– Broc Romanek, CompensationStandards.com
Here’s a piece from “Directors & Boards” penned by Prof. Charles Elson and Craig Ferrere:
Today, most boards justify their decision-making process for setting executive pay by referencing the pay of other “peer” company executives. In compensation disclosures most companies will use this “peer group” to explain that their particular executive is paid commensurately with others and that therefore the board has acted reasonably in setting compensation figures. However, now that they must publish the corresponding figure for median worker pay, companies will be forced to explain executive compensation decisions in a very different context. Rather than looking externally, to other executives, they will have to address the relation of pay to internal compensation dynamics.
Fodder for Discontent
Besides investors, a company’s own employees are the most important consumer of proxy statements and annual reports. The information that is conveyed and the impression that is imparted have the potential to greatly affect how employees — whether middle management or assembly-line workers — view the company’s mission, purpose and integrity. An employee’s perception of these reports will affect their confidence in the enterprise long term. Done well, an annual report can help solidify employee commitment and facilitate a highly functioning organization. Done poorly, however, the reporting and the substance can become fodder for discontent and disillusion, creating broad-based dissension.
Employees will pay particular attention to this antagonistic pay-disparity ratio. Moreover, pay comparisons to other executives will not provide an adequate justification of board decision making as far as this important constituency is concerned. Such explanations will only inflame the pre-existing broad-based concerns about preferential treatment and meritless reward for executives. Peer group references to other executives will only serve to reinforce the common notion of a clubby and back-scratching boardroom culture. Rather, boards and compensation committees will have to work closely with their human resources professionals to design and explain executive pay around internal company compensation system protocol.
No, It’s Not ‘Political’
All employees understand that as one is successful and promoted within the enterprise, pay goes up concurrently. It must be communicated that executive pay, and the CEO-to-median-worker ratio, are ultimately the result of this dynamic internal incentive structure and not of “political” or unfair treatment. This, instead of simple reference to other executives, will make executive pay disclosures relatable and palpable to more employees. Additionally, if done correctly, by communicating the character of the incentive structure of the organization, and valorizing the potential rewards to long-serving and successful employees, this disclosure may in fact provide positive benefits.
A company’s response to this rule needs to involve more than just a change of approach with regards to proxy disclosures. The aforementioned peer groups are not just utilized to explain pay but are also heavily relied upon in setting it too. In a mechanistic fashion companies will target the total value of a CEO’s compensation to a specified percentile, or benchmark, almost always at the 50th percentile or above. This process has become a substitute for a careful board consideration of the company’s internal compensation dynamics and, in effect, drives the decision-making process.
Major Disconnect
The result has been executive pay practices that are increasingly disconnected from the internal contextual factors that should otherwise shape and influence their development. However, in order to respond effectively to this new disclosure in a manner that will be acceptable to employees and avoid dissension, companies will need to incorporate these factors and concerns. Companies will have to move away from the rote application of peer benchmarking and percentile targeting and engage in a more holistic approach to setting pay.
As such, the ratio disclosure could be the impetus for a sea change in compensation practice, one which we have advocated before — see “What Is a CEO Worth? Don’t Look to Peers,” Directors And Boards, Third Quarter 2011. This change will ultimately benefit the compensation area and, through that, corporate America greatly.
We’ve posted dozens of memos on the new rules in our “Pay Ratio” Practice Area. Also see this CFO.com page which has 3 different articles with different perspectives on pay ratio…
– Broc Romanek, CompensationStandards.com
As the pressure to use “Total Shareholder Return” becomes more intense with the SEC’s proposed rules to mandate disclosure of pay-for-performance through the TSR lens comes this study by Pearl Meyer that it’s not a magic metric…
– Broc Romanek, CompensationStandards.com
I’ve kinda fallen off the “reporting on say-on-pay failures” bandwagon as the number of failures seems to be relatively flat every year – at least in the big picture. We’ve had 54 failures so far in 2015 – compared to 60 in ’14; 71 in ’13; 61 in ’12; and 43 in ’11 (per this video). This latest Semler Brossy report gives the head count for 2015. The primary interesting tidbit regarding the failures is how many companies who score 90% in one year then fall the next. About 15% who received 90% support face lower support the next year, and the average drop is 20%…
– Broc Romanek, CompensationStandards.com
This is how this memo from Frederic W. Cook begins:
This alert is a reminder to compensation professionals that, beginning with 2016 financial statements, the concept “extraordinary items” as a technical accounting term will no longer exist. Going forward, the correct terminology will be items that are “unusual in nature” or “infrequently occurring,” as explained below. This will be important when drafting beginning-of-year resolutions establishing performance measures and goals for incentive plans. Any pre-exclusionary language should refer to items that are unusual in nature or infrequently occurring, and references to extraordinary items should be of the generic sense and not explicitly referencing accounting rules. Shareholder-approved plan documents and grant agreements should also be reviewed and changed as appropriate.
– Broc Romanek, CompensationStandards.com
A few days ago, I blogged on TheCorporateCounsel.net about ISS’ new policy survey results (here’s the press release – and the full summary). As noted in this Towers Watson memo, this year’s survey was light in questions related to executive compensation, with only three main questions overall. Here’s an excerpt from that memo:
Incentive Plan Design (U.S.)
The use of adjusted (non-GAAP) metrics within incentive plans has been common among U.S. companies. Investor survey participants generally agree that adjusted metrics are acceptable, depending on the rationale for their use and the degree of adjustment made by companies. Investors believe that performance goals and results should be clearly disclosed in the proxy. In addition to disclosing the rationale, companies should also disclose how the adjusted metrics reconcile with similar GAAP metrics.
Regarding the types of adjustments, investors generally feel it’s appropriate to adjust results for such items as discontinued operations, extraordinary charges and foreign exchange volatility, but not for compensation or litigation expenses. Some investors commented that adjustments should be considered on a case-by-case basis as industry and/or business model considerations may have a bearing on appropriateness. Some respondents also commented that the type of adjustments made should be consistent year over year. (For more on the extent to which companies adjust performance metrics for currency movements, see “Survey Reveals How U.S. Companies Address the Impact of Currency Fluctuations on Incentive Plans,” Executive Pay Matters, July 22, 2015.)
Say-on-Pay at Externally Managed Issuers (U.S. & Canada)
For externally managed issuers — generally real estate investment trusts that use external management — ISS sought guidance on the appropriate course of action with respect to say-on-pay resolutions where the issuer provides minimal (or no) disclosure about executive compensation because that is paid by the external manager. Almost three-quarters of investor respondents suggested that ISS should recommend a vote against the proposal for lack of disclosure.
When a say-on-pay resolution is not on the ballot, such as when the issuer doesn’t hold an annual say-on-pay vote, some investors noted that they might consider voting against compensation committee members if the disclosure did not meet minimum informational needs. Factors like stock price performance, the independence of directors and any history of pay or shareholder activism would be considered in these cases.
In the case of either of these topics, proxy disclosure that includes additional information and a clear explanation of the company’s rationale are key to helping investors make informed voting decisions.
Outside Directors & Equity (Global)
ISS sought feedback in the survey on which types of equity compensation, if any, are appropriate for non-executive directors. The investor respondents generally favored grants of shares in lieu of cash retainers or meeting fees, while a slight majority suggested that stock options/stock appreciation rights are inappropriate and over 60% said that performance-based restricted stock is inappropriate for outside directors. The general theme was that tying director compensation to management performance can create a conflict of interest, perceived or actual, because the directors are in charge of setting the underlying performance goals.
– Broc Romanek, CompensationStandards.com
This excerpt from this blog from “Crooks & Liars” is startling (see the video of Graham from that blog):
Phil Gramm, a former three-term Republican senator from Texas who once ran the Senate Banking Committee, told the House Financial Services Committee yesterday that “it was an outrage” that his friend Edward Whitacre, the CEO of AT&T, only got “$75 million” when he retired in 2007.
“If there’s ever been an exploited worker” it was Whitacre, said Gramm, testifying on the fifth anniversary of passage of the Dodd-Frank financial reform bill. Gramm appeared genuinely aggrieved by Whitacre’s shabby treatment and literally pounded the table while speaking.
Whitacre actually received a retirement package totaling $158 million.
Gramm attributed public anger at CEOs like Whitacre to “the one form of bigotry that is still allowed in America,” which is “bigotry against the successful.”
Talk about tone-deaf…
– Broc Romanek, CompensationStandards.com
With a lot of focus on how to eventually explain pay ratio disclosures to employees, I thought this Towers Watson memo about better communicating incentive plans to employees went hand-in-hand…
– Broc Romanek, CompensationStandards.com
No big surprise. This Towers Watson survey finds that the top corporate concern is how folks will perceive their pay ratio. And the survey also finds that few are prepared to comply…
Gain access to the archive of our “Pay Ratio Workshop” now – and also gain access to our upcoming two-day proxy disclosure/compensation practices conference (available live in San Diego or live/archive by video webcast)…
– Broc Romanek, CompensationStandards.com
Here’s an excerpt from this Towers Watson memo:
Heading into the 2014 incentive year, about two-thirds of the companies participating in our survey had not implemented a policy for making adjustments for currency fluctuations in their incentive plans. But, as companies were tallying financial results for 2014, it was apparent that the dollar’s rise, which accelerated in the fourth quarter of 2014, had a negative impact on many companies’ full-year profits — and, thus, on the bonus results.
One of the key questions our survey sought to answer was when it came time for discussions of the bonus decisions in early 2015, did the pressures from currency fluctuations lead companies to consider making adjustments to bonus plan results to address the unanticipated impact of the strong dollar. The answer from our survey was an emphatic no. Our survey found that, despite the negative effects from foreign exchange volatility, nearly all companies with nonadjustment policies stuck with those policies. In other words, they maintained the original bonus goals and used the financial results as reported, even though bonuses may have been adversely affected.
However, another group of companies — roughly a quarter of our sample — took a different approach. At the start of 2014, these companies had established a policy of neutralizing the impact of currency fluctuations. For example, some companies planned to calculate financial results after applying constant currency conversions throughout the year, and to use these results for bonus purposes. Not surprisingly, at the end of the year, the vast majority of these companies maintained their policy and neutralized the impact of currency volatility when determining the bonus payout.
Of these companies that adjusted for currency fluctuations in 2014, most applied adjustments to both corporate and business-unit results. And if they had a long-term performance plan in addition to an annual incentive plan, most neutralized currencies in both types of plans, although some adjusted only for specific incentive plan metrics (e.g., revenues only).
– Broc Romanek, CompensationStandards.com
In the wake of yesterday’s merger announcement, a reporter sent me this question: “What do you make of Korn Ferry’s acquisition? Does this raise independence issues under Dodd-Frank for companies that might pay a substantial amount to Korn Ferry for CEO, board search etc. who also consult with Hay Group on executive compensation? Most companies use the same consultant for executive and director compensation consulting. Is there extra due diligence required by the comp committee if they use the same firm for both services? Additional disclosure? Will boards have to start reporting how much they pay for executive and board searches?”
Here’s an answer that I received from Mark Borges:
I wouldn’t think board recruiting would trip a comp consultant’s independence. As you know, advisor “independence” must be considered, but there’s no requirement that a Compensation Committee use an independent advisor. So the assessment is really all about whether, in the opinion of the Compensation Committee, the highlighted relationship with the company impairs independence.
As you note, there is, on its face, a possible independence issue where a company retains Korn Ferry for specific services (such as a CEO, director search) while the Compensation Committee also uses the Hay Group for its executive compensation consulting. It’s really no different than the issue that the major HR firms faced a few years ago when they had to choose between their retirement and health care consulting services and their executive compensation consulting services. They chose the former because it presented a larger revenue stream and spun off their consulting businesses.
You can argue that an organization such as Korn Ferry is large enough to establish an effective barrier between its general services and its consulting business to avoid actual conflict situations (and, I suspect, that’s exactly what they will do). However, for many companies, it’s the appearance rather than the reality of a conflict which caused them to shy away from relationships with companies where they may have been receiving both consulting and non-consulting services. This may, in fact, happen here.
While the rules don’t prevent anyone from using Korn Ferry for their general services and Hay Group for their compensation consulting, it’s probably going to lead to a little extra diligence to justify the arrangement to be able to respond to inquiries about independence.