State of pay

The past few months have brought a flurry of dramatic executive compensation announcements, including draconian caps on CEO compensation, and some equally dramatic about-faces. With the passage of the economic stimulus bill on February 17, however, the roughly 400 companies that received government bailout funds were forced to rethink pay practices fairly radically and without further ado.

‘If you’re a company that’s accepting Troubled Asset Relief Program (TARP) funds, you’re now subject to a set of very, very strict regulations under the American Recovery and Reinvestment Act (ARRA),’ says Deborah Lifshey, a managing director at Pearl Meyer & Partners, an executive compensation consulting firm in New York. Over the past few months, it’s become abundantly clear that government help comes ‘with a lot of strings attached,’ she says. Just how onerous the new executive compensation regime will be remains to be seen. ‘The ARRA has so many holes you could drive a truck through it,’ laments Lifshey.

One example, she says, is the limitation on restricted stock. Restricted stock grants to executives are now capped at one third of the total amount of annual compensation. The problem is that no one knows whether annual compensation means just base salary or includes other elements of compensation, such as stock options and/or perks, for example.

The 960 companies that RiskMetrics recently identified as having a ‘CEO-pay disconnect’ are also finding themselves in the hot seat, says James Reda, founder and managing director of James Reda & Associates in New York. A pay-for-performance disconnect is defined as an increase in a CEO’s total compensation when a company’s one-year and three-year stockholder returns are in the bottom half of its industry group. ‘You’re not quite sure what RiskMetrics wants, but you don’t want to find out after your proxy is published,’ warns Reda. ‘It’s not a fun time for companies on that list.’

Although life may be marginally easier for companies outside the ailing financial sector and those that haven’t been fingered by RiskMetrics, all savvy companies should be actively revisiting their pay practices. That’s because legislators today are committed to revamping executive compensation.

‘Not doing anything is not an option,’ says Steve Adamske, spokesman for Representative Barney Frank (D-MA), who chairs the House Financial Services Committee. ‘There are 700 billion reasons to be angry about the financial system. We have to have hearings, do research, and talk to stakeholders, academics and economic historians to find the path forward. But corporate boards and compensation committees need to know there’s no sympathy.’

Given the current climate, Reda urges public companies to be prepared: ‘Corporate secretaries should be alerting management that things are changing, and that what we’re doing now is going to be out of conformance next year. You should at least be raising the flag that there’s a problem.’

Restrain yourself
Although Adamske acknowledges that there’s a raging controversy over the remedies for runaway executive compensation, he points out that hearings, beginning in March, will consider new financial regulations and the appointment of a systemic risk regulator. ‘We’re finding a perverse incentive to take on risk. It’s what Barney Frank calls Heads I win, tails I break even,’ says Adamske. ‘This year, we want to look at executive compensation in context of systemic risk regulations.’

For the so-called TARP companies, Paul Hodgson, senior research associate for executive and director compensation at the Corporate Library, advises ‘enormous restraint’ in all pay decisions. ‘I would stay underneath the radar,’ he says.

At the moment, it’s often simpler to identify what not to do than to decide upon positive action. Hodgson warns that quarterly bonuses on EPS targets or other short-term incentives are mistakes. Far better, he says, are stock grants restricted for a minimum of five years and tied to a recovery in stock price or a return to profitability.

Ideas for regulating pay abound, says Gary Lutin, an investment banker who runs the Shareholder Forum (www.shareholderforum.com), but many regulatory fixes like capping executive salaries won’t deliver. ‘Fussing with labels and rules may get you elected to Congress, but it’s not going to fix things,’ he contends.

One plus is that the financial crisis  spurred debate about pay practices. ‘Compensation needs to be rethought, not just regulated,’ explains Lutin. ‘It has to be refocused on long-term, substantive performance objectives.’ Compensation practices, he emphasizes, need to be practical. ‘You have to focus on the very simple question: what are you paying the guy to do? Period. Then you have to figure out how to pay the guy to do what you want done.’

Today’s problems, up to and including the implosion of the financial sector, stem from having paid CEOs to maximize quarterly stock prices, says Lutin. He analogizes the current debacle to the Titanic’s demise. ‘Nobody stress-tested bolts, they cut back on the number of lifeboats they carried, and they ran full steam ahead knowing there were icebergs, figuring the probability of hitting one was low,’ he points out. ‘They wanted to set a crossing record on their maiden voyage.’ Similarly, CEOs at financial firms were determined to hit short-term targets regardless of risk.

Say on pay
Among the many changes on the horizon is ‘say on pay’, the non-binding shareholder vote on a company’s executive compensation practices. With the passage of the economic stimulus bill, all companies that received government bailout money are now required to implement say on pay this proxy season. For many, doing so means making substantial revisions to the existing proxy draft that was almost ready to be filed at the time the stimulus bill was signed into law.

Lifshey was surprised by this turn of events: ‘By imposing this requirement in the current year rather than prospectively, the government really tied the hands of companies that were just about to file their proxies.’ Lutin makes a similar point: ‘You can bet a lot of companies were burning up their shredders.’

What’s worse, foisting say on pay on TARP companies so suddenly deprives them of a chance to think through the issue, says Lutin. He points out that the companies acting as guinea pigs for say on pay are already mired in serious trouble.

‘The focus is going to be on punishing, not on saying, Gee, what works?’ says Lutin. ‘If you asked me a month ago, I could not have even imagined such a bad way to design a test for say on pay.’

TARP companies are not the only ones wrestling with a shareholder pay vote. As of March 1, 2009, 100 companies faced say-on-pay proposals on their proxies. Around a dozen have since had those proposals withdrawn following negotiations with shareholder proponents.

Meanwhile, a handful of non-TARP companies, including Ameriprise Financial, Occidental Petroleum and Intel, recently took the plunge, voluntarily embracing say on pay. ‘We thought it would be useful and appropriate to step in now and not waste time opposing the matter,’ says Cary Klafter, Intel’s vice president of legal and corporate affairs and its corporate secretary. Klafter is convinced that a year’s worth of experience will give Intel a leg-up should the SEC require a shareholder pay vote next proxy season.

Intel shareholders are being asked whether they approve of the compensation committee’s philosophy, policies and practices as described in the CD&A, explains Klafter. To provide more ideas on how to structure a say-on-pay proposal, Lutin and Corporate Secretary launched the ‘Say on Pay 2009 Forum’ at www.crossbordergroup.typepad.com/say_on_pay_forum, an online resource with examples of how public companies are approaching this issue and comment from a range of stakeholder groups.

Another place to look for clarity is the UK, which embraced say on pay in 2002. ‘Shareholders don’t want to be in the boardroom and on remuneration committees,’ says Deborah Gilshan, corporate governance counsel at Railpen Investments in the UK. ‘That’s the directors’ role.’

At the same time, Gilshan contends that say on pay and similar corporate governance reforms would improve shareholder democracy, and make investing in US companies a better experience for UK and European institutions.

Priority number one
Obviously, companies are concerned about the outcome of say-on-pay votes and what high negatives might mean. ‘It’s not a majority against you that’s going to set off alarm bells,’ says Klafter. ‘Anything beyond 20 percent to 25 percent, you’ll want to delve into it.’

Experts agree that say on pay should top a corporate secretary’s agenda when addressing the board and compensation committee. Lifshey recommends considering say on pay a year in advance because a vote during the 2010 proxy season will be a referendum on the practices of 2009. In other words, says Lifshey, ‘as compensation committees make their decisions this year, they have to know the decisions will be under the microscope and may well be subject to a shareholder vote next year.’

Francis Byrd, managing director at the Altman Group, a Manhattan-based proxy solicitation firm, agrees. ‘I’ve told people that say on pay is coming, and there’s no sense trying to stop it,’ he says. ‘You can’t stop the sun from rising or waves from hitting the shore. It’s best to be prepared.’

That said, many TARP companies are unhappy, arguing against ‘pay by regulation’, observes Richard Ferlauto, director of corporate governance and pension investment for the American Federation of State County and Municipal Employees union. Corporate secretaries at TARP firms have made calls to Ferlauto to discuss ways of gaining more flexibility. ‘My response is: start helping shareholders think through what a better pay model is, and then we’ve got a basis for discussion,’ he says.

Even as executives bemoan say on pay, many compensation consultants and other experts believe that it’s only the opening salvo. ‘After TARP and the bad bets we’ve seen, we’re seriously wondering whether say on pay is enough,’ says Adamske.

When President Barack Obama introduced a $500,000 cap on executive compensation, the proposal led to much consternation in boardrooms across America. Although absolute pay caps were eventually cut from the stimulus bill, they are still a subject of frequent and fervent debate. Ferlauto points out that the value of salary caps is largely symbolic. ‘I see salary caps as being a very stern signal to compensation committees that they’ve got to reform their current pay practices in a very big way,’ he says.

Salary caps are the issue, but Reda notes that there are many red flags in executive compensation packages today. For instance, should a company have a CEO whose compensation is rising while performance is declining, that’s bound to attract notice. Another warning sign, says Reda, is tying less than 50 percent of the CEO’s long-term incentive pay to performance.

Reda also anticipates that shareholders and proxy governance firms will be scrutinizing companies with tax gross-ups for golden parachutes or other severance agreements. A gross-up occurs when a company pays the excise taxes that are owed by executives for severance benefits or perks.

Akin Gump Strauss Hauer & Feld notes that roughly two thirds of S&P 500 companies offer gross-ups. And according to a RiskMetrics survey of 2008 proxy statements, the average golden parachute at companies offering gross-ups (excluding the cost of the gross-up) was approximately 38 percent more than the average golden parachute at companies without tax gross-ups. That same poll also found that 76 percent of institutional investors considered gross-ups ‘problematic’.

The death of gross-ups
Ferlauto argues that taxes on severance and other perks should ‘be treated as ordinary income, and the executives themselves should pay the taxes.’ He notes that there are around a dozen shareholder proposals this proxy season asking companies to discontinue gross-ups. He also believes shareholders will be closely watching ‘golden coffins’ or hefty payouts to an estate after an executive dies.

Finally, many companies are tinkering with worthless stock options to make these grants deliver value to executives. Paul Schulman, executive managing director at the Altman Group, estimates that there are roughly 15 shareholder proposals considering option exchange programs to deal with underwater stock options. He warns that implementing such a plan without shareholder approval could result in withhold votes against directors or might mean that shareholders refuse to support future equity plan proposals.

What lies ahead
Ferlauto finds fault with the prevailing compensation model, which aims to recruit and retain executives by comparing them to their peer group. Instead, he says, ‘we really want to look at the value added by the CEO or named officer over time. We want to see metrics that look at three-to-five year performance. Things like return on invested capital make sense at that level.’

As positive examples, Ferlauto highlights two current shareholder proposals that aim to expand the time horizons for gauging an executive’s success. In one shareholder proposal, companies are asked to create bonus banks to escrow bonuses for a three-year period.

And in the second proposal, executives are awarded stock grants or options, but a substantial portion of the award is held for at least two years after the executive leaves the company. Such an incentive, says Ferlauto, encourages the CEO to find an able successor and to orchestrate a smooth transition.

Lutin supports Ferlauto’s point of view and applauds these efforts. ‘The general attention to compensation among thoughtful and responsible people is already having a very significant effect in causing people to rethink the whole approach,’ he says. In addition, he urges corporate secretaries to make the most of whatever opportunities they are given in order to find ways to improve pay practices.

‘If you’re a TARP company you have to focus on compliance. Do the paperwork this year and whatever else you must, and don’t do anything to create further public outrage,’ concludes Lutin. As for non-TARP companies, he has this to say: ‘This is one of the great opportunities in modern history to think how to rebuild things to get them done right. You’ve got to restore common sense to compensation.’