– 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?
Those of you who have concerns about the continued value and effectiveness of stock options as an employee incentive device may be interested in an alternative by reading an article written by a colleague, Kathryn Neel, and me in the May-June issue of WorldatWork’s Workspan. It describes a new equity device, which we call Market Stock Units, or “MSUs” for short. It is a market-leveraged RSU grant that has the following characteristics:
– More market leverage than RSUs; less than options
– Symmetrical market leverage, not asymmetrical like options
– Uses average period market pricing for measurement purposes, unlike single-day pricing with options
– Avoids the alluring but risky feature of options that allows employees to cash in at will after vesting
– Is performance based without requiring goal setting
– Eliminates situation that leads to pressure to reprice options when they go underwater
– Includes dividend equivalents, hence aligning to total shareholder return, unlike options which align to stock price growth only
We want to alert compensation advisors to MSUs in case you are asked about them by clients. And we want to engage those of you with a technical interest so that you can ferret out the accounting 162(m) and 409A implications of MSUs in advance if you wish.
Schumer’s “Shareholder Bill of Rights”: Why, What, When and If
– Broc Romanek, CompensationStandards.com
Yesterday, Senator Charles Schumer – along with Senator Maria Cantwell – finally introduced the “Shareholder Bill of Rights Act of 2009” (this is the final proposed bill). Here is my ten cents on your burning questions:
1. Why? – Typically, it would be expected that this type of legislation would originate in Rep. Barney Frank’s House Financial Services Committee. So why did Senator Schumer begin frontrunning his own bill a few weeks ago. The likely answer is that influential parties wanted governance reform as part of the discussion over Obama’s “First 100 Days” to keep these issues in the spotlight. And Frank was too busy with financial regulatory reform to drum up something as a placeholder.
2. What? – As noted in this blog before, the bill is a virtual “wish list” for investors interested in reform (eg. CII’s press release and Nell Minow’s observations in “The Corporate Library Blog”) as it tackles every hot governance there is today (with the notable exception of CEO succession planning).
3. When? – The big question: “What are the odds of this bill getting passed?” I think the odds are fairly slim that this bill becomes law because it includes too many items that potentially contravene state law and open it up to a Constitutional challenge. However, if another big scandal suddenly surfaces, Congress could push this through unexpectedly (just as WorldCom’s implosion pushed Congress to adopt Sarbanes-Oxley).
The fact that only one other Senator placed her name on this bill is a “tell” that there might not be a lot of momentum for it. My guess is that Sen. Schumer wanted to make a mark within the first 100 days of the Administration – and that he wanted this bill to influence what Rep. Frank produces later in the year as well as influence the financial regulatory reform that is being crafted now. In the end, I think the chances of certain provisions of this bill becoming law by the end of the year is fairly high, including say-on-pay and shareholder access – just not as part of this bill.
4. If? – What if this bill gets passed? Wow…
Looks like the parameters of today’s proxy access proposal have been made available to the mainstream media since this NY Times’ article states: “The proposal would permit large shareholders — typically institutional investors like pension funds or hedge funds — or alliances of shareholders to nominate as many as one-quarter of the directors. For the 700 largest public companies, the proposal would require approval by 1 percent of the shareholders for a dissident slate to be nominated. For smaller companies, it would be either 3 percent or 5 percent, depending on the size of the business.
One of those things I’ve been meaning to blog about – and no one else was blogging about until Mark Borges covered it this morning in his blog. A few weeks ago, Ed Durkin and the United Brotherhood of Carpenters Pension Fund has submitted a new shareholder proposal to 20 companies seeking a triennial vote on pay rather than an annual one.
The rationale is that this would help shareholders by reducing the number of companies they would have to analyze each year – and would help companies as they wouldn’t have to face an annual battle over their pay practices.
As Mark notes, the triennial executive pay (known as “TEP”) proposal would require:
– In addition to an overall vote on named executive officer compensation, separate votes on a company’s (i) annual incentive plan, (ii) long-term incentive plan, and (iii) post-employment benefits (including retirement, severance, and change-in-control payments); and
– A “forum” between the compensation committee and shareholders on at least a triennial basis to discuss senior executive compensation policies and practices.
In talking to company representatives, they obviously find a vote every three years more palatable – although I think they have overlooked the fact that the Carpenter’s forum idea is something that could be much more frequent (eg. Intel recently launched a stockholder forum leading up to tomorrow’s annual shareholders meeting).
I agree with Mark that this idea’s weakness is how to deal with corporate implosions between the triennial votes. My solution would be a safety valve where shareholders could gather and trigger a vote, much like the idea of triggering proxy access. In other words, if a group of shareholders got together that met a ownership threshold and filed some type of certification with the SEC that states they seek a say-on-pay vote (with the filing made by a particular deadline), the company would be forced to put say-on-pay on the ballot.
But note that I’m still dubious whether say-on-pay is really meaningful anyways. I would rather rely on votes “against” compensation committee members as the signal to the board that shareholders are unhappy over pay practices. In a say-on-pay world, I worry that board will routinely get their pay packages blessed (see yesterday’s WSJ article) and that excessive pay practices won’t change.