Until a few years ago, director pay received little public attention, especially when compared to the amount of focus executive compensation garners from investors and the press in this ‘say on pay’ era.

That has changed. Recent legal decisions have empowered shareholders to turn an eye towards the amount of pay directors approve for themselves. Oversight organizations have followed suit. This has forced compensation committees to increase their diligence in ensuring that their director pay matches levels similar to the industry in which they operate. If not, the board could face a financial – and public – backlash.

Given the fiduciary nature of director responsibilities, director pay flew under the radar, especially compared to executives, which require higher compensation due to their strategic and operational responsibilities. The lack of distinction in director pay led to fairly limited and standardized compensation programs, which typically included a cash and equity retainer with the opportunity to earn additional amounts for committee service and leadership roles. Executives, on the other hand, receive more performance-based pay programs.

It’s not surprising, given the style of pay, that director average annual pay increases have stood at 2% to 3% in recent years, well short of executive pay growth rates. Total director pay figures, when compared with executive pay levels, remain at a modest percentage.

In recent years, however, investor focus on executive compensation has indeed spilled over into director compensation. Boards at public companies must now work to show a similar reasonableness and transparency for their own compensation.

Legal Wake-up Calls Change The Game
You can trace the heightened focus on director compensation to 2016, in the Investors Bancorp, Inc. Stockholder Litigation, which reached the Delaware Supreme Court.

Shareholders noticed the company directors had unusual and significant outlier pay levels, which resulted in a payout of more than $2 million annually to each director. It’s a rate that was roughly 10 times higher than median pay levels for similarly-sized companies. The investors sought meaningful limits on the company’s director compensation.

The court ruled in late 2017 that companies must follow a clear process to ensure that director compensation is not in excess of peers without meaningful, business-based rationale, such as increased level of activity during a transaction, strategic reset, or leadership change.

Likewise, in Solak vs. Barrett, the Delaware Chancery Court in 2018 approved a settlement whereby Clovis Oncology agreed to submit a binding proposal for shareholders, who indeed went on to reject the new director compensation plan. Clovis had paid its directors an average of $429,000 a year, or twice the S&P 500 average.

These lawsuits have had a pronounced effect. Three-quarters of large-cap companies now have set limits on their director pay, which usually fall between $500,000 and $1 million.

ISS Embraces Director Compensation Oversight
Institutional Shareholder Services (ISS) has, unsurprisingly, followed the court’s embrace for oversight.

ISS introduced its first formal director compensation policy in 2018. It warned that it would begin recommending against Board members if it found excessive director pay for two consecutive years. The advisory firm defines “excessive” as pay that stands within the top 2% to 3% of companies in the same sector and index. Therefore, a real estate company in the Standard & Poor’s 500 index would have director pay compared to other real estate firms, as well as the index.

ISS noted it would take one-time mitigating factors into account, such as one-time awards due to director onboarding or M&A activity, and compare directors on a similar-role basis – assessing lead independent directors only against other lead independent directors, for example.

The 2020 proxy season, which just started, marks the first year that ISS will use these criteria to issue “against” recommendations. Other proxy advisor firms have yet to announce similar policies.

New Diligence for Board Compensation Committees
This new level of scrutiny requires extra diligence by boards in understanding competitive pay levels relative to the company’s comparators, including company’s peer groups and the ISS-defined peers. That’s particularly important when considering pay increases, both for “typical” directors and for board leadership roles.

It’s also important to consider the frequency of pay increases. Many companies have already begun to shift from large, periodic pay increases, to smaller, more frequent increases. It ensures a more stabilized way of remaining appropriately aligned with market comparators.

Perhaps most importantly, boards will want to expand and enhance their disclosure on director pay, detailing the overall pay philosophy, the process for assessing and setting director pay, the rationale for each element and explain how it aligns with shareholder interests.

Time will tell whether the recent focus on director compensation is only temporary or here to stay. But boards are advised to take these issues into account during annual pay discussions, just as they would when discussing their executives’ compensation. Your shareholders will likely notice, if you don’t.