The Advisors' Blog

– Broc Romanek, CompensationStandards.com

We have posted the transcript for our recent webcast: “What the Top Compensation Consultants Are NOW Telling Compensation Committees.”

– Broc Romanek, CompensationStandards.com

While I was on vaca last week, John Plender wrote the following column – entitled “To avoid a backlash, executives must act on pay” – in the Financial Times that I thought was noteworthy (note the internal pay equity ratios provided):

Richard Lambert, director-general of the Confederation of British Industry, drew attention this week to a very inconvenient truth: that the chief executives of the UK’s 100 largest companies will, according to Income Data Services, have earned 81 times the average pay of full-time workers in 2009. This is up from 47 times the average wage in 2000. While performance has no doubt improved at many of these organisations over the period, it is hard to see how pay increases on this scale could possibly be justified.

Yet this differential is dwarfed by that in the US, where the Institute for Policy Studies estimates that in 2008 top executives earned 319 times more than average US workers. That compares with the benchmark of 20 times that Peter Drucker, the great management guru, thought sensible. In both countries income inequality and corporate profits as a percentage of gross domestic product have recently touched their highest levels since 1929, a year in which the Jazz Age gave way to a financial crisis second only in historical impact to the one we have just experienced.

Meanwhile, another inconvenient truth has emerged at Kraft Foods, where chief executive Irene Rosenfeld was awarded a 41 per cent pay increase to $26.3m partly on the basis of her performance in acquiring Cadbury through a hostile bid. Given that a majority of takeovers fail to work and the widespread suspicion that Kraft could suffer a “winner’s curse” for overpaying, this looks objectively crazy.

It also suggests the Kraft board has learnt little from the banking crisis, despite having a compensation committee led by Ajay Banga, a banker from Citigroup. One of the big lessons was that rewards should be related to the period over which returns are earned and that, if upfront payments have to be made, they should at least be subject to a clawback.

All this comes against the background of a growing political backlash against bankers’ bonuses on both sides of the Atlantic. This may be populist, but it is based on yet another inconvenient truth. We now know that much of the profit on which bank bonuses were based before the crisis was fictional. Much of the phenomenally high return on equity that did exist arose from banks riskily shrinking their equity capital rather than boosting the return on assets.

At the same time, academics Thomas Phillipon and Ariell Reshef estimate that 30 to 50 per cent of the wage differential between the US financial sector and the rest of the private sector comes from rent-seeking – the economist’s euphemism for ripping off customers in opaque and inadequately competitive markets. This is probably also true of the UK.

Mr Lambert rightly fears that the hostile perceptions of a public that is paying for bank bail-outs will rub off on the wider business community so that wealth creation is damaged. Society’s tolerance for high levels of inequality is also being tested to destruction. In a country such as China, the current very high level of inequality is just about tolerable on the basis of real growth rates of 10 per cent or more. In debt-sodden developed countries facing years of low growth as balance sheets are rebuilt, the political consequences could be much more harsh. So where do we go from here?

Some natural corrective mechanisms are at work in both the political marketplace and the economy. High levels of profit will come down as anti-business sentiment prompts heavy-handed regulation and increased taxation, causing animal spirits to flag. It is possible that labour will win back ground relative to capital as rising living standards in Asia lead to a weakening of the downward pressure Asians have exerted on pay in the west. In finance, a return to more utility-style banking will mean less spectacular profits, while financial jobs will become less skill-intensive, complex and highly paid.

Yet huge increases in top pay regardless of performance represent, among other things, a failure of leadership. They also reflect a failure of accountability and stewardship. So if the boardroom pay ratchet is to be stopped, incentive structures and boardroom behaviour have to change.

Mr Lambert wants businesses to hold up a mirror to themselves and see how they look to the outside world. The trouble is that Lloyd Blankfein of Goldman Sachs has done this and found, notoriously, that he is “doing God’s work”. For others the problem is more that well-intentioned directors are locked in a procedural box, advised by pay consultants who are conflicted and using metrics that are flawed. Even where money is not the chief motivation, it is a race in which no chief executive wants to fall behind his or her peers.

Institutional shareholders, in the UK though not the US, have engaged in intensive dialogue with management on pay. They have done well in eliminating rewards for failure and improving incentive structures. Yet they have been unable to address absolute levels of compensation.

Breaking this vicious circle requires a catalyst. If business leaders and institutional shareholders do not address the conflicts of interest inherent in their respective positions more directly, there is a danger that government will.

The remedy of disclosure has failed, simply encouraging the ratchet effect. Boards must raise their game – but that in itself will not be enough. So maybe the time has come for institutional shareholders, with encouragement from politicians, to take a majority of the seats on remuneration committees, as they do in Scandinavia on nomination committees.

If business is not to suffer from a permanent legitimacy deficit, with all that that implies for the economy and society, something radical has to be done.

– Gregory Schick, Sheppard Mullin Richter & Hampton

The April 5th issue of Business Week included an article – “CEO Pay Drops But . . . Cash is King” – that provided an early look at 2009 compensation for CEOs at 81 large companies. The article’s survey data covered companies whose CEOs had been the same person in both 2008 and 2009. The data was obtained from proxy statements that were publicly filed by March 12, 2010.

For corporate governance advocates who have been railing against perceived excessive compensation, the article happily reports that CEO compensation dropped by 8.6% as compared to 2008. But, the article also reports that CEO cash compensation rose 8.3%. Furthermore, employer contributions to CEO pension plans reportedly gained an average of 15.4%.

As noted in the article, for cash and pension compensation to have materially increased at a time when economic growth (and inflation) were at relative lows does not appear to be consistent with paying for long-term performance and which seek to ensure that CEOs have skin in the game.

The article reports that, apart from TARP companies which were subject to federal limitations on compensation, declines in equity compensation were the principal reason why total compensation decreased. This would mean that at-risk long term incentive compensation was being replaced with short-term cash compensation which is not as directly linked with the welfare of shareholders.

The article measures the drop in equity compensation in dollar terms and reported that option values decreased by 30% and stock awards by 12%. Ideally, all of the survey’s proxy statement data would reflect the SEC’s new equity compensation reporting rules which now utilize FASB ASC Topic 718 grant date values, rather than annual expense amounts so that equity value comparisons are one-to-one (calendar year companies filing their Form 10-Ks and proxy statements before February 28, 2010 would have been permitted to file under the SEC’s pre-amended rules).

Note that a decline in reported FASB 718 dollar values would not necessarily translate to a decrease in the magnitude, or potential value, of equity awards. This is because, all other things being equal, lower share prices at the time of grant will result in lower FASB 718 grant values. The article did not comment on whether differences in stock prices (or other option valuation variables) at the times of grant were accounted for in concluding that equity compensation values had decreased.

In the very near future, there will be much more 2009 CEO compensation data to digest and analyze. It will be interesting to see if the Business Week survey findings will continue to be representative of CEO pay trends when compensation information from other companies becomes available.

– Broc Romanek, CompensationStandards.com

With Congress moving quickly on financial regulatory reform, huge changes are afoot for executive compensation practices and the related disclosures – that will impact every public company. We are doing our part to help you address all these changes – and avoid costly pitfalls – by offering a special early bird discount rate to help you attend our popular conferences – “Tackling Your 2011 Compensation Disclosures: The 5th Annual Proxy Disclosure Conference” & “7th Annual Executive Compensation Conference” – to be held September 20-21st in Chicago and via Live Nationwide Video Webcast (both of the Conferences are bundled together with a single price). Here is the agenda for the Proxy Disclosure Conference (we’ll be posting the agenda for the Executive Compensation Conference in the near future).

Special Early Bird Rates – Act by April 15th: Register by April 15th to take advantage of this discount.

– Jim Reda, James F. Reda & Associates

Recently, we completed our latest performance metrics study, which provides a review of the 2009 proxies regarding choice of performance metrics, weight of long-term incentive vehicles and pay for performance curves for both short- and long-term incentive plans for 200 of the S&P 500 companies. This is a continuation of our study from last March that looked at 2007 proxies.

Not surprisingly, new market based equity such as relative total shareholder return (TSR) plans continue to emerge as the predominate way to promote performance and address shareholder criticism of traditional stock option plans. We expect this trend to continue in 2010.

– Ning Chiu, Davis Polk & Wardwell

Just a reminder that some of the press reports of executive pay continues to differ from the total in the Summary Compensation Table from the proxy statement. The Associated Press’ calculation of total pay include salary, bonus, incentives, perks, above-market returns on deferred compensation and the estimated value of stock options and awards granted during the year. They exclude changes in the present value of pension benefits.

The AP stories are picked up by the NYTimes and others (Forbes, Reuters). So what you’ve been reading from various sources on different companies’ pay is most likely the AP calculation. And the WSJ uses the SCT as reported in the proxy statement, indicating that they include changes in pension values.

– Broc Romanek, CompensationStandards.com

Following up on my blog this morning about the Dodd bill passing the Senate Banking Committee, I forgot to mention that there were two corporate governance amendments that made it into the Manager’s Amendment on the Dodd bill, both offered by Sen. Menendez (D-NJ):

– Require issuer disclosure of the ratio of average worker pay to CEO compensation

– Prohibit broker discretionary voting in advisory votes on executive compensation

And speaking of pay disparity, as a follow-up to my blog on the recent spate of shareholder proposals on pay disparity, it appears that the SEC Staff is rejecting requests from companies to exclude them under Rule 14a-8, as noted in this Reuters’ article.

– Broc Romanek, CompensationStandards.com

Yesterday, the Senate Banking Committee voted along party-lines, 13-10, to send Senator Dodd’s reform bill to the Senate floor. As noted in this NY Times article, the Committee’s Republicans decided not to offer amendments during the bill’s markup, preferring instead to seek changes before the full Senate vote.

– Ed Hauder, Exequity

After a general industry decline in long-term incentive (LTI) opportunity from 2008 to 2009, we recently analyzed insider filings (Form 4) for the CEOs from Fortune 500 companies to gauge the percent change in LTI opportunity from 2009 to 2010. Overall, our study found that median LTI opportunity increased 8% relative to a 36% stock price increase over the prior year.

This Quick-Take Study presents the key findings from the analysis, including percent change in LTI opportunity relative to three stock price categories (greater than 60% increase, less than 60% increase and greater than 20% increase, and less than 20% increase), percent change in LTI opportunity by industry, and an in-the-money option analysis for 2009 stock option awards.

– Broc Romanek, CompensationStandards.com

Just when “bonus” has become the equivalent of a four-letter word in households across the country, the WSJ ran this article noting that at least 50 companies have recently disclosed plans to pay semiannual bonuses, with more than half of them having adopted the plans since 2008 (fyi, the Hay Group did the research for the WSJ on this). This piece ignited a hailstorm in my world as nearly 2 dozen journalists called me yesterday seeking comment.

My immediate take was that there wouldn’t seem to be justification for such a widespread move and that this short-term approach fostered by more frequent bonuses could cause even more managers to manipulate the numbers and all the other perils of short-termism. And for the most part, that is still my position.

However, I checked in with some of the responsible experts that we deal with frequently and got this feedback:

Semi-annual bonuses were adopted by a small fraction of companies due to those companies’ inability (or unwillingness) to set 12 month financial targets due to the uncertainty of the economy. I’ve seen companies adopt the semi-annual approach and they seem to only pay the bonus when the calendar year is over. I imagine the compensation committees made sure the goals were stretch-based on the best available information at the time the goals were set. Some of these same companies retained the discretion to reduce bonuses prior to payment after taking stock of the year as a whole.

I do not disagree with you that using six-month measurement periods is too short-term, but it’s possible that the compensation committees took comfort in the fact that LTI represented the largest component of pay and most executives have substantial ownership, so the risk of maximizing short-term results at the expense of long-term performance was fairly modest.

This too shall pass, as compensation committees hate negotiating bonus targets two times per year (or even four times if you count the end-of-the-period negotiations on what to include – or exclude – in the final performance calculations).

Another expert noted that the two industries highlighted – tech and retail – are long-time users of semi-annual and quarterly bonuses. Take those out of the data and this is only a handful of companies. See Fred Whittlesey’s blog about “when is a trend not a trend”…