Thanks to Eleanor Bloxham and her “Corporate Governance Alliance Digest” for this blog by Tama Copeman, Chair of the Board of Mid Atlantic Diamond Ventures (tama@alcyone7.com):
Rising CEO compensation frustrates many board members and for good reason: setting CEO pay-above-the-50th percentile broadly leads to unbounded growth in pay. (Similar results will occur if a large portion of companies set aggressive increase targets each year.) Although advisory say-on-pay votes now available to shareholders provide a check, the votes provide a weak check on rising pay.
System dynamics is a methodology for understanding the behavior of complex systems which can be applied to understanding the dynamics of executive compensation. Originally developed by Forrester at MIT Sloan in the 1950s to provide insight into corporate and managerial problems, system dynamics is currently being used by the public and private sectors for policy design, environmental change, economic behavior, project management and supply chain analysis.
The basis of the method is the recognition of feedback, interlocking, and time-delayed relationships among components of a system. A system’s feedback structure drives the dynamics of the system. So-called causal loop diagrams provide a visual representation of the feedback loops in a system and enable the creation of mental models for qualitative analysis.
In a system dynamic of growth, loops with all positive links are self-reinforcing and produce unbounded growth. Balancing loops provide self-correction in the system. They are created when there are an odd number of negative links and are self correcting. John D. Sterman (“Business Dynamics – Systems Thinking and Modeling for a Complex World”, McGraw Hill, 2000) provides many examples of applications of causal loop diagrams.
As a CEO’s compensation is set above the 50th percentile within the peer group, the average of the peer group rises correspondingly. The causal loop model in Figure 1 illustrates self-reinforcing compensation behavior. If the majority of boards employ above 50th percentile pay positioning, the peer-group compensation increases with the rate of growth dependent on the fraction of companies using this strategy. If the majority of boards employ below 50th percentile pay positioning, the peer-group compensation decreases. The latter case is, naturally, less likely. Conversely, as CEO pay increases, say-on-pay concern also increases with a corresponding push to reduce pay. The causal loop model illustrates self-correcting say-on-pay behavior. Within a corporation, the internal “say on pay” is far stronger than the advisory shareholder vote, as senior management, human resources and budgetary factors weigh in.
Figure 1. Causal Loop Model applied to CEO compensation
The above cycles occur on a one-year basis; however other balancing factors can enter throughout the cycle. The Wall Street Journal (June 30, 2011) reported: “Companies may not have to abide by shareholder advisory say-on-pay votes mandated under the Dodd-Frank Act, but lawyers specialized in securities class action suits have already brought a half dozen suits against directors and executives for ignoring their results. A number of firms have tried to settle the claims quickly.”
Peer benchmarking has been a powerful tool in compensation. System dynamics provides a simple perspective to understand the dynamics at work. Unless there are changes to the current systems-dynamics for CEO pay, CEO compensation will continue to spiral upward.
On Monday, Corp Fin granted this no-action relief to Fenwick & West regarding the use of restricted stock units for employees at pre-IPO companies under certain conditions without the company needing to register the securities under Section 12(g) of the ’34 Act (generally, the conditions are similar to those in Rule 12h-1(f) for options). By granting the letter to a law firm – and not a specific company – this no-action letter serves as broad relief for those pre-IPO companies hoping not to be forced to go public before they are ready, a hot topic as it has even attracted attention on Capitol Hill where proposed legislation is afoot to raise the 12(g) thresholds, etc. Previously, Corp Fin had been granting relief in this area on a case-by-case basis (egs. Twitter, Facebook – see this blog).
Yesterday, Corp Fin issued new ’34 Act CDI 169.07 to provide clarity about how companies should be listing their say-on-pay proposals on proxy cards and voting instruction forms. The CDI lists four examples that the Staff believes is consistent with Rule 14a-21 – and one example that the Staff believes is not consistent (ie. “To hold an advisory vote on executive compensation”). I believe many companies are going to need to make a tweak to their proxy cards and VIFs as they used the “inconsistent” language last year…
I’m not sure what to make of this NY Post article noting that a whistleblower – someone at an unnamed proxy solicitor – is claiming that a mid-level employee in ISS’s Boston office has been exchanging confidential voting data for gifts or cash from solicitors. Allegedly, the whistleblower has complained to the SEC – but whomever it is wouldn’t respond to questions from the NY Post reporter. We’ll see if this develops or is an urban myth. Among the odd things, it seems like the information could be valuable to arbitragers in a merger vote, but really not worth that much to companies (and their agents). Here’s today’s WSJ article on the topic…
Last week, Glass Lewis and Equilar announced that they have agreed to strategically partner. This comes on the heels of an announcement six months ago that ISS and Equilar had terminated their agreement…
Cydney Posner of Cooley recently wrote this alert::
You might be interested in this Special Report from the Washington Post entitled “Breakaway Wealth.” Although it’s been known for quite some time that the gap between rich and poor has been widening in the U.S., what accounted for the spectacular increase was not well known. The speculation was that most of it was going to folks like LeBron, Shaquille and Brangelina. Not so, according to a number of recent studies cited in the Post’s Report. Recent significant research into this topic attributes a substantial component of the rising income disparity to hikes in executive pay: “The largest single chunk of the highest-income earners, it turns out, are executives and other managers in firms, according to a landmark analysis of tax returns by economists Jon Bakija, Adam Cole and Bradley T. Heim. These are not just executives from Wall Street, either, but from companies in even relatively mundane fields such as the milk business.”
According to the Report, 41% of the top 0.1% of earners -those making about $1.7 million or more, including capital gains — were executives, managers and supervisors at non-financial companies, and an additional 18% were managers at financial firms or financial professionals at other firms. In total, almost 60% of all top 0.1% of earners were one of those two categories. It turns out that pay for media and sports figures represented only 3% of the total, hardly the significant proportion of very high-income earners that many believed.
Other recent research highlights the data underlying the growth in income disparity. This data shows that executive compensation at the nation’s largest firms has roughly quadrupled in real terms since the 1970s, while pay for the remaining 90% has remained flat or even declined. Anecdotally, the Post reports that, for one milk producer, “[o]ver the period from the ’70s until today, while pay for [the company’s] chief executives was rising 10 times over, wages for the unionized workers actually declined slightly. The hourly wage rate for the people who process, pasteurize and package the milk at the company’s dairies declined by 9 percent in real terms, according to union contract records. It is now about $23 an hour.”
The statistics show that in 1975, the top 0.1% of earners — roughly 140,000 earners — earned about 2.5% of U.S. income, including capital gains, according to data collected by UC economist Emmanuel Saez. By 2008, the top 0.1% earned 10.4%, more than four times the percentage in 1975. Over the same period, the share earned by the top 0.01% — representing about 15,000 families — rose from 0.85% to 5.03%, approximately $27M each on average. According to the Post, that data puts the U.S. in league, not with Europe, the UK and other developed countries, but rather with countries like Cameroon, Ivory Coast, Uganda and Jamaica.
Some commentators have attributed the rise in executive pay to the increase in the size and complexity of companies. However, the Post reports, recent research by economists from MIT and the Federal Reserve shows “that while executive pay at the largest U.S. companies was relatively flat in the ’50s and ’60s, it began a rapid ascent sometime in the ’70s.
“As it happens, this was about the same time that income inequality began to widen in the United States, according to the Saez figures. “More importantly, however, the finding that executive pay was flat in the ’50s and ’60s, when firms were growing, appears to contradict the idea that executive pay should naturally rise when companies grow.”
Instead, the Post reports, some economists are now suggesting a possible alternative explanation for the rise in executive pay: “changes in the social norms that once reined in executive pay have disappeared.” The argument is that norms that would at one time have called into question excessive executive pay increases as unseemly or potentially harmful to employee morale no longer hold the same sway.
A similar theme regarding executive pay excesses is reflected in this column by Gretchen Morgensen in yesterday’s New York Times. The column suggests that the failure to provide stockholders with more context when describing executive pay may account for the overwhelming proportion of favorable say-on-pay votes. Describing recent research, the author suggests that total executive pay should be compared to overall labor costs or disclosed as a percentage of marketing or R&D expenditures, depending on the drivers of the company’s business. Citing recent studies, the column reports that there were 24 companies last year where cash compensation –just salary and bonus – was equivalent to 2% or more of the company’s net income from continuing operations. Similarly, 11 companies analyzed in the study gave top executives a combined pay package amounting to 1% or more of the companies’ average market value over the course of the year. The column notes that “[t]otal executive pay increased by 13.9 percent in 2010 among the 483 companies where data was available for the analysis. The total pay for those companies’ 2,591 named executives, before taxes, was $14.3 billion….[an amount that] is almost equal to the gross domestic product of Tajikistan, which has a population of more than 7 million.”
These articles appear as the SEC begins to mull rules implementing executive pay-ratio disclosure and some members of Congress consider, in light of complaints from corporate lobbyists and trade associations, whether to water down provisions of Dodd-Frank. Whether articles like these will have any impact on legislation or regulations remains to be seen.
As noted on Mark Poerio’s “ExecutiveLoyalty.org“, the WSJ ran this article noting that Goldman Sachs and Morgan Stanley have altered their clawback policies for employees due to negotiating the withdrawal of shareholder proposals related to their policies. The proponent was the Comptroller of the City of New York. The WSJ reports that the main clawback changes involve the following:
– permit recovery of compensation for failure to appropriately supervise or manage an employee;
– cover actions or omissions; and
– remove the term “material” regarding losses as a trigger for recovery.
Despite a decline in economic activity, golden parachute payments for CEOs increased by 32% over the past two years, according to a study by Alvarez & Marsal Taxand. The study, which analyzed current change in control arrangements among the top 200 publicly traded U.S. companies, revealed the increase was driven primarily by equity-based payouts and tied to a company’s performance.
Of note, double trigger vesting has increased, as shareholders are more reluctant to pay out CEOs upon a change in control without termination of employment. 53% of companies in 2011 offered at least one plan that provided double trigger vesting, up from only 28% in 2009. Additionally, companies are reducing gross-up payments, which cover the full amount of any excise tax imposed upon the executive in a change in control situation.
Key findings include:
– 78% of CEOs and 80 percent of other named executive officers (NEOs) are entitled to receive a cash severance payment upon termination in connection with a change in control
– The majority (59.4%) of benefits are long-term incentive benefits, such as restricted stock/options, that are tied to performance
– Only 49% of CEOs have excise tax gross-up or modified gross-up protection, compared with 61% in 2009 and 66% in 2007.
Here’s something that ISS’s Ted Allen blogged last week:
The California State Teachers’ Retirement System (CalSTRS), the second-largest U.S. public pension fund, has released a report, “Lessons Learned: the Inaugural Year of Say-on-Pay,” that details its experience during the first year of marketwide U.S. advisory votes in 2011.
CalSTRS reported that it voted against 23 percent of the 2,166 management say-on-pay proposals that it considered between Jan. 3 and June 30, 2011. The predominant reason for the pension fund’s opposition was a pay-for-performance disconnect. Other reasons included: a pay disparity between CEO compensation and that of other named executives (43 percent of CalSTRS’ negative votes); CEO base pay above a $1 million (38 percent); and auto-renewing executive employment contracts (12 percent), according to a CalSTRS analysis of a sample set of 120 companies.
“We believe that poorly structured pay packages harm shareholder value by unfairly enriching executives at the expense of owners–the shareholders. On the other hand, a well-aligned compensation package motivates executives to perform at their best. This benefits all shareholders,” according to CalSTRS, which had a portfolio valued at $144.8 billion as of Dec. 31, 2011.
While noting that the compensation discussions in proxy statements are “largely too complex and lengthy for the average investor,” the pension giant praised the many companies in 2011 that provided “short and simple executive summaries which described in ‘plain English’ the companies’ approach to compensation.”
At the same time, CalSTRS expressed concern about companies that have used peer benchmarking to rachet up pay, and said this issue would be a “renewed focus” in the future. “Although peer groups can be a helpful check to determine if the internal structure and policy setting of pay is reasonable and competitive, peers should not be the starting point when structuring pay. CalSTRS found it especially troubling when companies targeted pay above the median, particularly when companies targeted the 75th or 90th percentile. When pay is initially targeted at these above-average levels, it sets the base pay at above-average levels. As a consequence we saw companies over paying for on-par or below-average performance,” the report said.
To pile onto Sunday’s TV commercial extravaganza known as the Super Bowl, here is a FedEx TV commercial from last year that is a riot. It’s about two-sided paper and when a woman notices at the end of the skit that one side says “Executive Compensation,” the officer leaps over the conference room table and swallows her sheet of paper so that no one else can read how the compensation figures were arrived at…
Yesterday, as noted in this Bloomberg article, the Senate voted 96-3 to approve a bill prohibiting executive bonuses at Fannie Mae and Freddie Mac (the House is expected to pass a similar bill next week). The measure was introduced after the companies’ regulator, the Federal Housing Finance Agency, approved nearly $13 million in bonuses to 10 executives. Geesh. For doing what is essentially a government job? Ludicrous. The CEOs of both companies recently left their jobs (see this WSJ article), after earning several million dollars per year for overseeing entities that were mere shells of their former selves. Great work if you can get it…