CEO Pay Ratio Disclosure, Rules & Regulations

Posted by board-advisory on April 29, 2014  /   Posted in Compensation Committees

Matt Ward’s comments below are excerpted from a Mini-Roundtable on CEO Pay Ratio Disclosure published in the April-June 2014 issue of Risk & Compliance Magazine.

RC: What are the key issues and arguments in the debate over CEO pay disclosure?

GoldenRatioWard: Probably the biggest challenge is defining who the median employee is and calculating their pay. The rule is deceptively simple at first glance, but implementation can be fraught with complexities depending upon the company. Timing is crucial, and despite what looks like a long lead time, the wise firm would act sooner than later on this issue. Under the proposal, a company would be required to disclose the pay ratio with respect to compensation for its first fiscal year commencing on or after the effective date of the final rule. Companies would be permitted to omit this initial pay ratio disclosure from their filings until the filing of the annual report on Form 10-K for that fiscal year or, if later, the filing of a proxy statement following the end of that year, provided the proxy is filed in a timely manner – within 120 days after the end of the fiscal year. For example, if the final requirements were to become effective in 2014, a calendar-year company would be first required to include pay ratio information relating to compensation for fiscal year 2015 in its proxy statement for its 2016 annual shareholder meeting. Thankfully, the proposal would also provide a transition period for newly public companies. For these companies, initial compliance would be required with respect to compensation for the first fiscal year commencing on or after the date the company becomes subject to the reporting requirements. As a result, pay ratio disclosure would not be required in a registration statement on Form S-1 for an initial public offering or a registration statement on Form 10.

RC: In 2013, the SEC proposed new pay ratio rules, including rules governing the disclosure of CEO compensation. Could you provide a brief outline of these rules, and when companies can expect their implementation?

Ward: Under the proposed rule, the SEC to amend its executive compensation disclosure rules to require disclosure of the ratio of the CEO’s ‘total compensation’, as disclosed in the proxy statement, to the median amount of total compensation for employees of the issuer. Under the proposed rules, all employees of the issuer and its practically all employees of the company must be included in identifying the median employee’s annual total compensation. This includes all full -time, part-time, seasonal or temporary workers employed by the company or any of its subsidiaries “Aside from union pension plans and a small number of other, investors seem to be largely indifferent to the rules.” as of the last day of the company’s prior fiscal year. Despite concern over the compliance costs of including foreign employees in the determination, the proposed rule extends to non-US employees of the company and its subsidiaries. Workers not employed by the company or its subsidiaries, such as consultants or temporary workers employed by a third party, will not be required to be included in the determination. Again, most importantly, the proposed rule will only apply to those employees employed by the company on the last day of the company’s prior fiscal year.

RC: What factors are behind the introduction of these new rules? How have they been received by businesses and investors?

Ward: The rules, promulgated as required by the Dodd-Frank Legislation, took quite a while to come about. The SEC likely had hoped that the legislation would be repealed or amended. The pay ratio provision of the legislation came about from a longstanding criticism that CEO pay in the US was unreasonably high as a multiple of employees, especially when compared with other countries’ practices. Critics used to cite Japan as an example of successful and powerful companies that managed to keep pay of the CEO at a much lower multiple of the typical worker. However, savvy observers pointed out that indirect CEO pay at Japanese companies such as numerous servants, private jets and mansions around the world was not measurable and quite considerable. Despite this, the criticism was a regular part of annual executive pay disclosure cycles ever since. After the financial collapse of 2008, the groundswell of support for anti-CEO pay legislation was unstoppable. It is safe to say that, like the SEC, businesses and investors had hoped that the legislation would be repealed or amended, but so far no such luck.

Timely manner

RC: What steps can firms take to prepare for the proposed rules? What guidance has the SEC provided?

Ward: We think that companies should not procrastinate on this issue and should at least run some initial calculations now to get ahead of the curve on choosing a methodology. While it is obvious for very large multinationals to address this, even a mid-sized firm with far flung operations needs to act in a timely manner. In fact, it is the small to mid-size firms that could be blindsided by waiting too long to address this calculation.

RC: In determining pay ratios, companies must first determine the salary of the ‘median employee’. What methods can firms use to determine this value? What sampling methods have been approved by the SEC?

Ward: The SEC permits public companies to select a methodology for identifying the median employee under the proposed rule. The proposed rule does not set forth a methodology that must be used to identify the median employee and permits companies the ability to select the method that works best for their own facts and circumstances. For example, the company could identify the median by calculating the total compensation per employee under existing executive compensation rules or through a statistical sampling of its employee population. To address commenter concerns about the compliance costs of calculating total compensation per employee under existing executive compensation rules, the SEC will also permit the usage of a ‘consistently applied compensation measure’ in identifying the median. For example, companies could identify a median employee by using more readily available methods such as total direct compensation – such as annual salary, hourly wages or other performance-based pay – or cash compensation and then calculate that median employee’s total compensation in accordance with executive compensation rules. Compensation for a permanent employee who did not work a full year – such as a new hire or an employee who took an unpaid leave of absence – would be permitted but not required to be annualized. However, the company would not be permitted to annualized compensation for temporary or seasonal workers. The company would be given the flexibility to measure compensation by choosing a method that best reflects the way it pays its employees, as long as that method is consistently applied.

RC: What impact do you believe the new rules will have on business practices, particularly in terms of structuring compensation packages? Do you expect the rules to significantly impact levels of executive pay?

Ward: We don’t believe the rules will have any meaningful impact whatsoever on pay levels for CEOs or median workers. The flexibility for companies in choosing methodologies and determining the median employee’s pay essentially renders peer-to-peer comparisons useless, even in industries with very close comparability of firms, such as oil companies, airlines, and so on. When coupled with the cost to comply, hopefully there will eventually be support for repealing the legislation. We have had clients estimate they will need to add full-time equivalent employees just to gather this data.

RC: What final advice can you offer to companies on the proactive steps required to address the issue of CEO pay ratio disclosure in today’s business world?

Ward: The SEC has provided great flexibility in applying the proposed new rules in each specific company. However, there are still going to be data collection issues and meaningful choices to be made in carrying out the calculations and choosing a methodology. We recommend that companies exercise the due diligence up front to form a task force of accounting and compensation professionals from both inside and outside the company to make the most well-informed choices. Thereafter, the annual calculation will be much easier and subject to change only to comply with rule changes or industry trends in making the calculation.

For a full copy of the article, download here: R&C CEO PAY RATIO DISCLOSURE

Annual Executive Compensation Levels: Where We Veered Off the Road

Posted by Paul McConnell on August 30, 2013  /   Posted in Compensation Committees

[Originally published in Board Member Magazine 2013 Q3.]

VeerIn our last article, we noted that somewhere along the way, executive compensation veered off the road.  Executive compensation plans became too complex, isolated from true performance and downside risk, and in many cases, total compensation was just too high.  While there is no shortage of blame to go around, we find one obvious flaw is the prevailing practice of treating executive equity as annual compensation.

Assume that you had money to invest in a business and I was going to run it for you.  I’d get a salary and bonus for my labor.  You might also give me shares of the company to align our interests and ensure I was fully “bought in” to the venture. It would be clear between us that the stock was my “share of the deal” and would remain invested with the company until we parted ways.

As an unintended consequence of the thirty-year effort by the SEC to improve the oversight of executive pay, we have effectively created a bias against the “share of the deal” approach to equity.  To provide greater transparency and comparability, the SEC requires companies to report all remuneration in annual terms – even if it is not an annual event.  Consequently, we stopped thinking about executive equity as a “share of the deal” and we fell into the mindset that it was all annual compensation.

Obviously, equity awards have a compensatory effect, and are a key part of an executive’s total pay.  The best talent will seek opportunities where they can share in the value they help create.  However, by seeing executive equity as a piecemeal annual reward rather than as one’s share of the deal we have created the perception that the equity is indeed a cash equivalent, to be exchanged for cash when needed.

From an owner’s perspective, the critical issue should not be the annual increment of equity, but the total equity commitment necessary for each key executive role to achieve the following investor objectives:

•        Providing an attractive package to recruit and retain the management talent needed;

•        Matching executive performance and wealth more closely to the company risk horizon; and,

•        Aligning executive wealth proportional to investor gains or losses.

Unfortunately, in the current “tail wagging the dog” scenario, we find companies think about equity in annual terms because we report it and compare it on annual terms.  This has the perverse impact of:

•        delaying the formation of a substantial equity position for several years in order to comply with annual compensation practices;

•        rewarding volatility by granting more equity (as a percent of outstanding stock) when the company does poorly and fewer shares when the company is highly successful; and,

•        thinking of equity as a cash equivalent that can be sold during the term of employment.

It makes far more sense to manage equity decisions using established target equity levels for each of the key executive roles.  Achieving the target ownership may be accomplished in one step (e.g., in a turnaround), or parsed out over time.  The key difference, however, is that executives and investors know the annual grant is not a bottomless pit of investor dilution.  Periodic grants would represent the execution of a strategy rather than an attempt to chase some market median practice.

With this approach companies, executives, and investors benefit three key ways:

•        We answer the question “how much is enough?” — the elephant in the room nobody currently wants to talk about;

•        We simplify pay by distinguishing an illiquid career investment from annual cash pay.  This change in perspective removes much of the concern driving the Dodd-Frank pay-ratio debate; and,

•        We assure all parties that executive management is a long-term investor in the company, with upside and downside risk, and full accountability for the economic consequences of risks through a sizeable stake held throughout their career.

It is time we begin to think and act like owners and treat equity as if we were making partners out of management – by granting them a piece of the enhanced value of the business over time, not doling out shares simply to reach a “competitive” amount of annual compensation.

Download this article in the PDF format.

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.

Download as PDF

Dodd Frank: Another Chance for the SEC to Get Pay For Performance Right

Posted by Paul McConnell on October 21, 2010  /   Posted in Compensation Committees

The Dodd-Frank bill contains two new disclosure requirements regarding executive pay: the ratio between the CEO’s compensation and that of the median employee, and the relationship between compensation actually “paid” to executives and company stock performance.

The new pay ratio is flawed on many fronts: it ignores organizational scope and size, it can be biased by outsourcing lower-paid work, it ignores the inordinately large role of benefits in the pay of lower level employees, and most importantly, it ignores the differences between guaranteed compensation and the risk inherent in equity based pay.

In contrast, the disclosure of pay in relation to performance has the potential to present a true picture of executive pay from which shareholders and the public can draw meaningful comparisons.  The key is how the SEC eventually defines “pay”.

The Amounts Shown In The Summary Compensation Table Are Not Pay. Disclosure of executive pay has vastly improved over the last two decades.  We now have accurate data on all the relevant components of compensation.  While this data is extremely useful in designing competitive pay opportunities, the current required format does not show what executives actually earn — or how that pay might relate to company performance.

Cash bonuses are typically paid for financial performance versus targets, rather than for shareholder gain.  Presumably, the cash payment relates to drivers ultimately reflected in stock price, but not necessarily reflected in the current year stock price.

For most executives, the largest portion of their reported pay is the disclosed value of stock awards.  For performance based stock, the disclosed value is a “target” value on the date awarded.  It does not reflect the actual number of shares earned or the realized value of the stock over the requisite holding period.  Similarly, options awards are shown as the expected value from a probability distribution, not the actual realized gains.

These valuations were never intended to represent the actual value the executive would receive, and were only intended to satisfy the accounting world.  Consequently, using current proxy data to explain the link between pay and performance is like using a baseball slugger’s “at bat” statistics to explain the team’s won/loss percentage.

The Best Comparison Comes From a Multi-Year View of Realizable Pay. To best evaluate board decisions regarding pay and to test the overall alignment of executive pay to investor gains, one must compare the value actually realized by the executive to the returns of investors.  For this purpose we look at the cumulative salary and cash bonuses received over a multi-year period (e.g., five years) plus the ending-period value of actual stock awards granted, stock acquired from previous awards, and embedded option gains (e.g., the paper profits).

Such pay comparisons are extremely important when evaluating the relative wisdom of a board and their executive pay decisions.  By looking at the cumulative effect of decisions over a 5 year period – perhaps the shortest time period when executive effectiveness can be reasonably assessed – management and the Board can more effectively establish for investors the degree of alignment between executive rewards, business strategy and shareholder gains.

The data required to perform these calculations are readily available through existing public company disclosure in proxy statements, related SEC filings, and commercial data sources.  The general public could produce these calculations; however, use of multiple data sources and obscure reporting rules makes it difficult and time consuming.

Our investor and board clients have found this longer-term pay comparison to be an extremely effective tool for understanding the compounding effect of compensation decisions over time, and as an aid in calibrating prospective equity and cash incentive decisions.  Perhaps more importantly, the analysis serves to bridge the communications gap between investors, the board and executive management by simplifying pay arrangements in terms everyone can easily grasp.

Conclusion. Much of the public’s understanding (or misunderstanding) of executive pay is driven by the annualized and hypothetical values disclosed in proxies.  Regrettably, the format of the SEC disclosure also shapes how many boards make annual executive compensation decisions.  The SEC will not release new rules until the second quarter of 2011, but regardless of the reporting form eventually chosen by the SEC, forward thinking Boards should supplement their CD&A disclosure with a true pay for performance analysis such as that presented above.  For most boards this can convey a critical story line for investors wanting to understand how and why executives are rewarded.

Download this article in a PDF format.

Paul McConnell and Jeff McCutcheon are Managing Directors of Board Advisory, LLC

© 2010 Board Advisory.
^ Back to Top