Monthly Archives October 2012

Keeping Dodd-Frank in Perspective: Lame Duck Session for the SEC

Posted by Jeff McCutcheon on October 31, 2012  /   Posted in Compensation Committees

ducksAs the election approaches and candidates swap jibes at each other, we’re curious to see how the results affect executive compensation regulations. Up to now, the SEC has been sluggish—to the point of inertia—to adopt final rules for the “gang of four” regulations outlined in the Dodd-Frank act. Troubling though it is, their inaction has not slowed us down a bit.

Some background: Enacted in July 2010, Dodd-Frank is a behemoth of a law, registering at a whopping 2319 pages. The table of contents alone sprawls to fifteen pages. As you can imagine, the thicket of financial regulations are dizzying in number and complexity. And yet…the devil is in the details. Congress left it to the Security and Exchange Commission to sort out the nitty-gritty, including the more controversial issues. As of July, only a third of the rulings had been issued.

With respect to executive compensation, the act provided for a number of executive pay “reforms” of clawbacks, independence standards and increased company disclosure. The SEC has adopted final rules for “say-on-pay,” golden parachutes, and compensation committee independence standards. But the SEC appears to have run out of steam. Specifically, the whole “gang of four” is still up in the air (pay-for-performance, hedging policy, clawbacks and internal pay ratio.)

In a presentation to the NACD in July, Commissioner Troy A. Paredes said he was “troubled” that the Dodd-Frank regulatory regime went “too far.” His comments recognize that the legislation, if acted upon by the SEC, could have regrettable consequences not envisioned by the drafters. We agree with the Commissioner’s conclusions and share his concern regarding the executive pay regulation. However, we are less comfortable with the executive branch’s passive resistance to legislative action.

In our view, the SEC is playing “wait-and-see” until the election results come in, reticent to sift through the remaining Dodd-Frank executive pay issues in case a change in the political winds means a repeal (unlikely) or incremental reform of the problematic legislation (hopefully).

Still, we’re not holding our breath. Though we’re more than ready to help our clients navigate the murky waters of Dodd-Frank whether the political tides change in November or not, we hardly need to wait around to act on our experience and knowledge to devise winning compensation strategies. Politics aside, we’re on firm ground as far as that’s concerned.  When all is said and done, we believe that executive compensation should be driven by the needs of the company and the desire to enhance shareholder interest, not what is coming out of Washington.

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Recommended Business Books : October “Board Break”

Posted by board-advisory on October 19, 2012  /   Posted in Compensation Committees

booksThe Power of Habit: Why We Do What We Do in Life and Business by Charles Duhigg

Duhigg divides the book into three sections: The Habits of Individuals, The Habits of Successful Organizations, and The Habits of Societies. This is a very, very informative and entertaining book. It reminds me a great deal of The Checklist Manifesto: How to Get Things Right by Atul Guwande, in that the ideas contained in both are “duh, why didn’t I think of that?” simple but profound. He uses hundreds of examples of how we develop good and bad habits and how we can improve by simply understanding the science behind our habitual behavior.

George F. Kennan: An American Life by John Lewis Gaddis

This is the best biography of 2012 and perhaps of the last several years. Kennan was, of course, known as the architect of the Cold War, through his “long telegram,” autonomous letter from X, and other writings that influenced policy makers and gave the blueprint for the containment of the Soviet Union. Gaddis, the author of several books about the Cold War, tells us about the human side of Kennan but also brilliantly covers an important and challenging time for the U.S.   You will enjoy this book even if you are either already versed in 20th century foreign relations or simply don’t think you would want to know this much about it. It is that well-done.

 

The Risks of Accelerating Executive Bonus Payments for Tax Benefit

Posted by Jeff McCutcheon on October 19, 2012  /   Posted in Compensation Committees

accelerateWith continuing uncertainty regarding the nation’s finances fueled by current 2012 election banter, executives are faced with the temptation to accelerate executive bonus payments to be paid in 2012 to avoid increasing income tax liabilities.  If Congress does not act, the typical executive could save in excess of 5%[1] of the amount of the bonus payments.  In reviewing these requests, board members are advised to consider the old adage, “There is no such thing as a free lunch.”

Companies have accelerated compensation payments to executives in the past to avoid tax rate changes.  Most notably, in late 1993 a significant minority of companies accelerated executive bonus awards that otherwise would have been paid in 1994, to avoid the uncapping of the 1.45% Medicare tax.  Unfortunately, tax increases under presidents George H.W. Bush and Bill Clinton did not provide the same opportunity for tax planning.

With the risk of Bush-era tax cuts expiring, board members could be asked to consider acceleration of incentive payments for their organizations.  Should your board be asked to weigh in on this issue, we suggest you consider the following.

  • While the request is typically for the benefit of senior executives, the benefit of accelerating income may go well beyond the executive ranks.  Nearly all full-time wage earners could face a tax increase of at least 3%.  Given the public concern over exceptional treatment of executives, particularly the CEO, we suggest boards discuss whether a limited action only benefiting senior management is appropriate, or whether an all-or-none approach may be warranted.
  • While the executive may save 5% in taxes, the acceleration has an economic cost to shareholders.  It is objectively fair to assess the economic cost of the accelerated payment at the company’s cost of incremental debt.  While some companies are currently experiencing very low borrowing costs, for others, the 2 ½ month advance payment will likely have an economic cost to shareholders of 2-3% or more.  While this economic cost is not an expense reported on the summary compensation table it is a cost incurred by the company and should be part of an informed discussion.
  • There are consequences of accelerating payment in terms of making individual or organization performance assessments and in terms of protecting the company in the event of and termination of employment prior to the end of the performance period.  Board members should consider whether contractual protections are warranted to clawback or adjust any award made in error or made prior to a having a full appreciation of company and individual performance over the entire performance period.  Further, an advance payment that is contingent upon later results could conceivably constitute a loan specifically prohibited by Sarbanes-Oxley[2].
  • There may be risks to the company’s public image and brand.  Given the level of public scrutiny currently provided executive compensation, it is not inconceivable that the act of taking exceptional action to avoid taxation for executives may draw the company and the board into a public debate they cannot win.  Keep in mind that the rationale for the acceleration would likely require some narrative in the Compensation Disclosure and Analysis section of the proxy statement.
  • Lastly, there could be tax consequence with accelerated payment.  Most companies’ 162(m)-qualified plans require compensation committee certification of results and prohibit “positive discretion.  Any acceleration could potentially jeopardize the company’s tax deduction for the award.

Clearly, we do not consider the acceleration of payments to be a “slam dunk” decision.  While it may be appropriate and non-controversial under many circumstances, such a decision can only be made by a board when benefitting from a full appreciation of each organization’s unique facts and underlying economics.

 

–          Jeff McCutcheon

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[1] i.e., Reversion of the top tax bracket from 35% back to 39.6%, plus the impact of reinstatement of the phase out of itemized deductions.

[2] Section 402 of Sarbanes-Oxley prohibits companies from making loans or arranging credit for named executive officers.  Public companies should seek legal advice prior to accelerating payments to executive officers.

Board of Director Compensation Trends: “Follow That Bandwagon”

Posted by Paul McConnell on October 19, 2012  /   Posted in Compensation Committees

Originally published in Board Member Magazine (2012 Q4).

bandwagonBoard Director compensation continues to evolve. We have seen director pension arrangements arrive and depart (1980s), board compensation using stock options have had their time in the spotlight (1990s through the mid-2000s), and now board meeting fees are waning. The clear trend and dictate of proxy advisory firms is to eliminate board meeting fees, set board pay at median, and pay at least 50% of the total in the form of shares held until retirement from the board. However, before we jump onto that bandwagon headed down the path of least resistance, perhaps we should consider for a moment reasons for paying directors in a specific form or amount.

Annual comparisons of director pay levels have led to a focus on an elusive “median director compensation level.” As one-half of companies find they are below median, they increase director pay and find a corresponding increase in the new average pay level. Unlike the fictional Lake Wobegon, we can’t all be above average. Rather, since the required level of reputation risk, personal energy, and talent commitment varies dramatically between boards, so too should remuneration.

The trend in form of pay, from options (incentive) to shares (investment), is easily understood in the context of the director’s role. An unintended consequence of options is that they can pit directors against all other investors with respect to the timing of exercise. While options may reward equity growth, they are inherently biased against dividends and can, under certain circumstances, provide an imbalanced reward for risk since the investment downside is limited to any embedded gains. More important, as a reward for price appreciation, the concept of any incentive may work directly against the director’s role—to provide risk oversight on behalf of investors.

Executive management is tasked with developing long-term strategies, executing those strategies, and managing the day-to-day enterprise. With the separation of capital and management inherent in our modern capitalist environment, the role of the board should be focused on ensuring the risks taken and strategies employed by management are reasonable, that controls are in place to avoid misuse of investors’ assets, and that the best executive talent is in place to lead the effort.

By establishing incentives for directors, we are distorting the balance in their assessment of risks by encouraging results without a corresponding risk offset. Incenting directors to improve performance may also unintentionally encourage boards to interject themselves into areas rightfully in management’s domain, at the expense of the board fulfilling its core responsibilities. On another front, what most analyses of director pay seem to avoid is any consideration of a director’s role in light of the value proposition companies communicate to their investors. Clearly, the board of a company held by a private equity fund will have a different role than a board of a company held primarily by retail investors. Similarly, an investor in early-stage pharma will have dramatically different expectations of the board than the same investor viewing a commercial real estate REIT investment. Just as the role of the board member should reflect these investor expectations, so should the pay.

Without belaboring the point any further, we have to ask, “How should directors be paid in the modern environment?” Clearly, each board is unique and must refine its objectives and define its role vis-à-vis investors and management. The role of a board of an immature, fast-growing company will clearly be different than that of a mature company. Chances are that the management team and the investors will look quite different as well. However, the concept of how to pay the board remains unchanged.

In summary, we believe boards should:

1. Pay an amount that reflects the board’s talent needs, as well as the level of reputation risk and commitment asked of the directors; this may involve paying well above or below industry standards when appropriate.

2. Pay in a form that reflects the board’s mission and does not create an imbalance with respect to risk oversight.

3. Implement ownership and shareholding guidelines that are consistent with the company’s message to investors.

This simply suggests the use of common sense, taking a fresh look at intent prior to racing to the trend. After all, it was Albert Einstein who observed, “The man who follows the crowd will normally go no further than the crowd.”

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© 2012 Board Advisory.
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