“Every company has its own specific risks, which aren’t necessarily dealt with effectively through broad-brush legislation.”
Jim Woodrum is a Senior Advisor with Exequity, which is the fourth largest independent executive compensation advisory firm in the United States. In addition to this role, Jim is an adjunct faculty member at the University of Wisconsin–Madison. He also serves as a member of the Board (and Compensation Committee) at Packaging Corporation of America, a producer of containerboard and corrugated products with 2009 revenues of more than $2 billion. Jim was with Hewitt Associates from 1984 until 2006, where he spent the majority of his time advising large companies on executive compensation matters.
C-Suite Insight: You were one of the panelists at Equilar’s Executive Compensation Summit in Washington, D.C. The topic of “unintended consequences” emerged as a principal theme during the discussion about risk. What unintended consequences have you witnessed resulting from various pieces of legislation?
Jim Woodrum: The classic one that everyone in the executive compensation industry deals with is Code Section 162(m), which imposes a deductible limit of $1 million on compensation. This started out as relatively simple legislation, but ultimately got watered down, and performance-based pay got exempted. This meant that options were more or less exempted, as they were considered performancebased, so overall compensation actually rose quite dramatically in the years after 162(m).
Christopher Cox (the SEC chairman under President George W. Bush) has said that 162(m) belongs in “The Museum of Unintended Consequences.” More recently, we’ve had Sarbanes-Oxley. To me, the biggest concern with Sarb-Ox is that so much time is spent on a given set of compliance issues that companies can, to some degree, miss the forest for the trees. The reality is that every company has its own specific risks, which aren’t necessarily dealt with effectively through broad-brush legislation. And we can see that in the financial collapse of 2008, very few of the things that caused it were anticipated by Sarb-Ox.
CSI: Do you foresee any unintended consequences arising from the Dodd-Frank Bill?
JW: One thing I’m concerned about is the idea that you’ll compare CEO pay to the median pay of all other employees. Although this idea seems logical at first blush, calculating the median pay at companies with employees in many different places with a number of different benefits programs will be challenging and potentially very expensive.
Further, if a company has lots of low-paid employees (say a call center, for example), and therefore has a ratio between CEO and median employee pay that looks bad, they could, in theory, simply outsource those employees. This will make the ratio look better but is not necessarily the best thing for the employees or the company. I don’t think anyone intended to push companies down that path.
CSI: From your perspective, will Dodd-Frank have an effect on consultants, too?
JW: Yes, there’s also this notion that a compensation committee has to take into account any business or personal relationship with an outside advisor when determining whether they are independent. Taken to the extreme, companies might be reticent to hire a consultant that works with a committee member at another company. Within the confines of Dodd-Frank it could viewed as a conflict of interest, ignoring the possibility that someone may get additional opportunities because they are good at their job.
So yes, people may look back at certain aspects of Dodd-Frank and say, “Oops, we didn’t mean for that to happen.”
CSI: Legislation tends to be reactive; the mindset is, “Hey, there’s a problem. Let’s fix it!”
JW: Yes. Legislation tends to address yesterday’s scandal. But it’s entirely possible that yesterday’s scandal won’t happen again because of market forces.
CSI: How’s that?
JW: Once people have figured out how a particular game can be played, the market is likely to prevent it from happening again. Pension funds are much less likely to buy collateralized obligations of various kinds today, because they’ve seen that these things are not worth as much as they were portrayed to be worth.
CSI: You mentioned during the Summit that it might be time for companies and their top executives to start acting with “modesty, transparency, and certainty.” What exactly does this mean?
JW: There was a time, during the 80s and 90s, when the justification for the latest bonus plan or stock-option plan was “it won’t matter as long as the shareholders make money.” But somewhere along the way, the numbers got big enough that things changed. With seven- or even eight-figure stock-option grants, it does matter.
Modesty means “don’t stick out.” Look at the market data, look at the world in which you’re operating, and unless you have some very good business reasons to do so, you don’t want to be operating on the edges.
CSI: How about transparency?
JW: There’s an old adage in sales compensation called the “dome light test.” If your salespeople can’t read and figure out their compensation plan under the dome light of their car, then it’s too complicated.
This simplicity relates to transparency: how many benefits and perks do you have and how many moving parts are there? Over time, we’ve developed this notion that executive compensation is very complicated. The result is you can have plans that are not only difficult for shareholders to figure out, which is bad, but now, maybe even your executives can’t figure it out.
If your executives need a spreadsheet to figure out the compensation implications of the various decisions they make, your company clearly doesn’t have enough transparency in its approach to executive compensation.
CSI: And what of certainty?
JW: Certainty is a tradeoff for modesty. As you go through a transition from a highly leveraged plan, in which you had a good chance of sticking out, to one where that’s not as likely, then a reasonable tradeoff is to tell your CEO, “You’re going to have less upside, but your odds of getting something will be enhanced along the way.”
Remember, executive compensation is not only about how you choose to pay, but also about who you choose to pay. So this is where compensation and succession planning come together—the idea of creating the right program and finding executives who will be happy with it.
CSI: Is it reasonable to require that all public companies fall under the same penumbra of scrutiny as a result of the problems that were centralized, for the most part, in the financial services industry?
JW: I’m not sure it’s relevant whether it’s reasonable or fair. The reality is that were it not for the reasons that caused the crash, this sort of regulation might have happened anyway with a different justification.
The arrow is pointing to more regulation. If and when energy companies are further regulated because of the recent oil spill in the Gulf of Mexico, the legislation and regulations may certainly include more companies than just energy companies. It may even include additional regulation of executive compensation.
So the management and boards of public companies have to be reconciled to two things: first, there will be continued regulation, and second, new regulation is very difficult to take out once it’s in place.
Going back to 162(m), most people would agree that it’s not a terribly helpful piece of legislation, but it’s about to celebrate its 20th anniversary and it’s not going anywhere.
CSI: With all the emphasis on reducing risk these days, how can companies sustain a healthy balance of risk-taking?
JW: One very important point to think about is that executives—and the entire population of an organization— are human beings, and human beings don’t always act rationally.
There’s been a lot of literature published about behavioral economics and behavioral finance, which addresses how people are inherently unpredictable and don’t always act rationally when interacting with their financial life.
CSI: And this notion extends to top executives and how they behave?
JW: Yes, I think it holds true for compensation programs. There’s probably too much focus on technical compliance and corporate finance and not enough on how people are going to react (rationally and irrationally) to the things that are put into place for them.
By way of example, it’s generally thought that stock ownership guidelines are a good thing, and that more executive stock ownership is a good thing. But there exists the possibility that holding a bunch of company stock may make some people risk-averse. They may think, “I already have enough money where my net worth meets my needs, and I don’t want to blow it.”
CSI: During the Summit, you commented that CEOs may in fact have many more eggs in their basket than many of the largest institutional investors. Could you elaborate on this thought?
JW: Yes, there’s this interesting phenomenon underlying this, and that is that large shareholders—mutual funds, pension funds, etc.—have the option of being fully diversified, whereas executives do not. A particular stock might be 2 percent of the fund’s portfolio, but the executives may have 70 to 80 percent of their net worth tied up in stock through their compensation program.
The program was designed to do just that, but it might cause executives to act in ways that are very different from what shareholders might want, given their concentration of ownership.
People also tend to measure their net worth at its peak. So if a stock drops significantly, an executive might think, “Hey, I’m not worth as much and I feel bad about not having what I had before.” As a result, they may do some risky things in an attempt to get their net worth back up to where it was.
To me, thinking about the behavioral implications of executive compensation, as opposed to just the tax accounting and financial implications, is very important.
CSI: You wear many hats, among them consultant, board member, and professor. How did that evolve and how does each role influence the other?
JW: After 20-plus years in consulting, I had the opportunity to do some guest lecturing at the University of Wisconsin-Madison. I focused on that, and now help direct the Evening and Executive MBA program.
But I missed consulting soon enough, so decided to have a few clients to create a balance. Then the opportunity to join a board came along in 2009.
I crave variety, and now have it with teaching, consulting, and board service. Fortunately, each of these roles makes me better at the others. As an example, the preparation required to teach Organizational Behavior to MBA students definitely makes me better in the other two roles.
CSI: And what is your current academic focus on?
JW: The biggest question that has been raised is about the inherent value of an MBA. Beyond that, we seek to deliver a program for working professionals that furthers the University of Wisconsin’s history of producing as many CEOs as Harvard University.
John Morgridge, a Wisconsin graduate and the former Chairman of Cisco, once told a group of our students that companies are likely to focus on the East Coast if they’re looking for financial engineers, the West Coast if they’re looking for start-up executives, but will go to the Midwest if they’re trying to find a good general manager.
So we focus on helping our Executive and Evening MBA students find their “inner general manager.”