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.

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

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.