– Broc Romanek, CompensationStandards.com

According to this study by the Institute of Internal Auditors a while back, only 45.3% of respondent organizations conduct even limited reviews of the appropriateness of executive compensation and benefits and about one-third of such reviews are spearheaded by internal auditing. Moreover, the survey indicates that when conducting such reviews, internal auditors are most likely to focus on program compliance rather than on overall program design.

Personally, I’m not surprised given the expertise it would take to conduct a real review of compensation programs – expertise that internal auditors would not be likely to possess. Although I guess that’s true for most areas that internal auditors are called upon to review – that is one tough job…

– Broc Romanek, CompensationStandards.com

I have fond memories of attending a ISS conference about seven years ago, with Disney’s brand new CEO Bob Iger delivering a memorable address on governance (Iger succeeded Michael Eisner not long after the Delaware Supreme Court’s famous executive pay decision). Now, as detailed in this WSJ article by Joann Lublin, Disney is fighting ISS hard over a negative say-on-pay recommendation having filed two separate pieces of supplemental proxy materials on March 1st. As noted in this Davis Polk blog, Disney’s SOP passed yesterday with 56.6% support.

Here are some thoughts from a member about this battle:

Disney is in a “no win” situation with ISS, as they are being compared to Winn Dixie, Best Buy and other consumer goods companies due to the lack of sufficient media companies. I think Disney’s approach of going direct to shareholders with their compensation rationale makes the most sense.

I also believe that companies have to do a much better job defining what pay for performance is, and not allow shareholders to fill the pay for performance void with ISS’ methodology, as it is fundamentally flawed. The ISS pay-for-performance model compares 1 and 3 year historic TSR to potential future compensation values ( i.e., grant date values of long-term incentives) that will be earned on future performance results.

ISS’ methodology is a bit like keeping score at today’s basketball game using the players average points the last three years. You do not win or lose today’s game based on how you scored in the past. If that was the case, why play the game at all? Same for compensation. If future performance did not matter, then why not just write the exec a check for the grant value and call it a day?

In the WSJ article, Joann Lublin tries to make the company’s desire to focus on realizable pay sound like some nefarious way to fool shareholders. But, if CalPERS gets it, then there is a good chance all shareholders will come around and consider realizable pay and performance is far better than using grant date values.

– Broc Romanek, CompensationStandards.com

In our “Say-on-Pay” Practice Area, we have posted the court order issued last week in the Superior Court of California-LA that rules against the plaintiffs. We have also posted this week’s order from the US District Court for the District of Maryland dismissing the lawsuit against BioMed Realty Trust.

As Mark Poerio notes in his blog:

The directors and officers of Jacobs Engineering, and their compensation consultant, have successfully challenged a complaint alleging that poor corporate financial performance made their authorization of significant pay increases for executives “unreasonable, disloyal, and not in good faith, and violated the Board’s pay-for-performance executive compensation philosophy.”

A Los Angeles Superior Court dismissed the complaint for failure to adequately allege either (1) demand futility or (2) facts sufficient to constitute their claim. Notably, the court observed that “The Dodd-Frank Act did not create any binding obligation on the Board” [through its advisory say-on-pay vote requirement], and that there was “no actionable misrepresentation alleged or culpability” alleged to support claims based on false disclosures in the company’s proxy statements.

– Mike Kesner, Deloitte Consulting

ISS published its GRId 2.0 ratings last Monday and updated its technical document too. ISS determined the ratings using its updated GRId scoring system, which examines a company’s board structure, compensation, shareholder rights and audit, and 2011 proxy data as a “trial run” for their new approach. Consistent with the prior GRId System, compensation, by far, has the most evaluation criteria (41 questions in all), including a number of new questions for 2012. The GRId 2.0 score will be updated once 2012 proxies are filed.

ISS not has released the scoring system it is using in calculating a company’s score, so it is impossible to figure out what steps a company can take to move from a high risk to a medium or low risk rating without purchasing ISS’ GRId Analytics for $28,000.

Based on my review of several GRId 2.0 reports, it appears there is a short-circuit in the scoring system. Some companies appear to have very solid pay practices, but received a “high risk” score on one of the four pay for performance questions resulting in a very low GRId score (e.g. 5 of 100). Other companies appear to pass pay-for-performance with flying colors, yet received a high concern on GRId because they did not have holding periods or specific minimum vesting periods in the equity plan and they had employment contracts with excise tax gross-up (in this case a score of 21 of 100).

I also noted companies with very high results (92 of 100) that were lacking holding periods, allowed share recycling, had excise tax gross-ups, permited option repricing without shareholder approval, did not have a hedging policy and allowed the cash buyout of underwater options.

My conclusion based on this review is there might be something wrong with the scoring system since companies with very similar pay practices and pay-for-performance can receive very different scores.

So what to do?

If you have not already done so, check your preliminary GRId 2.0 to make sure it is correct based on your 2011 proxy. ISS made a number of errors – and it is important that companies identify these errors early.

If you have already subscribed to GRId Analytics, you should evaluate how actual – or potential – changes to your pay practices may influence your 2012 GRId score. If you have not already purchased GRId Analytics, you may want to ask your ISS representative when they plan on publishing the scoring system so you can evaluate which changes will most positively impact your GRId score.

It is important to note that any changes you might make (like adopting minimum stock option vesting requirements or committing not to enter into future employment agreements with an excise tax gross-up provision) need to be discussed in this year’s proxy – or filed in an 8-K – to document the change.

– Scott Oberstaedt and Sharon Podstupka, Towers Watson

As we recently blogged: It’s the most wonderful time of year for business writers, especially those looking for a compelling story line that’s sure to generate discussion: “How much did that CEO make this year?”

Yes, it’s the proxy season and, as has become an annual tradition, executive pay is back in the headlines. The inevitable eye-popping ones capture readers’ attention, to be sure, but the narratives often provide few insights into what really was paid — or worse, they mislead the reader into thinking that compensation committees took actions that are not in shareholders’ best interests.

Clearly, there are situations in which media criticism of a company’s executive compensation program is totally warranted. However, if you find yourself staring at an unflattering headline about your company’s executive pay that seems less than fair (or are worried about what future press coverage may bring), you might want to be ready to explain the real story. A little advance planning for negative publicity can help go a long way in helping you prepare an explanation for your key stakeholders. Here are some suggestions for laying the groundwork to respond to six hypothetical headlines (based on real-world examples) that some companies may encounter in the upcoming proxy season.

1. “CEO Pay Rises Dramatically in 2011”

– What the reporter may have done: The reporter may have looked up the Summary Compensation Table’s (SCT) rightmost column, which shows Total Compensation for the past three fiscal years, and then subtracted the 2010 total from the 2011 total to uncover a large increase.

– What you can say in response: “The total shown on the SCT is not what we paid our CEO in 2011. It includes the accounting cost of equity grants we made that don’t vest for years or, in the case of stock options, have no value unless the stock price rises. It even includes things like 401(k) contributions and pension value changes. Our CEO’s W-2 compensation for the year was only a fraction of the amount listed.”

– What you can do: Include a table in your CD&A that highlights realized or realizable compensation. These amounts can be parallel, and in many instances, better indicators of annual executive compensation.

2. “CEO Pockets Huge 2011 Bonus”

– What the reporter may have done: Here, it’s likely that the reporter compared the 2011 annual cash incentive number listed in the SCT to the 2010 annual cash incentive number.

– What you can say in response: “Our target bonus amount did not change, but our business performance improved substantially. Our executives’ bonuses paid below target in 2010, but above target in 2011 due to improved performance. We have not changed our approach to bonus payments or targets.”

– What you can do: Include a pay-for-performance chart in your CD&A that plots variable compensation against key financial metrics, such as income growth or TSR. This can be historical performance or relative to a peer group. Explain how pay and performance are aligned, and if not, what the compensation committee has done to ensure better alignment in the future.

3. “Executive Stock Grants Skyrocket in 2011”

– What the reporter may have done: This journalist probably looked at the value of the equity-based awards grants in 2011, also from the SCT, and compared that line to 2010.

– What you can say in response: “If you look at the detail in the Grants of Plan-Based Awards on the following page, you’d see that we granted the same number of options/shares in 2011 that we did in 2010. The accounting cost changed on each share/option, but we haven’t changed our approach to annual share grants.”

– What you can do: Provide a clear explanation of how the company determines equity grant practices. For example, does the committee follow a fixed-value or fixed-share approach in making equity grants? (Note that illustrating realized or realizable compensation and pay-for-performance alignment will also help.)

4. “Departing CEO Gets Huge Parachute”

– What the reporter may have done: This reporter may have compared the pay of an outgoing CEO (which often includes accelerated accounting charges on multi-year vesting of stock and pension benefits) to last year’s pay levels.

– What you can say in response: “The total 2011 compensation cost we reported in the proxy statement is for both current year and future payments that were part of the former CEO’s contract. This included deferred compensation and a pension that was earned over many years of service with the company.”

– What you can do: Explain in the CD&A which payments were made upon termination versus which are payable in future years. Also, it may be helpful to list the values of any awards or other compensation that were forfeited upon termination, such as unpaid bonus or unvested stock options and performance shares. Most termination payment disclosures are one-time events that will cause a temporary disclosure headache, and there may be potential for the company to be accused of “paying for failure,” so stay vigilant about how you explain this one-time payment and how it might compare to future payments for outgoing executives.

5. “CEO Takes Massive Pay Cut”

– What the reporter may have done: This is the inverse of our first headline, involving a comparison of 2011 total pay to 2010 total pay in the SCT, and reporting a large year-over-year decrease.

– What you can say in response: “Our approach to compensation has not changed in the past year. We provide market-competitive target compensation levels that are earned over time based on the company’s performance. We take a long-term approach to compensation, just as we take a long-term approach to building company value. Financial statement users should not read too deeply into one-year changes in reported numbers.”

– What you can do: Provide details on each executive officer’s target compensation value as well as actual compensation paid in the last year. While a decrease in CEO pay may seem like a good thing to some outsiders (and to shareholders especially if the company had a particularly bad year), it will be helpful to highlight the consistency in target pay levels year over year, especially when performance (and pay) bounce back.

6. “Overpaid CEO Cashes in on Millions of Dollars in Options”

– What the reporter may have done: This reporter may have looked at an 8-K filing or the Options Exercised table of the proxy and concluded that the CEO got a massive payment in a year when shareholder returns were flat.

– What you can say in response: “Options are granted to provide our CEO incentives to increase shareholder value over a period of time. By their nature, options give the CEO discretion over the timing of any gains, and this exercise is in line with sound financial planning decisions. It reflects the increased value the CEO has delivered to all shareholders over the past several years.”

– What you can do: Provide a table within your CD&A or in a press release that would illustrate the value delivered to shareholders over the period in which the CEO’s options increased in value. Here again, a pay-for-performance depiction based on realizable pay would best help illustrate the close alignment between CEO pay and shareholder returns.

Ultimately, a company’s ability to affect the numbers reported in the SCT itself is limited by SEC rules. Many companies will decide that a public debate with any reporter or media outlet on executive pay has a limited upside and substantial potential downside. However, the inclusion of realized or realizable compensation tables and/or pay-for-performance charts in the CD&A is becoming increasingly common as more companies view the SCT as providing only an incomplete picture. And, of course, if there is a misalignment between pay and performance, an explanation of why it occurred and how the company’s programs are designed to ensure that pay will be aligned in future years is a critical consideration for investors.

Companies should look to use the CD&A as an opportunity to continue a dialogue on executive rewards between the company and its investors. And, while it may not garner a Pulitzer or be turned into a Hollywood screenplay, a clear and dynamically written CD&A that fully explains a company’s executive compensation philosophy — and how it reinforces the company’s long-term business strategy — is the best defense against media or other outside scrutiny of executive pay practices

– Broc Romanek, CompensationStandards.com

We have posted the survey results regarding how companies are preparing now for the SEC’s upcoming pay disparity rulemaking, repeated below:

1. At our company, the board:

– Does not consider internal pay equity when setting the CEO’s compensation – 51.8%
– Does consider internal pay equity as a factor by comparing the CEO’s pay to all employees – 1.8%
– Does consider internal pay equity as a factor by comparing the CEO’s pay to other senior executives – 44.6%
– Does consider internal pay equity as a factor by comparing the CEO’s pay to a formula different than the two noted above – 1.8%

2. Ahead of the SEC’s mandated pay disparity disclosure rulemaking under Dodd-Frank, our company:
– Has not yet considered how we would comply with the rules – 58.9%
– Has begun considering the impact by assessing whether we could comply with the precise prescriptions in Dodd-Frank but we have not yet tested statistical sampling – 35.7%
– Has begun considering the impact by assessing whether we could comply with the precise prescriptions in Dodd-Frank including assessing whether we could use statistical sampling – 5.4%

3. As one of the companies that have assessed the impact of the SEC’s mandated pay disparity disclosure rulemaking, our company:
– Believes we could comply with the precise prescriptions in Dodd-Frank without too great a burden – 13.5%
– Believes we could comply with the precise prescriptions in Dodd-Frank but it would be too burdensome unless statistical sampling is allowed – 13.5%
– Believes we could comply with the precise prescriptions in Dodd-Frank but it would be burdensome even if statistical sampling is allowed – 45.9%
– Believes we wouldn’t be able to ever comply with the precise prescriptions in Dodd-Frank – 27.0%

4. In your own opinion, do you think that statistical sampling would have too high a potential for manipulation or material error:
– Yes – 38.2%
– No – 29.1%
– I don’t have an opinion – 32.7%

Please take a moment to participate in this “Quick Survey on Board Minutes & Auditors” – and this “Quick Survey on GRC Software.”

– Broc Romanek, CompensationStandards.com

Recently, Kyoko Takahashi Lin and Gillian Emmett Moldowan of Davis Polk gave us this blog, repeated below:

Among the new proxy disclosure requirements under the Dodd-Frank Act is the mandate that issuers disclose in their CD&A “[w]hether, and, if so, how the registrant has considered the results of the most recent shareholder advisory vote on executive compensation… in determining compensation policies and, if so, how that consideration has affected the registrant’s executive compensation decisions and policies.” Thus far, the vast majority of the 110 large accelerated filers who filed proxy statements in the 2012 season through February 29, 2012 have addressed this new requirement in their CD&As. Generally, the disclosure has been fairly predictable: those that received lower shareholder approval ratings on say on pay in 2011 have provided lengthier disclosure, often addressing changes made to their compensation programs, while those that received stronger shareholder support have simply stated that they have considered the results and decided to continue their previous compensation practices in light of the support.

However, 14 large accelerated filers have failed to disclose the effect of the 2011 say on pay vote results in their CD&As. Of these, 9 did not mention the say on pay vote in their CD&A at all. Five companies reported last year’s vote results but did not go on to discuss whether or how the company considered the result.

Interestingly, the failure to disclose the effect of last year’s say on pay vote has not negatively affected either ISS recommendations regarding this year’s say on pay proposals or say on pay results in 2012. Of the 14 companies discussed above, the 9 that have received a recommendation on their 2012 say on pay proposal from ISS have all received a “for” recommendation. Of the 14 companies discussed above, the 6 that have reported their 2012 say on pay results as of February 29, 2012 have all received above 90% shareholder support. The lack of focus on the new disclosure by ISS and shareholders may be because all of these companies received at or above 89% shareholder support in 2011. Query whether the SEC will be as forgiving with respect to companies that do not address the new disclosure requirement.

– Broc Romanek, CompensationStandards.com

Recently, Mark Poerio of Paul Hastings posted this on ExecutiveLoyalty.org: In litigation against two CFOs re their failure to disclose perquisites provided for the CEO, the SEC has prevailed in a motion to have its expert testify about a “primary purpose” methodology that is applicable under from the Internal Revenue Code for determining whether an item is a business or a personal expense. The federal district court decision in SEC v. Das states:

(1) “Contrary to the Defendants’ assertion, a comparison of the two methodologies reveals that a methodology borrowed from the IRC [Internal Revenue Code] would be less conservative and rigorous, and therefore, should result in fewer items being classified as perquisites, than the SEC methodology”; and

(2) “Although such a methodology might not reveal the exact amount of perquisites received by Info’s CEO, it would not prejudice the Defendants, and it would be helpful to the jury because it is relevant and reliable to show the general scope of the perquisites received by Info’s CEO during the relevant time period.”

– Broc Romanek, CompensationStandards.com

With the proxy season in full bloom, the mass media is covering the latest just like us. For example, there was this WSJ article on Thursday about ISS recommendation’s on Disney – and then this follow-up on Friday with Disney’s rebuttal (here’s Steve Quinlivan’s related blog). Not to mention the two WSJ articles noted in this blog by Mike Melbinger. And then there is this WSJ article by Joann Lublin from Thursday:

Shareholder votes on executive pay are starting to change the shape of compensation at some big companies. A group of institutional investors recently joined forces to seek executive-pay and governance changes at 10 companies where nonbinding “say on pay” votes narrowly passed last year. The informal coalition, led by unions and public pension funds, already has persuaded Allstate Corp., Northern Trust Co. and five other companies to ban “gross-up” payments to executives. Those payments cover taxes executives owe on benefits provided by their employer.

Coalition members also withdrew 2012 shareholder resolutions opposing pay policies after a few companies required top managers to hold their company’s stock longer and put limits on accelerated vesting of equity grants after a takeover. “The changes demonstrate that say-on-pay votes are working to make companies more responsive to shareholder concerns about runaway CEO pay levels,” said Brandon Rees, deputy director for the AFL-CIO’s Office of Investment. He helped coordinate the coalition, which includes the International Brotherhood of Electrical Workers union and the pension system for firefighters in Kansas City, Mo.
In legally mandated advisory votes on executive-compensation policies last year, 358 publicly held companies got less than 80% support from their investors, according to proxy adviser Institutional Shareholder Services. Some of those companies have revamped pay practices, rather than face investor criticism during annual meetings this year.

Among them is Allstate. The big insurer got the support of about 58% of the votes cast for its executive-pay practices, and Chief Executive Tom Wilson was re-elected to the board by just 68% of the votes, the lowest margin last year for any CEO of a company in the Standard & Poor’s 500-stock index, according to ISS. After the vote, Mr. Wilson spoke with owners of 30% of Allstate’s shares, because he wanted to know “why people were concerned,” he said in an interview. “My job is to make our shareholders happy.” As a result of those efforts, the company was on its way to changing its practices when coalition members submitted four resolutions for this year’s annual shareholders’ meeting, Mr. Wilson said.

During talks, Allstate accepted a compromise suggested by the firefighters pension plan: require executives to hold on to 75% of their company shares until they meet their stock-ownership requirements. “That was a good idea,” Mr. Wilson recalled. Similarly, Allstate named its first permanent lead independent director last November, just before the electrical workers’ union offered a resolution favoring a split between the chairman and CEO posts. A separate chairman isn’t “the right model right now,” said Mr. Wilson, who holds both titles at the insurer. The union pulled its proposal after Allstate agreed to expand the lead director’s duties. They now include communicating with significant shareholders about broad corporate policies and practices.

Investment manager Northern Trust did away with tax gross-ups for new employment accords with top officers and tightened stock ownership rules, according to Greg Kinczewski, general counsel for Marco Consulting Group, an investment adviser for several coalition members. A Northern Trust spokesman confirmed both changes, and said the company’s proxy statement, scheduled for release next week, will “speak for itself.”

– Broc Romanek, CompensationStandards.com

On Tuesday, the PCAOB issued a proposed auditing standard that would change how an auditor evaluated a client’s identification of, accounting for, and disclosure about its relationships and transactions with related parties. As noted in this Towers Watson alert, this proposal could bring added involvement of independent auditors into executive pay decisions. Under this proposal, a company’s auditor would have to review its client’s pay programs and determine if they might encourage excessive risk-taking.

I haven’t read the proposal yet myself, but it seems that going down that slippery slope, might it be possible that an auditor would say to a company, “too risky, we can’t sign off on the financials” – so auditors could possibly play a role of essentially pre-approving pay programs? Comments are due by May 15th.