Wednesday marked a significant day in the ongoing involvement of the US government in executive compensation, as Treasury Secretary Geithner outlined a series of broad-based principles that companies – particularly financial institutions – should consider in connection with the design and implementation of their executive compensation programs. Secretary Geithner’s statements followed a meeting involving SEC Chairman Schapiro, Federal Reserve Governor Dan Tarullo and several compensation experts. We have begun posting memos regarding this development in a new “Treasury Guidance” Practice Area.
The principles that Secretary Geithner outlined should come as no surprise to those who have been reading our publications over the last several years. The principles draw on best practices that we have seen developing in the marketplace over time, and for the most part can be universally applied. (Nothing in Geithner’s comments seemed to indicate that the guidance was limited strictly to financial institutions, but banks will see these standards in more concrete terms as they are worked into the supervisory process of bank regulators.)
Here are the principles:
1. Compensation plans should properly measure and reward performance – Incentive compensation plans should be tied to performance in the sense of long-term value creation, which could be accomplished by using a wide range of internal and external metrics (and not just the company’s stock price), including metrics that distinguish the company’s performance from its peers.
2. Compensation should be structured to account for the time horizon of risk – Continuing the theme of aligning pay with long-term value creation, the principles encourage conditioning compensation on longer-term performance and thereby obviating the need for specific clawbacks, while encouraging the holding of equity awards for longer periods.
3. Compensation practices should be aligned with sound risk management – As we have heard repeatedly since the financial crisis, compensation committees are encouraged to conduct and publish risk assessments of compensation plans in order to “ensure that they do not encourage imprudent risk taking.”
4. Golden parachutes and supplemental retirement packages should be reevaluated – Companies should reexamine the extent to which golden parachutes and supplemental retirement packages are aligned with shareholder interests, whether they incentive performance and whether they result in value to executives even when shareholders lose value.
5. Promotion of transparency and accountability in the compensation-setting process – Citing the lack of independence of compensation committees and the lack of clarity in disclosures (including the lack of a true “walkaway” number for top executives), two legislative initiatives are proposed.
The first legislative initiative outlined yesterday is a push for an advisory vote on executive compensation, which goes beyond the previously introduced legislation and the pending Shareholder Bill of Rights, in that it would require a vote on executive compensation as disclosed in the proxy statement (including the CD&A and the compensation tables) and a vote targeting the compensation reported for each of the named executive officers. Similar to the prior proposals, a non-binding vote on golden parachutes would also be required in merger proxies.
The second legislative initiative coming out of the announcement is a new framework for compensation committees that would be analogous to the audit committee provisions of the Sarbanes-Oxley Act. Under SEC-mandated listing standards, the compensation committee members would be subject to the higher independence standards applicable to audit committee members, the compensation committee would get resources to hire and oversee its own advisors and independence standards would be prescribed for outside compensations consultants and outside counsel. This initiative comes as somewhat of a surprise to me, because while compensation consultant conflicts have been a concern, I have not heard much in the post-Sarbanes-Oxley era about concerns that compensation committees lack sufficient independence.
Chairman Schapiro also released a statement on Wednesday, reiterating the rulemaking efforts under consideration on executive pay and corporate governance. Proposals are expected on these in the next several weeks. Not to be outdone, Congressman Barney Frank issued a statement, generally supporting Secretary Geithner’s principles (except for the compensation committee proposal), but also indicating that Congress should go further and “adopt legislation that mandates that the SEC adopt appropriate rules that embody these principles.”
Treasury Issues Much-Anticipated Rules Implementing TARP Exec Comp Restrictions
We also saw the Treasury announce that it had finally published interim final rules implementing the executive compensation provisions from the Recovery Act. The lack of guidance had created difficulties for financial institutions participating in the TARP program, since they were not sure what to do with their compensation programs in the absence of greater clarity in how the legislation was to be applied.
The rules implement and expand on the Recovery Act provisions. Some new provisions that go beyond the statutory requirements include:
– Prohibiting tax gross-ups to senior executive officers and the 20 next most highly compensated employees;
– Requiring additional disclosure of perquisites in excess of $25,000 for employees subject to the bonus restrictions, including a narrative description of, and justification for, the perquisites.
– Requiring a disclosure of the use of compensation consultants, including a discussion of any non-compensation services performed and the use of “benchmarking” procedures.
Is it just me or is it kind of weird that the Treasury is now setting executive compensation disclosure standards for the proxy statement?
In considering an option repricing program, a significant factor for companies to weigh is the advisory services’ positions on repricing, as their support is usually necessary to win shareholder approval. RiskMetrics’s general view is that option repricing is never a good practice. Repricing weakens—and if done on a serial basis, destroys—the incentives that make up the foundation of a stock option program. However, RMG has taken a case-by-case approach in determining whether to support repricings and considers six factors in making its decision (the first two are the most important):
– Value neutrality – is the exchange value-for-value?
– Participation – are executive officers and directors included?
– Rationale – was the sustained stock price decline beyond management’s control?
– Timing – why is the company choosing to conduct a repricing at this particular time?
– Term and vesting of surrendered options – what is the duration, exercise price, and vesting of replacement awards?
– Disposition of cancelled option shares – will cancelled options shares be available for future issuance under the company’s plan(s)?
While these factors create a high burden, there is evidence that RMG does support repricing programs when warranted. For example, in determining whether to support Cardinal Health’s repricing proposal, RMG noted in their report that the program excludes NEOs and directors from participating and that the exchange was value-for-value. Additionally, because the proposed program would recycle surrendered shares by returning them to the pool, RMG conducted a burn-rate analysis and shareholder value transfer analysis on the potential cost of all plans and found the results to be better than industry averages. As a result, RMG considered the repricing program to be “reasonably structured” and recommended a “For” vote. The Special Meeting will be held June 23rd.
For more on repricings, see our “Stock Options” Practice Area. Also note that Panel 7.1 of the “17th Annual NASPP Conference” is a special Double Session entitled “How to Implement Responsible Option Exchange Programs AND Effectively Administering an Option Exchange Program ” devoted to this topic and the panel includes RiskMetrics’ Pat McGurn. Should be a good one…
Tune into our CompensationStandards.com webcast tomorrow – “The Latest Compensation Disclosures: A Proxy Season Post-Mortem” – to hear Dave Lynn, Mark Borges and Ron Mueller analyze how the executive compensation disclosures looked during this proxy season.
In his “Proxy Disclosure Blog” last night, Mark does a great job of summarizing the recent news that Treasury may finally be issuing its executive compensation guidance this week – and that it may apply to all financial institutions, not just TARP participants. Mark also raises some good questions, such as whether the new “pay czar” will be responsible for interpreting ARRA guidance or whether it will be Treasury or someone else. Chaos reigns supreme.
Coming Soon: SEC’s New Executive Compensation Rules
As noted in this WSJ article, the SEC intends to roll out new proposals to change its executive compensation disclosure rules sometime in early July. Mark Borges did a great job of recapping what the proposals will likely look like in his blog.
With the SEC’s goal to have its rule changes effective before next proxy season – combined with the real likelihood of say-on-pay legislation and the loss of broker nonvotes for director elections – our the “4th Annual Proxy Disclosure Conference” (whose pricing is combined with the “6th Annual Executive Compensation Conference”) will be more important than ever.
These Conferences will be held at the San Francisco Hilton and via Live Nationwide Video Webcast on November 9-10th; here is the agenda. And many also attend the NASPP Annual Conference that follows directly thereafter – the full Conference program was justed posted. Take advantage of reduced rates that will expire on June 26th by registering now.
Following up on this blog, the real problem when dealing with performance metrics is the accounting system/GAAP; that is mostly what Fred Whittlesey wrote about. GAAP has left its original roots (i.e. cost accounting) – and is now being used as single comprehensive measure of a business. That goal mostly is a fantasy and so the “books” are largely fiction.
Financial statements should measure only things that can be accurately measured, like cash in and cash out, and other aspects of the disclosure system should address other less precise issues.
On Tuesday, I attended a clawbacks seminar hosted by the Institutional Investor Educational Foundation here in DC and the idea of annual ratification of compensation consultants was floated by a few panelists. This would require public companies to place an item on their annual meeting ballot to allow shareholders to “ratify” the company’s compensation consultants, just like most do for independent auditors today. It’s an interesting idea – and I’m not surprised to see it since concerns over comp consultants often has been patterned on the concerns over auditor conflicts.
Here are some reasons why I think this idea is not a good one:
1. Leave Blame for Excessive Pay Where It Belongs – I worry that ratification of compensation consultants would place more attention on consultants than is warranted. Consultants just provide guidance when asked – it’s the board that makes the final decisions and should be accountable for badly designed pay packages. Leave the onus on the board to defend its pay package.
2. What Does Ratification Accomplish? – Just like my concerns over say-on-pay, I worry that merely placing a comp-related item on the ballot won’t drive change. In fact, I worry it may relieve pressure on the board to create change as the compensation consultants likely would routinely be ratified, just like independent auditors are today. And boards may read into the ratification that their pay design is acceptable, even if it’s not. A professor at Texas A&M did a study back in ’03 and found that the average ratification rate was 97%.
3. Compensation Consulting Industry is Limited – There is an unbelievable amount of misinformation about the pay-setting process. That is why most reform efforts sound ill-fated to me – the folks with the ideas don’t understand what is causing excessive pay, thus they don’t know how to fix it. There is so much concern over compensation consultants (conflicts, etc.) – yet most boards don’t use their services at all. [Note that companies are required to have auditors, but not consultants. However, there’s no corporate law requirement to place auditor ratification on ballots – although if a company doesn’t, ISS will recommend a vote against re-electing the board.]
In fact, there are no more than three dozen or so consultants that actually go into boardrooms to provide guidance. That’s how small the industry is! And my experience has been that the views of one consultant in a particular firm will not necessarily reflect the views of the others. There is no standardization of views within firms – so shareholders would find it quite difficult to decide how to vote with any real confidence.
4. Compensation Consultant Role May Vary – Another key difference between the role of the independent auditor and compensation consultants is that the role of the auditor is always the same, but that the role of the comp consultant often varies. Sometimes the comp consultant is heavily involved with helping a board design the pay package – but many times the consultant is limited to just providing data and general technical guidance.
Another key difference is that there is no standard code of conduct or rules about for engagements of compensation consultants; there is a full set of laws that exist for auditors.
5. Compensation Consultants Aren’t the Problem – Although the compensation consulting industry clearly perpetuates some of the problems associated with excessive pay (eg. peer group surveys), I believe that most consultants have “gotten religion” during the past five years and provide responsible guidance. Or they at least provide a responsible alternative when they respond to a client request.
This makes sense given their reputation is on the line and quite a few have already been dragged through the mud. Plus, if they lose a client, they are in high demand and can fairly easily find a new one. Given that the number of compensation consultants is fairly small – and that I regularly communicate with at least half of them – I feel like my anecodotal evidence may border on empirical.
I can’t say the same for many of the lawyers that provide guidance to compensation consultants; I hear very few speaking out for responsible practices. And of course, directors themselves need to look in the mirror.
Your Views: Ratification of Compensation Consultants
I’m just a guy in pajamas, so don’t be swayed by me. Let us know your views in this anonymous poll:
– Alberto Bagnara, Salvatore Tedesco, and Eeva-Liisa Räikkönen, RiskMetrics’ European Research
From RiskMetrics’ Governance Weekly: The European Commission (EC) has released two recommendations on executive remuneration and financial services sector pay as a first step in a strategy outlined in March on “Driving European Recovery.” The recommendations, released April 29, are non-binding instruments that advise member states to introduce measures to facilitate the convergence of national legislation on issues of common interest within the European Union.
This initiative follows conclusions drawn in December by the Ecofin (Economic and Financial Affairs) Council, which represents the economics and finance ministers of the EU’s 27 member states. In light of the recent financial crisis and the current focus on executive and director remuneration, the EC sees its role as “leading a wide-ranging reform to apply the lessons of the crisis and deliver responsible and reliable financial markets for the future.”
The recommendation on remuneration at listed companies is intended to complement recommendations adopted in 2004 and 2005 on executive pay and the role of non-executive directors and board committees, respectively. While the existing compensation recommendation is based on the idea of pay for performance through disclosure of the remuneration policy, the EC now considers it necessary to address the structural flaws of remuneration policies that have become apparent.
The new principles are based on best practices found in the national legislation or corporate governance codes of member states. It is important to note, however, that the recommendation does not aim at harmonizing pay levels. Guidance is given with regard to the structure of remuneration policies to better align pay with performance. The main focus is on variable pay. Variable components should be capped, and the award of variable compensation should be subject to predetermined and measurable performance criteria.
In addition, severance payments should generally not exceed two years’ fixed salary, and should not be paid if termination is due to inadequate performance. Other principles focus on promoting a company’s long-term sustainability. The guidance advocates a minimum three-year vesting period for stock options, as well as a requirement to hold a fixed number of shares until the end of employment. The EC also promotes the deferment of “a major part” of variable pay. Furthermore, “clawback” provisions should be included in contracts to enable companies to reclaim variable pay granted on the basis of accounts that are subsequently proved to be manifestly misstated.
The recommendation further sets out principles relating to the governance of remuneration policies, which mainly focus on strengthening remuneration committees by requiring, for instance, at least one member of the committee to have knowledge and experience in the field of remuneration policy. The impartiality of remuneration consultants used by remuneration committees should also be ensured. To mitigate conflicts of interest, non-executive directors should not receive stock options as part of their remuneration. The EC also states that companies should encourage shareholders to participate at general meetings and use their votes regarding director remuneration.
The second EC recommendation specifically deals with remuneration at companies in the financial services sector. According to Internal Market Commissioner Charlie McCreevy, “Up to now, there have been far too many perverse incentives in place in the financial services industry. It is neither sensible nor sane that pay incentives encourage excessive risk-taking for short-term gain.”
Member states are urged to introduce stricter remuneration rules for financial firms having an office within their territories that apply to all employees whose activities have an impact on the company’s risk profile. Accordingly, the recommendation outlines principles to address four areas of concern:
– First, remuneration policies for risk-taking staff should be consistent with and foster sound and effective risk management. Consequently, there should be “an appropriate balance” between fixed remuneration and bonuses. Companies should be allowed to withhold bonuses if performance criteria were not met and the payment of the major part of the bonus should be deferred. Moreover, performance criteria should be aligned with the long-term financial performance of the firm.
– Second, remuneration policy should be “transparent internally, clear, and properly documented.” Board members and consultants involved in the formulation of the remuneration policy should be independent.
– Third, remuneration policy and its features should be adequately disclosed to shareholders in a clear and understandable way that explains the main components of the remuneration policy, its design, and operation.
– Finally, the EC stresses the importance of supervision. Supervisory authorities should ensure that financial services companies apply the principles of sound remuneration in compliance with effective risk management.
While maintaining disclosure as an underlying principle, these two new recommendations stress the importance of a balance between fixed and variable pay, the existence of measurable performance criteria, and the presence of sound supervision. In setting such guidelines for remuneration policies, the EC intends to improve risk management and align pay incentives with sustainable performance.
These two initiatives are part of a broader strategy that the EC intends to pursue, and there is a possibility of similar steps in other financial sectors, such as insurance. To complement the recommendation on financial services pay, European regulators plan to amend the existing Capital Requirements Directive in June to address risk management and supervision of remuneration policy at banks and investment firms.
The impact of the recommendations and their application by member states will be assessed in one year. The EC intends to keep monitoring the remuneration practices adopted by listed companies and financial services providers, and their impact on the long-term sustainability of the European financial sector.
– Ira Kay and Steve Seelig, Watson Wyatt Worldwide
As many of you have read, one of the items on SEC Chair Mary Schapiro’s “to-do list” for 2009 is to revise some of the executive compensation rules. She’s mentioned Say-on-Pay and whether the compensation committee considered if a pay program caused executives to take excessive risks as priority items, but she’s also mentioned the SEC will look at how executive pay is depicted on the Summary Compensation Table as worthy of consideration.
While the Chair’s latter comments may have been narrowly focused on the issue of the equity grant disclosures, known by most readers to have been changed right around Christmas 2006 to mirror the FAS 123R financial statement disclosures – the Associated Press resolutely ignores this change in its news stories – we thought it was a fine time to raise a more important issue with the rules.
From our perspective, showing start of the year grant fair values, as the rules would have required before the last-minute change, does not fix the problem of properly depicting how much an executive earned during the year – what we call realizable pay – it would only show the pay opportunity an executive could earn. In the spirit of getting a dialogue moving with the Corporate Finance Staff, we submitted a Petition for Rulemaking to the SEC last week to reconsider its approach to so that equity gains (or losses) are valued at year-end, same as you would depict a bonus earned or a change in pension value.
We feel strongly about coming up with a method to more accurately depict the actual value of what executives earn from year-to-year, especially as companies will likely confront Say-on-Pay advisory votes to accompany their 2010 proxies. Simply having shareholders look at the grant opportunities will not give them a full appreciation of whether their company actually ended up paying for performance. Adopting our approach might help shareholders be able to make that call with a minimum of extra effort.
Here is the third in a series of blogs exploring the different approaches to say-on-pay that companies can take:
Retrospective and Prospective Model – The RiskMetrics ’08 Model
RiskMetrics Group is, among other things, the largest proxy advisor in the United States. As a result, it is expected to meet the highest standard of governance with respect to its own affairs. RiskMetrics voluntarily implemented a say-on-pay policy in June 2008 following its IPO in 2007 and put the following three resolutions to a shareholder vote in its 2008 proxy statement:
(1) that shareholders approve the Company’s overall executive compensation philosophy, policies and procedures, as described in the Compensation Discussion and Analysis in the Proxy Statement;
(2) that shareholders approve the compensation decisions made by the Board with regard to named executive officer performance for 2007, as described in the Compensation Discussion and Analysis in the Proxy Statement; and
(3) that shareholders approve the application of the Company’s compensation philosophy, policies and procedures to evaluate the 2008 performance of [sic], and award compensation based on, certain key objectives, as described in the Compensation Discussion and Analysis in the Proxy.
The first and second resolutions essentially separate the “Broad Retrospective Model” into two resolutions. The first resolution addresses the company’s philosophy, policies and procedures and the second resolution addresses actual compensation decisions. Separating these two resolutions arguably enables shareholders to indicate displeasure with a company’s overall compensation philosophy while, at the same time, approving actual compensation paid. The third resolution, however, breaks from both the “Narrow Retrospective Model” and the “Broad Retrospective Model” by asking shareholders to approve the application of the company’s compensation philosophy to the then-current fiscal year.
To this end, RiskMetrics included in its 2008 proxy statement both the metrics and the specific targets for each metric that the compensation committee would use in determining whether management is entitled to incentive compensation for the 2008 fiscal year. The third resolution represents a radical departure from the say-on-pay policies that most companies would be willing to implement and that are envisaged by most shareholders, because it requires disclosure of information that is not required to be disclosed under SEC rules and, as discussed above, that most companies strongly resist disclosing.
The wording of RiskMetrics’ third resolution also leaves some areas of doubt. For example, RiskMetrics’ 2008 CD&A states prospectively that the CEO’s target incentive compensation for 2008 will be twice his base salary. It is not clear whether the third resolution calls on shareholders to approve the amount of the CEO’s target incentive compensation or whether it solely calls on them to approve the application of the Company’s “compensation philosophy, policies and procedures” in determining whether to pay that amount. In addition, the resolution states that the “compensation philosophy, policies and procedures” are based on “certain key objectives,” but it is unclear whether shareholders are being asked to approve those objectives.
Note that RiskMetrics’ didn’t use the same wording for this year’s proxy statement. For unknown reasons, it dropped the third resolution.