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The best ways to pay directors.

Companies are casting about for innovative ways to compensate quality directors for their labors. Here is a panoply of ideas for consideration.

DIRECTORS & BOARDS enlisted five specialists in board organization and compensation for their best ideas on fashioning a forward-thinking pay and benefits program for directors and on enhancing the director pay/performance link. Here are their recommendations.

Make a Meaningful Commitment

David J. McLaughlin is President of McLaughlin and Co. Inc., a consulting firm in Essex, Conn. He serves as the chairman of the compensation and human resources committees of three public-company boards: Scientific-Atlanta Inc., Exide Electronics Group Inc., and Smart & Final Inc. He is also a management advisor to several multinational corporations in the United States and Europe; Executive Director of the Senior Personnel Executives Forum (a nonprofit association); and Publisher of The Organization Frontier, a new management journal.

An old English proverb says, "Some men go through a forest and see no firewood." The proliferation of data and opinion on director pay levels and practices may be diverting us from the real issue: How can we make our boards as effective as possible? The challenge is not how to pay directors. If we start with that question, the answer will look a lot like the executive compensation scenarios of the 1980s: Keep paying more. The real question is, can remuneration be used to make boards more effective?

In my opinion, there are four major obstacles to board effectiveness:

-- The mix and level of commitment of board members;

-- The organization structure prevalent in most boards;

-- The time span on which boards are focused; and

-- The tendency of boards to work as clubs rather than teams.

Remuneration can play some role in overcoming these obstacles.

Compensation is supposed to help attract and retain talented people. While board retainers have increased about 60% in the last five years, anyone involved in director selection can tell you that it is easy to fill the job with well-credentialed individuals but hard to get the right combination of committed people. Most boards do not have enough women, for example; or they have too many members with domestic rather than global business experience. A high level of commitment is necessary for effective participation, and many able candidates (particularly other CEOs) simply do not have the time.

More aggressive forays, often with the help of an executive search firm, are turning up better candidates, and independent nominating committees have raised the selection standard, but more attention also needs to be given to the remuneration package.

Average board compensation, particularly below the top several hundred companies, is a pittance for a CEO or successful professional but a true attraction for those coming from other sectors. To enhance the appeal to all types of candidates, I believe companies should offer recruiting bonuses in the form of restricted stock, with gross-up payments on the taxes due, or sizeable, front-end-loaded stock option grants.

Boards need to be more flexible than the traditional structure (meetings of the whole and standing committees) allows. I see boards using ad-hoc groups more extensively, particularly to address major strategic questions or handle top-level succession; resorting to conference calls more frequently; and stepping up the flow of information. Most companies have been slow to tie directors into their voice mail systems and online data networks, but it is clearly coming. In this unfolding world, the meeting fee may become an antiquated device. For this reason, director remuneration should be simplified to a sizeable retainer and ongoing stock options.

Some have argued that director compensation should fluctuate with bottom-line results, but I am dubious both about the appropriateness of any fixed formula and about the short-term orientation encouraged by such methods. The strongest incentive for directors to do their jobs well is to have a sizeable stake in the enterprise. I believe board members should be expected to make a meaningful stock commitment upon joining a board. A significant portion of director fees -- at least 25% -- should be paid in stock. Stock option vesting should extend over five years, not shorter periods, and there should be a threshold level of corporate performance required before options can be exercised. Further, directors should be expected to retain at least half of the stock they acquire through option grants and, over time, own stock with a market value of at least five times their annual retainer.

Maintaining an effective board also requires that more attention be paid to the performance of board members. The initial term of a board member should be a trial period, with a formal assessment at the end of a two- or three-year term by both the incumbent and a committee of outside directors charged with overall board governance.

Board charters should establish parameters for the retirement of board members. A common practice has been to set an "outside" date for retirement, such as age 68, but this may be too early for some and too late for others. An alternative would be to adopt a process under which the governance committee reviews all directors automatically. The committee could then recommend extended terms of service (an additional three years, for example) on a case-by-case basis. This would formalize a practice now followed by well managed boards. There should also be a director's retirement program that enables the company to transit with dignity individuals who have made a significant contribution in the past but are no longer active in business. Board members should be intensely interested in the company's business: while being a director is a part-time role, it is not a part-time commitment.

One additional practice from "Management 101" would improve board effectiveness. Boards should formally appraise their group performance periodically. Either a board governance committee could take on this task or a disinterested outside party. The evaluation should include not only such obvious factors as information flow and decisionmaking but also the ability of the group to raise and resolve issues (particularly unpopular issues that management may not want to hear), to deploy their resources, and to operate as a team.

Pay All Director Fees In Stock

Thomas J. Neff is President of SpencerStuart. His consulting practice focuses on CEO and other top-level recruiting, board of director studies and searches, and succession counseling. The following commentary is adapted from his presentation to a SpencerStuart-sponsored conference on corporate governance held at the Wharton School in the fall of 1992.

In looking at the proxies of hundreds of companies, I am struck by how often shareholders are urged by management to re-elect directors, often well-known corporate executives, whose personal investment in the company on whose board they serve amounts to no more than a couple hundred shares of common stock, with a market value that is often only a fraction of what the annual director's fees are. One wonders how deeply committed to the company and its shareholder interests such directors are and how strictly they hold the CEO accountable for promoting those interests -- especially since it is the CEO who normally determines the size of their director fees.

These speculations, along with my own experience as a director, lead me to offer some items for the agenda of board reform.

Item One is that a company should require its directors, upon joining the board, to make a substantial personal investment in the company stock and maintain it as long as they serve. By substantial, I mean large enough to be of real meaning to the individual involved. Obviously, the amount is more for a corporate CEO than it would be for a director who is a university professor and who may require assistance in the purchase of the stock. This immediately demonstrates that the new director has a tangible stake in the company and a vested interest in its long-term success.

Item Two is that all directors' fees -- I mean all -- should be paid in company stock. If phantom stock is used, then shares would accrue to the director, along with dividends, during his or her term of service on the board and be paid out after the director leaves the board. If outright grants of stock are made, provisions could be arranged to pay meeting fees or part of the retainer in cash to cover taxes.

This second recommendation comes out of my own personal experience. On two occasions when invited to join boards, I asked to be paid in stock rather than cash. Neither of those boards had been asked that question before, but they both readily agreed to it. The arrangement worked out satisfactorily in one instance and spectacularly well in the other. In the latter case, the company stock appreciated vigorously during my seven years on the board and then virtually doubled again during a tender offer.

As my stake in that company grew, there was no need to remind myself that as an independent, outside director, I had been elected by the shareholders to represent their interests. I was one of them.

There are arguments to be made against these recommendations, an obvious one being that they might limit the pool of directors available to a company. But that might not be so bad either, since it may also encourage a reduction in board size to a more effective number.

My final recommendation is a follow-up to the first two. If a company's directors are required to invest in its stock and be paid their fees in stock, the same principle should apply to management. That is, all long-term incentive plans and a portion of any annual bonus should be paid out in stock, not cash, and the plans should be tied to shareholder value. This would do a lot to eliminate the indifference to shareholder interests which appears to exist in the management of some companies, as the takeovers and abuses of the 1980s made clear. It would also shrink some of the outrageous cash compensation packages that are not justified by company performance.

The Task Ahead: Reward Individual Contribution

Pearl Meyer is President of Pearl Meyer & Partners Inc. She serves as an adviser to the top management and boards of major corporations here and abroad in matters of executive compensation, performance, organization, and selection. She also has expertise in the development and negotiation of senior executive employment contracts and agreements.

As any corporate director knows, these are times of heightened focus on corporate performance, thanks to financial turmoil, attacks by institutional shareholders, challenges regarding management compensation, anticipated regulatory and tax changes, as well as a new administration in the White House. Not surprisingly, the last year or so has not been the best time for making changes in board compensation. In fact, all over America, many companies have taken the step of placing new compensation plans on hold so their boards could tend to more important issues confronting their companies.

Now, in 1993, changes abound -- stringent new proxy disclosure rules from the SEC, a potential charge to earnings for stock options from the FASB, and proposed tax changes from President Clinton that are sure to change the make-up of compensation programs.

Where do all of these developments leave directors, and their compensation? According to proxy disclosure among the top 200 Fortune industrials, total cash for directors is relatively static, having grown a mere 2% to $48,873 on average last year. Retirement plans, after years of tremendous growth, have stagnated in the last several years, with usage remaining flat at just under two-thirds of companies. Deferred compensation plans, in which cash compensation is deferred into stock accrual accounts until termination or retirement, have leveled off at around 31% for the last three years. Only stock-based compensation plans have grown -- 59% of companies reported such plans versus 54% the previous year.

Retirement plans, which appear to have peaked, have recently come under fire by institutional shareholders (and others) as "give-away" compensation, not appropriately linked to the all-important interests of shareholders. Supporters of retirement plans will remind us that such plans allow older directors to receive recognition for their leadership upon retirement while also facilitating changes in direction at the board level, such as recruiting minority directors.

However, while cash compensation and retirement plans have basically remained flat, stock compensation is still on the rise. Among the various elements of compensation, we expect an expanded role for stock and a change in emphasis in the use of cash compensation at the board level.

Thanks to greater time demands and increased rigors of board membership, cash compensation will be used to pay directors as warranted by their individual contributions to the board. As shareholders demand more time than ever before from their directors to attend to issues of greater technical and strategic complexity, the old adage "say it with pay" will ring true, forcing board and committee meeting fees to keep pace. The issue of compensation is no longer how much directors should be paid as a group; instead, the question is how to reward those individual contributors who give the most of their time and the best of their knowledge. This could mean that the practice of paying additional fees or an annual retainer for chairing a committee will increase, and that meeting fees might actually in some cases give way to per diem arrangements, so that individual directors who provide the greatest contribution can be paid accordingly.

Fortunately, a mini-trend toward linkage of directors' fortunes to the yearly bottom line or rate of return appears to be stopping in its tracks. While a few companies have introduced an incentive element tied to annual business performance, we believe that this practice sends the wrong message to board members, virtually inviting them to meddle in corporate operations and tainting their approval of annual performance targets and potential management rewards. Focusing on short-term performance also jeopardizes the directors' ability to select a corporate path that might be financially painful in the short term, even if such a course would ultimately result in a stronger and more profitable company. Simply put, introducing performance elements into compensation programs for directors also introduces a potential conflict of interest.

In sharp contrast, stock-based compensation is viewed in only the most positive light by all concerned -- powerful shareholder constituencies, the media, and directors themselves -- because giving stock to directors accomplishes the all-important task of aligning director interests with shareholder interests. Thus, in spite of a slowdown in growth (5% last year as compared with 20% the year before), we expect to see new stock plans again, now that companies know what the new SEC proxy disclosure regulations are, have begun to understand their impact, and are undertaking the task of designing new plans and/or refining old ones.

Outright grants of stock are at an all-time high of 29%, edged out slightly by restricted stock at 30%. For the second year in a row, options led in prevalence at 35%. Several companies also offer either deferred stock programs or link their retirement plans to the use of stock. And 8% of companies actually offer more than one form of stock-based compensation to their directors.

As more and more companies substitute stock for portions of cash compensation, this practice will only increase. Of course, should the FASB take action, we might see a shift in the types of equity vehicles most frequently offered at the board level. Overall, the use of stock plans can be helpful in attracting new talent, especially in an era of tremendously heightened responsibilities and serious liability risks for directors.

Liability coverage is critically important in light of finger-pointing and growing numbers of shareholder suits by powerful shareholders and shareholder advocates. However, directors and officers (D&O) liability coverage has not kept up with the accountability issues that currently face Corporate America, so directors need the broadest possible indemnification agreements from their corporations as additional protection. And because even corporate indemnification in this day and age can be inadequate, comprehensive D&O coverage should be obtained. Still, glaring holes in coverage remain, especially in light of the sizeable personal assets many directors stand to lose.

While this is a particularly trying period in the history of board service, the challenges are great, can be exciting, and should be rewarding. In fact, in order to be able to continue to attract the "best and brightest," compensation must offer attractive psychic and financial rewards. After all, making directors think like shareholders by making them shareholders can only build far better, stronger boards and ultimately lead to sounder, more stable, and profitable companies.

The Benefits Of Using Restricted Stock

Ira T. Kay is Senior Vice President and Managing Director in charge of the executive compensation practice for The Hay Group. He works closely with clients to help them use compensation to increase shareholder value. He is the author of the book, Value at the Top: Solutions to the Executive Compensation Crisis, published last year by Harper Collins.

Using restricted stock instead of cash to pay directors is rapidly coming into favor in the 1990s. It has advantages for both directors and shareholders:

* Restrictions save directors tax dollars. In effect, they move compensation from active employment into the retirement years. With brackets re-emerging in our tax system, this can make a significant difference in the applicable tax rate. And in the meantime, the full pretax compensation is at work in the market. If a true preferential capital gains rate reappears, we would expect to see section 83(b) elections reappear with it.

* Restrictions ensure that directors hold stock in the companies they govern, as shareholders prefer. At today's annual director pay rates of $30,000 to $75,000 for larger companies, the amount of stock they own can mount fairly rapidly. Ownership is achieved without the leverage inherent in options or financed purchases, the two major alternatives to restricted stock. Director ownership is proportionate to length of service instead of net worth, in which there are great disparities on most boards.

Two notes of caution. First, restrictions for directors must be drawn differently than for executives. Directors are not employees, and leaving the board involves different types of events than with executive departures. Care and thought must be applied to draft provisions that are both workable and tax-effective.

Second, restricted stock is the best way of introducing a pay-for-performance scorecard for the board, but it is really just that. Given the ages and backgrounds of most directors, the amounts of money involved are rarely a large percentage of their total assets. Director compensation has never been parallel to executive compensation. Looking back on the executive compensation bulge in the 1980s, there is no reason to start a similar movement in director compensation, even in miniature.

New Plans That Are Generating Interest

Gregory P. Giles is President of Management Compensation Group-Chicago Inc. He has designed and assisted in the implementation and funding of non-qualified, supplemental executive benefit plans for many Fortune 500 corporations over the past 10 years.

Much has been written in the past year about the changing roles and responsibilities of board members of publicly held corporations, Quite simply. the decision to accept a corporate directorship carries with it far more responsibility, activity, and liability today than ever before.

Case in point: The SEC in late 1992 issued new compensation disclosure regulations which revolutionize corporate reporting of executive compensation. Directors serving on the compensation committee are now required to attest to a statement of rationale for the methodology used in executive compensation.

As a result of the increased responsibility and burden placed on directors, many companies in America are casting about for new and innovative ways to compensate quality directors for their labors. Quite appropriately, the axiom that has been bandied about in the executive compensation and benefit arena in recent years, "pay for performance," is now being applied to the strategies that companies employ when assessing how to reward directors for their contribution to the corporation's and the shareholders' well-being.

The traditional directors' compensation package consists of meeting fees which average from $20,000 to $30,000 per year. In addition, some companies have added some core benefits for directors such as medical insurance and life insurance.

Among the newer approaches being employed are:

* Performance-driven deferred compensation plans: In such a plan, the director opts to defer receipt of his annual meeting fees and in return receives interest on those funds at a rate that emulates the performance of the corporation's common stock. As a result, the director receives not only the immediate deferral of current income taxation but also more fully aligns his or her interests with the shareholders'. Ultimately, the deferred compensation plan pays out a stream of income (comprised of the deferred compensation plus interest) to the director, typically after his or her term has expired.

* Charitable-giving programs: These plans have received a substantial amount of press in the past several years and have taken many forms but boil down to one key benefit. The director and the corporation "partner" to convey a substantial contribution to a charity or charities in the name of the director, with the well-publicized sponsorship of the corporation. In such an arrangement, a life insurance policy is purchased by the charity, the director, or the corporation, but the premium is usually paid by the corporation. The policy is issued on the director, a pair of directors, or the director and his or her spouse. At death, the policy pays a sum in the director's name to the charity. This type of plan, while marketed widely, carries with it considerable need for proper structure and planning to ensure the best results for all parties involved.

* Performance share retirement plans: These plans, though seen less frequently than the above, are generating interest as corporations and boards try to structure meaningful benefits for directors. The corporation creates a non-qualified, supplemental retirement plan under which a director may accumulate "units" of retirement benefit. These "units" are awarded on either an "all or nothing" basis or a percentage basis in reward for the director's having contributed to the achievement of specific corporate goals. This plan can have particular appeal given the Internal Revenue Code limits placed on benefits delivered by qualified retirement plans, and can serve as a meaningful supplement to basic director fees.

* Director wealth-transfer plans: Given that many directors of publicly held corporations are either current or retired executives of other corporations and have had opportunities to accumulate wealth through their participation in various plans through their employment, some corporations have addressed an acute director need by providing benefit plans that assist the director in estate planning strategies. More often than not, the appeal of these types of plans is their ability to create liquidity for heirs to pay estate taxes. In such an arrangement, the director and the company enter into an agreement to acquire a life insurance policy on the life of the director, or the director and his/her spouse. Typically, the corporation recovers its investment in the arrangement at the death of the director or the director and spouse. At death, the insurance policy also pays a death benefit directly to the heirs or to a trust that was established during the director's lifetime.

Just as the expectations and rewards for executive performance have been challenged by both the private and public sectors, so too will the 1990s bring a re-evaluation of the evolving role of corporate directors and the way in which corporations attract, retain, and motivate them.

Moderate Rise Reported in Director Pay

Compensation of boards of directors in top corporations rose more moderately in 1992 than in 1991, according to The Conference Board's 1993 edition of its corporate directors' compensation survey.

The comprehensive study, coveting 824 U.S. companies in 50 industries, shows that directors' compensation increased by 9% in manufacturing, but only by 4% in the service sector, and 3% among financial firms. In 1991, directors' compensation was up 10% overall from 1990.

In 1992, a median total annual compensation of $29,700 was paid to board members of manufacturing companies, $24,500 in service companies, and $24,000 in financial companies.

Petroleum companies led all individual industries in reported pay to outside board members, with typical compensation amounting to $46,750. Telephone companies rank second, with a median total compensation of $40,000. Other industries with medians of $35,000 or more are manufacturers of food, beverages, and tobacco; industrial and consumer chemicals; paper and allied products; biotechnical, pharmaceutical; and aerospace and aircraft parts.

Stock payment trend on the rise. "Company stock plays an increasingly important part in outside directors' pay, with 45% of all companies reporting some form of stock compensation," says Kay Worrell, senior research associate at The Conference Board and author of the report. "Part of the impetus for stock compensation is a need to reduce cash payments for board service during times of financial constraints."

Among the major industry groups, 55% of the manufacturers, 42% of financial firms, and 34% of service companies report some form of stock compensation. All three types of stock plans became more prevalent in 1992: payment of part of the basic retainer in stock (11%, compared with 8% in 1991), award of stock options (32%, compared with 26% in 1991), and restricted stock grants (10%, compared with 8% in 1991).

Retainers or fees? The mix of retainers and fees has been relatively constant from 1991 to 1992. Virtually identical proportions were reported among manufacturing companies in both years -- 83% use both, 11% pay retainers only, and 6% pay per-meeting fees only. Among financial and service firms, slightly fewer report use of only per-meeting fees than in 1991; slightly more report paying only a retainer than in 1991.

Total compensation for committee service is down. The proportion of total compensation paid for committee service is down slightly -- from 16% to 14%. Eight out of 10 companies still report paying extra for service on board committees.

Of benefits and bonuses. The prevalence of reported insurance and other benefits to outside directors remains largely unchanged from 1991, with directors and officers liability insurance still being the most frequently reported benefit (used by 8 out of 10 companies). Nearly half of the companies offer deferred board compensation, white one-third offers retirement plans.

Only eight service companies and six manufacturers paid annual bonuses or incentives to outside directors. No financial firms reported such payments.
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Title Annotation:corporate directors
Author:McLaughlin, David J.; Neff, Thomas J.; Meyer, Pearl; Kay, Ira T.; Giles, Gregory P.
Publication:Directors & Boards
Date:Mar 22, 1993
Previous Article:The retired CEO: on or off the board?
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