Here’s something that I recently blogged: A key ingredient of the six remarkably similar say-on-pay lawsuits filed recently involves a lack of specificity by the defendant companies and directors in disclosing what they mean in their executive compensation policies when they say they have a “pay for performance” program. Most companies leave their policies deliberately vague or describe them only at a high level, yet stating that a company will pay for performance has made its way into most policies we see.
Has this vagueness helped? In the suits filed so far, the plaintiffs have claimed that the defendants do not pay for performance when their executives’ pay has increased while total shareholder returns (TSR) have decreased. While that may appear to compensation professionals to be an overly simplistic view of the world, absent a different argument being made by the company in its proxy and Compensation Discussion and Analysis (CD&A), this basic measurement may be the only criteria by which the issue can be evaluated, at least until the next round of pleading on the cases.
The language used as the basis for the plaintiffs’ complaint in each of these cases comes directly from the company proxy and consistently cites the company’s claim that its pay program is designed to reward outstanding performance. However, none of the pleadings filed to date cite any mention of how the compensation committee explains to shareholders the rationale for reaching that conclusion, or how they would prove it. In most of the cases, this is because that explanation is absent from the CD&A.
Said differently, the defense of these cases might be easier if companies were able to describe in their proxy disclosures that they measure performance in a different way than the plaintiffs, who simply use the Summary Compensation Table number and compare it to TSR.
This heightens the need for companies to take additional care to demonstrate how they pay for performance and in a manner that reflects the consideration the compensation committee gave to the matter before making its pay decisions. Certainly, this should mean looking at what pay versus performance would look like for the company as it attains various levels of TSR. But, more importantly, it should take into account:
1. How the company measures pay
2. What it means by “performance”
3. Whether the company believes pay and performance should be measured absolutely or in relative terms (by comparison to peers), or in some combination
4. The time period over which they should be measured.
Enhancing the CD&A with this information can facilitate shareholder support for a favorable vote on say on pay — and a more proactive defense than not making the case at all.
As a threshold matter, the litigation should not be successful. Courts in the past consistently have given boards broad latitude in setting compensation, see, .e.g., the Walt Disney litigation, and there is no reason to believe that the imposition by Congress of non-binding say-on-pay votes is going to change that. But there is an inconvenient truth here, and that is that at most companies the CD&A overstates the company’s commitment to the compensation approach described. In fact, the common thread among the seven cases that have been filed so far is that the compensation awarded did not fully reflect the compensation approach described in the CD&A.
In reality, a board often has to be more flexible than as described in a CD&A, and where a company has gone through several difficult years, the board easily can conclude that it needs to pay management better than the CD&A might contemplate in order to prevent an exodus of talent or to reward management for doing as well as it did in tough times.
The question then is whether CD&As should be “softened” in order to contemplate variances. Two views exist on this within my own office. One is that you cannot overtly state in a CD&A that you may not follow the approach that you have described because it will undercut the integrity of the compensation process and disclosure and lead to an ISS recommendation against your say-on-pay proposal. The other is that you must or you put yourself at risk of proxy statement based litigation. In an upcoming proxy statement, one of our clients intends to include the following:
Even under our pay-for-performance approach there may be periods of poor financial performance by the Company during which we may decide that it is appropriate and in the best interests of our shareholders to give raises, grant equity awards, or award bonuses. For example, we might conclude that the poor financial performance was not due to the performance of the executives, or we might conclude that the compensation of one or more executives is not competitive such that we are at risk of losing important talent.
Similarly, we might conclude that the financial performance would have been worse but for the efforts of one or more executives and that it is appropriate to reward them for their efforts. In addition, we may hire a new executive and for competitive reasons determine to pay the executive at a level necessary to attract and retain him or her. While we expect these exceptions to be uncommon, they may occur and are not intended to diminish our overall commitment to pay-for-performance.
In the end, if well defended, we do not expect any of the remaining lawsuits to be successful, and we hope that boards continue to base their decisions on what is good for shareholders and not what they have said in prior CD&As. It is unfortunate that some companies – see Broc’s recent blog – have been settled as that simply encourages more.
Here’s news from Cooley’s Cydney Posner culled from this news brief:
Here’s some potentially happy news for issuers: a report from BNA indicates that ISS plans to review certain of its methodologies in light of company complaints that ISS negative recommendations on say-on-pay proposals during the most recent proxy season were unwarranted.
First, during a recent webcast, ISS Executive Director Patrick McGurn said that ISS will review the way it values options. More specifically, in SEC filings, companies report the grant date fair value of options in accordance with GAAP, while ISS uses valuations provided by Equilar Inc. However, Equilar valuations tend to be higher because of the volatility measures that it uses. (See, for example, the additional soliciting materials from GE, which contended that, by using the wrong volatility measures, ISS had overvalued the grant date fair value of the CEO’s option by over $7 million.) According to the article, ISS plans to request comment on the issue related to option values from its institutional clients and expects to settle the issue by next year.
The second issue that has frustrated companies is ISS’ methodology in developing peer groups for purposes of evaluating pay for performance. Pay-for-performance “disconnects” were among the most common reasons for negative ISS recommendations. In determining compensation, companies typically evaluate their pay and pay-for-performance statistics relative to selected peer groups. ISS’ concern is that companies inappropriately pack their peer groups with “outsize” companies to inflate comparable compensation and thereby justify otherwise insupportable pay packages. Instead, McGurn believes that companies should be “‘baking in pay-for-performance metrics’ that drive the company’s compensation strategy.” In making its own peer group determinations, ISS uses Global Industry Classification Standard (GICS) codes, a private market industry standard familiar to institutional investors, according to ISS.
Companies argue that ISS’ peer groups exclude many companies that are generally recognized as true competitors and include many companies that are not true competitors and may even be in entirely different and unrelated businesses. (See, for example, the additional soliciting materials from Northern Trust.) Unfortunately, the article suggests that we should not expect much movement in this area: according to McGurn, “I don’t see us moving away from that methodology.” However, he did indicate that ISS “will consider providing clients with a ‘matrix of different ways’ to look at pay-for-performance. A handful of metrics would be available for each company that would help institutional investors judge a company’s pay practices.”
A recent Marketwatch article concludes with one quotation condemning golden parachute tax gross-ups for executives as a “skeleton in the closet” (Paul Hodgson of GovernanceMetrics International), and another one saying “It’s time for these to go” (Charles Elson, a University of Delaware professor specializing in corporate governance).
What really should go are tax gross-ups that are poorly considered or poorly structured. Employers certainly need to understand the significant cost for these commitments. There are instances, however, when a tax gross-up may represent a fair balancing — or arms’ length negotiation — of employer interests and executive incentives. For example, the shift to performance-based stock awards and longer-term incentives dramatically changes the calculus behind the golden parachute rules, by increasing the parachute payments that are deemed to occur from an acceleration of vesting.
While good governance often warrants longer-term incentives, there are occasions when the consequent shift in compensation structures should include a limited tax gross-up (such as for some protection above threshold materiality triggers). The protection is often key to the hiring of an executive to turn-around a failing or stalled company, especially if the lion’s share of the compensation package comes in the form of performance-based incentives that become vested on a change in control. This is not meant to defend tax gross-ups generally, but instead to suggest that exceptions be recognized for soundly considered actions and constructs. Unfortunately, say-on-pay’s empowering of proxy advisors is at times resulting in excessive rigidity. Check out my “Executive Loyalty” Blog…
Last week, the IRS proposed new regulations under Section 162(m), which would significantly change the rule that applies to pre-existing stock option plans of private companies that then go public. Among other things, the proposal also reinforces that individual award limits must be stated in an option plan. We are posting memos in our “Section 162(m) Compliance Practice Area.” In addition, the NASPP will be covering this proposal in detail (here’s the NASPP’s Blog if you haven’t checked it out yet).
New movie on the horizon? Will Ferrell will star as “a narcissistic hedge fund manager who thinks he has seen God.”
Last week, a seventh company was sued regarding its pay practices – Bank of New York Mellon in a state court in New York (here’s the complaint). One of the big differences in this lawsuit is unlike the six lawsuits filed against companies that failed to garner a majority of votes in support of their say-on-pay, Bank of New York Mellon received overwhelming support for its say-on-pay (although there was a huge number of broker non-votes). Here’s the Form 8-K reporting the company’s voting results.
Mark Borges notes “this lawsuit appears to be fundamentally different from the others that have been filed following a failed say-on-pay vote. This suit alleges that the company’s board (and its Compensation Committee) acted in contravention of the terms of their long-term incentive plans. What’s interesting to me is that the details of the complaint could only have been drawn from the Compensation Discussion and Analysis, so it’s a classic example of the disclosure providing a roadmap for second-guessing the decisions of the directors.” We continue to post pleadings from these cases in our “Say-on-Pay” Practice Area.
By the way, two of the oldest of the say-on-pay cases have been settled. As noted in this Davis Polk blog: “KeyCorp agreed, according to Reuters, to pay $1.75 million in attorneys’ fees and expenses to settle related suits and Occidental Petroleum, faced with three suits, settled one for an undisclosed amount and had two dismissed.”
I was struck recently by a story, in the New York Times, written by Gretchen Morgenson regarding retail shareholder restiveness. The article focused on a group of individual shareholders of the Celgene Corporation, inspired by the Arab Spring revolutions and the use of social media, to push back against the board’s Say on Pay request. According to the story, the shareholders are upset with a perceived CEO/NEO pay-for-performance disconnect. There are a couple of lessons here for companies, directors, shareholders and Ms. Morgenson from the Celgene cyber battle:
– While institutional investors are often supportive of management, retail shareholders tend to be far more supportive of management positions (when they vote) than institutional investors. Retail holders are more likely, in our experience (and those of solicitation firms), to back a management request or vote against a shareholder proposal. In the instant case with Celgene it is much more the exception than the rule.
– Boards and their advisors need to pay much more attention to the still untapped and vast potential of the social media. 2.7 million shares may seem to be a very small amount but for some of the companies that lost their advisory vote on executive compensation small shareholders could have tipped the balance – remember in a tight contest every vote counts.
– Bad news or perceived bad news is a strong motivator for both institutional and retail shareholders. Boards and senior management need to maintain control and disseminate positive and honest messages to their investors on strategy and growth prospect to stay one step ahead of problems.
Stop the ‘ISS Ate My Homework’ Comments
As the first portion of the 2011 proxy season comes to a close, we have detected not only the usual weariness from the institutions we’ve spoken with but some frustration from some of the issuer engagements they have had thus far this year.
The point of contention is the issuer attacks on ISS for their negative vote recommendations, whether the vote in question is on Say on Pay, a stock incentive plan or the proxy advisor’s support for a shareholder proposal. Issuers will disagree with a specific recommendation from ISS (or Glass Lewis) and that is not unusual, however many institutional investors have grown tired of hearing ad hominem attacks on the proxy advisory firms during dialogue with companies.
As one major investor put it to me earlier this week, “…we are not stupid. ISS does not think for us. If you have done a poor job of crafting your CD&A and proxy – don’t blame ISS for your sub-par disclosure.” This is not to say that issuers should not file 8K’s pushing back against ISS, but that the tactic should focus on clarifying the earlier disclosure from the proxy statement not railing against ISS or Glass Lewis.
In issuers’ defense, while many major investment firms and the governance advocates spend the time and money necessary to review the information from the proxy advisory firms they subscribe to, they are also willing and able to engage with companies and importantly are open to voting with the board and against the recommendation of the proxy advisory firms. However, far too many institutional investors use the proxy advisory firms as a shield against undertaking investment in the staff and resources necessary to make informed decisions – that is the issue requiring attention from investors, issuers and regulators.
Yes, Im happy that I’ve got a quote in this interesting column in Sunday’s NY Times by Gretchen Morgenson – but it’s also a piece worth reading as she analyzes a fascinating report that compares CEO pay with a number of different metrics:
WHEN does big become excessive? If the question involves executive pay, the answer is “often. “But despite the reams of figures about pay in any given year, shareholders often have to struggle to put those numbers into perspective. Companies typically hold up pay from previous years as a benchmark, but just how this paycheck stacks up against, say, a company’s earnings or stock market performance is rarely laid out.
Investors can run the numbers themselves, of course, but it’s a pretty laborious process. As a result, pay for most public companies’ top executives exists in a sort of vacuum, as far as investors are concerned. Shareholders know they pay a lot for the hired help, but a lot compared with what?
Answers to that question come fast and furious in a recent, immensely detailed report in The Analyst’s Accounting Observer, a publication of R. G. Associates, an independent research firm in Baltimore. Jack Ciesielski, the firm’s president, and his colleague Melissa Herboldsheimer have examined proxy statements and financial filings for the companies in the Standard & Poor’s 500-stock index. In a report titled “S.& P. 500 Executive Pay: Bigger Than …Whatever You Think It Is,” they compare senior executives’ pay with other corporate costs and measures.
It’s an enlightening, if enraging, exercise. And it provides the perspective that shareholders desperately need, particularly now that they are being asked to vote on corporate pay practices.
Let’s begin with the view from 30,000 feet. Total 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. That’s some pile of pay, right? But Mr. Ciesielski puts it into perspective by noting that the total is almost equal to the gross domestic product of Tajikistan, which has a population of more than 7 million.
Warming to his subject, Mr. Ciesielski also determined that 158 companies paid more in cash compensation to their top guys and gals last year than they paid in audit fees to their accounting firms. Thirty-two companies paid their top executives more in 2010 than they paid in cash income taxes.
The report also blows a hole in the argument that stock grants to executives align the interests of managers with those of shareholders. The report calculated that at 179 companies in the study, the average value of stockholders’ stakes fell between 2008 and 2010 while the top executives at those companies received raises. The report really gets meaty when it compares executive pay with items like research and development costs, and earnings per share.
The report, for instance, compared earnings per share with cash pay — just salary and bonus, if there is one. It identified 24 companies where cash compensation last year amounted to 2 percent or more of the company’s net income from continuing operations. Topping this list is Allergan Inc., the health care concern whose top executives received, after taxes, an estimated $2.6 million in salaries last year. That amounted to 50 percent of what the company earned from continuing operations, the report said. Caroline Van Hove, an Allergan spokeswoman, said that the salaries were large when compared with net income in 2010 because one-time charges reduced earnings significantly that year; in previous years, she noted, earnings were far higher than executives’ pay. She also said the company’s C.E.O. had not received an increase in salary over the past three years.
Moving on to R.& D. costs, the report examined the 62 technology companies in its sampling that reported such an expense, excluding certain costs associated with acquisitions. Mr. Ciesielski found that the median level of executive pay was equal to 5.3 percent of these companies’ R.& D. expenditures. Topping the pack was Jabil Circuit, a manufacturer of electronic circuits and boards for computer, communications and automotive markets. In 2010, its $27.7 million in total executive pay almost matched the $28.1 million it spent on R.& D. While last year may have been an outlier, over the past four years, Jabil’s pay equaled 57.2 percent of the amount it spent on research and development. Jabil did not respond to a request for comment.
Finally, there’s the comparison of executive pay with market capitalization. As Mr. Ciesielski noted, this calculation provides the biggest shock value. Eleven companies analyzed in the report gave top executives a combined pay package amounting to 1 percent or more of the companies’ average market value over the course of the year. The Janus Capital Group, the mutual fund concern, topped the list, with pay totaling almost $41 million for five executives. This accounted for 1.95 percent of the company’s average market value over 2010. “To earn their keep,” the report said, “managers would have to create stock market value in the full amount of their pay.” The executives at Janus failed to increase value in 2010, when the stock closed out the year roughly where it had begun it. This year, the company’s shares are down almost 30 percent. Janus declined to comment.
Mr. Ciesielski says he believes that shareholders need more context when it comes to pay practices — and that rule makers should improve pay reports. “The disclosures really are not sufficient to get people fired up,” he said in an interview last week, “unless they add up the compensation and find out how it relates to other things.” “We need a different model,” he added. “There is a real lack of information here about how shareholders’ funds are being managed.”
THIS may explain why shareholders at annual general meetings so rarely vote against pay practices. Broc Romanek, who is editor of CompensationStandards.com, said that a majority of shareholders at only 34 companies, or 2 percent of those that have held votes so far this year, have rejected executive pay packages.
If shareholders could size up the impact of pay on a company’s operations, they’d be more informed, Mr. Ciesielski said. For example, why not show a company’s total executive pay against its overall labor costs? Or disclose top pay as a percentage of marketing expenditures, if that is what propels a company’s results? “How does executive pay relate to the basic drivers of what makes the company work?” Mr. Ciesielski asked. “We should be exploring that kind of information.”
Tune in tomorrow for the CompensationStandards.com webcast – “The Latest Compensation Disclosures: A Proxy Season Post-Mortem” – to hear Mark Borges of Compensia, Dave Lynn of CompensationStandards.com and Morrison & Foerster and Ron Mueller of Gibson Dunn analyze what was (and what was not) disclosed this proxy season.