On Tuesday, I attended a clawbacks seminar hosted by the Institutional Investor Educational Foundation here in DC and the idea of annual ratification of compensation consultants was floated by a few panelists. This would require public companies to place an item on their annual meeting ballot to allow shareholders to “ratify” the company’s compensation consultants, just like most do for independent auditors today. It’s an interesting idea – and I’m not surprised to see it since concerns over comp consultants often has been patterned on the concerns over auditor conflicts.
Here are some reasons why I think this idea is not a good one:
1. Leave Blame for Excessive Pay Where It Belongs – I worry that ratification of compensation consultants would place more attention on consultants than is warranted. Consultants just provide guidance when asked – it’s the board that makes the final decisions and should be accountable for badly designed pay packages. Leave the onus on the board to defend its pay package.
2. What Does Ratification Accomplish? – Just like my concerns over say-on-pay, I worry that merely placing a comp-related item on the ballot won’t drive change. In fact, I worry it may relieve pressure on the board to create change as the compensation consultants likely would routinely be ratified, just like independent auditors are today. And boards may read into the ratification that their pay design is acceptable, even if it’s not. A professor at Texas A&M did a study back in ’03 and found that the average ratification rate was 97%.
3. Compensation Consulting Industry is Limited – There is an unbelievable amount of misinformation about the pay-setting process. That is why most reform efforts sound ill-fated to me – the folks with the ideas don’t understand what is causing excessive pay, thus they don’t know how to fix it. There is so much concern over compensation consultants (conflicts, etc.) – yet most boards don’t use their services at all. [Note that companies are required to have auditors, but not consultants. However, there’s no corporate law requirement to place auditor ratification on ballots – although if a company doesn’t, ISS will recommend a vote against re-electing the board.]
In fact, there are no more than three dozen or so consultants that actually go into boardrooms to provide guidance. That’s how small the industry is! And my experience has been that the views of one consultant in a particular firm will not necessarily reflect the views of the others. There is no standardization of views within firms – so shareholders would find it quite difficult to decide how to vote with any real confidence.
4. Compensation Consultant Role May Vary – Another key difference between the role of the independent auditor and compensation consultants is that the role of the auditor is always the same, but that the role of the comp consultant often varies. Sometimes the comp consultant is heavily involved with helping a board design the pay package – but many times the consultant is limited to just providing data and general technical guidance.
Another key difference is that there is no standard code of conduct or rules about for engagements of compensation consultants; there is a full set of laws that exist for auditors.
5. Compensation Consultants Aren’t the Problem – Although the compensation consulting industry clearly perpetuates some of the problems associated with excessive pay (eg. peer group surveys), I believe that most consultants have “gotten religion” during the past five years and provide responsible guidance. Or they at least provide a responsible alternative when they respond to a client request.
This makes sense given their reputation is on the line and quite a few have already been dragged through the mud. Plus, if they lose a client, they are in high demand and can fairly easily find a new one. Given that the number of compensation consultants is fairly small – and that I regularly communicate with at least half of them – I feel like my anecodotal evidence may border on empirical.
I can’t say the same for many of the lawyers that provide guidance to compensation consultants; I hear very few speaking out for responsible practices. And of course, directors themselves need to look in the mirror.
Your Views: Ratification of Compensation Consultants
I’m just a guy in pajamas, so don’t be swayed by me. Let us know your views in this anonymous poll:
– Alberto Bagnara, Salvatore Tedesco, and Eeva-Liisa Räikkönen, RiskMetrics’ European Research
From RiskMetrics’ Governance Weekly: The European Commission (EC) has released two recommendations on executive remuneration and financial services sector pay as a first step in a strategy outlined in March on “Driving European Recovery.” The recommendations, released April 29, are non-binding instruments that advise member states to introduce measures to facilitate the convergence of national legislation on issues of common interest within the European Union.
This initiative follows conclusions drawn in December by the Ecofin (Economic and Financial Affairs) Council, which represents the economics and finance ministers of the EU’s 27 member states. In light of the recent financial crisis and the current focus on executive and director remuneration, the EC sees its role as “leading a wide-ranging reform to apply the lessons of the crisis and deliver responsible and reliable financial markets for the future.”
The recommendation on remuneration at listed companies is intended to complement recommendations adopted in 2004 and 2005 on executive pay and the role of non-executive directors and board committees, respectively. While the existing compensation recommendation is based on the idea of pay for performance through disclosure of the remuneration policy, the EC now considers it necessary to address the structural flaws of remuneration policies that have become apparent.
The new principles are based on best practices found in the national legislation or corporate governance codes of member states. It is important to note, however, that the recommendation does not aim at harmonizing pay levels. Guidance is given with regard to the structure of remuneration policies to better align pay with performance. The main focus is on variable pay. Variable components should be capped, and the award of variable compensation should be subject to predetermined and measurable performance criteria.
In addition, severance payments should generally not exceed two years’ fixed salary, and should not be paid if termination is due to inadequate performance. Other principles focus on promoting a company’s long-term sustainability. The guidance advocates a minimum three-year vesting period for stock options, as well as a requirement to hold a fixed number of shares until the end of employment. The EC also promotes the deferment of “a major part” of variable pay. Furthermore, “clawback” provisions should be included in contracts to enable companies to reclaim variable pay granted on the basis of accounts that are subsequently proved to be manifestly misstated.
The recommendation further sets out principles relating to the governance of remuneration policies, which mainly focus on strengthening remuneration committees by requiring, for instance, at least one member of the committee to have knowledge and experience in the field of remuneration policy. The impartiality of remuneration consultants used by remuneration committees should also be ensured. To mitigate conflicts of interest, non-executive directors should not receive stock options as part of their remuneration. The EC also states that companies should encourage shareholders to participate at general meetings and use their votes regarding director remuneration.
The second EC recommendation specifically deals with remuneration at companies in the financial services sector. According to Internal Market Commissioner Charlie McCreevy, “Up to now, there have been far too many perverse incentives in place in the financial services industry. It is neither sensible nor sane that pay incentives encourage excessive risk-taking for short-term gain.”
Member states are urged to introduce stricter remuneration rules for financial firms having an office within their territories that apply to all employees whose activities have an impact on the company’s risk profile. Accordingly, the recommendation outlines principles to address four areas of concern:
– First, remuneration policies for risk-taking staff should be consistent with and foster sound and effective risk management. Consequently, there should be “an appropriate balance” between fixed remuneration and bonuses. Companies should be allowed to withhold bonuses if performance criteria were not met and the payment of the major part of the bonus should be deferred. Moreover, performance criteria should be aligned with the long-term financial performance of the firm.
– Second, remuneration policy should be “transparent internally, clear, and properly documented.” Board members and consultants involved in the formulation of the remuneration policy should be independent.
– Third, remuneration policy and its features should be adequately disclosed to shareholders in a clear and understandable way that explains the main components of the remuneration policy, its design, and operation.
– Finally, the EC stresses the importance of supervision. Supervisory authorities should ensure that financial services companies apply the principles of sound remuneration in compliance with effective risk management.
While maintaining disclosure as an underlying principle, these two new recommendations stress the importance of a balance between fixed and variable pay, the existence of measurable performance criteria, and the presence of sound supervision. In setting such guidelines for remuneration policies, the EC intends to improve risk management and align pay incentives with sustainable performance.
These two initiatives are part of a broader strategy that the EC intends to pursue, and there is a possibility of similar steps in other financial sectors, such as insurance. To complement the recommendation on financial services pay, European regulators plan to amend the existing Capital Requirements Directive in June to address risk management and supervision of remuneration policy at banks and investment firms.
The impact of the recommendations and their application by member states will be assessed in one year. The EC intends to keep monitoring the remuneration practices adopted by listed companies and financial services providers, and their impact on the long-term sustainability of the European financial sector.
– Ira Kay and Steve Seelig, Watson Wyatt Worldwide
As many of you have read, one of the items on SEC Chair Mary Schapiro’s “to-do list” for 2009 is to revise some of the executive compensation rules. She’s mentioned Say-on-Pay and whether the compensation committee considered if a pay program caused executives to take excessive risks as priority items, but she’s also mentioned the SEC will look at how executive pay is depicted on the Summary Compensation Table as worthy of consideration.
While the Chair’s latter comments may have been narrowly focused on the issue of the equity grant disclosures, known by most readers to have been changed right around Christmas 2006 to mirror the FAS 123R financial statement disclosures – the Associated Press resolutely ignores this change in its news stories – we thought it was a fine time to raise a more important issue with the rules.
From our perspective, showing start of the year grant fair values, as the rules would have required before the last-minute change, does not fix the problem of properly depicting how much an executive earned during the year – what we call realizable pay – it would only show the pay opportunity an executive could earn. In the spirit of getting a dialogue moving with the Corporate Finance Staff, we submitted a Petition for Rulemaking to the SEC last week to reconsider its approach to so that equity gains (or losses) are valued at year-end, same as you would depict a bonus earned or a change in pension value.
We feel strongly about coming up with a method to more accurately depict the actual value of what executives earn from year-to-year, especially as companies will likely confront Say-on-Pay advisory votes to accompany their 2010 proxies. Simply having shareholders look at the grant opportunities will not give them a full appreciation of whether their company actually ended up paying for performance. Adopting our approach might help shareholders be able to make that call with a minimum of extra effort.
Here is the third in a series of blogs exploring the different approaches to say-on-pay that companies can take:
Retrospective and Prospective Model – The RiskMetrics ’08 Model
RiskMetrics Group is, among other things, the largest proxy advisor in the United States. As a result, it is expected to meet the highest standard of governance with respect to its own affairs. RiskMetrics voluntarily implemented a say-on-pay policy in June 2008 following its IPO in 2007 and put the following three resolutions to a shareholder vote in its 2008 proxy statement:
(1) that shareholders approve the Company’s overall executive compensation philosophy, policies and procedures, as described in the Compensation Discussion and Analysis in the Proxy Statement;
(2) that shareholders approve the compensation decisions made by the Board with regard to named executive officer performance for 2007, as described in the Compensation Discussion and Analysis in the Proxy Statement; and
(3) that shareholders approve the application of the Company’s compensation philosophy, policies and procedures to evaluate the 2008 performance of [sic], and award compensation based on, certain key objectives, as described in the Compensation Discussion and Analysis in the Proxy.
The first and second resolutions essentially separate the “Broad Retrospective Model” into two resolutions. The first resolution addresses the company’s philosophy, policies and procedures and the second resolution addresses actual compensation decisions. Separating these two resolutions arguably enables shareholders to indicate displeasure with a company’s overall compensation philosophy while, at the same time, approving actual compensation paid. The third resolution, however, breaks from both the “Narrow Retrospective Model” and the “Broad Retrospective Model” by asking shareholders to approve the application of the company’s compensation philosophy to the then-current fiscal year.
To this end, RiskMetrics included in its 2008 proxy statement both the metrics and the specific targets for each metric that the compensation committee would use in determining whether management is entitled to incentive compensation for the 2008 fiscal year. The third resolution represents a radical departure from the say-on-pay policies that most companies would be willing to implement and that are envisaged by most shareholders, because it requires disclosure of information that is not required to be disclosed under SEC rules and, as discussed above, that most companies strongly resist disclosing.
The wording of RiskMetrics’ third resolution also leaves some areas of doubt. For example, RiskMetrics’ 2008 CD&A states prospectively that the CEO’s target incentive compensation for 2008 will be twice his base salary. It is not clear whether the third resolution calls on shareholders to approve the amount of the CEO’s target incentive compensation or whether it solely calls on them to approve the application of the Company’s “compensation philosophy, policies and procedures” in determining whether to pay that amount. In addition, the resolution states that the “compensation philosophy, policies and procedures” are based on “certain key objectives,” but it is unclear whether shareholders are being asked to approve those objectives.
Note that RiskMetrics’ didn’t use the same wording for this year’s proxy statement. For unknown reasons, it dropped the third resolution.
If you haven’t heard, The Corporate Library has launched a new blog. They’ve launched them in the past but they didn’t “take.” Based on the frequency of entries for this one already, I think this one will have staying power. Below is an entry from Nell Minow worth reading:
In yesterday’s Wall Street Journal, Princeton economist Alan Blinder wakes up to the fact that the problem with excessive compensation is not the absolute levels but the incentive structure. Incredibly, he says that “the ruckus has been over the generous levels of compensation, or the fact that bonuses were paid at all, not over the dysfunctional incentives that inhere in the way many compensation plans are structured.”
I’m not sure which ruckus he has been referring to as pretty much everyone commenting on this subject, from the institutional investors to the financial press and our own testimony and reports (see especially the testimonies dated October 6 and 7, 2008 in our online store), has been focused on problems like rewarding executives based on the number or size of transactions rather than their quality. We welcome Blinder to the debate but wish he had come up with a stronger proposal than suggesting boards do better. Without some incentives like a better pay-performance link for directors and disincentives like the risk of removal by shareholders, we are unlikely to see much improvement and a homus economicus like Blinder should know that.
Below is some important reading that has recently been brought to our attention that we commend to each of you. It shows that this country has some pretty amazing leaders:
1. Pepsi’s CEO Indra Nooyi, who was educated in India and then the Yale Business School, recently gave these impressive remarks about corporate values (you can watch Ms. Nooyi deliver them on this video).
2. JPMorgan’s CEO Jamie Dimon annual letter to shareholders is a “must” read, particularly starting on page 13. Note what Mr. Dimon says about compensation: “It also is clear that excessive, poorly designed and short-term oriented compensation practices added to the problem by rewarding a lot of bad behavior.” And see the steps he has taken at JPMorgan (at pg 26). When I saw the bullet about no special severance provisions, I remembered that he had a huge severance provision in his contract when he went from BankOne to JPMorgan in 2004. Well, I did a little research and sure enough, it turns out that he voluntarily gave it up in ’06 without any fanfare.
3. Roger Martin, Dean of the Rotman School of Management at Toronto puts a fresh lens on compensation and metrics in “Undermining Staying Power: The Role of Unhelpful Management Theories.” His important observations recently were summarized in this Financial Times article.
4. Finally, one of this year’s best media articles is this one entitled “The Executive Pay System is Broken” by Alistair Barr of MarketWatch. It explores possible solutions to fix executive pay and answers why it’s important to do so…
With ARRA’s prohibition on “any compensation plan that would encourage manipulation of the reported earnings to enhance the compensation of any of its employees” there’s finally a legislative impetus to deal with one of the real problems with executive pay. This has received scant attention, however, given the media focus on simpler and politically-sexier provisions such as the $500,000 pay cap. Who really wants to read about financial performance measures when we can debate whether $500,000 is a lot of money?
As a consultant, it’s easy to shoot at the simplistic knee-jerk TARP and ARRA pay provisions but I have to say that I appreciate the government’s institutionalization of an idea that many of us have been harping about for (I hate to admit) decades. While we don’t yet know exactly what that sentence in the legislation really means, allow me to speculate on the potential it holds.
Much research and a basic knowledge of financial accounting indicate the potential issues with a large percentage of executive incentive programs using earnings per share (EPS) and other potentially flawed measures as a primary measure of company performance. Many research studies show no relationship between EPS and shareholder value creation so we must ask why such a measure should be the basis for short-term cash-based awards to senior executives. The lack of relationship between some measures and value creation should be enough to end the use of such, but it has not been. The far bigger problem is the ease with which such measures are manipulated. Now these programs may be in direct violation of the new prohibition for TARP companies and raise questions for all companies as other TARP provisions have.
This blog posting could easily be a chapter and that chapter could easily be a book. It’s a deep and difficult aspect of compensation design that has been given too little attention for three reasons:
1. It’s a deep and difficult aspect of compensation design. It takes more analysis, more understanding of both accounting and finance, and a thorough understanding of the firm’s business strategy. That’s a lot harder than looking in a survey. Peter Drucker was not exaggerating in his comment that “fundamentally, businesspeople are financially illiterate.” There are some Compensation Committee members in that category. Why, EPS is right there at the bottom of the income statement. The FASB requires reporting it. It must be good. Next slide please.
2. The most “popular” measures are the most easily manipulated. Surprise! Anyone with a basic understanding of accounting knows that the accrual-based income statement is nothing more than one possible and very subjective version of business performance resulting from hundreds of decisions. It’s the set of numbers that the company chooses to report. LIFO or FIFO? Black-Scholes or binomial? Exactly when it that piece of machinery going to wear out? Is all that inventory in the warehouse really saleable? What about all that goodwill on our balance sheet, it’s still valuable, right? Let’s do a value-for-value option exchange. There we go, a nice big fat EPS number. Bonus time!
3. The survey says. How can a company be wrong if it’s doing what 70% of the peer group is: determining incentive compensation based on EPS. Well, I think we have seen an answer to the “everybody’s doing it” rationale.
It has always annoyed me that there are surveys, and annoyed me more that companies reference those surveys, measuring “what other companies do” in terms of prevalence of performance measures. That’s about as meaningful as deciding what to have for dinner based on a survey of what other people on my street are eating tonight.
A few years from now we’ll look back on this economic crisis and likely try to ferret out the good that came from the economic devastation, misguided government efforts, and associated effects. I am hopeful that a survey will show that this period created a new attention to short-term and long-term performance measurement and that no one got in trouble for manipulating reported earnings to enhance their compensation.
Although I count myself among those who believe that say-on-pay will impose business burdens that outweigh the benefits, this Financial Times article about Royal Dutch Shell’s 59% “no” vote last week has me thinking. The front page article focuses on the “right” concerns in my estimation – holding boards accountable for paying bonuses when financial targets are not met. Here is a related WSJ article.
The financial downturn certainly places a premium on cogent explanations for executive compensation decisions, and the FT article suggests the increasing importance that shareholders attach – globally – to both corporate disclosures and the input of proxy advisory firms such as RiskMetrics.
Note that in response to our generous early bird offer for the “4th Annual Proxy Disclosure Conference” (whose pricing is combined with the “6th Annual Executive Compensation Conference”), we are on pace for a record number of attendees (despite the economy). A true reflection of how important executive compensation is this year! These Conferences will be held at the San Francisco Hilton and via Live Nationwide Video Webcast on November 9-10th.
Act now, as this tier of reduced rates will not be extended beyond the end of today! With the SEC intending to propose new executive compensation rules in the near future – and Congress looking to legislate executive compensation practices this year, these Conferences are a “must.” Register today. If you’re in need of a few days to get a check cut, email me today to hold this rate.
Recently, the SEIU Master Trust – the pension funds managed on behalf of the SEIU – sent letters to the boards at 29 major financial services companies, demanding that they investigate more than $5 billion in compensation to their NEOs that may have been tied to derivatives and other instruments that are now worthless. The SEIU argues that if the payments – including cash and equity – are shown to be based on false economic metrics, they may be subject to clawbacks. They further demand that the boards overhaul their executive compensation practices so that the NEOs don’t reap bonuses and other incentivized pay regardless of corporate performance. A list of the 29 companies is at the bottom of this press release.
In this podcast, Mike Barry of Grant & Eisenhofer and Stephen Abrecht of the SEIU explain this movement by SEIU’s Master Trust to seek clawback of excessive pay, including:
– How did the SEIU choose the targeted 29 companies?
– What legal theories are being used to seek recovery of excessive pay?
– What did the letters request? Do they seek responses from the boards of the companies?