As a response to the fraying over pay-for-performance and alignment of stockholder and director interests, more and more Canadian corporations are compensating directors in the form of deferred stock units. Besides providing a context for such soaring popularity, this author compares DSUs with other forms of director compensation, notably stock options.
The granting of deferred stock units (DSUs) — a type of compensation designed to align the interests of non-executive, or outside, directors with those of the stockholders — has practically become standard practice among Canadian corporations. This article will first describe why corporations have shifted to DSUs instead of stock options. The remainder of the article is organized into four sections. First, we analyze director compensation from the perspectives of risk and opportunity costs and tie this analysis to the increasing level of overall director compensation in Canada. Second, we compare DSUs to other types of compensation. Third, we discuss contingent and non-contingent forms of director compensation, and show how different components of a compensation package can be grouped under each of the two. Finally, we estimate how much the granting of DSUs might be costing a large Canadian corporation.
The shift to DSUs: Mitigating agency costs
An appropriately designed compensation structure is one of the more important factors in reducing the agency problems between directors and stockholders. Agency problems stem from the appointment of directors (agents) by the stockholders (principals) to safeguard the interests of the latter. Although directors are supposed to safeguard and promote shareholders’ interests, in practice they may consciously promote managers’ interests, in order to maximize their own interests. According to security analysts, activist investors, and compensation experts, blending cash retainers with two types of incentives—stock grants and stock options—can mitigate agency problems between directors and stockholders. As a result, ownership of company stock has become essential to creating the perception — and reality — that directors share the interests of shareholders.
This shift from cash to stock-based director compensation is a response to strident calls by influential experts and activist groups. Beginning in the 1990s, large institutional activists such as CalPERS, the largest public pension fund in the U.S., and the National Association of Corporate Directors (NACD) Blue Ribbon Commission Report on Director Compensation, have called for a significant amount of director compensation to be paid in the form of stock grants and options (Daily, C.M., Certo, S.T., & Dalton, D.R. 1999. Pay directors in stock? No. Across the Board, 36: 46-50). However, for about ten years now, emerging wisdom in Canada and the U.S. has been saying that options for directors are inappropriate. The push to move from stock options to share-based awards such as DSUs has been and still is more pronounced in Canada than in the United States. Institutional investors, as well as advocates of corporate governance reform, have largely been influencing this shift. The Canada Pension Plan Investment Board (CPPIB), Canada’s largest institutional investor, established guidelines for a set of key governance issues, including its support for stock grants rather than stock options for executives and directors, emphasizing that a majority of shares be held until the individuals’ departure. Similarly, the Canadian Coalition for Good Governance (CCGG) maintains that directors who hold options do not have capital at risk and so do not share the financial interests of long-term shareholders (Winter, N. 2003. Fair pay for fair play. CA Magazine, December: 34). In response, boards have been introducing mandatory share ownership guidelines for directors. For example, Abitibi-Consolidated ceased to offer stock options to directors in 2004. Other companies, such as Barrick Gold and Bombardier, followed suit around the same time.
1. Risks and opportunities
There are important differences in the risk characteristics of stock pay or grants and stock option pay, in that they involve different degrees of risk-taking on the part of directors. Stock grants result in a change of directors’ and shareholders’ wealth in the same direction. With stock grants, if shareholders’ stocks lose some of their value, so do directors’ stocks. On the other hand, stock options, because they have a convex payoff schedule (which implies a return function with higher returns at the extreme values of an underlying asset), induce greater risk-taking on the part of directors. Thus, the downside risk for directors is much less with stock options. In other words, payment in the form of stock options, which have a relatively low market value when they are granted, ties directors’ wealth to that of shareholders more closely when the value of the firm rises than when its market value drops (Ryan, H., & Wiggins, R. 2001. The interactions between R&D investment decisions and investment policy. Financial Management, 31: 5-30). On the other hand, if directors own DSUs and the firm’s market value drops, both directors and stockholders stand to lose. Therefore, it is hardly surprising that stock grants, or their variant, DSUs, are growing in popularity for the fact that they more closely align the interests of directors and shareholders. Consider these examples. As of January 1, 2007, Abitibi-Consolidated directors were required to own stocks worth U.S. $150,000.00 An outside director of BCE is expected to own at least 10,000 BCE common shares or share units. Until this threshold is reached, the annual fee for a director will be paid in share units. Once the threshold is reached, a director can decide what proportion of his or her compensation will be paid in DSUs.
An increasing popularity of DSUs may reflect a corresponding increase in overall director compensation in large Canadian corporations. Therefore, it is important to understand the set of factors that have contributed to this increase. The following section explains these factors.
Shareholder interests and director compensation
According to critics, high levels of compensation might have compromised Enron directors’ ability to monitor management. Failings on directors’ part in Enron, WorldCom, and Global Crossing led to calls for stricter and more effective governance of U.S. public corporations, culminating in the passage of the Sarbanes-Oxley Act (SOX) in 2002. The situation is different in Canada, however. Evidence abounds that non-compliance with the guidelines, principles, and practices recommended in the Dey and Saucer reports is still rampant. Many Canadian companies have failed to match new, groundbreaking U.S. guidelines, such as those that call for a majority of directors to be independent, and for the audit, nominating, and compensation committees to be made up of totally independent directors (Globe & Mail, 2002. Board games, October 7:B1). More surprisingly, many companies do not even comply with the TSX’s voluntary standards, which require that boards have a majority of independent directors and fully independent audit committees.
Since 2002, the TSX relinquished its responsibility for setting corporate governance standards, leaving provincial securities regulators to do so. Because of mounting pressure from various stakeholders, especially institutional investors, the Ontario Securities Commission (OSC) has been introducing specific guidelines to strengthen various governance standards, including the mandatory disclosure of director compensation. In addition, in cases where boards fail to protect shareholder interests, Canadian courts are stepping forward to protect retail and institutional investors.
Complying with the additional legal requirements has increased directors’ time commitment. As a result, their workload has grown disproportionately to that time commitment, while the corresponding legal risks have increased substantially. This could be one of the reasons why Canadian companies find it difficult to recruit competent directors with proven track records. A compounding problem is that salaries for directors on U.S. boards are much higher than they are in Canada, making it difficult to recruit directors from the United States. However, having American directors on the boards of large Canadian corporations is important for doing business in the United States. For example, some of the largest Canadian corporations are cross-listed on U.S. exchanges. The requirement of a cross-listing —satisfying the same U.S. regulations as their U.S. counterparts do — can be met by having American directors on boards. Collectively, the above factors justify enhancing remuneration for directors who sit on the boards of Canadian corporations. While the pay for Canadian directors has gone up over the years, it has not kept pace with the additional workload and risk exposure. The gap is narrowing, however. According to a 2007 report by Spencer Stuart, the median total board compensation for the 100 largest Canadian companies is $91,612, a seven percent increase over 2006.
2. DSUs and other types of director compensation
As we have discussed earlier, stock grants can be offered as a form of deferred or long-term compensation. DSUs are one type of stock grant. Directors can convert retainers and other fees into DSUs as well. After a director who has received a unit has satisfied the vesting requirement, the company distributes shares or the cash equivalent of the number of shares used to value the unit. Depending on company rules, the director may be allowed to choose whether to settle in stock or cash. Technically, vesting requirement for DSUs may be either time-based (a stated period from the grant date) or performance-based (financial and/or non-financial measures of company performance). However, we have not seen a performance-based vesting requirement in any of the proxy circulars that we consulted for this article. Since DSUs in essence entitle directors to stock appreciation rights in the future, some compensation consultants also include stock appreciation rights (SARs) under the genre of DSUs.
As we mentioned earlier, the popularity of DSUs in large Canadian corporations has been increasing. According to an estimate in a 2007 Spencer Stuart report, the median value of director equity holdings in the largest 100 Canadian corporations is $452,926, more than twice the minimum requirement. Directors’ stakes in the companies they govern are on the increase, and the growing proportion of DSUs in the total compensation package bears testimony to this. Below, we present six criteria for evaluating and comparing the individual components of a compensation package.
Clarity and tangibility: Much of a director’s compensation, especially stock options and DSUs, involves some form of future promise, such as a fixed percentage of an annual bonus every year. Such promise should not be vague and subject to future redesigns (McLaughlin, D.J. 1991. Does compensation motivate executives? In F.K. Foulkes (Ed.), Executive compensation: A strategic guide for the 1990s: 59-80. Boston: Harvard Business School Press). Stock options are most vulnerable to this requirement. Because the components of a director’s compensation package are generally limited (see Exhibit 2), the scope for any real confusion with DSUs is limited.
Measurability: The elements of compensation have to be measurable. Although retainers and fees, if paid in cash, are clearly measurable, some of the long-term compensation components are more difficult to measure. For example, the vesting or earn-out period of most performance unit plans may be clear, but the payout schedule can be quite obscure and complex (McLaughlin, D. J. 1991. Does compensation motivate executives? In F.K. Foulkes (Ed.), Executive compensation: A strategic guide for the 1990s: 59-80. Boston: Harvard Business School Press).
Performance sensitivity: Generally speaking, there must be a link between a director’s performance and compensation. To some extent, this link must be a function of the measurability of a compensation component. Although the performance of directors was not something that would generate much attention a decade ago, it is certainly under stringent scrutiny now. In 2004, for example, 60 percent of companies disclosed the attendance records of individual directors (McFarland, J. 2006. Why it pays to be in the boardroom. Globe and Mail, January 16: B1). The relatively recently begun practice of director evaluation has also been used to tie performance and compensation.
Alignment of shareholder/director interests: Because DSUs tie the directors’ and shareholders’ wealth equally — whether the firm’s value rises or falls—they are becoming increasingly popular with the investors. DSUs are categorized under an array of long-term incentives, and this is precisely why both institutional investors and residual stockholders favor DSUs.
Costs to the corporation: Perhaps the most perplexing dimension of any component of executive and/or director compensation is its associated costs. Costs are largely a function of the assumptions that underlie the component. Because we are focusing on a few common components of director compensation, it is not that perplexing. The costs of cash retainers and committee meeting fees are high, as these have to be readily charged to earnings. Compared to stock options, DSUs are more costly to the company, since the entire value of the shares at the time they are granted, as well as all dividends paid during the restriction period, must be charged to earnings.
Comparison of the Components of Director Compensation
|Clarity and tangibility||High||High||Low||Medium|
|Costs to the Corporation||High||High||Low||High|
*Each component is considered on a scale from low to high on each of the five dimensions.
It must be clear from the above comparison why the popularity of DSUs keeps soaring. As a long-term incentive mechanism, it fares favorably on four of the five dimensions we considered. Another reason is that the shareholders care mainly about only two of the five dimensions—performance sensitivity and interest alignment—and DSUs fare most favorably on each of these two dimensions.
3. Contingent and Non-contingent compensation
The two different forms of pay—contingent and non-contingent—are meant to expose directors to different levels of risk. Each also serves different incentive objectives. Contingent compensation, though it is tied to the long-term value appreciation of the company, creates uncertainty in a director’s pay. Non-contingent compensation, on the other hand, provides directors with a stable stream of income. Logically, shareholders will prefer contingent pay for the directors, whereas directors will prefer non-contingent pay. Therefore, some trade-off between the degree of risk-sharing of the former and the latter is likely to determine the proportion of contingent and non-contingent pay in a director’s compensation package. Although the distinction between contingent and non-contingent pay represents a clear dichotomy in a director’s objective functions, they are still paid in a variety of ways, as Exhibit 2 illustrates.
Components of Director Compensation
A look at Exhibit 2 leads to the following conclusions. Quadrants 1 and 2 show that retainer/fees can be used as both non-contingent and contingent forms of compensation. This appears to be the case in most large Canadian corporations, such as BCE, Bombardier, EnCana, Manulife Financial, Potash Corporation, and Scotiabank. Directors have leeway in deciding whether to receive all or part of their cash retainer/fees in cash, common shares (purchased in open market), or DSUs. As Quadrant 3 shows, stock—or DSUs— is a contingent form of compensation. Therefore, corporations are able to manipulate retainers/fees more for the purpose of aligning the interests of directors and stockholders.
Components of compensation
Components of director compensation can be arranged in different ways. One convenient classification for components is direct and indirect compensation.
There are two forms of direct compensation, cash and stock. The first and most common method of remunerating directors in Canada and the U.S. is cash in the form of retainers and/or fees for both committee service and non-meeting activities. An annual retainer is a direct payment to directors, typically made on a monthly or quarterly basis. In Canada, the average retainer for the largest 100 corporations was $69,500 in 2007, an increase of 12 percent over 2006. There may be an additional retainer, known as a dedicated board retainer, which is paid in common shares or DSUs. Scotiabank, for example, allows director compensation in this form.
Outside directors normally serve on one or more committees, and the time they devote to committee meetings is usually compensated for separately, in fees. According to a 2007 Spencer Stuart report, 17 of the 100 largest companies give a flat, all-inclusive fee to their directors. These companies include Alcan, Barrick Gold, Husky Energy, Nortel Networks, Research in Motion, and the Toronto-Dominion Bank.
Outside directors who chair a board committee are usually paid additionally. This amount varies, depending on the nature of the committee and the type of education and expertise required of the director. Typically, the chair of the audit committee is paid the highest additional cash compensation for committee work. In addition, a director who also serves as the chair of a subsidiary board of a parent company may be paid additional cash compensation.
When used, fees are paid in the form of a retainer or a payment per meeting. Some companies pay meeting fees separately from the annual retainer, in order to encourage and reward attendance (Overton, B. 1991. Remuneration of outside directors. In F.K. Foulkes (Ed.), Executive compensation: A strategic guide for the 1990s: 383-398. Boston: Harvard Business School Press). Bombardier directors, for example, are entitled to additional fees of $2,500 for attending a meeting. Some companies also pay travel fees and additional annual fees. Abitibi-Consolidated and Bombardier are two such examples.
The forms of cash compensation made to directors vary substantially across corporations. To illustrate, a comparison of Abitibi-Consolidated, BCE, and Bombardier is presented below.
A Comparison of the Components of Compensation of Directors across Three Companies in 2007
|Components of Direct
|Abitibi-Consolidated* (in US dollars)||BCE (in Canadian dollars)||Bombardier (in Canadian dollars)|
|Annual board retainer||50,000||150,000||66,000|
*Abitibi-Consolidated changed its name to AbitibiBowater Inc. Abitibi-Consolidated Inc.’s Management Proxy Circular is available until 2006.
**Per board or committee meeting
Stock awards, such as stock options or stock grants, are occasionally paid in addition to, or in lieu of, annual retainers and committee fees. Because most outside directors do not own a great deal of company stock, their stock ownership can be increased by providing shares instead of increasing fees. BCE, for example, pursues this route by converting directors’ fees into shares until the threshold of 10,000 common shares.
Retirement pension plan: A very limited number of companies also offer retirement pension plan for their directors. . According to a 2007 Spencer Stuart report, only two of the largest 100 companies in Canada (e.g., Abitibi-Consolidated and ATCO) provide a retirement pension plan for their directors. However, according to its 2007 Management Proxy Circular, Abitibi-Consolidated had not extended this plan to directors who joined the board after April 20, 2000.
4. Costs of DSUs
How much do DSUs cost large corporations in Canada? Because costs are essentially a function of assumptions, it is not easy to provide a precise answer. Consultants’ estimates vary, depending mainly on whether the corporations in question are the largest 100 or the largest 237 (TSX Benchmark Index firms).
Although there are different approaches to cost estimates, the most relevant approach for DSUs is the one that can readily determine what the value of the DSUs would be today, if the director wanted to sell them. In other words, we are talking about the current economic costs for DSUs, that is, the stock price at the grant date. So, it is fairly straightforward to find out the total costs of DSUs for each director on a company’s board. However, the cost of DSUs for directors is not specifically disclosed in proxy statements; it is combined with other DSUs—presumably for executives—and typically revealed in a footnote in the company’s annual financial statements.
According to a study by Patrick O’Callaghan and Associates, and Korn/Ferry International, directors at Canada’s largest public corporations received an average of $45,454 worth of shares or DSUs as part of their compensation in 2004. They received $32,210 in 2003 (McFarland, J. 2006. Why it pays to be in the boardroom. Globe and Mail, January 16, B1). According to a 2007 Spencer Stuart report, median stock compensation for a director of one of the 100 largest corporations in 2007 was $57,112. Of these two estimates, Spencer Stuart’s appears to be relatively conservative, given that its median dollar amount is based on the 100 largest corporations, and that too, in a survey done 3 years later. Therefore, caution has to be exercised in interpreting the costs of DSUs.
Director compensation has become an increasingly important issue in Canada and the United States. There appears to be two opposing views on the subject. One camp maintains that directors are given too much money for what they do, while the other believes that they are underpaid. Consensus is building around the second camp. In fact, an increase in director compensation is occurring already. It is also clear that a change in the composition of the compensation package is also taking place. Stock options, once so popular, are becoming less so. In their place, companies are compensating their directors by awarding deferred stock units. Because DSUs serve as an instrument for eliminating the potential for conflict of interests between shareholders and directors, such a development seems desirable for better governance of our large corporations.
Acknowledgment: The author acknowledges financial support from the Institute for Governance of Private and Public Organizations (IGPRO) in Montreal. The author is indebted to Michel Nadeau, Executive Director, IGPRO, for his input and support for the project.