After giving commenters two new bites at the apple – and releasing a DERA memo to analyze costs & benefits – the SEC is aiming to (finally) adopt clawback rules this fall. The end result of the rules will be that listed companies will need to adopt & disclose policies for recovery of incentive compensation that exceeds what would have been paid in the absence of an accounting restatement. It sounds like a simple concept, but it’s very, very complicated. And the topic hasn’t gotten any more straightforward since 2010, when it was first mandated by the Dodd-Frank Act.
I blogged earlier this year about notable comment letters that pointed out these challenges. New research from two accounting professors reinforces that notion (although I’m not sure that’s entirely the point they set out to prove).
The professors started out by measuring the “severity” of voluntarily adopted clawbacks, as disclosed in 821 SEC filings for non-financial companies from fiscal years 2007 to 2010. I was struck by the fact that the data set is a dozen years old, but apparently that’s because they wanted to leave a cushion of time to detect a subsequent restatement announcement. Their measurement is based on 27 attributes across these 8 categories:
1. Span of employees covered (e.g., current and/or former CEOs, CFOs, key executives);
2. Retrospective number of years the clawback applies to (i.e., the look-back period);
3. Trigger events (e.g., financial restatement);
4. Absence of hurdles inhibiting a clawback (e.g., absence of proof of materiality);
5. Compensation subject to recovery (e.g., short-term, long-term);
6. Reach of compensation subject to recovery (e.g., excess compensation, full compensation);
Here’s where things get interesting. The professors not only found a wide variation in the strength of clawback policies, but that the more stringent policies tended to exist at companies where directors were paid in cash & stock awards, rather than stock options. They suggested that directors who receive stock options are more motivated to focus on short-term performance and implement weaker clawbacks.
They also looked at unintended consequences: specifically, R&D spend. They conclude that clawbacks can be a “double-edged sword” because management may decrease R&D spend to overcome an earnings decrease due to financial misreporting. Other unintended consequences that weren’t part of the study could include the delay of bad news or ineffective changes to compensation structures.
Lastly, the analysis suggests that some boards are “giving the illusion of good governance to placate stakeholders, as their window-dressed clawbacks lack teeth.” In other words, all clawbacks are not created equal – and that may not come through in the DERA analysis.
Reading this research paper reminded me of a conversation I had with a benefits lawyer when these rules were first proposed. She told me she didn’t even want to think about all the complications here and that she hoped she would be retired by the time they went into effect (it does not appear her wish will come true). While we do have a “Clawbacks” Practice Area for members and guidance in the “CD&A” chapter of Lynn & Borges’ Executive Compensation Disclosure Treatise about how to disclose policies & related forfeitures, I think a lot of folks have shared that sentiment and have understandably been sticking their heads in the sand on this issue, while we all “wait & see” what happens with the rules.
Now that SEC action appears to be imminent, it’s time to get up to speed. If you want the crash course, register for our “Proxy Disclosure & 19th Annual Executive Compensation Conferences” – we have a session on “Clawbacks: Preparing for Final SEC Rules” with Davis Polk’s Kyoko Takahashi Lin, Gibson Dunn’s Ron Mueller, Hogan Lovells’ Martha Steinman, and our very own Mike Melbinger. Plus, 17 other panels, including an interview with Corp Fin Director Renee Jones. The Conference is being held virtually over 3 days – October 12th – 14th. Sign up online (via the conference drop-down), email sales@ccrcorp.com, or call 1-800-737-1271.
John blogged earlier this week on TheCorporateCounsel.net about whether buybacks are truly evil – or just misunderstood. One of the recurring criticisms of share repurchases is that they unfairly benefit executives in two ways: (1) by inflating stock prices on which awards are based, and (2) by providing executives with shares that they can resell at those inflated prices. John notes a recent study from three finance profs, which found little evidence for this. Here’s more detail:
It is well known that CEO pay increases in firm size and revenues and that bonuses are tied to accounting performance (Healy, 1985; Core et al., 1999; Murphy, 2013). Therefore, it is not surprising that the above-median repurchase firms’ CEOs earn more pay than the smaller, no-repurchase firms. Whether this difference represents excess pay for the above-median repurchase firms can be evaluated using the pay model described above. As reported in Table 4, the estimated excess pay for the CEOs of the above-median repurchase firms is $71,000. This amount is economically small, only about 0.9% of the average CEO’s total pay, and statistically insignificant.
Compared to the no-repurchase firms’ CEOs, the above-median firms’ CEOs earn $51,000 more excess pay on average (= $71,000 – $20,000). However, this difference is not statistically significant and is also economically small in relation to the average CEO’s pay. Overall, the small difference between the above-median firms and no-repurchase firms, the even smaller difference between all firms and no-repurchase firms, as well as the lack of a monotonic relation across the groups, collectively suggest that repurchases are not associated with excessive CEO pay.
In a recent WSJ article, Rick Wartzman & Kelly Tang of the Drucker Institute analyzed whether high pay ratios drag down the health of businesses, as Peter Drucker, “the man who invented management,” had predicted. Using the Drucker Institute’s measure of management effectiveness (which looks at 34 indicators of customer satisfaction, employee engagement & development, innovation, social responsibility, and financial strength), they arrived at this result:
The pattern that emerged was clear and consistent: The higher the pay ratio, the higher the average scores in our rankings. This was true for overall effectiveness, as well as for every one of the five areas we gauge.
Wartzman & Tang were surprised by this result: Drucker himself had said that resentment & falling morale would set in for ratios above 20:1, but the most “effective” companies in this analysis clocked in with a median pay ratio of 481:1. They note:
A key reason, we suspect, is that the majority of CEO pay comes in the form of stock and stock options, and the most effectively managed companies in our rankings have, by and large, watched their shares perform very well in recent years, easily outpacing the benchmark Dow Jones U.S. Total Stock Market Index.
To be sure, when exploring different variables than we do, other experts have produced evidence more in line with Mr. Drucker’s thinking. For example, a 2016 study by MSCI Inc. indicates that when pay imbalances between the CEO and everybody else are greater, labor productivity is lower. And a 2017 study by Harvard University’s Ethan Rouen found that “pay disparity matters to employee satisfaction, with consequences for firm performance”—specifically, year-ahead, industry-adjusted return on net operating assets.
Notwithstanding the correlation here, the authors aren’t advocating for higher CEO pay. They caution that the resulting income inequality risks tearing society apart, which would probably wipe out most of those market gains.
I blogged last week about a rulemaking petition that the “Working Group on Human Capital Accounting Disclosures” submitted to the SEC – which, among other things, urged the SEC to require companies to disaggregate labor costs on their income statements. This blog from Cooley’s Cydney Posner says that the FASB also recently revived a project to disaggregate income statement expenses – including labor costs. At a late-July meeting, the FASB considered feedback on the topic from both preparers & investors. Cydney’s blog summarizes the discussion from the meeting. Here’s an excerpt:
At this point, a loose consensus appeared to form around a two-pronged hybrid approach (somewhat similar to the approach being taken by the IASB): a prescriptive component that would require disaggregation of some specific costs, including labor, depreciation and amortization and, in some cases, materials or purchases; and a principles-based component for disaggregation of other costs, which might involve management judgment or a quantitative threshold or backstop. More elusive perhaps may be a simple approach to addressing inventory and capitalized expenses.
The staff plans to perform analysis and develop alternatives for discussion at a future Board meeting. Clearly, there’s still a way to go here, but the project does appear to be moving forward. Separately, the FASB is working on a proposal to require more granularity about segments.
The attention on “labor cost” transparency follows two years of new disclosure under the principles-based human capital disclosure rules that the SEC adopted in 2020. A recent academic study (from accounting professors Demers, Wang & Wu) found that, at least in Year 1, Form 10-K HCM disclosures tended to focus on qualitative info and be phrased optimistically. If you’re preparing these disclosures, you should know that someone out there is measuring your word count and “positive tone.” Here’s more detail (cleaned up):
– The mean (median) HC disclosure consists of 501 (420) words. The length of the HC disclosure varies considerably across firms, ranging from 37 words at the 5th percentile to 1,305 words at the 95th percentile.
– In relative terms, HC disclosures represent 8.59% (5.53%) of Item 1 for an average (median) firm. The proportion of Item 1 represented by HC disclosures varies greatly across firms, however.
– “Numerical intensity” is low – just 3.87% (2.61%) for an average (median) firm in the sample – 5% of firms provide less than one number for every one hundred words in their HC disclosures,
whereas the 5% with the highest numerical intensity provide approximately one number for every 10 words.
– Firms use approximately four times as many positive words as negative words in their HC disclosures.
The professors concluded that the new disclosures lacked comparability and weren’t very informative to investors:
Our results confirm that, in the absence of detailed guidance, corporate HC disclosures are extremely heterogeneous in terms of their length, numerical intensity, tone, readability, and similarity with peer firms; they are generally not very numerically intensive, but they are very positively toned; and they inherit many of the properties of the firm’s other Item 1 disclosures.
Firms with higher levels of institutional investors have longer and more net positively-toned HC disclosures, but these disclosures are not necessarily more informative as they are not more numerically intensive nor more specific. More profitable firms tend to have more idiosyncratic disclosures, whereas firms with lower ROA tend to provide more boilerplate disclosures. Firms for which HC is strategically important, on the whole, do not appear to provide superior HC disclosures.
Finally, time trends suggest that firms have learned over the first year of the non-directive regulation to provide HC disclosures that are longer and more optimistic, but less informative (i.e., more similar or boilerplate, less specific, and less numerically intensive). Overall, our comprehensive descriptive evidence suggests that, consistent with widespread criticism, the SEC’s new principles-based rule has generated HC disclosures that are likely to be grossly insufficient for investors’ needs.
It will be interesting to see whether the new HCM disclosure that the SEC intends to put forth this fall will swing the pendulum all the way to the “prescriptive” side of the spectrum, which seems to be the direction that the tea leaves are pointing. I’m sure I’m not the only one who finds the criticisms of early disclosures a little unfair, when companies were scrambling to navigate an 11th-hour rule.
That said, now is the time to get out in front of the next round of rulemaking, because your future disclosures also will be picked apart. Our “Proxy Disclosure & 19th Annual Executive Compensation Conferences” will provide loads of practical guidance. That includes get the very latest on what you need to be doing to prepare for new HCM disclosures that the SEC plans to require – and in the meantime, meet continuously advancing investor demands.
With so much SEC rulemaking on the horizon, our Conferences are a “can’t miss” event for anyone who is preparing SEC disclosures, engaging with shareholders, or advising compensation committees or boards. Check out the agendas – 18 fast-moving, practical sessions held virtually over 3 days – October 12th – 14th. Sign up online, email sales@ccrcorp.com, or call 1-800-737-1271. With human capital also being a very relevant topic to anyone navigating ESG issues, you can also add on our “1st Annual Practical ESG Conference” for a bundled discount! Tell your colleagues, and save even more for multi-seat registrations…
We recently received the following member question on our “Q&A Forum” (#1414), which John also noted on TheCorporateCounsel.net:
Should the compensation of NEOs be approved or ratified at an annual stockholders meeting? I believe it should be ratified because the Board previously approved it and now the stockholders are ratifying and approving the board’s action.
This was John’s response:
I think the general practice is to ask shareholders to “approve” the compensation. I think there are a few reasons for that. First, it’s an advisory vote, not one that is intended to have the legal effect associated with ratifying board action under state corporate statutes. Second, the relevant rule uses the term “approve.” Rule 14a-21 requires companies to “include a separate resolution subject to shareholder advisory vote to approve the compensation of its named executive officers, as disclosed pursuant to Item 402 of Regulation S-K.” Finally, the Instruction to Rule 14a-21 includes a non-exclusive sample of an acceptable resolution, which also speaks in terms of shareholders “approving” the compensation. Here’s the text:
“RESOLVED, that the compensation paid to the company’s named executive officers, as disclosed pursuant to Item 402 of Regulation S-K, including the Compensation Discussion and Analysis, compensation tables and narrative discussion is hereby APPROVED.”
When it comes to other say-on-pay questions, don’t forget to consult our “Executive Compensation Disclosure Treatise” – a comprehensive, well-organized resource on executive compensation disclosure that is available online to members of CompensationStandards.com.
I blogged last week on TheCorporateCounsel.net about BlackRock Investment Stewardship’s annual stewardship report – which details its engagement & proxy voting stats and the rationale for voting decisions. On the one hand, the report had some good news for companies when it came to the asset manager’s view of corporate ESG progress. The picture wasn’t as rosy for executive compensation, though. At S&P 500 companies, BlackRock’s support for say-on-pay proposals has declined continuously over the past 5 years.
When it came to Americas-based compensation-related proposals (primarily say-on-pay & incentive plan proposals), BlackRock supported management 89% of the time – compared to 92% past year. For say-on-pay specifically, it supported 91% of management proposals this year compared to 94% last year – with the most significant decline happening at S&P 500 companies (BIS supported proposals at 87% of those companies this year, compared to 90% at the rest of the Russell 3000). It says that the main reasons for diminished support include cases of:
– Lack of clarity regarding the alignment of performance metrics and their weightings with company strategy;
– Concerns regarding performance goal rigor;
– Awards that were not aligned with sustained long-term performance; and
– Front-loaded awards without a compelling rationale for long-term shareholders.
The report provides case studies of say-on-pay “no” votes on page 42 and a success story on page 43. BlackRock also voted against 382 directors in the Americas to signal compensation-related concerns.
Emily blogged last week about the resurgence this proxy season of shareholder proposals relating to severance arrangements. I’m pleased to follow up with more detail via this guest post from Orrick’s J.T. Ho and Bobby Bee (and join us at our “19th Annual Executive Compensation Conference” for more on this topic…):
The 2022 proxy season has seen a spike in a recurring 14a-8 proposal that requests issuers implement policies limiting executive severance amounts. As of publication, at least fifteen issuers have been required to include this proposal in their 2022 proxy statements.
The proposal at issue dates back, essentially unchanged, to as early as 2003, and has been submitted by well-known shareholder activists (such as John Chevedden, Kenneth Steiner, James McRitchie, and Myra K. Young). In each case, the proposal requests that boards seek shareholder approval of any executive pay packages providing for severance or termination payments exceeding 2.99 times the sum of base salary plus bonus. The activists include as severance or termination payments not only cash payments but also, notably, the cash value of most other severance or termination compensation, including outstanding equity awards that accelerate upon a separation event. Acceleration of equity is common upon termination of top executives, however, and the value sometimes dwarfs cash payments. How should issuers prepare for the possibility of such a proposal, or respond if they receive one?
Despite proxy advisors’ general support of such proposals, most issuers faced with these proposals have been able to secure a shareholder vote rejecting it. In justifying their “no” vote recommendations, issuers have pointed to existing practices or policies limiting cash severance benefits. Some have also succeeded by pointing to limits newly adopted in response to the proposal. Of note, however, many issuers have obtained a “no” vote even while specifically excluding from their limitations the cash value of accelerated vesting of outstanding equity awards, justifying that exclusion by the need to offer competitive compensation packages to top executives. Consider Verizon’s experience – and the success of other companies that have been able to point to existing policies that cap cash severance:
In 2003, Verizon’s shareholders approved a proposal brought by Jack Cohen through the Association of BellTel Retirees. In response, in 2004, Version adopted a cash severance policy that requires Verizon’s board to seek shareholder ratification of any senior executive severance agreement providing for total cash value severance exceeding 2.99 times the sum of base salary plus bonus. The 2004 limitation did not apply to equity vesting policies. Verizon has been subject to the same proposal no less than nine times since, and each time the proposal has failed to obtain majority vote.
Many other companies have found similar success without limiting outstanding equity awards. Eight of the fifteen issuers identified as of the date of this publication for the 2022 proxy season received “no” votes on this proposal by pointing to existing policies or practices capping only cash severance payments and not equity, including: Allegiant Travel Company, UnitedHealth Group Incorporated, XPO Logistics, Inc., Lincoln National Corporation, Southwest Airlines Co., Verizon Communications Inc., General Electric Company, and The AES Corporation.
Even policies enacted between receipt of the proposal and the issuer’s annual meeting have been effective. For example, the Colgate Palmolive Company adopted an “Executive Officer Cash Severance Policy” on April 11, 2022, just one month prior to its 2022 annual meeting. As a result, and despite the adopted policy excluding accelerated equity vesting from its limitations, 56% of shareholders voted against the proposal. Similarly, NCR Corporation adjourned its 2022 annual meeting solely with respect to this proposal to allow additional time to engage with stockholders regarding a proposed Cash Severance Policy (which also excluded accelerated equity vesting) prior to voting. 61% of NCR Corporation shareholders ultimately voted against the proposal.
Our research shows activist proposals for this issue are on the rise and there is limited opportunity for excluding it under Rule 14a-8(i)(7) “ordinary business” grounds, as the SEC has historically rejected attempts to do so. Accordingly, issuers without existing severance limitation policies should consider, and may benefit from adopting and publicizing, a formal severance policy that limits cash severance payments to 2.99 times the sum of base salary plus bonus (with latitude granted to the issuers in determining whether such policy limitations will include or exclude the cash value of accelerated vesting of outstanding equity awards). Such action may put issuers in a better position to avoid receiving such a proposal, or to address it without needing to hastily adopt a policy in advance of the annual meeting.
Way back in 2017, before many folks had even heard the term “human capital,” the investor-led “Human Capital Management Coalition” submitted a rulemaking petition to the SEC – calling for additional disclosure about policies, practices & performance. I taped a podcast around that time with Cambria Allen of the UAW Retiree Medical Benefits Trust (the HCM Coalition’s leader), to discuss that petition. By 2019, the SEC proposed amendments to Regulation S-K that added “principles-based” human capital disclosure requirements in response to investor appetite for that info. The SEC adopted those rules in 2020.
But, those rules didn’t go as far as many investors wanted, and there are continued calls for more prescriptive line-item disclosure requirements. I blogged earlier this summer that HCM continues to be part of SEC Chair Gary Gensler’s Reg Flex Agenda – with a proposal expected this fall.
A recent rulemaking petition submitted by the “Working Group on Human Capital Accounting Disclosures” gives an idea of how far that proposal might go. The Working Group is co-chaired by Stanford Law & Columbia Business School profs Colleen Honigsberg & Shivaram Rajgopal – and members include former GC and Acting Director of the SEC’s Division of Corporation Finance John Coates, former SEC Commissioner and current Stanford Law prof Joe Grundfest, former SEC Commissioner and current NYU Law prof Rob Jackson, Wharton’s Daniel Taylor, and other academics.
The petition calls for enhanced MD&A disclosure that explains what portion of labor costs are investment in growth vs. maintenance, very detailed tabular disclosure of labor-related info, and income statement disaggregation of labor costs. Here’s the tabular info that the petitioners are calling for, which they suggest breaking out to show by the categories of full-time employees, part-time employees & contingent workers (also see this Forbes op-ed):
– Mean Tenure, Employee Turnover & Number of Employees
– Total Compensation by Category:
– Salary
– Bonus
– Pension
– Stock Awards
– Option Awards
– Non-Equity Incentive Compensation
– Pension & Deferred Compensation
– Health Care
– Training
– “Other”
For most companies, it’s already a heavy lift to provide compensation info for NEOs. We have an entire Disclosure Treatise that walks through how to do it! That effort would pale in comparison to this workforce-wide exercise, but the petitioners argue that it would be money & effort well-spent. Time will tell whether the SEC includes anything like this in its proposal.
Rest assured that we’ll be sharing practical guidance on this topic at our “Proxy Disclosure & 19th Annual Executive Compensation Conferences” – specifically, during our session on “Human Capital Disclosure: Mastering SEC & Investor Expectations.” That’s only one of the many rulemaking topics that we’ll be covering. Check out the agendas – 18 fast-moving, practical sessions held virtually over 3 days – October 12th – 14th. Sign up online, email sales@ccrcorp.com, or call 1-800-737-1271. With human capital also being a very relevant topic to anyone navigating ESG issues, you can also add on our “1st Annual Practical ESG Conference” for a bundled discount! Tell your colleagues, and save even more for multi-seat registrations…