– Liz Dunshee

So far, this year’s say-on-pay failure rate is about 2% higher than last year. This “As You Sow” blog gives a take on why that’s happening. Here’s the intro:

Not all the votes are in, but there are already a significant number low votes and outright losses among the S&P 500 on pay packages. So far there are seven S&P 500 companies that have lost majority votes that I’m aware of for this calendar year: Ameriprise, Disney, Halliburton, Mattel, Mondelez, Western Digital and Wynn Resorts. Chesapeake Energy which was removed from the S&P 500 on March 19, 2018 due to “market capitalization changes” also had a failed pay vote.

Most of the early low votes and failures fell under two categories: transition packages and pay/performance disconnect. In many instances both factors were in play.

– Liz Dunshee

New this year, ISS started taking a closer look at director pay. In the absence of a “compelling rationale” or other mitigating factors, it will recommend a vote against members of the board committee responsible for setting non-employee director pay if the pay has been “excessive” for two or more years. This means that we could start seeing negative vote recommendations in 2019. Here’s more detail from this Meridian memo:

ISS guidance indicates how it will determine whether director pay is “excessive”: To determine outlier cases, ISS will compare individual non-employee director (NED) pay totals to the median of all non-employee directors at companies in the same index [e.g., S&P 500] and industry [i.e., two-digit GICS group]. The purpose is to identify a pattern of extreme outliers, which historically has represented pay figures above the top 5% of all comparable directors [based on ISS back testing].

One area of concern raised by ISS’s evaluation of NED compensation is with respect to non-executive chair pay levels. We have received informal guidance from ISS that it has been comparing non-executive chair pay levels against the median pay of all NEDs at companies in the same index and industry, rather than against the median pay of other non-executive chairs. This methodology will cause non-executive chair pay at many companies to rank high against the comparator group, because non-executive chair pay is often significantly greater than other non-employee directors’ pay. As director pay levels tend to be closely clustered, moderate increases in total compensation can have a material impact on percentile calculations.

To reduce the risk of a negative recommendation, companies should consider disclosing the rationale for director pay (including non-executive chair pay). It’s also helpful to describe the director pay-setting process.

This earlier blog notes that the ISS policy is a good reason to evaluate director pay annually, and lists some practices to avoid. Also see this blog from Mike Melbinger: “Boards Should Review Non-Employee Director Compensation in Light of Adverse Court Decisions.”

– Liz Dunshee

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, and Ron Mueller of Gibson Dunn analyze what was (and what was not) disclosed this proxy season.

– Liz Dunshee

Recently, I blogged about the business case for adopting robust clawback policies. One of the arguments against doing that is research that shows executives subject to clawbacks might be more likely to resist needed restatements. But according to a new 7-year study of the Russell 3000, that concern is overstated. This “CFO.com” article explains the findings (also see this Cooley blog):

The study, by Peter Kroos and Frank Verbeeten of the University of Amsterdam and Mario Schabus of the University of Melbourne, finds clawback adoption to be associated not with weakened ties between pay and company performance but “with greater CFO bonus incentives tied to accounting measures.” On average, the sensitivity of CFO bonus pay to a company’s return on assets nearly doubles following clawback adoption. Such sensitivity is found to be less pronounced for other top executives.

These developments, the study concludes, have occurred because companies are not only boosting bonuses based on accounting integrity, they’re also increasing bonus pay for strategic output that improves performance. In short, CFOs have less incentive to manage earnings through accounting then they did previously because (1) they’re getting paid for accounting integrity, and (2) they prefer not to jeopardize the bonus money extended for the more creative aspects of their job.

“Prior to clawback adoption,” the professors write, “firms have been under-incentivizing CFOs’ decision-making duties to emphasize the role CFOs have as watchdogs for financial reporting integrity. The implementation of clawbacks could enable firms to incentivize CFOs’ decision-making duties more appropriately … without increasing their propensity to misreport.”

The study also finds that when a company has control weaknesses and other signs of accounting manipulation, there’s a weaker correlation between CFO incentives and clawback policies.

– Liz Dunshee

Last month, I shared some predictions about the impact of tax reform on executive pay. And although other surveys show that companies have considered eliminating “performance-based” structures, this recent “Deloitte Consulting” survey confirms that for now, companies aren’t making many changes in response to the repeal of Section 162(m). Here are the key findings:

– None of the survey participants expect to reduce pay due to the loss in tax deductibility.

– 92% of participants indicated that they aren’t going to change the pay mix (fixed versus variable compensation) or executive incentive design structure. The most common change in executive pay structure reported by participants was adopting a new formulaic incentive plan.

– 55% of participants said they aren’t going to change the administrative provisions in their incentive plan documents.

– Only 44% of participants knew whether their pre-tax reform awards would be “grandfathered.”

– Broc Romanek

I gotta blog about anything entitled “Compensation Wormhole,” right? Love this piece by Performensation’s Dan Walter. Here’s the intro:

Time Travel. In the movies, it usually requires some door into a wormhole or some type of hyper-drive. In the business world, it’s one of the easiest things to do. No special skills or tools are required. Leaping ahead 4 or 5 years is as simple as changing the destination in your GPS.

We have been living in an age of 3% annual increases for several years. Sometimes it’s a bit more; sometimes it’s a bit less. On average, it’s not too inspiring. We do our best to give a bit more to our best performers, but those in the middle must fend for themselves. It’s not hard for them to find a time machine.

Let’s look at it from the perspective of an employee who is doing a good, but not outstanding job.

Let’s say you’re making $100,000 in base pay. You don’t know it, but you are on the low end of your pay range. This is mainly because of the pay from your start date combined with budgetary restrictions. It’s likely that this number is also the basis for much of the rest of your total rewards. Perhaps your STI target is 30% of base. Maybe your LTI target is 40%. Even your 401K contribution is based on your overall pay. Next year all of these things will climb by 3% (if you’re lucky). Over the next three years, the increase will be about 10%.

– Broc Romanek

In this presentation, Stephen O’Byrne makes an effort to explain the weaknesses of current pay practices in a way that directors can understand. Here’s a summary:

1. Summarizes the three basic objectives of executive compensation: strong incentives to increase shareholder value, retain key talent & limit shareholder cost.

2. Re-caps the evolution of executive pay design from value sharing plans in the first half of the 20th century to competitive pay concepts in more recent times. Value sharing plans make it hard to retain key talent, while competitive pay concepts make it hard to create strong incentives.

3. Shows that competitive pay concepts (e.g., targeting 50th percentile pay) create systematic performance penalties that undermine the alignment, or correlation, of cumulative pay & cumulative performance. Poor performance leads to more shares, superior performance to fewer shares. Since incentive strength is alignment x relative pay risk, low alignment undermines incentive strength. Gives a simple example showing a 139% pay difference for the same cumulative performance due to differences in the number of grant shares needed to provide competitive pay each year.

4. Shows that there is a compact and highly informative analysis that measures a company’s success in achieving the 3 basic objectives. The analysis plots relative pay against relative performance to measure incentive strength, retention risk and shareholder cost. The analysis can be used for management, directors, asset managers and the average employee.

5. Uses this analysis to show that the alignment of relative pay and relative performance is very weak measured across companies and quite weak measured within companies. This is true for CEO pay and director pay. Alignment (r-sq) across companies for the last ten years is 11% for CEOs and 14% for directors. Alignment (r-sq) within companies for the last ten years is < 50% in 60%+ of S&P 1500 companies for both CEOs and directors.

6. Shows that companies and proxy advisors don’t have meaningful measures of the 3 basic objectives. Percent of pay at risk – as well as the ISS measures – do not a provide a meaningful measure of incentive strength.

7. Shows that better measurement of the 3 basic objectives is important because it leads to better pay design:

– There are three “perfect” pay plans that achieve the 3 basic objectives: the perfect investment manager fee contract developed by Don Raymond of Canada Pension Plan, the “Dynamic CEO Compensation” plan developed by finance professors Alex Edmans and Xavier Gabaix and the perfect performance share plan developed by O’Byrne.

– All three take account of competitive pay but find a way to avoid the performance penalty and mis-alignment created by translating target dollar pay into shares. These plans solve the retention vs incentive problem companies have been struggling with for 100+ years.

– Gives a simple example of the Edmans-Gabaix plan showing that a 50% decline in stock price requires a 30% reduction in the PV of future salary (with the savings going to purchase additional stock).

8. Argues that companies should:

– Test their pay designs using the relative pay vs relative performance analysis,

– Benchmark pay alignment and performance adjusted cost, not just gross pay levels, for management, directors and the average employee and use long horizons, e.g., ten years, to measure alignment, and

– Consider benchmarking and pay design using an operating measure of relative performance.

9. Argues that investors and proxy advisors should use the relative pay vs relative performance analysis to measure the 3 basic objectives for management, directors, and asset managers and focus their engagement on companies with pay for performance problems and a well matched peer with much better pay practices.

– Broc Romanek

Time to act on the registration information for our popular conferences – “Pay Ratio & Proxy Disclosure Conference” & “Say-on-Pay Workshop: 15th Annual Executive Compensation Conference” – to be held September 25-26 in San Diego and via Live Nationwide Video Webcast. Here are the agendas – nearly 20 panels over two days.

Among the panels are:

1. The SEC All-Stars: A Frank Conversation
2. Parsing Pay Ratio Disclosures: Year 2
3. Section 162(m) & Tax Reform Changes
4. Pay Ratio: How to Handle PR & Employee Fallout
5. The Investors Speak
6. Navigating ISS & Glass Lewis
7. Proxy Disclosures: The In-House Perspective
8. Clawbacks: What to Do Now
9. Dealing with the Complexities of Perks
10. Disclosure for Shareholder Plan Approval
11. The SEC All-Stars: The Bleeding Edge
12. The Big Kahuna: Your Burning Questions Answered
13. Hot Topics: 50 Practical Nuggets in 60 Minutes
14. Dave & Marty: True or False?
15. Steven Clifford on “The CEO Pay Machine”

Reduced Rates – Act by June 29th: Huge changes are afoot for executive compensation practices with pay ratio disclosures on the horizon. We are doing our part to help you address all these changes – and avoid costly pitfalls – by offering a reduced rate to help you attend these critical conferences (both of the Conferences are bundled together with a single price). So register by June 29th to take advantage of the discount.

– Broc Romanek

Recently, a member posted this query in our “Q&A Forum” (#1241):

Having read about ISS’s “wisdom of the crowd” approach to the construction of company-selected peer groups, my thoughts have once again turned to something that has always puzzled me concerning how ISS determines pay-for- performance alignment for the most recent performance year. I’m leaving to one side the issue of how closely the ISS peer group resembles the company’s proxy peer group, as that has improved significantly since 2012. (In any event, some years ago ISS said that its peer group is intended to serve a different purpose than the peer group selected by a compensation committee to benchmark executive pay, and that ISS’s pay-for-performance analysis is not intended to benchmark pay directly, nor is it intended to evaluate the effectiveness of a compensation program in attracting and retaining executives. I’m unclear as to whether that is still the case, but if it is, it argues against compensation committees trying to mirror the ISS peer group, since each peer group group is intended to serve a different purpose.)

Even assuming that a company’s peer group is identical to that constructed by ISS, the compensation and performance data available for each member of the peer group may vary widely, depending on when 10-Ks and final proxy materials are filed. In our case, fully 65% of our ISS peer group files proxy materials after us. In such cases, ISS says that it uses “…the latest compensation data available for the peer companies, some of which may be from the previous year.” U.S. Compensation Policies FAQs, at 33. (Dec. 14, 2017). Of course, due to the one-year lag in reporting equity grants in the Summary Compensation Table, some of the information ISS is using is two years old. That is, a 2017 Summary Compensation Table will show equity grants made in 2016 for 2015 performance.

Furthermore, even assuming that members of a peer group file at the same time, the information they provide will vary based on whether they provide a supplemental table that corrects for the one-year lag in reporting equity awards in order to better tie compensation to the most recent performance year. If Company A provides a supplemental table, it is providing ISS with an advance look at what will be in next year’s Summary Compensation Table. If Company B does not provide a supplemental table, ISS will rely on the Summary Compensation Table, which will show Total compensation that is distorted by the one-year lag in reporting equity awards.

Considering all of this, what is your opinion of the validity of ISS’s pay-for-performance methodology when analyzing the most recent performance year for members of its peer group?

Here’s the response that I posted from Carol Bowie of Teneo Governance:

As you note, the purpose of ISS’ peer groups does differ somewhat from that of the company, which is generally looking to benchmark pay to whatever market its management and board believe is appropriate to attract and retain talent.

According to its policy, ISS’ aim is to compile a peer group of companies that have specific similarities (primarily in size and industry) to the company being reviewed, as the first step in evaluating whether CEO pay and company performance are reasonably aligned. If that initial step indicates potential misalignment, what follows is a more in-depth (than normal) analysis and evaluation of the components and decisions related to the compensation program, with the ultimate recommendation based on whether the company’s disclosures indicate a robust pay process that clearly links pay outcomes to long-term company performance.

In working with our clients, we’ve found that there is no perfect peer group for such an analysis for many reasons, including the primary one the writer notes – i.e., various timing discrepancies. ISS may aim to utilize data as consistently as possible in the quantitative portion of their analysis, but there will almost always be anomalies to some degree, which is why it is critical that the company’s proxy disclosure – which ISS and other advisors rely on for their analyses — be as clear, comprehensive, and compelling as possible to support its pay programs and the decision-making underlying them.

– Liz Dunshee

When it comes to local “pay ratio” taxes, Portland is the only jurisdiction to-date that’s enacted this kind of surcharge. For businesses that earn income in that city, there’s a 10% surcharge if their pay ratio exceeds 100:1 and a 25% surcharge if their pay ratio exceeds 250:1. This blog from Cooley’s Cydney Posner notes that the median pay ratio for the Russell 3000 is 70:1 and summarizes some of the early results from Portland’s “experiment”:

According to this article in Bloomberg BNA, about 500 public companies have now been notified that they will be facing the surcharge because they earned income in Portland and reported pay ratios in their proxy statements that exceeded the thresholds. In one example provided on the city’s website, a public company that pays Portland $250,000 in regular business license taxes that reports a pay ratio of 1,000:1 would have to pay a surtax of $62,500 (25% of its business license tax), resulting in a total tax due to Portland of $312,500. This year, the city expects to raise about $3 million from the surtax, which is “earmarked for Portland’s affordable housing efforts and for funding its police force and fire stations,” according to a current Portland Commissioner. The Commissioner also indicated that, “the penalty is meant as a way to help tackle income inequality, [and she] hopes that it sparks an increase in what companies pay their average employees.”

Bloomberg observes that supporters and opponents alike admit that the surtax is “not likely to put a dent in the coffers of most companies, and whether it spurs changes in corporate compensation practices is likely to hinge on this strategy’s widespread adoption. ‘As a practical matter, it’s still a drop in the bucket for these companies,” [the Commissioner said], ‘Little Portland is not going to make much of a difference on its own.’” According to the Mayor of Portland, quoted in this NYT article, the city has “‘a habit of trying things…; maybe they’re not perfect at the first iteration. But local action replicated around the country can start to make a difference.’”

But as I blogged last month, “pay ratio” taxes don’t seem to be taking off…