Recently, Cisco shareholders narrowly supported a say-on-pay proposal by a majority. In this podcast, Julie Tanner of Christian Brothers Investment Services discusses the recent Cisco vote on say-on-pay and other CBIS activities, including:
– What were the results of your say-on-pay proposal on Cisco’s ballot? How did that compare to last year?
– How does Christian Brothers select which companies to which it will submit shareholder proposals?
– What types of proposals has Christian Brothers submitted for the 2010 proxy season?
– Does Christian Brothers engage with companies before – or after – it submits shareholder proposals?
Just a few moments ago, the SEC issued a notice that it will hold an open Commission meeting next Wednesday, 12/16 to consider adoption of its executive compensation and other corporate governance proposals. It’s unknown at this time whether they will apply to the upcoming proxy season.
In the UK, the final Walker Review recommendations were recently issued. This is a sweeping governance reform of the United Kingdom’s financial industry, including strengthening the role of non-executive directors and giving them new responsibilities to monitor risk and compensation. Here’s an excerpt from a recent RiskMetrics’ newsletter:
The review’s more than three dozen recommendations remain largely unchanged from a draft released in July for public comment, which prompted a broad spectrum of financial market participants, including institutional investors, remuneration consultants, shareholder associations, and bank representatives to weigh in on the proposed guidance.
However, many of the recommendations, particularly those regarding remuneration, have been re-worded to be less prescriptive in nature. Britain’s Financial Services Authority has taken a similar approach with respect to its own remuneration code, which will take effect next year. A primary example of this is the definition of “high end” employees, who fall under a variety of Walker recommendations, which are now defined as those who perform a “significant influence function,” rather than meeting a certain pay level threshold. Still, other defined elements, such as the level of bonus deferral, have remained untouched.
A key element of better executive compensation practices is whether an employer has a clawback policy which enables the employer to recoup incentive compensation from an employee under certain circumstances. Typically, a clawback may apply if an employee has committed an egregious act or if there is a restatement of the financial results from which the incentive compensation payment was derived. To the delight of corporate governance reform advocates, many public companies have voluntarily adopted clawback policies.
The federal government has also increasingly mandated the clawback of incentive compensation. The Sarbanes-Oxley Act of 2002 and the American Recovery and Reinvestment Act of 2009 each compel a clawback of incentive compensation paid to certain enumerated employees if the employer has a financial accounting restatement. Even more recently, in October 2009, the Federal Reserve Board of Governors proposed guidance that would generally compel banks under its supervision to delay the actual payout of an incentive award to an employee until significantly beyond the end of the applicable performance period. This proposed guidance would require that any such payments should be decreased for actual losses or other aspects of performance that become clear only during the deferral period.
The California Supreme Court recently rendered a decision in the Schachter v. Citigroup case which dealt with incentive compensation. The ruling itself was not all that surprising – but the court’s opinion did indirectly highlight a potential pitfall for clawbacks. In Citigroup, the employer maintained a program whereby an employee could voluntarily elect to reduce his/her salary by a stated percentage and in exchange receive restricted shares (at a discount) that would vest over time. The restricted shares would be forfeited without consideration if the employee resigned employment prior to vesting. However, if the company terminated the employee’s employment without cause prior to vesting, then the employee would receive a cash payment equal to the amount of the foregone salary as consideration for the forfeited shares.
A former employee, who had resigned his employment, filed suit challenging the compensation arrangement. He argued that he should have received his foregone salary after his resignation on the theory that various California labor code statutes generally prohibiting the disgorgement or nonpayment of wages were violated. The California Supreme Court disagreed and ruled that, as is typically the case with unvested equity compensation arrangements, failure to satisfy the vesting conditions meant that the incentive compensation was not earned and that the employee was not deprived of any wages.
However, the court’s opinion took notice of the differing consequences for the incentive compensation depending on whether the employer or employee had initiated termination of employment. The court noted that payment of the incentive compensation if the employer was the initiating party to terminate employment was consistent with “contract law principles prohibiting efforts by one party to a contract to prevent completion by the other party.” The court further noted that an employee may be able to recover at least a pro-rata share of a potential bonus if the employee’s employment is terminated by the employer without a valid cause prior to completion of the terms of the bonus agreement. In addition to the applicable California labor code statutes, as support the court cited California state regulatory agency opinions and state appellate law decisions.
The point is that state laws, regulations and/or agency decisions could potentially impede the ability of an employer to recoup or delay/deprive an employee from receiving incentive compensation. For example, California Labor Code Section 221 specifically states “It shall be unlawful for any employer to collect or receive from an employee any part of wages theretofore paid by said employer to said employee.” If a clawback was implemented to comply with a specific federal law, then such clawback may be better able to withstand a challenge under state law by virtue of federal law pre-emption.
But what if the clawback was being voluntarily implemented by the employer purely as a matter of good corporate governance? In such case, the clawback could be vulnerable to being invalidated based on state laws that protect an employee’s rights to compensation particularly if the employee was not culpable and/or if the employee could argue that the incentive compensation was already “earned” (or paid) under applicable state law.
The WSJ reported that Goldman has been visiting with shareholders in an attempt to justify its extraordinary compensation practices. As the article notes: “So far, Goldman has shown no signs of backing down to anger over the firm’s pay and benefits, on track to hit a record high of about $717,000 per employee, consultant and temporary worker for 2009, nearly double last year’s $364,000.”
As part of these efforts to justify the compensation, Goldman has been distributing a memorandum that asserts that Goldman outperformed other “sectors” of the economy. As the memorandum notes: “Goldman Sachs generated an average pre-tax margin of 29% between 2000 and 2008, besting all the sectors in the Fortune 500.” It is, of course, a cherry picked set of comparisons, one that does not claim it outperformed all other companies, only sectors of the Fortune 500. Presumably other companies have done the same thing without needing to resort to the same levels of compensation as Goldman.
The memorandum by the way put considerable weight on the approval of compensation practices by the independent board of directors. While the compensation of these directors for 2009 has not yet been disclosed, they were paid in 2007 almost $700,000 each. Its not only the officers and other employees who do well at Goldman.
Goldman has certainly done well during the financial crisis. But the amounts and the efforts to justify them reflect at best a tin ear and at worst an indifference to the economic situation of most Americans. Just as this story broke, the Journal reported that the economy had shed another 169,000 jobs, with unemployment remaining at 10.2%. Moreover, as Goldman raises the tide, other companies will likely float along with it, raising their compensation (and justifying it by arguing that they will otherwise lose talent to Goldman).
The story was paired with one about Bank of America deciding to repay its TARP money to the government. The repayment will largely free BofA of government oversight of compensation practices, particularly the onerous requirements imposed by the Pay Czar.
In other words, the limitations in TARP were temporary. The effort to use morality or public pressure to reduce compensation have failed abysmally. Legal restrictions on compensation are necessary. As we will discuss, the American Financial Stability Act is going in the right direction. It contains a prohibition on excessive compensation. Its time to impose a federal standard, one that will subject directors to meaningful standards in setting compensation.
A company’s Compensation Committee decided to provide the CEO with a company car and asked what color car he wanted. The CEO wanted to ensure that his choice of color was consistent with market norms so he asked the HR department to research the car color of the CEOs of its ten peer companies.
The results were presented to the CEO, indicating that, on average, CEOs in the peer group drove a pink car. The CEO, who knew his peer CEOs well, commented that it was hard for him to believe that so many CEOs were driving pink cars (given the absence of any multi-level cosmetics marketing organizations in their peer group.) “Is that the average or the median?” he asked. “Both the average and the median are pink” was the reply. He asked to see the raw data which indicated that five of the CEOs drove a red car and the other five a white car.
Is this a silly parable? Would such a simplistic analytical shortcoming really occur? I recently spoke with the head of compensation for a technology company who was questioning the data for their peer group data cut from a well-known survey. The data indicated that equity grants at the executive level among the peer group companies were averaging a mix of 50% stock options and 50% RSUs. His anecdotal knowledge of the peer practices made him feel that this couldn’t possibly be correct. When the raw data was examined, however, it turned out that only two of their 20 peers had an options/RSU mix near the 50/50 average. Nine were granting all or almost all (80% to 100%) options and the other nine were granting all or almost all (80% to 100%) RSUs. The pink car problem.
At a time when more individuals and organizations than ever are collecting, analyzing, and opining on executive pay levels and practices, it is critical that the underlying data be collected, analyzed, and reported correctly. Could the CEO have identified the pink car problem without access to raw data? Of course. Simply looking at the 10th, 25th, 75th, and 90th percentiles would have told the story. And when n=10 (or any even number), after all, the median is a computed number in a spreadsheet. While “ratcheting” to the median is an oft-mentioned flaw with the benchmarking process, summary statistics can contribute to flawed decision-making even absent any such intent.
The three-legged analytical stool of collection, valuation, and reporting of data needs to receive more integrated attention. Accurate collection has been made more difficult over the past 18 months due to the prevalence of “special actions” taken during the economic crisis. Valuation continues to be a challenge as experts continue to disagree on how to measure pay. The reporting of pay reflects the turmoil in collection and valuation, sometimes exacerbated by the media. Compensation professionals cannot assume that push-button data provides the answer – that data only provides a starting point for questions.
In my next blog posting, I will provide an illustration of another variant of the Pink Car Problem which created a recent headline indicating that a CEO’s pay was “cut by about half.” (the perceived difference was not “about half” and pay was not “cut.”)
We just dropped your Fall 2009 issue of the Compensation Standards print newsletter in the mail. If you want to access it now, we have posted the Fall 2009 issue online. It provides timely analysis of compensation action items that boards should be focused on now.
Time to Renew – Your Membership Expires Soon: Note that because all memberships expire at the end of December, it is time to renew for 2010 for CompensationStandards.com. With all the change going on in the executive compensation area, you can’t afford to be without the critical resources on that site (and in the print newsletter, which you get as a bonus for being a member of CompensationStandards.com).
– Ira Kay and Steve Seelig, Watson Wyatt Worldwide
Sometimes the answer to a complicated question becomes clearer when different perspectives are considered. Such is the case in the debate about whether there has been pay-for-performance through the recent market meltdown. Recently, Paul Hodgson revealed the findings from a The Corporate Library study that found a weak link between CEO pay and firm performance in 2008, as evidenced by a decline in CEO total annual compensation of only 0.08% and a decrease in total realized compensation of 6.28% in 2008 for the more than 2,700 public companies surveyed, compared to a 37% decline in the S&P 500 index.
Our “2009/2010 Report on Executive Pay” reaches a far different conclusion – that CEO pay is still strongly aligned with company performance. We find that the pay-for-performance model underpinning U.S. executive compensation design still works as intended — in good years and bad:
– There is substantial downside risk for CEO wealth: the 967 CEOs in our study lost an aggregate $53 billion in 2008, compared to $3.2 trillion for company shareholders. In fact, we found that the percent decrease for the typical CEO is actually larger than that for shareholders (-42 percent for the CEO versus -34 percent for shareholders).
– CEO pay decreased significantly in 2008: when measured as realizable pay, three-year cumulative realizable LTI values decreased with shareholder returns — down to $1.4 million for 2006-2008 compared with $2.9 million for 2005-2007 and $3.3 million in 2004-2006.
– CEOs at higher performing earn more than their low-performing counterparts: the typical CEO at a high-performing company has a three-year aggregate realizable LTI value that is 150 percent larger than at a low TRS company ($2.3 million versus $0.9 million).
So, how is it two firms well-respected for the important research they do in the area of executive pay can come to such widely disparate conclusions?
One thing both firms have in common is that each goes beyond the Summary Compensation Numbers, which depict only the equity pay opportunity granted, in determining what executives actually earn in measuring pay. Unlike the The Corporate Library study that focuses on realized pay, we look at “realizable” pay as a far more accurate measure of the pay earned by executives. The difference between the two may appear subtle – but will vastly influence the results:
– Realized pay = the W-2 wages reported for the year, including restricted stock vested + performance shares and RSUs vested and paid + options exercised + deferred shares paid
– “Realizable” pay = restricted stock value earned or lost + performance share and RSU value earned or lost + option in-the-money value earned or lost + deferred share value earned or lost
Our concept avoids a focus on when equity is actually paid or monetized, which might often be a volitional act by the executive or the company that fails to consider the equity value earned or lost until the date that happens. We believe strongly that realizable pay is the number that executives think about when they consider the compensation they’ve earned or lost for a year. A proper understanding of how corporate executives think about their compensation drives far better decision making by the compensation committees and, perhaps more importantly, better illustrates the connection between pay and performance. We continue to urge the SEC to consider requiring companies to use it in their proxy disclosure.
Other key findings from our report include:
– Companies with an executive compensation architecture that creates a strong link between CEO wealth and risk had lower realizable total direct compensation (TDC) and superior total returns to shareholders (TRS) than companies with a weaker link to risk reduction.
– The value of broad-based employee option grants declined by 17 percent in 2008.
– Realized gains from employee stock option exercises declined by 55 percent last year — from an average $54 million per firm to $24 million.
– The estimated in-the-money value of options outstanding declined by approximately $100 billion for the firms in our sample in 2008.
From our blog: The Securities Docket reported recently that the SEC was going after Ian McCarthy the CEO of Beazer Homes – using Sox 304 – for clawbacks of his incentive payments, just like it did for CSK Auto Corporation’s CEO. The issue here is the same. The SEC is not alleging that either CEO was responsible for fraud, but simply that the incentives and other compensation were earned based on misstated financial accounts. The accounts are already being restated for 2004-2007 and they are likely to be restated for 1999-2003 as well.
That’s quite a lot of pay. Even for 2004-2007, in bonuses and option profits alone that’s $38 million.
Ian McCarthy has been the CEO for 15 years, so it’s going to be tough to point the finger elsewhere anyway. And we’ve already blogged about this. In the face of a Federal investigation, Mr. McCarthy claimed not to have any knowledge of what was going on, none whatsoever, not at all, no idea, nada, completely bemused by the whole thing, just couldn’t have come as more of a surprise to him that there was mortgage fraud, discount point fraud, down-payment assistance fraud, HUD-licensing fraud, and stated income fraud. Before all this he probably wasn’t even sure how the word “fraud” was spelt, I bet.
As we said then, knowledge has nothing to do with it. Responsibility is everything. And was he responsible? Well, we said yes back in July and apparently the SEC agrees with us.
This is about the clearest evidence yet that a simple fraud-based clawback policy is completely useless and a waste of paper.