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Todd Sirras
Principal
Semler Brossy Consulting Group

Editor's note: Each month, we ask a Directors & Boards reader to comment on critical issues facing directors today. If you'd like to participate in this section in the future, please email Scott Chase.

What are the implications of new responsibilities, and attendant risk, borne by directors in today’s regulatory and governance environment?

Directors today are asked to walk a tightrope between stewarding shareholders’ interests and delving into strategy-setting and operations. This is a consequence of legislative, judicial, and philosophical changes in what is expected of an outside director, and has several implications:

Commitment required of directors has substantially increased, in terms of time and knowledge needed. Further, the burden to maintain protection from personal liability under the Business Judgment Rule is significantly higher, as evidenced most prominently in the ongoing case against Disney’s Board.
Much more than a cursory review of operating performance is currently demanded of directors, and developing such an appropriate depth of understanding in a reasonable timeframe is possibly the single largest challenge facing Boards today.
Compensation of outside directors has been going up significantly, although some directors may feel that the risk of personal liability has increased even more. In every instance where we discuss director pay with sitting Board members, we hear concerns about the relationship between pay and liability.

In our opinion, the evolution of director roles, responsibilities, liability, and compensation has implications for the ability of companies to continue to attract qualified directors and to retain those that are already serving. We appear to be at the threshold of a period where directorship, especially of public companies, is less appealing as a next step in an executive’s career because it’s simply too risky – we as a business community thus risk losing one tool by which management expertise traditionally has been transferred to emerging executives.

How are Boards addressing director pay in light of this role evolution?

In the current environment, Boards that re-evaluate their director pay programs most often focus on three areas:

(1) valuing the pay package as a whole rather than as separate parts,

(2) considering the different roles, responsibilities, and liabilities borne by directors fulfilling different functions within the Board, and making differentiation in pay levels (for example, Audit Committee Chairs), and

(3) determining the appropriate form of equity compensation. (In some respects, then, the issues that Boards are wrestling with in executive pay are also reflected in their own.)

Total Value Assessment:
Director pay packages traditionally treated each director relatively equally – an annual cash retainer; an equity grant, typically options; and per-meeting fees for Board and Committee meetings were the common components. Each was intended as compensation for a specific element of directors’ responsibilities, and rarely was the combined value of the entire package considered as the key driver of changes to a single component. Indeed, with increased stock option usage, direct valuation and comparison to other companies became a mostly academic exercise. Now, however, we are involved in many discussions with Boards, management, and outside advisors attempting to put a dollar value on the role of a director before deciding how the specific elements of pay should be used to fill that bucket.

Role Differentiation:
Heightened scrutiny on corporate governance has highlighted the different levels of responsibility among directors on the same board. The most common changes in director pay structures are the modification of retainers and per-meeting fees for specific Board duties. These changes are intended to ensure that those directors whose roles and responsibilities entail the greatest commitment and liability earn higher compensation as a result. Additional retainers for Committee Chair and Lead Director roles, and increased per meeting fees for Committees dealing with more regulatory and governance-focused matters, are the most common tools to differentiate pay levels among directors. These retainers are most often paid in cash, but sometimes in full-value shares, depending on the other objectives of the pay program.

Equity Compensation:
The principle that director equity awards should be paid in the same form as management’s has a certain pureness to it. However, in the form of options, equity pay has often had consequences that were unwanted. The changing accounting rules for equity compensation, combined with a more sanguine view towards the role of equity incentives in general, have created a trend away from stock options, both in executive as well as director compensation. Principles that we often rely on in deliberations on director equity include:

Ownership in the firms they serve: For directors, the trend towards full value shares is more pronounced than for executives. This is mostly a governance issue, based on the prevailing sense that the corporate watchdog, an emerging portion of director responsibility, should not have a leveraged pay opportunity that is susceptible to short-term swings in stock price. Often, a program of all options does not provide ownership, or any value at all in a sideways market. The trend is for full-value share grants to have shorter vesting and retention guidelines or deferral terms that encourage continued ownership through an individual director’s tenure.
Alignment with management: All of the above being said, we still feel that directors and management should be somewhat aligned with respect to equity incentives. The goals of the management and director equity programs may have some overlap, the implication being that if a large part of management incentives are stock options, then directors should have some options as well. In that regard, directors should know what management is experiencing when option grants are well out of the money or vice versa. However, this alignment and overlap should not extend towards goal-based programs such as performance shares – directors would have an untenable conflict of interest if participating in a program for which they are responsible for goal-setting.

Pay-related issues facing Boards and Compensation Committees are similar across the multiple constituencies for which they are responsible – executive, director, and to a lesser extent, management pay. The “correct” answers are always situational, as with every compensation program design question. By developing guiding principles, setting program objectives, and applying consistent and rigorous judgment to decisions, Boards can most effectively execute their duties to shareholders on compensation matters, including director pay.

Todd Sirras is a Principal at the Semler Brossy Consulting Group (SBCG), a compensation consulting firm that specializes in executive compensation.

Mr. Sirras has been in the compensation field since his graduation from New York University’s Stern School of Business in 1998. In addition to consulting, he also served Bank of America as a Senior Vice President. He joined Semler Brossy Consulting Group in 2002.

Until 1996, Mr. Sirras worked in capital markets, as an equity derivatives market maker for O’Connor and Associates, and then trading equity index futures and options for a New York-based hedge fund. Resulting from this experience, he is also a leading adviser in the design of equity participation vehicles for private investment companies.