Vol. 51, No. 11
The new federal rules for disclosing executive pay and perks in plain English will mean a major new responsibility and a higher profile for HR.
The new federal rules requiring detailed public disclosure of top executives’ compensation are putting HR professionals in the spotlight—not for the size of their paychecks but because of their important role in assembling the information.
In one of the most significant actions affecting business practices since the Sarbanes-Oxley Act of 2002, the U.S. Securities and Exchange Commission (SEC) this past summer adopted rules designed to give investors and others a clearer picture of what publicly listed companies pay their top executives and the members of their boards of directors.
While such information is available in documents such as proxy statements and annual reports issued by publicly traded companies, it’s usually not easily understood by individual shareholders because it is couched in complex financial terms.
That’s no longer allowed. Beginning with annual reports filed on or after Dec. 15, executive compensation information must be described in “plain English,” the SEC has ruled. That mandate supports the agency’s drive to “help investors keep an eye on how much of their money is being paid to the top executives who work for them,” as SEC Chairman Christopher Cox explained when the disclosure regulations were proposed in January.
Ultimately, the new rules will require more effort from HR executives. But they also will play to HR’s strengths, experts say, and place these executives in position to play an even larger role advising and working with boards of directors on key executive compensation issues.
The Biggest Changes
The new rules do not impose significant changes in the amount of executive compensation being disclosed, but they substantially alter the organization of information to make it much clearer.
To that end, the rules specify several key points, including the executive compensation data that must be provided in proxy statements; the executives for whom such information must be provided (typically the CEO, the CFO, the three other highest-paid executive officers and the directors); and the ways in which the information is to be set forth.
Nearly all of the compensation figures have been available in proxy statements under the old disclosure rules. But the information has been “presented in such a way that you really have to piece things together, and really dig and comb through the filings, to be able to determine what the total compensation is,” says Jack Dolmat-Connell, president and co-managing partner of DolmatConnell and Partners, a compensation advisory firm in Waltham, Mass.
Once the new proxy statements begin appearing early in 2007, the compensation information should be much easier to locate, understand and compare.
The most significant of the new features now required in proxy disclosures under the SEC rules include:
- New tables for organizing various components of current and future executive and director compensation.
- New guidelines for identifying and placing values on perquisites.
- The compensation discussion and analysis (CD&A) section, which must be written in understandable English.
The “plain English” and CD&A requirements, according to many compensation experts, will draw directly on HR executives’ strengths. The purpose of the CD&A is to communicate a company’s compensation strategy; the designs, policies and practices it uses to execute the strategy; and the degree to which that execution succeeds. Throughout the rule’s 400-plus pages, the SEC makes it clear that the CD&A and the narratives accompanying the tabular disclosures should avoid legal jargon, boilerplate language, and highly technical business and accounting terminology.
The CD&A, which is authored by management and subject to compensation committee approval, focuses on intent. In many instances, crafting the CD&A will require soul-searching at the highest level of the organization: What have we invested in our top talent, and what is our return—and our shareholders’ return—on that investment?
“It’s almost as if these new rules are what HR executives should have been preparing for throughout their career,” says Myrna Hellerman, senior vice president for Sibson Consulting in Chicago. “Who else but HR should know this? Who else but HR should be taking the lead role in describing the organization’s compensation policies and practices?”
A Triumvirate of Tasks
Three areas of major change—the CD&A, the tabular disclosures and the perk valuations—will be major challenges for HR, according to indications from compensation, legal and HR professionals. In a webcast hosted by Buck Consultants soon after the rules were adopted, 64 percent of the 175 HR and compensation professionals who took part identified the CD&A section as the toughest facet of the new rules.
“The CD&A is already making some companies rethink their entire compensation program,” says Suzanne Hanselman, a partner in the Cleveland-based law firm Baker Hostetler and a member of its securities and corporate governance practice team.
The reason the CD&A could be troublesome, says Ed Hauder, a Chicago-based Buck Consultants principal, is that it “asks companies to discuss every element of executive pay and explain how those elements relate to the company’s performance during the past year.” The SEC’s guidance on this narrative is that it be “principles-based,” which means that senior management teams have some leeway in crafting their narratives.
Some HR executives and management teams prepared CD&A drafts for their compensation committees’ autumn meetings in hopes of avoiding major last-minute revisions during the drafting of current proxies—the proxies that will go out in the coming months with the 2006 annual reports.
“If I were the chief HR officer,” Hellerman says, “I would write the CD&A or have someone from the corporate communications group help me write it. And then I would run it by the legal department to make sure I covered all of the items I needed to cover. But I would not let them edit it for style.” The CFO and the CEO also ought to review the document, which in most instances will be subject to certification by both officers.
The tabular disclosures are defined more explicitly than the CD&A but nonetheless will present data-collection difficulties. Often, the information that seeds the tables is housed in disparate information systems “owned” by distinct functions such as HR, finance and legal. For that reason, Hellerman advises HR executives to take on a “project manager” role in overseeing the data-gathering process.
Moreover, the data in some tables can affect the information in others. For example, the accuracy of the Summary Compensation Table—designed to make it easier for shareholders and others to compare executive pay packages among all public companies—depends on the accuracy of several other tables and calculations, including a new definition and valuation process for perquisites.
The rules define a perk, or “personal benefit,” as something that is not “integrally and directly related to the performance of an executive’s duties” and “confers a direct or indirect benefit that has a personal aspect.”
In the four weeks following the new rules’ adoption, Hanselman received more questions from HR executives about perks than about any other facet of the new regulations. “Defining what is and what is not a perk will create some difficulties,” she says. “And accounting for perks can create headaches because the information is often located in different functions.”
With executive compensation details more accessible to ordinary investors, some companies—particularly those that have been performing poorly—are likely to feel a backlash from shareholders. “Executive pay levels are related more to company size than they are industry, so the bigger firms likely have the biggest multiples,” says Dolmat-Connell. “The biggest companies that are the poorest performers are likely to experience the biggest backlash.”
Employees bruised by recent layoffs, pay freezes, benefit reductions or benefit cost increases are also more likely to react negatively to the new disclosures. Little of that anger will be directed at HR executives, however; most are not in the ranks of their companies’ top five highest-paid executive officers. Dolmat-Connell estimates that in 95 percent of publicly listed companies the top HR executive is not among the top earners.
Labor unions are likely to mine the disclosures to support their negotiating positions, says Scott Olsen, principal and head of the compensation practice at PricewaterhouseCoopers HR Services in New York.
Bruce Ellig, an adviser to corporate boards on compensation matters and author of The Complete Guide to Executive Compensation (McGraw-Hill, 2nd edition due in 2007), raises the possibility of another type of reaction. He says employees or others who compare the summary compensation figures in the proxy statement with total pay figures in the business press may be confused if they see that the numbers don’t match. The total compensation number in the proxy represents a combination of past (salary), present (bonus) and future (grants of stock) compensation. Most news accounts cite pay for a given year.
Ellig suggests that the SEC add another table to the new proxy disclosures—a table that would quantify total pay received in a given year.
The First Wave of Suggestions
Even before proxy statements reflecting the new disclosure format have begun reaching shareholders, HR executives and other experts have started to make recommendations in several areas:
Provide employee education. Given the possibility that employees will react to the new executive compensation disclosures with confusion or even anger, it makes sense to communicate the new regulations’ key points before the first proxy statement appears.
“Many employees will see a lot of zeroes in the proxy statement and not quite know what to do with those numbers,” Hellerman says. “This is a wonderful opportunity for the organization to explain to its employees how compensation works.”
Hellerman suggests that HR executives share portions of the proxy language with a trusted focus group to identify the sorts of questions and reactions the information may spark. Use those insights to craft an internal communication that paves the way for the proxy.
Ensure management collaboration. Get top executives together and talking about executive compensation—the sooner, the better—some say. The first step Hauder advises clients to take in complying with the new rules is to assemble a team of executives and outside experts who can gather and analyze all of the information required for the tables, the accompanying narratives and the CD&A.
Emphasize the need for quick action. Hanselman of Baker Hostetler cites an example of how long it can take to resolve compensation issues. She recently worked with a compensation committee to introduce a new feature to an existing design. The process took nearly 12 months, she says, because “every tweak the comp committee made in the interest of sound corporate governance affected accounting processes and the company’s financial statements. … I think there has to be a lot more communication on executive compensation among the top HR, finance and accounting, and legal executives.”
Support compensation committees. The CD&A “is intended to enable the investor to be a fly on the wall during compensation committee deliberations,” Olsen says. As such, the CD&A will help guide compensation committees as they “think through the strategic and competitive rationales for their decisions, and to ensure some consistency in their reasoning,” he adds.
Skilled HR executives, Hellerman says, can help guide compensation committee members to the best decisions by asking the right questions. “The HR head can really help compensation committees think through challenging issues,” she says.
John Mutch, a former compensation committee chair and founder of hedge fund MV Advisors LLC in Solana Beach, Calif., agrees. “If I were a comp committee head now, I would be talking to the head of HR to find out the real compensation story in this company,” he says. “I would want to know all cumulative compensation, and I would want to effectively benchmark that figure with the competition.”
A Challenge for HR
Although the new compensation disclosure rules will likely result in a reduction in the use of expensive perks in executive compensation, the rules are not expected to inspire across-the-board changes in executive compensation plan design. But many compensation experts do expect that publicly listed companies will continue to increase executive compensation vehicles, such as performance shares, that clearly link incentive pay to shareholder interests.
For HR, however, the impact of the new rules could be more significant. To the extent that HR collaborates with the compensation committee in complying with the new rules, it will elevate its profile within a rarified group of decision-makers, including the CEO, the CFO and members of the board.
Ellig proposes that the top HR officer at publicly listed companies serve as the secretary to the board’s compensation committee, a position he held for 12 years as an HR executive. “As the top HR executive, you really want to have a major role in working with the chair and the entire committee,” he says. “It’s a lot easier to do that from inside than it is from the outside, lobbing memos into the committee. If HR leaders are not on the committee, they should be demonstrating how they can add value so that they will be brought in as the secretary.”
Stepping into a lead role in addressing the new proxy disclosure rules represents an ideal opportunity to demonstrate that value.
Eric Krell is a business writer based in Austin, Texas, who covers HR and finance issues.