– Broc Romanek, CompensationStandards.com

Last week, ISS issued this set of FAQs about its newly-minted compensation policies; 15 about pay-for-performance, 3 about management say-on-pay responsiveness and 2 about equity plans.

– Broc Romanek, CompensationStandards.com

Recently, ISS posted this commentary on ISS’ new pay-for-performance methodology by Carol Bowie, ISS’s Head of Executive Compensation Research (here’s ISS’s white paper discussing the new methodology).

We have posted memos analyzing ISS’s new methodology in our “ISS Policies & Ratings” Practice Area.

ISS recently issued this new paper entitled “Post-Crisis Trends in CEO Pay.”

– Broc Romanek, CompensationStandards.com

In the wake of President Obama’s State of the Union address, the front-page headline in the Washington Post screamed “Obama: Nation Must Address Inequality.” Some claim that the President is playing a class warfare card ahead of the November elections and maybe he is. But that is because he can. Not only is it abundantly clear that the vast majority of those in this country – and around the world for that matter, remember Britain’s actions just this week – are angry about increasing pay disparity, but quite a few experts believe our country’s ability to continue to be a high achiever is at risk because the rich are getting richer at the expense of the middle class. So even more than it was for the last Presidential election, excessive CEO pay will be a lightning rod once a GOP nominee is found and we head into the general election.

So what does this mean for advisors that help set CEO pay? It means a lot because the governance reforms of the past few years have changed only a few practices at the margins – but the bulk of the procedural deficiencies that led to an unsightly climb in pay over the past two decades remain. As I’ve said many times, boards need to get over their heavy reliance on peer group surveys since they are well known to be unreliable given that most boards sought to pay their CEOs in the top quartile for many years – thus tainting the database with a slippery slope upwards. How can boards continue to use these as a crutch when the plaintiff’s bar can so easily prove that the data is unreliable – and thus directors arguably didn’t fulfill a fiduciary duty because they knew they weren’t fully informed by not considering alternatives?

There are still too many cases of underachieving CEOs earning a lifetime’s worth of money in a single year. Sometimes they are fired before a year of service is even over – yet they walk off with a more than generous severance package. And this is not just a handful of outliers – this is the norm. It is far past time to do something about it.

An Alternative to Peer Group Benchmarking? Internal Pay Equity

Recently, a group of trade associations jointly sent this letter to the SEC regarding the need for further research before implementing Section 953(b) of Dodd-Frank, the pay ratio provision. The SEC Staff repeatedly has noted that Dodd-Frank grants the SEC fairly narrow latitude to veer from what Section 952(b) dictates, so I’m not sure how successful this letter will be. And I am well aware of the technical issues – and potential burdensome costs – of how the provision was written by Congress.

But how are boards (and their advisors and trade associations) embracing the spirit of this law? We’ve been touting internal pay equity as an untainted alternative to peer group benchmarking for the better part of a decade. We’ve told the story about how American capitalist J.P. Morgan is reputed to have had a rule that he would not invest in a company whose CEO was paid more than 50% above the executives at the next level. He reasoned that, if the CEO was paid more, he wouldn’t have a team but only courtiers. Internal pay is a primary factor when a company determines how to pay its workforce – why shouldn’t that principle apply to how CEOs get paid?

It’s shocking to me how few companies employ internal pay equity today. It’s use by DuPont, Whole Foods and a handful of others is no secret. And Dodd-Frank’s mandate for disclosure is well known. Shouldn’t boards demand to see what those ratios look like ahead of the mandated disclosure? And even more important, as noted above, shouldn’t boards demand to see those ratios to protect themselves from liability given the known bad data in the peer group surveys they get year after year? Of course, advisors should be willingly recommending the use of this alternative since it’s their job to protect the board. Sadly, most advisors blindly adhere to the status quo as too often happens.

I just can’t see what is wrong with putting together internal pay numbers for a board to consider. Where is the evil here? I suppose the downside is it likely will reveal how badly the board has been doing its job setting CEO pay levels over the past 20 years when historical numbers are crunched. But it’s better to make a fix now than perpetuate the problem. Note that I am not saying boards need to demand the ratios as called for by Section 952(b) as simpler ratios are easy to generate. We have sample spreadsheets posted in the “Internal Pay Equity” Practice Area on CompensationStandards.com.

By the way, I also don’t see any problem with using peer group benchmarks either. It’s just that the data in those surveys now are useless due to “pay in the top quartile” craze. There needs to be a reset before that type of data can be relied upon again. This reset will be hard to do, but it’s necessary and certainly doable, particularly if CEO pay levels are brought down to Earth on a widespread basis. The longer boards wait, the harder the medicine will be to take. See Exhibit A: Congress trying to force it upon boards through a misguided formulation of Section 953(b) of Dodd-Frank. If boards hadn’t waited so long to consider internal pay equity, Congress probably wouldn’t have felt compelled to act…

– Broc Romanek, CompensationStandards.com

As noted in its Form 8-K, Actuant is the first company holding its annual meeting in 2012 to fail to gain majority support for its say-on-pay with only 46% voting in favor. A list of the Form 8-Ks filed by the “failed” companies is posted in the “Say-on-Pay” Practice Area.

– Broc Romanek, CompensationStandards.com

As I’ve blogged before, the United Kingdom has been on a path to revise its executive compensation laws to rein in excessive pay. Yesterday, the UK announced a slew of proposals that would push the envelope in the executive pay area – here are the proposals (or the closest thing I could find to them), as well as British Business Secretary Vince Cable’s oral statement, a summary of responses to the related discussion paper and a comparison with the High Pay Commission’s report that came out a few months ago (note that the HPC is not an independent commission; it’s a left wing charity). And here is a Towers Watson memo, ISS blog and NY Times article discussing these proposals.

The proposed major changes include:

– Say-on-pay votes would be binding
– Approval threshold increased to 75% from 50%
– At least two compensation committee members would have no prior board experience
– Clawbacks of bonuses if executives failed
– Enhanced disclosures

It’s notable that Britain’s opposition party is quoted in media reports as criticizing these proposals as not going far enough! Is this looking at tea leaves for the US? Remember Australia’s new “two strikes” law…

– Broc Romanek, CompensationStandards.com

We have posted the transcript for our recent webcast: “The Latest Developments: Your Upcoming Proxy Disclosures-What You Need to Do Now!”

– Broc Romanek, CompensationStandards.com

Last week, Mark Borges gave us the disturbing news on his blog that: “Since the middle of December, I’ve been monitoring what companies have been disclosing in their Compensation Discussion and Analyses about the impact of last year’s “say-on-pay” vote. Probably the most startling thing I’ve discovered is the number of companies that have failed to provide the disclosure entirely (even though it’s required by Item 402(b)(1)(vii)). I’d say that almost 15% of the CD&A’s I’ve read don’t address the subject at all.” He then went on to pan the uneven quality of the disclosure and gave examples. Not good – although I guess the tea leaves were being read when I blogged back in September that companies seemed to be slow to engage in the wake of their votes last season.

Last month, Barbara Nims and Gillian Emmett Moldowan of Davis Polk blogged that – as of December 16th – 14 large accelerated filer companies have filed proxy statements for the 2012 season and noted that the ten companies with high shareholder approval ratings (83% and higher) have provided simple and unremarkable disclosure about what happened last season.

– Broc Romanek, CompensationStandards.com

In this memo, Eric Larre of Towers Watson notes that the results of his firm’s recent survey of 265 companies reveal the potential for some unpleasant surprises at the close of the current executive pay cycle. Based on their operating performance through the end of October in what’s been a relatively good year for many companies, a majority of the responding companies anticipate that annual bonus pools will be funded at or above target levels, and almost half also project above-target funding for long-term incentive cycles ending in 2011. What’s more, very few of the respondents anticipate that their compensation committees will apply discretion to make adjustments to formulaic incentive payouts.

In short, many companies appear to be viewing the current incentive cycle as a time for “business as usual,” with executive incentive plans paying out in accordance with the plan formula and specific performance goals for the period. However, for the 42% of the responding companies that expect their companies’ shareholders to see negative total shareholder return (TSR) in 2011, it’s likely that some companies could experience a chilly response to the news of their incentive payouts for 2011 operating results from investors who view performance from the perspective of portfolio returns. It’s a very different landscape for investors today versus a year ago, and compensation committees and management should already be considering how different perspectives on pay for performance can best be addressed in their 2012 proxies.

– Broc Romanek, CompensationStandards.com

I talked to Ross Kerber of Reuters when he was working on this story a few times – the article repeated below digs into what is truly a perplexing set of circumstances:

Federated Investors Inc (FII.N: Quote, Profile, Research, Stock Buzz) objected to hundreds of executive pay packages in last year’s corporate proxy voting, a rarity in the don’t-rock-the-boat mutual funds industry. A review shows ambiguities in Federated’s record as a shareholder activist, however. For one thing, at the same time Federated mutual funds rejected pay plans at the likes of Bank of America Corp (BAC.N: Quote, Profile, Research, Stock Buzz), Apple Inc (AAPL.O: Quote, Profile, Research, Stock Buzz) and General Electric Co (GE.N: Quote, Profile, Research, Stock Buzz), they backed directors who set the pay.

Also, labor leaders do not view Federated as an ally in their efforts to reign in pay and other executive powers, since the funds also sided with management in controversial governance questions at companies such as Abercrombie & Fitch Co (ANF.N: Quote, Profile, Research, Stock Buzz) and Nabors Industries Inc (NBR.N: Quote, Profile, Research, Stock Buzz).

Federated’s voting “seems almost schizophrenic,” said John Keenan, corporate governance analyst for labor union AFSCME. Executives at family-controlled Federated would not discuss voting by the funds, a spokeswoman said. Federated’s outlier stance on proxy voting reflects how even the most striking votes may have just a minor impact on CEO pay under new rules passed after the financial crisis.

The goal was to give shareholders more oversight. Under so-called “Say on Pay” provisions of the 2010 Dodd-Frank financial reforms, most companies must hold advisory votes on executive compensation at least once every three years. The rule became effective last year and most companies got stamps of approval. Of 2,481 companies in the Russell 3000 index, through October only 38 failed to get a majority of shareholder support on pay, according to New York research firm GMI. Another 157 got less than 70 percent approval. Many of these companies now face pressure to make changes, since proxy advisory firms have promised closer scrutiny in 2012 of companies that did not get solid majorities last year.

Figuring out what changes to make may be difficult, however. About 40 percent of large investors will not give feedback, even in private, about their votes or the changes they might like to see, said David Drake, president of Georgeson Inc, a proxy solicitation firm. Some wish Federated were more forthcoming about the warning its votes seemed to send on pay. “If Federated is going to throw a yellow flag, Federated should at least describe what the foul is,” said Richard Susko, a partner at Cleary Gottlieb Steen & Hamilton. It represents corporations on compensation and governance matters.

CRISIS BLOWBACK

Mutual fund firms control about a quarter of U.S. stocks, but like Federated, most will not discuss specific votes, making their annual disclosures a rare window into their oversight. At Reuters’ request Jackie Cook, principal of Vancouver research firm Fund Votes, reviewed the voting of 28 Federated mutual funds during the year ended June 30. They opposed executive pay 83 percent of the time at S&P 500 companies, voting against the plans in 346 of 416 contests. In contrast, most mutual fund firms backed 80 percent or more of pay plans, Fund Votes found. That support was in line with recommendations of proxy adviser Glass, Lewis & Co.

In securities filings Federated said it will vote against compensation proposals that replace existing stock incentives with those having more favorable terms and against plans that fail to spell out maximum compensation levels. Frank Glassner, head of Veritas Executive Compensation Consultants, said the details do not explain the votes. Federated has “given a philosophy and not a methodology,” he said.

LYING LOW

Federated makes an unlikely executive pay critic. Its cofounder and chairman, John Donahue, graduated from West Point in 1946, then flew military bombers and began Federated in 1955 with friends from Pittsburgh’s Central Catholic High School. Donahue is now 87 years old and his 62-year old son Christopher is chief executive. The company was so traditional it prohibited women employees from wearing pants on the job until 2000. That was also the year Federated put up a big sign on its downtown headquarters, although it is now one of Pittsburgh’s largest financial firms.

Despite its low profile, Federated has a history of shareholder activism when it comes to compensation. A 2006 study by AFSCME and others ranked Federated as the third toughest “pay constrainer” among 18 fund firms, based on their voting on measures such as management-sponsored pay resolutions. (AFSCME and other unions have been clients of Fund Votes, as have shareholder groups and academics.) Proxy votes are overseen by a Federated funds board that includes both Donahues, plus nine other trustees who would not comment for this article. John Conroy, a former funds trustee who retired early least year before most pay votes were cast, said the board at the time had no particular agenda on executive pay, but studied proxy matters closely. “We call them as we see them,” Conroy said.

Federated shares had fallen 34 percent in the 12 months ended January 10, compared with a 16 percent decline for an index of peers. The company has been dogged by heavy reliance on money market funds at a time when low interest rates forced it to waive fees. Unhappy investors have pressed for a bump in the dividend that has been 24 cents per share in recent quarters. Christopher Donahue has resisted, but says his family’s ownership helps him keep investor interests in mind. “I grew up with nine sisters,” he said at a conference in June. “I think they’re all stockholders and I like going to Thanksgiving dinner, too.”

MORE LEEWAY

Federated’s tough set of pay votes contrast with its own practices. Federated has two share classes of which only those held by a Donahue family trust had voting rights at its annual meeting. As a result, holders of Federated’s publicly-traded Class B shares did not vote on John Donahue’s $2.7 million 2010 compensation, or the $3.6 million paid to Christopher Donahue. Another feature of Federated’s structure also could play a role in its proxy voting. Many fund companies have an incentive to vote with management because the firms also seek to manage corporate retirement assets. But at Federated, those assets stood only at $2.5 billion, according to the latest survey by PlanSponsor magazine, compared with Federated’s $352 billion in total assets at September 30.

Such a small retirement business would give Federated the flexibility to vote its heart on pay, said University of Michigan professor E. Han Kim. Although it might anger executives with its pay votes, Kim said, Federated has “nothing to lose.” Even as they were swatting at pay plans, Federated funds opposed only two percent of corporate directors in the last proxy season, Fund Votes found. Many other shareholders also went easy on directors, according to ISS, which advises institutional shareholders on proxy voting. It found only 45 directors at U.S. companies who lost elections last season, roughly half the 91 directors defeated in 2010.

Behind the trend was the new ritual of “Say on Pay.” Many negative votes – such as Federated’s – did not send the harshest possible message on compensation. Rather, said Georgeson’s Drake, the votes were “like a pressure release valve.”

– Broc Romanek, CompensationStandards.com

According to this memo from Wachtell Lipton:

In a decision reaffirming directors’ authority to determine executive compensation, the United States District Court for the District of Oregon has ruled that a suit against bank directors arising out of a negative “say on pay” vote should be dismissed. The court determined that plaintiffs failed to raise a reasonable doubt that the challenged compensation was a reasonable exercise of the board’s business judgment. This is the first federal court decision to dismiss such an action, a number of which have been filed in state and federal courts across the country in the wake of the Dodd-Frank Act. Plumbers Local No. 137 Pension Fund v. Davis, Civ. No. 03:11-633-AC (Jan. 11, 2012).

At issue in Davis was a decision by the compensation committee of Umpqua Holdings Corporation to pay increased compensation to certain executive officers for 2010 — a year in which the bank’s performance had improved and met predetermined compensation targets, but total shareholder return was allegedly negative. In a subsequent advisory “say on pay” vote, a majority of the shares voted disapproved of the 2010 compensation. Plaintiffs claimed that it was unreasonable for the Umpqua board of directors to increase compensation and that the shareholder vote rejecting the compensation package was prima facie evidence that the board’s action was not in the corporation’s or shareholders’ best interest.

The court rejected both of plaintiffs’ arguments. Applying Delaware and Oregon law, the court determined that plaintiffs’ “essential position . . . that if a simple comparison reveals a level of compensation inconsistent with general corporate performance, the business judgment presumption is necessarily overcome, [is] a position that is unsupported by the applicable standards.” The court also held that the Dodd-Frank Act did not alter directors’ fiduciary duties and that a negative “say on pay” vote alone does not suffice to rebut the business judgment protection for directors’ compensation decisions. In so holding, the court expressly declined to follow a prior federal court decision which had denied a motion to dismiss in a “say on pay” action in the Southern District of Ohio, NECA-IBEW Pension Fund v. Cox, No. 11-451 (S.D. Ohio, Sept. 20, 2011).

Davis is a powerful reminder that directors of both financial and non-financial companies may base compensation on long-term goals and choose the yardsticks by which to measure executive performance with confidence that courts will respect their good faith business judgment.