– Broc Romanek, CompensationStandards.com

Last week, the “Burdensome Data Collection Relief Act” (HR 414) was introduced to repeal Dodd Frank’s Section 953(b), the pay ratio disclosure requirement. The bill is real simple – a single paragraph. This same bill was introduced in 2013 and went nowhere. Not sure what will happen this time around…

– Broc Romanek, CompensationStandards.com

Here’s an excerpt from this article from Accounting Today:

The clawbacks on executive compensation mandated by the Dodd-Frank Act may discourage one type of accounting manipulation only to encourage another, according to a new study. Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act contained a provision requiring all publicly listed companies to recover from executives any incentive compensation that was paid to them on the basis of erroneous financial statements. The Securities and Exchange Commission has still not determined exactly how the clawback provision will be enforced and it is not yet mandatory. But many companies have voluntarily enabled or required themselves to implement them.

While previous research has found that such provisions reduce the number of corporate financial restatements and increase investor confidence in financial reports, the new research suggests that the gains implied by those findings may be more illusory than initially thought. The study appears in the January/February issue of The Accounting Review, a scholarly journal from the American Accounting Association, and was written by Kevin C. W. Chen and Tai-Yuan Chen of the Hong Kong University of Science and Technology, Lillian H. Chan of the University of Hong Kong, and Yangxin Yu of the City University of Hong Kong.

The new paper found that the clawback provision reduces the incidence of one kind of earnings manipulation—”accruals management”—only to increase the incidence of another that is equally, if not more, adverse to investors—that is, “real-transactions management.” Accruals are particularly subject to manipulation because they often entail some element of guesswork, such as predictions of future write-offs for bad debts or estimates of inventory valuations. Real-transactions management, in contrast, involves altering actual expenditures to achieve a temporary earnings boost, such as by cutting research and development or by slashing prices or easing credit terms to accelerate sales.

Clawback provisions “deter managers from using accruals management because high accounting accruals tend to attract more scrutiny from the SEC and auditors,” according to the study, increasing the likelihood of clawback-triggering financial restatements. But “real-transactions management, such as cutting back on R&D or on selling, general, and administrative (SG&A) expenses, is considered less risky.” Even though it “represents a deviation from optimal business practices…it is unlikely to be deemed improper by auditors and regulators.”

– Broc Romanek, CompensationStandards.com

Here’s a teaser of this longer piece from Equilar about personal use of corporate jets:

In 2014, over two-thirds of Fortune 100 CEOs received a perquisite relating to personal use of corporate aircraft. Although scrutiny of aircraft perquisites has declined since 2008, the high degree of variability and intricacy surrounding the disclosure of how aircraft perquisites are calculated and justified remains a topic of discussion. Equilar’s latest analysis summarizes aircraft perquisite practices across the Fortune 100 and provides relevant disclosure examples.

– Broc Romanek, CompensationStandards.com

Tune in tomorrow for the webcast – “Executive Compensation Litigation: Proxy Disclosures” – to hear Pillsbury’s Sarah Good, Shearman & Sterling’s Doreen Lilienfeld and Winston & Strawn’s Mike Melbinger as they drill down on how proxy disclosure-related lawsuits are faring and what you can do to avoid them. Please print these two sets of course materials in advance:

– Course Materials: Litigation Developments
– Course Materials: Litigation Stats

– Broc Romanek, CompensationStandards.com

Here’s the final tally of say-on-pay votes from this Semler Brossy report. The report notes that a majority of companies continued to pass say-on-pay with substantial shareholder support: approximately 92% of companies passed with over 70% shareholder approval – and 60 companies failed out of the Russell 3000 (2.4%).

And from a while back, as noted in this WSJ article (in which I am quoted), Oracle lost their say-on-pay vote for the third year in a row…

– Broc Romanek, CompensationStandards.com

Aon has seen an uptick in the use of mandatory post-vest holding periods as a design trend in the past year – so they recently launched a new web portal – HoldAfterVest.com – which currently has these articles:

– “Maximizing Your Investment in Equity Compensation with Holding Requirements”
– “SEC and FASB Requirements for the Disclosure of Post-vesting Restrictions and Illiquidity Discount”
– “Mandatory Holding Periods: A New Approach for Mitigating Compensation Expense”
– “The Many Governance Benefits of Mandatory Post-Vest Holding Requirements”

– Broc Romanek, CompensationStandards.com

This article from “Accounting Today” illustrates the need for the compensation risk assessment required by the SEC since December 2009:

Slashing a CEO’s compensation after a company produces disappointing financial results may help improve earnings for a time, but it can also encourage earnings manipulation, according to a new study. The study, which was presented at last month’s annual meeting of the American Accounting Association, acknowledged that some prior academic research has found company performance to improve when boards of directors cut CEO remuneration, but found the improvement could stem from financial and managerial manipulations as opposed to solid gains. “In the year following a pay cut, CEOs are more likely to engage in earnings management because it will lead to a faster improvement in the reported performance and a speedier restoration of CEO pay to earlier levels,” said the study, co-authored by accounting professors Gerald J. Lobo of the University of Houston, Hariom Manchiraju of the Indian School of Business in Hyderabad and Sri S. Sridharan of Northwestern University.

For the most part, the tactic works, the researchers found, noting that “the board does not punish manipulative activities sufficiently,” despite the fact that CEO earnings management “impos[es] significant agency costs on the firm in terms of both lower market returns and diminished operating performance…in the longer term.” Researchers attributed the board failure to the CEO’s dominant influence on the pay-setting process. “The CEO accepts a cut in the wake of poor performance to placate stakeholders and subsequently, when the firm’s performance improves (though via earnings management), the CEO’s pay is restored to earlier levels, thereby avoiding negative publicity and scrutiny,” said the study.

The CEO’s pay is frequently restored the following year to nearly the same level as it was prior to the cut. The median pay cut in the study was 42.2 percent, while the median compensation rise the following year was 40 percent. “Certainly the issue of CEO pay cuts is a tricky one for investors,” Lobo said in a statement. “On the one hand, they welcome slashing CEO pay in response to inferior company performance and hope this will light a fire under the CEO. On the other hand, they need to be on the alert for the kind of manipulation our study uncovers.”

A good rule of thumb recommended by the researchers is to be particularly wary of CEO pay cuts at companies where institutional investment is low, especially where there are CEO-friendly governance mechanisms such as poison pills, golden parachutes, and rules that diminish board power over the CEO. “We find that a high level of institutional investment tends to constrain earnings management following pay cuts, while a high degree of CEO entrenchment tends to foster it,” said Lobo.

To produce the study, the researchers drew on a database of executive compensation and examined an 18-year period up through 2011. They analyzed data on 1,330 single-year cuts of 25 percent or more in CEO pay (including salary, bonuses, long-term incentive plans, and stock and option awards) and compared the performance of companies where there were CEO pay cuts with companies constituting the study’s control group. In analyzing the corporate financial reports, the researchers focused on two types of earnings manipulation. The first category consisted of what “discretionary accruals”—that is, non-cash accounting items that typically entail some element of guesswork, such as predictions of future write-offs for bad debts or estimates of inventory valuations. Companies that cut CEO pay reported discretionary accruals that were 2.33 times greater than those of companies in the control group, a level suggestive of earnings manipulation.

The second category consisted of company operations designed to produce a short-term boost in corporate income. The authors specifically looked for three factors: 1) acceleration of sales through price discounts, 2) overproduction of goods to lower the manufacturing cost per unit, and 3) reduction of outlays for research and development, advertising and other discretionary expenses.

Companies that slashed CEO compensation experienced an increase in reported financial performance the following year, both in terms of stock gains and bottom-line returns on assets.

Median share prices rose at a market-adjusted rate of 1.1 percent, a marked improvement over negative returns totaling about 18 percent in the two previous years. Meanwhile, the return on assets rose to about 5.7 percent, which represented about a 50 percent increase over the average for the previous two years and matched the profit margin of companies in the control group.

Yet when the researchers took into account abnormal accruals and real-activities manipulation, the profit picture changed markedly. Without these earnings boosts, the median return on assets fell to 0.3 percent among the companies that slashed CEO pay, compared to approximately 5.3 percent among those that did not. The fact that the profit ratio shrunk nearly 100 percent in the first group, and only 10 percent in the second group, suggested the considerable amount of earnings manipulation occurring in the companies where there were CEO pay cuts. Professor Manchiraju estimated that over one-third of the companies where there were CEO pay cuts would have needed to report their bottom-line losses, were it not for the lifts they received from earnings manipulation.

In terms of whether the stock market is aware of what is happening, the study found that investors do seem to respond negatively to the high level of accruals in the pay-cut companies, but not to their operational manipulations. In any event, investors who shun these companies proved wise in doing so, as the earnings management occasioned by the CEO’s pay cut led on average to a decline in the industry-adjusted return on assets beyond the first year after the pay cut.

– Broc Romanek, CompensationStandards.com

Here’s news from Steve Seelig and Puneet Arora of Towers Watson:

As part of their alternative to the Republican agenda, House Democrats have dusted off last year’s proposal to limit the deductibility of executive pay to $1 million for companies that fail to increase their rank-and-file pay to keep pace with U.S. economic growth. (Here’s the version of the bill introduced in the last Congress by Rep. Chris Van Hollen (D-Md.). This bill is part of larger democratic “action plan” focusing on the middle class that also would provide tax breaks to workers earning under $100,000 per year.

The House previously voted down Van Hollen’s procedural motion to consider the bill, but he’s expected to reintroduce the bill later this year. The Democrats appear determined to keep the CEO-versus-worker-pay issue in the news pending the Securities and Exchange Commission (SEC) release of final CEO pay ratio regulations, as evidenced in the “dear colleague” letter released by House Minority Leader Nancy Pelosi (D-Calif.) on the opening day of the new session. (For more on the SEC rulemaking outlook, see “Updated SEC Calendar Pushes Dodd-Frank Pay Rules Back to 2015,” Executive Pay Matters, November 26, 2014.)

The Van Hollen bill would take a different approach than the California bill we blogged about last year, which would have limited state tax deductions for executive compensation on a sliding scale depending on the ratio of executive pay to rank-and-file pay. (For more on the California proposal that was defeated in the state legislature, see “California Legislation Would Limit Tax Deductions for Companies Where the CEO Pay Ratio Is Too High,” Executive Pay Matters, May 1, 2014.) Instead, it would add a new section to existing Section 162(m) of the tax code to limit to $1 million the deductibility of compensation (including performance-based compensation) paid to any current or former employee, officer or director if the average pay of all of the company’s U.S.-based non-highly-compensated employees (as defined under the qualified plan rules, i.e., those below $115,000 for 2015) does not keep pace with the growth of the U.S. economy. U.S. economic growth would be based on the average of productivity growth (based on Bureau of Labor Statistic measures) plus adjustments in the cost of living under the tax code.

The bill would also expand the reach of Section 162(m) to cover certain nonlisted, publicly traded companies, make sure the CFO is re-included as a “covered employee” and make it clear that income paid to beneficiaries is included in an executive’s remuneration for 162(m) purposes. Given the GOP’s wider majority in the House and control of the Senate in the new Congress, any democratic proposals are even more of a long shot than before. But, we’ll keep you up to date if there’s any movement.

– Broc Romanek, CompensationStandards.com

Here’s a blog from Towers Watson’s Steve Seelig and Dave Suchsland (which summarizes this longer memo):

Summary Compensation Table (SCT) disclosures of changes in pension values are set to see the largest increase in recent memory in 2015 proxies, thanks to a confluence of two events that took place in 2014:

– In October, the Society of Actuaries (SOA) released updated mortality tables to be applied when retirement plan sponsors estimate the financial obligations associated with their plans. The new tables reflect that life expectancies have improved more than predicted under the existing tables, issued in 2000. This means many companies will use updated mortality assumptions for this fiscal year in accounting for their retirement obligations that, in turn, will apply to proxy values.
– Second, interest or discount rates for 2014 decreased markedly from 2013, which means pension liabilities increase because the plan will earn less interest on investments in the future.

These changes will directly increase the change in pension value reported in the SCT, even in situations where an executive may have a frozen pension benefit. For those executives still accruing additional benefits, the impact may be even more profound. This is because the SCT change-in-pension-value calculation is tied to the assumptions used to compile a company’s overall financial statement liability.

– Broc Romanek, CompensationStandards.com

Tune in tomorrow for the webcast – “The Latest Developments: Your Upcoming Proxy Disclosures” – to hear Mark Borges of Compensia, Alan Dye of Hogan Lovells and Section16.net, Dave Lynn of CompensationStandards.com and Morrison & Foerster and Ron Mueller of Gibson Dunn discuss all the latest guidance about how to overhaul your upcoming disclosures in response to say-on-pay-including the latest SEC positions-and the other compensation components of Dodd-Frank, as well as how to handle the most difficult ongoing issues that many of us face.