The “newest old thing” these days is designing compensation plans that do not encourage excessive risk taking. “Experts” have identified risk as the hottest emerging issue for compensation committees, stating that “we” do not yet know how to create the proper relationship between pay and risk.
I fully agree that the word “risk” has never been used more in compensation committee meetings than in the last six months, but that doesn’t mean the concept is new. In fact, responsible directors have considered the risks and potential impact, good and bad, of every pay decision for decades.
While not explicitly termed “risk assessment” each time a salary increase is considered, or a short- or long-term incentive plan is adopted or modified, management and boards consider the risks associated with their actions, or lack of action. But in the old days, the considered risk was how decisions would impact the company, its operating results and stockholders. Now boards are confronted with the added risk of how regulators, legislators and the public will view their decisions, today and tomorrow, with the added benefit of 20-20 hindsight.
Debate continues as to whether Wall Street and its regulators had the proper controls to manage risk. However, it was aggressive business plans, approved by directors, which led to the highly-leveraged positions fatal to some firms. Compensation programs implemented to support such business plans were not the drivers of risk, but rather were designed to incent plan achievement.
Ironically, Wall Street has been down this road before. About twenty years ago, Wall Street recognized the high risk to shareholders if executives were paid solely in cash for short-term results achieved in a manner detrimental to the long-term success of the firm. Sound familiar? In response, Wall Street firms began to pay part of annual bonuses in shares subject to future price fluctuations. Therefore, if an individual earned an annual bonus through actions that were not in the best interests of customers, those customers would leave and, as the business suffered, so would the stock price on shares held by executives.
Additionally, such deferred payouts served as a retention tool, as well as creating significant ownership and shareholder alignment. It is clear from the losses realized by executives at Bear Stearns and Lehman Brothers that there was significant “skin in the game,” a fact that should have counterbalanced any desire to take risky positions only to generate short-term payments. Sometimes businesses make bad decisions, and pay has nothing to do with it. Given the investment these employees had in their firms, it is difficult to believe how compensation plans alone created a high risk culture.
Let’s be clear – risk assessment should be an important part of every pay-related decision made by compensation committees. Specifically, assessment should focus on:
– Whether performance goals are fair and reasonable in light of past performance, market conditions and the competition. Are they based on a thorough review process by the full board that defines the pay for performance range from minimally acceptable to exceptional?
– Consideration of unintended consequences. Could the pay program create an incentive for behavior that rewards executives, while detrimental to the company and its shareholders? Has the probability of a black swan been considered?
– Will the compensation program address the often unmentioned risk that the firm may not be able to attract, retain and motivate executives essential to the firm’s success?
– Are currently accepted “best practices” considered in the design? If not, why not? Unfortunately, to complicate the issue, there are examples of “old” best practices that are now viewed negatively.
– Is the program sufficiently flexible to permit the compensation committee to recognize and adjust for special situations that, left ignored, could either create undeserved windfalls or penalize executives unfairly?
The events of the last two years have been tragic from a business and stockholder viewpoint. The fact that many employees of impacted companies were recipients of very large pay packages prior to the market collapse certainly provides blame-seekers with a terrific target. Unfortunately, with the benefit of hindsight, the cause of the downfall is not compensation-related, but rather, poor business decisions driven by risky business strategies. Decisions to take on increasing levels of risk were pushed by investors and analysts focused on short-term growth, earnings and stock gains with little concern for the risk profile necessary to achieve the desired performance.
But, one must consider the fates of management and boards who resisted the push. Their lack of relative performance would certainly have doomed their tenure given market demands for ever higher earnings and stock price. Lest we forget, although it is true that the last several years saw high investor gains mirrored by huge pay packages, we also saw dramatically shorter tenures, particularly at the most senior levels as boards quickly replaced “non-performers.”
There are undoubtedly many reforms to be considered as boards work to rebuild shareholder confidence, and assuring that pay programs continue to support business strategy is certainly one of them. But it is foolish to believe that a new, elaborate exercise that considers pay and related risk is a new approach that will magically avoid past mistakes. This process has been firmly entrenched in the work of compensation committees for many years. The real need is for recognition that engaged board oversight of rigorous business planning, including risk assessment, will serve to avoid the mistakes of the past far better than a more complex compensation process.
Yesterday, the SEC voted 3-2 to approve the NYSE’s proposal to amend Rule 452 (and Listed Company Manual Section 402.08) to eliminate broker discretionary voting for director elections. The amendment to Rule 452 will be applicable to meetings held after January 1, 2010 (but won’t apply to a meeting that was originally scheduled to be held in 2009 if adjourned to a date after January 1st).
As I’ve mentioned before, in my opinion, this change is the biggest of the reforms that companies face – bigger than proxy access, say-on-pay, etc. Here is the SEC’s press release addressing all of its actions yesterday – and here is Chair Schapiro’s opening remarks (and Commissioners Walter’s statement and Aguilar’s statement).
Commissioners Casey and Paredes opposed the proposal, both stating that the broker nonvote issue should be considered in the broader context of rejiggering the proxy process (read “proxy access”) as well as examining more completely the impact of this change on companies. In his opening remarks, Commissioner Paredes noted they weren’t alone – 93 comment letters (out of a total of 136) also urged a comprehensive review of the proxy system. They also expressed concerns that the change would disenfranchise retail holders at the expense of more control by institutional investors.
Since all the other Commissioners agreed with the importance of studying the proxy system’s “plumbing,” near the end of the meeting, Chair Schapiro stated that the SEC would conduct this type of review later this year. I see roundtables in our future. If interested in reviewing “live tweets” that occurred during the meeting, see @footnoted and @simonbillenness.
Oh, boy! Check out today’s front-page article from the Washington Post about how the SEC was warned in ’04 by a SEC Staffer about Madoff – but yet the SEC didn’t follow up. And that Staffer’s boss ended up marrying Madoff’s niece. The article is quite in-depth and is likely to result in more headaches for the SEC. I’ll cover this more extensively next week.
The Surprise: SEC Proposes Expedited Disclosure of Voting Results
Although most of the SEC’s big open Commission meeting went as telegraphed by earlier statements by the SEC Chair, there was one big surprise. The SEC proposed a new Form 8-K requirement for companies to disclose the results of a shareholder vote within four business days after the end of the meeting at which the vote was held (in contested elections, the final results would be permitted to be delayed under certain circumstances).
As I’ve complained before, the current disclosure standard doesn’t elicit voting results for weeks – or sometimes months – after the vote, which doesn’t really work in today’s more competitive annual meeting environment.
Not a Surprise: SEC Proposes Say-on-Pay for TARP Recipients
Not surprisingly, the SEC also proposed rules – by a 5-0 vote – that would help implement Section 111(e) of EESA to permit an annual advisory non-binding shareholder vote on executive compensation. The SEC’s proposal clarifies how these requirements apply to TARP recipients in the form of new Rule 14A-20. The SEC has already posted the proposing release for this one; could be record time for that. Here is Corp Fin’s opening statement.
During the open Meeting, it was pointed out that – outside of the EESA mandate – the SEC Staff has allowed the inclusion of say-on-pay proposals. Commissioner Casey note that she only supported this proposal because it was required under EESA.
SEC Proposes Changes to Executive Compensation Disclosure Rules
No surprises here either. As expected, the SEC proposed amending Item 402 of Regulation S-K as follows (here is Corp Fin’s opening statement):
– Broader CD&AS to cover risk – provide information about how a company’s overall compensation policies create incentives that can affect the company’s risk – and the management of that risk, including policies for employees generally, including non-executive officers. Such disclosure would only be required if the risks arising from those compensation policies may have a material effect on the company. The SEC did not propose any requirement that would not require the disclosure of specific salaries of any individuals beyond those already required.
– Improved reporting of stock and option awards – revise way in which stock and option awards are reported in the Summary Compensation Table and Director Compensation Table so that it’s based on the award’s fair value on the grant date. This would reverse the December ’06 “surprise.”
– More disclosure about compensation consultants – in an effort to allow shareholders to evaluate potential conflicts, require disclosure about compensation consultant fees and services (and their affiliates) when they play any role in determining the amount or form of compensation for executives and directors, but only if those consultants (or their affiliates) also provide other services to the company.
In his “Proxy Disclosure Blog,” Mark Borges provided in-depth analysis of the proposals yesterday.
SEC Proposes More Corporate Governance Disclosures
Finally, the SEC proposed a few governance disclosure enhancements, including revising Item 401 of Regulation S-K to require more disclosure about each director’s particular experience, attributes and skills that are appropriate for the person to serve as a director and as a member of any committee to which the person is appointed; extend the disclosure of the director’s board memberships to the past 5 years; and expand disclosure of legal proceedings to the prior 10 years.
In addition, the SEC proposed requiring disclosure of why the board selected a particular management/leadership structure, particularly why the board chose to combine or separate the board chair and CEO positions. Although not proposed, the SEC’s proposing release will solicit comments about whether the SEC should require disclosure about director diversity, including whether diversity is a factor considered when nominating director candidates.
Yesterday, two of the heavyweights in the compensation consulting business agreed to merge in an effort to cut costs through job cuts and streamlining operations. Under the deal, Towers Perrin (a privately-held entity) and Watson Wyatt (a public company) will combine to form “Towers Watson.” The combined company will have 14,000 employees which reportedly will rival Hewitt and Mercer as the largest compensation advisory firm. Here is a Washington Post article.
Okay, the big question for those of us focused on CEO pay – what will happen to the board advisory practices of the firms. As I understand the answer (made in response to a question asked about the consultant independence issue on the merger conference call yesterday afternoon: “They are committed to all aspects of our human capital practice and will plan on integrating the two practices once the deal goes through.”
That sounds like the right answer for a deal that needs to get through. Of course, the answer could change suddenly – either in response to client demands for independence or to the SEC executive pay proposals that become public tomorrow. Does “Towers Watson” sound too much like Sherlock Holmes lore? Maybe “Towers Wyatt” would have been better?
In May, Senator Richard Durbin introduced two bills aimed at curbing “excessive” compensation: the “Excessive Pay Shareholder Approval Act” (Bill S. 1006) and the “Excessive Pay Capped Deduction Act of 2009” (Bill S. 1007).
The Excessive Pay Shareholder Approval Act would require a supermajority (i.e., 60 percent) of the shareholders to approve the compensation structure of any employee for any year in which the employee receives in excess of 100 times the compensation of the average employee of that company. Compensation would be defined to include salary, commissions, fringe benefits, deferred compensation, retirement contributions, options, bonuses, property and other pay.
In addition, a company would be required to disclose the following in its proxy materials:
– the compensation paid to its lowest paid employee;
– the compensation paid to its highest paid employee;
– the average compensation paid to all of its employees;
– the number of employees who are paid more than 100 times the average employee compensation; and
– the total compensation paid to employees who are paid more than 100 times the average employee compensation.
The Excessive Pay Capped Deduction Act would limit the normal federal tax deduction for compensation for executives to 100 times the compensation of the average worker at that company. Compensation would be defined to include salary, commissions, fringe benefits, deferred compensation, retirement contributions options, bonuses, property and other pay. Employers exceeding this deduction limit would need to report certain pay information to the IRS:
– the amount paid to the employee receiving the lowest amount of compensation during such year;
– the amount paid to the employee receiving the highest amount of compensation during such year;
– the average compensation of all of its employees during such year;
– the number of employees receiving compensation that is more than 100 times the average employee compensation during such year; and
– the amounts paid to the employees receiving compensation that is more than 100 times the average employee compensation during such year.
As promised by Chair Schapiro earlier this month, the SEC has calendared an open Commission meeting for next Wednesday, July 1st, where it will consider proposals related to executive compensation disclosures, TARP’s say-on-pay and other corporate governance issues. It also will consider approving the NYSE’s “elimination of broker non-votes for director elections” proposal. This is a biggie.
There is one curious item on the SEC’s agenda – I have no idea what the second part of Item 3 relates to: “to clarify certain of the rules governing proxy solicitations.” I haven’t heard anything about problems with the proxy solicitation requirements. Any ideas?
Early Bird Expires Tomorrow: With the SEC’s goal to have new executive compensation disclosure rules in place before next proxy season – combined with the real likelihood of say-on-pay legislation and the loss of broker nonvotes for director elections – our the “4th Annual Proxy Disclosure Conference” (whose pricing is combined with the “6th Annual Executive Compensation Conference”) will be more important than ever. These Conferences will be held at the San Francisco Hilton and via Live Nationwide Video Webcast on November 9-10th.
Take advantage of reduced rates that will expire tomorrow, June 26th by registering now. These rates will not be extended – there will be no early bird discounts after Friday!
To ensure that a company’s long-term incentive program is competitive and cost-effective, we evaluate its fair value transfer (the total pre-tax expense of LTI awards as a percentage of market capitalization at grant). A FVT measurement:
– Quantifies the aggregate pre-tax compensation cost of LTI grants in a given period (the cost of which will likely be spread over multiple years for purposes of determining earnings);
– Normalizes equity compensation values and costs for differences in stock price and resulting market-cap size; and
– Facilitates trade-offs between various LTI vehicles since all types of awards are expressed on an economically equivalent basis.
In this Alert, we recently compared the aggregate fair value transfer data for the first quarter of 2009 to the first quarter of 2008 to provide insight into how companies changed their grant practices to address the sudden market decline. We found that FVT rates increased in 2009 across all industry and size cuts of our 150-company sample. This increase in FVT was not the result of higher absolute equity compensation grant values, but was because companies granted more shares to offset stock price declines. At the median, the dollar-value of equity compensation decreased (-25%), but not as much as the median decline in stock price (-41%).
We have posted the transcript from our recent webcast: “The Latest Compensation Disclosures: A Proxy Season Post-Mortem.”
A Preliminary Postseason Report
Whew, the proxy season is over. And it’s now fair to ask: just how wild and crazy was this proxy season? Given all the coming reforms, probably not as crazy as next year’s proxy season will be – but it certainly was’t dull. You can read details about how the various proposals were supported in RiskMetrics’ new “Preliminary Postseason Report.”
Regarding one of the hottest topics, as of June 1, “say-on-pay” shareholder proposals averaged 46.7% support, representing an increase of over 5% from 2008. The 2009 figure is based on preliminary or final voting results for 50 of the 85 proposals voted so far this year. Meanwhile, RiskMetrics is tracking 18 majority votes in favor of the resolution as of June 1st, compared with 11 in all of 2008. Proposals at another five companies received between 49 and 49.9% support.
It’s Time to Weigh In: RiskMetrics Launches Annual Policy Formulation Process
Last week, RiskMetrics kicked off its annual global policy formulation process by inviting comments in its 2010 proxy voting policy survey. This year’s policy formulation process will include more outreach to investment industry groups as well as expanded outreach to the global corporate community.
Given that these comments could influence RiskMetrics’ views – and given that RiskMetrics’ views will be more important than ever given regulatory reform, say-on-pay, proxy access, etc. – you should take advantage of this opportunity. The survey period ends July 31st – and will be followed by an open comment period in October after RiskMetrics publishes its draft policies. Don’t wait for this 2nd comment period to weigh in – it’s better to influence the policies now before the train gets rolling…
With the SEC’s goal to have new executive compensation disclosure rules in place before next proxy season – combined with the real likelihood of say-on-pay legislation and the loss of broker nonvotes for director elections – our the “4th Annual Proxy Disclosure Conference” (whose pricing is combined with the “6th Annual Executive Compensation Conference”) will be more important than ever. Here is the agenda.
Early Bird Expires This Friday: These Conferences will be held at the San Francisco Hilton and via Live Nationwide Video Webcast on November 9-10th. Take advantage of reduced rates that will expire this Friday, June 26th by registering now. These rates will not be extended – there will be no early bird discounts after Friday!
Broc’s recent observation about how “lawyers have long ago given up…” is searing in its accuracy and something I’ve watched with pain over the years as an executive and lawyer. The profession itself has absolutely no insight into the phenomenon. To be balanced, however, I’d have to say that the cultural norms the profession rushed to embrace are no worse than those embraced by many other institutions in our society.
The accumulation of wealth issue is an interesting one, and here there’s an issue that’s troubling well beyond the empirical and logical infirmities of the claim that someone so rich (and, under this hypothesis, relatively unmotivated by the satisfaction of accomplishment and contribution) will somehow magically be energized by even more money he or she doesn’t need. That issue is whether such accumulations of wealth (which in financial services were widespread) were an actual contributor to the crisis in ways that went beyond the perverse incentives built into the structures that produced those payouts.
If you have in the bank more than you and your family will ever need under the most lavish of standards, does that incentivize reckless gambling (with corporate assets) to satisfy non-economic desires such as the desire to be big and command immense resources? Predating the current crisis, one thinks of the contrast between the empirical research on the consequences of acquisitions and the glee with which such transactions are pursued. In the context of the current crisis, it would seem that some of the key decisions must have been driven by a desire to be big and not lose ground (measured in size, not long-term profitability) to the competition.
I also wonder whether such accumulations create an outlook of superiority, entitlement, and invincibility that impairs objective assessment of risks, and disables the type of empathetic outlook that might otherwise have caused one to consider the possible consequences to those still dependent on our economic engines.
Keep in mind, I’m not calling for use of accumulated wealth as a marker for recklessness or bad character. I wonder, however, whether single-minded pursuit of such lavish packages by those with no rational need for them (especially where the collateral damage, such as loss of governmental or public goodwill, is foreseeably significant) should be a marker for potentially harmful proclivities. With the benefit of hindsight, the evidence in favor of that proposition is not inconsequential.
As this Reuters article pointed out, many companies have voluntarily implemented some form of clawback policies ahead of possible new laws that may mandate them. The article notes “Overall, 64.2 percent of the largest 95 publicly held companies in the Fortune 100 had disclosed clawback policies as of this year, up from 42.1 percent in 2007 and 17.6 percent in 2006, according to the study from pay research firm Equilar.”
Recently, I attended a clawbacks seminar hosted by the Institutional Investor Educational Foundation and took in a panel of of Nell Minow of The Corporate Library; Bill Patterson of CtW Investments; Jay Eisenhofer of Grant & Eisenhofer; and Steven Caponi of Blank Rome.
In addition to notes in this report, here are some worthy gems from the panel:
– Nell: “Pay is not just both a symptom of bad corporate governance and bad economic judgment, it’s also the disease. Pay that is out of whack with performance is the single most important indicator of a bad board – and my company rates boards of directors – but it’s also the single biggest risk factor that you can have in a company.”
– Bill: “Last week, Target had their annual meeting in Minneapolis and you all are aware that they were under attack by Bill Ackman of Pershing Square. The board of directors rallied to their own defense before the meeting and they visited CALPers and ISS – but once it became clear Ackman wasn’t going to win, they didn’t bother to show up – so they introduced the board with a slide show. And this is a shameful statement.”
– Jay: “Look, I think it’s very important that we keep in mind that there is a direct connection between some of the compensation abuses that we’ve seen in compensation systems as we’ve seen them and the financial problems that we have had recently. And I think it’s extremely important we draw that line clearly because it’s not just a question of companies with lax compensation policies – somehow or other are at risk of having problems because it indicates a lax attitude on the part of boards or officers. It’s much more fundamental than that.
There is study after study – by people who have absolutely no axe to grind on these issues – that have demonstrated that the way in which compensation systems are designed has a direct influence on the behavior of the officers of a corporation in terms of whether or not they are going to be more prone to manipulation of financial results, whether or not they are going to be more prone to enter into speculative transactions, whether or not they are going to enter into transactions and foster corporate behavior that encourages short-term results at the expense of long-term gains, short-term inflated results at the expense of long-term gains and that’s the academic research.”
– Steve: “There’s a big distinction between what seems like a good, reasonable compensation system at the time you set it. Most people are given their salary when they are hired, not when they quit or when they are fired versus what you do after the fact. And I think that’s really where the issue lies. You should look at these companies and say in 2004 and 2005 when individuals were making insane amounts of money for the companies, for the stockholders, for the people in this room, were they entitled to be compensated? Everyone at the time said, ‘yes.’ What they didn’t anticipate were the unanticipated consequences.
We’re all suffering from that. So, you now go back and say, ‘well, gee, like us, you didn’t understand so, therefore, you’ve got to give the money back.’ My back intuitively stiffens when someone talks about boardrooms and compensation and injustice out there somehow doesn’t seem to sit right with me. I’m not sure why. It’s not supposed to be a squishy thing. It is supposed to be more metric.”
Needless to say, I disagreed with what Steve said here. Most compensation arrangements for senior managers today are fluid or squishy – meaning that the ultimate amounts paid are not known until well after certain barriers are cleared. For the payouts related to options, it may be as long as ten years from the date of grant that the ultimate value is known. So the idea that there might be adjustments to pay later on is not a foreign concept.
And even if that concept wasn’t already mainstream, I didn’t find his arguments against adjustments persuasive. If a company allegedly hits certain performance targets that trigger a payout – but then it’s found that the company really didn’t hit those targets, I never heard a valid justification for why an executive should get to keep the money. It certainly doesn’t seem right from a fairness perspective. And allowing executives to keep money under these circumstances would certainly seem to incentivize them to ensure they “met” targets – even when they didn’t…