The Advisors' Blog

– Broc Romanek, CompensationStandards.com

In this 20-second video, Cap’n Cashbags – a CEO – is hoping to get his mega-grant of stock options soon:

– Broc Romanek, CompensationStandards.com

Here’s a blog by Davis Polk’s Ning Chiu:

The SEC has approved Auditing Standard No. 18, adopted by the PCAOB in June. The standards become effective for audits of financial statements for fiscal years beginning on or after December 15, 2014, including for emerging growth companies (ECGs).

We previously discussed the three areas of focus for Auditing Standard No. 18 in a prior post. Related party transactions, significant unusual transactions and financial relationships and transactions with executive officers (such as executive compensation and perks) will be under increased scrutiny. The new auditing standards subject these types of transactions to additional risk-based procedures that are designed to assist the auditors in identifying red flags that may cause material misstatements. Companies should also be aware that the auditing standard opens up possible new lines of inquiries from auditors to boards of directors.

Related Party Transactions and the Audit Committee. The revised standard includes a requirement that the auditors communicate to the audit committee their evaluation of the company’s identification of, accounting for, and disclosure of its relationships and transactions with related parties, as well as significant matters arising from the audit regarding the company’s relationships and transactions with related parties. This includes whether all transactions (a) were disclosed to the auditors, (b) were authorized in accordance with established policies and (c) have terms similar to those in arm’s length transactions. In addition, auditors may ask audit committees, or their chairs, about their understanding of the company relationships with related party transactions and whether the audit committee has any concerns about those transactions.

Executive Compensation and the Compensation Committee. While the standard explicitly provides that the auditors’ work does not include an assessment of the appropriateness or reasonableness of executive compensation arrangements, the changes are designed to heighten the auditors’ attention to incentives or pressures for the company to achieve a particular financial position or operating results, recognizing the key role that a company’s executive officers may play in the company’s accounting decisions or financial reporting.

The auditors may ask the chair of the compensation committee and compensation consultants about the structure of executive compensation, including incentive compensation and perks. Audit procedures may include reading employment contracts with executives and proxy statements. In addition, auditors will need to obtain an understanding of established policies and procedures regarding the authorization and approval of executive officer expense reimbursements.

– Broc Romanek, CompensationStandards.com

Last week, ISS announced that QuickScore 3.0 will be launched on November 24th for the 2015 proxy season (in other words, that’s the first date the new governance ratings will be included in research reports). Ning Chiu highlights some of the changes from last year in this blog – also see this Wachtell Lipton memo and Gibson Dunn blog. Here’s the home for QuickScore 3.0, where you can download the technical document – and here’s the new QuickScore factors by region.

Companies will have from November 3rd to November 14th to verify the underlying raw data and submit updates and corrections through ISS’s data review and verification site. As always, ratings are updated based on a company’s public disclosures during the calendar year.

– Broc Romanek, CompensationStandards.com

I’m always curious as to what Bob and Nell think about the issues of the day – here’s a USA Today interview that gives the latest from them. Here’s an excerpt:

Q: Why is that, given the widespread recognition CEO pay, especially relative to what average company employees earn, is a problem?

Monks: People with power are very reluctant to give it up. While all of us recognize the problem, those with the power to change it like things the way they are.

Minow: There’s a strong streak of narcissism, sociopathology, of killing the goose that lays the golden egg. In the long run who’s going to be able to buy products if we have an economy where resources aren’t more evenly distributed?

– Broc Romanek, CompensationStandards.com

Here’s something blogged by Towers Watson’s Jacob O’Neill:

The number of mergers and acquisitions announced in 2014 has increased over previous years and includes some of the largest deals in history. Through the third quarter of this year, 73 M&A deals with a total transaction value greater than $1 billion have been announced, including 10 that each had a value greater than $25 billion (three of these deals have since been cancelled). By way of comparison, only nine deals closed in the U.S. with a value of over $25 billion over the four years prior to 2014.

Towers Watson’s Executive Compensation Resources unit tracks and analyzes special compensation arrangements for executives involved in acquisitions on an ongoing basis. For our most recent analysis of retention award practices, we looked at U.S.-based public companies involved in 181 acquisitions with a transaction value greater than $1 billion between the beginning of 2010 and the end of March 2014.

Our analysis specifically reviews retention awards and/or programs put in place at acquired companies in the course of the merger and focuses on awards with executive participation. Our review identified 69 companies (39% of all acquired companies during this period) that offered some form of retention award to employees and/or executives prior to the close of the deal. While we focus on the companies with executive-level retention awards, we also note that there are other considerations involved in retaining and protecting employees during acquisitions, including change-in-control severance agreements as well as retention programs for employees below the executive level./blockquote>

– Broc Romanek, CompensationStandards.com

Here’s news from Paul Hastings’ Mark Poerio from his ExecutiveLoyalty.org site:

The hiring of a special compensation consultant increases CEO pay by about 10% (per median survey results), which this Univ. of Cambridge study reports as one finding supportive of the conclusion that there is “strong empirical evidence for the hiring of compensation consultants as a justification device for higher executive pay.” Along this line, an increase in CEO pay was found to reduce the probability that a compensation consultant would be replaced by a competitor. The study reports a result reflecting on the independence of compensation committees, in that median CEO compensation was 13% lower when a board committee hired a compensation consultant than when management made the hire. See more on this blog.

– Broc Romanek, CompensationStandards.com

As companies are staffing & gearing up for the FASB/IASB’s new revenue recognition rules, it dawned on me that folks in the accounting world might not be aware of the upcoming Dodd-Frank rulemaking on clawbacks. And those folks that live and breathe compensation might not be aware of the revenue recognition accounting changes that were adopted a few months back (but won’t be effective until fiscal years beginning after 12/15/16).

The implementation of the new revenue recognition rules will create all sorts of opportunities to get it wrong – and it looks like they will coincide with mandatory no-fault clawbacks that have to be applied to a broader range of executives for a longer period of time for any restatement. Section 954 of Dodd-Frank is quite prescriptive so I don’t know how the SEC will have much flexibility. Maybe in the implementation and grandfathering provisions. This convergence of forces may well make for a dandy of a sleeper in Dodd-Frank, years after it was enacted!

The upshot is that we may be living in a world where senior managers will be trying to persuade compensation committees to either have less performance-based compensation that is susceptible to a restatement – or to use metrics that are less susceptible. Stepping back from performance-based pay is not what shareholders want to see – so this likely will cause tension between companies and their shareholders.

It’s ironic that a new accounting standard that will cause more opportunities for restatements will apparently come on board near in time with the Dodd-Frank “super-charged” clawbacks. These newer clawbacks will be super-charged because you don’t need misconduct like under the Sarbanes-Oxley standard.

And the kicker to watch out for right now is that as more companies move to multi-year performance metric setting, there could be companies that are setting performance goals now for years that will be subject to both the new revenue recognition rules (no matter how they wind up getting interpreted) and the Dodd-Frank clawbacks.

The bottom line is that the new clawbacks will certainly up the ante in discussions among auditors, audit committees and management as to whether errors discovered in previously filed financials are material. As with any area of uncertainty, step with caution. Thanks to Steve Bochner of Wilson Sonsini for pointing this out!

– Broc Romanek, CompensationStandards.com

Last week, Fed Reserve Chair Janet Yellen delivered a speech about how income inequality concerns her as she issued a warning about the risks of it, as noted in this Huffington Post article.

Here’s other info recently published about income inequality:

– S&P study about income inequality dampening economic growth

– NY Times’ opinion piece on “Inequality Is Not Inevitable”

– Salon.com’s “Robert Reich: “Paid-what-you’re-worth” is a toxic myth”

– Analysis of Robert Reich’s views

– As You Sow’s new focus on executive compensation includes a number of resources about income inequality

– Broc Romanek, CompensationStandards.com

Yesterday, ISS released a group of draft policy changes for comment – two of them relating to the US: a new “scorecard” approach to evaluating equity compensation plan proposals and independent board chair proposals. Here’s what Ron Mueller & Beth Ising of Gibson Dunn have blogged about them:

Today, proxy advisory firm Institutional Shareholder Services Inc. (“ISS”) provided additional information on its plans to implement a new “scorecard” approach to evaluating equity compensation plan proposals at U.S. shareholder meetings and requested comments on its proposed policy change. This is one of two significant proposals ISS announced today that would impact U.S. companies for the 2015 proxy season, with the other proposed policy change relating to voting recommendations on independent chair proposals (which we discuss here). Companies considering seeking shareholder approval of equity plans at shareholder meetings in 2015 should consider these proposed changes now to the extent they want ISS to recommend votes “For” the equity plan.

Current ISS Approach to Equity Plan Proposals

ISS’s current approach uses a series of “pass/fail” tests. Specifically, ISS will recommend votes “Against” an equity plan if the total cost of the company’s equity plans including the proposed new plan is “unreasonable,” if the company’s three-year burn-rate exceeds the applicable burn rate cap determined by ISS, if the company has a pay-for-performance “misalignment” or if the plan includes certain disfavored features (e.g., if the plan permits repricing or includes a liberal change of control definition).

Companies seeking shareholder approval of a new equity plan or an amendment to an existing plan can often independently determine compliance with each of these factors except for cost. ISS evaluates the cost of a company’s plans using its proprietary shareholder value transfer (SVT) measure. ISS describes SVT as assessing “the amount of shareholders’ equity flowing out of the company to employees and directors.” ISS considers the SVT for a company’s plans to be reasonable if it falls below the company-specific allowable cap as determined by ISS using benchmark SVT levels for each industry. Thus, companies often engage the consulting side of ISS to determine the SVT of their plans and the number of additional shares that ISS would support for the new or amended equity plan.

New ISS Approach to Equity Plan Proposals

ISS previously announced its intention to implement a new “scorecard” approach to evaluating equity plan proposals at U.S. shareholder meetings. Today ISS provided more insights with the publication of its proposed new Equity Plans policy, which details ISS’s new Equity Plan Scorecard (“EPSC”). Under the proposed EPSC, ISS will determine its voting recommendations on equity plan proposals by determining an EPSC score for a company based on three broad categories of factors: (1) the total potential cost of the company’s equity plans relative to its peers; (2) the proposed plan’s features; and (3) the company’s equity grant practices. ISS has indicated that these scorecard factors and their relative weightings would be keyed to company size and status, with different weightings applicable to companies in the following categories: S&P 500, Russell 3000 (excluding the S&P500), Non-Russell 3000, and Recent IPOs or Bankruptcy Emergent companies.

With respect to the three categories that factor into a company’s EPSC score:

– Cost will continue to be evaluated on the basis of SVT in relation to peers. However, SVT will now be calculated for both (a) new shares requested, plus shares remaining for future grants, plus outstanding unvested and/or unexercised grants, and (b) only on new shares requested plus shares remaining for future grants.

– Plan features that will be evaluated under the EPSC include automatic single-triggered award vesting upon a change-in-control, discretionary vesting authority, liberal share recycling on various award types (which will no longer be a component of SVT), and minimum vesting periods for grants made under the plan, in each case as specified in the plan document itself rather than in practice through award agreements.

– With respect to company grant practices, ISS’s proposed EPSC will consider a company’s three-year burn rate relative to its peers (which will eliminate company “burn rate commitments” going forward), vesting requirements in the most recent CEO equity grants, the estimated duration of the plan (calculated based on the sum of shares remaining available and the new shares requested under the plan, divided by the average annual shares granted under the plan in the prior three years), the proportion of the CEO’s most recent equity awards subject to performance vesting (as opposed to strictly time-based vesting), whether the company maintains a clawback policy, and whether the company has established post-exercise/vesting holding requirements.

Although ISS has stated that certain highly egregious plan features (such as the ability to reprice options without shareholder approval) will continue to result in an automatic negative voting recommendation regardless of other factors, overall the EPSC will result in voting recommendations based on a combination of the above factors. This means that ISS may recommend votes “For” an equity plan proposal where costs are nominally higher than a company’s allowable cap when sufficient other positive plan features and company grant practices are present. Likewise, ISS may recommend votes “Against” an equity plan proposal even where costs are lower than a company’s allowable cap if sufficient other negative plan features and company grant practices are present.

Next Steps

ISS has invited comments on its proposed policy, and has specifically asked for feedback on: (1) whether any factors outlined above should be more heavily weighted when evaluating equity plan proposals; and (2) whether stakeholders see any unintended consequences from shifting to a scorecard approach. Comments may be submitted on or before October 29, 2014 via email to policy@issgovernance.com. For more information, here’s the ISS release discussing the proposed revisions.

We expect that corporate commenters will focus on the nature and extent of flexibility in the EPSC approach around plan features and past grant practices. For example, we understand that under the proposed scorecard, a plan will gain credit if it contains minimum vesting provision (for example, a minimum three year pro-rata vesting requirement), although companies may want flexibility to grant some awards free of any such restrictions. Thus, companies may wish to provide input to ISS on situations in which such grant practices may be warranted and should not result in negative weighting under the scorecard.

With respect to the proposed EPSC’s factors that take into account past grant practices, companies often propose new equity plans so that they can implement new grant practices in the future that were not feasible under their existing plans (for example, a company may wish to be able to implement a performance stock unit program, or increase the percentage of shares granted under such awards and correspondingly decrease its use of stock options). In those cases, overemphasis on past grant practices may be inappropriate. Thus, in order that ISS may consider such situations as it develops its EPSC methodology, companies may wish to provide comments to ISS regarding situations in which they have sought shareholder approval of a new plan so that they could implement new grant practices, as well as other situations in which past grant practices may not be indicative of future equity programs.

Companies that are developing new equity plans that they intend to submit for shareholder approval at their 2015 annual meetings may need to scramble to reflect ISS’s EPSC factors in their proposed plan if they want ISS to recommend votes “For” the plan. For example, even if a company’s SVT would not have exceeded ISS’s limits under its current voting policy, a “liberal share counting provision” under which shares retained to pay taxes again become available for grant under the plan may now contribute to a negative ISS voting recommendation on the plan. Likewise, the proposed EPSC methodology will contribute to more plans containing restrictions on how quickly equity awards are permitted to vest. It is worth noting, however, as ISS observes in its request for comments, that even though ISS historically has recommended votes “Against” approximately 30% of equity plan proposals each year under existing its policy, no more than 10 plan proposals have actually failed in any recent year. Nevertheless, ISS’s policies are based in part on feedback from its institutional shareholder clients, and thus companies will want to carefully consider the extent to which factors considered under the EPSC reflect emerging trends and shareholder-favored practices.

ISS’s final 2015 proxy voting policies are expected to be released in November and typically apply to shareholder meetings held on or after February 1. We expect that ISS will soon offer a new consulting product to help companies and their advisors analyze equity plans under the proposed new EPSC.

– Broc Romanek, CompensationStandards.com

Here’s more from McGuireWoods’ Steven Kittrell from this blog: In our prior blog, we discussed the case for eliminating the Section 162(m) disclosures in proxy statements. Here is an alternative view of the subject:

It is worth looking back at the reasons for virtually every CD&A having a Section 162(m) disclosure. Here is a brief history:

– Before the 2006 revamp of the rules, the SEC had required discussion of a company’s Section 162(m) policy.
– The CD&A rules give as an example of possibly material information: “the impact of the accounting and tax treatments of the particular form of compensation”.
– In the adopting release, the SEC stated:

Regarding the example noting the impact of accounting and tax treatments of a particular form of compensation, some commenters urged that companies be required to continue to disclose their Internal Revenue Code Section 162(m) policy. The adoption of this example should not be construed to eliminate this discussion. Rather, this example indicates more broadly that any tax or accounting treatment, including but not limited to Section 162(m), that is material to the company’s compensation policy or decisions with respect to a named executive officer is covered by Compensation Discussion and Analysis. Tax consequences to the named executive officers, as well as tax consequences to the company, may fall within this example.

Most companies interpreted the CD&A rules to apply the prior “presumption” of materiality to the Section 162(m) disclosure and continued their prior practice of making a disclosure. What is the right approach now? If a company wants to eliminate the disclosure, the question is materiality. As with most materiality questions, there are different ways to look at it.

Virtually all companies where the deduction may be in question will adopt Section 162(m)-compliant compensation plans and then follow the Section 162(m) requirements in paying some compensation. The potentially most material aspects of Section 162(m) from a disclosure perspective are the requirement to use preapproved performance goals and the limits on grant sizes and types. Also, most companies will not give up a deduction without Section 162(m) being a part of the decision process. Does this mean that Section 162(m) was material in the decisions?

On the other hand, the actual tax savings from Section 162(m) as a number is not material for most companies. And it is difficult to maintain that the disclosure continues to be useful to shareholders, particularly given shareholder complaints about the growing length of the CD&A and the SEC’s past statements that the CD&A should avoid boilerplate disclosures.

If a company determines that the Section 162(m) disclosure should be maintained, it is worthwhile to look at the disclosure in light of the shareholder litigation. There may be tweaks to the disclosure that would reduce the likelihood of a Section 162(m) disclosure-related shareholder claim.