When I first saw this press release from Towers Watson regarding how few companies are prepared for say-on-pay, I thought our marketing department had outdone itself since our far-reaching week of executive pay conferences comes up in less than a month – with an aggregate of over 50 panels on executive pay topics. If these conferences don’t help get you prepared, nothing will. You can either register for the three days of the “18th Annual NASPP Conference” (in Chicago) – or the two days of the “5th Annual Proxy Disclosure Conference” & “7th Annual Executive Compensation Conference” (in Chicago or by video webcast).
Here are highlights from the Towers Watson press release:
– Only 12% of respondents said they are very well prepared for the say-on-pay legislation, while 46% said they were somewhat prepared. Just under one-fourth of respondents (22%) didn’t know if their companies were ready.
– 69% said they were identifying potential executive pay issues and concerns in advance, while 60% said they were improving their CD&A to better explain the executive pay program’s rationale and appropriateness for the company. In addition, many companies indicated they are engaging with proxy advisors (44%) to discuss areas of concern, meeting with key institutional shareholders (29%) and preparing a formal communication plan (23%).
– More than one-half (59%) of respondents believe that proxy advisory firms have substantial influence on executive pay decision-making processes in U.S. companies. However, 42% said that guidelines established by proxy advisory firms have had no or minimal impact to this point on the design of their executive compensation programs.
With the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act a renewed focus has been placed on the alignment of executive pay with company performance. In addition to requiring Say on Pay – where companies will be seeking shareholder approval of compensation programs at least once every three years – the Act also requests that the SEC require filers to disclose information regarding the relationship between actual pay received by executives and company performance. Ensuring that pay is appropriately aligned with performance, a long debated and important shareholder issue regarding executive compensation, will now be brought further to the forefront of annual disclosures.
As Compensation Committees await SEC interpretation on the Act’s executive compensation provisions and begin thinking about how to accurately test and communicate to shareholders their executive pay and performance comparison, an interesting question arises: will companies be able to show that pay is in fact aligned with performance?
Despite the constant criticism of the lack of pay for performance in executive pay, we believe the answer is YES for most companies. Our micro and macro research, with our clients and in the broader market, has shown that executive compensation is indeed well aligned with company performance…when pay is properly calibrated as realizable pay.
In a recent partnership with Equilar, we studied pay and performance at 100 large U.S. companies (median market capitalization of $27B) that filed proxies in early 2010. Making the comparison between 2009 one-year total shareholder return (TSR) performance and 2009 realizable pay (base, annual incentive earned, current in-the-money value of restricted share and stock option awards, and payouts from long-term performance plans), our findings provide further evidence that there is pay for performance – showing that pay is well aligned with company performance (see Table 1). Our analysis for Table 1 finds that CEOs leading higher-performing companies have higher realizable values ($13.8M at median) than their counterparts at lower-performing companies ($8.6M), representing a 60% premium for CEOs of high-performing companies. Other findings include:
– The 2009 shareholder return for high-performing companies (those with above overall median TSR) was 41% and the CEO for these same high-performing companies earned $13.8M in realizable value for 2009.
– Low-performing companies returned -5% for shareholders while their CEOs earned realizable values below the overall median ($8.6M compared to an overall median of $10.6M)
Reviewing the annual change in realizable pay from 2008 to 2009 in relation to performance yields a similar result (see Table 2). There is differentiation in the change in realizable pay from 2008 to 2009 based on company performance. Specifically, high-performing companies delivered 46% to shareholders in 2009 while realizable pay for the CEOs increased by 61% and when shareholders lost (-6% for low-performing companies) CEOs did as well.
While this particular study finds that pay is well aligned with performance over a one-year period – 2009 a particularly important year given the volatile economic environment – we typically make this comparison over multi-year periods, three to five years and in some cases over entire CEO tenure. In fact, we think it is probably best to view the relationship between pay and performance over a longer time period than one year as many compensation programs are meant to span the long term just as many business decisions impact long-term company and shareholder performance. It is important note that the findings for our one-year study are consistent with our past studies of pay and performance over multi-year periods.
Many proxy advisory firms now run pay for performance analyses for their annual withhold votes; comparing TSR or other performance measures to some form of pay opportunity (typically from the summary compensation table). While it is still unclear what the SEC will mandate for this comparison within proxies – whether the required definition of pay will be comprised of summary compensation table values, options exercised and shares vested table values, some combination of the two, or something new entirely – we believe that the Dodd-Frank Act recognizes that pay opportunity is not the best measure of pay for comparison to company performance.
Compensation Committees can now strengthen their message to shareholders for Say on Pay by exploring the alignment between executive pay and performance. Our experience is that most companies already do pay for performance – low realizable pay when performance is weak and higher realizable pay when performance is strong – and that they should get credit for this with shareholders when it is time to vote.
As I blogged a few weeks ago, SEC Chair Schapiro announced that the SEC would go the extra yard ahead of its blistering rulemaking schedule and start accepting comments on its various projects right away through this Dodd-Frank comment page. The comment letter page is broken up by the Titles in the new legislation, with 31 separate areas for comment, including a section under Title IX which covers the governance and executive compensation provisions. Each rulemaking will have its own comment period as usual – and as required by the Administrative Procedures Act – but this “field day” may help to shorten the comment periods and get rules in place before next year’s proxy season.
When I blogged all that, I didn’t think that the SEC would receive much in the way of comments ahead of specific proposals. But the first few comment letters have started to dribble in on the executive compensation stuff, including this one from Frederic W. Cook & Co.
Recently, the Norwegian Corporate Governance Board proposed to revise its corporate governance code to require an absolute limit to performance-related compensation. And while companies listed in Norway would be able to decide at what level to cap performance pay, they would be required to disclose that limit to shareholders. Note that Norway is not part of the European Union.
– Vania Petrella and Gianluca Russo, Cleary Gottlieb Steen & Hamilton
On May 25th, the Italian Government adopted a draft law decree contemplating, inter alia, an additional 10% tax to be levied on the portion of any variable compensation paid (in the form of bonuses and stock options) to certain executives in the financial sector exceeding three times the fixed component of the executives’ remuneration (the “Additional Tax”). The law decree became effective on May 31, 2010 upon publication on the Official Gazette (Law Decree No. 78) and it was confirmed by the Italian Parliament on July 31st (Law No. 122).
The rule introducing the Additional Tax has not been amended during the confirmation procedure. Therefore, as of May 31, 2010, any portion of variable compensation taking the form of bonuses or stock options exceeding three times the remuneration’s fixed component is subject to the Additional Tax. However, such tax is applied exclusively to certain executives (i.e.employees treated as “dirigenti” and certain consultants and directors characterized as quasi-employees (“collaboratori coordinati e continuativi”) for labor law purposes) employed in the financial services sector. The Additional Tax takes the form of a withholding tax and is effectively borne by the recipient; it does not affect the applicable social security regime.
Since the new legislation does not include a grandfathering rule for plans already launched or awards already vested at the time Law Decree No. 78 became effective, such plans and awards should be subject to the Additional Tax.
Black-letter law raises some doubts as to the actual scope and application of the new rule. For instance, it is not clear whether it applies to options only or also to other equity-settled awards, and how to determine the time frame material to compute the relevant threshold (i.e. three times the fixed component). For the time being, there is no indication as to whether and when the tax administration will issue any guidance with respect to this rule. Read more in our memo.
Below is a recent article from the NY Times’ DealBook:
Corporate boards appear to routinely use compensation peer groups to artificially inflate pay for their chief executives, helping to contribute to the cascading increases in executive compensation over the last several years, according to an academic study on corporate governance. While the rate of pay increases was nearly 11 percent in one recent year, the study highlights one of the various ways that corporate boards go about determining huge compensation packages for executives.
Executive pay has increased substantially over the last few years. For example, in 1965 chief executives at major American companies earned 24 times more than a typical worker, while in 2007 they made 275 times more, according to the Economic Policy Institute. This sharp increase in income for chief executives, coming as wages for ordinary Americans remained relatively flat, has become one of the more perplexing questions in social science and business. Are chief executives that much more valuable now than they were 45 years ago?
Social scientists have looked at a number of reasons for the disparity in pay, with many believing that it has something to do with weak corporate directors simply giving into the demands of management, which are often leading the boards. The common answer as to why chief executives are paid so much money is that boards want to “retain talent” and fear losing their chief executive to a competitor. Compensation committees on boards hire consultants to advise them on how much other chief executives at rival companies are paid to make sure that they are not undercutting their own top executives.
Michael Faulkender of the University of Maryland’s R.H. Smith School of Business and Jun Yang of Indiana University’s Kelley School of Business, sought to answer these questions in a new study examining the use of comparable companies in the role of determining chief executive compensation. The study, “Inside the Black Box: The Role and Composition of Compensation Peer Groups” (an abstract is available here), found that companies usually benchmark their executive pay with peers in their industry group, but that they also choose peers that pay more than others.
“Boards do look at labor market practices, so this is not an entirely corrupted process,” Ms. Yang told DealBook. “They do look at industry, they do look at size, the past talent flows, their visibility in everything, so that’s still the major part in the peer choices.” “But on top of that, if you can choose between company A or company B, which are pretty similar except that A pays their C.E.O. a little bit more generously than B, the board members tend to choose the slightly better paid company as the peer,” Ms. Yang said.
The research showed that from 2006 to 2007 this selection bias toward the higher-paying peers led to a 10.7 percent increase in the median pay for chief executives for more than 600 companies in the Standard & Poor’s 500-stock index and S.&P. MidCap 400 index, equating to a median pay increase of $470,000. “If we see this each and every year, the compensation is going to go up and up,” Ms. Yang said. “You can call this an upward spiral, you can call this ratcheting up, but yes, it is going to go up.”
The motivation of corporate boards to consciously chose peers that are more generous than ones that are very similar but are just less generous helps to explain, at least in part, the huge increases in chief executive compensation over the years. But this does not completely explain why boards believe that their chief executives are necessarily worth the extra cash. In the end, the boards may feel that they must do whatever it takes to make their chief executives happy, which at the end of the day may or may not be in the best interest of shareholders.
Last year, someone from ISS blogged about 13 Canadian companies that agreed to try say-on-pay based on a resolution drawn from a draft model “say on pay” policy crafted by the Canadian Coalition for Good Governance (CCGG), which represents 41 investors managing over $1 trillion in assets.
In January, the CCGG finalized their model SOP policy. That policy – as well as a model shareholder engagement policy – is posted on this CCGG page. A list of Canadian companies that have adopted SOP is maintained on this SHARE (Shareholder Association for Research & Education) page.
The following is a Financial Timescolumn from yesterday, written by Roger Martin, Dean of the Rotman School of Management:
Answer the following question quickly: what incentive effect does stock-based compensation generate? The chances are that your answer will mirror the accepted wisdom: it causes executives to work harder to make their company perform better, whether that means growing faster, increasing profitability or increasing market share.
If that is your answer, however, you would be wrong. A stock price is simply the consensus of investor expectations about the future performance of the company, and linking compensation to it is an incentive for executives to focus more on raising investor expectations than improving actual performance. While we might imagine that real performance drives expectations of future performance, the link is exceedingly tenuous.
Just ask the executives of Microsoft. Last month, it reported a blow-out fourth quarter with sales up 22 per cent and profits up 45 per cent. The stock? It jumped a mere 2.9 per cent on the announcement. And that wasn’t because there had been a recent big run-up on the stock in expectation of a strong quarter. With a few brief exceptions, Microsoft has traded (adjusted for splits) in a narrow range between $20 and $30 per share for the past 10 years. During that decade, revenue and profit nearly tripled but the stock has remained flat. Had a dutiful executive been given a generous grant of 100,000 options on January 2 2001 at $21.69 and held on to them to today, the executive would be able to exercise those for a profit of a mere $440,000 (at the current price of about $26 per share) – after 10 years of hard slog to triple the company’s real performance.
Of course, this is one example and there are examples all over the map – including those in which expectations track real performance exactly. But that is precisely the point: the relationship between real performance and expectations is all over the map.
The only way an executive can be sure to realise a return from the incentive compensation provided is to work first, foremost and directly on raising expectations from the current level – the only thing that makes a stock price rise – often at the expense of improving the actual underlying value and performance of the company.
There are much easier ways to accomplish that objective than working for a decade to triple the revenue and bottom line. It is much easier to go to the City and hype your stock. Or change your accounting treatment to appear to produce a jump in performance. Or make stupid acquisitions to appear like a fast-growing company.
Stock-based compensation was originally conceived as a way to align the interests of senior executives with those of the shareholders. Interestingly, it has created a wonderful alignment between segments of each: bloody-minded executives and hedge fund investors. Both profit most from expectations volatility. A bloody-minded executive bent on doing whatever is necessary to maximise stock-based compensation earnings will happily drive down expectations in order to get more low-priced stock compensation (whether options, stock or phantom stock) and then drive expectations back up to realise huge gains, then repeat the process until fired. Hedge funds, meanwhile, make all their money from volatility – the rise and fall of expectations – so they are totally aligned with and actually help out the bloody-minded executives in producing and profiting from volatility.
One might ask, what is the harm in all of this: a little hyping, some accounting hanky-panky, a few acquisitions that might not have been needed, executive compensation going through the roof, hedge funds making extraordinary profits. The problem is that this is a short-term game. Expectations cannot be made to rise forever – Jack Welch was the last chief executive to master that ancient art form – so executives need to raise expectations as precipitously as possible, and then simultaneously get out and cash out.
More than anything else, stock-based incentive compensation is responsible for short-termism in the modern corporation and the shrinking average tenure of today’s chief executives. It is an incentive for manipulating expectations rather improving real performance.
The solution is to replace stock-based compensation with incentives that affect underlying value – whether that is increasing revenues, profitability, market share, customer service or, optimally, a combination of all of these. And for longer-term incentives based on the actual market not the expectations market, use royalties on real results, as are given to designers, inventors and musicians. The bottom line is that if you want to skew reality, use stock-based compensation. But if you want to build the real company, use incentive compensation anchored in reality-based measures.
The Investor Responsibility Research Center (IRRC) Institute and PROXY Governance Inc. (PGI) recently released a new study, “Compensation Peer Groups at Companies with High Pay,” that identifies a subset of S&P 500 companies with high pay that is not aligned with high performance. The data reveal that high executive pay companies self-select larger than appropriate peers – in terms of market capitalization and revenue – for compensation benchmarking purposes. The self-selected peer groups also are better performers. Then, not content with systemically skewing the comparables for the purpose of setting executive compensation, the boards of directors of the high pay companies basically ignore the peer groups to compensate chief executive officers (CEO) an average of more than double, or 103 percent, above the median of the self-selected peer group.
By contrast, the baseline, or non-high pay, companies paid CEOs an average of 15 percent lower than the median of benchmarking peers. The key research findings are as follows:
– While all companies in the study tended to select larger compensation peers, the differential was more dramatic for companies with high pay. Measured by market capitalization, companies with high pay were an average of 45 percent smaller than self-selected peers versus an average of 5 percent smaller among baseline companies. Measured by revenue, companies with high pay were an average of 25 percent smaller than self-selected peers, while baseline companies averaged only 17 smaller.
– Unlike baseline companies, companies with high pay tended to select higher-performing companies as compensation peers. On average, companies with high pay performed 7.7 points worse than self-selected peers, based on the studyʼs aggregate scoring metric. By contrast, baseline companies performed an average of 3.0 percentile points better than their self-selected peers.
* Companies with high pay were also more likely (21 percent) than baseline companies (17 percent) to select other companies with high pay as compensation peers. Conversely, however, the average company with high pay appeared in fewer S&P 500 compensation peer groups, at 8.5, than the average baseline company, at 10.3.
– Companies with high pay compensated their CEOs an average of 103 percent above peer group median despite being 25 percent smaller than those peers by revenue. Baseline companies, by contrast, paid their CEOs an average of 15 percent below peer group median – a discount roughly in line with approximately 17 percent smaller average revenue.
– Companies with high pay also structured their larger CEO pay packages with a disproportionately richer mix of equity awards (69 percent of total pay) than either their self-selected peers (62 percent) or baseline companies (61 percent). Full value equity awards at companies with high pay constituted 41.3 percent of total pay, versus 35.2 percent among self-selected peers and at baseline companies.
– Contrary to general perceptions, having an external CEO on the compensation committee appeared to act as a mild deterrent to high pay. Among the S&P 500 companies, 6.5 percent of companies with high pay had external CEOs on the compensation committee, versus 9.0 percent of baseline companies. Across the broader Russell 3000, only 1.7 percent of companies with high pay had external CEOs on the compensation committee, versus 10.5 percent of baseline companies.
– Nearly 65 percent of companies with high pay had a CEO who was also chairman, slightly higher than the 60 percent rate among baseline companies. Baseline companies, however, were moderately more likely to have a classified board (29 percent versus 24 percent) or have had a shareholder pay proposal on the ballot in the prior three years (29 percent versus 24 percent).
In my experience, companies that benchmark to larger than appropriate peers do so because they pick their peer group based on aspiration, rather than reality. Yeah, I’d like to play like Tracy McGrady. If my board pays me to match his $23,239,561, will that motivate me enough to play as well as McGrady?
Just as the Sarbanes-Oxley Act of 2002 reduced the ability of a private fund’s representative to serve on the audit committee of a U.S. public company (a “public portfolio company”), it appears that the Dodd-Frank Act will have a similar impact on the service of a private fund’s representative on a compensation committee.
The Act requires the SEC to adopt rules no later than July 16, 2011, directing NYSE and Nasdaq to prohibit listing any company not complying with enhanced independence requirements for compensation committee members. In determining compensation committee “independence,” the Dodd-Frank Act requires public companies to consider at least the following factors:
– the source of compensation received by a compensation committee member, including consulting, advisory, or other compensatory fees (apparently including management fees paid by the public portfolio company to the private fund), and
– whether the compensation committee member is an affiliate of the public portfolio company or any of its subsidiaries.
Although subject to SEC rulemaking, the SEC will likely base “affiliate” status on the SEC’s traditional definition, i.e., a person that directly or indirectly controls, or is controlled by, or is under common control with, the issuer, with a presumption that more than 10% direct or indirect ownership of a an issuer creates affiliate status. If so, a representative of a private fund owning more than 10% (or of a group of private funds acting in concert and owning in the aggregate more than 10%) of a public portfolio company would be precluded from serving on the company’s compensation committee, subject to the “controlled company” exception described below.
While the Dodd-Frank Act exempts a “controlled company”–i.e., a company with more than 50% of its voting power held by an individual, a group or another issuer–from this compensation committee independence test, the Act does not exempt a public portfolio company if the private fund owns between 10% and 50% of its stock.
This compensation committee independence provision is apparently inconsistent with other provisions of the Dodd-Frank Act. On the one hand, the Act seeks to expand stockholder powers by giving stockholders (including a private fund stockholder) both a “say on pay” and access to the company’s proxy statement for the election of directors. On the other hand, however, as discussed above, it would apparently deny a stockholder owning between 10% and 50% of the company’s stock (including a private fund) the right to have its representatives serve on the company’s compensation committee. Furthermore, the Act fails to address why is it acceptable for a private fund that owns more than 50% of the public portfolio company’s stock to serve on the compensation committee but not acceptable for one that owns between 10% and 50%.
It is particularly noteworthy that, in contrast to the Sarbanes-Oxley Act, the Dodd-Frank Act does not impose an absolute and inflexible definition of “independence” and thus leaves discretion to the SEC, NYSE and Nasdaq in this regard. The SEC should carefully consider this provision of the Dodd-Frank Act–especially the “affiliate” requirement–before implementing rules that potentially disenfranchise those stockholders with the greatest interest in ensuring that executive compensation is appropriate and properly balanced.