The federal budget earlier this year contained a provision requiring prescribed corporations to develop an approach to remuneration with respect to directors and employees who are “members of senior management.” The regulations have not yet defined “senior management," but we are apparently heading toward a “say on pay” vote similar to that which exists in the United States. These votes are advisory only, but if many shareholders express discontent it will be difficult for the board to ignore.
Almost half of TSX-listed companies already include such a vote in their proxy material, though it will be new territory for many small-cap companies and their investors. Institutional investors often subscribe to services where they can delegate this research and decision-making: What about the individual investor with a handful of stocks in a portfolio?
The management proposal will be supported by extensive research by the compensation committee of the board, who may have spent several hundred thousand dollars on compensation consultants. So your default position will be to endorse the proposal and move on. The alternative is to scrutinize the management information circular, which nowadays approaches the length of a paperback novel. Don’t skip the details: This disclosure is your opportunity as a shareholder to decide whether you are receiving value for money or whether management is appropriating too much of the value-added.
After working through many of these documents, here are my rules of thumb to cut through the verbiage. I won’t name names because this is an anecdotal survey of my portfolio, not a research study, but it is a starting point for your analysis.
- First, you need to deal with the level of total compensation for senior executives at large cap companies. The range at many banks and utilities for the top five named executive officers (NEO) is $3-million to $9-million and higher. The compensation committee will argue that this pay level is necessary in order to attract top-notch executives and you may agree – especially if you occupy one of these positions yourself. However, recent experience with the “six-million-dollar-man” at Hydro One suggests a different possible outcome. The board initially pushed back with that argument, but then found a competent replacement from BC Hydro within the $1.5-million ceiling imposed by the government. So, you may decide that current compensation structures are simply “too high” and vote accordingly.
For a more rational approach to this decision, calculate the total compensation paid to the entire NEO group and compare it with the company’s pretax income in recent years. A total compensation figure that amounts to more than a couple of percentage points of pretax income requires evidence that management is truly adding value to the company.
- Next, take a look at the base salary trend over the past few years. In an environment where employee salaries have been inching up slowly, significant increases in base salary for the NEOs should raise questions in your mind. Particularly in the case of a company where there has been recent downsizing and layoffs. Especially if incumbent management was responsible for the need to restructure in the first place.
- A significant portion of management compensation is variable or “at risk," so the base salary may be only 25 per cent to 40 per cent of the total compensation package. The balance will be made up of performance bonus payments and stock options or their equivalents. The committee should list the targets for growth or profitability that will trigger a payout. You decide whether these are stretch targets or numbers that can be achieved by sleepwalking managers and not worthy of additional compensation.
The stock-option component of the pay package is calculated as of the date of grant based on a complicated formula and it will be some time before these options vest. As a result, if the stock price craters, the ultimate payout may never reach the level shown in the compensation table. A compensation committee in this situation may respond by shovelling out more options at lower strike prices in subsequent years to make up for the shortfall. If the option-plan strike price is simply following the stock price down and there is a request to replenish the plan, then it may be appropriate to vote against.
- The compensation section often contains a chart that shows the value of $100 invested five years ago in the S&P/TSX Composite Index, the company stock and the relevant industry sub-index. The five-year time frame is arbitrary, but this is a good snapshot to see whether management has delivered value to the shareholders. In some cases, the loss to shareholders is so great you may wonder why management should be compensated at all for destroying value. Remember that you are being asked to vote on the compensation approach. If it rewarded past incompetence, you are not obliged to endorse it today even if management has changed.
- Finally, check for a section headed “Change of Control." Strictly speaking, this is not part of current compensation as it covers payments that will only be made to the NEOs if they are terminated after a takeover. These amounts are often two or three times the average compensation paid during the preceding few years. The logic behind this award is to encourage senior management to deal positively with a takeover bid that will benefit the shareholders – even if the consequence will be the loss of their own job after the takeover.
Once again, judgment is required here: Hostile-takeover offers that emerge because of sustained underperformance by management create the impression that change of control payments are a reward for incompetence. Also, excessive change-of-control termination fees act as a “poison pill” and discourage a takeover.
The compensation committee report is a complex document because it attempts to develop workable formulae in an area of inexact science. It deserves close attention on the part of the individual investor so that the board receives prompt feedback when shareholders disagree with the outcome.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.