It’s the time of year my mailman hates. For him, the annual reports carried in his pack are nothing more than a pointless burden slowing him down. He always seems skeptical when I greet his handful of envelops with a welcome smile.

At, NFI, we’re firm believers in paying for (actual) performance. Ideally, all CEO’s would receive a living wage and generate the rest of their compensation from bonuses based on performance.

Performance, however, is an illusive concept and corporate Boards are often left with the task of determining CEO compensation. Unfortunately, rather than thinking, many boards delegate this critical task to outside consultants who, for a fee, legitimize an ever increasing number which boards can easily rationalize to shareholders as correct. CEO’s, of course, rarely complain about the payday.

Given that the CEO typically chooses the board members and the board members pick the consultant and determine compensation, you can see how this incestuous relationship can quickly become one that benefits everyone but the shareholders. It would be better if Boards spent more time thinking about and creating the right incentives than outsourcing such a crucial task.

However, this undertaking is not as easy as it sounds. Something as simple as rewarding a CEO for increases in shareholder equity can be very dangerous. If the long-term historical return on equity is 10% how much should a CEO be paid for average performance? How do you account for inflation? Risk free interest rates? The incentive to leverage the company? Shareholder equity, after all, is not the same as invested capital. What about the fact that you can lag the S&P 500 and still collect massive compensation?

Pay is such a hot topic that activist shareholders often mention it as one of the things they want to change. That is, until they are in charge. And so it goes.

After determining performance objectives, Boards often have to adjust reported numbers as these can be materially misleading. An undertaking, I fear, which makes a lot of them uncomfortable.

Let’s look at some examples of how, not adjusting things, can quickly lead to paying CEO’s well above their actual performance.

Consider the Dr Pepper Snapple Group’s focus on Earnings Per Share. This company considers earnings per share increases as one of the key components to the CEO’s incentive compensation. Next year the board will face a tough question: should we include the gains resulting from Coke and Pepsi taking the bottlers private or should we make adjustments? These gains are non-operating, non-recurring, and outside the control of anyone inside the company. So will the company exclude them when making compensation decisions? We’ll have to wait and see.

What about a CEO, who, because of a spike in oil prices increases earnings or shareholders equity? Should they be rewarded simply for the price of oil?

Another example would be companies placing an emphasis on “return on invested capital.” While this sounds good, again, the success of this system lies buried in the details. Unfortunately for shareholders, a lot of executives find it pretty easy to hide poor capital allocation skills. They manipulate the system. If, for example, a company marks down goodwill they also reduce invested capital. In the process they lower invested capital because they’ve lowered the denominator. Assuming the return part is constant, the company, increases return on invested capital with the stroke of a pen.

I’ve read more than a few proxies this year which place an emphasis on “return on invested capital” (calculated without adjustments) for companies which, over the last two years, were all too eager to rid themselves of goodwill. You can be sure those executives will be handsomely rewarded this year.

Some companies do understand pay for performance and those are companies we eagerly keep a close eye on. Companies with a large shareholder on the board seem, generally, to better understand pay for performance.

Not all companies need a large shareholder to ensure thoughtful compensation. A great leader can sometimes rise above the folly. JPMorgan Chase & Co.’s proxy generally stands out and this year was no exception.  Thanks in large part to Jamie Dimon, JPMorgan is clearly a cut above the rest of Wall Street when it comes to compensation philosophy.

Let’s take a look at some of  JPMorgan Chase &Co.’s discussion on compensation in their most recent proxy statement:

Highlights of some changes introduced in 2009 and 2010 include the following:

In addition to our long standing recoupment policy which enables the Firm to recover cash and equity incentives in the event of material restatement of the Firm’s financial results or a termination for cause, we also implemented terms and conditions in January 2009 for all employees that enable the Firm to clawback or recover these incentives in the event they were based on materially inaccurate performance metrics or on misrepresentations by employees.

In January 2010, we implemented enhancements to our provisions in equity awards to enable recovery: 1) for conduct detrimental to the Firm, insofar as it causes material financial or reputational harm to the Firm or its business activities, and 2) for members of the Operating Committee, members of LOB Management Committees and certain other employees, failure to properly identify, raise or assess, in a timely manner and as reasonably expected, risks and/or concerns with respect to risks material to the Firm or its business activities.

For Operating Committee members (i.e. the Firm’s most senior officers), we introduced terms and conditions in January 2009 that enable the CEO, with ratification by the Compensation Committee, to determine that awards may be reduced, forfeited or delayed if the executive’s priorities or those of the Firm are not achieved at a level deemed appropriate.

For incentives awarded in 2010, the Firm increased the portion deferred into equity based on incentive compensation level to further align deferral rates with global regulatory principles like those of the Financial Stability Board and endorsed by the G-20, specifically to provide longer term incentives for those earning greater compensation and engaged in more material risk-taking activities. Members of the Operating Committee received on average at least 75% of their incentive compensation in equity.

Beginning in 2010, approximately 15,000 employees across multiple businesses had the mix of their total compensation adjusted to provide more fixed compensation (i.e., salary) and less variable compensation (i.e., incentives) going forward.

Management has engaged the Compensation Committee in more discussions and reviews of the relationship between risk and compensation and the Compensation Committee will now meet at least annually with one or more members of the Risk Policy Committee of the Board of Directors.

JPMorgan Chase has policies that would permit recovery of incentive compensation awards in appropriate circumstances.

Stock-based awards vest over multiple years, and such awards granted in 2010 are subject to the Firm’s right to cancel an unvested or unexercised award, and to require repayment of the value of certain shares distributed under awards already vested if:

• the employee is terminated for cause or the Firm determines after termination that the employee could have been terminated for cause,
• the employee engages in conduct that causes material financial or reputational harm to the Firm or its business activities,
• the Firm determines that the award was based on materially inaccurate performance metrics, whether or not the employee was responsible for the inaccuracy,
• the award was based on a material misrepresentation by the employee,
• and for members of the Operating Committee – the Firm’s 16 most senior executives – and certain other employees, there is a failure to properly identify, raise, or assess, in a timely manner and as reasonably expected, risks and/or concerns with respect to risks material to the Firm or its business activities.

Under our recoupment policy adopted in 2006, the Firm may seek repayment of incentive compensation (cash and equity) in the event of a material restatement of the Firm’s financial results for the relevant period.

Appendix D
JPMorgan Chase Compensation practices and principles

We believe that JPMorgan Chase has consistently been at the forefront of sensible compensation practices. We have a rigorous performance and compensation management system that incorporates the following practices and principles:

• A focus on multi-year, long-term, risk-adjusted performance and rewarding behavior that generates sustained value for the Firm through business cycles
• An emphasis on teamwork and a “shared success” culture
• A significant stock component (with deferred vesting) for shareholder alignment and retention of top talent
• Recoupment and clawback provisions in addition to disciplined risk management to deter excessive risk taking
• A recognition that competitive and reasonable compensation helps attract and retain the best talent necessary to grow and sustain our business
• Strict limits or prohibitions on executive perquisites, special executive retirement or severance plans
• Independent Board oversight of the Firm’s compensation practices and principles and their implementation

These practices and principles are supported by additional beliefs that guide how we operate.

Compensation should not be overly rigid, formulaic or short-term oriented

• Compensation programs should be designed as much as possible to allow for the Firm to exercise discretion and retain flexibility in compensation decisions. Multi-year guarantees should be kept to an absolute minimum. More generally, the assessment of performance should not be overly formulaic and should not overemphasize any single financial measure or single year, as that can result in unhealthy incentives and lead to unintended, undesirable results.
• Performance should be considered using a broad-based evaluation of people and their contributions to ensure that the right results are being encouraged. Factors such as integrity, compliance, institutionalizing customer relationships, recruiting and training a diverse, outstanding workforce, building better systems, innovation and other outcomes should be included. Performance feedback should be obtained from multiple sources across the Firm to ensure it is both balanced and comprehensive.
• Commission-based incentives generally should be limited to sales or production oriented employees who do not control credit or investment decisions. The different risk profiles such as liquidity risk, time horizons for realized gains or losses, and reputational and operational risk all should be appropriately taken into account.

In a fiduciary business, certain roles are evaluated solely on individual and business unit results. In addition, some of these roles are paid long-term compensation with incentives linked directly to their investment strategies in order to more fully align their interests with those of the clients.

In the end, Boards need to understand the key business drivers, human nature, and incentives. Even then, they need to make adjustments to ensure the company doesn’t pay someone for something they didn’t actually do. Too often CEO’s are rewarded for the wrong reasons. Let’s start paying them for the right reasons.