The Advisors' Blog

– Arthur Kohn, Cleary Gottlieb Steen & Hamilton

It is obvious that there is no simple and broadly accepted way to assess either the performance of a company’s management team or the value of a pay package. In that light, the challenges of developing rules and disclosure in response to the new pay-for-performance disclosure obligation under Dodd-Frank become clear. Aside from widely-noted issues related to the valuation and timing rules for inclusion of different elements of pay, we readily identified many types of business and other considerations that could materially affect the disclosure approach in our recent memo. We suspect that companies will identify many others as they begin to consider how the new requirement could apply to them. We describe a few of them below:

– Lean Management – Arguably, pay versus performance assessments should take into account how much “bang for the buck” a company gets from its total management team. That is, assume two companies that have performed equally well and in which the five most highly-paid executives have earned the same compensation. Now assume further that one of the companies has a senior management team that is twice as large as the other. It would seem that the company with leaner management should provide pay versus performance disclosure that tells that story by looking at the issue on a relative basis and including more than just named executive officers in its analysis. Precise data to support this approach might be difficult to obtain, but it may not preclude the company from making the point.

– Cyclical Businesses – Companies in classically cyclical industries should consider presenting data in a manner that reflects that business reality. Possible approaches could include presenting data using multiple periods, or measuring performance based on the extent to which the variation in profitability was mitigated through the entirety of the cycle.

– Crisis Management – A disclosure approach that fails to distinguish performance in ordinary business environments from performance during short-term crisis periods will often not provide meaningful information. During the recent financial crisis, for example, the performance goals that underlie most incentive programs were set aside as many companies focused on steps needed to manage through the crisis. In addition, not surprisingly, management turnover increased, particularly at financial institutions. In order to present useful information on pay versus performance, those factors should be taken into account.

– Business Organization and the Identity of the NEOs – Between one and three of the named executive officers for a company will typically have divisional responsibilities, while the CEO, CFO and one or two other NEOs will have corporate-wide responsibility. Different divisions could have very different performance profiles. Often, using only corporate-wide performance metrics – or a crude “lumping together” of divisional metrics – to assess the relationship of pay to performance will be uninformative and unreflective of the actual correlation between pay and performance. Similarly, aggregating the pay of the entire executive team may mask significant interesting information about the relationship of pay to performance.

– Allocating Pay to Performance Periods – There are both obvious and subtle challenges in deciding how to best allocate pay to specific performance. For example, should an option be considered “actually paid” – i.e., taken into account in the pay for performance analysis – at the time it is granted or exercised, or at some other time? Should it matter whether the number of options awarded is fixed by contract or practice in relation to base salary levels, or instead varies from year to year based on individual performance assessments?

– The Need to Attract – Should elements of compensation that are explicitly not intended to reflect performance be included in the analysis? In many industries, companies must pay signing bonuses or other guaranteed minimum payment elements to attract employees. Is it appropriate for those elements of compensation to be excluded from the pay for performance presentation on the basis that the compensation committee’s incentive pay decisions should not be obscured by pay elements that are not intended to be performance-driven?

– Risk, Diversity and Other Intangibles – The correlation of pay to performance may be affected by aspects of compensation plan design whose purpose is to mitigate risk. Similarly, other “intangibles,” such as diversity or relative pay levels between senior management and rank and file employees, may be taken into account in assessing pay for performance. Can and should these factors be considered?