Boardroom challenges – executive compensation and say on pay

May 2012 | TALKINGPOINT | BOARDROOM INSIGHT

financierworldwide.com

FW moderates an online discussion on the boardroom challenges of executive compensation and say on pay between Ann Murray at McKenna Long & Aldridge LLP, John L. Anderson at Meridian Compensation Partners, LLC, and Simon Patterson at Patterson Associates LLP – a Pearl Meyer & Partners Practice.

FW: In general terms, could you explain the reasons behind the increased scrutiny and criticism of executive pay that we have seen in key markets around the world?

Murray: I don’t know that it’s necessarily that abuses in executive pay have gotten worse or didn’t exist before, but as with so much in our society today, the increased access of the media and the availability of the internet have brought alleged abuses to the attention of the public more quickly and with more detail than ever before. Add to that the economic turmoil in the US and other countries over the past five years, resulting in a widening gap between the haves and the have-nots. The general public is angry about the state of the economy and its position in it.

Patterson: Fundamentally, executive pay is seen by the investing public as too high relative to the returns that investors actually experience. The rewards of the most senior executives have been a longstanding area of debate in the UK, but the new ‘front’ opened up in the financial media here is the comparison to the pay of the ‘average worker’. This has been well publicised by the media, in a constant stream of articles and by a number of high profile reports. In the UK, this included a very critical report from the High Pay Commission. The situation has been further exacerbated by the lack of economic growth, with executive performance being ever more closely scrutinised by shareholders, employees and the media. The complexity of packages only serves to further confuse the situation, making it hard to compare compensation among different companies, and generating misconceptions about the actual value of pay packages.

Anderson: Executive compensation, especially CEO pay, has been a lightning rod for media and public reactions for the past few decades. Much of this is in response to some sensational examples of large compensation payouts not aligned with shareholder returns and excessive termination packages – ‘pay-for-failure’ and ‘golden parachutes’ – for exiting top officers. In recent years, increased visibility of executive pay globally has been enabled by more explicit disclosure of compensation schemes mandated for public companies, along with the adoption of say-on-pay voting. And, with even greater awareness, public outrage and scrutiny of executive compensation has intensified, fuelled by heightened institutional shareholder activism that followed the financial crisis and stock market losses of 2007-10, and the ensuing instability of the global economy. This scrutiny is especially high for the financial services sector due to its historical pay practices, implied involvement in the financial crisis and subsequent government interventions and ‘bailouts’. No doubt, executive compensation will continue to be a very sensitive topic around the world. Nevertheless, the ability to provide market-based executive compensation aligned with performance will continue to be a competitive advantage for companies as they compete for increasingly scarce leadership talent in the global market – and frankly many institutional investors understand that reality.

FW: In your opinion, are there material benefits to disclosing CEO versus median employee pay ratios? Are we likely to see more of this information released, going forward?

Patterson: This popular proposal stems from the difficulty in expressing executive pay as a simple number and the fact that compensation of senior executives has increased at a faster rate than the national average wage in recent years. However, defining and publishing a median pay ratio will not solve this issue or lead to meaningful comparison across companies. Acceptable ratios would vary across sectors and their interpretation would be subjective – consider a company with a small, highly skilled workforce against one with many unskilled, low-paid workers. Additionally, over several years strong company performance would result in a higher level of performance-based remuneration for executives compared to the rest of the workforce, resulting in a misleadingly high ratio. In the UK, such ratios have been excluded from ongoing consultations although the companies will likely be asked to demonstrate how they have taken employee earnings and pay differentials into account when setting pay.

Anderson: The central issue underlying any mandated proxy disclosure is whether investors will benefit from the disclosed information. The current proxy standards already provide investors with extensive disclosures on executive compensation matters at public companies, including: information about how and why compensation is set by the board, details about performance conditions and outcomes, and the relationship of pay schemes with market levels and practices. The CEO pay ratio would provide little added substance to these disclosures, and it seems very unlikely that institutional investors, other than union funds, will consider the disclosure of CEO pay versus median employee pay as meaningful in making investment decisions. Whatever limited benefit that may be derived from the CEO pay ratio disclosure is outweighed by the substantial administrative burdens that will be incurred by large multinational companies in accumulating the data necessary for making the disclosure. Unlike the disclosure of the absolute quantum of CEO pay, the ratio in itself is without proper context and easily misconstrued. As such, the pay ratio disclosure arguably would just serve to sensationalise and politicise pay differences when, in fact, pay levels are heavily driven by genuine labour/talent market differences. Nevertheless, we may see some companies providing this information voluntarily – but with added context and explanation.

Murray: As anyone who has been employed in the upper management ranks within a company knows, success is not driven solely by the CEO. Although one of the key attributes of a CEO is the ability to surround himself or herself with a quality senior management team, it is still this senior management team that does a significant portion of the hard work that leads to the success of the company. Thus, if the CEO’s compensation is disproportionate to the compensation of the lower senior executives, it could indicate that there is not enough in place to incentivise and retain these senior executives. I think there will be more of a push from shareholder groups to obtain information about how this compensation compares.

FW: What is your view of the regulatory changes that have been implemented to deal with executive compensation? What are the main objectives from a political standpoint?

Anderson: The substantial enhancement of proxy disclosure requirements is one of the most significant regulatory changes impacting executive compensation in North America in the past several years. The expanded disclosure requirements have provided investors with added meaningful information about how and why public companies compensate their executives and whether executive pay is adequately linked to company performance. And, this has prompted new, meaningful engagement between companies and their key shareholders regarding executive compensation matters. Companies also have been responding to increasing shareholder concerns about corporate governance by adopting compensation ‘clawback’ policies, executive share ownership guidelines and the engagement of independent compensation consultants to provide objective advice to boards. Additionally, with increased visibility, companies have been making significant changes to their compensation programs, including eliminating tax gross-ups and perquisites, increasing the use of performance-based equity grants, and moderating cash severance multiples. In turn, the principle objectives of the regulatory requirements are being achieved – that is, to improve companies’ accountability and increase responsiveness to shareholder concerns, as well as strengthen pay governance through increased transparency.

Murray: Unfortunately, many of the regulatory changes in the past 10 years are a political reaction to something bad happening and have resulted in too much complexity and penalties on the wrong people. For example, Section 409A of the Internal Revenue Code was enacted in the wake of Enron and other high-profile scandals where executives cashed out their pay when they knew the boat was sinking and left little for remaining employees and retirees. Section 409A, however, has done little to take away the ability of executives to bail themselves out when times are tough – the prime example being the ‘take your money quick’ exception to the six-month specified employee delay rule. A top executive of a public company can easily avoid the required six-month delay by simply making sure that his or her package fits within the short-term deferral exception or one or more of the other exceptions under Section 409A. I don’t see a lot of push back on these types of provisions.

Patterson: Further regulatory changes are inevitable, because the free market has failed to regulate what is perceived as spiralling executive pay, creating pressure on governments to address the issue. Here in the UK, the government and investors are discussing a series of major new regulatory requirements, including a binding shareholder vote with a 75 percent threshold; votes on exit payments; and the restructuring of the Remuneration Report to increase transparency and simplicity. The 75 percent threshold proposal is very radical and its prospects are uncertain. In contrast, simplifying disclosure is generally a good thing, given the varying quality and clarity of information in today’s Remuneration Reports. However, increased regulation can also be onerous and expensive for companies, particularly when they must comply with overlapping regulations. Overregulation can also act as a damper on creativity, if companies shy away from innovative but unusual remuneration plans that would better reflect their strategy.

FW: In terms of clawback provisions on executive pay, the SEC is yet to clarify the rules in this area. What impact is this uncertainty having on the way businesses treat clawbacks, and is any predictability in sight?

Murray: At this point, I have not seen companies put this high on their list of priorities. Within a short time after Dodd-Frank was passed, we saw a few companies include catch-all language in their executive agreements and plans, usually giving the company a unilateral right to amend the applicable executive agreement or plan to the extent required to comply with Dodd-Frank’s clawback requirements, or providing that the pay would be subject to forfeiture as provided under Dodd-Frank’s clawback rules. I think there’s just so much uncertainty on how the clawback rules will actually apply and whether existing agreements will be grandfathered that it’s more of a ‘wait and see’ approach. There’s definitely no question that it will be a big deal when the regulations are finally issued.

Patterson: Clawbacks are often misunderstood as meaning that if it turns out the required performance conditions for a deferred bonus were not met, the bonus won’t be paid. Rather, in a clawback, a company seeks recovery of any bonus already paid out on the basis of performance that turns out not to be genuine. For example, profits at Lloyds Bank Group were retrospectively reduced due to subsequent penalties related to miss-selling of Payment Protection Insurance (PPI). This meant that executive bonuses previously paid out were actually based on an illusory level of performance. The bank subsequently ‘clawed back’ the bonuses already paid to senior executives. The uncertainty over this issue is leading most Remuneration Committees to delay or rethink development of policy on clawbacks. We expect the continued use of deferrals in remuneration packages to negate the need for clawbacks other than in exceptional circumstances.

Anderson: We will hopefully have more clarity later this year regarding clawback policies that US public companies are required to implement under Dodd-Frank. The SEC plans to issue proposed rules by 30 June and adopt final rules by 31 December of this year. Whether the SEC keeps to that timetable remains to be seen, as the agency has already delayed issuing other compensation-related rules several times over the past few years. The vast majority of large US public companies have already implemented some form of clawback policy. Today, many companies have a ‘triple-trigger’ clawback policy in place where they may recoup incentive pay if there is: a material restatement of financials; the restatement is due to noncompliance, misconduct or fraud; and, the compensation to be clawed back is significant. Dodd-Frank has acted as a catalyst for many companies to review and modify their current clawback policies. Not wishing to wait until regulations are issued, some companies are subjecting a wider range of incentive compensation to any future clawback rules adopted by the SEC. However, in the absence of SEC guidance, it is virtually impossible for a company to determine if its clawback policy will be compliant with future SEC regulations, so most companies are holding off on making major changes for now.

FW: Today’s public companies are expected to engage with shareholders and meet governance demands. How is this dynamic working in practice? What lessons can be drawn from the results of 2011 ‘say on pay’ votes in the US?

Patterson: At the largest companies, the investor relations function is more actively communicating with investors about executive remuneration, which has been sufficient for some. But other companies have had surprising defeats, including insurance company Aviva, where 58.6 percent of investors voted against or abstained in voting for the remuneration report, and Barclays, which got a 31.4 percent negative vote. The proxy voting agencies are now a powerful influence on shareholders. Their traditional ‘tick-box’ mentality very narrowly defines what is acceptable and many companies are reluctant to go against this standard. Remuneration committee should clearly explain how the remuneration plan supports their strategy and if the plan varies somewhat from the norm, good communication to shareholders and proxy voting agencies will usually mitigate any concerns.

Anderson: The impact of say on pay on corporate governance is not obvious from say on pay vote outcomes alone. In 2011, less than 2 percent of Russell 3000 Index companies failed to receive majority support for their say-on-pay proposals. We expect to see very similar results in 2012. However, the advent of mandatory say on pay in the US has heightened boards’ and senior managements’ sensitivities toward the concerns of shareholders about executive compensation. Companies are employing various strategies to directly respond to these concerns. Many companies are enhancing their proxy disclosures by adding executive summaries that showcase the relationship between executive pay and company performance. Some companies have made supplemental security filings to respond to negative commentary or vote recommendations by proxy advisory firms, especially ISS. Additionally, companies are more actively engaging proxy solicitors to gauge shareholder sentiment, to communicate the merits of their compensation programs and to attempt to secure favourable vote outcomes. Many companies are directly reaching out to major institutional shareholders to fully understand and respond to their specific concerns – clearly not a common practice several years ago.

Murray: So far, there has been less pushback on the company side than I had expected. Senior executives seem to have embraced (or at least grudgingly accepted) most of these new governance rules and recommendations and are working to better position their companies for approval. They are focusing on simplifying compensation programs, cutting out one-off or insignificant fringe benefits that might be more difficult to explain to shareholders. On repeated occasions, I have heard the company ask ‘why are we doing this?’ or ‘how would we explain this’ when faced with a compensation decision – this reflects more of an accountability mindset than before. The overwhelming number of ‘in favour’ votes in 2011 has definitely calmed the fears of many companies that the say on pay rules would create problems for them. While I don’t see companies backing down from their focus on simplifying and better explaining their programs, there is definitely less worry than in 2011. And, for those whose say on pay votes were strongly in favour, they are certainly making a note of this in their proxy statements.

FW: What advice would you give to companies on designing effective compensation strategies, in light of current market and regulatory pressures? How can companies align pay with performance? Are risk and sustainability important considerations in today’s compensation arrangements?

Anderson: Current market and regulatory pressures are leading public companies to provide more transparency to ensure that compensation programs are appropriate and linked to measurable results. Those companies that have effective and transparent compensation strategies will attract, retain and motivate top talent to help create sustained shareholder value through the achievement of the company’s short and long-term business objectives. And, shareholders respond favourably to companies that demonstrate strong alignment between pay and performance. Consequently, we regularly advise boards and senior management teams to actively monitor the relationship between pay and performance relative to peers, to more easily identify potential misalignments in their programs. Key principles for a strong pay-for-performance pay philosophy include the following. First, establish appropriate target compensation opportunities with fixed pay (for example, base salary) pegged to market median Second, provide incentives with reasonable, achievable but stretch performance goals. Third, use normal (not extreme) leverage curves on incentive plan payouts, with maximum upside payouts. Fourth, have a well-conceived peer group for benchmarking pay that considers similar size business and labour competitors, suppliers and customers, as well as companies used by advisory firms, stock analysts, investors and other critics in measuring the success of the company. Fifth, use industry-relevant performance metrics that support the short- and long-term business objectives of the company and creation of shareholder value. Sixth, have a discipline of well-communicated programs. Finally, to mitigate ‘risk’ and promote sustainability, compensation programs should consist of multiple incentive vehicles with varying time horizons, and contain several performance metrics that are based on a combination of absolute, internal goals as well as relative financial performance metrics.

Murray: Companies and their boards can’t simply rely on the ‘this is the way we’ve always done it’ or a ‘one size fits all’ approach. Nowadays, you have to not only focus offensively on whether you are incentivising a particular executive’s performance and creating adequate retention tools, but also act defensively in making sure you are considering what your competitors are paying for the same role and shareholder reaction. You also have more legal requirements than ever before – from 280G performance-based compensation requirements to 409A deferred compensation limits to Dodd-Frank clawbacks. And you have to make sure that enough flexibility is built into the arrangement to react promptly to ongoing changes in the law and environment. Unfortunately, this means that compensation programs for the executive team have become more expensive, with compensation consultants and specialised legal advisers involved, sometimes on both sides. This is, however, a necessary expense in order to keep the incentive value high, the risk low, and the flexibility needed to react to future changes.

Patterson: Executive pay is now one of the most intensely scrutinised and commented upon elements of management. It’s vital to think through the link between pay and performance and to tell that performance story to the market, including how it will pay out in a range of scenarios. An effective incentive program can motivate and reward short-term behaviours and actions that will drive long-term performance and shareholder value. So the starting point is to really understand company strategy and the key metrics that drive it. Design annual and long-term incentives to work together, set targets to reward only genuine long-term performance and therefore ensure sustainability. Avoiding one-off payments such as discretionary bonus payouts – particularly when the Long Term Incentives are underwater – is essential if the link between pay and performance is to remain crystal-clear.

Ann Murray is a partner at McKenna Long & Aldridge LLP. With a business-oriented and practical approach to the practice of law, Ms Murray focuses her practice on helping companies attract and retain their workforces by offering attractive benefits programs and rewards. She regularly assists clients with matters relating to their qualified retirement plans; health, life, disability and other welfare benefits; stock options and similar equity programs; and executive compensation. Ms Murray also advises buyers and sellers regarding their benefits risks and concerns in the sale of a business. She can be contacted on +1 (404) 527 4940 or by email: amurray@mckennalong.com.

John L. Anderson is a partner and lead senior executive compensation consultant at Meridian Compensation Partners, LLC. He has more than 30 years of consulting experience in all forms of executive and director compensation. John consults directly with senior leadership and compensation committees at a number of public companies in wide variety of industries, including manufacturing, energy, professional services, financial services, technology, and telecommunications. Mr Anderson has extensive background in executive total compensation strategy, analysis, design and valuation. He can be contacted on +1 (847) 235 3601 or by email: janderson@meridiancp.com.

Simon Patterson is a managing director at Patterson Associates LLP – a Pearl Meyer & Partners practice. He manages the firm’s London office and is a member of its Operating Committee. Before founding Patterson Associates, he served as a Worldwide Partner in Mercer’s London office and co-founded SCA Consulting in Europe. Patterson Associates focuses on delivering business results by linking remuneration and reward systems to business needs. Mr Patterson can be contacted on +44 (0)203 384 6712 or by email: simon@pattersonassociates.co.uk.

THE PANELLISTS

Ann Murray

McKenna Long & Aldridge LLP

John L. Anderson

Meridian Compensation Partners, LLC

Simon Patterson

Patterson Associates LLP