The firestorm in Washington that translated into new legislation and regulations governing executive compensation will intensify the heat and scrutiny over pay packages in 2011 and beyond, as provisions of Dodd-Frank begin to take effect some as early as January.
Among other things, the financial reform bill voted into law July 21 mandates shareholder votes on golden parachutes; requires non-binding shareholder votes on compensation plans (dubbed say-on-pay); orders companies to compare CEO pay to average worker pay and to corporate performance; orders companies to have clawback policies to take back executive pay when financial performance is restated; and makes it easier for shareholders to have their own candidates for boards listed on proxy ballots.
Those proxy access rules, announced Aug. 26 by the Securities and Exchange Commission, require firms to include in proxy materials the board nominees of shareholders who have owned at least 3 percent of the company's shares continuously for the prior three years. However, a company does not have to include a shareholder slate that would replace more than 25 percent of the board.
The rules take effect in late October, making them effective for next year's proxy season.
It is a new world with say-on-pay, majority voting for proxy elections, improved access for shareholders to nominate their own candidates for the board, and the stipulation that brokers can no longer vote without express voting instructions from the shareholders they represent, said Joe Mallin, managing director of the Atlanta office of Pearl Meyer & Partners LLC.
How that will all play together could have a big impact on how boards look at executive compensation, he said. Companies will need to put everything about pay and the board's analysis of executive compensation into a few pithy paragraphs for stockholders. They are doing a good job today on providing information about pay, but not on the analysis of pay. The SEC wants companies to tell more of the whys, not just state what they are doing.
Christine Oberholzer Skizas, senior consultant and practice leader for executive compensation in the Chicago office of Towers Watson & Co., agreed. The compensation and discussion analysis in proxy statements will need to explain why boards are doing things and how the pay programs are aligned with performance, or companies will run the risk of a negative vote on compensation plan by shareholders.
The act won't necessarily change how compensation committees put executive compensation packages together, but it will certainly impact how they have to describe and explain their programs, said Oberholzer Skizas.
Mandated clawback policies will likely lead to a change in how companies structure equity packages for long-term incentive plans, and the requirements to disclose the ratio of CEO pay to both the average worker and corporate performance will create a number of challenges, she added.
But SEC has yet to determine what a clawback policy must govern or how firms must calculate the relationship between CEO compensation and company performance as well as the ratio of CEO pay to the median compensation of all company employees.
Regardless of what SEC decides, such ratios will bring unwanted visibility and confusion as firms don't typically calculate them now. For the most part, they are estimated by public interest groups or unions and often as a single group number. For example, the Institute for Policy Studies suggests the pay ratio of the average CEO to the average worker in 2008 was 319-1.
And it's not just that those ratios have to be disclosed; shareholders will have a say-on-pay through a non-binding vote on compensation plans.
The impact of these ratios with be even greater with say-on-pay, because the ratios could become a lightning rod for a 'no' vote on say-on-pay, said Oberholzer Skizas. It will be important for a company to show the difference between the grant value of stock options as required by the SEC and the actual value that is earned.
In addition, when companies talk about corporate performance, she said, they will not want to talk about pay only in relation to their own corporate performance, but they will want to talk about pay relative to a company's peer groups.
Mallin agreed. The companies with ratios outside the norm will stick out and garner unwanted attention. The CEO with the highest ratio is going to get whacked on the head and get a lot of attention whether it is deserved or not, he said. It will create pressure to keep that ratio from rising.
Oberholzer Skizas also predicts there will be problems just with calculating the ratios of CEO pay to worker pay, no matter how that definition is worded by the SEC.
That type of ratio doesn't recognize differences across industries and between companies that are global in nature, she said. How does it work if your company has a large union workforce or a workforce in the U.S., and your ratio is compared to a company that does its manufacturing overseas?
Gathering that data will be cumbersome and the information gathered will likely be inconsistent between companies.
No one seems sure how firms will recover from current and former executives any excess incentive compensation paid out when corporate financial performance is restated.
The clawback rules go much further than what most companies do in their clawback policies now, so a lot of the devil will be in the details, said Ellen Odoner, corporate partner and head of the Public Company Advisory Group which focuses on SEC disclosure and corporate governance issues at the law firm of Weil, Gotshal & Manges LLP in New York.
What do you do if you need to take back pay and it violates an executive contract? asked Odoner. And what will it cost you to sue an executive whose conduct was innocent and you need to try and recover $2,000?
Oberholzer Skizas also sees problems with clawbacks.
With clawbacks for recovering pay going back three years, that will potentially change how companies grant incentives, she said. I believe compensation committees will require more mandated deferrals of LTI or require that equity gains from LTI be held in trust accounts until that three-year period passes.
It's also unclear how some other provisions of Dodd-Frank will play out.
For example, the frequency of say-on-pay votes at each company will be every one, two or three years, depending on how shareholders vote on that issue every six years.
Further, brokers will now be barred from voting for shareholders in director elections, compensation votes and any other significant matter as determined by SEC.
That adds an unknown element and uncertainty both to board elections and compensation votes. If you factor out the usually favorable broker votes, all those votes could be challenging, Odoner said.
James Reda, founder and managing director of James F. Reda & Associates LLC in New York, agreed.
With this bill, Congress is letting the market decide what's best and reserving for the SEC the role of oversight, said Reda. It is going to let shareholders and the market put a brake on a lot of the decisions that boards have made in the past to jack up pay. I think that is a great direction to go in. You don't need the government to come into the boardroom and take control.
But corporate governance and compensation expert Charles Elson of the University of Delaware thinks the reforms will actually have the effect of hindering boards from properly doing their job of overseeing executive compensation.
I think boards will act to avoid liability not to address problems with pay packages, said Elson, director of the John L. Weinberg Center for Corporate Governance at the university.
I believe that boards will become more gun-shy and regulatory-focused and not do the real job of oversight. They will focus on avoiding liability and not on how pay relates to performance, he said. You will effectively emasculate the board and reduce compensation committees to being a paper tiger. That doesn't get you anywhere toward improving compensation policies and plans. Ultimately, pay will just creep up.
Patrick McGurn, special counsel to corporate governance and financial research firm RiskMetrics Group Inc. in Rockville, Md., has similar concerns. There is the danger that companies and boards will be so busy adopting a compliance mentality for the SEC that they will forget that their true audience is investor, he said. Exactly how the reforms might reshape executive compensation is still uncertain.
But avoiding risk and embarrassment could become the top priority of many companies, suggested Blair Jones, managing principal in the New York office of Los Angeles-based Semler Brossy Consulting Group LLC. The changes taking place legislatively and regulatory may put us on the conservative side of of risk. We will have to see what that means for business over the next five years.
The reforms don't necessarily mean lower compensation levels for executives, but they could mean that compensation won't rise as fast, and that there will be fewer pay packages that attract media attention.