A Broader View For The Remuneration Committee
Most people do not immediately associate executive compensation with a disco hit from the 1970s. Yet for guest speaker Leo Strine, the song More, more, more, by Andrea True Connection, accurately captures the evolution of executive compensation over the past few decades. Strine is of Counsel at the U.S. law firm Wachtell, Lipton, Rosen & Katz specializing in corporate law and was formerly Chief Justice of the Delaware Supreme Court and Chancellor of the Delaware Court of Chancery. Strine lectures on this area of law at Harvard University and the University of Pennsylvania.
Strine noted that under pressure from institutional investors to make executive pay packages riskier and more tied to measures of total stock return (TSR), the job of corporate boards having to address remuneration has become far more difficult. Thus, Strine cited empirical evidence showing that not only have the salaries of top executives in the U.S. increased exponentially since the late 1970s, but 'more, more, more' also applies to the legally required accountability for pay structure. His colleague Erica E. Bonnett, an Executive Compensation and Benefits partner at Wachtell, Lipton, Rosen & Katz who regularly advises large U.S. corporations on executive compensation matters, illustrated these increased demands, noting that: 'To comply with all legal requirements on disclosure, upwards of 60 pages of the annual report of an American publicly traded company is often needed to explain the remuneration of the small group of managers.' That adds huge pressure to the organization and the Remuneration Committee . Especially since, in addition to overseeing the remuneration structure, the Supervisory Board members are being given more and more responsibilities in areas like consumer protection, environmental responsibility and diversity, equity and inclusion. Supervision of the sustainable performance targets in the company's strategy is one salient example of a responsibility that has been added recently. Dutch Supervisory Directors who sit on the Remuneration Committee are also seeing their workload increase.
Dynamics are changing
Strine and Bonnett noted that companies are looking for ways to better align top management compensation structures with their focus on long-term value creation and fair sustainable business practices that are equitable to workers. Because of the intense demands from investors for returns to themselves and tying executive compensation to stock market returns, there is still much work to be done in that area for Compensation Committees, Strine stresses. Strine presented empirical data showing that, between 1979 and 2018, the productivity of American workers increased by nearly 70%. The gains from increased productivity accrued disproportionately to Executives and shareholders; where U.S. workers' wages grew by nearly 12% during this period, CEO compensation grew by 940%. Reevaluating approaches to pay structure is an opportunity, Strine hopes, to make companies ‘more responsible employers,’ but this can only be done if the powerful institutional investors support boards in that effort. His point: ‘the RemCo needs to understand the compensation of top management in the context of the pay and working conditions of all employees.'
Scope of the Compensation Committee’s Role
For U.S. public companies, the Compensation Committee is typically asked to consider and determine the pay of a few top executives in the organization, but is usually not provided with information about, or asked to consider, the compensation of other employees, Bonnett noted by way of introduction to this topic. In her role advising companies and top executives on compensation issues, she sees how American companies and their boards of directors increasingly are required to dedicate time and resources to designing, determining, managing and disclosing executive compensation. The amount of time needed to prepare annual disclosures grows with each new requirement, such as the recent rule requiring companies to disclose the relationship between executive compensation paid and financial performance. This rule, which requires a new table presenting various financial metrics, will add pages to the already lengthy annual compensation disclosure as disclosure requirements are continuously added and not removed. Bonnett notes that if the Compensation Committee is going to be asked to take on a broader role of setting a company’s compensation strategy, then additional capacity will need to be created for such responsibility, given that directors currently have a full calendar managing executive compensation. This would require, among other things, a simplification of executive compensation, as discussed below. And if the Compensation Committee is going to take on this role, Strine notes that it would be good for the Compensation Committee to have an overview of employee compensation and benefits, including information about the skillset of the employees, in order to provide necessary context. Flex workers and freelancers should not be left out of the list, Strine says: 'Some tech companies in Silicon Valley pride themselves on paying their employees a living wage (wages sufficient to meet basic needs, ed.).’ But, he noted that many companies have large contracted workforces and may not focus as much as they ideally would on the pay and benefits of such contractors.
Simplify reward structure
Strine and Bonnett see that a potential pathway to creating more capacity for Compensation Committee directors is to simplify the pay structure. Ms. Bonnett pointed to the fact that the very strong focus on pay for performance, while well-intentioned, has led to significant complexity in award design, which in turn requires significant resources from the Compensation Committee to design, establish, and measure performance results. It also necessarily focuses executives on the specific metrics included in the award terms (for example, the company's share price or TSR) potentially to the exclusion of other important measures and goals for the organization. And the design of the awards creates downside that is somewhat disproportionate to the downside that shareholders experience (after all, Bonnett notes, variable pay can end up at zero in some years). An alternative executive pay structure of similar quantum but that provides a simplified incentive structure, including a substantial component of long-term, time-vesting restricted stock, could be an alternative way of thinking about pay that still provides meaningful upside and downside, but that is more directly correlated with the upside and downside experienced by shareholders. Strine noted that Bonnett’s suggestion would also better align incentives with objectives for sustainable growth and the respectful treatment of stockholders, because restricted stock focuses recipients on the long-term and because it has real value and thus a downside, also avoids unhealthy incentives to seek bubble profits and encourages a focus on making money the right way.
Evolving role of the remuneration committee
Roel van der Weele, Director Executive reward advisory practice at Deloitte, sees the responsibilities of Remuneration Committees changing "slowly but steadily”. Sometimes this is visible in the name - Rabobank for example has a Remuneration and HR Committee. Supervisory Board members are increasingly expected to oversee the HR and ESG issues facing the organization. Topics that contribute to the culture in the company and well-being of employees. 'Think about equal pay for men and women and a living wage for employees worldwide.' Unlike many other areas of supervision, Supervisory Directors still have a lot of freedom in how they shape this oversight. 'Several HR topics are implicitly mentioned in the most recent Dutch corporate governance code, but are not formalized in it.' This is very different from the UK, where in 2018 a large number of HR topics were included in the corporate governance code. There, the Remuneration Committee has a much greater responsibility to monitor whether Directors' actions are in line with the company's strategy, purpose and values. 'That has changed the dynamics of these Committees. We are still far from this situation in the Netherlands, but the first changes are visible.'
Risk oversight at the board level
Strine emphasizes that organizations have much to gain from a broad view of supervision. 'We now know that the main risks in organizations reveal themselves at the points where ESG issues clash with shareholder interests. These often have to do with 'S' of Social in ESG. How do we pay our people? Is there a safe working environment and are they treated in a respectful manner? But also consider product safety.' There is an opportunity for organizations to become better positioned to deal with such risks, he observes. Commissioners - and certainly RemCo members - can add a lot by taking some responsibility for overseeing these and other non-financial risks that have fallen to the Audit Committee. Originally, oversight of internal risks rested with the Audit Committee. Today, Audit Committees are more often expected to oversee other non-financial risks as well, such as the environment, sustainability and climate and diversity. 'But the Audit Committee still primarily focuses on financial risks, especially after the credit crisis,’ Strine says. He sees the consequences of this oversight gap in large multinationals that got into trouble because of unethical sales methods of opiates and fatal production errors in aircraft models.
In the CEO's Seat
The ideas for a new look at Executive Compensation resonate with the invitees. In fact, some of them already have good experiences with such a broad approach. For example, at organizations that align Executive Compensation with the performance measurement and remuneration of employees. The question does arise, however, whether this does not put the Supervisory Board member too much in the seat of the CEO. According to Bonnett, it will be important to achieve an appropriate balance between the role of the executive management of the company, which remains responsible for operating the business and making day-to-day decisions about the compensation of employees, and the potential role of the Compensation Committee in helping to determine overall compensation strategy and principles.
This is certainly also in the interest of the Supervisory Directors themselves, Van Weele says. After all, the various stakeholders are looking increasingly critically at Executive pay. He cites as an example the organization of institutional investors Eumedion, which recently pointed out that Supervisory Directors of Dutch listed companies last year did nothing with the advisory vote of shareholders on Remuneration Policy. ‘That attitude has consequences,’ says Van Weele. ‘Eumedion points participants to the previous wait-and-see attitude of the SB when reappointing a member of the Remuneration committee.'
Compensation Committee members face increasing scrutiny
In this context, Bonnett also points to the increasing power of proxy advisory firms and their views on pay practices. Influential proxy advisors such as Institutional Shareholder Services and Glass Lewis, who advise large institutional clients regarding how to vote matters submitted for shareholder approval, including the annual “say on pay” vote in the United States, have a meaningful effect on executive compensation at U.S. listed companies. Compensation Committee members who approve compensation packages that are not in line with proxy advisor guidelines and preferences face a potential failed “say on pay” vote and, if the proxy advisor concerns are not addressed, may ultimately find themselves voted off the Board of Directors by shareholders acting in accordance with the proxy advisor recommendations.
Bonnett and Strine note that one way to take the pressure off, to provide flexibility for Compensation Committee directors to exercise their business judgment on compensation matters without facing undue scrutiny in the short-term, would be to move to a less frequent “say on pay” vote. Current U.S. law permits the vote to occur as infrequently as every three years. However, given that the market has moved to an annual vote and given the stated preference of proxy advisors for an annual vote, a move to a less frequent vote could itself result in adverse feedback for the board of directors. A theme both Bonnett and Strine again emphasized is that boards cannot move in a different direction unless the strong investors and proxy advisors support that direction, and that investors need to support efforts to simplify compensation, focus it on sustainable growth, and to make sure that workers also receive their fair share.
This article is designed to provide helpful perspectives on the emerging issues confronting compensation committees and boards regarding executive compensation and other important workforce issues. It does not represent an official position of Wachtell, Lipton, Rosen & Katz as a firm, and the views of each speaker may be distinct from each other. We recommend that any reader consider the article in the context of their own company’s specific governing instruments and business dynamic, consistent with the need for companies to shape an approach to corporate governance that makes sense for their specific business in its industry and societal context. Published in Management Scope 03 2023.