The Advisors' Blog

– Broc Romanek, CompensationStandards.com

I’m proud that Cap’n Cashbags has been included in Aon Hewitt’s nifty “2014 Holiday Card” – the card also includes Monte Carla, the co-winner of the “Survivor of the Top Consultants” panel from our conference! Click the image below to enlarge…

– Broc Romanek, CompensationStandards.com

Here’s an interesting piece by Todd Lippincott and Erik Nelson of Towers Watson, responding to recent articles in the Harvard Business Review that suggested that corporate executives, with complicit directors, focus more on self-enrichment and managing the stock market than creating real value and managing the fundamentals of their companies…

– Broc Romanek, CompensationStandards.com

To investigate what – and how much – is being shared in proxy statements about executive pay and how incentive pay is designed, Arthur J. Gallagher has conducted a study of the 2014 disclosures for 200 of the top US companies based on revenue and market capitalization. This is the 6th consecutive year they have conducted this analysis…

– Broc Romanek, CompensationStandards.com

It’s pretty rare that we see a comp committee uses its discretion to reduce pay – so I’m highlighting this recent disclosure example from Johnson Controls below. Apparently the CEO was dating a partner of their outside talent management consulting firm and is now in the midst of a divorce. Juicy stuff. But he’s a lucky fella as that only cost him 20% of his bonus, not his job:

As previously reported in the press, independent outside counsel was retained to advise the Executive Committee (other than Mr. Molinaroli, who recused himself for all purposes in this context) and to assist it in reviewing reports of a personal relationship between Mr. Molinaroli and a principal in an outside consulting firm that performed services for the Company relating to talent management and organizational development. Based upon that review, the Executive Committee concluded that there had been no misuse of corporate assets and that the assignments given to the consulting firm, which had served the Company for approximately 30 years, and related compensation to that firm had not been improperly influenced by Mr. Molinaroli. The Executive Committee also concluded that the principal of the consulting firm had no input to the Board of Directors regarding the Board’s 2013 decision to promote Mr. Molinaroli to the position of CEO. The Executive Committee and the Board (other than Mr. Molinaroli, who further recused himself) did determine that Mr. Molinaroli had failed to comply with the Company’s Ethics Policy, which required Mr. Molinaroli to timely alert the Audit Committee to a situation that could be perceived to raise issues of conflict of interest.

As a result, the Compensation Committee exercised discretion to reduce Mr. Molinaroli’s fiscal year 2014 Annual Incentive Performance Program (AIPP) payment by 20%. In addition, in light of the nature of the work performed by the outside consulting firm for the Company and to avoid any perception of conflicts or potential future conflicts, the engagement of the outside consulting firm was terminated under an agreement dated September 30, 2014, with no payment other than for incurred but as yet not paid fees and expenses and fees and expenses associated with a discrete list of projects already in process and to be completed no later than January 31, 2015. The Board concluded, in the exercise of its business judgment, that no further action be taken in respect of this matter. It also expressed its confidence in Mr. Molinaroli’s leadership of the Company as its CEO, which it also deemed to be in the best interests of the shareholders.

– Broc Romanek, CompensationStandards.com

Here’s an interesting memo from Towers Watson:

In mid-2014, Towers Watson launched its “Principles and Elements of Effective Executive Compensation Design,” a compendium of research, insights and viewpoints about effective executive compensation (EC). The Principles serve as a counterpoint to the familiar mantra of “following market norms” and the often narrower perspectives of proxy advisors and pay commentators (and even some pay consultants).

In parallel, we launched an assessment framework to support the ongoing management of executive pay programs. This tool allows companies and their compensation committees to evaluate how closely their programs align with the Principles. More importantly, the framework helps to ensure that pay programs are carefully tailored to a company’s business strategy, even where that means varying from the market or even the Principles themselves.

Since the launch, we’ve had in-depth discussions with hundreds of companies and have used the tool in approximately 75 in-depth EC program reviews. Below, we highlight some of the initial findings from the assessments. We believe they offer important insights about the future direction of EC design.

Before jumping to the findings, here’s a quick recap of the Principles and the framework. The 75 Principles cover the gamut of critical EC considerations: from peer group selection and benchmarking to incentive design and pay-for-performance assessment, from governance to employment terms and special circumstances (e.g., M&A, retention, new hires and exits). The framework helps companies systematically assess their EC programs and processes, indicating areas where a company is tracking with the Principles (“alignment or high alignment”) or varying from them (“low alignment”).

AREAS IN WHICH EC PROGRAMS ARE PROVING EFFECTIVE

Based on the assessment tool results to date, the two categories of EC programs most aligned with the Principles are peer groups and benchmarking, and EC governance. For those who track EC developments, this isn’t a big surprise. Peer group selection has been under the microscope for several years and many companies have worked hard to develop a sensible and generally robust approach to benchmarking. There’s still work to be done in certain aspects of benchmarking, such as considering total rewards versus only direct compensation, and thinking of market data as a range instead of a single data point (e.g., the 50th percentile). But on the whole, most companies are aligned.

Moving to governance, especially in the say-on-pay environment, compensation committees are generally approaching their roles with vigor and increasing expertise. In parallel, pay disclosure has become more transparent and shareholder engagement more regular. Again, while overall alignment is strong, the Principles highlight specific items for focus, especially around the committee’s role in promoting the transparency and rigor of pay-for-performance relationships.

PRIORITY AREAS FOR IMPROVEMENT

The two categories with the lowest levels of alignment are pay-for-performance (P4P) assessment and incentive targets, ranges and discretion.

The disclosure of P4P is definitely on everyone’s radar screen as we await Securities and Exchange Commission (SEC) guidance on the Dodd-Frank disclosure requirements. However, disclosure aside, the breadth of many companies’ P4P assessments appears rather limited in terms of pay definitions, performance measures and regularity. Moreover, the results indicate that few companies are leveraging P4P analyses to test if they are getting the downside of pay “right” (i.e., ensuring pay outcomes track with performance when performance weakens). We know that the combination of weak company performance and poor P4P alignment is very likely to trigger shareholder and proxy advisor concerns. The Principles’ focus on enhanced P4P assessment points the way to improved pay design and mitigating say-on-pay risks.

Incentive vehicles and performance measures receive significant attention from executives, committees and investors alike. But this focus appears to weaken, at least based on our assessments, when companies endeavor to set robust incentive targets and ranges, and to apply informed judgment on incentive payouts. Admittedly, target and range setting and discretion are challenging areas for management and committees alike. However, it appears that they aren’t using many of the tools in their potential toolkit to tackle these issues more directly. Some of these tools include analytics around historical company and peer group financial performance as well as shareholder expectations, referencing so-called enduring standards around growth and returns in setting targets and applying a “discretion framework” to assess if and how discretion should be applied to incentives.

FUTURE DIRECTION

One might suggest that the Principles may be too aspirational or impractical, especially in these areas of P4P assessment and incentive targets, ranges and discretion. The assessment results suggest otherwise. As for P4P assessment, roughly a third of the companies in our database achieved overall standards of “alignment” or “high alignment.” For incentives, about 45% of the companies in our assessment database achieved these standards. They are clearly within reach.

While we don’t have longitudinal data, our experience shows that standards in these areas have evolved over the past several years. The companies that are aligned with our Principles are at the forefront of the market and are pointing us to the future. This is a future where robust and holistic P4P assessment is going to be the norm (likely beyond what’s required for proxy disclosure by the SEC), incentive targets and ranges are going to receive greater scrutiny from shareholders and directors, and more companies and directors are going to be comfortable applying informed discretion to balance the heavy financial and formulaic orientation of incentive plans.

The assessment results also highlight somewhat narrower topics that may attract greater focus in the future. Among these are:

– Promoting greater line of sight and shareholder alignment in incentive programs
– Scaling share ownership guidelines to equity compensation levels
– Strengthening share retention and holding requirements.

Overall, we know that EC will continue to evolve, much as it has over the past two decades. Through the lens of our Principles and systematic EC program assessment, companies can chart their own course, while also being informed by the experience of their peers.

– Broc Romanek, CompensationStandards.com

Dig this new “2015 Compensation Committee Handbook” from Skadden Arps. Written in a style that is easily understood and 100 pages long…

– Broc Romanek, CompensationStandards.com

Did you ever want to see Cap’n Cashbags cry? In this 20-second video, Cap’n Cashbags – a CEO – is still hoping to get his mega-grant of stock options soon (here’s the related video):

– Broc Romanek, CompensationStandards.com

Check out this memo from Pay Governance entitled “Does Your Executive Pay Plan Create “Drive, Discipline and Speed”?” that applies new research to a new approach of thinking about executive compensation…

– Broc Romanek, CompensationStandards.com

Here’s a Glass Lewis blog:

British oil & gas multinational BG Group plc has revised the pay package of incoming CEO Helge Lund in the face of a potential shareholder revolt regarding a proposed (and now withdrawn) £12 million recruitment award, which exceeded the company’s pay policy approved just a few months ago. Instead, BG will grant a £10.5 million award subject to more stretching and transparent performance conditions; because the revised award is allowed for under the approved pay policy, it will not be subject to a shareholder vote.

Despite the slight reduction in maximum award size (and larger reduction in expected value) Mr. Lund will continue to be one of the highest paid CEOs on the London Stock Exchange, with an annual potential pay package in the region of £15 million; however, the climb down from BG represents a victory for investors, as well as Vince Cable, whose introduction of a binding vote on companies’ remuneration policies meant that the Company was required, by law, to seek shareholder approval of the golden hello, due to it falling outside the Company’s approved remuneration policy.

The U-turn on the original pay package follows public complaints from a number of the company’s largest shareholders over the size of the proposed award, and particularly the opacity of performance conditions attached to it; as disclosed by BG, the award would only be reduced if Mr. Lund’s performance deteriorated significantly, with no connection to overall company performance or shareholder returns. The Company had originally described the award as necessary to lure one of the industry’s top executives. While not serving to reduce his pay opportunity greatly, investors may well be satisfied that the new CEO’s joining award will be subject to company performance measures, namely TSR, cash flow and capital efficiency measures, as opposed to relatively vague an unstretching personal objectives.

In addition, investors had spoken of their hesitancy to vote upon a remuneration proposal a mere six months after the policy’s approval, with BG stating: “A significant number of shareholders questioned the structure of the package, in particular whether it was appropriate to go outside the remuneration policy approved by shareholders earlier this year. Both the board and Mr Lund recognise and wish to respond to shareholder concerns.”

While unexpected, the reversal is not entirely unusual; just two years ago, Cairn Energy similarly withdrew a proposed transaction bonus before submitting it to shareholders after institutional investors raised concerns (BG should note that even after withdrawing the award, Cairn Energy faced significant opposition to its next remuneration report). The cancellation of the BG meeting aptly demonstrates the ever-increasing significance of shareholder engagement at UK issuers, with shareholders seemingly defeating a proposal without even casting a vote.

– Broc Romanek, CompensationStandards.com

This op-ed from Simpson Thacher’s Avrohom Kess & Yafit Cohn ran in yesterday’s WSJ:

In 2015 the Securities and Exchange Commission is expected to finalize a new rule that imposes excessive compliance costs on public companies with no discernible benefits to investors. The rule requires that public companies calculate and disclose the ratio of the CEO’s pay to the median annual total compensation of all company employees. Part of the 2010 Dodd-Frank law, this ill-advised rule clearly advances the agenda of interest groups worried about income inequality, politicizes the SEC’s disclosure regime and is inconsistent with the purpose of federal securities laws.

The Securities Exchange Act of 1934, which established the SEC, was intended to protect investors by mandating increased—and truthful—disclosure. After the 1929 stock-market crash, it was thought that enhanced disclosure would restore investor confidence in U.S. capital markets and protect investors against stock manipulation and other deceitful practices.

The law’s stated purpose is “bringing safety to the general public in the field of investment and finance” and regulating the operation of securities and commodities exchanges “for the protection of investors.” The extensive disclosure requirements at the heart of the Exchange Act were predicated on Congress’s philosophy that “[t]here cannot be honest markets without honest publicity.” To this day, the SEC’s mission is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”

The pay-ratio requirement is at odds with the SEC’s mission and the objectives of its disclosure framework. Companies are already required by law to disclose the compensation of their most highly paid executive officers, along with the reasons for both the level and type of pay accorded to them. How exactly will investors benefit from a comparison between the compensation of a U.S. CEO and the entirety of the company’s workforce—including part-time and seasonal workers, as well as those based in other parts of the world?

The legislative history of the provision in Dodd-Frank compelling pay-ratio disclosure is strangely silent on that question. The SEC has also struggled to pinpoint the rule’s value, noting in its September 2013 proposed rule that “the lack of a specific market failure identified as motivating the enactment of this provision poses significant challenges in quantifying potential economic benefits, if any, from the pay ratio disclosure.”

The SEC acknowledged that “precise comparability across companies may not be relevant and could generate potentially misleading interpretations or conclusions.”

Left unsaid is the obvious truth: The pay-ratio rule is an attempt to shame companies and their boards to advance the “social justice” goal of more equitable income distribution. It comes with a high price tag: Complying with the pay-ratio rule will require the private sector to spend $710.9 million and 3.6 million hours a year, according to a recent report by the Center for Capital Markets Competitiveness.

This is not the only instance of Congress abusing securities laws to advance social and political goals. Dodd-Frank also required the SEC to promulgate regulations requiring certain companies to investigate and disclose annually whether particular minerals in their products originated in the Democratic Republic of the Congo or an adjoining country. The disclosure is intended to target “the exploitation and trade of conflict minerals” that are “helping to finance conflict characterized by extreme levels of violence” and “contributing to an emergency humanitarian situation therein.”

Presumably, Congress expected that the disclosures would damage the reputations of “offending” companies and pressure them to stop using conflict minerals, whose trade may have funded armed groups in Africa.

But again, using the SEC disclosure framework to push social and political agendas places a significant financial burden on public companies and their shareholders. For example, while the SEC admitted in its 2012 final rule release that the social benefits of the conflict minerals statute “are quite different from the economic or investor protection benefits that the SEC’s rules ordinarily strive to achieve,” the agency estimates that initial compliance would cost between $3 billion and $4 billion.

Annual compliance would cost between $207 million and $609 million. The losses borne by the U.S. economy may be even greater, as these rules will hinder the ability of U.S. issuers to compete with companies that are not subject to the disclosure requirements.

The ostensible political goals advanced by Congress may be important and laudable. Requiring shareholders to bear the costs is not. It obfuscates SEC filings with immaterial and potentially misleading information, to the detriment of investors, and could impair the SEC’s ability to focus its attention and limited resources on fulfilling its intended functions.

Congress must find alternative ways to address social and political ills without upending the SEC’s disclosure regime, taxing American shareholders and further complicating the efforts of the SEC.