– Ira Kay and Steve Seelig, Watson Wyatt Worldwide
We enjoyed reading Broc’s posting of John Wilcox’s views of the benefits of mandating “Say on Pay” votes for the plans disclosed in a company’s proxy. Mind you, this is not a vote on the magnitude of the pay packages themselves, or whatever shareholders might think they are voting on if a blanket “Say on Pay” vote was mandated; John is simply suggesting a vote that would permit shareholders to tell the company if the plans they disclose in their proxy make sense and are properly disclosed. And John comes from an organization that “gets it” about how to write a proxy disclosure – TIAA-CREF absolutely “walks the walk” on making sure its own proxy disclosures are as transparent as they possibly could be.
While our firm remains on the sidelines regarding whether a Say on Pay vote, or John’s modest proposal, will accomplish the goals being sought, we agree wholeheartedly that many companies have fallen far short in telling shareholders how their plans actually accomplish the illusive goal of providing ‘pay for performance.” Search any proxy. You will invariably find the company touting its “pay for performance” story, with very few actually proving it. We found this to be a common failing when we performed out 2nd Annual “Report on Proxy Statement CD&A Compliance.”
We have been recommending that companies do their best to prove their case, and include the results right at the start of their CD&A in an Executive Summary so investors immediately can know:
– How the company performed for the year,
– How the company paid for those results,
– How corporate performance compared to peers, and
– How their pay compared to peers.
While we acknowledge calculating and accumulating these results can be burdensome, we believe companies owe it to their shareholders to explain these results up front. You know, something that catches people’s attention, like: “It was the best of times, it was the worst of times.”
Of course, the problem in assembling our Executive Summary is that it is based on sound analysis. And our survey found that companies have not taken the time to do the work – as encouraged by the SEC – to explain the type of performance their plans are designed to reward. We found:
– Only 46% of the companies disclosed long-term incentive compensation earned in 2007 for attaining plan goals during the 2005-2007 cycle.
– Slightly more than half – 56% – described in detail the link between total pay earned during 2007 and company performance.
– Only 36% compared the company’s performance with the performances of its industry peers.
Although roughly half of companies provided some analysis that linked pay to corporate performance, most did not provide a detailed comparison of the pay earned by their executives with the pay earned by peers. This omission leaves these companies vulnerable to criticism from institutional investors and other pay critics that their pay programs are not solidly grounded in performance.
I continue to be impressed (to use a polite term) by the complexity of 409A as it applies in the context of what I call the “fringe areas” of nonqualified deferred compensation under Section 409A. For someone who does this for a living (as I do), it should not be such a brain teaser to make a typical employment agreement safe from 409A foot-faults.
For example, to focus on just one recurring conundrum: Is it too late to tighten up a non-safe-harbor “good reason” definition to avoid a six-month delay in separation pay to a specified employee?
The answer depends on a number of factors, including:
– How far off the mark the existing good reason definition is,
– Whether you have a single-trigger or double-trigger termination arrangement,
– When employment termination might occur, and
– In the case of a double-trigger change-in-control arrangement, when the change in control might occur.
The “Good Reason” Definition Matters — Even if it is Never Triggered
As background, a “good reason” definition lists a number of employment-related indignities that if imposed upon an employee would allow her to resign and be entitled to the same severance benefits as if she had been fired without cause. Typical “good reason” triggers are a reduction in compensation, diminution of duties, or a forced relocation.
To secure a 409A exemption, the goal is to have an arrangement in which a “good reason” resignation is tantamount to an “involuntary termination” of employment. An involuntary termination can be a necessary component of both the short-term deferral exemption and the involuntary termination (two-times/two-years) exemption, but for very different reasons:
1. Under the short-term deferral exemption, an arrangement that provides for payment within a designated short time after the lapse of a substantial risk of forfeiture is not deferred compensation. Payment contingent upon involuntary termination is subject to a substantial risk of forfeiture. Resignation for a valid “good reason” is treated as involuntary termination.
2. Under the two-times/two-years exemption, the key is that the severance payment not be accessible in any manner other than an involuntary termination (which can include a resignation for a valid “good reason”).
If the contractual “good reason” definition does not meet the safe-harbor definition in Treas. Reg. §1.409A-1(n)(2)(ii), it still may be in the “close enough” category described in Treas. Reg. §1.409A-1(n)(2)(i). The problem is that you cannot be 100% confident that the Service would agree with your assessment of “close enough,” and there is probably not going to be an IRS agent standing by at the termination date to give a thumbs up or down. Some people yearn for more certainty.
For Those Who Yearn for More Certainty
Here are the possibilities of what you can do at this point:
– If you have an existing good reason definition that is “close enough” to be deemed an involuntary termination trigger (see Treas. Reg. §1.409A-1(n)(2)(i) to make an informed decision as to this), then there is still time in 2008 to change to the safe-harbor definition and be confident of the ability to satisfy either the short-term deferral exemption or the two-times/two-years exemption (assuming all other exemption requirements are met).
– If you have a single-trigger arrangement and the existing good reason definition is not “close enough” to be deemed an involuntary termination trigger, then it already is too late to change to the safe-harbor definition for purposes of regaining the ability to satisfy the short-term deferral exemption. This because the “bad” good reason definition makes the payment not subject to a substantial risk of forfeiture, and you can never regain that once is it lost. (Sound familiar?)
– BUT, if (1) you have a double-trigger arrangement (i.e., must first have a CIC followed by resignation for good reason or termination without cause), and (2) the CIC has not yet occurred and will not occur in 2008, then there is still time to change even a blatantly bad good reason definition to the safe-harbor good reason definition for purposes of regaining the ability to satisfy the short-term deferral exemption.
– Regardless of how bad your current good reason definition is, you can still change it to the safe-harbor definition and avail the (less generous) two-times/two-years exemption. This is because the two-times/two-years exemption is not concerned with whether the severance payment was ever subject to a substantial risk of forfeiture (so you can reform a woefully deficient definition), as long as it does not apply to a termination occurring in 2008). . Whew!
All This Just to Avoid a Six-Month Delay in Payment?
An executive who has negotiated a lenient good reason definition may well conclude that a six-month delay in payment is a small price to pay for the increased chance of triggering the severance payment in the first instance. That decision is a personal one and will be influenced by the facts and circumstances.
However, I am in the camp that it is generally worth positioning for a 409A exemption where possible (assuming the executive is willing to change the good reason definition) — not just to avoid the six-month delay but also to preserve flexibility to make changes to the agreement in the future without the worry of “substitution” issues and to avoid later complications if Congress pursues the annual dollar cap on Section 409A deferrals. Who knows how that cap and the ensuing rules would be applied to non-exempt separation pay arrangements.
Limited Time to Take Action
Whatever you do, be quick about it! As expressed in Notice 2007-78, the Service views the modification of a good reason definition as a change in time or form of payment, which must be done in 2008 to be within the transition rule – so it does not work if the termination of employment occurs in 2008. It’s a head-scratcher why a change to make the payment more difficult to earn upon termination of employment (by changing to a more stringent definition of good reason) is changing the time of payment – the payment trigger is “separation from service” in any event.
The key is that by availing an exemption, the change is avoiding the six-month delay for specified employees and is thereby accelerating payment, at least in part. Best to go ahead and make any changes to the good reason definition in 2008 if you are so inclined.
I am Ed Burmeister, a partner in the Global Equity Services practice at Baker & McKenzie, LLP, based in San Francisco and this is my first blog. Maybe it’s my advancing age or my reaction to Michael Album’s recent blog, but I have also been musing about death and equity plans. As an aside, recently departed George Carlin, one of my favorites, had a great quote on death, impermanence and humor.
Overuse in Equity Plans
Anyway, one of my pet peeves is the over use of beneficiary designations in equity plans. There are a few valid reasons to consider beneficiary designations, primarily for executives, in long-term incentive plans. Even in these situations, care must be exercised, as most beneficiary form administration is not very good, to be blunt. For example, how many plan administrators know in which states a divorce invalidates a previous beneficiary designation, or whether and how community property laws come into play.
Overseas, of course, these are often not fully enforceable due to overriding local rules dealing with rights of spouses and children and procedural requirements which typical U.S. forms and procedures would not meet. Let me just say that an interpleader action is not a very attractive alternative if an optionee dies with a questionable beneficiary designation on file. Just depositing the option into the court is a challenge in and of itself, and, of course, you are normally dealing with a one year period at most to resolve the situation.
Particular Problems with ESPPs
But leaving aside long-term incentive plans, my real pet peeve is the use of these in employee stock purchase plans. Worse, some of these plans purport to apply beneficiary designations to shares in the so-called “plan account”. The problem here is that once the shares are in the brokerage account, the broker will normally permit title designations, such as joint-tenancy or community property. Moreover, the broker will likely be unaware of the plan provision applying a beneficiary designation to the shares in the account and of course would not typically have a copy of the beneficiary designation.
I frankly fail to understand why a company would want to be dealing with the shares in the brokerage account after the death of an ESPP participant. Whatever estate planning or other dealings the employee may wish to have with respect to the shares, he or she is certainly free to do so by dealing directly with the broker.
As to the cash accumulated in the account pre-purchase, almost all plans say that the cash is returned to the estate or beneficiary. Because a deceased ESPP participant will almost certainly have been an active employee at death, the employer will normally owe the employee some amount of money in any event (unpaid wages, bonuses, etc.) so why not just include the cash accumulated from ESPP payroll deductions and distribute that the same way company would distribute unpaid wages, i.e., to the personal representative of the estate of that participant.
Since every state and essentially every country has someone designated as a personal representative of the estate, in almost all cases it will be much easier for a plan administrator to deal with that individual and not worry about whether or not the designated beneficiary form on file is fully effective. Also, this approach always avoids an interpleader if the plan provision is clearly written to provide that the benefits go to the estate of the participant. So… for my two cents, I would avoid beneficiary forms in ESPPs altogether and be quite cautious in how these are used in long-term incentive plans, particularly with respect to overseas employees.
U.S. Estate Tax Issues
One more thing, stock of a U.S. corporation or an option over shares of a U.S. corporation will potentially subject the estate of the holder of the option/shares to U.S. estate tax even if the holder of the option/shares is not a U.S. citizen or resident and has never even been to the U.S. Also, the exemption for marital transfers and other U.S. estate tax exemptions (e.g., the lifetime exclusion) do not apply in most cases to the overseas situation. In this case, the plan/broker needs to deal with the U.S. estate tax issues, and these can be typically handled much more effectively with the personal representative of the estate rather than a beneficiary, who might even be a minor in some cases.
Enough of death…time to return to the world of the living…
The typical performance-based LTIP runs three years, with performance being measured at the end of the period. A three-year time frame encourages a longer-term performance focus as well as retention. However, a three-year term requires the ability to identify longer-term goals with some precision, a process that is usually fairly standard for large, stable or mature organizations.
The situation is different for smaller firms, high-growth companies and those likely to experience a major organizational change in the near future such as a sale or acquisition. Faced with uncertainty about their long-range performance, they are likely to be more comfortable adopting a shorter horizon that allows them to pinpoint the kind of realistic and predictable goals most likely to drive executive behavior.
As a way to add the long-term performance perspective favored by investors and encourage retention, those companies may incorporate a vesting period after the performance period is completed. Typically, companies in this situation might opt for a one-year performance period but also encourage a longer-term perspective through the use of graded vesting over the next two years.
As you have read, Dick Grasso won his case against the New York Attorney General a few weeks back. But if you read the media reports closely, you will notice he won on a technicality – he won because the NYSE changed its “form” since the lawsuit was filed, from a non-for-profit to a public company (a dissenting judge argues that NYSE still has a non-profit subsidiary, and thus is still subject to the New York non-profit rules).
Thus, according to the New York State Supreme Court’s decision, the Attorney General didn’t have the authority to challenge his compensation anymore, and Dick gets to keep his money without any adjudication of whether the amount was reasonable, whether he breached his fiduciary duties, or whether he (or anyone else) ever did anything wrong or improper in connection with his compensation. So although Dick’s been saying he was “vindicated,” it’s hardly so.
So what does this mean for you? It reminds us that a proper clawback can save a company the embarrassment of a lengthy court battle – and many millions of dollars (reportedly, the Grasso lawsuit cost the NYSE more than $70 million in legal fees). It’s time for you to go back and read our Winter 2008 issue of Compensation Standards to learn the “Ten Steps to a Clawback Provision with “Teeth.”
We are pleased to note a recent pair of reports from The Corporate Library that note the trend of clawback usage on the rise; one report noting the upward trend generally (13% of companies surveyed have them now, up from a handful a few years ago) and one report noting how clawbacks are more common at larger companies.
The Consultants Speak: How the Latest Compensation Disclosures Impacted Practices
We have posted the transcript from our recent CompensationStandards.com webcast: “The Consultants Speak: How the Latest Compensation Disclosures Impacted Practices.”
John Wilcox on “Say on Pay” as a Listing Standard
My good friend John Wilcox and I have been corresponding on “say on pay” and he’s given me permission to post his following thoughts on the topic. John recently left his job as TIAA-CREF’s SVP and Head of Corporate Governance (although he remains a senior advisor to TIAA-CREF) to become Chairman of Sodali. John constantly travels around the globe and is an intense student of governance frameworks used in other countries:
I agree that federal legislation or SEC rulemaking would probably not be the best way to implement an advisory vote on executive compensation. Nevertheless, I think the advisory vote would work best if it were applicable to all companies, rather than just to the few who act voluntarily. The best means to achieve universality without becoming prescriptive would probably be for the New York Stock Exchange and Nasdaq to adopt a listing standard calling for an advisory vote.
For example, a shareholder vote is now mandated for equity compensation under NYSE Rule 303A.08, “Shareholder Approval of Equity Compensation Plans.” The rule is straightforward. It reads as follows: “Shareholders must be given the opportunity to vote on all equity compensation plans and material revisions thereof . . . .”
If this approach were applied to an advisory vote, it would be minimally invasive and would permit a range of proposal formats. The rule might be entitled “Shareholder Advisory Vote on Compensation Disclosure,” and might read as follows: “Shareholders must be given the opportunity to cast a non-binding advisory vote on compensation plans disclosed in the proxy statement.”
A rule stated in such simple terms would enable companies to customize their advisory vote proposals to suit their circumstances. My belief is that companies drafting compensation disclosures with a view to a “pass/fail” advisory vote would try harder to achieve clarity and to highlight features of concern to shareholders, such as strategic links to performance and the creation of long-term value. Experience with mandatory votes under NYSE Rule 303A.08 demonstrates that companies are capable of making a good case for equity compensation when a vote is required.
I think it is unwise to argue that an advisory vote applied universally would be overly burdensome to shareholders. Shareholders must already shoulder the burden of reading dense and opaque compensation disclosures. Complaining about this responsibility surely does not serve the cause of transparency and good corporate governance, nor does it inspire confidence in the diligence of shareholders. Instead, shareholders should be pressuring companies to improve the quality of their disclosure, to provide summaries and to explain how pay and performance are linked. Incidentally, I have never heard shareholders complain about the burden of disclosure and voting rights on equity compensation plans under NYSE Rule 303A.08.
A fair argument can be made that CD&As are too complicated and the links between compensation and value creation are not clearly articulated, thereby creating an unacceptable burden on shareholders to digest and make sense of the data. If this is true, it is company executives, boards and compensation committees – not shareholders – who should be accountable. Simplification, clarification and better explanation of how compensation drives performance should be the responsibility of companies, not shareholders.
Shareholders have to read and evaluate compensation disclosures. However, if a company’s compensation narrative is not clear and convincing, shareholders should send the drafters back to the drawing board. An effective way to do this would be through an advisory vote.
If we see the advisory vote as the means to push for better compensation practices and clearer disclosure, rather than a means to punish companies, the concerns of both companies and shareholders are largely eliminated.
After the IRS’s recent and unanticipated 162(m) PLR (200804004) and Revenue Ruling 2008-13 on bonus payments in a termination context, a new (more normal) ruling dealing with “officer” status came as a bit of a relief. As most compensation practitioners know, Section 162(m) of the IRC is a provision that provides for a $1 million limit on non-performance based compensation that a public company can deduct for its named executive officers.
The goal then is to structure covered executive compensation agreements to provide for “good” performance based compensation. That was the problem with the IRS’s recent 162(m) foray – which took the position that full bonus payments made upon an involuntary termination were not performance based. Of course, Section 162(m) also has strict “procedural” requirements, apart from tying “good” compensation to performance. One such requirement is the provision mandating that objective performance goals be established by a committee of two or more independent “outside” directors.
Dealing With “Interim” Officer Status
In Revenue Ruling 2008-32, dated June 16, 2008, the IRS addressed the issue of who qualifies as an “outside” director. The facts of the ruling are as follows: Public Company X’s chief executive officer (CEO) unexpectedly resigned in January 2008. In response, the Board of Directors of Company X appointed Director A to serve as “interim CEO” while the Board conducted a search for a permanent replacement CEO. The service agreement between Company X and Director A did not limit Director A’s authority as interim CEO, was for an indefinite duration, and provided for termination of service upon selection of a permanent CEO. On February 1, 2008, the Compensation Committee of Company X approved, and the Board of Directors ratified, a compensation plan for the period during which Director A served as interim CEO.
The plan provided for a base salary of $1 million, as well as participation in Company X’s executive bonus plan. On December 11, 2008, after Director A served as an interim CEO for almost a year, Company X announced that Employee F was selected as Company X’s new CEO. Director A received final, prorated compensation for services as interim CEO on December 29, 2008. Following December 29, 2008, Director A did not receive compensation from Company X, directly or indirectly, in any capacity other than as a director. In January 2009, Director A was appointed to the Compensation Committee of Company X. Director A had not served on the Compensation Committee before.
162(m) and “Outside” Director Status: The Ground Rules
The issue before the IRS was whether Director A would qualify as an “outside” director for 2009 and subsequent years under Section 162(m)(4)(C)(i), after having served as an “interim CEO.” Under Section 1.162-27(e)(3)(i) of the 162(m) regulations, an individual is an outside director if the director:
– Is not a current employee of the publicly held corporation;
– Is not a former employee of the publicly held corporation who receives compensation for prior services (other than benefits under a tax-qualified retirement plan) during the taxable year;
– Has not been an officer of the publicly held corporation; and
– Does not receive remuneration from the publicly held corporation, either directly or indirectly, in any capacity other than as a director.
In This Case: Disqualifying “Regular and Continued” Officer Status
Not surprisingly, in the ruling, the IRS relied on the definition of “officer” in the 162(m) regulations. That provision provides that “officer means an administrative executive who is or was in regular and continued service . . . The determination of whether an individual is or was an officer is based on all of the facts and circumstances in the particular case, including without limitation the source of the individual’s authority, the term for which the individual is elected or appointed, and the nature and extent of the individual’s duties.”
In this case, the IRS highlighted certain facts:
– Director A was not employed as CEO for a special and single transaction;
– Director A was in regular and continued service from January 7, 2008 through December 11, 2008;
– Director A was hired for an indefinite period; and
– Director A did not merely have the title of officer, but had full authority to serve as CEO.
Under the facts before it, the IRS determined that Director A was an officer of Company X and thus not an “outside” director for purposes of Section 162(m). Thus, Director A’s officership status tainted any chance of subsequent appointment to the Compensation Committee. He may as well wear a scarlet letter on his chest, at least for compensation purposes. The bottom line is that once a bona fide officer of the issuer, the individual is forever barred from qualifying as an “outside” director, absent a successor situation (of the sort described below).
Planning Around Disqualifying “Officer” Status
Is there any good news in this revenue ruling? Consistent with the 162(m) regulations that define “officer,” a one-time, short-term, limited role as officer should not taint the individual in question. Section 1.162-27(e)(3)(vii) provides that an “officer” means an “administrative executive who is or was in regular and continued service.” So there is some wiggle room in structuring interim officership status so as not to constitute regular and continued service. Working off the factors in the revenue ruling and regulations – what if we structured the interim CEO position for a finite period, to handle specific matters and with limited authority?
On a related note, practitioners should also remember that there is a well developed line of private letter rulings that say officership in one entity does not necessarily disqualify the individual from “outside” director status in the new entity. For example, in PLR 200423012, Director served as secretary of Corporation Y from Year a to Year c. In Year d, Corporation Y merged into Corporation X. Director served on the Board of Directors of Corporation X. Director received no remuneration from Corporation X except in his capacity as director. The IRS ruled that Director qualified as an “outside” director of Corporation X, notwithstanding prior offcership status at Corporation Y.
There are also situations where the individual in question served as officer, but only in a limited ministerial capacity. These facts alone did not preclude the IRS from ruling that the individual qualified as an “outside” director. For example, in PLR 9732011, Corporation A proposed that Director B serve as the second “outside” director on its Compensation Committee. Corporation A had been a publicly held corporation since Year Y. Director B was not a current or former employee of Corporation A and did not receive any compensation from Corporation A other than in his capacity as a board member. Director B had served as the corporate secretary for Corporation A since Year Z. Corporation A represented that Director B’s functions as corporate secretary were limited to attendance at board and shareholder meetings and that Director B’s duties were ministerial in nature, with secretarial duties performed by the assistant secretaries.
As stated above, Section 1.162-27(e)(3)(vii) of the 162(m) regulations provides that the determination of whether an individual is or was an officer is based on all the “facts and circumstances” in the particular case, including the “nature and extent of the individual’s duties.” Therefore, in this case, the IRS ruled that Director B qualified as an “outside” director because the nature and extent of his duties as an officer were strictly ministerial and “ceremonial” in nature.
Finally, a “tainted” former officer who continues to serve as a director may still be able to observe Compensation Committee activity in the context of a non-voting role. In PLR 9811029, the IRS allowed a stock option plan approved by a Compensation Committee which included “inside” directors, as well as two “outside” directors, to qualify for “good” 162(m) treatment, based on the fact that the “inside” directors would abstain or recuse themselves. The IRS ruled that after giving effect to the abstention or recusal of the “inside” directors, the corporation had a subcommittee of, at a minimum, two “outside” directors, and complied with Section 162(m).
– Michael Album, Partner, Proskauer Rose; Morgan Gold, a summer associate from Fordham University School of Law assisted on this blog posting.
Okay, so after reading Frank Glassner’s blog that tells me, contrary to everything I learned in school, that you can take it with you, and highlights pay excesses that are guaranteed to make some shareholders’ a bit crazed about executive pay, allow me to weigh in on whether it’s a great idea to allow shareholders to have a direct “say-on-pay” for public company executives.
I say that, despite some of the excesses that are out there—including compensation continuing beyond the grave—Frank’s blog may indicate why “say-on-pay” is unnecessary.
Current Status of Say-on-Pay
First, what’s going on with “say-on-pay”? Is it the NEXT BIG THING or just a passing fancy? According to Brian Foley, managing director of Brian T. Foley & Co., White Plains, NY, who spoke at the recent ALI-ABA Executive Compensation Conference in NY last month, not only is it not a passing fancy it’s likely to become law.
Both major party candidates, Senators McCain and Obama, have come out publicly in favor of “say-on-pay” votes by shareholders. Obama sponsored S. 1181, a counterpart bill to Rep. Barney Frank’s (D-Mass) H.R. 1257, which mandates a non-binding, advisory vote on executive pay packages.
On June 10th, Senator McCain decried the “extravagant” pay and severance arrangements offered to executives and promised to force companies to seek shareholder approval of their executive-pay plans. “Under my reforms,” he is reported to have told a small business group, “all aspects of a CEO’s pay, including any severance arrangements, must be approved by shareholders.”
Will this become law or is it just great sound-bites for the campaign trail? Who knows. I for one have long since given up handicapping anything in D.C. The odds aren’t there.
Analyzing “Say-on-Pay”
The more important question, it seems to me, is whether say-on-pay is necessary or even a good idea? I say “no” on both counts.
Is say-on-pay necessary? Read Frank Glassner’s blog. One take away from his blog is something we all know: compensation is becoming much more transparent. Everyone is reading these proxies and openly criticizing the more egregious practices. This may be viewed as a good thing and shows that the new rules appear to be serving their stated purpose.
And shareholders of public companies already have a say-on-pay in a number of significant ways. First, all major exchanges require shareholder votes for equity plans (where most of the real money is) and any significant changes to those plans. Code Sections 422 and 162(m) require shareholder approval of plans that grant incentive stock options or may pay certain officers of public companies over a $1M annually, respectively.
Third, and most importantly, Shareholders can “vote the rascals out” if they think their directors are paving the streets with gold.
Sophisticated shareholders can and should read carefully the information required in the company’s proxy statement as part of the Compensation Discussion and Analysis. This will give them the fully story on compensation, including, of course, big pay packages that executives can figuratively take to the grave.
Just as importantly but often overlooked: if they read the CD&A thoughtfully, they will discern the arduous process employed by thoughtful compensation committee members as they attempt to figure out the “right” amount to pay their executives. While its currently in vogue for some shareholders and advisory groups to claim that compensation committee members are not doing their jobs, as a veteran of many compensation committee meetings, I can report that nothing is further from the truth. Shareholders who read the CD&A should question the wisdom of replacing the thoughtful process engaged in by committed individuals with the democratic process.
While some proponents of say-on-pay call voting directors out the “nuclear option” it is a very real option and not at all “nuclear.” What’s nuclear about exercising your voting right as a shareholder?
Besides being unnecessary, it’s not even a very a good idea. Say-on-pay—even the non-binding variety most often touted by proponents and approved by Apple and others – can not be in the long-term interest of successful public companies.
Not a Good Idea – and Not in Long-Term Interests of Shareholders
Why? Because it seriously blurs the line between those who are charged with running a company and those who are investors. A profit-making enterprise is not a direct democracy and treating it like one will set us off on a ridiculous downward slope. If “say-on-pay” initiatives pass, what’s next?
– “Say-on-way,” in which shareholders provide advisory votes on capital budgets and strategic planning?
– “Say-on-stay,” in which shareholders hold a referendum on who is to be hired and fired? Brilliant. Perhaps then candidates for positions in public companies will run campaigns for their positions. Position statements can be prepared. Polling can be done. Debates between leading candidates for CEO can be held. Professionally prepared commercials can be streamed to desk-tops of shareholders around the globe, ending with the would-be-CEO asserting that he is “Bill Carsonand he approves this message.” Imagine the ruckus when a minor (not leading candidate) demands his right to openly debate for the position of CEO of General Motors or Exxon.
Proponents on say-on-pay want to ignore the slippery slope argument, but offer no real response as to how say-on-pay is any different than having a direct, advisory say on any other aspect of the operation of a public company.
This blurring of the lines between shareholders and the boards they elect will not lead to better run companies–it will lead to companies that better run.
– Peter Marathas, Partner, Proskauer Rose (Boston)
We just had our monthly call among global benefits attorneys, and I heard that the European Union is hotly debating the regulation of executive compensation. Apparently, the impetus comes from the financial services sector, in response to the subprime meltdown. In the U.S., executive pay seems more broadly in the public crosshairs – with the legislative proposals focused on public companies (in the form of non-binding “Say on Pay” votes by shareholders to approve or disapprove of disclosed executive compensation), and on private companies (regarding the timing of taxation for equity-based compensation provided through private equity, aka hedge funds).
Although an election year would not seem likely to bring consensus for any law, I would not be surprised to see traction for ones such as these that ostensibly clamp down on executive pay. We saw this in 2004 when IRC Section 409A passed . . . in part because it was politically incorrect to defend executive pay. The question should be: will the U.S. be better off in the long-term if the legislation being proposed winds up passing?
“Say on pay” strikes me as warranting broad-based opposition from corporate America, if only to avoid the slippery slope of having shareholders vote on any front page issue of the day. Executive pay may be the cause celebre this year, but next year it could be outsourcing or right-sizing, or any number of emotion-laden issues. Boards of directors are elected to decide these hard issues, and it seems to me that full disclosure ought to suffice to enable shareholders to voice and express there interests. Say on pay is mere opportunistic piling on, in my view. As a result, if the legislation gets momentum, I’d hope voices of reason emerge to objectively assess its implications.
Mike Kesner’s recent posts on relative performance measures and peer group selection led to a spate of emails among our consultants at Watson Wyatt. Yes Broc, folks do read this blog! Here is our collective group-think, as articulated by Michael Marino, one of our consultants who focuses his practice in these areas:
Relative performance measures give the appearance of objectivity and simplicity but are very difficult to implement correctly for two reasons:
1. Identifying performance peers is a significant challenge and many firms underestimate this challenge.
2. Metric definitions can vary significantly and they are often adjusted from GAAP accounting to reflect specific factors unique to a particular company.
Peer Group Challenges: Business economics are often very different within a single sector or industry and executive performance peer groups often do not reflect these economics. For example, in the petrochemicals industry, upstream, midstream, downstream and fully integrated companies will have very different business economics. It is difficult to find two or three companies that have highly comparable businesses in any sector, let alone 10 or more, which is a common number for relative performance assessment.
Investment bankers and investment managers understand the limitations of peer groups as a valuation method. This is why they rely on multiple valuation approaches to assess business value. Executive performance assessments should recognize this limitation and should be more robust than simply measuring relative performance (see solution below).
Accounting and Financial Reporting Challenges: Financial metric definitions are often inconsistent between companies and they are often measured on a non-GAAP basis. It is very difficult and sometimes impossible to put companies on equal footing if a company uses a non-GAAP measure for incentive compensation purposes. In many cases, the non-GAAP measures reflect adjustments aimed at removing accounting distortions to better focus on business operations.
Consider also the effect of acquisitions on business performance and relative comparisons. Acquisitions can boost revenue growth and reduce return measures in the short-term thereby distorting performance in the short-term when the benefits of the acquisition are still uncertain.
One Solution: We recommend that our clients counterbalance absolute and relative goals in incentive plan design. Consider measuring absolute financial performance and relative financial performance on the same measure (e.g., absolute EPS and relative EPS) Companies should also consider balancing absolute financial performance with relative stock price performance or TSR. This way, operating performance is viewed in the context of the market’s expectations for future financial performance.
– Ira Kay and Steve Seelig, Watson Wyatt Worldwide
I just added ten executive compensation lawyers to the mix of this new – and popular blog. With the group of bloggers now comprising of twenty compensation consultants and these ten lawyers, I have renamed the blog: “The Advisor’s Blog.” For those who haven’t, you should input your email address on the left side of this blog – so you can be alerted when a new entry is made.
Mark Borges struck “Gold, Jerry, Gold” in his analysis recently of the new Item 402 interps in his “Proxy Disclosure Blog.” Meanwhile, Mike Melbinger continues to deliver on his “Melbinger’s Compensation Blog,” last week covering a new IRS revenue ruling on Section 162(m).
In-House Counsel’s Role in CEO Pay Setting Process
In this podcast, James Williams, General Counsel of Liquidity Services, provides insights into the role of in-house counsel in the executive compensation setting process, including:
– How much of your time do you spend on compensation-related issues?
– What is your role in scheduling, attending and preparing for compensation committee meetings?
– Where do you think you add the most value in the process?
– How do you handle the tricky issues of supporting the board as well as supporting senior management?
The Latest Compensation Disclosures: A Proxy Season Post-Mortem
We have posted the transcript from the popular webcast: “The Latest Compensation Disclosures: A Proxy Season Post-Mortem.”