You Are Not Alone: Reflections on Compensation and Succession Planning Problems


In connection with another successful Bank Director & Bank Executive Compensation conference, I thought it would be helpful to recap three important issues raised by the attendees, as well as some of the action items that need to be addressed in the short time left before year-end.

You are Not Alone

During the day-long Peer Exchange held prior to the conference, compensation committee directors met in small groups to discuss issues of common interest.  One of the universal feelings was that the directors are feeling awash in new regulations and regulatory guidance that are making it very difficult to do their jobs.  One director noted, to everyone’s agreement, that focusing so heavily on all of the new rules has materially detracted from time spent on truly strategic matters.

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Consistent with prior years, directors conveyed that their time commitment to board activities and the complexity of the rules they have to work through in compensation continue to increase.  When this is combined with the minimal annual increases in director compensation and the increasing threat of personal liability, it is a wonder that these directors continue to be as focused and committed to their institutions as they are.

Succession Planning at the Board Level

Though most directors felt that their boards are in a position to actively oversee their senior executives, including the wherewithal to replace underperforming or otherwise problematic individuals, there was almost universal agreement that this is very difficult (and increasingly more difficult) to do so at the board level.  The smaller the institution, the more likely it is that any given director may be either a founding investor, major business producer or both.  Though many directors indicated they had some level of succession planning for their executive ranks, few have actively planned for succession at the board level, other than using a mandatory retirement age for directors, which only guarantees transition rather than improvement.  This is consistent with the difficulties faced by many of our clients.  We frequently meet with board members to discuss proper succession planning at both the executive and board levels.

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The directors agreed that one of the best methods to surface these issues is to perform a review of each board member and the functionality of each committee.  Prior to nominating board members for each successive term, a summary of these reviews should be considered by the board, or its nominations committee.  If necessary, to arrive at the conclusion to remove a board member, it can be helpful to have a third party involved in the evaluation process.  A third party can take an independent role in the process and may also have a much more robust review process than would otherwise be developed internally.  The resulting evaluation report should be circulated to the relevant board members as part of the annual nominations process.  One director noted at the Peer Exchange that after the first 360-degree review was completed at the board level, the CEO/chairman decided it was best to keep the results of future reviews confidential from the other board members, so as to avoid conflict.  Unfortunately, this is not the end result you would hope for.

Risk is All Around Us

Not surprisingly, the general theme of the conference seemed to be risk.  The issue of risk, as it relates to compensation, was raised and discussed in almost every presentation and each director exchange.  This echoes our experience with our own clients over the past year.  For public and private banks of all sizes, the universal set of rules applicable to incentive compensation and risk is the Joint Guidance on Sound Incentive Compensation Policies (effective June 2010).  This guidance provides the principles-based approach to identifying, monitoring and mitigating risk as it may exist in your incentive compensation plans.  Subsequent risk-based rules found in Section 956 of Dodd-Frank and the proposed Interagency Guidance on Incentive-Based Compensation Arrangements (proposed April 2011) provide great direction on how Congress and the regulatory bodies will look at the risk associated with incentive compensation plans for banks with assets in excess of $1 billion, though they are not all currently effective. 

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Consistent with the Joint Guidance that is currently effective, every banking organization should be reviewing their incentive compensation arrangements to assess the risk such arrangements may pose to the institution.  The company should insure that proper oversight and controls are in place with respect to each plan to monitor ongoing risk and to participate in the design and development of new plans in a manner so that risk is fully understood and actively managed.  Lastly, the board, or a committee of the board, should regularly meet with the individuals responsible for the oversight and controls of these plans and the board minutes should reflect this process.  Together, they can properly judge whether changes need to be made to either the incentive compensation arrangements, or to the procedures and controls to monitor such programs, in order to protect the institution from unreasonable risk.  The board must be actively engaged in this process and have a good understanding of each element of incentive compensation as it exists at the bank.

Succession Planning Without Three Envelopes


three-envelopes.pngAccording to a recent WorldatWork survey of large companies, over 30% have no succession plans in place and 50% of executives say they do not have a successor for their current role.  Why?  They cited a number of reasons:

  • Not enough opportunities for employees to learn beyond their own roles (39%)
  •  Process isn’t formalized (38%)
  • Not enough investment in training and development (33%)
  • Not actively involving employees or seeking their input (31%)
  • It only focuses on top executives (29%).

A lack of succession planning can lead to a lack of strategic direction and weakened financial performance, but it is hard work and Boards tend to make it a task instead of a strategy. 

Or, you could use the three envelope approach.  I learned this approach from a fellow who had just been hired as the new CEO of a large, publicly held company.  The CEO who was stepping down met with him privately and presented him with three numbered envelopes. “Open these if you run up against a problem you don’t think you can solve,” he said.

Well, things went along pretty smoothly, but six months later, the net interest margin took a downturn and he was really catching a lot of heat. About at his wits’ end, he remembered the envelopes.  He went to his drawer and took out the first envelope.  The message read, “Blame your predecessor.”  The new CEO called a press conference and tactfully laid the blame at the feet of the previous CEO.  Satisfied with his comments, the press – and Wall Street – responded positively, the stock price began to pick up and the problem was soon behind him.

About a year later, the company was again experiencing a slight dip in margins, combined with serious balance sheet problems. Having learned from his previous experience, the CEO quickly opened the second envelope.  The message read, “Reorganize.”  This he did, and the stock price quickly rebounded.

After several consecutive profitable quarters, the company once again fell on difficult times.  The CEO went to his office, closed the door and opened the third envelope.  The message said, “Prepare three envelopes……….”

You don’t need three envelopes if you use succession planning as a strategy.

Are You Ready to Replace Your CEO?


Heidrick-WhitePaper.pngA board’s greatest obligation is arguably to assure leadership continuity at the institution it serves. The passage of the Sarbanes-Oxley Act in 2002 brought this function more to the front and center of director responsibilities. Recent events in the financial services industry have served to bring an even brighter spotlight to the challenges associated with managing leadership transitions. 

The increasing emphasis placed on this board responsibility has for the most part not been accompanied by a sufficient evolution in terms of our understanding of best practices in succession.  Key to the evolving succession planning process is to make the distinction between the event of a succession—and the steps needed to make it work—and the process of succession planning, an ongoing set of activities that boards must have the discipline to continually pursue.  

No one denies the fact that leadership continuity is critical to the success of any financial institution. When a succession event is poorly managed, there can be immediate negative effects on a firm’s performance, a loss of strategic momentum, and a stain on its reputation. 

In financial services, recent events make the identification of a strong successor both more important and more difficult.  To the first point, many see a leadership crisis based on decisions made in the past.  To the second point, many once well-respected executives are now less so—deservedly or not.  Have some of these executives demonstrated that they are poor decision makers without a moral compass, or have they had the most incredible learning experience from which to further their careers?   Boards will be struggling with questions like this one for some time to come.

So there are challenges to the board stemming from dramatic industry failures over the past few years—but there are also challenges that come from what the industry is likely to face in the coming years.  Waning consumer confidence, increasing government regulation, and consolidation are just a few of the very consequential forces leaders will confront.  So it is easy to see that there is every reason for boards of directors to work to get succession planning right.  Since there is plenty of evidence showing that “getting it right” is not intuitive, here are some recommendations from our research and experience that your board can put into practice right away.

Plan ahead, even when you don’t think there’s a need

Since CEO succession is a rare event, boards have little chance to practice to make the process perfect.  It also means it is difficult for board members to develop experience with the task.  This is a gap your board needs to fill—they should seek members as experienced with succession as they do members able to lead committees like audit, risk and compensation.

That said, your board must recognize that a healthy succession process begins long before the CEO plans to step down and it ends long after the new CEO has taken the reins.  Even if your current CEO has plenty of remaining “runway” in his or her career, the board cannot rest sanguine.  In the early spring of 2010, the BP board was likely not spending much time thinking about a successor to the company’s young and popular CEO, Tony Hayward.  The Deepwater Horizon oil spill—and Hayward’s flippant response—quickly changed the board’s priorities.  It’s simple—view succession as a process, not an event!  Building leaders is complex.  An event-based succession approach is naïve in its underestimation of the complexity of preparing leaders. 

Seeing succession as a continuous process has the added benefit of forcing your board to be focused on the future.  Too often, directors are looking in the rearview mirror to understand what the company needs for the road ahead.  A good experience with the departing CEO leads directors to want “another one of those.”  A bad experience leads directors to favor candidates who offer a stark contrast in some key way to the exiting executive. Though there are lessons to be learned from studying the past, it is clear that the real test of a candidate’s viability is the degree to which they are prepared to lead the company over the challenges ahead—not the degree to which they provide the desired contrast to the departing CEO.

It’s not just about compliance

Since the enactment of the Sarbanes-Oxley Act, many boards have adopted what we call a compliance-based approach to succession. A compliance approach allows directors to quickly point to an organizational chart with names in boxes.  In other words, there is a plan of some sort so that everyone can say with a straight face that there is a plan. Unfortunately, our private conversations with directors too often reveal a lack of consensus about the quality of the “name in the envelope.”  Further, it is too easy for the existence of a plan like this to allow complacency to set it.  Leadership needs are a moving target—if the plans that provide compliance are not continually revisited, then they are simply not operational.

The board must own the planning, not the CEO

Another common mistake we see occurs when boards delegate too much of the task of succession planning to the incumbent CEO.  As good a leader as the CEO might be, it isn’t clear they are best positioned to choose their successor.  First of all, very few CEOs have any experience evaluating and choosing a CEO.  They are probably biased by their own style and experiences.  They may prefer a successor who will solidify their legacy when it comes to the direction of the company, while instead they need to dispassionately evaluate what the company needs going forward.  Regardless of the CEO’s capabilities in identifying successors, the board of directors simply needs to own the process.  Succession planning is no more properly delegated than any of the other board responsibilities.  Of course CEOs play a role—but they must not be the owner of the effort.

Use strategic planning to look for new CEO

Each of these threats to effective succession planning is avoidable, as long as directors are able to recognize them as bad habits that do not serve the company.  If a board fails to do so, the odds increase that they will be caught by the surprise departure of a CEO.  Should that happen, it is a best practice to always be in a position to name a consensus emergency interim CEO—the Cathie Lesjak to HP’s Mark Hurd.  More generally, the board needs to regularly delve in to the company’s strategic plan to develop and then continually revise the skills and experience profile for the next CEO. This allows the board to regularly assess the internal candidates against the forward-looking needs of the company, to identify the gaps, and to take the steps required to address them.  Coincidentally, this effort also gives the board a framework to repeatedly assess the incumbent CEO and provide real feedback..  Such an effort is also valuable as the board assesses external hires.

The drawbacks of the horse race

One common strategy to succession is to create a horse race for the position— much like Jack Welch did in anticipation of his departure from GE.  Of course, a horse races creates a winner, but with many losers.   Boards have to think carefully about how publically they develop internal candidates—executives who lose the horse race likely leave.  Boards may prefer not to make  investments in developing their competitions’ next generation of leadership.

Finally, directors need to always keep context in mind—no two events are the same.  For example, when the other members of the leadership team are skilled, motivated, and synchronized, the board can take a bit more risk on a less experienced successor.  An additional contextual consideration concerns the role to be played by the outgoing CEO.  Sometimes the exiting CEO has a key role to play—perhaps as chairman—in the onboarding and support of the new leader.  Or perhaps, simply freeing the new leader of the chairman title for a time will allow a smoother transition into his or her  leadership position.  In other cases, the CEO may not have the ability to do that—or it may, in fact, not be necessary.   

Important questions for the board

As we noted at the outset, the first key to improving succession practice is to understand there are really two elements that require attention.  First, a continuous process needs to be in place that involves understanding the future needs of the firm, the degree to which current talent is prepared to lead in that envisioned future and ways to address any deficiencies.  Second, the succession event itself requires careful management—the way a board designs and executes the event will impact the new leader, the rest of top management, and the future of the firm.  To get ready for these responsibilities, make sure your board is spending sufficient time debating questions like these:

  • Based on our understanding of future business needs, do we understand what the next CEO looks like?
  • How do we begin to develop our internal candidates with potential?
  • How can we become more proactive in understanding the potential talent outside of our company?
  • What do we as board members need to do in order to prepare the successor—and the top management team— for success?
  • What specific steps can we identify and implement to make our succession a true, informed and ongoing process?