This week I want to welcome a guest blogger, Francis Byrd, SVP & Corporate Governance Risk Practice Leader at the Laurel Hill Advisory Group. As a proxy solicitor, Francis provides strategic advice on governance issues to boards of directors and senior executive management of corporate issuers. Francis was formerly Vice President at Moody’s Investors’ Service and prior to that role, he directed the shareholder engagement program for the NYC Retirement Systems & Pension Funds. In 2011, Francis was named to NACD Directorship’s “People to Watch” list.

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In the wake of last week’s announcement that Citigroup had lost its say-on-pay (SOP) vote with only a 45 percent “for” vote, I listened to a video blog from Bob Monks, one of the legends of corporate governance. I was surprised to hear Monks comment that Citigroup’s defeat was “a real milestone in the history of corporate governance.” Frankly, it’s not that clear to me.

The percentage of failed pay plans last year (41), and small number to date this year (5), do not a revolution make. Nor do I see Citigroup’s vote as a rejection of the firm’s business model or the state of the U.S. financial system (flawed as it may be).

Clearly, the rejection of Citigroup’s pay plan by investors impacts Citigroup’s board of directors, CEO Vikram Pandit, the named executive officers, the Citigroup executives, and outside advisors charged with getting the plan approved. I think throwing a marquee name like Citigroup into the failed SOP votes gets the attention of other companies to ensure that they are not the next villified brand as they seek shareholder approval of 2012 pay plans.

Why Citigroup Received a “No” Vote

I had a chance to read the Citigroup analysis done by the two major proxy advisory firms, ISS (founded by Bob Monks) and Glass Lewis, which both highlight key concerns that drove the negative recommendations and the vote. A selection of those include:

- A pay for performance disconnect for CEO Pandit versus Citigroup’s one- and three-year stock performance.

- Role of discretionary award in the total compensation package (a value opportunity of $10 million on a deferred stock award of 240,732 shares based on meeting a series of non-financial performance metrics including regulatory considerations, organizational culture and talent development). His success in achieving these goals was completely discretionary and determined by the compensation committee.

- Failure to disclose the value of award opportunities for the CEO (totaling $34 million) in the proxy statement.

In this scenario, I wasn’t surprised that the majority of Citigroup investors cast “against” SOP votes. In a 2011 study by the Council of Institutional Investors and Farient Advisors entitled: Say on Pay Identifying Investor Concerns, 92 percent of survey respondents voted “no” in their say-on-pay votes because of a pay for performance disconnect, 35 percent voted “no” because of poor disclosure and 57 percent voted “no” because of poor practices.

Lessons for Corporate America

So in 2012, history seems to be repeating itself. Both proxy advisors cited a disconnect between Citigroup’s stock performance over one- and three-year periods, and the pay realized by CEO Pandit and other named executive officers. Does this teach corporate America anything new? There may be some lessons for us which include:

- Identify and understand shareholders’ voting practices on say-on-pay and other executive pay issues — Compensation committees and senior management should work with their governance advisor/solicitor to identify their shareholders’ voting patterns and the levels of influence (if any) held by proxy advisory firms in their stock. This testing, which aids with investor engagement efforts, should be conducted prior to the printing and distribution of your proxy statement.

- Communicate frequently and consistently with shareholders — Over the past two years, the power of shareholder communication has been evident with companies like Disney, General Electric, and Johnson & Johnson reaching out to shareholders through DEF 14As and 8Ks to change questionable pay practices before their annual meetings. Much of this activity resulted in shareholders voting “for” company pay practices, and not relying soley on proxy advisor recommendations.

- Consider opening pre-filing communications with proxy advisory firms ISS and Glass Lewis — Both are open to holding a “proxy talk” with the company monitored by its investor clients). A well-coordinated effort can spare the pain of a public rebuke by shareholders. There is a clear benefit to preparing shareholders for any changes in your executive compensation plan (e.g., the context for your CEO and executive team retention awards). I encourage you to use every opportunity to communicate your compensation plan improvements after a shareholder rejection. This can have powerful results in obtaining investor approval.

- Remember shareholder support in 2011 does not guarantee shareholder support in perpetuity — Make no mistake, majority shareholder support for say-on-pay in one year does not  necessarily translate into support in future years. Citigroup is a case in point. It garnered a 92 percent majority on their 2011 SOP vote despite taking TARP funds, lawsuits and the mortgage crisis.

- Understand and manage the reputational impact of social and business issues — rightly or wrongly, the financial services industry has a reputational issue. From Occupy Wall Street, to TARP bailouts, to the mortgage crisis, everyone has an opinion on bankers’ pay. Certainly, pay packages need to focus, align and retain executives. However, today’s attitudes toward executive pay are not favorable, and Citigroup’s undisclosed, discretionary-type awards with low performance hurdles are an invitation for investor “no” votes.

As the first quarter of proxy season 2012 winds down and Q2 heats up, the number of failed SOP votes is in the single digits. Citigroup has certainly added drama to an otherwise uneventful voting season. In the end, investors don’t like surprises. So far this year, the companies that received “no” SOP votes in 2011 have, by and large, done a good job listening to shareholders, revising their pay plans, and communicating with shareholders.

Unfortunately, Citigroup has become the say-on-pay poster child for 2012. But all is not lost. I encourage Citigroup to rethink its compensation planning and disclosure, craft a strong narrative and proactively engage with shareholders once the proxy season has subsided.

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Robin A. Ferracone is the Executive Chair of Farient Advisors, LLC, an independent executive compensation and performance advisory firm which helps clients make performance-enhancing, defensible decisions that are in the best interests of their shareholders. Robin Ferracone is the author of a recently published book entitled “Fair Pay, Fair Play: Aligning Executive Performance and Pay,” which explores how companies can achieve better performance and pay alignment. Robin can be contacted at robin.ferracone@farient.com and click here to sign up for Farient’s electronic newsletter.

In the second year of Dodd-Frank, executive compensation continues to be top of mind as proxies roll off the presses and say-on-pay votes are cast. As part of the season, there is no shortage of director conferences to attend to hone our director skills, particularly in the area of executive compensation.  This is a good thing.

Recently, a prominent individual at an investment company was going to speak on a panel at one such conference.  In preparation for the panel, he asked my opinion on two governance policy questions:

1)      Should compensation committees include at least one compensation expert as a member of the committee?

2)      Should compensation committee members be rotated on and off of the committee?

As a business person who currently serves on boards and chairs a compensation committee, and as an executive compensation consultant who has served a myriad of compensation committees over the years, I have not surprisingly formed some opinions on these two topics.

I am always amazed when boards treat compensation, like human resources (HR) in general, as an area that should be intuitively obvious.  However, just like audit committee members are most effective when they are financially literate, compensation committee members are most effective when they have a certain amount of compensation literacy and expertise.  It helps when people on the compensation committee have a generally familiarity with both the strategic and technical aspects of compensation.  It helps when compensation committee members have a feel for the issues based on real experience with the subject matter, not just as a line executive or onlooker.

The good news is that board directors can either come to the table with compensation experience or obtain such experience “on the job.”  Take Laurie Siegel, for example, who chairs the compensation committee at CenturyLink, a $15B telephone company.  Laurie is a seasoned HR executive and early in her career worked with me as an executive compensation consultant.

Obviously, she comes to the table with ready-made skills and can be immediately effective as a compensation committee member.  But board directors without this deep knowledge also can gain expertise by engaging in educational programs, and insisting on getting a tutorial from the company’s internal staff and/or consultant that includes both Compensation 101 (i.e., executive compensation in general), and the compensation philosophy, programs, and processes for the specific company at hand.

These learning opportunities, coupled with about a year of service on the compensation committee, can give directors who are new to the compensation committee the experience and skills they need to become highly effective compensation committee members.  I’d also suggest that those on the nominating and governance committee put compensation expertise on the list of qualifications for new board members.

As for the second issue, whether or not board members should be rotated on and off of the compensation committee, my view is that rotation is a good thing, but in measured doses.  I would roll members on or off the compensation committee one at a time.  My experience is that new blood can bring fresh thinking, which is healthy, but institutional knowledge on the committee also provides needed stability and a deeper understanding of the company’s culture.

Further, compensation committee members should serve on that committee for a minimum of three years before rotating off.  Similarly, compensation committee chairs should stay in their role for at least three years.  Too much turnover in either compensation committee membership or the chair role can create too much disruption, which can be bad for the organization.  Clearly, these are board governance decisions, and board qualifications and rotational policies should not be dictated by investors or the government.

Finally, expertise and a certain amount of stability in the compensation committee membership help avoid one of the biggest mistakes that new compensation committee members make, which is to import their experience from a very different environment, such as academics or private equity, to the company at hand.  Not that experience in a different environment isn’t useful, it is.  But compensation is a delicate cultural issue and must be tailored to the unique circumstances of the organization at hand.  This means that what works in one environment often won’t in another, particularly when crossing industries or ownership structures (e.g., private to public).

To sum up, my experience is that compensation committees function best when the people sitting on these committees, and certainly the chair of these committees, have some expertise that is directly relevant, either through background or experience, and that rotating people on and off the committee in measured doses can bring new thinking to the table without the downside effect of wholesale disruption.  Aligning executives with investor interests can best be achieved when the right directors, with the right experience, training, and resources, and are in the right seats at the right time.

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Robin A. Ferracone is the Executive Chair of Farient Advisors, LLC, an independent executive compensation and performance advisory firm which helps clients make performance-enhancing, defensible decisions that are in the best interests of their shareholders. Robin Ferracone is the author of a recently published book entitled “Fair Pay, Fair Play: Aligning Executive Performance and Pay,” which explores how companies can achieve better performance and pay alignment. Robin can be contacted at robin.ferracone@farient.com and click here to sign up for Farient’s electronic newsletter.

2011 was a landmark year in many respects.  We saw the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act with the first mandatory Say on Pay vote.  We saw continued volatility in the stock market, reinforcing the seeds of uncertainty planted in the 2008-2009 recession, and we realized (if we didn’t already) that pay for performance alignment is and will continue to be the centerpiece of executive compensation programs for companies and investors alike.  Investors generally let us know that if performance is good, they are willing to pay up.  But if performance is poor, they want the pain to be proportionately shared by management, particularly the CEO.

So, what is on the horizon as we look forward to 2012?

Executive Pay Levels

Overall, executive pay levels will continue to increase at little more than an inflationary pace, with perhaps modestly higher increases in equity incentives if the stock market holds up.  But we also predict that overall trends will be misleading, and that a more segmented approach to talent will be required.  Some industries will show higher pay increases than others, and some will be subject to unique competitive forces for talent.  Within companies, the talent markets also will be uneven.  For example, there will be hot spots in technology and emerging markets, and little activity in low-growth regions and certain lower level job types.

One thing, however, is universal . . . pay for performance will continue to take a front seat with both companies and their investors.

Compensation Committees

Compensation Committees will continue to focus on pay for performance.  They will put more time and effort into incorporating performance into the pay system.  This will manifest itself in companies devoting a lower proportion of pay in time-based equity, like restricted stock, and a higher proportion of pay in performance-based equity, like performance shares.  It also will show up in how companies set well-considered goals.  Further, we anticipate that an increasing number of companies will incorporate strategic measures into both their short- and long-term incentive plans, as a way to encourage focus on the non-financial, as well as financial, drivers of value.  Finally, Compensation Committees will ask their consultants to analyze their relationship between pay and performance well in advance of their proxy going to print in order to address key issues and ensure that shareholders appreciate their pay for performance story.

Investors

In 2011, investors reported that they gave companies the benefit of the doubt on Say on Pay.  After all, over 70% of companies received a 90%+ “Yes” vote and only less than 2% received a 50%+ “No” vote.  We predict that investors will turn up the heat on companies in 2012, and that a slightly higher proportion of companies, but still less than 5%, will receive “No” votes; further, in consideration of the pay system, we predict that a slightly higher proportion of Directors will receive “Withhold” votes.  Because investors will have more time to analyze each company (since only about 75% of companies have an annual vote), we also predict that investor voting processes will be more nuanced.  For example, investors report that they will pay more attention to peer groups in making their voting decisions in 2012.

SEC

The SEC has published a new timeline for implementing Dodd-Frank.  We expect that clawbacks (Section 954) will be the next up for the issuance of proposed rules and new disclosures (Section 953) will be last up.  Having said this, there are stumbling blocks in both of these areas.  With respect to clawbacks, the devil is in the details, such as outlining the methods by which the amounts to be clawed back are to be determined.  With respect to disclosures, there is a political battle afoot on whether the requirement to report the ratio of CEO total compensation to median total compensation of all company employees is of any value to shareholders, and if so, how to calculate it.  We predict that companies will continue to work ahead of the SEC schedule by voluntarily adopting clawbacks and discussing pay for performance in their CD&As for 2012.  Given the past delays in the SEC timeline, we have no prediction on whether these rules will be finalized for the 2013 proxy season.

A Very Interesting Year

This year, as we look forward, we anticipate that pay for performance will continue to take center stage.  In addition, we anticipate continued jitteriness among Compensation Committees as they try to do the right thing amidst competitive forces that threaten retention, governance concerns among investors, new rules from the SEC, and public and political sentiments captured by the Occupy movement.  Already, 2012 is shaping up to be a very interesting year.

This article originally appeared in Laurel Hill’s The Advisor and was reprinted with permission. Special thanks to Francis H. Byrd, leader of Laurel Hill Advisory Group’s Corporate Governance/ Risk Advisory Practice.

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Robin A. Ferracone is the Executive Chair of Farient Advisors, LLC, an independent executive compensation and performance advisory firm which helps clients make performance-enhancing, defensible decisions that are in the best interests of their shareholders. Robin Ferracone is the author of a recently published book entitled “Fair Pay, Fair Play: Aligning Executive Performance and Pay,” which explores how companies can achieve better performance and pay alignment. Robin can be contacted at robin.ferracone@farient.com. Click here to sign up for Farient’s electronic newsletter.

One would surmise that the recent Dodd-Frank legislation, coupled with increased investor scrutiny of board behavior and effectiveness, would have at least some impact on the board of director selection process, i.e., filling vacant director slots, at least in part, by those with experience in executive compensation. But is this the case?

In an effort to better understand changes in the board selection process since Dodd-Frank, Farient senior vice president Gary Hourihan recently sat down with Joe Griesedieck , vice chairman of Korn/Ferry International, to talk about trends in director selection.

In his role with Korn/Ferry, Joe works across multiple industries and has completed numerous search assignments for c-suite executives and outside directors for both public and private companies. There are few, if any, in the marketplace with better hands-on knowledge of trends in director selection than Joe. I am delighted to have Gary and Joe share their thinking around this issue:

Gary Hourihan: Joe, you spend a lot of your time recruiting board members for Fortune 500 companies. To what extent has recent legislation, such as Dodd-Frank changed the landscape?

Joe Griesedieck: You’ll likely be surprised to hear that recent legislation, such as Dodd-Frank, hasn’t affected the board selection process that much, and certainty not to the extent that Sarbanes-Oxley did in 2002. There are many out there who believe that few things did more to scale back the “fraternal” nature of boards, and add a diversity component, than Sarbanes-Oxley.

Seemingly overnight, board members (and the audit committee in particular) became more directly accountable to shareholders and we saw a decline in the number of qualified people willing (or available) to serve on boards. In contrast, Dodd-Frank has not placed the entire board in the spotlight. While it has created some unwanted attention and a lot more work for compensation committees as they address Say on Pay and prepare for the upcoming provisions around claw backs and pay for performance disclosures, it has not had the ripple effect of Sarbanes-Oxley and has not impacted the supply of qualified directors.

Gary: Board effectiveness seems to be an increasingly important topic for investors and legislators. Has this changed the focus of your board searches in terms of the types of candidates being sought?

Joe: We are not far past the time when boards of directors were a rather homogenous group where collegiality often trumped specific experience or knowledge in the selection process. But, things are slowly changing. For example,  Korn Ferry’s 2011 annual report on board leadership found that in 2010, 81 of the 95 board appointees at Market Cap 100 companies had served on other boards. In addition, 69 of those available appointments went to someone with current or previous CEO experience.

Here are some specific areas where we are seeing changes:

Board members are more involved in company strategy. For the past 20 years we have seen a transition in power moving from management in the 90s, to board members in the early 2000s, to shareholders today. Board members are communicating more frequently with shareholders. As a result, boards are increasingly more engaged in helping to develop company strategy. Companies like American Express, General Electric, Microsoft, and Prudential are even emphasizing how the board is involved in strategy development in the narrative of their most recent annual proxies.

Board Members have more functional experience and industry expertise, and are more diverse than in the past. I have seen an increase in boards looking for people with very specific experience. Recently, one of my clients acquired a mining company and wanted the newest board member to have mining experience. In the past six months, companies like Starbucks, eBay and IAC have invited 20 and 30 year olds to round out their boards and focus on the company’s digital strategy and a younger customer demographic. I am also seeing more requests for supply chain expertise and international experience as companies expand into Brazil, Russia, India and China.  The reality is that boards are incorporating more diverse perspectives which are having a positive impact on corporate governance. Importantly, the candidates for these roles typically are not former board members or CEOs. These changes add up to a shift in future board demographics.

Re-emergence of the professional director (without the previous negative connotations). Notwithstanding what I just noted, I am seeing more retired CEOs sitting on multiple boards and genuinely engaging with each board. They are truly interested in the company, provide great value, and receive tremendous value back from their participation on the board. The re-emergence of the professional director has minimized the number of directors who are “over committed,” which as you know, is a big concern among the proxy advisory firms. This new crop of ex-CEOs is also bringing down the average age of the board.

Gary: Joe, this brings up an important question in terms board diversity. Most of us think of board diversity in terms of adding more women and minorities to boards. How are you defining diversity?

Joe: Someone recently asked me if we were confusing board composition with board diversity. Certainly diversity has a role in board composition, but diversity covers a lot of ground today. In addition to women and minorities, it can include age, functional experience, personal experience, and international expertise, among other things. It’s really about bringing the right people into the boardroom, eliminating “group think,” breaking down the “old boy” network, and managing risk. From my point of view, it’s all about creating and sustaining shareholder value, and that begins with an effective board.

Gary: One last question that I can’t resist asking as a compensation consultant is how big of a part compensation plays in recruiting qualified directors?

Joe: You may find this surprising, but my experience is that good directors are in it much more for the experience and gratification of contributing to company success than for the money. Money never hurts, but it is rarely the deciding factor.

Gary: It’s been great getting your insights today. My takeaway is that boards are indeed evolving for the better in terms of greater strategic involvement and increasing diversity of functional expertise attuned to business needs. While likely influenced somewhat by legislation, these changes appear more related to general pressure on enhancing overall board effectiveness. And, perhaps surprisingly, pay may be less of a factor than many perceive. These are all positives in a world about which many are skeptical. Thanks Joe. I appreciate you spending time with me today.

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Gary Hourihan is a Senior Vice President at Farient Advisors, LLC, an independent executive compensation and performance advisory firm, which helps clients make performance-enhancing and defensible decisions that are in the best interests of their shareholders. He has 35 years of consulting experience focused on compensation, organization, leadership and talent management, with the overall objective of supporting business strategy, value creation and shareholder interests. Prior to joining Farient, Gary Hourihan was founder and Chairman of Korn/Ferry’s Leadership & Talent Consulting Group, co-founder, Chairman, and CEO of SCA Consulting, and a Partner at Booz, Allen & Hamilton. Gary can be contacted at gary.hourihan@farient.com.

Robin A. Ferracone is the Executive Chair of Farient Advisors and author of the book, “Fair Pay, Fair Play: Aligning Executive Performance and Pay,” which explores how companies can achieve better performance and pay alignment. Robin can be contacted at robin.ferracone@farient.com. Click here to sign up for Farient’s electronic newsletter.

In light of the Company’s Compensation Committee agenda for its upcoming meeting, Ron and I wanted to offer our viewpoint regarding the role of external consultants and the sources of value such trusted advisors can bring to the Committee.  While we will be available during the meeting by phone, this memo outlines our beliefs based on our widespread experience working with compensation committees.  Your proposed process of encouraging the Committee to come to agreement on this topic is a commendable objective and ensures that both the Committee and management have a clear understanding on the role of the outside advisor, including who the consultant ultimately reports to and the scope of services provided.

As described below, we believe our involvement adds value in four principal ways, including offering outside technical expertise, providing objective external compensation and performance benchmarking, ensuring clear alignment of total rewards with performance, and facilitating shareholder communication, not necessarily in that order.  Ideally, this external perspective best adds value when we, as the trusted advisor, understand the Company’s business strategy, value creation process, and the opportunity to use rewards that support these outcomes.

Technical Expertise

As an advisor, we provide the Committee with a technical resource that appreciates emerging issues and implications for the Company’s executive compensation programs.  Specifically, we expect to periodically:

- Offer an overview of general trends and creative approaches, such that the Committee understands not just current practices but appreciates where the market for executive compensation is heading.

- Provide technical assistance with complex compensation issues, such as performance-based equity programs, qualified performance-based compensation, stock option expensing, dilution methodologies, and equity incentive valuation.

Competitive Pay and Performance Benchmarking and Program Evaluation

An outside advisor can educate the Committee on the overall compensation market place, and explain variations across industries, thereby creating contextual understanding and ensuring that Committee members have a broad perspective beyond their specific industry background. Specifically, the advisor can:

- Screen and identify relevant peer sets to gain Committee consensus on competitive sets for pay and performance comparisons.

- Assess the executive compensation strategy and program in light of the current environment.

- Provide a balanced and objective assessment of the appropriateness of the executive compensation program relative to the external environment and internal business context.

Pay-for-Performance Alignment

One of the highest return opportunities where we add value is through our examination of the Company’s performance measurement framework and its alignment with expected behaviors and results. As such, we bring the shareholder viewpoint to the table on both the performance side of the equation (i.e., measures and target-setting) as well as the pay side.  Ideally, we help to ensure that measures align with value creation and that goals are set with the proper degree of difficulty to correspond with executive rewards.  As an outcome of this process, we typically:

- Identify key gaps in the current program and directional refinement in programs for the Committee to consider.

- Assist with implementation of any changes agreed to by the Committee and management based on our experience with other clients.

Shareholder Communication

Recently, we have noted a favorable view within the institutional investor community that the Compensation Committee should have access to independent advisors to ensure credible calibration of pay with performance and to deliver independent, objective input to the Committee’s decision-making process.  In particular, we endeavor to safeguard the Company’s Committee from a governance perspective by:

- Helping the Company to “see around the corners” when we see issues emerging on the horizon (e.g., a negative ISS recommendation or the expected shareholder reactions to certain actions or proposals).  For example, if the Company were to adopt employment agreements, we would insist on not only looking at competitive provisions, but also calculating potential liabilities under various scenarios, particularly negative ones like termination for bad performance.

- Supporting effective governance processes through use of executive sessions and other forums that ensure independence of Committee thought on highly sensitive matters.

- Noting where the Company might be challenged regarding its compliance with the spirit of disclosure, accounting, or shareholder approval matters.

For this process to work most effectively, we prefer continuity of the relationship, which means being present at most Committee meetings, even if only participating through a listening role. Obviously, we need not join if the agenda is particularly light and administratively oriented for certain meetings. Ideally, our involvement is best determined through an annual planning meeting of the Committee calendar, which we have suggested with the head of HR and the head of Executive Compensation as an outcome from the next Compensation Committee meeting.

We look forward to the outcome of your discussions of this topic among the Committee members and trust that you find our insights on this topic helpful. If you would like to discuss this topic in advance of, or during your meeting, please do not hesitate to call either of us.

Best regards,

Robin A. Ferracone

Executive Chair, Farient Advisors LLC

cc: Ron Bottano

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Robin A. Ferracone is the Executive Chair of Farient Advisors, LLC, an independent executive compensation and performance advisory firm which helps clients make performance-enhancing, defensible decisions that are in the best interests of their shareholders. Robin Ferracone is the author of a recently published book entitled “Fair Pay, Fair Play: Aligning Executive Performance and Pay,” which explores how companies can achieve better performance and pay alignment. Robin can be contacted at robin.ferracone@farient.com and click here to sign up for Farient’s electronic newsletter.

As we wind down for the holidays, and put the first year of Dodd-Frank behind us, now is a great time to look forward and backward. I am thrilled to introduce our guest blogger Ken Daly, president and CEO of the National Association of Corporate Directors (NACD), the nation’s largest member-based organization for corporate board directors, Ken is a recognized expert on corporate governance, executive compensation and corporate board transformation.

Ken’s team at NACD, and my company, Farient Advisors, have been working closely over the past year in a number of areas including the development of the NACD Directorship 2011 Guide to Executive Compensation, and most recently the NACD Compensation Committee Chair Advisory Council which includes Fortune 250 compensation committee chairs, investors, regulators and proxy advisors. 

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I am sure that we can all agree that “pay for performance” has become the buzzword for 2011. Compensation committee members who are active with NACD often tell me that their compensation objective is to award “pay for performance.” Of course, as someone who lives and breathes corporate governance, this is music to my ears.

NACD has been preaching pay for performance since our first Blue Ribbon Commission on the topic of executive compensation two decades ago—and repeated with every new edition over the past several years.  After all, directors represent shareholders, who naturally favor performance-based pay. And since investors only make money when the company performs—it stands to reason that they would want the same approach to executive pay.

Clearly shareholders don’t want directors to “pay for failure,” and in 2012 we may see more directors “voted off the island” if they don’t align pay for performance and communicate their pay decisions to investors. And now, with the Securities and Exchange Commission determined to mandate disclosures on “pay for performance” in 2012, the drum beat for performance-based pay is getting louder.

The Traditional Definition of “Pay for Performance”

But not so fast! During the recent holiday season I had a chance to step back from the buzzwords and really think about it. What do we mean by “performance?” Shareholders generally define this as total shareholder return in relation to peer companies—namely the appreciation of stock price over a specific period, plus dividends, as compared to peers. Regulators are most likely to go along with that definition.

Fair enough. Yet an important nuance is missing here. The definition of pay for performance can and should vary by company. Remember, Total Shareholder Return (TSR) cannot be calculated by business unit, it requires the entire company. Also, the period of time chosen may be very short. And this is a backward looking measure. There is no consideration of future potential (unless that is impounded in the stock price, not always the case when it comes to our stock market, driven as it often is by a herd mentality.)

Here too, one size (and one formula) does not fit all. And hence my caveat emptor—a warning to the buyers of executive talent. Promising “pay for performance” to shareholders, or worse yet regulators, without defining the terms can lead to trouble.

Potential Dangers of “Pay for Performance” Determined by Investors

I have witnessed several troubled scenarios over the years involving investor communications. One example includes a company with a highly effective CEO—one who has strong relations with employees, lenders, customers and some key shareholders. The board says they will structure the CEO’s pay based on performance, but the board does not disclose any specific share-based metrics beyond the ones included in its proxy filing.

Behind the scenes, the board has set a number of internal goals that lead to a long-term sustainable company. However, the board does not use a reporting format to disclose these to shareholders or to regulators. In the course of the CEO’s first year the company makes a number of capital investments that have a payback of five years.

In this scenario, the CEO, in the eyes of the board, has performed well, because these investments will benefit the company long-term. However, for the first year of the payback period, the stock price declines, because the market does not appreciate the value of the capital investments; the market sees only a decline in earnings and fears the worst. Because the board had not disclosed and communicated all aspects of pay and performance, investors unfairly accuse the board of paying for failure.

Potential Dangers with “Pay for Performance” Designed by Regulators

I hope I don’t insult anyone’s intelligence if I remind you of the unintended consequences of federal mandates. Need I say 162(m)? Twenty years ago, most CEOs had salaries of well under $1 million per year. Then the Internal Revenue Service, implementing a provision of The Omnibus Budget Reconciliation Act of 1993, created Section 162(m). This new tax code section removed the deductibility of pay for executives unless their pay was approved by an independent compensation committee. Disclosures of the $1 million-plus packages created a demand among CEOs to top that mark, making $1 million the new floor rather than a ceiling.

So the danger with having a pay for performance mandate enshrined into law by the SEC rule is clear. The SEC will define what performance means and boards will try to adhere to it. If they had more stringent or comprehensive standards for measuring performance these could get lost in the rush to have “pay for performance” designed by Congress. Probably not the best long-term solution!

Six Steps to Redefine “Pay for Performance”

I can’t take credit for all of these insights. I have come to them from serious reflection grounded in extensive dialogue with board leaders, as well as deep primary and secondary research. By dialogue, I’m referring to the deliberations that led to the 2010 Report of the NACD Blue Ribbon Commission on Performance Metrics, co-chaired by John Dillon and William White. In this report, stakeholders and thought leaders agree that directors need to take six measurable steps that go far beyond the simplistic cry for aligning “pay for performance.” These steps include:

1. Understand and agree on the company’s key performance metrics. These key metrics, set for both the enterprise as a whole and for major business units, should be used to track progress.

2. Establish company performance metrics to cascade throughout the entire enterprise. The board should ensure that management has used the metrics to establish more robust and detailed metrics at lower levels.

3. Track company performance against metrics on an ongoing basis. Metrics need to be set annually and monitored over time.

4. Establish consistent and appropriate executive performance metrics. These measures should be used not only for compensation of top officers, but also for managers throughout the organization.

5. Reward executives based upon performance as measured by appropriate metrics. Determine compensation payments based upon an assessment of performance, including consideration of risk, for top officers and other levels of management.

6. Communicate with shareholders regarding how the company has paid for performance. Use clear language to convey the reasons and results of pay.

As you can see, these steps use well-defined metrics that are defensible and encourage ongoing communications between shareholders and directors. At the end of the day, the best board/shareholder relationships avoid any hidden dangers in the dialogue. This relationship is evolving and will continue to benefit from disclosure, transparency, and clarity. As we wind down the most interesting year in proxy season history, fasten your seatbelts—2012 promises to hold many surprises in terms of who stays and who goes.

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Robin A. Ferracone is the Executive Chair of Farient Advisors, LLC, an independent executive compensation and performance advisory firm which helps clients make performance-enhancing, defensible decisions that are in the best interests of their shareholders. Robin Ferracone is the author of a recently published book entitled “Fair Pay, Fair Play: Aligning Executive Performance and Pay,” which explores how companies can achieve better performance and pay alignment. Robin can be contacted at robin.ferracone@farient.com and click here to sign up for Farient’s electronic newsletter.

I hope you all had a nice Thanksgiving weekend.  Just before the weekend, one of our tech clients commented on the obvious misstep by Zynga, the hot video game maker of Farmville, Mafia Wars and other popular games, in threatening to recoup restricted stock from certain employees, lest they face dismissal.

If you are still catching up on your reading, this bit of news was first uncovered by The Wall Street Journal in an article published on November 10, 2011 titled, “Zynga Leans on Some Workers to Surrender Pre IPO Shares.”  In the competitive market for talent, it was unbelievable to my client how a company could withstand the negative PR and fallout from such a breach of trust.

This situation raises a number of questions:

• How did Zynga get here?
• What other alternatives could it have considered?
• What is likely to be the fallout from this situation?
• What should Zynga do now?

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These questions look like they are straight out of a Harvard Business School case study.

I have no personal knowledge of this situation, but one doesn’t need to be an executive compensation expert to see that the company likely found itself between the proverbial rock and hard place through a combination of poor planning and lack of clarity around corporate values.  In my previous column “Executive Compensation Before and After the IPO” that I co-authored with Ron Bottano, a VP at Farient, I outlined ten compensation strategies for transitioning through an IPO.  One strategy that Zynga might have benefitted from was:

“Consider pay structures to be your friend – High-growth IPO companies often eschew anything that is perceived to constrain creativity.  But establishing a pay structure (i.e., setting salary ranges, target bonus opportunities as a percentage of salary, and equity grant ranges) is one of the keys to scaling the business.  If there is no structure, then everything is an ad-hoc negotiation, which is sure to lead to pay inequities (and discontent).” [Italics added for emphasis.]

One of the first things that any of us do at Farient in assisting very early stage clients is to create a spreadsheet that shows all of the positions by level that the client has now and likely will have in the foreseeable future.  It also lays out the equity that likely will be granted to each person in that position or level, as well as the anticipated dilution of each person’s equity stake through progressive rounds of financing up to and through the IPO.  That way, the client can effectively manage its equity spend during the heavy phases of growth and recruiting, and avoid the issues associated with ad-hoc decisions on compensation.  These issues include:

• Granting too much equity, causing a shortage of equity when it is most needed and/or causing excessive dilution
• Severe “inequity” in the equity allocations, i.e., inappropriate differences in how much equity each person has
• Providing too much equity to those who are not making the contributions that they were expected to make
• Not forecasting the relative cost of equity and various equity vehicles, particularly in choosing between restricted stock and stock options for employees at different levels in the company
• Giving equity where it is not needed for competitive or recruitment purposes, and/or granting equity to those who don’t really value it relative to its cost (usually those at lower levels in the organization)

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In addition, we think long and hard about the type of equity that our clients are granting.  If they are granting options, then shorter (e.g., seven year) terms, for example, might be appropriate to allow the client to refresh the pool.

As for the second question – “Could Zynga have considered other alternatives?” – there are almost always other alternatives.  It would seem that those responsible for the mistake, i.e., top management and the board, should have held themselves accountable.  Could top management and the board have sold a portion of its equity back to the company, which in turn, could have been used for the incentive pool?  Could the company have bought out the unvested equity of certain individuals and then reissued this equity to those who most needed it?  Could the company go public with a higher than normal equity pool, and promise to carefully manage its equity spend going forward?

As for my third question – “What is the likely fallout?” – we’ve already seen a glimpse of it.  First, there is the reputational damage from negative PR.  Then there’s the trust issue that Zynga likely has created.  Third, employee retention may be an issue, at least following the IPO after the big gains are realized (particularly when stock vesting allows employees to cash-out upon the occurrence of a qualifying liquidity event, as in the case of the Zynga IPO).  Fourth, employees may start asking for shorter vesting on future equity grants, or more short-term cash in their pay mix.  Fifth, there are likely to be legal issues.  And lastly, all of these negatives may create a potential drag on the company’s valuation when it goes public.  After all, a company’s value is comprised of both its tangible and intangible assets.

So, what should Zynga do now?  It could stay the course, hoping that a wildly successful IPO will cure all evils.  Alternatively, it also could reverse course, make an apology, and implement one or more of the alternatives discussed above.  Second, following its IPO, Zynga may want to heed another piece of advice that was in my previous column:

“Plan for declining burn rates and overhang - A burn rate is the percentage of shares that a company uses annually for incentive grants.  Overhang is the percentage of shares that are outstanding and available for incentives.  The fact of the matter is that both burn rates and overhang are higher for pre-IPO than post-IPO companies.  Overhang comes down as employees exercise their options and take gains off the table following the IPO.  So, IPO companies need to carefully budget their equity usage and manage to a declining burn rate and overhang over time.”

Third, Zynga should think about its corporate values, and if it hasn’t already done so, codify its values into a cogent set of statements that employees help craft and commit to live by.  And fourth, Zynga should ensure that it has a highly capable compensation committee of the board, experienced in all matters of compensation.

As for shareholders, they will want to scrutinize Zynga’s prospectus for the IPO to ensure that it has a very transparent and cogent plan for managing its incentive equity pool and employee engagement going forward.  After all, the “name of the game” going forward for Zynga will need to be “TrustVille.”.

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Robin A. Ferracone is the Executive Chair of Farient Advisors, LLC, an independent executive compensation and performance advisory firm which helps clients make performance-enhancing, defensible decisions that are in the best interests of their shareholders. Robin Ferracone is the author of a recently published book entitled “Fair Pay, Fair Play: Aligning Executive Performance and Pay,” which explores how companies can achieve better performance and pay alignment. Robin can be contacted at robin.ferracone@farient.com and click here to sign up for Farient’s electronic newsletter.

It’s been hard to miss the unfolding drama at Hewlett-Packard (HP) over the past few years, from the eavesdropping incident among board members, to Mark Hurd’s alleged improprieties, to the recent dismissal of Leo Apotheker for obvious missteps. As the Dodd-Frank Act became reality in 2010, HP was one of the first companies to receive a majority “no” say on pay vote, due largely to the lucrative sign-on and “pay for failure” severance packages offered to its previous three CEOs, which by our estimates, topped $100 million.

Just over one month ago, Meg Whitman signed on as HP’s new president and CEO, while Ray Lane signed on as the executive chairman of the board, with both being paid for performance in their new roles. So, I asked myself, “Do their pay packages reflect HP as a ‘learning’ organization?”

To answer this question, we first need to review the pay packages themselves. In this regard, Meg Whitman received:

- $1 salary

- $2.4 million target bonus, with $6.0 million maximum bonus

- 1.9 million stock options that carry an 8-year term and a $23.59 exercise price, and vest upon meeting the following conditions:

• 300,000 that vest ratably over 3 years contingent upon Whitman’s continued employment
• 800,000 that vest upon one year of service and achieving a closing stock price of 120 percent of the option exercise price (i.e., $28.31) for 20 consecutive trading days
• 800,000 that vest upon two years of service and achieving a closing stock price of 140 percent of the option exercise price (i.e., $33.03) for 20 consecutive trading days

- A severance benefit equal to 1.5 times the sum of base salary and the average actual bonus for the preceding three years, upon involuntary termination without cause

By my calculation, the target value of this total direct compensation package sums to approximately $16.5 million.

In addition, Ray Lane received:

- No salary

- No bonus

- 1 million stock options that carry an 8-year term and a $23.59 exercise price, and vest upon meeting the following conditions:

• 200,000 that vest ratably over 3 years contingent upon Lane’s continued employment
• 400,000 that vest upon one year of service and achieving a closing stock price of 120 percent of the option exercise price for 20 consecutive trading days
• 400,000 that vest upon two years of service and achieving a closing stock price of 140 percent of the option exercise price for 20 consecutive trading days

- No severance

By my calculation, Lane’s package is worth approximately $7.5 million in target grant value, so the value of the two executives combined is about $24 million.

So, is this a good deal for shareholders? In my view, the answer is a “qualified yes.” In fact, there is good news for shareholders about this pay package. The $16.5 million target, or expected value (i.e., neutralized for performance), for Whitman is at the low end of a competitive range. The annualized competitive total direct compensation (i.e., salary, bonus and the target value of long-term incentives) for a CEO of a tech company of HP’s size (about $125 billion) is easily about $20 million. And they brought Whitman on with no sign-ons, buy-outs, relocation allowances, etc.

One could argue that the HP executive chair role, while not a freebie, has been thrown into the mix for a rather modest premium. In addition, both Whitman and Lane’s pay package pay out only if performance materializes. Granted, Whitman and Lane received their options at practically a 5-year low in the stock price (see Exhibit 1). However, the stock price needs to appreciate to the low to mid $30s in order for Whitman to earn her target pay package of $16.5 million, assuming a target $2.4 million bonus award also is earned. And the stock price would need to appreciate to the mid to high $30s in order for her to earn two times her target award (i.e., $33 million), assuming a maximum $6.0 million bonus award. So, it is clear that Whitman (and Lane for that matter) will win only if shareholders win.

But here are the qualifiers. First, Whitman was given a highly leveraged pay package, meaning that once the options vest, her award levels will increase significantly with only modest gains in performance.  It could be argued that Whitman and Lane’s highly leveraged deal could cause them to take undue risks. However, in both cases, Whitman and Lane have not taken on these roles for the money. So, I think the risk argument all but goes away in this specific instance.

Second, a modest uplift in secular stock prices could drive a significant part of the compensation gain. At the time of this writing, HP’s stock price was about $28, up almost 20 percent from the price at the time of the grant, due largely to an uptick in the secular stock market.

Finally, shareholders will need to keep an eye on what comes next. If Whitman and Lane are successful in turning around HP, I would argue that next year’s package for Whitman should be rather straightforward, i.e., in line with competitive norms, could possibly include a salary, and would be consistent in format with the compensation plans offered to other HP executives.

I would also expect that Lane would not receive incremental compensation for his role because, if it is done right, this role should eventually transition from his executive to a more normal non-executive chairman role. In addition, shareholders will want to make sure that HP does not make cash or equity awards in the future to offset poor stock price performance. This means that HP would not make special awards, retention awards, or discretionary awards, nor would it offer lucrative perks, nor would it increase the severance multiples. In other words, it would work within the “four corners of the incentive plans.”

So, there you have it. Shareholders should give HP high marks for signing on two of the most talented executives in Silicon Valley. As of right now, the parties involved are set up for a rather leveraged win-win. But stay tuned. Future actions are the ones that will tell us whether experience was really the best teacher at HP.

(Click image to enlarge).

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Thank you to my colleagues Dan Mumenthaler, Rob James and Randi Caplan who provided research assistance for this blog.

Robin A. Ferracone is the Executive Chair of Farient Advisors, LLC, an independent executive compensation and performance advisory firm which helps clients make performance-enhancing, defensible decisions that are in the best interests of their shareholders. Robin Ferracone is the author of a recently published book entitled “Fair Pay, Fair Play: Aligning Executive Performance and Pay,” which explores how companies can achieve better performance and pay alignment. Robin can be contacted at robin.ferracone@farient.com and click here to sign up for Farient’s electronic newsletter.