Posts Tagged ‘Executive Compensation’

How to Improve Compensation Committee Effectiveness

Finding the time and resources for board and committee development is an ongoing challenge.  But enhancing the effectiveness of your Compensation Committee can be done with a few key actions.  This blog and ones that follow will address:

  • Setting a workable Committee calendarCompensation Committee Calendar
  • Selecting membership
  • Continuing education on executive compensation

The beginning of the year is a great time to update or set up a calendar for your Compensation Committee.  Committee responsibilities and activities need to be spelled out in advance and scheduled throughout the year to:

  • Balance the Committee’s workload
  • Allow sufficient time for review before decisions are required
  • Ensure that decisions are well-timed for effectiveness as well as meeting any regulatory requirements

The first step in building the calendar is listing and grouping activities.  You may be surprised at how many issues need to be addressed when you write them all down.  Our basic categorized list includes:

  • Compensation Philosophy Statement
    • This roadmap for guiding Committee decisions should be reviewed at least annually.
    • If you don’t have one, you would be surprised how helpful having written principles can be.
    • Market and Peer Group Review
      • Update the peer group for relevancy.
      • Gather compensation data from surveys and proxies.
      • Monitor performance versus peers.
      • Performance and Salary Review
        • Board/Committee review of CEO performance; and CEO review and report on other senior officers.
        • Committee review of CEO salary and adjust based on market/peer pay levels and executive job performance.
        • Committee review of CEO recommendations for other senior officers.
        • Annual Incentive Plan
          • Update plan in terms of participation, payout ranges, objectives, weights, and performance ranges.
          • Review performance and potential payout levels at mid-year.
          • Complete end-of-year review and approve payouts.
          • Long Term Incentive Plan (if you use stock)
            • Review existing grants and remaining share reserve.
            • Determine any need for updating plan and/or share reserve.
            • Determine new grant (type of grant, total shares, terms, CEO allocation).
            • Review and approve CEO recommendation for grants to other officers.
  • Compensation Risk Assessment
    • Conduct at least annually – ideally just after the end of the year so the Committee can look back at the prior year and plan for the year just beginning.
    • Director Compensation
      • Determine frequency of review (we recommend an annual review; but at least every third year as a minimum).
      • Conduct review and recommend changes to Board.

Of course, companies participating in government programs like TARP or those who are required to report to the SEC have a number of other requirements and activities that we won’t try to cover here.  Suffice it to say that these requirements are a significant expansion of the previous list.

Filling out the calendar is best done using a grid with the major categories of work down the left side of the calendar, and the months across the top.  This approach allows you to schedule the items in each category in logical order as well as look at the volume of Committee work in each month.

Finally, this is a task best completed by the Committee Chair, CEO, and outside compensation consultant if you have one.  You may also want your CFO and Chief Human Resources Officer involved if they interact directly with the Committee.

Please add comments below, and if you want to know more about how we can help, call me at 919-644-6962 or ask us to contact you at http://matthewsyoung.com/contact.htm.

How to Improve Executive Compensation Committee Effectiveness – Membership Selection and Committee Structure

In a previous blog entry, I talked about improving Executive Compensation Committee Effectiveness by setting up an annual Committee calendar to balance workload, set priorities, and ensure timely and effective decisions.

This follow-on blog highlights four important elements for effectiveness from the standpoint of Committee membership, structure, and decision-making authority:

  • Characteristics of effective committee members
  • Appropriate committee size and turnover
  • Balancing other committee assignments
  • Assigning sufficient authority

 

Characteristics of Effective Committee Members

Some Director backgrounds are more appropriate than others for the Compensation Committee.  Candidates with formal corporate management experience or service as professional directors tend to have a better perspective for dealing with complex compensation issues.  Directors with entrepreneurial or smaller company experience may not have faced these kinds of issues before.

 

Appropriate Committee Size and Turnover

Our experience shows that the Compensation Committee needs at least three independent members but typically not more than five.  Decision-making is streamlined with a smaller committee; but don’t get so small that you limit important interaction and having a range of perspectives that ultimately builds strong consensus.  Also, you should change no more than one-third of the committee’s members in a year.  Otherwise, you lose “institutional memory” and valuable experience and expertise that takes a while to develop.

 

Balancing Other Committee Assignments

Because of the importance placed on the governance of executive compensation, membership on the Compensation Committee should be a director’s primary committee assignment.  If at all possible, don’t place directors on both the Compensation and Audit Committees.  While you want your best directors on your most critical committees, you don’t want to stretch them too thin.

 

Assigning Sufficient Authority

And finally, all Boards of Directors should take the time to determine what level of authority the Compensation Committee will hold.  We believe that Compensation Committees are most effective when the Board assigns them specific decision-making authority.   Where full Board voting is desired or required, the Committee should always bring a specific recommendation that the Committee has developed and fully supports.

If you would like a sample Compensation Committee Membership Profile, we would be happy to send you one.  Complete the following request form:

 

Bankers and Regulators, “Incentive” Is Not A Four Letter Word

The Wells Fargo incentive pay problem is at least as old as Matthews, Young; and we’ve been advising the banking industry on performance-based incentive compensation for over 40 years.  Decades ago when we discussed design of incentive plans, we would half-joke about avoiding the creation of an employee mindset of “open an account and get a new toaster; open three new accounts and get three toasters”.

Our experience tells us that a cardinal rule of incentives is that you get what you pay for – in terms of employee behavior and results.  If your bank sets new account goals without incorporating a balancing measure like branch customer satisfaction, you are sending a problematic message:  account growth matters and gets rewarded and customer satisfaction does not.  If your incentives are driven by Net Income growth without corresponding Return on Assets / Equity measures, you are telling management that it’s okay to inflate the balance sheet for that extra dollar of profits.   If loan growth is the key to incentive earnings without corresponding credit quality requirements . . . well, we all know where that got us in the recent past!

Business news reports of the Wells Fargo problem indicate that another cardinal rule of incentives may have been violated:  employees must have a reasonable chance of achieving goals and not fear losing their jobs for failing to achieve what they perceive as unobtainable results.  Such a situation will cause some employees to quit trying and others to start their search for different employment.  Or in the Wells Fargo case, employees will find a way to achieve goals even when they know their behavior is inconsistent with customer interests and, ultimately, shareholder return.

We also believe that Wells Fargo’s decision to cancel incentive plans is an over-reaction.  Well-designed incentive plans are an effective management tool to:

  • focus attention and action plans on key results
  • motivate individual effort and teamwork
  • link company and employee success

The Wells Fargo story will fade in the press, but we believe it should be a wakeup call for banks to take a fresh look at incentive plans.  With the new year approaching, now is the time to ask the tough questions:  Are performance measures balanced with respect to growth, profitability, soundness, and customer satisfaction?  Are expectations reasonably obtainable and do employees have the proper tools and training to perform at their best?  Are payout levels competitive but reasonable compared to base pay (e.g., are high incentives necessary for cash compensation to be competitive)?  Are we supporting our incentives plans with effective employee communications that explain expectations for results and behavior?

Matthews, Young has been advising banks, thrifts, and credit unions for over four decades on the use of sound incentive compensation.  We are experienced in the design of new plans as well as the review of existing plans.  Contact us at: Info@MatthewsYoung.com.

How to Improve Compensation Committee Effectiveness

Finding the time and resources for board and committee development is an ongoing challenge.  But enhancing the effectiveness of your Compensation Committee can be done with a few key actions.  This blog and ones that follow will address:

  • Setting a workable Committee calendarCompensation Committee Calendar
  • Selecting membership
  • Continuing education on executive compensation

The beginning of the year is a great time to update or set up a calendar for your Compensation Committee.  Committee responsibilities and activities need to

be spelled out in advance and scheduled throughout the year to:

  • Balance the Committee’s workload
  • Allow sufficient time for review before decisions are required
  • Ensure that decisions are well-timed for effectiveness as well as meeting any regulatory requirements

The first step in building the calendar is listing and grouping activities.  You may be surprised at how many issues need to be addressed when you write them all down.  Our basic categorized list includes:

  • Compensation Philosophy Statement
    • This roadmap for guiding Committee decisions should be reviewed at least annually.
    • If you don’t have one, you would be surprised how helpful having written principles can be.
    • Market and Peer Group Review
      • Update the peer group for relevancy.
      • Gather compensation data from surveys and proxies.
      • Monitor performance versus peers.
      • Performance and Salary Review
        • Board/Committee review of CEO performance; and CEO review and report on other senior officers.
        • Committee review of CEO salary and adjust based on market/peer pay levels and executive job performance.
        • Committee review of CEO recommendations for other senior officers.
        • Annual Incentive Plan
          • Update plan in terms of participation, payout ranges, objectives, weights, and performance ranges.
          • Review performance and potential payout levels at mid-year.
          • Complete end-of-year review and approve payouts.
          • Long Term Incentive Plan (if you use stock)
            • Review existing grants and remaining share reserve.
            • Determine any need for updating plan and/or share reserve.
            • Determine new grant (type of grant, total shares, terms, CEO allocation).
            • Review and approve CEO recommendation for grants to other officers.
  • Compensation Risk Assessment
    • Conduct at least annually – ideally just after the end of the year so the Committee can look back at the prior year and plan for the year just beginning.
    • Director Compensation
      • Determine frequency of review (we recommend an annual review; but at least every third year as a minimum).
      • Conduct review and recommend changes to Board.

Of course, companies participating in government programs like TARP or those who are required to report to the SEC have a number of other requirements and activities that we won’t try to cover here.  Suffice it to say that these requirements are a significant expansion of the previous list.

Filling out the calendar is best done using a grid with the major categories of work down the left side of the calendar, and the months across the top.  This approach allows you to schedule the items in each category in logical order as well as look at the volume of Committee work in each month.

Finally, this is a task best completed by the Committee Chair, CEO, and outside compensation consultant if you have one.  You may also want your CFO and Chief Human Resources Officer involved if they interact directly with the Committee.

Please add comments below, and if you want to know more about how we can help, call me at 919-644-6962 or ask us to contact you at http://matthewsyoung.com/contact.htm.

Is It Time to Rethink the Annual Merit Salary Increase?

For years, larger companies have routinely budgeted to increase base salaries of employees by a few percent based on what everybody else is doing. Then, the annual increase is usually spread among employees based on where they are paid in their job’s policy salary range and, hopefully, based on a merit performance score. There is a good deal of logic in such a process, but it is worth rethinking given the realities of today’s labor market.

payrollWhy does an annual increase in the guaranteed base salary make sense? The fact that it is routinely done at the same time each year gives employees a sense of security and if your strategy emphasizes low risk, steady growth with retention of a stable staff, then this approach to base salary management makes sense. On the other hand, if your organization’s strategy is for more risky growth where high levels of performance can make a big difference, perhaps a different approach to base pay would make better sense.

Maybe some of the base should be shifted over time to incentive pay. Perhaps base salary reviews should be done less often with bigger increase potentials when salary increases are eventually granted. How you mix pay between the guaranteed portion and the at-risk portion is a matter of strategy and to be effective, your pay strategy must support your business strategy. We hear HR professionals worrying about the annual 2% to 4% increase having become an entitlement. However, management of companies that have had depressed revenues during the recent economic recession have little patience for any entitlement attitude. HR professionals need to think about how their office can better support the organization’s strategy. Rethinking the annual base pay increase entitlement is a good place to start.

Of course, every organization is unique and there is no one-size-fits-all solution to managing base salaries and overall compensation. Having worked with hundreds of organizations, for-profit and not-for-profit, fast growing and declining, risk-averse and risk-tolerant, we understand the need for a custom solution. As the economy slowly improves, this is a good time to step back and question your organization’s compensation management. We would appreciate your thoughts. Please email, call or comment below.

Citigroup, Inc.’s New CEO Compensation Plan

Citi is finally getting CEO pay plans right! After losing their shareholder “say-on-pay” vote at the 2012 Annual Meeting of Shareholders, new Chairman Michael E. O’Neill, who just took over as Chairman last April, interviewed a large number of important shareholders. He was told that paying their CEO a $6 Million Incentive based on a two-year (2011 and 2012) cumulative pre-tax profit of $12 Billion, may sound like a good deal for the shareholders, but it was fraught with problems.

carrots

Incentive Pay Must Be Carefully Designed

To begin, the Company had 2010 pre-tax profit of approximately $12 Billion. So, the hurdle for earning the $6 Million was half of the actual earnings in 2010. Yes, the economy has made earnings difficult to produce, and yes, Citi is trying to overcome internal problems, but shareholders were unwilling to allow a hurdle rate that low. There were other problems with the design of the Plan.

Cumulative two-year pre-tax earnings ignores the fact that the bank could grow assets at a decreasing return on each dollar and meet the earnings hurdle while increasing their capital requirements significantly. Using volume of profit as a management performance measurement always has this inherent problem. In fact, increasing volume of profit can and often does result in lower returns on equity in banking. For that reason, shareholders can lose as management earns more, and a lose-win plan is never good.

Finally, building on the last point, there is no clear link between shareholder returns and management pay in the Plan Citi was using. A common objective of executive compensation plans is to align the interests of management with those of the shareholders. The old Citigroup, Inc. Plan did the opposite to some degree. The Board of Citigroup consists of intelligent and successful people, but they got some bad advice along the way. After Chairman O’Neill spoke with shareholders, he tasked the Board’s Compensation Committee to redesign the CEO’s Compensation Plan to address the shareholders’ concerns. He was not about to get a negative “say-on-pay” vote after his first year as Chairman.

Now, in my many years of studying and designing executive compensation plans, I have yet to see the perfect plan. It just does not exist. Business is too complex to allow for such a thing, and the need to keep the plan as simple as possible is an important constraint.  Yet, the new Citigroup, Inc. Management Compensation Plan addresses shareholder concerns with an elegantly simple design.

Executives will be granted units worth a certain amount in three years if certain performance is achieved.  Citigroup stock must perform in the top three-quarters of a carefully selected peer group of stocks of similar companies, and Citigroup’s Return on Average Assets over the three years must beat a hurdle equal to the previous year’s actual or there will be no units rewarded.  Furthermore, if the Return on Average Assets over the three years is better than the previous year by a significant percentage, then a target number of additional units will be awarded.

This design is superior to the old design because it clearly:

  1. aligns management’s interests with those of the shareholders and
  2. it is tied to relative performance compared with peers as well as the Company’s strategic goals.

There are some potential draw backs to such a plan, but the new plan is so much better than the old plan, I will not spend words on the risks in this particular blog.  Perhaps in the future, we can look at some of the potential flaws.  In the meantime, I say congratulations to Mr. O’Neill.  I may go buy some Citigroup stock!

Executive Pay Equity

A recent headline from WorldatWork indicates the gap between CEO and CFO pay is growing farther apart.   The study conducted by BDO USA, LLP indicates that CFOs average 40% of CEO pay at 600 public companies included in the study.  One reason offered for the increased disparity is due to CEO pay being more commonly tied to the increase in the company’s equity, which for most public companies, increased substantially in 2010 and 2011.

While CEO’s have historically been paid at levels higher than the rest of the executive team, this recent trend of an increased gap could lead to problems.  Shareholders may assume that the change in the CEO – CFO pay comparison could be a reflection of how the Compensation Committee values the relative roles of risk-taker vs. risk-controller.   Let’s hope not.  That led to some serious problems in the past.  It is more likely that the bigger recent gap is due to the 2010 and 2011 run up in stock prices and the CEO’s larger percentage of compensation tied to stock price gains.  Should the mix be so different for the two positions?  A return to a more equitable internal pay structure will help avoid potential perceptions among shareholders that CFOs are not valued as much as they have been in the past.

With slowly improving economic indicators, organizations are reviewing current compensation practices.   In addition to the scrutiny on executive compensation as a Pay Equityresult of Dodd-Frank, this renewed focus on executive pay will require organizations to focus on their philosophy and implement equitable compensation plans.  Compensation Committees may want to look at how relative compensation has changed over time and consider ways of optimizing compensation mix to stabilize the fluctuation in the comparisons.

In our Firm’s work with client executive teams, we have historically measured the internal pay equity of senior executives measured as a percentage of the CEO’s pay.   We have significant, historically viable data showing the relative pay for all executives on the senior team as related to that of the CEO.   Two critically important objectives of any company’s compensation philosophy should be to target external competitiveness and be internally equitable.

If you would like a review of your company’s current compensation practices measured against market, industry and custom peer groups, please give us a call (919-644-6962) or visit us at http://matthewsyoung.com.

SEC Rules on Executive Compensation, Committee Governance and Advisor Independence

The Dodd-Frank Act, signed into law in July 2010 by President Obama, shines a bright light on many issues related to Executive Compensation and Corporate Governance.  Specifically, one section (952) requires the SEC to adopt rules  regarding Compensation Committee members’ independence and suggests a specific list of factors to be identified that will govern the Committee’s advisors.  To quote chapter and verse, Section 952 – The Commission is directed to establish competitively neutral independence factors for all who are retained to advise compensation committees

First, a couple of definitions according to Webster’s dictionary:

Independentnot subject to control by others, not requiring or relying on something else, not looki ng to others for one’s opinions or fo r guidance in conduct

Neutral – having no personal preference, not supporting or favoring either side…

Personally, I don’t know how “independence” can be anything other than “neutral”…this seems a little redundant, but I digress.

The SEC is required to adopt the new rules by July of 2011 (within one year of the law being signed).   The rules will require that public companies disclose in their proxy when they hire an outside compensation consultant, whether potential conflicts of interest exist (in other words – if the consultant has a personal preference or is potentially subject to control by others) and what the Committee has done to address the potential conflict.  This will obviously influence Committee behavior in hiring such advisors by encouraging them to avoid any potential conflicts or breaches of neutrality and independence.    In only the most extreme cases, could a Committee justify hiring an advisor that violates the independence test without public scrutiny and shareholder unrest.

Much like Sarbanes-Oxley’s requirements of independence and neutrality with regard to Audit Committee advisors, these new rules on corporate governance seem to fall into the category of “doing the right thing”.  Some consulting activities that seem to contradict this characteristic would be selling products to companies whom you advise, simultaneously working for management on other projects without full disclosure and prior approval of the Committee or an engagement advising companies for fees where the consulting principals have a significant ownership position (i.e. shareholder).

At Matthews-Young, we have always subscribed to the higher ideal of “doing the right thing”.  We require that we be hired and report directly to the Compensation Committee when we are engaged for Executive Compensation work.  We have no sources of revenue other than being paid for our  time and knowledgeable, expert advice without “supporting or favoring either side”.

If we can assist you with improving your company’s governance and committee effectiveness please give us a call at 919-644-6962 or ask us to contact you at http://matthewsyoung.com/contact.htm.

A Creative Answer to Implementing Executive Stock Ownership Guidelines

There is a clear trend among companies to strengthen the linkage between shareholder and executive interests.  Many companies are responding to this trend by evaluating the effectiveness of having stock ownership and/or stock retention guidelines for their executive officers.

We observe that implementing such guidelines in the current economic environment can be challenging for these executives.  Since executive cash compensation is flat or increasing only slightly, achieving stock ownership requirements can represent a greater burden than in the past.

However, these difficult times also present a partial solution.  Many companies decided not to give salary increases to key executives for 2009 and, some cases, 2010 as well.  Hopefully, those companies are having better financial results this year, are concerned that executive salaries may trail the market, and are considering giving an additional salary increase beginning in 2011 – say five percent on top of whatever a regular raise might be.  Herein lies the opportunity to address some of the challenge of increasing executive stock ownership.

Instead of granting the additional raise, consider an equivalent value in Restricted Stock Units (RSU’s) with a reasonably short restriction period (e.g., two years).  Since the salary increase is an annuity as long as the executive is employed, then the company would grant the same dollar value in RSU’s every year.   RSU’s also offer an interesting feature that is not available with Restricted Stock grants – RSU’s can be voluntarily deferred beyond the restriction period as long as the executive complies with IRS Code Section 409A requirements related to the deferral.

This approach offers several benefits both to the company and to the recipient:

  • The executive defers income taxes until actual shares are finally received at the end of the restriction period, including the voluntary deferral period.  Thus, the executive accrues more shares than if the additional salary were used, on an after-tax basis, to buy stock.
  • The company’s stock ownership guidelines would give credit for RSU’s that have been granted and not yet converted into actual shares.  By using the voluntary deferral procedure, the executive can count all RSU’s towards meeting stock ownership guidelines as well as postpone income tax.
  • There is also the option to take cash in lieu of shares (or a portion in cash to pay income tax and the remainder in shares) at the end of the deferral period, or to defer the cash payout as long as the executive complies with IRS Code Section 409A rules.
  • The company does not have to issue actual shares until the end of the voluntary deferral period.
  • Since this will be an ongoing program of annual grants and increasing stock ownership among executives, there is also a pretty nice story to tell shareholders.

These are challenging times for addressing executive compensation issues.  But maybe this is one of those instances of being handed “lots of lemons”, but using the opportunity to “make some lemonade”.

Market Information Helps With Tough Salary Planning Decisions.

In a recent blog, we talked about taking a broader perspective when planning salary increases for 2011.  We were also waiting for better forecasts for 2011.  More comprehensive reports are now available and suggest the following:

  • We are seeing a clear increase in the percent of employers and banks granting pay raises.  While two-thirds of employers gave increases in 2009, nearly 85% gave increases in 2010.  And we expect this percentage to increase for 2011.
  • U.S. employers report they are budgeting  average raises of 3.0% in 2011, as are banks and other financial institutions.
  • The middle 50% of employers report  2011 salary increase budgets between 2.6% and 3.5%.
    • Again, financial institutions are very similar – ranging from 2.5% to 3.2%.
  • History shows some fluctuation between forecast and actual increases among general industry as well as financial institutions:

Industry

2008 Actual

2009 Forecast

2009 Actual

2010 Forecast

2010 Actual

2011 Forecast

All

3.9%

3.9%

2.2%

2.8%

2.7%

3.0%

Financial

3.9%

3.9%

2.3%

3.0%

2.8%

3.0%

If this fluctuation between projected and actual continues, banks may give less than 3% in actual raises in 2011.

In addition to the broader questions we raised in our previous blog, budgeting for pay raises eventually comes down to practical questions:

  • What’s your best estimate of what the competitive market will do?
  • How long has it been since your last round of raises?
  • What can you afford to do, considering your expected financial performance?
  • And as we pointed out in an earlier blog, how do your overall salary levels stack up against current market salaries?  If you haven’t checked the market lately (perhaps because you didn’t grant raises), then you lack important information on competitiveness and whether (a) you are still paying competitive rates or (b) a gap has opened between your organization’s salary levels and the market.

We have also seen a couple of other techniques to mitigate the cost of salary raises:

  • Postpone the effective date of raises until later in the year.  Granting raises on July 1 rather than December 1 saves half the expense for the calendar year.
  • Grant merit pay in a lump-sum to employees high in their salary ranges but performing at a superior level.   While the lump-sum payment is a current expense, it does not increase the employee’s future pay rate.

These are challenging times for compensation planning.  If we can be of help, please don’t hesitate to contact the firm at (919) 644-6962 or me direct at (404) 435-6993.

What do you say about Say on Pay?

Say on Pay is not a new concept to executive compensation but since it’s now law (Dodd-Frank Act), a quick look at history might be useful.

  • Shareholder votes on executive compensation practices initially surfaced in the UK as early as 1999.
  • The first negative vote on executive compensation occurred in 2003, when GlaxoSmithKline shareholders voted against the report of compensation paid to executives.
  • In 2007, in the U.S. there were about 50 companies that had shareholder resolutions calling for an advisory vote on executive compensation.
  • In the 2007 – 2009 proxy seasons combined, there have been about 200 companies with shareholders voting on compensation practices.
  • In 2009, under the American Recovery and Reinvestment Act, all companies receiving funds from the US Treasury (TARP) were required to include a non-binding advisory vote on compensation to the highest paid group of executives.  This resulted in approximately 400 companies required to hold such vote, mostly banks.

On July 21, 2010 the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Act”), was signed into law by President Obama and includes a provision requiring public companies to allow shareholders a non-binding advisory vote on executive compensation.

Specifically, the Act requires:

  • A vote at least once every three years, beginning with the first shareholder meeting that occurs after January 21, 2011.  Therefore, say-on-pay will be required for many public companies this upcoming proxy season.
  • Also at this first annual meeting, the shareholders must decide on whether the vote should be held every one, two or three years (thereafter a vote on frequency must be held by a separate resolution no less often than every six years).

What are Shareholders actually voting on?

With the non-binding advisory vote, what are shareholders actually going to be voting on?  Are they voting on the amount of compensation paid? Are they voting on the compensation philosophy of the company?  Are they voting on the types and delivery of compensation?  Ultimately, you would think the vote would be on all of the above but the compensation philosophy seems to be the most important issue.  Poor compensation philosophy can lead to many other problems, specifically overpayment for poor performance.

Issues to Consider

As with many of the provisions in the Act, there will unintended consequences of the new legislation.  Here are a few issues to consider when asking shareholders to vote on executive compensation:

  • Companies will need to revise proxy statements to include the mechanics of voting on compensation.  Will the Board make a recommendation on the vote?
  • Institutional shareholder advisory services will have a greater influence on compensation practices as a result of the vote and therefore companies will more likely want to comply with mandates from such advisory firms (i.e. employment agreements, change in control provisions, severance arrangements).
  • Ongoing educational efforts of a company’s compensation plans and philosophy will be necessary to inform shareholders required to vote, especially since retail shareholders/brokers will need instructions from beneficial owners in order to vote the shares in favor of compensation plans (no instructions = a no vote).
  • While the vote is “non-binding”, Directors will be forced to react to such votes or risk a “withhold” vote on their re-election as board members.  In the 2010 proxy season, there were three companies that received a no vote (KeyCorp, Occidental Petroleum and Motorola)…so it can happen.
  • A more subtle influence of the Say on Pay shareholder vote of confidence will be the risk of focusing senior management on shorter term performance results so that a company’s annual performance will justify higher compensation when a longer-term, strategic investment focus would result in greater shareholder value in the long run.

With the many issues to consider and the potential of getting a negative vote from shareholders on compensation practices, companies would be wise to get an early start on reviewing current practices and seek advice on their proxy draft now.

The Increased Prevalence and Focus on Clawback Policy

In 2002, as a result of a few high profile cases of corporate wrongdoing and scandalous financial behavior, Congress passed The Sarbanes-Oxley Act of 2002 that required clawback of incentive compensation from the CEO and CFO.  According to Equilar’s 2009 Fortune 100 Clawback Policy Report, between 2006 and 2009 the percentage of companies reporting Clawback Policies jumped from 17% to 72%.  Furthermore, as a requirement of all banks participating in the Troubled Asset Relief Program (TARP), all incentive compensation paid to the top 20 highest paid executives must be subject to clawback policies in the case of materially inaccurate financial data or performance metrics.  So, the public company arena has an increasingly heightened awareness of such a risk reduction policy.   And now most recently, The Dodd-Frank Wall Street Reform and Protection Act of 2010 includes a provision requiring Clawback Policies.

Dodd-Frank Wall Street Reform and Consumer Protection Act 2010

The new law signed by President Obama on July 21, 2010 requires all companies listed on national security exchanges to develop and adopt a policy to recoup incentive-based compensation upon the discovery of misreported or erroneous financial information.  The requirements under the new law are more far reaching than those under Section 304 of the Sarbanes-Oxley Act (SOX 304).

Provisions of the Dodd-Frank Act

  • Any time a company is required to prepare an accounting restatement as a result of material noncompliance with any financial reporting requirement the clawback policy will be triggered.  This expands the requirement under SOX 304 which applied only when a restatement of financial statements is “required” and is the result of “misconduct”.
  • The clawback policy would apply to all incentive-based compensation (cash or equity) paid to any former or current executive.  SOX 304 applied only to the CEO and CFO.
  • The look-back period is for the thirty-six (36) months preceding the date on which the restatement is required.  The look-back period under SOX 304 is only twelve months.
  • The amount to be recovered would be the difference in the amount actually paid based on the erroneous data and the amount that would have been paid based on the corrected data.

Policy Design/Review Considerations

  • Review any existing policies to determine any possible changes required by new law.
  • Identify the specific party required to enforce the policy (i.e. senior risk assessment officer, Compensation Committee, full Board of Directors)
  • Determine what method of recoupment will be necessary for recovery of any incorrect payments (i.e. deduction from future payments/awards, enforcement of re-payment by executive or potential litigation against former executives)
  • Determine whether policy should be more expansive than required by Dodd-Frank Act to include poor performance, violation of non-competes, negligence, etc.
  • Determine if policy is strong enough to be a mitigating factor to deter excessive risk under SEC rules which requires narrative disclosure in the CD&A in proxy.
  • Conduct a review of all compensation arrangements (i.e. incentive plan documents, employment agreements, equity award agreements) to insure proper integration with a new clawback policy.

So, while there may be many “unintended consequences” of the Dodd- Frank Act and there is much final government regulation yet to be published, it appears that Clawback Policies contribute to risk mitigation in compensation and are likely here to stay.

Are SERPs On Their Way Out?

Increasingly, Compensation Committees are asking if Supplemental Executive Retirement Plans should be eliminated from executive pay packages along with Change in Control Parachute payments and country club dues.  SERPs are misunderstood as unnecessary expenditures of shareholders’ hard earned capital, but in a 2009 survey of executive benefits, conducted by Clark Consulting, Inc., 67% of responding companies reported having supplemental executive retirement plans (SERPs), similar to the prevalence in 2007.  Let’s look at the history of SERPs to see why they are so prevalent.

During the last quartile of the Twentieth Century, the capitalist world moved away from offering defined benefit retirement plans.  Shifting mortality rates and increasing volatility of investment markets rendered Plans that promise certain retirement benefits much riskier and companies found it increasingly difficult to forecast their future costs.  Most of those old defined benefit retirement plans provided for a retirement at roughly 75% of a career employee’s final five-year average base salary.  There were variations, but that was about the average Plan’s promised benefit.  Along came ERISA (Employee Retirement Income Security Act) which established by statute that highly compensated folks could not benefit at the same percentage as the average worker in these IRS qualified plans.  The limits that ERISA imposed on participation in qualified retirement plans, like defined benefit and defined contribution 401(k) Plans, meant that executives can only provide for about 40% of their final five-year average base salaries during their retirement years.  This is still true.

So, Companies realized that the folks who were having the greatest impact on the organization, were being discriminated against on their ability to participate in the retirement plans.  Supplemental Executive Retirement Plans were then created to plug the gap.  Over time, some have forgotten what SERPs were designed to do and some of the benefits got out of hand.  Those high benefit SERPs were criticized, and rightfully so, by stakeholders.  One old argument was that executives make so much on stock-based long-term incentive plans that they should not need to save supplements for retirement savings.  Recent trends in stock markets and other forces have pushed previously granted stock options “under water,” meaning the cost to the executive to exercise the option is now greater than the value of the underlying stock.  Who wants that?  Some would say, “well, to bad for the executives.  It is their fault that the stock price has declined.”  Maybe the executives should be replaced, but if a Board decides that they want to retain their executives, or recruit new executives, the SERP issue will need to be resolved.

Retirement funds are like “bread, butter and mortgage money.”  People do not want to risk it too much, especially now that traditional sources of savings, like Social Security, are shaky.  Congress, long ago, in all its wisdom, decided that highly compensated folks did not need help saving for retirement.  So, what happened?  SERPs were born…..and my guess is that they will be around for the foreseeable future.

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