NYSE incorporate a requirement for:
We will now address the three mandates proposed by the NYSE regarding the compensation committee and CEO compensation.
NYSE mandate 1. ) "Review and approve corporate goals and objectives relevant to CEO compensation"
We agree with the NYSE that the compensation committee should review the proposed corporate goals and CEO compensation to ensure alignment with pay for performance. This is operating performance that creates shareholder value, not just stock market performance. The Compensation Committee should establish the Compensation Policy & Pay for Performance Principles for the enterprise to define stakeholder value and how this will be measured.
Our review of S&P 500 proxy statements shows that 55 % of these companies are not establishing goals nor measuring business performance for the CEO beyond 1 year. If the top three levels of the enterprise have the same short-term metrics and the same short-term time horizon for planning and decision making, then what is the unique contribution of the CEO role that is different from their direct reports?
This furthers the view that too many CEOs are being held accountable for the wrong work and wrong metrics relative to those roles reporting directly to them.
Thus we recommend that goals at the CEO level, approved by the compensation committee, must be measured over at least a rolling 3 to 5 year time duration. These goals must also include measures of true value creation such as ROIC relative to WACC over a multiple year time period.
Currently only 5 % of the S&P 500 use any type of broader non-financial performance measures.
To create a more balanced scorecard, measures related to customers, employees, the organization, environment and society should also be included. For Best Practice see the 2002 Corporate and Social Responsibility Report from Unilever. We thus recommend that performance metrics used by NYSE listed companies should also include these non-financial measures.
NYSE mandate 2.) "Evaluate the CEO's performance in light of those goals and objectives"
The effective evaluation of CEO performance can ONLY be carried out if 3 questions have been dealt with in advance by the compensation committee:
1) What is the correct level of executive work complexity and unique contribution of the CEO role?
2) What is the optimum time frame over which planning, innovation, leadership are expected to achieve results for all stakeholders at this differentiated level of work? (depends on the level of complexity of the CEO role.)
3) What are the appropriate metrics to evaluate CEO leadership performance and value creation over this time period and at this level? (depends on the level of complexity of the CEO role.)
To provide a level of consistent quality control to the CEO performance evaluation process for NYSE listed companies, we recommend that compensation committees incorporate the answering of the above 3 questions into their responsibilities.
The compensation policy and related metrics disclosed in the proxy statement to shareholders should be consistent with the basis upon which CEO performance is actually evaluated. Some CFOs and other experts in governance suggested recently this is not the case. These CFOs of NYSE listed companies recently commented:
E. Norman Veasey, Chief Justice of Delaware's Supreme Court, has all but issued an invitation to plaintiffs to file a lawsuit on this point. In a recent panel discussion for Harvard Business Review he said, "If directors claim to be independent by saying for example that they base decisions on some performance measure, and don't do so-or if they are disingenuous or dishonest about it-it seems to me that the courts in some circumstances could treat their behavior as a breach of fiduciary duty of good faith."
We recommend for listed companies the compensation committee decisions on evaluating performance and board minutes should reflect the compensation policy and related metrics disclosed in the proxy statement for shareholders. If the compensation policy is not followed then a disclosure to shareholders explaining the difference should be provided.
NYSE mandate 3.) "Have sole authority to determine the CEO's compensation level based on this evaluation"
This mandate is meaningless unless the compensation committee has effectively established defensible benchmark comparisons for the Level of Work Complexity in the enterprise. Without a clear framework to define the Level of CEO Work, the board has NO basis to calibrate equitable compensation, either internally or externally, or to make defensible compensation decisions.
Principles versus Process, Rules and Competence
Jamie Heard, CEO of Institutional Shareholder Services stated " the system of checks and balances that we depend on to make sure we have good governance has broken down...... we have had a very sad and expensive lesson ..... we never dreamed we would see the megagrant options and dilution levels....wholesale repricing of underwater options.... and had a naive faith that the compensation committee would and could police these practices". Thus a principles approach to governance does not seem to be working.
Just as financial literacy is a must for the audit committee, we recommend that there is a minimum literacy for the Compensation Committee in:
Only then can we ensure a minimum level of competence to make CEO pay for performance a reality.
While this letter seems specific about process, roles, disclosures rules, and skilled knowledge, based on the performance of too many boards, too few Compensation Committees have asked the right questions, or shown the competence to effectively carry out their charter. Without the process, disclosure rules, and competence we have outlined, CEO compensation and Pay for Performance will remain disconnected from enterprise performance and sustainable value creation for shareholders and society.
I appreciate the opportunity to share with you our recommendations based on recent research, and would be pleased to be of assistance.
CC: Hon. William Donaldson, Chairman, SEC
CA Magazine - Dec 2003 issue - The Magazine for Chartered Accountants
Governance - ( author Mark Van Clieaf )
The Board's Due Diligence - Raising the Bar on Executive Accountability to Restore Investor Confidence
Capitalism in North America has mutated; corporate managers are growing wealthy at the expense of majority shareholders. Weak corporate governance, questionable accounting, excessive executive pay and greed have damaged investor confidence. Some even wonder if the capitalist system is broken.
Scientists tell us that any system that is allowed to self regulate will either destroy itself or restore its own equilibrium. This basic law underlies Adam Smith's Wealth of Nations and is the backbone of the capitalist system. Will modern corporations depend on government regulatory controls or be able to self regulate?
In other words, will Boards, CEOs and CFOs restore the investor confidence required to drive a healthy capitalist system? There is a way to do this. However, just as changes in natural systems like earthquakes and hurricanes have unforgiving and unintended consequences, so the corrections in our corporations have to be dramatic and thought through at a systems level.
At the start of this year's annual meeting season, more than 200 proxy resolutions were aimed at curbing CEO pay. But addressing the level of pay only deals with half the issue of executive pay for performance. In many cases, CEOs are still being held accountable for the wrong work and wrong metrics. Three questions need to be addressed: What exactly should executives be held accountable for? What dimensions of performance should be measured and reported? And over what time duration should they be measured?
Boards are accountable for determining the CEO's accountability, how CEO and enterprise performance will be measured, and how performance will be tied into compensation. If there was ever a time to clarify these issues, that time is now.
The foremost question for any Board's Compensation Committee is - how well is executive compensation connected to business performance? Using data provided by Stern Stewart, prior to the bubble bursting in 2000, we identified that over five years 32% of the S&P 500 failed to provide a positive operating profit after tax, after cost of capital (economic profit). In Canada, similar data from the Corporate Renaissance Group, shows that 65% of the TSE 300 companies did not return a positive economic profit over four years. The business model/strategy in these poorly performing companies is not working. There appears to be no link to executive compensation.
The Board of Directors needs to make clear their expectations regarding the creation of value. This includes the focus of the corporation's financial function and the link between value creation and business metrics. The traditional financial audit needs to be supplemented with an audit of the organization design, accountability structure and metrics to ensure the organization is designed appropriately to create value (a review of the Organization Value Added). This new audit can also assess the company's leadership talent against key value creation measures. How many Boards have taken this accountability seriously?
Many companies are using an increase in stock price and related market value added (MVA) of the enterprise as key measures of success. Economists and Wall Street analysts suggest 60% to 70% of the change in stock price is driven by global macro-economic factors (interest rates, GDP growth, exchange rates) all beyond the direct control of CEOs and their leadership teams.
Some 30% to 40% of the change in stock price is within management's control. But while stock price measures wealth creation (or destruction) for the shareholder, it does not directly measure the value creation capability of the business or its underlying economics.
Wall Street equity analysts have suggested that traditional measures such as earnings per share growth and return on equity are inadequate performance measures, and are too easily engineered. EPS growth does not take into account risk in the industry/ business; capital intensity / new capital required for growth; time value of money for capital invested; future NOPAT potential after the cost of capital; and the expense of stock options.
S&P in the U.S. has created a new measure "Core Earnings" to better capture its view of true value creation versus current GAAP. CSFB has found correlations between the increase in a firm's total value in the equity markets over two to five years (a measure of wealth creation for shareholders) and its business performance (actual financial results). There is a 50% correlation with increase in free cash flow and/ or net operating profit after tax (NOPAT) minus cost of capital; 35% with return on equity; and 18% with EPS growth.
To evaluate leadership effectiveness and enterprise performance properly, Boards, CEOs, and CFOs need at least two separate financial measures- economic profit and shareholder economic return.
The Economic Profit concept began in the 1920s as "residual income". It is calculated as NOPAT minus the weighted average cost of capital (WACC). It has been used by such firms as McKinsey, Stern Stewart, Marakon and others under the banner of Value Based Management. Key underlying metrics include sales, sales growth rate and operating profit margin relative to the total invested capital of the enterprise. The spread between the return on invested capital and WACC shows the capital efficiency of the business model the leadership team has developed and the amount of true free cashflow the business will generate. This is the key to determining the market value of the enterprise in the equity markets.
Shareholder economic return includes the appreciation of the firm's stock price and dividends paid relative to investing in a risk free T-bill. The spread indicates an assessment of true cash earnings potential and the ability to realize the discounted current or future cashflow of the business strategy. The reflected increase in market value of the enterprise must be greater than the risk free T-bill to create risk adjusted shareholder wealth. Shareholder economic return also reflects how well senior management has communicated expectations for the future, the business strategy and financial forecast to analysts, key institutional investors and the business media. A positive shareholder economic return indicates incremental shareholder value has been created.
Establishing Multi-year Performance Measurement
Our analysis of the S&P 500 proxy statements identified that 55% of these companies are only measuring leadership performance and business results over single-year periods.
Longest stated duration for performance measurement
The granting of stock options was supposed to align the interest of management and directors with shareholders. Companies have confused three to five year vesting of stock options with three to five year measurement of true business operating performance, mistakenly assuming that the vesting period would focus management on the longer term. Standard stock options failed to create the line of sight to operating performance that creates sustainable shareholder value. Executive compensation consultants who were advising Boards and Management did not understand the unintended consequences of the use of options. Surprisingly, many have said they are experts in compensation, NOT measurement and pay for performance.
If investor confidence is to be restored, public companies should disclose their policy for performance measures and executive compensation, including:
Designing Organizations for Accountability and Sustainable Performance
We often encounter senior executives and CEOs who are not clear on what their unique contribution should be. We have found that they commonly:
Accountability in organizations in a knowledge-based economy should move decision authority from a centralized vertical command and control structure to distributed decision-making at the right level. Compensation should no longer be based on the size of the business, budget or team, but on the complexity and added value of the work. Decision-making authority should no longer be based on title or status, but on the capability to plan and manage resource investments at various levels of work and levels of innovation.
Through our research and experience we have developed an organizational audit & design framework based on the unique accountability and contribution at each level of real work. Seven levels of work are defined, based on complexity jumps of scope, variety, uncertainty and decision making in relation to factors such as innovation, planning horizon, resource management and leadership. Each level contributes to sustainable value creation (see graphic). Designing in these requisite work levels and related accountability and decision authority helps to ensure the enterprise's sustainability and its ability to anticipate change and create value for customers, shareholders, and societies in both the short and long term. This framework indicates how many organizational levels are required for sustainable growth and value creation, and what is the unique contribution of each level.
We have used this framework to conduct accountability audits in sectors such as financial services, packaged goods, retail, pharmaceutical, advertising and government. We have found two key organizational barriers to designing executive work and accountability that adds value.
First, the financial planning, reporting and measurement systems tend to be one-year focused. Also, the financial metrics may not include a capital efficiency measure linked to return on invested capital or economic profit.
Second, job evaluation methodologies are outdated. They tend to be based on the size of the business, budget and team managed with no link to value-added contribution, such as the impact on multi-year growth in revenue, cashflow and return on invested capital. Few competency models and approaches to succession planning define the unique executive skills required to create value. Human resource methodologies designed for middle management in an industrial economy do not work for executive work design and talent management in a knowledge economy.
In re-inventing corporate governance, executive accountability, and pay for performance the Board and CEO should ensure the level of work and related accountabilities of the CEO are matched the business strategy. They should also ensure that the accountability and decision authority structure is appropriately cascaded into the organization, and that performance measurement and the requisite leadership capabilities are aligned at each work level. Compensation for both internal value creation and external wealth creation should be tied into this organizational structure.
The Board, CEO, CFO, and senior human resource executive need to ensure alignment of organizational systems (work design and accountability, performance measurement, pay for performance, and talent management) to create the leadership selection and development plans that will drive sustainable growth in economic profit and capital-efficient business results in the long term. This organizational capability is the underlying driver of growth in shareholder value and the Board of Directors needs to ensure this capability is in place. Such self-regulation is only a matter of time.
Mark Van Clieaf is Managing Director of MVC Associates International, based in Tampa and Toronto, and was formerly with Price Waterhouse.
Technical Editor: Peter Jackson, CA, partner with Peter Jackson & Assoc.