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Shareholder "Say-on-Pay": Is it the Answer?Jack Dolmat-Connell
The Current State of Executive CompensationThere have certainly been compensation packages for executives that were excessive and not defensible by any standard of reasonableness, and the overall link between executive pay and firm performance needs to be strengthened, but the fundamental system of executive compensation is not broken or “rotten to the core,” as many in the mainstream media would like everyone to believe. Unfortunately, it is from this popular media, whose main purpose is to sell advertisements and increase their audiences, that the vast majority of Americans, including politicians, get their information. Sadly, this information only focuses on what sells – in this case, the high profile “abuses” in the largest companies in the country, which are definitely not representative of the nearly 10,000 public companies that reside in the United States. Although the amount of direct compensation (salary, bonus, and equity) gets the media attention, the issues are primarily focused around the packages of CEOs (usually not other executive officers) in very large (Fortune 200) firms, and mainly concentrated in the arenas of employment contracts, severance agreements, and change-in-control agreements. They are also, almost always, not the result of Boards acting egregiously or nefariously, but rather stem from the Board not asking the right questions, not having the packages modeled out, and not spending enough time to reach an understanding of the complexities involved. This issue is not something that is going to be easily fixed by putting executive compensation up for shareholder votes. If Boards have difficulty understanding the subtleties and complexities involved in executive pay packages, which consultants, lawyers, and accountants spend hundreds of hours to design, how are the typical shareholders going to understand them enough to vote on them? The answer is, they won’t. The vote will be emotional, not rational and fully informed. This issue is also not going to be resolved by establishing somewhat arbitrary limits (essentially, price fixing). These types of limits most often don’t work. So, then what are appropriate responses to the current situation?
Appropriate Responses to the Current SituationLikely means of improving the current state of executive compensation lie in four primary areas: I. Shareholder Approval of Executive Severance PackagesThere are two important precedents that illustrate the current regulatory environment that frame the limitations placed on Boards of Directors’ actions regarding executive compensation. The first is the so-called “million dollar” rule under Section 162m of the Internal Revenue Code. Under this rule in order for companies to receive a tax deduction for compensation expenses above $1 million, shareholders must approve at five-year intervals a plan outlining the terms and conditions. The second is the requirement under certain securities laws and rules of the national stock exchanges that shareholders must approve equity compensation plans that specifically set limits on share usage for a specific time period. In keeping with the above, it would not be unreasonable for Congress or one of the regulatory entities, such as the IRS or the SEC, to require shareholder approval of executive severance plans. The approved plans would set forth the appropriate parameters for independent members of Boards to follow. During the 1990s, the use of stock options as compensation exploded in corporate America, and the potential for shareholder dilution as a result of this type of compensation became excessive. As a result, institutional investors and their advisors campaigned against shareholder approval of new plans that would increase the amounts of stock that could be awarded to executives. Recent history has shown that many companies have become averse to asking shareholders for additional shares for executives because of the high potential for dilution. Requiring shareholder approval of executive severance plans along with corresponding marketplace forces, will significantly curtail abuses in this area, while still allowing legitimate business uses of these programs.
II. Emphasize Fiduciary Responsibilities of Independent Board MembersWhile not perfect, the system of electing independent (non-employee) members of the Board of Directors to represent the interests of shareholders is a fundamental tenet of good corporate governance for publicly-held companies. For such companies polling large numbers of shareholders would be an unmanageable process with poor outcomes. Additionally, the intent of independent directors is to bring business expertise to the company. Such business acumen may not be found among the stockholders. Most Boards act responsibly. Egregious executive pay packages that are dramatically above market norms result from a combination of a lack of specific limitations imposed by regulations, and shareholder approval that is given without adequate concern for the consequences of their actions. Thus, we believe that Congress should consider strengthening penalties for misconduct by Board members.
III. Integrate Efforts to Oversee Executive Compensation PracticesGenerally, there is a lack of integration among the various overseers of executive compensation. In some instances, there are unintended consequences that call into question the appropriateness of their oversights. Two recent examples highlight concerns in this area. First, while anyone involved in nefarious backdating of stock options should be terminated from their employment and possibly prosecuted, American taxpayers are paying the price for a somewhat over-zealous review of the problem. Companies are re-filing financial statements from the 1990s to reflect non-cash expenses for discounted stock options, resulting in lower profits. Lower profits relate to tax liability, so these firms are amending tax returns for prior years in order to receive tax refunds. Magically, non-cash expenses are turned into cash in the form of outflow-from the U.S. Treasury. Second, the new proxy Disclosure Rule from the SEC has many good attributes, but there is going to be a big surprise when an investor finds out, for example, that the CEO of General Electric has a zero in the Summary Compensation Table under “Bonus,” but has a rather large number under the column heading “Non-Equity Incentive Plan Compensation.” Instead of being substantive and enlightening on this matter, the SEC actually created more confusion by taking the simple word bonus and destroying its definition. Over-zealous regulation by those who do not intimately understand the arena of executive compensation, or its relationship to other areas (taxes, disclosure, accounting, etc.), confuses the average investor – the very people the SEC is trying to protect. Before any substantive proposals for change occur, we strongly believe that representatives from the SEC, the FASB, the IRS, and Congress should convene and work together on a unified approach that takes all major factors and constituencies into consideration.
IV. Strengthening the Pay for Performance RelationshipThe issues that surround perception with respect to executive pay are far deeper than just the absolute levels of pay. If this were indeed the real issue, Americans would be outraged with the pay of celebrities and sports stars, and yet they are not. The Top 100 Highest Paid Celebrities earn more than the Top 100 Highest Paid CEOs almost across the board (see chart below), and yet there is no furor over this.
There are likely two primary reasons why executive compensation and celebrity compensation are not viewed in the same light. The first is that most Americans work in companies of some kind, and thus they relate their pay to that of the CEO and believe that the pay disparity is too big. Second, and likely more important, is the fact that many view the largest pay packages as not being linked to performance, and thus the higher levels of pay for CEOs often seem inappropriate for the performance delivered. We believe this latter issue is the much more valid of the two reasons. For an exceptional discussion of the income and wealth gap in the U.S., see Income and Wealth by Alan Reynolds. To increase the link between executive pay and firm performance, only a few changes to the new SEC disclosure requirement would be necessary to provide shareholders with much greater visibility on this topic, as well as giving Boards and CEOs a much stronger reason to understand and strengthen the relationship. Our recommendations are:
The SEC should enhance its disclosure requirement to increase the discussion and information required about Peer Group selection, and mandate that companies disclose their percentile positioning both on pay and performance against the Peer Group that they have selected. “Say-on-Pay” through shareholder votes may not be the magic elixir to a perceived crisis surrounding executive compensation. On the other hand, giving shareholders input need not be feared. We believe that Boards of Directors should continue to improve their oversight responsibilities by further linking executive compensation to company performance and embracing clear and forthright disclosures.
Investors should consider the investment objectives, risks and charges and expenses of the contract and underlying investment options, risks carefully before investing, The prospectus contains this and other information about the investment company and must precede or accompany this material. Please be sure to read it carefully. The opinions, estimates, charts and/or projections contained hereafter are as of the date of this presentation/material(s) and may be subject to change without notice. RCG endeavors to ensure that the contents have been compiled or derived from sources RCG believes to be reliable and contain information and opinions that RCG believes to be accurate and complete. However, RCG makes no representation or warranty, expressed or implied, in respect thereof, takes no responsibility for any errors and omissions contained therein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this presentation/material(s) or it contents. Information may be available to RCG or its affiliates that are not reflected in its presentation/materials(s). Nothing contained in this presentation constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any investment product. Investing entails the risk of loss of principal and the investor alone assumes the sole responsibility of evaluating the merits and risks associated with investing or making any investment decisions. Jack Dolmat-Connell and Gerry Miller This material has been used with the express permission of the author and does not represent the ideas or recommendations of Retirement Capital Group or its subsidiaries or affiliates
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