The Advisors' Blog

– Broc Romanek

This column by Joe Bachelder looks at mega-grants. The ‘pros’ & ‘cons’ are analyzed on pages 5-6…

– Broc Romanek

Here’s an excerpt from this Willis Towers Watson’s panel summary about diversity on compensation committees:

When asked if diversity objectives should be included in the management incentive plan, Ms. Mulcahy said that one cannot “comp” everything. Diversity goals should not be hardwired to the compensation plan, but they should be part of management’s subjective evaluation – part of a people engagement dashboard – where the board and/or the CEO can provide constant feedback to management. The management team will soon get a picture of how it’s doing. “It is a system and not just one thing you are doing…When it becomes consistent over the long term and successive leaders are championing it, you develop a reputation and that compounds the benefits of it. We created that reputation (at a former employer) and had diverse candidates lining up.” I&D has to be embedded in every part of the employee life cycle from recruitment, to promotion and separation.

Mr. McCormick shared that one company deliberately conducted exit interviews using senior leaders who had the same diverse attributes as those of the departing employee. This led to more honest feedback and better insights on why employees were leaving.

– Broc Romanek

This report from Semler Brossy gives us the final tally for last year’s say-on-pay results. The firm also does a nice job of recapping what it predicted correctly – and incorrectly – about pay developments over the last year…

– Liz Dunshee

Following a low say-on-pay vote, you might earnestly try to right the ship with something like this 14-point recovery plan. But however you get there, this Equilar blog says that the way the data shakes out, most companies with a failed vote end up cutting CEO pay via a shift in the pay mix. Specifically, by reducing option awards. Here’s an excerpt:

Breaking down the average pay mix of companies that failed Say on Pay depicts a trend that could be a major player in a failed vote: options. According to the 2018 Equilar CEO Pay Trends report (available for purchase), options made up an average of 11.8% of CEO pay mix in 2017. However, of the companies that failed Say on Pay in 2017, options made up 23.2% of pay mix, almost double the amount. Over time, compensation professionals realize the power of Say on Pay and take appropriate actions.

Diving into the details on a per-company basis allows for a highlight of an example among companies that have failed Say on Pay proposals. Bed, Bath and Beyond (BBBY) is particularly illustrative of the trend in CEO compensation. After its first time failing Say on Pay in 2014, rather than reducing CEO Steven Temares’ pay, BBBY increased the option and stock awards granted to Temares. Perhaps not surprisingly, after this increase in options and stock, BBBY then failed its Say on Pay vote in 2015.

As a result, option award values decreased by 52.4% in 2016 and then were decreased by about $850,000 the following year. Though the company failed Say on Pay in both 2016 and 2017, the total compensation of the chief executive decreased by 20.9% from 2014 to 2017. This shows that the company made a concerted effort to gain approval in the eyes of its shareholders. Additionally, it seems as if companies that fail Say on Pay consecutively make a greater point of altering their CEO pay plans, especially when it comes to options.

– Liz Dunshee

In December, Broc reported that ISS had released its “Equity Compensation Plan” FAQs – and its final “Executive Compensation Policies” FAQs. As part of those updates, the proxy advisor confirmed that it wants companies to continue some practices that initially became common because of the now-repealed Section 162(m) performance-based compensation exemption.

Specifically, it’s encouraging companies to continue frequently submitting equity plans for approval (by increasing the weighting of the plan duration factor in its Equity Plan Scorecard) and discouraging any shifts away from performance-based pay to discretionary or fixed-pay elements (by defining that behavior as a “problematic pay practice”). Here’s what Ron Mueller had to say about this in our recent webcast, “The Latest: Your Upcoming Proxy Disclosures“:

Not surprisingly, the repeal of the exemption is not having dramatic effects, at least among my clients. Everyone is still aligned with pay for performance. Some of those compensation plans that have had two sets of performance goals – one for 162(m) and one that were the determinative goals – now might only have the determinative goals.

There is still alignment with pay for performance, and ISS has reiterated that it very much expects some of the practices from 162(m) to continue. I think that will be the case as well, and that there will be a continued focus on setting pre-established performance criteria.

There will be continued frowning upon discretionary increases above what a performance goal allows, other than just perhaps some percentage of the target being based on personal performance, generally positive discretion. I don’t think we’re going to see that being widespread.

Companies should consider whether they need to amend their proxy discussion of the implications of tax rules on their compensation programs. One company, Unum Group, in their 2018 proxy had a good statement that reaffirmed the comp committee’s commitment to a pay for performance alignment. I think we will see more of this in 2019.

– Liz Dunshee

This Equilar blog says that although there’s high-level consensus around peer group criteria – with most companies using some combination of industry, talent pool, revenue and market cap – the number of criteria actually used varies widely – and so does peer group size. And if your peer group rationale is unconvincing, investors are less likely to accept the benchmarks that underlie all your executive pay decisions.

So it’s not a bad idea to revisit your peer group selection process, with an eye toward the best practices in this FW Cook memo. And while you’re at it, be wary of these common pitfalls:

– Using “aspirational peers”: Attracts negative scrutiny from proxy advisors and shareholders who think the selection is being used to ratchet up benchmark pay

– “Cherry-picking” peers: Focus on objective criteria, don’t select companies to maximize benchmarks or justify certain pay practices

– Focusing on non-executive talent pool: Often, there’s a more diverse universe of companies that compete for non-executive talent, but these companies may not be relevant for executive benchmarking purposes

– Defaulting to valuation peers: Valuation peers often don’t comply with peer group standards used by compensation consultants, proxy advisors or institutional investors

– Liz Dunshee

Some pundits like to say that “everything is securities fraud” – and one pretty common example is lawsuits and penalties stemming from cybersecurity or privacy issues. Now it’s starting to feel like everything that could be securities fraud could also, on the front end, be an executive pay metric. For instance, Disney’s proxy statement includes this shareholder proposal from Jim McRitchie:

RESOLVED: Shareholders of The Walt Disney Company (the “Company” or “Disney”) ask our board of directors (the “Board”) to publish a report (at reasonable expense, within a reasonable time, and omitting confidential or propriety information) assessing the feasibility of integrating additional cyber security and data privacy metrics into the performance measures of senior executives under Disney’s compensation incentive plans.

In opposing the proposal, Disney makes the case in its proxy and additional soliciting materials that it already considers data security & data privacy in its executive compensation design – by factoring non-financial performance factors into awards for individuals who have direct responsibility for those matters. In his supporting statement and voluntary exempt solicitation, Jim emphasizes the cost of data breaches and privacy issues and argues that the metrics should apply to all high-level executives. Shareholders voted down a similar proposal last year at Verizon.

– Broc Romanek

Tune in tomorrow for the webcast — “How to Use Cryptocurrency as Compensation” — to hear Perkins Coie’s Wendy Moore and Morrison & Forester’s Ali Nardali and Fredo Silva discuss the groundswell in the use of cryptocurrency as compensation among private companies — and the legal framework that applies.

– Liz Dunshee

Nobody expects the repeal of Section 162(m)’s “performance-based” exception to cause companies to limit CEO pay to less than $1 million. This research from two economists finds as much when looking at tax deduction limits in the health insurance industry imposed by the Affordable Care Act. Here’s an excerpt:

The ACA prevented insurers from deducting more than $500,000 of a CEO’s pay from their profits for tax purposes. This meant that instead of CEO pay costing the firm 65 cents on the dollar (the tax rate was 35 percent at the time), it cost them 100 cents on the dollar, effectively raising the cost of a marginal dollar of CEO pay by more than 50 percent.

If health insurers are setting the pay equal to the value the CEO adds to the shareholders, the increased cost of pay to the company from the loss of tax deductibility should have unambiguously had the effect of lowering CEO pay, after controlling for other factors. We ran a large number of regressions, controlling for increase in revenues, profits, share prices, and other factors that could plausibly affect pay.

It was a small sample size – but in none of them did we find any evidence that CEO pay in the health insurance industry had been lowered by this provision in the ACA. This would seem to support the view that CEO pay does not bear any relationship to the returns CEOs produce for shareholders.

That last sentence is…disturbing? Incorrect? I’m not sure. You would think shareholders would care about lower returns – but rightly or wrongly, I think they’re more likely to blame the government than CEO pay for any reduction in earnings that’s caused by changes to the Internal Revenue Code. But there is an outside chance that shareholders will do more to limit CEO pay – e.g. by voting down “say-on-pay” or voting against directors – now that they bear the full cost. Here’s what the economists concluded:

In order to limit CEO pay it may be necessary to alter the rules of corporate governance in ways that increase the power of shareholders over the CEO.

– Liz Dunshee

About a year ago, Broc blogged about ISS’s acquisition of EVA Dimensions – and how it would likely impact the pay-for-performance analysis. Sure enough, in the 2019 updates to its voting policies, ISS said that it would start showing EVA measurements in its research reports and would consider adding them to its quantitative pay-for-performance screens in 2020. This Sullivan & Cromwell memo says that ISS essentially defines EVA as net operating profit after tax, less the cost of providing an acceptable return to capital providers.

We don’t know yet whether investors will develop a preference for EVA-based plans. But if this article is correct in asserting that a focus on economic profit improves long-term results, it stands to reason that having the ISS data point will move everyone in that direction. The article notes that some companies are already starting to incorporate these measures into plans – but customization might be necessary. Here’s an excerpt:

Maximized independently, traditional performance measures – e.g. revenue growth, margins, asset efficiency, and rates of return – can actually destroy value when taken to extremes. Luckily, all of those metrics are captured in economic profit measures such as EVA, where economic profit tells you whether the traditional measures of performance are optimally balanced in a way that maximizes value.

For example, a large capacity investment might drive up asset intensity, driving down rates of return. And the incremental sales growth from increased volumes may come at a lower price and, therefore, lower margins. But the growth from a large capacity expansion can be significant and offset the impact of some of the other measures.

An economic profit measure is the ideal tool to decide if growth is worth it or not. You may still convey it to investors using traditional measures and using statements like, “although margins and returns will come down slightly, the significant new growth potential is so valuable that we expect this investment to drive our share price higher over time.”