The Advisors' Blog

– Broc Romanek, CompensationStandards.com

Recently, Mark Borges blogged his thoughts on comment letters that ask the SEC to specify the form of say-on-pay resolution. Here is a summary of the 60 comment letters submitted so far from ISS’s Ted Allen:

The SEC has received more than 60 comments on its proposed rules to implement the Dodd-Frank Act’s requirements that public companies hold shareholder votes on executive compensation, the frequency of future “say on pay” votes, and “golden parachute” arrangements. The SEC has not indicated when it might finalize the rules, but agency officials have said they hope to have final rules in place before the end of the year. Companies are required to hold a “say on pay” vote and a frequency (annual, biennial, or triennial) vote at their first shareholder meeting on or after Jan. 21, 2011, so the SEC is seeking to get the rules approved before a significant number of issuers have to file their 2011 proxy statements. A few companies with late January meetings have already released their proxy materials. (For more details, see this week’s “In Brief” section.) The pay vote rules are not on the agenda for the agency’s Dec. 15 open meeting, but SEC observers say the commission could issue final rules without holding a formal meeting.

Unlike the SEC’s proxy access rulemaking, the pay vote regulations haven’t generated significant controversy. Most companies expected that “say on pay” votes would be mandated by the Dodd-Frank Act, and the SEC issued similar rules in 2009 to govern advisory votes at financial firms that participated in the U.S. government’s Troubled Asset Relief Program. Here are examples of the comments offered by investors and issuer advocates on the various topics addressed by the draft rules:

The National Association of Corporate Directors (NACD) expressed skepticism about the value of an advisory vote on compensation, noting, “we believe that it is poor substitute for dialogue. It is much more valuable to have shareholder communication well in advance of [pay] plans or votes on plans.”

Two U.K. investors, Railpen Investments and the Universities Superannuation Scheme, suggested that the SEC require companies to hold a conference call or an Internet forum a week before their proxy voting deadline to answer questions about pay. “Providing a specific vehicle for handling questions, with responses posted and available to all shareholders via the internet, would improve transparency and efficiency of the process,” the investors wrote in their comment letter.

Should smaller issuers or newly public companies be exempted from holding pay votes?

Most of the institutions that submitted comment letters urged the SEC to maintain its position that all public companies must conduct votes on compensation and golden parachute packages. The Dodd-Frank Act authorizes, but does not require, the commission to exempt small issuers.

“Although absolute pay amounts may be lower at small companies, we are not aware of any evidence that problematic pay practices are less common at smaller companies. Indeed, smaller companies tend to lag behind larger ones in adopting corporate governance best practices,” the American Federation of State, County, and Municipal Employees, a long-time “say on pay” proponent, wrote in its comment letter.

Walden Asset Management and other investors argued that holding such votes would not be a significant burden. “We do not believe that an advisory vote on pay is any more burdensome for smaller companies than other routine votes, such as those for director elections or to ratify auditors,” Walden said in its letter.

The Social Investment Forum, the Florida State Board of Administration, and the Council of Institutional Investors (CII) expressed similar views. Likewise, CII argued that newly public issuers should not be exempt from holding pay votes at their first annual meeting as a reporting company.

However, the United Brotherhood of Carpenters and Joiners asserted that small firms should be exempted to reduce the voting burden on investors. “In order to allow shareholders acting as fiduciaries to properly undertake their new voting responsibilities the scope of the pay vote obligation should be limited to a universe of large cap companies. Such a limitation would allow shareholders to focus limited research and voting resources on those companies whose pay practices directly influence market practices,” the Carpenters wrote.

In its comment letter, the U.S. Chamber of Commerce urged the SEC to exempt companies with less than $75 million in market capitalization and called on the commission to do a cost-benefit analysis of the burden the rules would place on all firms. The NACD also supported an exemption for small companies and new issuers.

Should companies be allowed to exclude shareholder proposals that seek a different frequency for future pay votes?

Under the proposed rules, companies would be allowed to omit shareholder proposals that seek a different frequency if they heed the views of a plurality of investors during the “say when on pay” vote. Under the Dodd-Frank Act, companies only are required to hold frequency votes every six years. AFSCME, Walden, and the Social Investment Forum all argued that the SEC should not force investors to wait years to express their views on frequency, particularly if there has been a “material” change in a company’s pay practices.

“Significant changes can occur in a company’s compensation practices during a six-year period, and such changes could affect shareholders’ views regarding the desirable frequency of SOP votes,” AFSCME stated. “The hiring of a new CEO from outside the company shortly after the frequency vote, however, might bring with it practices, such as guaranteed incentive compensation or relocation benefits, of which shareholders disapprove. . . . Forcing [investors] to wait four or five years for the next frequency vote is unnecessary when a non-binding shareholder proposal advocating annual SOP votes would allow shareholders to register their sentiment on this issue in a non-disruptive way.”

Corporate representatives did not agree. The NACD argued that such votes would be “disruptive.” In its comment letter, Eaton Corp. argued: “There is no compelling justification for permitting additional votes on matters where a plurality of the shareholders have spoken, and the company’s policies conform with that vote. Obligating issuers to respond to such proposals and/or include them in the proxy statement would only serve to increase burdens on issuers and would be confusing to shareholders who have already voted on these matters.”

Boeing warned that allowing shareholders to seek new frequency votes after a “material” change in pay policies would force the SEC to evaluate numerous no-action letters and decide whether a particular change was “material” for that particular issuer. “Practically speaking, such a rule would also give shareholders seeking a ‘redo’ of the prior frequency vote an easy opportunity to simply declare that whatever change was recently made was ‘material’ and thereby seek to redo the frequency vote,” the aerospace company argued.

Boeing said that issuers should have flexibility when interpreting the results of the frequency vote. “For example, if shareholders’ preference is split 34 percent for an annual vote and 33 percent each for a biennial and triennial vote, an issuer may determine that a biennial vote best reflects overall shareholder preference. As a result, issuers should be permitted to choose any frequency that is reasonably believed to more accurately reflect shareholder preference,” the company said.

Keith Bishop, a California-based securities lawyer, said the SEC should allow companies to design proxies that may better assess shareholder preferences. For instance, he said companies may want to use a Borda count to allow investors to rank their preferences rather than select one frequency.

Should companies be allowed to omit similar shareholder proposals?

Issuers and their representatives also argued that the SEC also should permit the exclusion of similar shareholder resolutions on the grounds that the company has “substantially implemented” those requests. Boeing argued for the omission of proposals that ask for more specific compensation votes, either those that target particular pay aspects (such as incentive compensation or pension benefits) or “that wish to make the result of such votes binding in any respect.” “Permitting such ‘extra’ votes would (a) dilute the importance of the core shareholder vote proposed by these rules, (b) needlessly add to the length of companies’ proxy statements, (c) be extremely difficult for investors to analyze, and (d) be extremely difficult for issuers to adequately respond to . . .,” the company said.

Should the SEC mandate specific language for advisory vote proposals?

One issue that most commenters agreed on is that the SEC should not prescribe specific language for advisory votes, as long as there are minimum guidelines.
“Companies that have already implemented ‘say on pay’ votes under pressure from shareholders can provide good examples of the usefulness of offering some flexibility in this area. For instance, some companies have split votes into several sections to address a broader subset of issues, while others have tested specific executive pay points in different years,” the First Affirmative Financial Network, an ESG-oriented investor, said in its comment letter.

Should companies have to address if they considered previous shareholder votes on compensation?

There was debate over whether companies should be required to disclose whether they considered the results of previous shareholder votes on compensation in determining their pay policies and decisions. In its comment letter, TIAA-CREF said such disclosure should be mandatory. “This disclosure will ensure the Advisory Vote is not an afterthought and will encourage a healthy dialogue between shareholders and issuers on the topic of compensation on an annual basis,” the educational pension giant said.
UnitedHealth Group disagreed. “In the vast majority of instances, requiring this announcement will lead to boilerplate statements, further lengthening [the] CD&A without providing shareholders with meaningful information. Indeed, empirical evidence demonstrates that for most companies, this information will not be material: in 2010, management proposals for an advisory vote on executive compensation received average support of approximately 89.6 percent. In other words, there would be nothing to disclose in this mandatory disclosure,” the health insurance company said.
Pfizer argued that this disclosure shouldn’t be required and should be limited to those companies that received less than majority support during their most recent advisory vote.

Will the proxy system be able to handle four-ballot options?

The Society of Corporate Secretaries & Governance Professionals expressed concern that some proxy system participants won’t be able to handle the four ballot options–annual, biennial, triennial, or abstain–proposed for the frequency votes. The group suggested a two-question alternative whereby investors would be asked: 1) if they had a preference on pay vote frequency; and 2) whether they preferred votes to occur every one, two, or three years. Broadridge Financial, which processes proxy votes for 900 custodian banks and broker-dealers, said it is modifying its systems to accommodate four ballot options. “We estimate that the initial systems effort requires an investment of over 18,400 people hours for specification, development, testing, audit, and quality assurance,” Broadridge said.

In addition, there have been comments submitted ahead of the SEC making proposals on the other Dodd-Frank governance provisions, including this one from Davis Polk.

– Broc Romanek, CompensationStandards.com

In our “Say-on-Pay” Practice Area, I have posted a sample voting instruction form created by Broadridge (check out the director names!) with the four alternatives for the “say-when-on-pay” proposal (i.e., 1-, 2-, 3-year, abstain) that most companies will be placing on their ballot this proxy season.

I am also wrapping up the Winter 2011 issue of the Compensation Standards newsletter that will be out right after New Year’s Day (available to all 2011 members of CompensationStandards.com). This issue will contain more practical guidance on say-on-pay preparation, supplementing the July-August 2010 issue of The Corporate Counsel that I wrote a few months back. One topic I tackle is what you need to check now to ensure that Broadridge’s systems work properly with other players in the meeting process so that tabulation is done correctly. Since all memberships expire at the end of this month, renew now to receive this issue as soon as it’s out.

– Broc Romanek, CompensationStandards.com

With the spotlight on excessive pay practices never brighter, you would think that the age of the option mega-grant would be over. Yet, this press release from The Corporate Library earlier this year listed the top ten largest stock option mega-grants of 2009, with an unrealized gain of nearly $230 million as of May 24, 2010. Here is The Corporate Library’s related blog on the topic.

– Broc Romanek, CompensationStandards.com

In this podcast, Peter Gleason of the National Association of Corporate Directors explains the NACD’s perspective on say-on-pay, including:

– What is the NACD’s position on the SEC’s proposed say-on-pay rules?
– What are potential business risks and consequences of the proposed say-on-pay rules if they are not changed before adopted by the SEC?
– What are the potential implications for directors and boards once the say-on-pay rules are finalized?
– How does the NACD suggest the SEC amend the proposed say-on-pay rules?
– How is the NACD preparing its members and the director community to address new say-on-pay, and other rulemakings, associated with Dodd-Frank?

– Broc Romanek, CompensationStandards.com

Given the new importance on clawbacks due to Dodd-Frank, it’s not surprising that firms are conducting clawback studies (as they have been actually even before Dodd-Frank). Here is the latest clawback study from Frederic W. Cook & Co.

And Equilar’s latest study found that 82.1% of Fortune 100 companies have some kind of clawback policy – a major increase from 2006, when just 17.6% had one. The industry with the highest prevalence of clawback policies is the Financial, Insurance, and Real Estate, due to the mandatory clawback requirements of TARP. 90.5% of companies in that industry had a clawback policy in 2010, compared to 82.4% in 2009 and 50% in 2008.

– Broc Romanek, CompensationStandards.com

We just mailed the hard copies of Lynn, Borges & Romanek’s “2011 Executive Compensation Disclosure Treatise & Reporting Guide” to those that ordered it. As you can imagine, our members believe this is a critical resource for this proxy season. This hard copy of the 2011 Treatise is not part of CompensationStandards.com and must be purchased separately – however, CompensationStandards.com members can obtain a 40% discount by trying a no-risk trial now. We will then quickly deliver this 1000-plus page comprehensive Treatise as soon as you try the trial.

If you need assistance, call our headquarters at (925) 685-5111 or email info@compensationstandards.com.

– Broc Romanek, CompensationStandards.com

The subtitle of a press release relating to a recent survey conducted by PricewaterhouseCoopers of directors jolted me (the survey results are covered in this CNBC article). I know boards had trouble controlling CEO pay, but I have always figured one of the reasons why the excesses have not yet been fixed is that boards were confident they were doing the right thing. I guess even they realize they have trouble controlling CEO pay – although they may be thinking “it’s those other boards, not the ones that I sit on.”

Anyways, here is an except from the PwC press release (the press release was emailed to me, but is not online):

PwC research found that 58 percent of the 1,110 directors surveyed felt US company boards are still having trouble effectively controlling CEO compensation. The boardroom directors surveyed said the three most important factors that should be considered by compensation committees to improve CEO pay policies are:

– Ensuring peer group companies are realistic (83 percent).
– Re-evaluating compensation benchmarks (82 percent);
– Setting minimum stock ownership guidelines and/or holding periods (65 percent)

And here is a summary of the survey, excerpted from Tom Gorman’s “SEC Actions’ blog:

Board in general

– Over half of the directors indicated that more time and focus should be spent on risk management.

– Over 70% of the directors stated that they do not believe their board should have a separate risk committee, while 67% concluded that the board is very effective at monitoring risk management to mitigate corporate exposures.

– Over half of the directors stated that the board does not receive general and/or specific customer satisfaction research.

– Most directors stated that during the last 12 months the board had discussed an action plan that would outline steps the company would take if faced with a major crisis.

– Almost 80% of directors indicated that sustainability/climate change is already a major focus and no additional time on the question is required.

– Almost 90% of directors surveyed stated that no additional time is required on social responsibility issues because it is already a major focus.

Regulatory and compliance

– Almost 75% of the directors stated that compliance and regulatory issues are already a major focus and do not require more time.

– The top five items identified as “red flags” in signaling a director to step up his/her board involvement are: (1) a restatement of the financial statements; (2) charges or investigations; (3) management missing strategic performance goals; (4) an adverse 404 opinion; and (5) multiple whistle-blower incidents.

– Almost 25% of the companies involved in the survey do not have an FCPA compliance program.

– Significantly less than half of companies in the survey have an FCPA program which covers employees and agents, while almost 20% have a program limited to employees.

Management

– 90% of the directors surveyed concluded that the board is very effective at standing up and challenging management when appropriate.

– 58% of directors stated that U.S. company boards are experiencing difficulty controlling the size of CEO compensation.

Effectiveness of board

– Only about 30% of directors concluded that the company had an effective board evaluation process.

– Over 81% of directors stated that the most important technique in ensuring that directors continue to be effective on the board is an effective evaluation process.

– Bruce Brumberg, myNDQC.com

Recently, we decided to take myStockOptions.com one step further by launching a new site: myNDQC.com. Many executives and highly paid key employees are eligible to participant in these plans. The goal of myNQDC.com is to provide educational content and tools for nonqualified deferred compensation plan participants, their advisors and attorneys, plan providers and administrators, and companies with NQDC plans. With clear writing and independent, unbiased expertise, myNQDC provides education about the financial planning, taxation, risk, and legal issues surrounding nonqualified deferred compensation and encourages participants to fully understand these topics and maximize the value of their plans. With tax rates likely to rise in the future, the tax-deferral advantages of NQDC will make these plans increasingly popular.

– Paul McConnell and Jeff McCutcheon, Board Advisory, LLC

The Dodd-Frank bill contains two new disclosure requirements regarding executive pay: the ratio between the CEO’s compensation and that of the median employee, and the relationship between compensation actually “paid” to executives and company stock performance.

The new pay ratio is flawed on many fronts: it ignores organizational scope and size, it can be biased by outsourcing lower-paid work, it ignores the inordinately large role of benefits in the pay of lower level employees, and most importantly, it ignores the differences between guaranteed compensation and the risk inherent in equity based pay.

In contrast, the disclosure of pay in relation to performance has the potential to present a true picture of executive pay from which shareholders and the public can draw meaningful comparisons. The key is how the SEC eventually defines “pay”.

The Amounts Shown In The Summary Compensation Table Are Not Pay – Disclosure of executive pay has vastly improved over the last two decades. We now have accurate data on all the relevant components of compensation. While this data is extremely useful in designing competitive pay opportunities, the current required format does not show what executives actually earn — or how that pay might relate to company performance.

Cash bonuses are typically paid for financial performance versus targets, rather than for shareholder gain. Presumably, the cash payment relates to drivers ultimately reflected in stock price, but not necessarily reflected in the current year stock price. For most executives, the largest portion of their reported pay is the disclosed value of stock awards. For performance based stock, the disclosed value is a “target” value on the date awarded. It does not reflect the actual number of shares earned or the realized value of the stock over the requisite holding period. Similarly, options awards are shown as the expected value from a probability distribution, not the actual realized gains.

These valuations were never intended to represent the actual value the executive would receive, and were only intended to satisfy the accounting world. Consequently, using current proxy data to explain the link between pay and performance is like using a baseball slugger’s “at bat” statistics to explain the team’s won/loss percentage.

The Best Comparison Comes From a Multi-Year View of Realizable Pay – To best evaluate board decisions regarding pay and to test the overall alignment of executive pay to investor gains, one must compare the value actually realized by the executive to the returns of investors. For this purpose we look at the cumulative salary and cash bonuses received over a multi-year period (e.g., five years) plus the ending-period value of actual stock awards granted, stock acquired from previous awards, and embedded option gains (e.g., the paper profits).

Such pay comparisons are extremely important when evaluating the relative wisdom of a board and their executive pay decisions. By looking at the cumulative effect of decisions over a 5 year period – perhaps the shortest time period when executive effectiveness can be reasonably assessed – management and the Board can more effectively establish for investors the degree of alignment between executive rewards, business strategy and shareholder gains. The data required to perform these calculations are readily available through existing public company disclosure in proxy statements, related SEC filings, and commercial data sources. The general public could produce these calculations; however, use of multiple data sources and obscure reporting rules makes it difficult and time consuming.

Our investor and board clients have found this longer-term pay comparison to be an extremely effective tool for understanding the compounding effect of compensation decisions over time, and as an aid in calibrating prospective equity and cash incentive decisions. Perhaps more importantly, the analysis serves to bridge the communications gap between investors, the board and executive management by simplifying pay arrangements in terms everyone can easily grasp.

Much of the public’s understanding (or misunderstanding) of executive pay is driven by the annualized and hypothetical values disclosed in proxies. Regrettably, the format of the SEC disclosure also shapes how many boards make annual executive compensation decisions. The SEC will not release new rules until the second quarter of 2011, but regardless of the reporting form eventually chosen by the SEC, forward thinking Boards should supplement their CD&A disclosure with a true pay for performance analysis such as that presented above. For most boards this can convey a critical story line for investors wanting to understand how and why executives are rewarded.

– Broc Romanek, CompensationStandards.com

A week or so ago, the WSJ ran the following op-ed from Holman Jenkins (this came out before the former Comverse CEO agreed to a $53 million settlement with the SEC):

An array of influential friends urged leniency for Bruce Karatz in his stock-option backdating sentencing last week, including former Los Angeles Mayor Richard Riordan and philanthropist Eli Broad. But these personages weren’t the reason Judge Otis D. Wright II rejected prosecutors’ request for a six-year prison sentence and instead gave Mr. Karatz probation. Judge Wright said he couldn’t see putting the former CEO away for a crime that did no harm to his company, KB Home, or its shareholders.

So endeth another episode in the annals of backdating, in which a fairly meaningless violation of accounting rules (though violation it was) became trumpeted from the media pulpits as the business crime of the century. We suppose it’s humanly understandable that, finding themselves compelled to bring these cases, federal prosecutors stretched and kneaded the evidence to fulfill the media’s stereotype of backdating as theft and fraud against shareholders. Let this be a lesson to the children in how not to respond constructively to cognitive dissonance.

Such prosecutorial misconduct led to the dismissal of the backdating case last year against Broadcom founder Henry Nicholas. A judge also threw out the guilty plea of his partner, Henry Samueli, saying he didn’t think Mr. Samueli committed any crime. The first conviction of former Brocade Communications CEO Greg Reyes was similarly overturned on grounds of prosecutorial misconduct (though Mr. Reyes was retried and convicted by a new jury, and now is appealing). A further irony is that backdating was abetted by a nonsensical accounting rule at the time that treated one kind of option as having value and another kind as having no value (though both have value). This split-the-baby rule itself arguably evolved out of the media’s perennial insistence on portraying stock options as emblems of greed rather than as business tools.

By the estimate of the University of Iowa’s Erik Lie, some 2,000 public companies must have engaged in backdating at some point, as testified by otherwise inexplicable patterns of options pricing. Some 150 companies eventually restated their past results to conform to the proper rule for expensing such options. Yet only a few executives were singled out for criminal prosecution, in a manner that left an observer scratching his head as to why the justice roulette wheel chose some but not others.

Further reason for pause: The handful of subsequent convictions seemed to turn less on the act of backdating than on the self-preserving prevarications executives uttered once the posse arrived at their doorstep.

The ultimate statement in this vein, of course, was the decision by Kobi Alexander, former CEO of Comverse Technology, to decamp to Namibia. We can think of two reasons somebody might flee the law–because he fears he will get justice, or fears he won’t. Presumably Mr. Alexander will one day appear in a U.S. court. It will be interesting to see what countenance he puts on his decision to become a fugitive–perhaps he will cite as a precedent the behavior of the legal system in Salem, Mass., circa 1692.

Meanwhile, the larger lessons of the backdating furor were drawn in an epic piece in May in the American Bar Association’s ABA Journal. By freelance reporter Anna Stolley Persky, the piece connected the dots between (among other things) the backdating witch-hunt, the tainted prosecution of Sen. Ted Stevens, and the government’s use of the vague “honest services” statute to criminalize various kinds of behavior post hoc (a practice the Supreme Court finally curbed earlier this year).

One critique can be found in the title of a book by Boston defense attorney Harvey Silverglate: “Three Felonies a Day: How the Feds Target the Innocent.” Mr. Silverglate believes that only a mobilization of “civil society” can stop what he calls rampant abuse of prosecutorial discretion. In contrast, former federal prosecutor Joseph diGenova puts the onus on DOJ overseers: “If anyone thinks it’s anything other than prosecute at any cost, then they are wrong. . . . The department has been AWOL in supervising the ethics of its prosecutors,” he told ABA Journal.

But it’s also hard not to see the self-interested ethics of the plaintiff’s bar spilling across the entire legal profession. In their official roles, prosecutors invent Kafkaesque new ways to ensnare the unpopular wealthy in legal trouble, then jump to private law firms and make seven-figure livings protecting the wealthy from the monster they themselves unleashed. Shakespeare had a solution, but, alas, this would also be illegal. Thus it must fall to bloggers, the media and judges like Judge Wright to protect Americans from overzealous prosecutors.