Friday, March 07, 2008

Beware the Compensation Headlines: Apples and Oranges

Beware the Compensation Headlines: Apples and Oranges
by Fred Whittlesey, Principal,
Compensation Venture Group, Inc.

I have often said that when one reads an article about executive compensation in any of the leading business publications – the Wall Street Journal, Business Week, Forbes – one should assume that the pay amounts cited are incorrect. While they are not always incorrect, such an assumption will be valid the vast majority of the time, and saying it’s wrong makes you right most of the time.

With proxy season upon us, we now have many headlines every day reporting executive pay as reported in the proxy statements. The new disclosure rules have resulted in large amounts of additional data, reported in different formats and under different methods. What was granted, earned, paid, and realized are very different numbers and can all be construed as “pay.” The media go further by adding terms of received, valued at, payment, and worth. Not to mention the adjectives they include: excessive, exorbitant, lofty, huge, and so forth.

Despite many companies’ best efforts to go beyond the new requirements and produce additional tabular disclosures and associated narrative explaining their executive pay programs, the technical complexity and sheer volume of the information leads to misinterpretations.

Yesterday, three prominent companies had their CEO’s pay reported in the media. All three were reported incorrectly.

§ The WSJ reported pay for the CEO of Coca-Cola Company that was 13.9% higher than actual, off by $3.9mm. This is because the number used for stock awards was pulled from the Summary Compensation Table rather than the Grants of Plan-Based Awards Table. They reported all apples with one orange.

§ The New York Times did a little better in the treatment of the pay for the CEO of General Electric, getting the numbers generally correct. I say “generally” because they are consistent with the SEC-mandated reporting which requires accounting-based values for long-term incentive awards and which are completely irrelevant for compensation analysis purposes. They reported all apples but then mixed their fruit when it came time to discuss pay that was “earned” – earned pay (again according to accounting rules) was up 9.7% ($1.7 million) not down 6% as reported in the article. Earned and granted are both important measures but who wants to eat an apple and an orange at the same time?

§ Back to the Wall Street Journal, and a piece about the new CEO of E-Trade. This should be easy because it’s a new-hire package, no confusion over what was granted vs. earned vs. paid. But alas, complexity is here too. While it is true that he would receive a severance payment of $5 million if terminated without cause or in connection with a change in control (five times base salary) he also would receive accelerated vesting of the stock awards. Because his agreement entered in 2008 ends in 2009, and given E-Trade’s potential as a takeover target, there’s a good chance he’ll get that $15.4 million in accounting value of his stock and option awards. (That’s about $21 million for a year or so of work and we can put that in the queue for the next batch of Congressional hearings.) More importantly for this discussion, that $15.4 million is a vast understatement of what those awards will be worth in any change in control scenario or even in a business-as-usual scenario. What we know is that his severance likely will be not $5 million but a multiple of $5 million. Those apples and oranges will more likely end up a watermelon, or two.

At a time when CEOs, Chairs of Compensation Committees, and compensation consultants are being summoned to Congressional hearings on the topic, it is critical to interpret market information properly. Journalists show a continued inability to do that and it’s not their fault. The reporting rules were designed by legislators, government agencies and lawyers. The data are prepared by various combinations of lawyers, accountants, actuaries, and consultants. And very few journalists have any of the foregoing backgrounds. Various interest groups, with admittedly less objectivity than journalists are hoped demonstrate and no greater expertise, use the multifaceted data to bolster their views. Experts in the field, like me, disagree with each other on how to properly measure pay so as we point our finger the others are indeed pointing back at us.

Companies must understand that the proxy disclosure requirements are a poor basis for understanding executive pay practices. The data are a starting point for analytical approaches that can provide that understanding, and nothing more. The footnotes and narrative contain critical information that isn’t presented in the structured tables but often are the key to determining the real value of pay.

Compensation Committee members, executive teams, and compensation professionals have a more important responsibility than ever for understanding, analyzing, and basing decisions on correct interpretations of market data. We’ve never had more data, never had better electronic means for getting and analyzing that data quickly, and never had more opportunity to get it wrong. This week’s headlines are proof of that, and each week ahead of us will provide more examples.

Disclosure: My family owns shares of Coca-Cola, does not own shares of GE, and sold our position in E-Trade shares last year. I do not believe that my past or current financial position in these companies has any impact on my opinion of their compensation practices or the reporting thereof.

Monday, November 19, 2007

Google It: "overpaid CEO Calcutta"

At this point I should not be surprised when I inadvertently discover that a blog that I wrote long ago was referenced last month in an online article about CEO pay. I also should not be surprised that the article appeared in "Calcutta Online" which is published by the India Institute of Management though I don’t know anyone there and have never spoken to them. Least surprising of all is that it would appear in the "Diatribe" section of the site. Of the alternative definitions of "diatribe" I prefer of course Merriam-Webster's third one.

The article, authored by Sidarth Mohan, is titled "CEO Compensation Debate" and the excerpt he quoted from me is:

“Most CEOs I've dealt with are highly intelligent, have advanced degrees--often from one of the top universities in this country or elsewhere in the world--and have worked 70 or more hours per week for most of their career. Even if they weren't CEO of a public company, people with a background like that get paid much more than the average person.”

This is from an opinion piece I authored for Cnet's News.com site 18 months ago. What's most interesting is that while 18-month old news can be quite outdated, when I re-read this piece I thought it could have been written yesterday, and likely could be republished 18 months from now and seem just as fresh. This is because the CEO pay debate is not dying down; it is still escalating and will continue to do so, particularly as we head into a presidential election year in the US.

Compensation Committees must be aware that the SEC's scrutiny of proxy disclosures will continue next year, the media will piggy-back on those disclosures as never before, and Committees will be under increasing pressure to have a diligent, data-based decision process that is thoroughly and clearly disclosed in the proxy statement.

Compensation Committees also need to be aware that in a global economy with investments crossing international boundaries compensation practices are subject to scrutiny of those beyond America’s borders. An article in Calcutta Online might have a similar impact to an article in the San Jose Mercury News (not to suggest that they are of similar journalistic status – I don’t know if they are or not) and could influence a shareholder or shareholders to view differently the executive compensation arrangements at a company. We all know where that can lead.

I also don’t know how Sidarth Mohan’s influence compares to that of Gretchen Morgenson or how Calcutta Online stacks up against the New York Times, but I do know that people easily find information online, don’t always know much about the source, and are often influenced by what they read.

For those Compensation Committee members that remember the uproar over “Oh, Calcutta!” – which debuted off-Broadway in 1969, was revived on Broadway in 1976 and ran for 13 years briefly becoming the longest-running play in Broadway history, with a total of 5,959 performances - they will remember how events thought to be innovative are easily re-defined as "scandals" and capture the public’s attention, and executive compensation has become ensconced in the scandal category. As we wind down 2007, have Compensation Committee meetings planning for 2008, and anticipate the continued evolution of the regulatory, disclosure, political, and media environment in the new year we should all remember that things said and done long ago (in Internet time) can have quite a lifespan.

(The worst thing about an 18-month old web page is that my affiliation is incorrect. I am now, in addition to my role as Principal Consultant of Compensation Venture Group, Inc., a Fellow with Salary.com (NASDAQ: SLRY), advising them on executive and equity compensation matters in connection with their CompAnalyst Executive data service.)

Wednesday, February 07, 2007

Did You Hear the One About the Compensation Committee Member…

Fred Whittlesey
Compensation Venture Group, Inc.

…who worked 300 hours on Compensation Committee matters last year? Neither did I. But I expect that this time next year we will be hearing those kinds of tales. The Business Week article “Board of Hard Knocks” (22 January 2007) cites the “new rules for directors” including that Audit Committee members should be prepared to spend 300 hours per year on committee responsibilities. (Disclosure: I am quoted in the article.)

But that’s the Audit Committee; the Compensation Committee can’t require that level of time commitment, can it?

Business Week’s cover teaser was “Board Seat, Anyone?” I’d ask “Compensation Committee Membership, Anyone?” Let’s look at the numbers.

In small and midcap technology companies, the typical Compensation Committee met six times last year. I’ll assume that these typical Committees were diligent Committees and spent four hours in each meeting. I’ll further assume that the individual Committee members always received the materials well in advance of the meeting and spent four hours reviewing and considering the materials. Let’s give them credit and assume they spent another 2 full days before each meeting in talking to one another, talking to management, and so forth. That’s still only 144 hours. And that’s the problem. Let’s add, say, 3 days at training courses. That takes it to 168 hours which is 8% of a year of 40-hour weeks. We’re still 16-and-a-half days short.

Audit Committees experienced trial by fire with the advent of Sarbanes-Oxley. Compensation Committees experienced the Sarbox zeitgeist, but didn’t have the numerous and onerous new requirements to contend with. Instead, Compensation Committees have experienced a slow water torture of changes in accounting rules (FAS123R), tax rules (409A), corporate governance expectations, proxy advisor and institutional shareholder policies, and SEC rules (disclosure requirements). All of these took time but were driven by technical specialists who presented the issues and solutions, went away and crunched numbers and drafted documents, and then ran it by the Committee for approval. That is, until the new SEC disclosure requirements came along. And, that is, until the media and shareholder noise level resulting from the new disclosures creates the need for earplugs like a front row seat at a Metallica concert. And creates hours and days and weeks of work. 300 hours is roughly two full-time months of the work year.

We have seen a pay hierarchy emerge in director pay. Of course, committee members earn extra pay for the committee work, and committee chairs earn even more pay for their role. But the differences in workload have already been reflected in director pay programs: Audit Committee members typically receive about a third more than Compensation Committee members, who typically receive a third more than members of other committees such as the nomination and governance committee. Further, the Chair of the Audit Committee is typically paid much more than the Chair of the Compensation Committee in additional retainer and/or meeting fees.

Over the past year, I have heard many people say “the comp committee is the new audit committee” or “compensation 2007 is audit 2003-2005.” If so, Compensation Committee members may need to discuss whether their compensation deserves a similar level of attention to those of the executives they are monitoring.

The other challenge facing compensation committee members, also cited in the Business Week article and the subject of a recent article in McKinsey Quarterly, is the need to refocus on strategy in a time of compliance.

That is the topic of our next issue of The Compensation Committee Adviser.

Wednesday, November 29, 2006

Global Warming for Compensation Committees

Fred Whittlesey
Compensation Venture Group, Inc.

Greetings from Seattle, where this month we had snow, sleet, hail, record rainfall, wind, and record low temperatures. These unusual weather patterns caused much of our citizenry to be confused, intimidated, and many just stayed home - after all, we’re accustomed to some rain this time of year but the snow/sleet/hail/wind/cold is a different game. Yesterday it was sunny with a clear blue sky – still cold, but you could see where you were going and get there reasonably safely, with just a little ice on the roads – proceed with caution and you were OK. Today, another storm hit. Of course many are attributing this to global warming which is curiously ironic.

Members of Compensation Committees across the country are feeling a bit like Seattle residents did this week as they experience the equivalent of global warming in the compensation environment – disruption and continual change from the norms of the preceding decades. They were accustomed to an ongoing challenging, but stable, role and then everything changed – accounting, tax, shareholder activism, proxy advisor policies, and then the new SEC disclosure rules. The feeling now is that proceeding with caution will be enough. Yet just as we’ve scraped the ice from the windshield and plowed the roads to get through the new tables, CD&A, and associated requirements for the next proxy statement, here comes another storm: ISS 2007.

Many are unaware that Institutional Shareholder Services (ISS) has already issued their policies for 2007. They have not been this far in front of the calendar in the past. The US, Canada, and International policies total about 45 pages. This issue of the Compensation Committee Adviser summarizes the key points that Compensation Committee members, executives, and compensation professionals need to know.

While admittedly oversimplifying, I’ve organized compensation practices onto Good and Bad lists for quick reading. As I’ve been discussing with my clients over the past few years, the Good and Bad categories keep changing and continue to vary among the various list-makers. We all remember when stock options were Good and restricted stock was Bad; then after Enron and the Breeden Report, among other events, options were Bad and restricted stock was Good. Next, the shareholder advocates chimed in and, at least for executives, options might be OK, restricted stock is Bad, and performance plans are Good.

Here is the new checklist of the Good and the Bad, from the perspective of ISS which – pardon the cinematic reference – is becoming increasingly ugly. Many of the Good are now defined by ISS as “best executive pay practices” and the Bad as “poor pay practices.”

Good

* Burn rates that fall below the level of the mean plus one standard deviation for the industry, with “industry” based on the company’s GICS code. It is critical to ensure that ISS has your company properly classified as misclassification has led to erroneous voting recommendations by ISS

* Employment contracts entered into under limited circumstances with a term of 3 years or less, no automatic renewal, and a specified termination date
Severance provisions “not so appealing that they become incentives for executives to be terminated”

* Severance agreements excluding tax gross-ups (here I say “hurray” to ISS for underscoring the rapacious nature of tax gross-ups)

* Change-in-control payments only based on double-trigger conditions (change-in-control and loss of employment)

* Supplemental Executive Retirement Plans (SERPs) that exclude sweeteners and formulae that include equity awards and variable pay (i.e., annual bonuses)

Bad

* Employment contracts with multi-year guarantees for bonuses and grants

* Excessive severance provisions

* Single-trigger change-in-control provisions that result not only in payments but in full acceleration of stock award and option vesting

* Excessive perks (e.g., tax gross-ups for personal use of corporate aircraft)

* Large bonus payouts with poor performance linkages and/or performance metrics changed during the performance period

* Overly generous new hire packages for CEOs

* Internal pay disparity (i.e., CEO pay more than x times that of direct reports, with “x” not defined)

* Above-market returns or guaranteed minimum returns on deferred compensation amounts

* Anything that does not comply with the characteristics of the Good list

(That last bullet, while perhaps sounding flip, is consistent with the SEC’s approach to defining a “non-equity incentive plan” in the new disclosure rules. They say “A ‘non-equity incentive plan’ is defined as an incentive plan…that is not an equity incentive plan.” I think a sentence like that in graduate school would have drawn a lot of professorial red ink to my paper.)

This Good and Bad list only reflects ISS’s US policy – they have separate policies for Canada, the UK (not yet released), and other International locations. For example, a new view of Matching Share Plans (Sweden, Norway) for 2007 is that they are acceptable with significantly discounted prices for executives (up to an 80% discount), as long as performance criteria are attached. Contrast this to the unilateral hatred of discounted stock options by ISS and virtually all shareholder groups, a view reflected in the 409A rules.

ISS also has changed four key points of their share value transfer methodology (see p. 14 of the linked document). The four changes increase the calculated cost of equity-based compensation plans. Said another way, whatever was done last year just became more “costly” this year, in the eyes of ISS. You may have driven down that road at 45 mph last year, which was the speed limit then, but they just lowered the speed limit to 35 mph so you were speeding last year and here’s your speeding ticket. Yes, that is how the logic works.

In addition, ISS has revised the criteria for the Corporate Governance Quotient (CGQ) ratings model with a focus on two of this year’s hot topics, financial restatements and option backdating.

If your shareholders’ voting habits are not driven by ISS you might conclude that none of this matters which, tactically, may be true. But in this environment of viral spreading of compensation ideas, good and bad, it behooves all to keep this list in mind during the year-end compensation planning – and disclosure – processes.

Some recent cases in point: The Commissioner of the Internal Revenue Service recently put all cash- and stock-based incentives on the Bad list, but only for CFOs, General Counsels, and Non-employee Board Chairs – not that this changes the tax rules but just adds more fuel to the already heated discussion. Similarly, Moody’s put stock options, EPS as a performance measure, and stock buybacks on the Bad (i.e., you’re a credit risk) list, but only if they all three are used together, which is true for the majority of large US companies.

Once a company identifies the relevant policies of other proxy advisory firms (such as Glass Lewis), major institutional shareholders with policies that sometimes contradict and sometimes compliment those of ISS (Fidelity, Dimensional, CalPERS, CalSTRS), and other policy-setters (Moody’s) all the Committee must do is approve the design, amounts, and operation of the company’s executive compensation programs - within the constraints, of course, of FAS123R; IRC 409A, 162(m), and 280G; and all of the tabular disclosure requirements. And then management can write that up for the proxy statement CD&A.

One might notice that ISS’s cumulative policies, over the years, have converged with the SEC’s disclosure agenda. Many of the practices that ISS considers Bad are those that have received the most attention in the SEC’s new disclosure rules. Now that everyone can see it, the logic goes, you’ll have to stop doing it – “it” being pay-for-failure agreements, tax gross-ups, egregious severance deals that provide downside coverage despite the rationale that large equity awards were needed due to the “high-risk high-reward” culture, and so on.

The forecast? Continued evolution of accounting, tax, and securities rules, increasing levels of critique and commentary from increasingly diverse sources, new behavioral and financial theories about Good and Bad pay, academic studies finding answers in mountains of data…and increasing workloads and time commitments for Compensation Committee members. As the heat increases on Compensation Committees, things will continue to get more unpredictable and change will be the only constant - like the weather. But you will find my forecast to be much more accurate than those of meterologists.

Next Issue: UK Policy Creeps into US Practices: Payback Time

Wednesday, September 20, 2006

The New ROI of Executive Pay

Fred Whittlesey
Compensation Venture Group, Inc.

In May 2006, I presented at WorldatWork’s Annual Conference a session titled “The Real Meaning of ROI…for HR Professionals.” It was a financially-oriented look at how HR professionals should present their ideas – in dollars, just like the other areas of the business organization. It has been named “Best of Conference” and I have been invited to present it again, as a webcast, on 01 November. It is telling that such a highly technical and complex topic was so well-received by an audience not known for its financial savvy. This shows that the notion of ROI is now a central topic in compensation.

We are beginning to discuss this with regard to executive compensation but we have not yet begun to call it “ROI.” The analysis of executive pay has focused on two metrics: The total dollar amount paid to executives (numbers that are usually misrepresented in the media and by proxy advisory groups) and the associated return to shareholders over a period of time (which typically is misaligned with the purported pay period). This forms the basis for the “pay for performance” analysis.

The idea of relating executive pay levels to company performance is an important one, and continuing work must be done to ensure both the measurement of pay and the relation to performance are correct. We might consider this “external ROI” – the return realized by shareholders as a result of their investment in an executive team.

This pay-for-performance focus has overshadowed what may be an equally important analysis, however, in light of the growing complexity of pay plans and the new governance environment. The cost of designing and administering executive compensation plans, particularly equity-based plans, is significant and more so for global plans. As accounting and tax rules have both constrained and enabled the features of these plans, the design and administration costs have increased. The new SEC disclosure rules add still more cost, due to both the processes required and the documentation and reporting of those processes and decisions.

As a group of professions (consultants, accountants, HR executives, lawyers, plan administrators) we have never calculated the total cost of the intricate executive compensation programs we collectively design, and related that cost to the compensation delivered through those plans. As one lawyer asked during a recent conference panel discussion, “Is it costing us ten dollars to deliver one dollar of perks?” We might consider this “internal ROI” – the relative efficiency of expenditures. When we donate to a charity we often ask what the administrative expense ratio is so we understand how much of the dollar we give actually goes to those in need. In executive compensation, we need to be asking how many of the dollars we pay actually go to the executives to reinforce the corporate goals of retaining those executives and focusing their efforts on value-creating activities.

The new disclosure rules will provide more fodder for shareholders, pay critics, and the media to take potshots at executive pay practices and, more critically, the members of the Boards of Directors approving those practices. There will be knee-jerk reactions, poor decisions, and then revisiting of those decisions a year later. That will create more work, and more professional fees and internal costs, and will reduce ROI.

This year’s executive compensation reviews must focus on ROI, both external ROI (eROI) and internal ROI (iROI). These analyses should form the underpinning of the narrative required by the new SEC disclosure rules and ensure that the Compensation Committee and the executive team are able to address those requirements within a data-based analytical framework. It will be unfortunate if resources are focused solely on compliance activities indicated by the rules rather than the structure and operation of the programs that led the government to perceive there was a need for those rules.

Friday, September 15, 2006

Welcome to The Compensation Committee Adviser

Fred Whittlesey
Compensation Venture Group, Inc.

The recent article "Shaping Strategy from the Boardroom" in the McKinsey Quarterly begins by stating "As companies turn their attention from compliance to growth and innovation, boards must focus on strategy." The article goes on to say that since boards of directors have now "come to terms with the new governance rules...it's time to move on." While that may apply to the overall activities of the Board, there are areas of Board responsibility where this is not yet so - like those of the compensation committee.

It is critical for Compensation Committees to focus on strategy and avoid letting the compliance tail wag the design dog. Most Compensation Committees, having now gotten through FAS123R accounting, option valuation, and most of 409A deferred compensation rule changes are again besieged with the option backdating scandal, new SEC disclosure rules published last week, and continuing changes in investors' criteria. Just about the time they digest the new disclosure rules they'll be seeing Institutional Shareholder Services' 2007 Policy Statement.

I agree with the McKinsey authors' statement that "too many (boards) simply lack directors who have the industry expertise to participate effectively in shaping strategy - much less to reshape it on the fly as the business climate changes." When we view "industry" as the "compensation industry” we find this statement applies to compensation committees as well. But in the directors' defense, no one - consultants, accountants, lawyers - has much "experience" with these new rules. What is needed is a strong commitment by compensation committee members, and their advisers, to devote the time and attention needed to communicate, understand, assimilate, and act upon the continuing changes in the executive compensation environment. This requires a multi-disciplinary approach, not an accounting viewpoint from the auditor, then a tax viewpoint from the CPA followed by a legal viewpoint from the lawyers.

The Compensation Committee Adviser is a resource for clients, colleagues, and interested parties to maintain a day-to-day awareness of the changing landscape in executive compensation in the hope that we can indeed balance the attention to compliance with sound strategy, good design, and effective execution. Like our firm’s compensation consulting practice, it emphasizes a multi-disciplinary approach to decision-making in the complex executive compensation environment. I hope this resource, plus additional education opportunities you will find listed on our website, provide valuable support for the difficult job of compensation committee membership in these turbulent times.