As happens so often, there is now a mad rush for folks to register for week of proxy disclosure and executive pay conferences that starts in three weeks – on Monday, September 20th. With an aggregate of over 50 panels, if these conferences don’t help get you prepared for the upcoming proxy season of change, nothing will. You can either register for the three days of the “18th Annual NASPP Conference” (in Chicago) – or the two days of the “5th Annual Proxy Disclosure Conference” & “7th Annual Executive Compensation Conference” (in Chicago or by video webcast) or a combination of both. Note that we just extended the length of the last panel of the” 5th Annual Proxy Disclosure Conference” to cover proxy access in more depth. Register Now.
Amongst the many, many, changes wrought by the Dodd-Frank Wall Street Reform & Consumer Protection Act, is this requirement in Section 952(d)(1):
“The compensation committee of an issuer, in its capacity as a committee of the board of directors, may, in its sole discretion, retain and obtain the advice of independent legal counsel and other advisers”.
In addition, Section 952(d)(2) makes the compensation committee “directly responsible” for the appointment, compensation, and oversight of the work of independent legal counsel; Section 952(e) requires that an issuer provide “appropriate funding”; and Section 952(b) provides that a compensation committee of an issuer may only select independent legal counsel after consideration of factors to be identified by the Securities and Exchange Commission as affecting the legal counsel’s independence.
Recognizing that many compensation committee charters already include somewhat similar provisions, these new requirements may seem less than radical. However, they do raise some interesting and important questions.
First, and foremost, has Congress redefined state professional responsibility rules regarding the identity of a lawyer’s client? Rule 3-600(A) of the California Rules of Professional Responsibility provides that in representing an organization:
“a member shall conform his or her representation to the concept that the client is the organization itself, acting through its highest authorized officer, employee, body, or constituent overseeing the particular engagement”.
Thus, it seems to me that when a lawyer is asked to advise a compensation committee, that lawyer’s client is the corporation and not the committee or the committee members. I often hear lawyers say that they represent the committee. But do they? After all, a compensation committee is generally not considered a separate legal entity. Indeed, Congress’ mandate that the issuer provide “appropriate funding” implicitly recognizes that the compensation committee isn’t a separate entity with its own purse. Of course, it is possible that the lawyer means that he or she represents the committee members. However, if a lawyer were to represent the individual committee members, the lawyer would generally be required to obtain the members’ informed written consent pursuant to Rule 3-310(C) and Rule 3-600(E). Also, Rule 3-600(D) requires that when a lawyer deals with an organization’s directors, officers, employees, members, shareholders, or other constituents, he or she must explain the identity of the client for whom he or she acts, whenever it is or becomes apparent that the organization’s interests are or may become adverse to those of the constituent(s) with whom the lawyer is dealing.
So, if the lawyer advising the compensation committee and the lawyer representing the corporation have the same client (the corporation), what does it mean to say that the lawyer advising the committee is independent? Of what exactly is a lawyer representing a corporation required to be independent? If the idea is that the lawyer should be independent of management, that should already be the case – the lawyer’s client is the corporation. Moreover, professional rules, such as California’s Rules 3-310 and 3-600(D), already govern conflicts of interest vis-a-vis a lawyer’s client. The lawyer’s role as advocate and adviser should not be conflated with that of auditors whose job it is to provide an independent assurance function.
Finally, Congress’ insistence that an issuer provide “adequate funding” strikes me as unusual. I haven’t looked, but I would be surprised to learn that their are other examples of a Congress mandating that someone pay for a lawyer when legal representation isn’t required by the constitution.
A Massachusetts pension fund has filed a derivative lawsuit against Hewlett-Packard’s board members and former CEO that seeks an independent board chairman, three shareholder-nominated directors, and other novel governance changes. In an Aug. 10 lawsuit in California state court, the Brockton Contributory Retirement System alleges that HP’s board members breached their fiduciary duties, committed gross mismanagement, and wasted corporate assets by agreeing to pay as much as $40 million in severance benefits to outgoing CEO Mark Hurd. The pension fund further alleges that Hurd and interim CEO Catherine Lesjak engaged in insider trading in violation of California state law because they sold HP shares while in possession of non-public information.
Hurd was forced out by HP’s board on Aug. 6 after a company contractor made sexual harassment allegations, and a board-commissioned probe found that he falsified expense reports. The Palo Alto, California-based technology company’s shares lost almost $9 billion in value on Aug. 9, the first trading day after Hurd’s departure.
“Regardless of whether this was a firing ‘for cause,’ or a resignation, Hurd was not entitled to severance benefits under his employment agreement with HP, and the Board’s authorization of these payments was an abuse of their discretion and a violation of their duty of loyalty to HP and its shareholders,” the complaint asserts. HP has declined to comment on this lawsuit, according to news reports.
The complaint asks a court to compel the return of Hurd’s severance package and award triple damages based on the alleged insider trading. The Brockton pension fund also seeks a court order that directs the company to seek shareholder approval for an amendment to the company’s articles of incorporation to require that the chairman be an independent and non-executive director. The fund also seeks article amendments that limit the number of executive directors on the board, require stricter independence standards than mandated by the New York Stock Exchange, and require that all board committees be comprised of independent directors.
The pension fund also seeks the adoption of provisions to allow HP investors to nominate at least three board candidates, to permit greater shareholder input into board policies, to require that each board member attend a directors’ college to “ensure they understand their fiduciary obligations,” to permit shareholders to question all executive directors at annual meetings, and to “establish a more transparent process for receiving and evaluating shareholder proposals.”
The lawsuit was filed as a derivative compliant, which means that the company is the nominal plaintiff in the case and would receive any damages collected from Hurd, Lesjak, and the director defendants. In a typical derivative lawsuit, a shareholder must either ask the board to authorize the lawsuit or demonstrate that such a demand would be futile. In this case, the Brockton pension fund argues that the demand requirement should be excused because all the directors approved Hurd’s severance agreement and thus would not authorize a lawsuit that would expose them to personal liability.
HP’s board has faced derivative suits in the past. In 2006, two labor funds filed a derivative action over the $21.4 million severance package received by former CEO Carly Fiorina, who was forced out in 2005. A judge dismissed that case in 2007.
Investors also filed a derivative lawsuit over HP’s 2006 boardroom spying scandal, during which then-chairman Patty Dunn resigned. As part of a settlement with California’s attorney general and investors, the company adopted governance changes and revised its Standards of Business Conduct. In the most recent lawsuit, the Brockton pension fund contends that these measures “went largely unimplemented,” while the board allowed Hurd to serve both as chairman and CEO, and “was permitted to run HP as his own private fiefdom — free from Board oversight.”
When I first saw this press release from Towers Watson regarding how few companies are prepared for say-on-pay, I thought our marketing department had outdone itself since our far-reaching week of executive pay conferences comes up in less than a month – with an aggregate of over 50 panels on executive pay topics. If these conferences don’t help get you prepared, nothing will. You can either register for the three days of the “18th Annual NASPP Conference” (in Chicago) – or the two days of the “5th Annual Proxy Disclosure Conference” & “7th Annual Executive Compensation Conference” (in Chicago or by video webcast).
Here are highlights from the Towers Watson press release:
– Only 12% of respondents said they are very well prepared for the say-on-pay legislation, while 46% said they were somewhat prepared. Just under one-fourth of respondents (22%) didn’t know if their companies were ready.
– 69% said they were identifying potential executive pay issues and concerns in advance, while 60% said they were improving their CD&A to better explain the executive pay program’s rationale and appropriateness for the company. In addition, many companies indicated they are engaging with proxy advisors (44%) to discuss areas of concern, meeting with key institutional shareholders (29%) and preparing a formal communication plan (23%).
– More than one-half (59%) of respondents believe that proxy advisory firms have substantial influence on executive pay decision-making processes in U.S. companies. However, 42% said that guidelines established by proxy advisory firms have had no or minimal impact to this point on the design of their executive compensation programs.
With the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act a renewed focus has been placed on the alignment of executive pay with company performance. In addition to requiring Say on Pay – where companies will be seeking shareholder approval of compensation programs at least once every three years – the Act also requests that the SEC require filers to disclose information regarding the relationship between actual pay received by executives and company performance. Ensuring that pay is appropriately aligned with performance, a long debated and important shareholder issue regarding executive compensation, will now be brought further to the forefront of annual disclosures.
As Compensation Committees await SEC interpretation on the Act’s executive compensation provisions and begin thinking about how to accurately test and communicate to shareholders their executive pay and performance comparison, an interesting question arises: will companies be able to show that pay is in fact aligned with performance?
Despite the constant criticism of the lack of pay for performance in executive pay, we believe the answer is YES for most companies. Our micro and macro research, with our clients and in the broader market, has shown that executive compensation is indeed well aligned with company performance…when pay is properly calibrated as realizable pay.
In a recent partnership with Equilar, we studied pay and performance at 100 large U.S. companies (median market capitalization of $27B) that filed proxies in early 2010. Making the comparison between 2009 one-year total shareholder return (TSR) performance and 2009 realizable pay (base, annual incentive earned, current in-the-money value of restricted share and stock option awards, and payouts from long-term performance plans), our findings provide further evidence that there is pay for performance – showing that pay is well aligned with company performance (see Table 1). Our analysis for Table 1 finds that CEOs leading higher-performing companies have higher realizable values ($13.8M at median) than their counterparts at lower-performing companies ($8.6M), representing a 60% premium for CEOs of high-performing companies. Other findings include:
– The 2009 shareholder return for high-performing companies (those with above overall median TSR) was 41% and the CEO for these same high-performing companies earned $13.8M in realizable value for 2009.
– Low-performing companies returned -5% for shareholders while their CEOs earned realizable values below the overall median ($8.6M compared to an overall median of $10.6M)
Reviewing the annual change in realizable pay from 2008 to 2009 in relation to performance yields a similar result (see Table 2). There is differentiation in the change in realizable pay from 2008 to 2009 based on company performance. Specifically, high-performing companies delivered 46% to shareholders in 2009 while realizable pay for the CEOs increased by 61% and when shareholders lost (-6% for low-performing companies) CEOs did as well.
While this particular study finds that pay is well aligned with performance over a one-year period – 2009 a particularly important year given the volatile economic environment – we typically make this comparison over multi-year periods, three to five years and in some cases over entire CEO tenure. In fact, we think it is probably best to view the relationship between pay and performance over a longer time period than one year as many compensation programs are meant to span the long term just as many business decisions impact long-term company and shareholder performance. It is important note that the findings for our one-year study are consistent with our past studies of pay and performance over multi-year periods.
Many proxy advisory firms now run pay for performance analyses for their annual withhold votes; comparing TSR or other performance measures to some form of pay opportunity (typically from the summary compensation table). While it is still unclear what the SEC will mandate for this comparison within proxies – whether the required definition of pay will be comprised of summary compensation table values, options exercised and shares vested table values, some combination of the two, or something new entirely – we believe that the Dodd-Frank Act recognizes that pay opportunity is not the best measure of pay for comparison to company performance.
Compensation Committees can now strengthen their message to shareholders for Say on Pay by exploring the alignment between executive pay and performance. Our experience is that most companies already do pay for performance – low realizable pay when performance is weak and higher realizable pay when performance is strong – and that they should get credit for this with shareholders when it is time to vote.
As I blogged a few weeks ago, SEC Chair Schapiro announced that the SEC would go the extra yard ahead of its blistering rulemaking schedule and start accepting comments on its various projects right away through this Dodd-Frank comment page. The comment letter page is broken up by the Titles in the new legislation, with 31 separate areas for comment, including a section under Title IX which covers the governance and executive compensation provisions. Each rulemaking will have its own comment period as usual – and as required by the Administrative Procedures Act – but this “field day” may help to shorten the comment periods and get rules in place before next year’s proxy season.
When I blogged all that, I didn’t think that the SEC would receive much in the way of comments ahead of specific proposals. But the first few comment letters have started to dribble in on the executive compensation stuff, including this one from Frederic W. Cook & Co.
Recently, the Norwegian Corporate Governance Board proposed to revise its corporate governance code to require an absolute limit to performance-related compensation. And while companies listed in Norway would be able to decide at what level to cap performance pay, they would be required to disclose that limit to shareholders. Note that Norway is not part of the European Union.
– Vania Petrella and Gianluca Russo, Cleary Gottlieb Steen & Hamilton
On May 25th, the Italian Government adopted a draft law decree contemplating, inter alia, an additional 10% tax to be levied on the portion of any variable compensation paid (in the form of bonuses and stock options) to certain executives in the financial sector exceeding three times the fixed component of the executives’ remuneration (the “Additional Tax”). The law decree became effective on May 31, 2010 upon publication on the Official Gazette (Law Decree No. 78) and it was confirmed by the Italian Parliament on July 31st (Law No. 122).
The rule introducing the Additional Tax has not been amended during the confirmation procedure. Therefore, as of May 31, 2010, any portion of variable compensation taking the form of bonuses or stock options exceeding three times the remuneration’s fixed component is subject to the Additional Tax. However, such tax is applied exclusively to certain executives (i.e.employees treated as “dirigenti” and certain consultants and directors characterized as quasi-employees (“collaboratori coordinati e continuativi”) for labor law purposes) employed in the financial services sector. The Additional Tax takes the form of a withholding tax and is effectively borne by the recipient; it does not affect the applicable social security regime.
Since the new legislation does not include a grandfathering rule for plans already launched or awards already vested at the time Law Decree No. 78 became effective, such plans and awards should be subject to the Additional Tax.
Black-letter law raises some doubts as to the actual scope and application of the new rule. For instance, it is not clear whether it applies to options only or also to other equity-settled awards, and how to determine the time frame material to compute the relevant threshold (i.e. three times the fixed component). For the time being, there is no indication as to whether and when the tax administration will issue any guidance with respect to this rule. Read more in our memo.
Below is a recent article from the NY Times’ DealBook:
Corporate boards appear to routinely use compensation peer groups to artificially inflate pay for their chief executives, helping to contribute to the cascading increases in executive compensation over the last several years, according to an academic study on corporate governance. While the rate of pay increases was nearly 11 percent in one recent year, the study highlights one of the various ways that corporate boards go about determining huge compensation packages for executives.
Executive pay has increased substantially over the last few years. For example, in 1965 chief executives at major American companies earned 24 times more than a typical worker, while in 2007 they made 275 times more, according to the Economic Policy Institute. This sharp increase in income for chief executives, coming as wages for ordinary Americans remained relatively flat, has become one of the more perplexing questions in social science and business. Are chief executives that much more valuable now than they were 45 years ago?
Social scientists have looked at a number of reasons for the disparity in pay, with many believing that it has something to do with weak corporate directors simply giving into the demands of management, which are often leading the boards. The common answer as to why chief executives are paid so much money is that boards want to “retain talent” and fear losing their chief executive to a competitor. Compensation committees on boards hire consultants to advise them on how much other chief executives at rival companies are paid to make sure that they are not undercutting their own top executives.
Michael Faulkender of the University of Maryland’s R.H. Smith School of Business and Jun Yang of Indiana University’s Kelley School of Business, sought to answer these questions in a new study examining the use of comparable companies in the role of determining chief executive compensation. The study, “Inside the Black Box: The Role and Composition of Compensation Peer Groups” (an abstract is available here), found that companies usually benchmark their executive pay with peers in their industry group, but that they also choose peers that pay more than others.
“Boards do look at labor market practices, so this is not an entirely corrupted process,” Ms. Yang told DealBook. “They do look at industry, they do look at size, the past talent flows, their visibility in everything, so that’s still the major part in the peer choices.” “But on top of that, if you can choose between company A or company B, which are pretty similar except that A pays their C.E.O. a little bit more generously than B, the board members tend to choose the slightly better paid company as the peer,” Ms. Yang said.
The research showed that from 2006 to 2007 this selection bias toward the higher-paying peers led to a 10.7 percent increase in the median pay for chief executives for more than 600 companies in the Standard & Poor’s 500-stock index and S.&P. MidCap 400 index, equating to a median pay increase of $470,000. “If we see this each and every year, the compensation is going to go up and up,” Ms. Yang said. “You can call this an upward spiral, you can call this ratcheting up, but yes, it is going to go up.”
The motivation of corporate boards to consciously chose peers that are more generous than ones that are very similar but are just less generous helps to explain, at least in part, the huge increases in chief executive compensation over the years. But this does not completely explain why boards believe that their chief executives are necessarily worth the extra cash. In the end, the boards may feel that they must do whatever it takes to make their chief executives happy, which at the end of the day may or may not be in the best interest of shareholders.
Last year, someone from ISS blogged about 13 Canadian companies that agreed to try say-on-pay based on a resolution drawn from a draft model “say on pay” policy crafted by the Canadian Coalition for Good Governance (CCGG), which represents 41 investors managing over $1 trillion in assets.
In January, the CCGG finalized their model SOP policy. That policy – as well as a model shareholder engagement policy – is posted on this CCGG page. A list of Canadian companies that have adopted SOP is maintained on this SHARE (Shareholder Association for Research & Education) page.