Following the Energy Industry’s Lead

The world of executive compensation is struggling to find its balance. Over the last twenty years CEO compensation has tracked closely the growth in the economy, making the administration of executive pay relatively easy. But with the dramatic reversal of markets and high unemployment, executive compensation faces pressures from outside influences that make the job of administering executive pay very challenging. The volatility of the market is forcing general industry companies to deal with the same issues the energy industry has dealt with for decades – there’s no one right answer to successful executive pay programs. Today, the regulators and critics of executive compensation are influencing boards to administer executive pay programs in ways that fit with the latest definition of “best practices.” Although the current emphasis is on increased regulation, it is essential to remember that the job of administrators is not to conform to the generic definition of a good program, but to oversee pay plans that actually work! Over the years, I have observed that a well balanced approach to executive pay will pay great dividends to shareholders, and relieve some of the anxiety of outside directors carrying out their role.

The following are some basic principles that directors should consider as they navigate the changing environment of public company compensation committee membership:

It’s okay to be different. First and foremost, being different may actually be better than conformity in terms of encouraging optimum performance at the executive level. Empirical and experiential evidence suggests that one of the hallmarks of high performing companies is that they often do things differently. They may get second guessed by academics, but this does not deter them. Not all effective executive compensation plans are configured alike.

Not all “best practices” are best. Journalists and critics are not the de facto arbiters of best practices for executive pay. It is not effective to assume that what others cite as best practices are in fact the wisest course of action for every situation. In addition, most public companies in the United States are not in the Fortune 50 and the rules and best practices for the largest companies are not universally applicable. Last, many critics mistakenly think that pay practices from other countries should be adopted in the US, without considering the risk/reward implications.

Look for the “business case” in executive pay decisions. In today’s dynamic business climate, the momentum of best practices continues to move many companies away from certain pay practices just because it is the popular thing to do. In the case of golden parachute agreements, for example, shareholders may not be best served by categorically eliminating such arrangements. The merger and acquisition environment, the makeup of the executive team, and the nuances of the tax laws all have significant impact on the value proposition facing the company. These issues should be carefully studied in light of the business case before decisions are made. The energy industry has long been a fertile field for mergers and acquisitions.

Discretion is the better part of valor. Don’t be afraid of discretion in managing executive pay plans. Volatile markets make goal setting very difficult, which can dim the motivational effectiveness of incentive plans. The use of discretion however remains a very challenging process. Amidst pressure from both sides -- upwards pressure from management and downward pressure from board of directors -- compensation measurement and assessment is ever-evolving and goal setting is increasingly difficult. This pressure from both sides makes “soft issues” such as strategy, HS&E, organization development and other non-financial performance more important than ever. Directors of energy companies have known for a long-time that the exercise of discretion is key to maintaining motivational value of plans.

Not all risk is bad. Taking risks is a basic premise of being in business and most traditional pay plans are set up to balance risk. Boards cannot take the risk out of executive compensation plans and expect a company to perform at a high level. When viewed as a whole, the regulation and external pressure on executive pay is aimed at one thing – reducing risk. This doesn’t mean that we should take mindless risk, but if we eliminate the risk from our pay plans, we shouldn’t expect superior returns.

Understand the purpose of the elements of pay. Everyone involved should understand the basic role of the various elements of the executive pay plans and administer each plan according to its design intention. For example, annual bonus plans typically reward for short-term strategic and financial accomplishment while long-term incentive plans reward for creation of shareholder value (e.g., TSR). While the two should be closely related, administrators should understand the differences as they make decisions about results. Too many outside observers don’t know the difference.

Advance planning promotes optimum results. Upfront work on establishing the company’s compensation philosophy, strategy, and guiding principles goes a long way towards ensuring the effectiveness of administration and program effectiveness. These efforts help keep us on track as we walk the minefield.

Pay supports business culture. Executive pay is an important tool for the CEO in managing the business and supporting the corporate culture. Over time, we have felt the pressure to make it an academic exercise that is separated from the leadership of the organization, and more focused on compliance. This has led to dissatisfaction on several levels and continued debate that is often not productive.

Good people are good. Bad people are bad. Executives are not subject to the laws of cause and effect, and pay should not be viewed as a means to force certain behavior. Good people will still behave admirably and bad people poorly, despite the pay plans. The role of a director is to know the company’s people. It goes without saying that some compensation arrangements can lead to unintended results; the point is that the majority of arrangements in the market are well thought out and reasonable, and applied to reasonable and ethical people.

Constituent education is key. Shareholders and other constituents must be educated about the company’s compensation practices and supporting rationale in a clear and consistent manner. This will go a long way in developing the confidence of shareholders as it relates to executive compensation practices.

It’s okay to say no. Directors are under tremendous pressure to comply with expectations for executive compensation arrangements. It’s okay to say no to payouts, pay increases, and other compensation arrangements if it makes sense and is consistent with the company’s compensation philosophy. Many directors feel tremendous pressure to do what management expects them to do, but when directors are sensitive to external constituent interests, it may be prudent to say no.

Finding the balance in this time of transition will help ensure effective and meaningful executive pay plans for both the participants and the shareholders. The US based major oil companies are good examples of cyclical, businesses with long-term investment decisions where executive pay programs reflect this balance. These programs demonstrate well-conceived use of the elements of pay, support of their unique culture, and prudent use of discretion. General industry companies may soon figure out what these energy companies learned years ago.

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Steve Cross is Managing Partner of Cogent Compensation Partners, headquartered in Houston, Texas. He has over 20 years of experience providing executive compensation advisory services to some of the world's leading companies.