Executive compensation continues to creep upward. Critics define the problem as inadequate disclosure: You can’t tell what executives are being paid. That’s like saying the real evil of bank robbery is that you can’t identify the crooks because of those darned masks.
In January, the Securities and Exchange Commission proposed new “rules” overhauling proxy disclosure standards relating to executive compensation. The new proposal would:
The Process and Proposals
The public comment period for these Rules expired on April 10. The SEC will review comments, refine its proposals, and promulgate final Rules for the 2007 proxy season.
It is too late to have significant impact on 2006, and dangerous to mix new proposals with the rules which still apply, although speeches by SEC staff have urged companies to apply the new standards to 2006 disclosure.
Much has been written analyzing this 370-page release. Briefly, the SEC proposes:
a new Compensation Discussion and Analysis section (CDA), with detailed compensation disclosure, along with an expanded table showing all elements of executive compensation for an expanded group for three years, placing dollar amounts on each element of compensation and a grand total for each person.
All disclosures will be in “plain English.” Perks will be described in detail if they exceed $10,000 in value. Director compensation will be disclosed through a compensation table (much as executive compensation), rather than through a general narrative discussion of director independence. There would also be a heightened disclosure of relationships among executives, directors and their affiliated entities.
Comments on the proposed rules, filed with the SEC, can be reviewed at www.sec.gov/ rules/proposed/s70306.shtml.
To date, certain themes are apparent in the public comments. Members of the outraged public urge the SEC onward. And commentators with an ax to grind point to specific excessive compensation situations to demonstrate that these changes are necessary.
Steven Brill, editor of The Corporate Counsel, submitted as his comment the entire 8-page January/February 2006 issue of his publication, which (among many specific technical suggestions) notably calls for the directors on the compensation committee to sign the entire compensation section, and for even greater specificity. He also called for disclosure of the compensation committee’s reaction when it finally saw the grand total of each executive’s compensation, and the actions (if any) it took in response.
Other commentators have suggested that the principal executive and financial officers not be called upon to give their Sarbanes-Oxley certification as to the CDA. Another suggestion is for separate disclosure of shares “owned” in fact, net of shares obtainable upon option exercise because including earnings on non-qualified deferred compensation funds is problematical. Such earnings are not funded by the registrant and, further, compel distortions because they may reflect returns from fortuitous investments (creating the impression of over-compensation).
What’s Likely to Happen
Rules for executive and director compensation will be enacted by the SEC sometime this summer, giving lead time to gather data for the 2007 proxy season. These rules will require historical comparative compensation tables providing exact compensation of a larger number of executives, including value accretions in option plans and retirement plans and embarrassingly detailed disclosures concerning perks.
The CDA will be a long read. Compensation committees will explain in detail: the objectives of the compensation program; the elements which that program are designed to reward; the details of each compensation element; the methodology for determining the amount of each element; and explanation of how each element fits into the company’s overall compensation objectives. Indeed, the SEC’s detailed examples of proper disclosure include a full page of specific bullet points.
The most cynical observers expect executive compensation may increase following detailed explanation of perks, as executives peruse competitor CDAs for exotic perks for themselves. Another result may be a lack of transparency: eliminate perks, increase gross pay, and simply use increased dollar compensation to pay for private airplanes and club memberships.
Conversely, others expect that detailed disclosure will tend to result in greater compensation equity within a given company.
There will be wide diversity in reporting detail. The SEC’s admonition is that perks be specifically identified, and not described generically. Strict application of the draft rules could generate interesting disclosures: “President Smith, his wife and their minor son flew by company plane from Boston to Paris; the retail value of those tickets (if commercially booked at least one month in advance) would be between $1,900 and $2,600. They stayed three nights at the George V in a two-bedroom suite at a nightly rate of $800.”
Or, more whimsically perhaps but possible under the language of the SEC release: “18 percent of the salary of the president’s secretary should be allocated to matters of personal benefit to the president, including correspondence with charities, personal travel, and the arrangement of tee times with golf partners not related to the company’s business.”
Consultants already are speculating as to the governance impact of the rules. Compensation committees are expected more seriously to punish company non-performance (although interestingly, the currently required company performance graph is eliminated).
Severance arrangements may reflect whether an executive is near retirement, or has a large equity position that will provide substantial return (these kinds of factors are strenuously resisted by executives, claiming that severance stands on its own and should not be related to age or to equity position.)
Most observers expect downward pressure on parachute payments (in the event of change of control), which typically approximate the tax-deductible limit of three times base, drifting down to two times base. The rules could also result in the imposition of a “double trigger” – the parachute will occur not just upon change of control, but only in the case of a related job loss. Also expected is pressure to eliminate gross-ups to cover income tax on benefits executives must now include in taxable comp.
Some commentators expect a move toward a single amount for annual board service (perhaps adjusted for committee assignments), with directors electing to accept payment in cash or in restricted stock.
Others see a continuation in the flight from stock option compensation to restricted stock, noting that such a change clarifies profit-and-loss impact under FAS 123R and similarly clarifies compliance with the executive and director compensation charts under the rules.
Will it Work?
The rules are a classic SEC approach: “We don’t directly control what you do, we only force you to disclose.”
But consistent with the post Sarbanes-Oxley environment, this is disclosure with a bite: “We will make disclosure really embarrassing for you by forcing you to disclose details, thereby having indirect impact on your actions.”
Will it work?
No one has a crystal ball, but an assessment of the current comp disclosure scheme is not encouraging. Current requirements (the compensation committee report along with the company’s performance graph) might already have been expected to have prophylactic effect in controlling comp, but they have not.
It may be that future levels of compensation will be affected more by the general sea change following Sarbanes-Oxley and the scandals that engendered it. There is a lot of pressure on boards (and their compensation committees) to be more attentive to shareholder interests. The Disney litigation, squarely focusing individual board member responsibility for compensation and parachute provisions, feeds into this dynamic.
Proxy advisory firms such as Institutional Shareholder Services also will have impact. Overall tally sheets for calculating executive compensation are becoming standard, and deficiency notations in proxy advisory firm analyses will flow from a failure of companies to provide clear and properly formatted information tallying executive comp.
As one commentator noted, obscure disclosure of compensation derives from “executives and their boards of directors [sensing] a public perception of a moral problem.” Is over-compensation a moral issue? If so, will SEC-driven disclosure shame corporate America into a more moral posture?
These are serious concepts to be pondered by both the SEC and corporate management. Representative Barney Frank has introduced “The Protection Against Executive Compensation Abuse Act” in Congress, which would require of public companies: shareholder approval for executive compensation plans; claw-back provisions allowing companies to recapture compensation where subsequent financial results are disappointing; and, shareholder approval of parachutes related to acquisitions.
Such substantive interference with corporate governance, by federal legislation, is not in our legal tradition. But the sense of outrage, driven by excessive compensation, may change all that. It may be that these new rules had better work, or we will be facing a more Draconian legislated solution.
Stephen M. Honig is a member of Duane Morris’ corporate department in the firm’s Boston office. You can reach him at firstname.lastname@example.org.