Beefed Up Boards

July 13, 2005
More diligent and accountable, today's directors are scrutinizing executive compensation like never before.

Meet your firm's new board of directors. More independent of the company it serves. More accountable for the accuracy of financial statements. Better informed about how the company is run. And, maybe, less a pal to the company's chief executive officer and more a representative of shareholders' interests.

In the past three years boards have had a mantle of responsibility thrust upon them that some are unused to bearing. Borne of the corporate scandals of the late 1990s and early 2000s, these emerging boards are the result of the Sarbanes-Oxley Act and a wealth of additional corporate reform measures designed to rein in what appeared to many to be executives run amok.

"[Boards] are asking a lot tougher questions. They are really taking their roles very seriously," says Doug Jensen, the Walnut Creek, Calif.-based national executive compensation practice director for The Hay Group, a global human resources consulting firm.

These emerging boards are changing the dynamic of the board-management relationship. In the area of executive compensation, they are scrutinizing CEO performance and questioning the compensation of this high-priced help. To get the big payoff, CEOs need to play by the rules of a whole new game.

"Compensation committees and audit committees are sensitive to the fact that they are being blamed for runaway CEO pay," says Herbert C. Schulken, U.S. corporate governance leader, PricewaterhouseCoopers LLP.

"Boards are getting more involved in the details of the [compensation] plans, asking tough questions around performance metrics and the difficulty of the stretch of the goals that are being set," Jensen believes. "They used to give it a lot of attention before, but nowhere near the kind of scrutiny they're giving it now."

The increased scrutiny is being driven, at least in part, by the Sarbanes-Oxley Act (SOX), signed by President George W. Bush on July 30, 2002. "SOX is a major, major piece of legislation, in my opinion," says Raj Aggarwal, a Kent State University (Ohio) finance professor. "It comes along once every few decades. That's how big a change it is."

PricewaterhouseCoopers CEO Samuel A. DiPiazza Jr. expounded on its impact earlier this year at a Securities and Exchange Commission (SEC) roundtable. "It fundamentally created a shift in governance from the executive suite to the board room. Directors, particularly those serving on audit committees, are much more engaged, knowledgeable and empowered to act on behalf of investors," he said.

SOX's impact on executive compensation is both direct and indirect. For example, among its provisions, the legislation specifically called a halt to most personal loans to executives and directors. It also requires CEOs and CFOs to return any bonus or equity compensation profits earned within one year before any restatement of financial reports due to non-compliance or misconduct.

Less tangible is SOX's indirect impact. The legislation has altered how financial information reaches the board. Board members now receive financial information directly from external auditors rather than it being filtered through the management team. "Suddenly boards are going to have a lot more information about how the company is being run than what was just being provided by the CEO before," Aggarwal says.

Sarbanes-Oxley's impact on emerging boards is bolstered by stock exchange guidelines that call for greater board independence as well as increased disclosure; increased SEC action; and recent court rulings that have found directors personally liable for firms' financial misconduct. More recently, the American Jobs Creation Act has complicated the administration of deferred compensation plans.

Jensen expects even greater disclosure requirements in the near term, and he says the impact on executive compensation is clear. "Disclosure is so much more transparent now. And we're probably even going to see more specific requirements from the SEC in next year's proxy season because they are really interested in being sure everything is clearly stated, in terms of the compensation value of not only the cash compensation and equity grants, but also perquisites and other benefits that are before the executives. That openness is causing boards to take a look at the whole package and see how everything is integrated instead of just dealing with one item at a time," Jensen says. "As a result, they're questioning whether some of the levels of compensation are appropriate today, and that's being heightened by the requirement to expense options."

Investors' Voices Heard

And don't underestimate investor impact on compensation. United Technologies Corp. announced in late 2003 changes to its senior executive severance plan in the event of a change in control. The change was in response "to previous shareowner proposals on this subject and [to] fulfill the corporation's commitment made at the 2003 annual meeting," the company said.

Recently, the California Public Employees' Retirement System, which invests a giant pension fund, said it would draft and present to the SEC recommendations to improve disclosure of executive compensation.

"Investor groups, the big pension funds... that have large stakes in many companies are really making their voices heard, and if a company wants to go to shareholders to get an equity program approved, they're having very, very tough conversations with their investor groups to show why [the program] is a good thing for the shareholders," Jensen says. "[Investors] were always an active group [and] they are actually pooling resources together more now to be a stronger voice."

Board-CEO Relationship

Most companies already were open and aboveboard with regard to governance practices prior to the implementation of recent corporate reforms. In fact, says Jensen, "a lot of the Sarbanes-Oxley and New York Stock Exchange regulations that came out around governance often were the result of looking at some of the best practices that were in place."

Aggarwal says recent corporate reforms have strengthened the role of the board of directors and lessened the importance of the CEO role to a degree.

Recent Board Of Director Actions

Manufacturing company boards of directors continue to take actions, big and small, to improve corporate governance. Here are a few examples:

  • In April, Enerl Inc. reported the addition of an independent director to its board of directors. The Fort Lauderdale, Fla.-based company, which develops energy-efficient products, said the independent director would join its audit committee to further "our continuing efforts to increase the level of external oversight in our governance activities."
  • In June, Rockwell Automation, Milwaukee, announced two amendments to its corporate governance guidelines: one requires non-management directors to own specified levels of common stock; the other encourages directors to limit the number of public companies on which they serve "in light of the time commitment required for effective board service."
  • In June, the Compensation & Leadership Development Committee of Procter & Gamble's board of directors approved modifications to the company's incentive compensation programs. Should Procter & Gamble Co.'s proposed merger with the Gillette Co. gain all the required approvals, managers at the Cincinnati-based consumer products company will have added incentive to assure the integration of the two firms is successful.
Whether that has made for a better board is questionable, however, says Schulken. "Whether boards are better as a result of these changes, you'll see a lot of people saying just because a person isn't independent under a set of rules doesn't mean this person can't act in the best interest of the shareholders. And I would agree. But you have to have some guidelines and you have to have some rules."

It's been a difficult transition for some CEOs, opines Jensen. "These [CEOs] are people who have enjoyed the power, the authority and control of their business and in many ways were leading their board of directors as they manage their company. Now they have to share that leadership."

What direction will CEO pay take under these emerging boards? It's too soon to tell, says Aggarwal and Schulken. The latter points out that despite several years of down or flat performance, "CEOs continue to be rewarded rather generously." However, he adds, increasing emphasis on pay for performance clearly exists.

Jensen says it's unlikely compensation will decrease. "If you think of the 11th commandment 'thou shall not take away,' it's really hard to [reduce compensation], particularly if you've got a CEO and executive team that's doing really well."

He does believe "retention" will no longer be a valid argument to continually raise compensation. "Retention has always been a big objective of a lot of these programs," he says. "'How much is enough?' is what boards are saying. 'What are we getting in return?' These are questions that weren't always asked before. Retention is not going to be argument enough."

Goodbye Royalty?

What does this mean for CEOs of the 21st century? For the really good ones, says Jensen, it simply means they keep doing what they have been doing.

"The CEOs who have to change are the ones that pretty much felt that they were the kings and queens of their business, and they ran it pretty much the way they wanted to run it," Jensen says. "Boards aren't willing to operate that way anymore. There's too much risk for them to simply accept what management says is right without thoroughly checking and making sure they understand and have a role it."

PwC's Schulken agrees. "It used to be the board was the CEO's buddy, so they rubberstamped what the CEO brought to them," he says. "I think those days are over. The board is going to be looking for a CEO -- as they should -- who can provide shareholders the greatest value."

Collaboration may be a key, as suggested by the corporate governance philosophy of furniture maker Herman Miller Inc., Zeeland, Mich., which outlines the appropriate working relationship between its board of directors and management. "There must be a high level of trust between the board and the CEO. It should be through a process of collaboration where the board and management work together to set and achieve common goals," states the governance philosophy, which was formalized in 2004.

Going forward, it will be hard for an "imperial type" CEO to get a job, PwC's Schulken believes. But it doesn't necessarily spell the end of the imperial CEO, Jensen says.

"That's in the DNA of a lot of CEOs," he says. "If they are still the imperial dictator, then they are the enlightened dictator now, and they've got to learn to share the power. Tough as that may be, it's a different game."

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