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The Diligent team
GRC trends and insights

How should board of directors' compensation be handled?

August 2, 2018
0 min read
Committee members discussing board of director's compensation.

Boards are taking new approaches to succession planning because of legislative and regulatory changes. It's vital for boards to factor in director pay in trying to recruit the board directors who are best suited for their boards and those who will bring the most value to their organizations. Just as the economy and the marketplace have evolved over the last 20 years, how boards approach board member compensation is also evolving. A company's view toward corporate governance is a direct reflection on the company and its culture.

The Past Helps to Shape the Future of Board of Directors' Compensation

Best practices for corporate governance have adapted to meet the changing needs of corporations. Regulatory bodies and industry associations are narrowly defining best practices for improved governance within every industry. One of the areas where best practices have evolved in recent years relates to board of directors' compensation.

Current trends support governance by moving away from paying directors in similar ways to senior executives. In the interest of governance and to the satisfaction of the shareholders, companies are moving toward paying board directors for their time and contributions.

About 20 years ago, companies paid their board directors for certain benefits programs and pensions, just like the ones they offered their managers. Board directors usually became vested within three to four years. Companies gave directors awards in numbers of shares, without regard to grant value. Equity awards were usually equal to stop option grants. There were no lead directors or director stock ownership guidelines. Committee chairs and committee members received nothing for their service.

New Laws and Evolving Best Practices Drove Big Changes in Board of Directors' Compensation

In 1996, the National Association of Corporate Directors (NACD) issued the Blue Ribbon Commission Report on Director Professionalism, which had a great influence on board member compensation practices. The report recommended that companies start compensating board directors with cash and equity. They also recommended doing away with pension and benefits programs because they were too closely aligned with senior manager benefits. This report was the first major move toward encouraging companies to have at least one independent director. The report also led to companies appointing lead directors.

The Sarbanes-Oxley Act (SOX) of 2002 recognized that board directors were under increasing scrutiny over their performance. Major marketplace failures, such as the Enron scandal and multiple incidences of stock option backdating, highlighted the need for boards to be more accountable for their decisions.

Recognizing that board directors had increased responsibilities led to discussion about giving them higher pay. SOX also expanded the role of the audit committee. Companies realized that they needed to compensate audit committees for their increased workload, so they began compensating them for their service.

SOX also caused corporations to shift from using stock options to using full value shares for director equity grants.

Best practices in the past recommended boards to stagger board member elections, with no more than a third of board directors turning over at a given time, so that the whole board wouldn't turn over all at once.

Shareholders have insisted on having more say on pay to ensure that boards remain objective and independent. Today, less than a third of S&P 500 companies still have staggered boards. The current trend is to have annual elections for the full board. There's also a new trend toward placing more emphasis on board independence, diversity and quality.

In past years, board directors typically served for years or even decades, whether they provided genuine value to the board or not. Refreshing the board every year eliminates the concern over board directors staying on too long and taking up a seat that could be filled by more qualified directors. Electronic board assessments will help boards compose well-rounded, high-quality boards.

Also, in past decades, CEOs also served as board chairs. Best practices preach against this. It has been more popular for boards to utilize lead directors and non-executive chairs. The weight of their duties and responsibilities has motivated boards to develop additional retainers for these positions.

Another law that impacted board of directors' compensation is the Dodd-Frank Wall Street Reform and Consumer Protection Act, which led to the formation of compensation committees. The first 'say on pay' votes took place in 2011.

Considerations for Handling Board of Directors' Compensation in the Future

Moving forward, boards will have many new considerations to factor in regarding director and committee compensation.

Some boards have set up their board member compensation so that board directors get compensated for serving on committees, which is different than in the past. However, some have not considered that board directors who serve on one committee get paid the same as board directors who serve on multiple committees. There's also concern that flat fees may not be enough to compensate committee members in situations where a crisis creates the demand for many board meetings. Boards have flexibility in setting board member compensation, and it's best for them to decide in advance how to fairly compensate directors who attend many committee meetings, as opposed to those who meet a few times per year.

Deferred compensation is another hot topic around board of directors' compensation. Some companies prefer using deferred cash retainers or deferred stock that they can cash after they leave board service. The current trend is for boards to offer a lump sum or several affordable installments.

There has also been a lot of discussion on the fairness of mandatory equity deferrals, which are more attractive to older board directors. Boards must be aware that it's a less-than-perfect scenario for younger directors. Companies need to be sure that all directors understand the economics and ramifications regarding their service to the board before they accept an appointment.

Another idea is to set limits on director equity grants. This would reduce exposure to lawsuits based on director pay. Corporations should have meaningful equity limits to present for shareholder approval and set those limits in dollars.

Future Projections for Board Member Compensation Practices

As the evolution of governance matures, companies may be inclined to reduce other types of perks and benefits, such as reimbursing board members for trip expenses for their spouses and offering charitable contribution matches.

We might also see changes in how companies compensate CEOs. Many CEOs become board chairs upon retirement, and their compensation as chair may exceed their prior CEO salary. Companies may compensate CEOs less to avoid paying even higher monies when a CEO formally retires.

Lead directors have often gone without compensation. New trends may compensate them in amounts just above the audit committee members' compensation levels.

Many stakeholders find it difficult to differentiate between the non-executive and lead director roles. Lead director compensation may start rising above that of non-executive directors and help to eliminate some of the confusion around the roles in the near future.


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