How to determine how much to pay directors?

Friday November 12, 2010

How to determine how much to pay directors?
Whose Business is it anyway - By John Zinkin



IN my last article I wrote about the elements that have to be considered by the remuneration committee when determining the overall remuneration package of an independent non-executive director (INED).

The key factors are complexity; opportunity cost; roles and responsibilities; time spent; and experience, captured in the acronym CORTEX. Today's article will discuss how to structure such a package.

When deciding on the appropriate remuneration structure, two things must be considered: what can the company afford and what is the desired behaviour that the remuneration is designed to reward.

A start-up company may not wish to remunerate its directors on a fixed basis, preferring to keep payments variable and long-term so that the board package does not unduly burden the company when it is still short of cash.

Equally, a well-established company with ample cash flows will not be overly concerned about paying fixed fees to board members.

Any remuneration scheme must achieve the following six objectives:

·It must create a sense of responsibility for the long-term success of the business as opposed to encouraging thinking that all that is needed is for INEDs to merely attend meetings;

·It must reward any extra commitment and time spent during those times when the company is going through intense change or activity requiring a higher degree of involvement than usual – for example during a merger, acquisition or divestiture or a crisis that could destroy the company;

·It must encourage and recognise outstanding performance on the board;

·It must also create a sense of belonging to reinforce the idea that INEDs are stewards of the company and their contribution to the board of a given company really matters (this is particularly important for INEDs that sit on several boards);

·It must attract appropriate talent; and just as important (and often forgotten)

·It must also facilitate the departure of talent, whose presence on the board is no longer required because of changes in strategy or company circumstances.

Remuneration mechanisms

There are eight types of remuneration mechanisms identified in the recent PricewaterhouseCoopers report Performance Pays. Each has its own advantages and drawbacks, discussed below.

Fixed fees: These are paid regardless of the level of risk run by the INED or the number of meetings attended and time spent on the company's business.

They provide a base-load of income, but used in isolation may not adequately reward INEDs for the time they actually spend in meetings and preparing for them.

Moreover, currently in Malaysia, they do not represent a realistic return for the risk INEDs are exposed to.

Meeting fees: These are paid for the number of meetings attended, normally on a fixed rate per meeting.

They reward INEDs for the time and effort spent in preparing for and attending meetings and may encourage the use of too many unnecessary meetings to increase the fees paid.

More seriously, in isolation, attendance fees risk reinforcing the notion that all that matters is INEDs attending meetings.

This could lead to INEDs forgetting that they still bear the wider responsibilities for the business as a whole on an ongoing basis and to them not taking the time to become properly acquainted with the key people who matter for succession planning.

It could reinforce an aversion to visiting offices, factories or plantations and becoming familiar with the processes in the business that create value.

Performance loading: This is rather rare in Asia so it is not easy to decide what level of payment is appropriate.

Its advantages are that it rewards INEDs for temporary increases in time spent and is simple to administer and easy to stop when it is no longer appropriate.

Ex-post and ex-gratia payments: These are voluntary payments to recognise exceptional or long-standing service.

They send a message to other INEDs that such work is appreciated by the board, but because payment is not normally determined according to clear terms of reference or well-documented key performance indicators being met, they lack transparency and this can create its own problems of corporate governance.

Stock awards: These normally are paid in shares, often with specific conditions having to be met, such as minimum shareholdings and vesting periods.

They are supposed to foster a long-term orientation and have been defended as aligning INEDs' interests with those of shareholders.

They have the great advantage of reducing the immediate cash outlay, though they have been abused in the past by not being expensed.

Some have argued that stock options tie INEDs too closely to the fortunes of the firm and compromise their independence as a result.

They are also notoriously hard to administer and it is critical that they do not become a one-way bet, rewarding holders when options are "in the money" and being reset when they are "underwater".

The issue of options being abused and creating perverse incentives is at its most crucial in the case of executive directors and, in particular, the CEO.

If stock awards are to be given, the remuneration committee must consider very carefully how much is to be granted; the proportion of the total fees to be paid in stock; and the length of the vesting periods in order not to compromise INED independence.

Benefits-in-kind (BIK): These are payments in kind. They are normally medical expenses and insurance, use of company car and driver, secretarial support and discounted staff prices for company products or services.

The attraction of such payments is that they usually cost the company less than they are worth to the recipient, creating a win-win situation. However, if they become too closely identified with the INEDs' status and sense of self-worth, they can undermine independence of thought.

Sign-on and sign-off bonuses: These are one-off fees paid upon acceptance of the position of INED or agreement to leave the board.

The attraction is that they are one-time expenses that can be quite effective in achieving the desired objective, but they are cash payments and lack transparency.

Ninety per cent of the directors interviewed in the PwC study preferred a combination of fixed fees and meeting fees, and as long as the majority of the fees are fixed, this will not lead to a perverse desire to have board meetings for the sake of the fees.

Sixty per cent of INEDs of local banking groups were open to stock awards, though only 40% of directors of other financial firms were interested.

Once again 90% of INEDs were in favour of BIK payments, with medical coverage and insurance being unanimously identified as the benefits that were the most appreciated.

Admittedly these findings were limited to INEDs of financial institutions, but there is no reason to suppose that they do not represent a good guide to how INEDs in other industries would feel.

The point to remember is that the remuneration committee must look at all these tools, while recognising that there is no "one size fits all" solution.

The most appropriate structure for INED remuneration will always depend on the circumstances of the individual firm and the objectives the remuneration package is designed to meet.

The writer is CEO of Securities Industry Development Corp, the training and development arm of the Securities Commission.

http://biz.thestar.com.my/news/story.asp?file=/2010/11/12/business/7394429&sec=business

Buffett (2002): Guidelines for choosing independent directors who will think for the shareholders and not against them.

We learnt how independent directors at a lot of investment partnerships have put up disastrous performance through Buffett’s 2002 letter to shareholders. Let us further go down the same letter and see what other investment wisdom he has on offer.

Of practicing and preaching

Ok, we have heard a lot about the failings of independent directors and their apathy towards shareholders. However, preaching is one thing and practicing and offering a solution is completely another. Since Buffett himself runs a company, it will be fascinating to understand the guidelines he has set forth for choosing independent directors on his company's board as well as the compensation he pays them. He has the following views to offer on the kind of 'independent' directors he would like to have on his company's board:

Buffett says, "We will select directors who have huge and true ownership interests (that is, stock that they or their family have purchased, not been given by Berkshire or received via options), expecting those interests to influence their actions to a degree that dwarfs other considerations such as prestige and board fees."

Interesting, isn't it? If a person derives most of his livelihood from a firm and if he is made a director of the firm, he is quite likely to take decisions that result in maximum value creation. While this approach may not be completely foolproof, it is indeed lot better than approaches at other firms where such a criteria is not set forth while looking for independent directors.

Furthermore, on the compensation issue, Buffett has the following to say:

"At Berkshire, wanting our fees to be meaningless to our directors, we pay them only a pittance. Additionally, not wanting to insulate our directors from any corporate disaster we might have, we don't provide them with officers' and directors' liability insurance (an unorthodoxy that, not so incidentally, has saved our shareholders many millions of dollars over the years). Basically, we want the behavior of our directors to be driven by the effect their decisions will have on their family's net worth, not by their compensation. That's the equation for Charlie and me as managers, and we think it's the right one for Berkshire directors as well."

Buffett's superb understanding of human psychology is on full display here. If a person is not behaving rationally, force him to behave rationally by smothering his options.

• First, choose those people that have a large and true ownership in a firm so that they really think of what is good and what is bad for the firm in the long run. 
• Secondly, pay them a pittance so that like other shareholders, they too derive greater portion of their income from the firm's profits and not take a higher proportion of its expense. This is also likely to pressurise them further to take decisions that are in the shareholders' interest. 

Indeed, some great lessons on how an independent director should be chosen and to ensure that he continues to think for the shareholders and not against them.

http://www.equitymaster.com/detail.asp?date=8/6/2008&story=1