Fair pay for fair play

By Nadine Winter

New governance rules have made directors' work way more demanding. But has compensation kept up? The answer is no. So how should they be paid?

Outrageous behaviour by executives and their boards is not exclusive to corporate America. Bre-X Minerals Ltd., YBM Magnex International, Livent Inc. and Cinar Corp. all pre-dated high-profile corporate scandals in the US. These Canadian companies have also violated the basic tenets of good governance by loading their boards with insiders, rubber-stamping rich compensation packages and interest-free loans for executives and failing to disclose company financial dealings to investors. Consequently, Canadian investors are showing up at annual meetings in unprecedented numbers to vent their anger over what they see as excesses in executive compensation. They are also demanding a stronger, more independent role for company directors.

This reaction is understandable when considering the results of a 2002 Globe and Mail study on Canadian corporate governance practices. Rating companies in terms of board composition, shareholding and compensation arrangements, shareholder rights and disclosure, the study found many Canadian companies did not even meet existing Toronto Stock Exchange guidelines.

The TSX has since relinquished its responsibility for setting corporate governance standards, leaving it up to provincial securities regulators such as the Ontario Securities Commission. The OSC is expected to introduce guidelines strengthening audit rules, stressing the importance of independent directors and perhaps even mandating disclosure as to whether or not companies are in compliance with OSC guidelines. But these are still only guidelines for which there is no legal enforcement mechanism. According to OSC vice-chairman Paul Moore, the OSC prefers to allow companies to tailor the guidelines to meet their own needs.

Canadian courts, however, are willing to step in and provide legal recourse for retail and institutional investors when board members and company executives fail to protect shareholder interests. For example, take the case of Canadian forest products Repap Enterprises Inc. Steve Berg, a director and chairman of Repap's board, also took on an executive role within the company. As chairman, Berg unilaterally changed the company's counsel and instructed new counsel to prepare his employment agreement. The board rejected the counsel's compensation package, retained an independent compensation consultant and referred the matter to the compensation committee. The committee's chair and two directors, chosen by Berg, met for five minutes to discuss the package and recommended approval by the board. The package was approved by the board after a 30-minute discussion, without a review of the compensation consultant's report or the advice of independent legal counsel. The court ruled in favour of the shareholders, stating that not only had there been violations of the Canadian Business Corporations Act but the board and Berg had breached their duty to the company.

Clearly Repap's board was unwilling or unable to properly evaluate the proposed compensation package for Berg. With the advent of recent corporate scandals, directors not only have the responsibility for reviewing a company's strategic plan and its CEO's compensation arrangements, they are also responsible for understanding and ensuring compliance with a widening array of corporate governance rules.

This now means that directors are required to spend between two and 10 hours preparing for board meetings, which have become longer — four to five hours — and more frequent. Ten years ago the norm was four to six times a year; now 12 or more meetings a year are not uncommon, and most committees meet another three to six times a year.

However, the current demands and risks incurred by members of some of Canada's largest boards are not reflected in their compensation. The average annual retainer for a director in Canada's largest companies is less than $20,000; additional payments for board meetings and committee meetings range between $1,000 and $3,000; board directors are also paid with company stock, option grants and/or deferred share units and many companies require their directors to achieve a minimum level of company stock ownership, often as a multiple of their annual retainer, over a defined period.

Canada's largest institutional investor, the Canadian Pension Plan Investment Board, has established guidelines for voting on board nominations, executive compensation packages and other corporate governance issues. According to these guidelines, investors should support: share grants rather than options for executives and directors; executives holding the majority of shares until their departure; independence of the majority of board members; independence of directors comprising audit, compensation and governance committees; in-camera board and committee meetings; and formal annual reviews by boards of CEO performance and compensation. Annual compensation for directors must take into account the expertise required, the barriers to entry and the availability of qualified and willing candidates, the work demands and the risks associated with a highly accountable and visible role. We are seeing a greater emphasis placed on the annual retainer rather than on meeting fees. And given the responsibilities and risks associated with the role, annual retainers may soon be proportionate to pay levels for top executives for the time worked. For example, effective January 1, 2003, BCE Inc. established an annual flat fee of $150,000 for all outside directors, a flat fee of $225,000 for the chair of its audit committee and $300,000 for the non-executive chair of the board.

Book value Business reads to help you keep on top of it all Integrity in the spotlight: opportunities for audit committees By Maureen J. Sabia and James L. Goodfellow, The Canadian Institute of Chartered Accountants, $35 A practical how-to book that is both a call for audit committee reform and a guide for implementing it. For a review, go to www.CAmagazine.com/integrity. The naked corporation: how the age of transparency will revolutionize business By Don Tapscott and David Ticoll, Viking Canada, $40 A business case for open, ethical behaviour, and a road map for developing the organizational DNA to live by that behaviour. For a review, go to www.CAmagazine.com/transparency. What directors need to know By Carol Hansell, Carswell Publishing, $35 This resource for aspiring and current directors describes everything from shareholders' rights and directors' liability to current issues and best practices.  For a review, go to www.CAmagazine.com/directors.

Ownership of company stock has become essential to creating both the reality and the perception that directors share the interests of shareholders on whose behalf they act. However, there is a groundswell of opinion that stock options for directors are inappropriate. In introducing guidelines for public companies, the Canadian coalition for Good Governance, which represents 23 institutional investors with more than $400 billion in assets, said directors holding options don't have capital at risk and thus don't share the financial interests of long-term shareholders.

Outside directors for BCE are expected to own at least 10,000 BCE common shares or share units and have five years to reach this threshold. Until the minimum level is attained, the annual fee for a director will be paid in share units, after which directors can elect to receive their fee in cash or in additional share units.

To further safeguard the long-term interests of shareholders, directors are being offered restricted shares or deferred share units. Restricted shares cannot be cashed in by directors until they no longer serve on the company's board, eliminating the possibility and perception that directors will make decisions or recommendations based on their own short-term interests. Deferred share units (DSUs) are not actual shares but their value is tied to the value of a publicly traded share. The value of a DSU is also received when directors terminate their position on the board.

Stock option plans for directors can be structured so that options cannot be exercised while a director remains on the board, thus reducing the temptation of board members to take a self-interested, short-term view. However, a key problem remains. Stock options do not have the same downside risk as shares — a risk incurred by ordinary shareholders.

There are advantages to deferred share units and restricted shares. Share ownership more closely aligns director  (and executive) interests with those of shareholders, and shares provide a number of advantages over stock options. They incur the same downside risk for directors and company insiders as for retail and institutional shareholders, do not further dilute the value of shares held because they are purchased outright, and retain some value even if the share value declines.

There are, however, some disadvantages. For example, unlike options that are taxed only when the exercise price and market value are known, shares are taxed at the time of receipt. Although gains or losses at the time the shares are cashed in are subject to capital gains treatment under Canadian tax law, they are taxed up front as ordinary income.

Regardless of whether options or stock grants are used or executives are required to purchase stock, there is a movement afoot to address possible conflicts of interest arising from how directors are paid. At the same time, the skill and knowledge requirements, responsibilities and risks associated with board membership need to be recognized and compensated.

As demonstrated in the Repap case and other corporate scandals, boards have come under intense criticism not only for how they are paid but for how they manage executive compensation. There is widespread criticism of the apparent reluctance of boards to closely scrutinize and comment on executive performance. And, in the absence of a formal, confidential review of CEO performance, most boards are seen to simply rubber stamp CEO compensation arrangements.

The goal of aligning the long-term interests of company insiders with those of shareholders applies equally to directors and executives. To restore the integrity of executive pay and executives, boards need to take greater responsibility in setting performance goals, scrutinizing important financial and strategic decisions, and conducting formal reviews of CEO performance. And they need to ensure that executive pay is tied to performance.

Board approval of multimillion dollar salaries, large cash bonuses and highly dilutive stock options grants are often justified based on a perceived need to be market competitive. But the notion of paying competitively begs the question: competitive relative to what? Is it relative to other companies in the same industry, of similar size or in the same geographical location? Is it relative to companies achieving the same level of financial performance? It's all of these. How well the firm does should be the major driver of executive pay. That means placing an emphasis on "pay at risk," with cash incentives for reaching short-term results and stock or options for attaining long-term objectives accounting for 70% to 80% of executive compensation packages.

Whether a company uses stock options or grants, they should be awarded for meaningful contribution and treated as a true long-term reward, meaning they should be performance-based and/or restricted shares or options. This means designing equity-based compensation programs that tie the granting of future stock or options to achievement of key performance targets, requiring all shares granted and options vested to be held for at least three years, requiring executives to hold the majority of their stock and options (e.g., 60% to 70%) until they have held their jobs for a predefined period (e.g., five years) or until they leave the firm, not allowing executives to exercise options or sell any more than 20% of their shares in a single year, not allowing executives to exercise options or sell shares in a year when the company has not met its operating, net income, earnings per share or other key targets.

The focus of executive pay needs to be on reinforcing the core of the executive role — accountability for overall company success, including shareholder value.

Boards and executives must regain the confidence of investors. They expect board members to be independent, to be highly informed and involved, to police executives that fail to act in the interests of shareholders, and to act in the best interests of the company and its shareholders in how they manage executive pay.

Nadine Winter is president of The Winter Consulting Group. She can be reached at nadinewinter@wintergroup.com