– Paul McConnell and Jeff McCutcheon, Board Advisory, LLC
The Dodd-Frank bill contains two new disclosure requirements regarding executive pay: the ratio between the CEO’s compensation and that of the median employee, and the relationship between compensation actually “paid” to executives and company stock performance.
The new pay ratio is flawed on many fronts: it ignores organizational scope and size, it can be biased by outsourcing lower-paid work, it ignores the inordinately large role of benefits in the pay of lower level employees, and most importantly, it ignores the differences between guaranteed compensation and the risk inherent in equity based pay.
In contrast, the disclosure of pay in relation to performance has the potential to present a true picture of executive pay from which shareholders and the public can draw meaningful comparisons. The key is how the SEC eventually defines “pay”.
The Amounts Shown In The Summary Compensation Table Are Not Pay – Disclosure of executive pay has vastly improved over the last two decades. We now have accurate data on all the relevant components of compensation. While this data is extremely useful in designing competitive pay opportunities, the current required format does not show what executives actually earn — or how that pay might relate to company performance.
Cash bonuses are typically paid for financial performance versus targets, rather than for shareholder gain. Presumably, the cash payment relates to drivers ultimately reflected in stock price, but not necessarily reflected in the current year stock price. For most executives, the largest portion of their reported pay is the disclosed value of stock awards. For performance based stock, the disclosed value is a “target” value on the date awarded. It does not reflect the actual number of shares earned or the realized value of the stock over the requisite holding period. Similarly, options awards are shown as the expected value from a probability distribution, not the actual realized gains.
These valuations were never intended to represent the actual value the executive would receive, and were only intended to satisfy the accounting world. Consequently, using current proxy data to explain the link between pay and performance is like using a baseball slugger’s “at bat” statistics to explain the team’s won/loss percentage.
The Best Comparison Comes From a Multi-Year View of Realizable Pay – To best evaluate board decisions regarding pay and to test the overall alignment of executive pay to investor gains, one must compare the value actually realized by the executive to the returns of investors. For this purpose we look at the cumulative salary and cash bonuses received over a multi-year period (e.g., five years) plus the ending-period value of actual stock awards granted, stock acquired from previous awards, and embedded option gains (e.g., the paper profits).
Such pay comparisons are extremely important when evaluating the relative wisdom of a board and their executive pay decisions. By looking at the cumulative effect of decisions over a 5 year period – perhaps the shortest time period when executive effectiveness can be reasonably assessed – management and the Board can more effectively establish for investors the degree of alignment between executive rewards, business strategy and shareholder gains. The data required to perform these calculations are readily available through existing public company disclosure in proxy statements, related SEC filings, and commercial data sources. The general public could produce these calculations; however, use of multiple data sources and obscure reporting rules makes it difficult and time consuming.
Our investor and board clients have found this longer-term pay comparison to be an extremely effective tool for understanding the compounding effect of compensation decisions over time, and as an aid in calibrating prospective equity and cash incentive decisions. Perhaps more importantly, the analysis serves to bridge the communications gap between investors, the board and executive management by simplifying pay arrangements in terms everyone can easily grasp.
Much of the public’s understanding (or misunderstanding) of executive pay is driven by the annualized and hypothetical values disclosed in proxies. Regrettably, the format of the SEC disclosure also shapes how many boards make annual executive compensation decisions. The SEC will not release new rules until the second quarter of 2011, but regardless of the reporting form eventually chosen by the SEC, forward thinking Boards should supplement their CD&A disclosure with a true pay for performance analysis such as that presented above. For most boards this can convey a critical story line for investors wanting to understand how and why executives are rewarded.
A week or so ago, the WSJ ran the following op-ed from Holman Jenkins (this came out before the former Comverse CEO agreed to a $53 million settlement with the SEC):
An array of influential friends urged leniency for Bruce Karatz in his stock-option backdating sentencing last week, including former Los Angeles Mayor Richard Riordan and philanthropist Eli Broad. But these personages weren’t the reason Judge Otis D. Wright II rejected prosecutors’ request for a six-year prison sentence and instead gave Mr. Karatz probation. Judge Wright said he couldn’t see putting the former CEO away for a crime that did no harm to his company, KB Home, or its shareholders.
So endeth another episode in the annals of backdating, in which a fairly meaningless violation of accounting rules (though violation it was) became trumpeted from the media pulpits as the business crime of the century. We suppose it’s humanly understandable that, finding themselves compelled to bring these cases, federal prosecutors stretched and kneaded the evidence to fulfill the media’s stereotype of backdating as theft and fraud against shareholders. Let this be a lesson to the children in how not to respond constructively to cognitive dissonance.
Such prosecutorial misconduct led to the dismissal of the backdating case last year against Broadcom founder Henry Nicholas. A judge also threw out the guilty plea of his partner, Henry Samueli, saying he didn’t think Mr. Samueli committed any crime. The first conviction of former Brocade Communications CEO Greg Reyes was similarly overturned on grounds of prosecutorial misconduct (though Mr. Reyes was retried and convicted by a new jury, and now is appealing). A further irony is that backdating was abetted by a nonsensical accounting rule at the time that treated one kind of option as having value and another kind as having no value (though both have value). This split-the-baby rule itself arguably evolved out of the media’s perennial insistence on portraying stock options as emblems of greed rather than as business tools.
By the estimate of the University of Iowa’s Erik Lie, some 2,000 public companies must have engaged in backdating at some point, as testified by otherwise inexplicable patterns of options pricing. Some 150 companies eventually restated their past results to conform to the proper rule for expensing such options. Yet only a few executives were singled out for criminal prosecution, in a manner that left an observer scratching his head as to why the justice roulette wheel chose some but not others.
Further reason for pause: The handful of subsequent convictions seemed to turn less on the act of backdating than on the self-preserving prevarications executives uttered once the posse arrived at their doorstep.
The ultimate statement in this vein, of course, was the decision by Kobi Alexander, former CEO of Comverse Technology, to decamp to Namibia. We can think of two reasons somebody might flee the law–because he fears he will get justice, or fears he won’t. Presumably Mr. Alexander will one day appear in a U.S. court. It will be interesting to see what countenance he puts on his decision to become a fugitive–perhaps he will cite as a precedent the behavior of the legal system in Salem, Mass., circa 1692.
Meanwhile, the larger lessons of the backdating furor were drawn in an epic piece in May in the American Bar Association’s ABA Journal. By freelance reporter Anna Stolley Persky, the piece connected the dots between (among other things) the backdating witch-hunt, the tainted prosecution of Sen. Ted Stevens, and the government’s use of the vague “honest services” statute to criminalize various kinds of behavior post hoc (a practice the Supreme Court finally curbed earlier this year).
One critique can be found in the title of a book by Boston defense attorney Harvey Silverglate: “Three Felonies a Day: How the Feds Target the Innocent.” Mr. Silverglate believes that only a mobilization of “civil society” can stop what he calls rampant abuse of prosecutorial discretion. In contrast, former federal prosecutor Joseph diGenova puts the onus on DOJ overseers: “If anyone thinks it’s anything other than prosecute at any cost, then they are wrong. . . . The department has been AWOL in supervising the ethics of its prosecutors,” he told ABA Journal.
But it’s also hard not to see the self-interested ethics of the plaintiff’s bar spilling across the entire legal profession. In their official roles, prosecutors invent Kafkaesque new ways to ensnare the unpopular wealthy in legal trouble, then jump to private law firms and make seven-figure livings protecting the wealthy from the monster they themselves unleashed. Shakespeare had a solution, but, alas, this would also be illegal. Thus it must fall to bloggers, the media and judges like Judge Wright to protect Americans from overzealous prosecutors.
We have posted the transcript for our recent popular webcast: “Gearing Up for Say-on-Pay: What Clients Are Asking Now.” Don’t forget that those that renew for 2011 now – all 2010 memberships expire at the end of the year – will gain access to these two upcoming say-on-pay webcasts:
Just after I heard Pat McGurn speak this morning at the ABA Fall Meeting, ISS issued it’s 2011 Policy Updates. Courtesy of Ed Hauder of Exequity, here is a brief summary of the Updates that relate to executive pay:
– Equity Compensation Plans: Burn Rate–ISS is making a change to the Burn Rate policy so that the burn rate caps cannot increase or decrease by more than two (2) percentage points from year-to-year. The 2011 Burn Rate table will be released as part of ISS’ 2011 Summary Guidelines in December 2010.
– Say When on Pay Vote–ISS will support annual advisory votes on compensation, as its draft policies released at the end of October suggested. However, it still remains unclear what ISS will do if a company chooses a different frequency or the shareholder vote supports a different frequency.
– Problematic Pay Practices–ISS is revising the list of “major” problematic pay practices which alone could trigger application of the policy. The “major” problematic pay practices are now identified as the following:
– Repricing or replacing of underwater stock options/SARs without prior shareholder approval (including cash buyouts and voluntary surrender of underwater options);
– Excessive perquisites or tax gross-ups, including any gross-up related to a secular trust or restricted stock vesting;
– New or extended agreements that provide for:
1. CIC payments exceeding 3x base salary and average/target/most recent bonus;
2. CIC severance payments without involuntary job loss or substantial diminution of duties (Single” or “modified single” triggers);
3. CIC payments with excise tax gross-ups (including “modified” gross-ups).
– Additionally, ISS is slightly reworking how the presence of problematic pay practices will influences its vote recommendations. As before in such cases,
– ISS will recommend against management say on pay (MSOP) proposals,
– Then ISS will recommend against/withhold on compensation committee members (or in rare cases the full board) in (i) egregious situations, (ii) when no MSOP item is on the ballot, or (iii) when the board has failed to respond to concerns raised in prior MSOP evaluations, and/or
– ISS will recommend against an equity incentive plan proposal if excessive non-performance-based equity awards are the major contributors to a pay-for-performance misalignment.
– Problematic Pay Practices-Commitments–ISS will no longer accept future commitments on problematic pay practices as a way of preventing or reversing a negative vote recommendation.
– Voting on Golden Parachutes–ISS sticks pretty close to the draft policy it issued in late October 2010. Such proposals will be evaluated on a case-by-case basis, but the presence of certain practices could lead ISS to recommend against the proposal.
Recently, Professor Bainbridge ran this blog about a paper entitled “Riskmetrics: The Uninvited Guest at the Equity Table” written by Stanford business school professors David Larcker and Brian Tayan that that relates to the SEC’s proxy plumbing project.
With the new year quickly approaching, many companies are well into the process of considering whether to seek shareholder approval for additional share authorizations for their equity plans. In connection with this review, publicly-held companies that have any type of performance-based incentive compensation plan should also review whether performance-based goals need to be reapproved by shareholders at the next annual meeting pursuant to the regulations under Section 162(m) of the Internal Revenue Code.
Section 162(m) of the Code imposes a $1 million annual limitation on the deduction for compensation paid to each of the CEO and the three most highly compensated executives, other than the CFO, of publicly-held companies. However, “performance-based” compensation is not subject to the deduction limitation of Section 162(m), as long as it meets certain requirements. One such requirement is that the material terms of performance goals must be disclosed and approved by shareholders before the performance-based compensation is paid. For companies whose compensation committee has the authority to change the targets under a performance goal following shareholder approval, Section 162(m) regulations require that the performance goal be reapproved by shareholders no later than the first shareholder meeting that occurs in the fifth year following the year in which shareholders previously approved the performance goal.ยน In other words, reapproval of the performance goals by shareholders is needed at least every five years.
We remind public companies to check the date of the last shareholder approval for performance-based plans, and to ensure that the last shareholder approval covered performance goals for purposes of Section 162(m). Both cash and stock incentive plans may need reapproval at least every five years. If a company’s plan last received approval in 2006, shareholders may need to reapprove material terms of performance goals this coming year.
Not all plans that qualify for the performance-based compensation exception require reapproval every five years. Shareholder reapproval is not necessary if a company relies on an approach to plan design that is commonly referred to as a “plan within a plan” or an “umbrella” plan. Under that approach, generally, a fixed formula (often based on a percentage of earnings) is approved by shareholders and dictates the maximum amount of the payment to the covered executives. The compensation committee retains negative discretion to reduce payouts below the maximum, subject to whatever objective or subjective criteria the compensation committee may wish to apply from year to year. Similarly, a plan that permits only stock options and stock appreciation rights to be granted at fair market value will not require reapproval.
We’re done! Just in time for mandatory say-on-pay, Dave Lynn and Mark Borges have finished updating the Lynn, Borges & Romanek’s “2011 Executive Compensation Disclosure Treatise & Reporting Guide.” This means that:
2. Hard copy – For those that want a hard copy of this massive 2011 Treatise, note that it is not part of CompensationStandards.com – so it must be purchased separately. However, CompensationStandards.com members can obtain a 40% discount by trying a no-risk trial to the hard copy now. This will ensure delivery of this 1000-plus page comprehensive tome as soon as it’s done being printed after Thanksgiving.
If you need assistance, call our headquarters at (925) 685-5111 or email info@compensationstandards.com.
Although the concept of shareholder advisory votes on executive compensation has been discussed and debated for years, it’s only been since the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act in July that most companies have given much thought to what say on pay might look like in practice for them. Now that companies and investors have had several months to digest Dodd-Frank’s provisions and the SEC has now proposed rules to guide companies in conducting their shareholder votes, some preliminary points of view – and even a few areas of agreement – are beginning to emerge on how companies can best implement say on pay.
One thing that’s clear is that say on pay and the other Dodd-Frank governance and executive compensation reforms have been the hot topics of late on the conference circuit. This article summarizes what we have heard in recent sessions around the country.
Voting Frequency
One of the main topics of discussion is the appropriate frequency of say-on-pay votes. Under Dodd-Frank, companies must conduct a say-on-pay vote at least once every three years and must allow shareholders to vote on their desired frequency at least every six years. Neither vote is in any way binding. For the 2011 proxy season, companies will need to conduct both say-on-pay and say-on-frequency votes.
Based on their comments at recent conferences, many proxy advisors and institutional investors appear to consider annual votes as their “default” preference. At least one large investment firm is already writing letters to the companies in its portfolio requesting annual votes, and some investors expect companies are likely to receive formal shareholder proposals seeking annual votes.
While investors acknowledge that there may be situations in which less frequent votes are appropriate (e.g., compensation programs with sufficient long-term orientation, true performance goals and little or no board discretion), the onus will clearly be on companies to make a strong case for any frequency other than annual votes. Articulating a sound rationale in the proxy statement will be critical in these cases. What’s more, many observers note that there will be an added possibility of negative votes for board members in years in which no say-on-pay vote is held. In other words, the view is that annual votes may even “protect” compensation committees.
Defining Success
Another hot topic is how success or failure will be defined in a say-on-pay world. For most companies, a majority of shareholders casting negative votes on executive compensation would be viewed as an embarrassment, even though the vote is advisory. But what about something less than a clear majority “no” vote? It’s worth noting that more than 80% of the U.S. companies that have conducted say-on-pay votes thus far have received support from 80% or more of their shareholders casting ballots, although negative votes have occurred in a few cases.
While the stated views on this issue varied somewhat, there are emerging opinions that negative vote levels above 15% should be viewed as a signal that shareholder concerns need to be examined or addressed, depending on the circumstances. The trend from one vote to the next will also be an important barometer of shareholders’ views. For example, a company that goes from 95% favorable in one say-on-pay vote to 80% the following year may have more to worry about than a company that consistently receives 75% shareholder support for its pay programs.
Shareholder Engagement
There’s also been much discussion of whether and how companies should engage their shareholders in a dialogue about executive pay. The prevailing view on this score is that shareholder engagement efforts need to be situational, rather than an across-the-board activity undertaken by all companies just for the sake of it.
For example, institutional investors note that shareholder engagement might justifiably be less of a priority for companies with sound pay practices and little or no history of shareholder concerns about pay matters. Investor groups also have expressed the view that they don’t want to be cast as “pay czars” and have no interest in setting pay levels. But, in cases where shareholders do have significant concerns about pay, companies are advised to establish effective and ongoing channels of communication to help them understand and address investors’ concerns.
Varying Approaches
Similarly, it’s clear that many investors will take a situational approach in preparing for and casting say-on-pay votes. Some investor groups and proxy advisors say they’re planning to focus primarily on the “outliers” (i.e., companies that push the envelope in terms of questionable pay practices). Priorities also vary in terms of what investors will scrutinize most closely. Examples mentioned in recent forums include:
– Pay practices and programs, which may be reviewed from the perspective of “do they make sense”
– A combination of committee process, pay practices, pay for performance and CEO pay
Other investors say no one thing will be most important and that they’ll be looking to understand the big picture. Moreover, it seems clear that the largest institutional investors will follow their own counsel and may rely less on the recommendations of proxy advisors in making their vote decisions. This does not necessarily diminish the influence of leading proxy advisors if smaller institutional investors find themselves relying on their vote recommendations when faced with the task of reviewing many more say-on-pay proposals.
One point of agreement regarding say on pay is that the quality and clarity of companies’ proxy disclosures on executive compensation should improve next year for some companies dramatically. Many investors feel that improvements in the Compensation Discussion and Analysis (CD&A) should be the starting point for companies in preparing for say on pay. Desired CD&A enhancements include executive summaries (e.g., to highlight changes and provide context) and more graphics, especially to help shareholders see the link between executive pay and company performance. Overall, investors want more clarity and insight, and less legalese and boilerplate language.
A Big Deal?
Given the widespread expectation that most companies will enjoy high levels of shareholder support in their say-on-pay votes and that say on pay will have minimal impact on pay at the vast majority of companies, one frequently debated issue has been whether say on pay will be a big deal or a big bust. The consensus is that say on pay will not be a big deal for many companies, despite the general perception that it will be a “game changer” for executive pay overall.
Ultimately however, perceptions of say on pay vary widely depending on which side of the fence one sits on. While shareholder groups may see it as a welcome addition to the corporate governance landscape, others tend to view the votes as a distraction that will provide little insight into the compensation issues shareholders care about and will have no significant impact on executive pay levels.
I’ve developed an executive pay model that might be useful to directors and human resource professionals. I’ve used the 18 years of history in the Execucomp database to develop a model of future three year shareholder return as a function of four key pay variables (pay level, pay leverage, pay equity and stock ownership) and a set of company variables. The model can be used to quantify the excess return attributable to the four key pay variables and to make value enhancing trade-offs between the four factors. 55% of the company-years have a positive predicted excess return and 45% of the company-years have a predicted three year excess return of at least 3% (positive or negative). The formula for the predicted excess return is shown on p. 18 of this presentation.
I’ve also proposed to the SEC a “pay-versus-performance” analysis that you might find interesting. The analysis uses data on relative pay and relative performance to calculate three quantitative measures investors can use to assess a company’s pay program: a measure of incentive strength (pay leverage), a measure of incentive efficiency (the correlation of relative pay and relative performance) and a measure of compensation cost (relative pay at industry average performance). My comment letter shows the analysis for Wal-Mart, Pfizer and Bank of America to demonstrate that the analysis can be done with publicly available data.
This recent study entitled “CEO Pay and Shareholder Activism” by Prof. Fabrizio Fabri, Yonca Ertimur and Volkan Muslu allegedly refutes fears expressed by say-on-pay critics by showing that “just vote no” campaigns and voluntary say-on-pay votes did not lead to radical changes pushed by special interest groups. It’s worth a read.