Here’s the intro from this blog by Willis Towers Watson:
We’ve recently been hearing from some companies that they’re reluctant to employ statistical sampling in calculating their CEO pay ratios based on the notion that their calculation will not be as accurate as if they had used actual data for their entire workforce. This thinking draws an analogy to political polling, which is based on statistical sampling and has gotten a bad rap lately because certain polls have failed to accurately predict the outcomes of recent elections. Thus, the logic goes, if polling (and statistical sampling) do not lead to accurate or valid reflections of the true result, why would a company ever want to use this approach to disclose a number as highly charged as the CEO pay ratio?
In reality, however, the entire exercise of compiling the CEO pay ratio is based on estimates, regardless of whether a company uses statistical sampling. This is true because the Securities and Exchange Commission (SEC) does not require companies to calculate Summary Compensation Table (SCT) total compensation for all employees to identify the median employee. As a result, every company will be using a less-than-100%-accurate methodology to arrive at an estimate of the median pay, which is, of course, a permissible approach under the final SEC regulations.
This makes the calculation of the CEO pay ratio different from a political election in that there will never be an indisputable outcome. This may create concerns that some could challenge the approach used to compile the ratio as improper, a particular concern with respect to the plaintiff’s bar. This article is designed to help illustrate how companies can consider addressing those risks and makes the case that using statistical sampling actually can help companies defend themselves on this issue.
As part of my “Big Legal Minds” podcast series – check out this 25-minute podcast, during which Blair Jones of Semler Brossy describes her vast experience on being a compensation consultant, including:
1. How did you wind up getting into the compensation consultant industry?
2. Can you give us a sense of what the compensation consultant industry is like?
3. Can you give us a sense of what different types of roles folks play within a consulting firm?
4. What are the least understood things that you do?
5. What are the hardest parts of your job?
6. What are the best parts of your job?
7. What are consultants best at? Less effective at?
8. How has the job changed since you first got into the industry? How do you expect it might change over the next several years?
9. What advice would you give someone that is just joining a consulting firm?
These podcasts are also available on iTunes or Google Play (use the “My Podcasts” app on your iPhone and search for “Big Legal Minds”); you can subscribe to the feed so that any new podcast automatically downloads…
Tune in tomorrow for the webcast – “Proxy Season Post-Mortem: The Latest Compensation Disclosures” – to hear Mark Borges of Compensia, Dave Lynn of CompensationStandards.com and Morrison & Foerster, Ron Mueller of Gibson Dunn analyze what was (and what was not) disclosed this proxy season.
– It is extremely rare for any company to use GAAP earnings for bonus calculation purposes (word searching “non-GAAP” probably missed the other 42% of companies that refer to adjusted EPS, adjusted revenue, etc.).
– Most incentive plan targets are based on operating results, which is why it is common to exclude non-operating items – like FX or asset impairments – from the bonus calculation. It is also common for some industries to exclude non-cash expenses, like equity compensation expense.
– Agree that some items should not be excluded from GAAP results when calculating incentive payouts – and there is typically a very rigorous process that management and the compensation committee use to evaluate what to exclude.
– Lay-off expenses are mentioned as an example of a bad adjustment to GAAP results for incentive plan purposes. If you are the board, would you want to provide management with a financial incentive to delay a lay-off or plant closure until next year to avoid a reduction in the current year’s bonus? I can think of many examples where the entire industry faced excess capacity and closing facilities was not anticipated at the beginning of the year. Most boards would want the management team to get out in front on an issue like that – and would be happy to reward them for doing so, rather than create a financial penalty. I recognize that paying big bonuses to management during large layoffs is not a good practice and should be avoided.
– Agree that if management wants relief from FX headwinds one year, they need to exclude FX tailwinds in future years.
But these adjusted metrics aren’t just showing up in earnings releases. Pro forma figures have been proliferating in annual proxy statements, too. There, when used with compensation metrics, they can help executives draw bigger pay packets. Research firm Audit Analytics finds that the term “non-GAAP” appeared in 58% of proxies for companies in the S&P 500 that have released them so far this year. Five years ago, that term showed up in 27% of proxies for current S&P 500 constituents.
There is nothing improper about using non-GAAP measures as long as they are disclosed properly. And corporate boards decide on the measures they want to use for compensation purposes. Plus, there is an argument to be made for sometimes excluding items from results for compensation purposes. If, say, a natural disaster hits a company with expensive repairs, perhaps an adjustment is in order. But other items that often get excluded in pro forma results, such as layoff-related charges, do seem like a reflection of management’s performance. And boards have too often shown a willingness to set awfully low bars for executives to clear.
That, though, can disadvantage shareholders and wreck the idea of pay for performance. In that vein, the dramatic rise in the number of companies using pro forma measures to determine bonuses would indicate the balance between shareholders and executives is being skewed in executives’ favor. Indeed, an examination of the most recent proxy statements from companies in the Dow Jones Industrial Average shows about a dozen of the index’s 30 constituents had annual pro forma earnings well in excess of GAAP ones and used the pro forma ones in annual bonus calculations.
I asked Robert A.G. Monks, the founder of Institutional Shareholder Services, a leading corporate governance consulting firm, what he thought of BlackRock’s line of defense. “Sheer manure,” was his reply. Money managers who cast vote after vote in favor of management are “no longer upholding their fiduciary responsibility to shareholders. They’re acting solely in their own interest.” “The large money managers,” Monks explained, “don’t want a reputation for putting their finger in the eye of a CEO who might be in a position to give them more business.”
Such eye poking becomes particularly unlikely when the money managers who would do the poking have massive paychecks in their own pockets. But even mutual funds with top execs less outrageously rewarded than BlackRock’s Fink have proved reluctant.
As noted in this article, Senator Elizabeth Warren is leading the charge – along with other members of Congress and a group of unions and activists – to eliminate the Section 162(m) exemption. This bill – “Stop Subsidizing Multimillion Dollar Corporate Bonuses Act” (HR 2103) – was first introduced in the House last year. This is part of a new “Take on Wall Street” movement…
