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Break the mold on director pay.

At no other time in recent memory have boards of directors been subjected to such intense public, regulatory, and government scrutiny, as exemplified by the recent SEC action on executive compensation disclosure requirements. Shareholders and institutional investors, who have been a board's traditional constituencies, are increasingly active, vociferous in their demands, and more apt to seek recourse if those demands are not met. And a number of expanded constituencies - employees, management, customers, the community, and society at large - continue to emerge and require increasing attention.

But that's not all. As the business environment for most companies becomes more complex, with issues such as industry consolidations, global competition, escalating technology, capital needs, and restructuring opportunities, board members are under increasing pressure to assume a more dynamic role in the governance of their companies.

In response to this atmosphere of increasing scrutiny and complexity, boards of directors are becoming more involved in setting their companies' strategic direction and objectives than they have been in the past. Directors have redefined their criteria for success to be more committed to the company, to oversee its strategic and organizational direction, and to define acceptable company performance.

Little wonder then that potential directors are more selective than ever about the companies they will serve. Many companies haven't helped matters by maintaining a director compensation system that does not reflect directors' current efforts, responsibilities, and accountabilities - contributions that increasingly determine the board's requisite qualifications and how they will operate.

An effective director compensation system properly rewards directors for what they actually do based on the necessary qualifications for board members, and by clearly identifying the type of role the board plays in the company. With the right approach, compensation can be a powerful and effective tool to attract and retain qualified directors - and to reinforce behaviors that are in the best interest of the company.

The board's more strategic nature will be the basis for a new approach to director pay. The roles, risks, and exposure for corporate boards of directors vary, and these variations should be reflected in the qualifications of an effective director.

Nine Decisive Factors

The following nine factors, weighted by priority, can help companies determine the necessary qualifications for their directors and how the complexity of their situations will affect director compensation. By evaluating the company's position based on specific business needs relative to each of these factors, a company can determine how qualified and involved its board must be, as well as how its compensation levels should compare with other companies.

For purposes of illustration, we'll compare the board of directors of MacKey Industries, a food products company with $500 million in revenue, with the board of Byte Technologies, a $100 million high technology company. Each company requires different qualifications and levels of involvement from its board. These two companies should, as a result of these differences, pay their boards of directors very differently. (These company names are pseudonyms.)

1. Company financial position: All else being equal, the stronger and less complex a company's financial position, the less risk and involvement required from its board of directors. However, as financial arrangements become significantly more intricate, the time and expertise required to evaluate joint ventures, mergers and acquisitions, and capital needs have increased. The financial decision-making environment of a company undergoing rapid growth in a tight credit environment can approach the complexity of a company on the verge of bankruptcy. For example, the board of directors of Byte Technologies recently had to evaluate and approve the issuance of additional debt (denominated in French francs) to finance a foreign acquisition. On the other hand, the use of futures by MacKey Industries to hedge against adverse changes in the price of soy beans simplified its financial strategy.

2. Product breadth and diversity: As the breadth, diversity, and complexity of product and/or service lines increase, so do the variables of necessary trade-offs - in the board-approved capital budgeting process, in the management of multiple distribution channels, and in the allocation of management and board attention and focus. The tradeoffs involved frequently include enough risk and exposure to require board review. Opening a new plant to support an emerging product line may siphon off the capital available to refurbish an existing plant in another line of business. Or a decision to pursue an emerging technology might require significant organizational change.

When Byte's board decided to focus on its optical interface business and establish a new maquiladora plant in Calexico, the effect was to drain off capital needed to support its existing measurement products plant in Silicon Valley. By contrast, MacKey carried out its decision to diversify into the custom sauces line of products through existing distribution channels with only minor impact on its other businesses.

3. Constituencies, visibility, and risk: By answering to a growing number of constituencies, boards are finding the demands of their role increase according to the prominence of these constituencies' issues. And as constituencies' interests diverge, there is an inherent risk that shareholders will seek legal remedies for decisions that they feel are not in their best interests.

If the company is highly visible, its board will be subject to heavier scrutiny, more exposure, and more risk. The regulation, re-regulation, and deregulation of many industries, growing pressure from consumer and public activist groups, and the increased activity within the SEC and other government agencies have all combined to make the director's role more demanding.

For example, management and a group of institutional investors hold the bulk of Byte Technologies' stock. On the other hand, MacKey Industries' major shareholders include the late founder's family (which is primarily interested in dividends), management, a group of major soybean producers who want to ensure a market for their product, and the pension fund of the state where MacKey is located. The complex interests of MacKey's constituents will require more from the board if it is to address all their interests. In addition, MacKey's recent skirmish with a group of consumer advocates made it more difficult for the company to attract qualified directors, forcing them the re-evaluate their directors' pay package.

4. Industry: Unlike executives, a company's board of directors is commonly recruited from different industries. From the standpoint of directors' qualifications and pay, specific industry experience is less important than it is in executive compensation. However, the maturity and cyclicality or predictability of the industry, as well as the social forces at work within the industry, can significantly impact the difficulty of the board's review and decisionmaking processes. For example, Byte's products have short life cycles and the industry itself is subject to frequent "shake-outs" as companies vie for dominance. On the other hand, MacKey's product markets are much more stable with more predictable demand.

5. Geographic considerations: A multinational corporation faces complexities that come with doing business across borders and continents: a changing competitive market worldwide; different currencies, cultures, and customers; varying levels of regulatory scrutiny; and the intricacies of transferring funds internationally. These issues create more involvement by, and exposure for, board members, and thus should have a higher influence in determining pay levels. Because Byte is significantly more diversified internationally than MacKey, this factor would also influence pay at Byte.

6. Company size: Company size is overrated as a determinant of board pay. Although it is the easiest factor to evaluate, it can cloud the real differences between companies that require different levels of qualifications and involvement from board members. But size cannot be completely discounted either. Larger companies have more employees, more capital assets, and a longer planning horizon. While MacKey has more revenue than Byte, it has about the same number of employees and the same size capital budgets, so the impact of size on both companies would rate approximately the same.

7. Board's role: In addition to fulfilling their fiduciary roles, some boards also assist in other functions - consulting on acquisitions or capital planning, in the evaluation of new technologies, or in other areas of specialized expertise. Where the board's involvement with the company goes beyond typical roles, overall compensation levels should be evaluated using consulting fees for the board members involved. Several of Byte's directors received special consulting fees for their time spent evaluating potential joint ventures.

8. Board size: The size of the board determines the types and number of roles board members must play. Quite simply, smaller boards require individual members to play a number of roles requiring more qualifications than a member of a larger board with more resources on which to draw. The fact that MacKey's board has 16 members would influence its director pay program differently than Byte's six-person board.

9. Business connections: Where there is no direct conflict of interest, bringing customers, suppliers, and/or investors on to the board can ensure that the interests of these stakeholders are represented and help build a long-term partnership. A bank, for example, often wants its board members to know the community, as well as existing and potential customers. Byte doesn't have to pay as much to the several board members who represent investment groups because their board role dovetails with their investor role. MacKey, however, decided to recruit outside board members who had no relation to the company, thus increasing the time and effort required of board members, having implications for how the directors' pay is structured.

The Mix of Pay

These nine factors provide a means for defining the qualifications of an effective director based on what is currently going on in the company and the business environment. Positioning against these factors (as we have done with MacKey and Byte in the exhibit on the following page) will dictate an appropriate pay program by specifying the experience required of directors and the activity level of the role they must play.

The main reason that current director compensation programs do not adequately serve most companies' needs is that their structure emphasizes annual retainers. Retainers account for more than 73% of the median of manufacturing firms' director pay packages, according to The Conference Board's most recent survey of director compensation. Retainers have seen tremendous increases over the past five years - as much as 200% according to some surveys - and essentially pay directors to be available and on call to discuss the company's general business issues. But most boards do not operate that way anymore. Instead, future boards will operate in a more formal and intensive manner that requires more structure and personal efforts.

Instead of paying large retainers, companies should consider paying higher board meeting and committee fees to emphasize the importance of attending and preparing for board and committee meetings. Board fees reflect the broad participation of the entire board in staying informed and being able to act intelligently on matters subject to full board review. Committee fees reflect the work necessary to ensure that required action is based on a solid foundation.

Companies should also pay attention to how much they are paying for membership on a particular committee. Some committees require greater intensity, are higher on the scale of factors previously discussed, and are more critical to a company's success and shareholder interests than others, so the members of these more critical committees should receive more money for the additional preparation time and the issues they must resolve. This pay may translate into higher meeting fees and differentiation among committees, and also into premium fees for dealing with specific issues - a flat or hourly fee paid on top of regular fees.

Consulting Fees

In addition, consulting fees can be paid to individuals who have performed work above and beyond a board member's normal responsibilities. This may or may not be in conjunction with a particular committee, but it must be in connection with activities that are appropriate for a board member, such as participating in a task force for strategic planning. Board members should not work for management in a role that makes their income dependent on management pleasure. These fees should be equal to what would be paid to an outside consultant or professional (minus the overhead expenses built into outside contractors' fees) to do the same or similar work.

By finding the proper mix of retainer and board and committee fees, companies will be paying directors for the exposure they face, as well as the increasing amount of time and effort it takes to be an effective director in today's environment.

Many companies have begun offering directors pay that goes beyond this mix of cash compensation through noncash compensation - benefits, perquisites, and stock. However, doing so puts many companies, and their directors, on shaky ground and may create more problems than it solves. For example, life and health insurance benefits for directors have become more prominent. But with the increased visibility of benefits, companies must take care that benefit levels for directors do not exceed levels for the rank and file.

Retirement plans, another popular vehicle, are somewhat controversial because they go beyond what is appropriate compensation for directors. Retirement plans usually award benefits based on years of service, which creates a conflict of interest by encouraging directors to remain on the board for no other reason than to receive a retirement benefit. Directors must actively pursue the best interest of the company and its shareholders - and no one else's. (See "The Propriety of Retirement Plans" by James A. Kuhns, Directors & Boards, Summer 1991.)

In Consonance

Stock options and grants, on the other hand, can increase directors' interest and ownership in the companies they serve, if constructed properly. By placing resale restrictions on stock options and grants, companies can encourage long-term thinking among their directors. However, directors should never receive restricted stock. Restricted stock, like retirement plans, creates a conflict of interest by providing an incentive for directors to remain on the board to collect their shares.

As the range of responsibility, risks, and exposure for board members has increased, so has the range of pay. Unfortunately, many companies rely heavily on factors, like company size, that do not tell the entire story of a director's job. By developing a compensation program that is tailored to their specific needs, companies can put pay in consonance with the job that directors must do. Just as the board should do with management.
COPYRIGHT 1993 Directors and Boards
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Author:Kuhns, James A.; Chase, David A.; Amuso, Linda E.
Publication:Directors & Boards
Date:Jan 1, 1993
Words:2368
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