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Less Freedom to Pay: Executive Comp After Financial Regulatory Reform
 

By Brent M. Longnecker, with Chris Crawford and Josh Henke, of Longnecker & Associates  7/6/2010
 

Updated on July 21, 2010

Executive compensation is a central piece of a sweeping financial regulatory reform law, the Restoring American Financial Stability Act (H.R. 4173), signed into law on July 21, 2010.

A summary and commentary on the executive compensation provisions of the law, also known as the "Dodd-Frank Act" after its chief congressional sponsors (Senate Banking Committee Chairman Chris Dodd and House Financial Services Committee Chairman Barney Frank), follows.

Say on Pay

The “say-on-pay” provision included in the measure will give shareholders the opportunity to cast an advisory vote annually, biennially or triennially on disclosed executive compensation for the top five executives of a public company. “Small issuers”—companies with less than $75 million in market capitalization or less than $50 million in annual revenue—will be exempt from this provision.

Over the past several years, on a voluntary basis approximately 50 public companies—excluding those companies that have received government assistance via the federal Troubled Asset Relief Program (TARP)—adopted shareholder advisory votes on executive pay. At least three companies to date have had shareholders reject executive pay packages in voluntary say-on-pay votes, including Motorola, Occidental and KeyCorp. While the merits of say on pay have been hotly debated, the discussion is now over and companies must deal with the reality.

Commentary:

Yes or no vote. The say-on-pay system, as provided in the bill, does not create a forum for shareholders to say what they like or don’t like about executive compensation. Rather, it requires a yes or no vote, pressuring compensation committees and advisors to make determinations on their own.

More proxy advisor power. Major proxy advisory firms such as RiskMetrics Group (RMG) make voting recommendations and influence shareholders to push corporations to adhere to the advisory firms' favored policies. Say-on-pay will likely create more power and influence for these advisory firms, as many shareholders might not understand the complexities of executive compensation as disclosed in a proxy statement and will rely on the advice of such firms.

Among the consequences, for example, there might be an increased trend in the use of performance vested equity awards, a movement toward cash-based long-term incentive awards in light of RMG’s artificial dilution cap formula (shareholder value transfer), fewer excise tax gross-ups in the event of a change of control, and fewer executive perks. Some companies and outside advisors disagree with RMG’s policies, so tensions are likely to increase.

Companies will scrutinize institutional shareholders. A likely result of the increased power of proxy advisory firms will be public companies scrutinizing who holds the majority of shares. Specifically, when a company solicits capital in equity offerings, board members are likely to determine if the institutional money comes with strings attached via proxy advisor votes.

Directors might not be re-elected. A majority vote against a compensation program will pressure the company to make corrective changes. If a compensation committee fails to modify executive compensation to shareholder satisfaction, it might mean that votes will be withheld or cast against directors in the next election.

Increased voting power for institutions. The potential re-election problem for directors is compounded by the elimination of the broker discretionary vote in uncontested board elections, thus strengthening the position of institutional votes and proxy advisory firms that serve the institutions.

Compensation Committee Independence

The proposed act will require the U.S. Securities and Exchange Commission (SEC) to direct the securities exchanges to add a listing requirement that executive compensation must be set by “independent” directors. In defining independence, the stock exchanges would be required to identify factors impacting independence that could result in definitions that exceed those required at present under the New York Stock Exchange and Nasdaq exchange listing standards. This would include whether the director derived any income from the issuer through consulting, advisory fees or otherwise, and whether the director is affiliated with the issuer or one of its subsidiaries or affiliates. Depending on how such standards are implemented, they might result in an “independent” director who more closely resembles an “outside” director as defined under section 162(m) of the Internal Revenue Code.

Consultant Independence

Compensation committee members will be responsible for considering the independence of compensation consultants, outside counsel and other advisors retained by the committee. This will include considering the provision of other services provided to the issuer, the advisor’s policies and procedures regarding conflicts of interest, business and personal relationships, and stock ownership of the issuer by the advisor. And the retention of compensation consultants will need to be disclosed, as will any conflicts of interest raised by such inquiries and how they were addressed.

Commentary:

Increased demand for independent consultants. Further clarification will be needed regarding how to detail conflicts of interest among consultants. Given the definition of conflict of interest and the required disclosure, this provision might force many multi-service companies with executive compensation practices to make difficult decisions based on whether to retain their executive compensation practice. Many public companies are likely to reassess their relationship with their outside compensation advisor to ensure that no conflict of interest exists. And public companies that do not engage an executive compensation consultant might decide to do so.

Reinforced SEC policy. This proposal strengthens the SEC guidelines provided on Dec. 16, 2009, as well as previous guidelines detailed by each of the stock exchanges. Companies will need to ensure that they are electing independent compensation committee members.

Clarify independence definition. This provision will need further clarification as to relationships that have a conflict of interest, such as when board members of public companies are executives of companies in similar industries, to ensure that the appropriate expertise is brought to the board. However, there is a concern that these board members could be deemed “not independent” because of any number of business relationships.

Compensation Clawbacks

“Clawback” refers to taking back monies or benefits previously awarded because of changed circumstances. In response to shareholder outcry over executive compensation, the Senate version of the financial regulatory bill strengthens section 304 of the Sarbanes-Oxley Act (SOX) to require the clawback of incentive-based executive compensation, including stock options, in the event of an accounting restatement attributable to material noncompliance with financial reporting requirements. This would occur even if no one, including the executive whose compensation is at issue, engaged in misconduct. The provision would require the clawback of amounts paid based on overstated results for the three years preceding the restatement date. Compensation would be recalculated according to the restated performance.

Commentary:

Broaden SOX. Clawback policies have been in place for CEOs and CFOs since SOX was enacted in 2002. However, the new law will broaden the scope of potential clawbacks, including who would be subject to pay back monies, the time period to return monies, the amount to be paid back and what triggers a clawback (i.e., poor performance, etc).

Previously uncontested. Clawbacks have been largely uncontested in the U.S. court system, but the enforcement of expanded clawback rules could result in legal battles.

Devil in the details. Clawbacks are appropriate when financial statements are restated to the detriment of the company, as with SOX. However, as clawbacks are extended to a much broader scope, there will be real difficulty in application. For example, how do you collect money that has already been taxed?

Illustrate Pay for Performance

The law will require the SEC to amend Item 402 of Regulation S-K to require disclosure of how executive compensation relates to financial performance, taking into account changes in the value of stock and dividends and any distributions. The act mandates the SEC to issue rules that require disclosure of how median employee compensation compares to CEO compensation.

Commentary:

Window dressing. The SEC has struggled with forcing companies to report a connection between pay and performance, specifically as it relates to short-term incentives. While the act seeks to strengthen the transparency between pay and performance, the provision might result in more window dressing than reality, as performance can be measured in a variety of ways.

Proxy Access

The act amends section 14(a) of the Securities Exchange Act of 1934 to provide for shareholder access to proxies to nominate directors. The House bill requires and the Senate bill authorizes the SEC to prescribe rules and regulations granting shareholders such access. Senate supporters and shareholder activists have pushed for proxy access for years, arguing that it will help remedy a perceived lack of management accountability.

Current Senate considerations include a 5 percent ownership standard and a two-year holding period on shareholders who wish to nominate directors. Under either provision, the SEC is likely to enact rules for shareholder access.

Separation of CEO and Chairman

Under the act, the SEC must require companies to explain in proxy statements why the positions of chairman and CEO are separate or combined. This provision reflects a view among some shareholder advocates that best practices require separation of the roles of CEO and chair. Currently, Regulation S-K requires companies to disclose their leadership structure and why they believe the structure to be appropriate.

Compensation Committee Action

Big changes are coming in executive compensation. As a result, compensation committees and management are advised to consider the following action items:

Review the compensation committee charter for sound governance practices.

Review the process for determining executive compensation.

Conduct an analysis of institutional shareholders to determine which of them follow voting guidelines provided by RiskMetrics Group, Glass Lewis & Co. or other proxy advisory firms, and which have their own voting guidelines.

Start a dialogue with institutional shareholders to solicit feedback on the company’s executive compensation practices.

Review the role and independence of the company’s compensation consultant.

Consider appointing the head of HR as secretary to the compensation committee to ensure open lines of communication between management and the committee, and reinforcing the committee’s overall authority.

Review the SEC guidelines issued Dec. 16, 2009, for proxy disclosures.

Review RMG’s 2010 compensation policy guidelines for informational purposes.

Review the total direct compensation provided to the named executive officers to ensure a connection between pay and performance.

Consider conducting a compensation risk assessment.

Review the Compensation Discussion & Analysis proxy section to ensure that the company is disclosing compensation appropriately and telling the right story.

Brent M. Longnecker is chairman and CEO of Houston-based Longnecker & Associates, a corporate governance and compensation consulting firm he founded in 2003. With more than 25 years of experience, his primary mission is to create innovative solutions that attract and retain executives, bolster productivity and improve shareholder value, while demonstrating independence and integrity in corporate governance practices and executive compensation. Chris Crawford, executive director of Longnecker & Associates, with more than 15 years of experience, advises boards and committees of public, private and nonprofit organizations on developing executive and board compensation programs. Josh Henke, managing director of Longnecker & Associates, collaborates with clients to develop solutions to maximize their compensation strategy.

Related Article:

Few U.S. Companies Prepared for Executive Say-on-Pay Legislation, Survey Finds, SHRM Online Compensation Discipline, July 2010

Related Articles by the Authors:

A Different Say on Executive Pay, Dallas Business Journal, November 2007

Frankly Speaking, Say on Pay Is No Way To Act, Houston Business Journal, June 2007

Immediate Compliance Changes With New SEC Regulations, Longnecker & Associates, January 2010

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