The legislative history of say on pay is a long one.  Its sponsors have included some of the most famous and influential members of Congress.  It has passed one (but not both) houses of Congress on various occasions.  But for some reason, it has never crossed the finish line.
 

Most recently, the House passed a financial industry reform bill that included mandatory say on pay (as well as other governance reforms).  As House bills often do, it has bogged down in the Senate, which has its own bill (written by Senator Dodd no less).  Proponents of these reforms had reason for optimism though.  Senator Dodd, chair of the Senate banking committee with jurisdiction over the bill, has been a strong supporter of say on pay and other reforms.  More importantly, he has been in personal electoral need of tough legislation to show his independence from Wall Street.   As I noted awhile ago, Dodd turned down the opportunity to take the chair of the health care committee and help run the health care issue, which would have provided him an even bigger stage.   I viewed this at the time as suggesting say on pay and the other governance reforms were likely to pass, given the Senator’s tough reelection prospects and need to show results.

Well, I had the part about tough reelection prospects right.  Today, Senator Dodd announced that he will not run for reelection, in part because of public polls showing him losing by large margins.  He will instead retire at the end of this year.  Much will be written about what this signifies for national politics.  I think it also has interesting implications for say on pay and other governance reforms.

There are two key questions.  Who will replace Dodd as the banking committee chair and how quickly will Dodd turn over the reins to his replacement. 

As I understand them, Senate seniority rules will likely give the chairman’s seat to Tim Johnson.   Johnson hails from South Dakota, a reliably red state (it gave John McCain an 8 point margin of victory in the Presidential election), and he is generally considered a centrist Democrat.  South Dakota is also interesting in that finance is its single largest and most important industry, representing close to a fifth of its economy.  On a number of occasions (including recently), he has broken ranks with his fellow Democrats and voted against financial industry reforms.   Johnson also has the luxury of not facing reelection until 2014.   So, under a Chairman Johnson, I could well imagine the Senate producing a bill that is significantly different than the House version, resulting in a messy reconciliation process that might scuttle the entire project. 

Unless, of course, Senator Dodd tries to make this bill his swan song and avoid the usual fate of lame duck politicians (ie running out the clock and accomplishing nothing).   To that point, little can be said yet.  Press reports today have suggested that Dodd has health concerns, which might pull him away from Washington.   Were Dodd to try to rally the Senate behind his legislation, he might also be hindered by the fact that he is (based on polls) enormously unpopular among his constituents (recent polling showed him losing by double digits to one of his Republican challengers; Connecticut gave Obama a 22 point margin of victory over McCain in ‘08).  Just how much authority can such a person wield?  

While this announcement (along with some others today) proves that politics is unpredictable, I think it has meaningfully reduced the probability that we will see a comprehensive corporate reform package enacted in the near term.

Recent developments on both sides of the Pond show different approaches to executive pay.  Starting with the UK, yesterday saw the announcement of a one-time banker bonus tax.  The tax is equivalent to a 50% payroll tax applied to bonuses in excess of twenty five thousand pounds (around $40,000).  In other words, banks are free to pay whatever they like and the recipients will retain the same after-tax amount, but the banks will pay a penalty for doing so.  The NY Times reports that the chief advocate of the tax, chancellor of the Exchequer Alistair Darling, has essentially conceded that the tax is, not surprisingly, a political act.  To put that in context, the current British government is in fairly desperate electoral condition, with many observers expecting the rival Tory party to regain power at the next election, absent a miracle.  In that light, punitive banker bonus taxes make short term political sense.

The US is not immune to this sentiment of course.  Following the AIG retention bonus uproar, the House passed  a bill that would have imposed a 90% tax on bonuses paid by bailed out banks.  The bill failed to go anywhere, not least because it was not supported by the White House which was and is far more popular compared to the current UK government.

Rather than confiscating bonuses, the US has gone in the direction of governance reforms great and small.  The most significant reform proposals are embedded in Senator Dodd’s financial reform bill.  These include mandatory say on pay, proxy access, majority voting and many others.  Since it was proposed a few weeks ago, nothing definitive has happened with it.  On the other hand, the House bill, sponsored by Barney Frank, has been actively debated and amended.  In fact, the course it has taken resembles nothing so much as the health care reform proposals.  In the House, the bills have been pushed and pulled at the extremes--some call for new home loan subsidies for the unemployed; others call for limiting the states’ ability to regulating banks.  Meanwhile, the Senate plods along with a more centrist approach.  As with the health care legislation, it is very difficult to handicap whether (or in what form) financial industry legislation will succeed.

Which leads us to the SEC.  The Commission itself (rather than the staff) consists of only five individuals, a majority of whom are appointed by the President’s party.  This means that a motivated SEC, unlike Congress, can usually act quite quickly to make or amend rules.   Given the amount of criticism the SEC has taken over the last two years, they would seem to have ample motivation to take bold steps.  Indeed, this past summer, the SEC seemed to be doing exactly that.  In June, they released their “proxy access” proposal, which would enable stockholders to nominate their own directors to compete against the candidates proposed by issuers.  A month later, they proposed enhancements to the disclosure requirements on executive pay, director independence, comp consultant independence, risk taking and other items.  As I noted previously, the proxy access proposal has bogged down and was taken off the 2009 calendar awhile ago.  Similarly, the disclosure proposal seemed to fall off the map.  Issuers were left wondering, in particular, whether the rules would apply to the annual proxies to be filed next spring.

Yesterday, the SEC surprised us by announcing that they would hold a (previously unscheduled) meeting next Wednesday (Dec. 16th) to considering enacting the new disclosure rules.  It is almost certain that the SEC will finalize the rules or some version of them.  But, we still have no sense of whether they will go into effect for next year.   The fate of proxy access (as well as new federal legislation) remains murky.

Stay tuned for next week’s SEC meeting to learn what new disclosures (if any) you’ll be required to make next year. 

Not long ago, I speculated that Senator Dodd’s decision to pass on taking over Senate leadership of the health care bill (by turning down Sen. Kennedy’s committee chair) suggested that financial industry reform had much better prospects than health care reform. Yesterday, just days after the House’s 1000+ page health care bill landed in the Senate with a thud, Sen. Dodd released the “Restoring American Financial Stability Act of 2009,” a 1000+ page bill that purports to regulate consumer finance, end “too big to fail,” guard against systemic risk and rationalize federal bank regulation. And of course regulate executive compensation at all public companies, whether or not connected to the financial sector. You might reasonably wonder what pay practices at tech companies, equipment manufacturers, commodity producers and indeed any company that’s not in the financial industry have to do with the stability of the nation’s banks. Well, the argument given in the summary of the bill says that Wall Street’s compensation practices contributed to the meltdown, therefore everyone’s compensation must be regulated. The non sequitur seems not to have bothered or even occurred to the drafters. So, it’s not surprising that virtually nothing in the bill has anything to do with Wall Street’s pay practices; it is instead drawn from decade old arguments about public company pay (e.g., shareholder access, director independence, misuse of consultants, etc.).

The Dodd bill will have to compete with similar legislation proposed by others this year, but in the past (including with TARP), Dodd’s committee has held sway, with Administration proposals in particular being mostly ignored. So, I consider this bill the one to watch.  That being said, you probably don't need to watch very carefully, at least for awhile.  Congress has less than 20 working days left in the year.  Health care will likely dominate that period, which means this will become the Restoring American Financial Stability Act of 2010.

In many respects, the bill is like all the others:

-Mandatory “say on pay” votes, as well as a separate advisory vote on golden parachutes

-Tightened independence standards on compensation committee membership

-Additional disclosure on the use of compensation consultants

-Outside of the comp arena, the bill also includes proxy access, majority voting on directors and other broad corporate governance changes


Some important differences though:

-Mandatory clawbacks. Every public company would be required to implement a clawback policy. The policy would have to provide that, in the event of a restatement, any compensation paid during the prior three years to any executive officer (including former officers) based on the erroneous data must be repaid. Although on the surface this looks like a dramatic expansion of the Sarbanes-Oxley statutory clawback, the bark here is worse than the bite. The clawback only applies to amounts that were paid based on flawed accounting. Those kinds of restatements are, on the whole, few and far between. They do not arise simply because a firm incurs losses. I’m not aware of any major bank or financial institution that had to restate its financials during the last couple of years; they just had losses.

-Consultants, attorneys and other advisors to the comp committee (if any) must be “independent” (to be defined by the SEC). The notion here seems to be that committees must choose between getting no direct outside advice or getting advice solely from independent advisors. Notably, the bill requires any committee that foregoes outside advice to disclose that fact in its proxy, which no one will want to do. The net effect being a strong encouragement to use independent advisors.  It remains to be seen whether this rule would require management retained advisors to be completely cordoned off from the board.

-Enhanced committee oversight over advisors. The bill includes an express requirement that committees be directly responsible for hiring, compensating and overseeing their advisors. Hard to know what this would translate into in practice, but it has the potential to drive a deeper wedge between comp committees and management.

-New pay disclosures. The bill would require companies to include in their proxy information that relates exec pay to financial performance, including a graph or chart that compares exec pay to financial performance over a five year period. Interestingly, the SEC considered this type of disclosure when it rewrote the proxy rules a few years ago. They rejected the idea because it would lead to an excessive focus on stock price, and thereby overshadow other performance metrics that were material to decision making. Given the long time lags in many types of compensation (e.g., options with a four year vesting period and ten year exercise period), there is a serious risk that this kind of disclosure would be misleading to investors, unless the SEC is very careful with the implementation.

-New hedging disclosures. The bill would require companies to disclose whether employees (not just officers) are permitted to hedge their equity compensation. This is another issue that was debated when the SEC revised the proxy rules. The current rules require disclosure of shares that are actually pledged (as is often the case when a hedge is put on), as well as Form 4 filings when officers enter into or close out most types of derivatives used in hedges. In addition, many public companies already have some sort of policy or guideline that restricts hedging. Its inclusion in the bill is interesting as I’m not aware of any allegation that Wall Street executives avoided stock losses thanks to hedging. If anything the opposite was true.  

Anyone who has been involved in public company executive pay knows that the PR and IR aspects matter. The press, like never before, is willing and able (in some cases, excited) to run negative stories about executive pay. These stories can dull or even neutralize positive messages the company wants to tell. E.g., pay issues turn the focus from the company’s hiring a great new manager and the company’s prospects for improved performance to the new manager’s pay package. These stories are also not lost on shareholders, including institutional shareholders. As a result, directors appropriately consider how pay decisions will be disclosed to and received by the press and the public. Keep in mind, though, that the capacity of the press and pay activists to criticize knows no limits.

Case in point: The NYT ran a story in the business section this weekend, which described the latest outrage in Wall Street pay. It wasn’t guaranteed bonuses, it wasn’t big cash payments, it wasn’t the lack of clawbacks or pay for performance links. No, it was stock. At the end of last year, Wall Street firms, for a variety of reasons, paid their employees with a far higher proportion of stock than normal. One would think that this was praise worthy. After all, most best practice guidelines suggest stock-based pay is superior to cash (it has a better pay-for-performance link, a built-in clawback and generally carries better retention provisions). The G-20, which is working on financial reform guidelines to be implemented by its member states (including the U.S.), proposed increased levels of stock pay. The TARP rules that govern the bailed out banks prohibit bonuses to be paid in any form other than stock. The Pay Czar has even required salaries to be paid partly in stock. So what’s the problem? Windfalls. As bank stocks have recovered, the executives who received stock last year have seen big paper gains. This is a problem, suggests the story, because the bank stocks were protected from falling further last year by the Federal government and their recent rise is at least partially attributable to the government as well. As one source put it, “[t]his had nothing to do with people’s performance.” Hence, the windfall characterization.

Regardless of what you think about the macroeconomics embedded in the article’s argument, I think it speaks to a general point that directors should keep in mind. Doing everything right does not insulate you from attack. There is always an angle for the press to follow. The best current example is the unavoidable balance between performance incentives and risk taking--increase pay for performance and you encourage risk taking; reduce incentives to take risks and you reduce pay for performance. Note that this issue is not limited to the financial sector. One gets the sense that, with the possible exception of deep across the board pay cuts, there is no compensation decision that the press cannot find a reasonable basis to attack. The good news is that the courts continue to recognize that reasonable minds can always differ over compensation decisions and, as a result, will generally not interfere. The press is a different matter.

Hopefully, you are aware by now of the SEC’s proxy access proposal. This is the idea that public companies will have to allow shareholders the ability to nominate their own candidates to the board. The nomination, disclosures, voting materials etc. would be carried on the company’s proxy statement (i.e., shareholders can directly access the company’s proxy). This is in contrast to current law under which shareholders who want to nominate their own candidates must, in effect, produce, file and distribute their own proxy statement, which is expensive and complicated. The SEC considered proxy access a few years ago, and it quickly turned into one of the most contentious topics in its history. It ultimately was abandoned. The new SEC chairman has taken up the gauntlet again. A new version of the rule was proposed several weeks ago. Three of the five SEC commissioners announced publicly their support. The chairman suggested that unanimity was not going to be a requirement. Things looked good, in other words, for proxy access proponents.

Then the SEC received over 500 comment letters. Many were from practitioners who asked simple but important questions, such as: which shareholder gets to nominate the candidates (under the rule, no more than 25% of the directors can be nominated so someone has to decide who gets the nomination rights)? Under the proposed rule, it is first come-first served (seriously). Other commentators asked whether shareholders should have the right to inoculate the company from outside nominations. In other words, if a majority of shareholders don’t want the minority shareholders to be able to nominate board candidates, then why bother giving them that right. These are not easy questions to answer, which is no surprise because they were a big reason why proxy access fell apart when it was first considered a few years ago.

Now comes interesting news that the SEC no longer expects to have a proxy access rule approved in time for next year’s proxy season. Although deferral is not yet set in stone, the fact that the commissioners are discussing it publicly makes it fairly safe to assume that proxy access will be an issue for 2011, not 2010, proxies and shareholder meetings. More importantly, it suggests that the SEC is having a hard time finding good answers to all the thorny questions proxy access raises. More than one proposal like this has crashed and burned when it came time to settle the details.

The SEC has reiterated, on the other hand, that its proposed updates to the executive compensation disclosure rules will be finalized shortly and will be in effect for next year’s proxies. These are the proposals that introduce risk-incentive pay disclosures among other things.

It’s not me. It’s the report just issued by The Conference Board’s task force on executive compensation. You can find it at: http://www.conference-board.org/publications/describe.cfm?id=1692 For those who don’t know, The Conference Board is a non-profit organization that brings together business leaders to discuss important topics and provide, roughly speaking, the business community’s view of best practices. The committee that released the report was co-chaired by Robert Denham, former Chair and CEO of Salomon, and Rajiv Gupta, former Chair and CEO of Rohm and Haas.

The report is a clear and succinct review of both the general role and responsibilities of compensation committee members and the specific controversies and issues that comp committees are facing today. For someone stepping into a compensation committee position for the first time, the report is a great way to get up to speed quickly. For those with experience, it provides a nice tune up.

The report is also important because it is one of the first (and maybe the only) organized and coordinated responses of the business world to the increasingly aggressive posture taken by pay critics.  While everyone will find some points to quibble with, it is a calm thoughtful analysis, which makes it superior to much of what is published on this topic.

Here are a few important points made in the report:

-One-size fits all rules will fail. The report notes that there are more than 12,000 public companies in the U.S. Each has different circumstances and those circumstances change over time. Rule-based approaches cannot hope to succeed. Most of the tax law on executive comp is a perfect example (e.g. 162(m), which led to increased reliance on options; 280G, which lead to widespread use of tax grossups; 409A, which wasted vast amounts of shareholder wealth on compliance with trivial tax requirements).

-“Best practices” are not always the best for shareholders. As a corollary to the first point, the report notes that some companies in some circumstances will find that violating best practices is in their shareholders’ best interest. In fact, the report is very careful to avoid criticizing any specific pay practices on the merits. Instead, the report refers to them as “controversial pay practices”, and argues that controversy is generally worth avoiding unless there is a good reason to do so.

-Value of discretion. The report makes a case for comp committees to be free to adjust pay to account for whatever factors they think relevant. This view is somewhat controversial. If you look at the compensation debate over long periods, support for discretion ebbs and wanes. The view that comp committees abused discretion to overpay management was one of the culprits behind tax code 162(m) and 409A. Under the recent proxy rule changes, discretionary payments are relegated to the “bonus” column of the summary compensation table (which has negative connotations) rather than the better sounding “non-equity incentive compensation” column. I suspect many pay critics would be displeased to see compensation committees moving away from mechanical and formulaic compensation programs.

-External reactions (can) matter. In its discussion of controversial pay practices and other issues, the report notes that a poor public reception can harm the company even if the public reaction is wrong on the merits. It can hurt employee morale, disrupt management teamwork or damage relations with shareholders or regulators. It is in that light that the report suggests considering eliminating controversial pay practices and making better use of public disclosures (such as CD&A).

-Compensation decisions are inherently subjective.  Sounds obvious, and it is, but it has implications.  Subjectivity is an argument in favor of discretionary arrangements, which as noted above are somewhat disfavored and can be controversial.  It makes it easier for outsiders to criticize your decisions; after all, different minds can disagree on subjective decisions. In turn, this means that you can't please everyone all the time, and you shouldn't try.  Finally, it implies that general advice should always be taken with a grain of salt.  For example, if each member of your peer group made their comp decisions based on factors unique to them, how useful a comparison are they for you? 

Little has been said recently about say-on-pay. Not long ago, it was hard to avoid hearing about it. At least four separate bills were introduced, including one proposal from the White House itself. The bill sponsored by Rep. Frank was even passed by the House. No doubt much of the blame can be laid on the health care debate, which is clearly taking up much of the oxygen in the room. Nonetheless, it is still somewhat mystifying that a piece of legislation should grind to a halt when it has already passed the House, been advocated by the President and seen significant Senate support (it was a key element of the TARP legislation applicable to bailed out financial institutions). As it turns out, there is another possible explanation for the slow down.

Within the Senate, say-on-pay bills are within the jurisdiction of the Banking Committee, which has long been chaired by Senator Dodd who is a stronger supporter of say-on-pay and included it in the TARP legislation. It goes without saying that the chair of the Banking Committee can influence whether say-on-pay ever becomes law. Recent months have not, however, been quiet for Senator Dodd. Dodd is also a long-serving member of the Senate’s Health, Labor, Education and Pension Committee, which has jurisdiction over health care policy and was chaired by Senator Kennedy until his death. Dodd is reported to have been functioning, during the weeks that preceded Senator Kennedy's death, as the de facto chair of the HELP Committee. Given the attention health care has commanded recently, it is hard to imagine that Dodd or his staff have had much time to spend on executive pay reform.

Just as importantly, Dodd's seniority in the HELP Committee has left the leadership and direction of the Banking Committee up in the air. Under Senate rules, Dodd was entitled to take over chairmanship of the HELP Committee, and he has reportedly given much time and thought to doing so. This is relevant to say-on-pay because Senate rules prohibit any Senator from chairing more than one committee. Thus, a move by Dodd to chair the HELP Committee would have handed the leadership of the Banking Committee, and control of the say-on-pay issue, to Senator Tim Johnson of South Dakota, who is generally considered much more moderate than Senator Dodd. In addition, the mere uncertainty over who would eventually run the Banking Committee has made it difficult for Committee staff and others to push forward on significant legislation.

Yesterday, Senator Dodd settled the speculation. He has decided to remain at the helm of the Banking Committee. There is, of course, no way to know how much of the slowdown on say-on-pay is attributable to overshadowing by health care, on the one hand, or the lack of leadership or direction inside the Banking Committee, on the other hand. But now that Senator Dodd has made his announcement, we may find out.

The executive compensation reforms being floated today often contain an unspoken caveat: “all else being equal”. The next time you hear or read of a new fangled approach to compensation design, bear in mind that the alleged advantages of the new approach may only exist if all else is, in fact, equal. Odds are, of course, that they are not. In the U.S., two of the main directional changes being advanced by pay activists are (1) increase executives’ down-side risk (e.g., through escrows of bonuses, clawbacks, hold until retirement, etc) and (2) more careful consideration of the unexpected consequences of compensation strategy on business risk taking. I think it is also important to consider the unexpected consequences of changes in compensation strategy, such as increases in down-side risk, because it is highly unlikely that any such change can be made holding all else equal.

A good example of this is being played out in the British financial sector. The UK financial industry has been working on ways to enforce a longer-term focus on bankers. The notion there (as here) is that bankers did not care about the ramifications of their business decisions because bonuses were based on annual performance, rather than their firms’ longer-term performance. On that assumption, the industry and its regulators are thinking about reforms that would result in bankers’ pay being at risk for much longer periods of time. The leading reform is the escrowing of bonuses coupled with clawback provisions. (Exactly the same proposals are being made here, both in the financial sector and elsewhere.) But the additional hurdles to keeping a bonus do not reduce the fundamental desirability of that individual to competitors. It just increases the cost of hiring the individual away. This has raised the specter of more widespread and more valuable sign-on bonuses (i.e., new employers will have to make new employees whole for any escrowed bonuses that are forfeited). These guaranteed bonuses have been a favorite target of the British press and regulators, and encouraging them would be a PR disaster. Fixing one problem creates another.

To try to split that knot, an industry group has stepped forward and proposed that escrowed bonuses not be forfeited on departure, though they would still be subject to clawback for performance reasons. So, departing bankers would not lose their escrowed bonuses and hence no need for sign-on guarantees. All else being equal that might well work, but of course, all else is not equal. As the British newspaper, The Times, reports, the proposed solution doesn’t necessarily solve the problem at all as it leaves departed employees (now working for competitors) in the difficult position of leaving large sums of personal wealth behind in the control of their old firm, which creates obvious conflicts of interest. Not to mention that the contractual provisions necessary to put such an arrangement in place would be, as the paper puts it, “hellish”. (The article can be found at: http://business.timesonline.co.uk/tol/business/columnists/article6801247.ece)

Consider also one of the more aggressive proposals that has been advanced here in the U.S.--“hold past retirement”. Under this approach, executives would not receive cash or equity incentives until some fixed period of time, say two years, after they departed, subject to clawbacks. The advantage of the approach is that the executive is arguably prohibited from capitalizing on short-term gains (e.g., bonuses that are paid before losses are noticed; exercising stock options and selling the acquired stock at a momentary high in the stock price) and thereby increases focus on the long-term. So far, so good. But consider, among other disadvantages, what such a structure looks like from the executive’s standpoint. First, it looks like a significant pay cut, one that may be enough to trigger severance rights. Second, it subjects the executive’s earned compensation to the risks generated by his or her replacement and the rest of the executive team during the waiting period, which could be viewed as unfair and contrary to the pay for performance model. The most likely outcome is that other aspects of the compensation program would need to be modified as well; perhaps, an increase in base salary to offset the diminished value of incentive pay. But of course, those changes have their own repercussions (e.g., increasing base salary may increase target bonuses, pension benefits and severance), including on the relationship between incentives and business risk-taking. And on and on….

Bottom line is that each of the elements in a compensation program must fit together, and changing one has consequences for the others. Before taking the leap and adopting any of the latest panaceas, give careful thought to the side effects.

In my last post, I described some legislation recently proposed by the Treasury Department. The proposal made good on the President’s promise to further reform the executive pay market, including through the imposition of say-on-pay votes on all public companies. What I did not note was that Rep. Barney Frank proposed his own version of that legislation the day after the President. Since then, the President’s bill has gone nowhere and, just last Friday, Rep. Frank’s bill was approved by the House by a wide (though mostly partisan) margin. The bill now goes to the Senate where early press reports suggest it may be taken up this autumn. The bill will apparently fall under the jurisdiction of Senator Christopher Dodd, who was the author of the complicated compensation rules applied to TARP firms (i.e, the bailed out banks). The TARP rules notably included say-on-pay votes. Sen. Dodd is not, in other words, a likely opponent of Rep. Frank’s legislation.

Rep. Frank’s version of the bill is mostly the same as the President’s. The primary difference is that Rep. Frank would impose a variety of compensation design rules on financial industry firms. Not surprisingly, these rules are designed to deal with the risk/incentive pay argument that I’ve discussed here many times. Thankfully, the additional rules would not apply outside the financial sector.

For most public companies, there is little difference between the bills at the moment. It seems, however, that the President is not in control of the process. In the case of the compensation rules for TARP firms, the President initiated the debate with a relatively sensible set of proposals, which Congress preceded to mostly ignore on its way towards enacting a set of complex and impractical limits on pay practices. It will be interesting to see what the Senate, and Sen. Dodd in particular, do with the Frank bill and whether public companies will be saddled with something beyond say-on-pay votes.

The last few years have been a boom time for executive pay lawyers. The current recession has only made things better from our standpoint. Consider that during the last five years: Congress subjected virtually all compensation arrangements (not just executive level) to a horrifically complicated tax regime (Section 409A), burdened the compensation arrangements of multinational companies with a second and similarly complicated tax regime (Section 457A) and re-wrote the key pension funding requirements of ERISA; the SEC overhauled the proxy disclosure rules and did so on a “principles” basis which make disclosure decisions more complicated than ever; and FASB mandated expensing of stock options and full balance sheet recognition of benefit plan underfunding. These are just a few of the things that have created demand, and many more are on the way (e.g., new proxy disclosures).

Last Thursday, the Treasury department, on behalf of the President, proposed new legislation titled the “Investor Protection Act of 2009”. The bill covers many of the executive pay items the President has previously discussed. The keystone of the bill is the much anticipated say-on-pay requirement for all public companies. Nothing interesting to note there; the proposal would mandate the typical say on pay vote (i.e., to approve/disapprove compensation as disclosed in the proxy through a nonbinding vote).

The bill also includes a separate shareholder vote on golden parachutes and severance arrangements, which would be required to be held in any shareholder meeting involving a merger. The idea is that, without this vote, companies would wait to adopt golden parachutes until a transaction is announced and thereby avoid the scrutiny of shareholders. Interestingly, the requirement only applies where there is a shareholder vote or proxy solicitation. Until recently, public company M&A transactions were typically structured as “one-step” mergers, which require the approval of the target’s shareholders--thus, a shareholder vote or proxy solicitation is certain to occur. Today, thanks to the SEC’s fixing a technical problem with the tender offer rules, public M&A transactions are increasingly structured as “two -step” mergers. In this structure, the buyer first commences a tender offer to acquire the target’s stock. Buyers acquire at least a majority (and sometimes even 90+%) of the target’s stock in this first step. The second step is to acquire all the remaining stock through a merger. Because the buyer has at least a majority of the target’s stock, the outcome of this second step is a foregone conclusion (as would be any say-on-pay vote). If the buyer obtains enough stock in the first step, there may not even be a shareholder vote in the second step. Long story short, the additional say on pay vote for golden parachutes may not matter very much because companies can use (and are already using) acquisition structures that reduce the role of shareholder votes.

The bill also includes some mostly trivial corporate governance changes. For example, compensation committee members would be subject to different standards of independence, which are similar to those that already apply to audit committee members. The bill also jumps on the independent consultant bandwagon. While comp committees won’t be required as matter of law to have an independent consultant, they would have to explain in the proxy statement why they chose not to do so. This would be one of the only areas in which companies would be required to disclose what they did not do (as opposed to what they did).

Finally, and forming the basis for the title of this post, the bill strongly encourages compensation committees to engage their own independent counsel. This is the first time I can recall that the issue of independent counsel has been advanced as a way to mitigate executive pay problems (independent consultants, on the other hand, have been pushed for years). The bill directs the Treasury to write rules to define independence, but presumably any law firm that is or has recently represented a company or its management would be excluded from representing the comp committee. Again, the legislation does not require committees to engage their own counsel, but the intent of the bill is clear. If the market responds as the White House hopes, thousands of public companies will be looking to hire yet another set of lawyers. Not so long ago, it looked like public companies would not resort to the dueling consultant approach to setting pay (i.e., management’s consultant argues with the committee’s consultant). Today, thanks to proxy disclosures among other things, a large percentage of public companies in fact do use two consultants. Assuming the legislation passes, it will be interesting to see whether committees take the step of hiring independent counsel. It would then be even more interesting to see what the dueling lawyer dynamic does to the pay setting process--though, if the impact of adding the independent consultant is any guide, not much.

Given the scope of the other legislation Congress is already considering, it is certainly possible that this bill goes nowhere. Say-on-pay was strongly supported, and yet ignored, in less complicated times. Nonetheless, the mere fact that the White House has proposed it may mean that the idea of independent counsel for compensation committees will find itself on the ever-present “hot topics” and “emerging trends” lists that every company and comp committee receives. That alone could be enough to change behavior.

The SEC will hold a meeting on Wednesday of this week at which it expects to propose new rules on, among other things, proxy disclosure of executive compensation. Based on speeches from the commissioners, it looks like the new rules will require:

-Disclosure on how the compensation committee manages risk-taking through its compensation programs. A core assumption in the government’s analysis of the Wall Street crisis is the notion that compensation programs induced bankers to take excessive risks. Note that the new disclosure rules will apply to all public companies. This is just one example of how the compensation debate regarding the banks has set the agenda for the broader executive pay conversation.

-Disclosure on compensation programs below the executive level. Again, in the Wall Street pay debate, the argument is made that compensation programs for lower level employees (e.g, CDO traders) encouraged short-term risk taking without regard to the long-run risks. Even though there is no consensus that this issue exists beyond the banking sector, the entire public equity market will be subjected to these new disclosures. Importantly, we do not yet have a sense of how broadly this rule will be written. In the context of the firms that received federal bailout funds, the disclosure requirements are onerous and will require a great deal of time and effort to satisfy. Companies will need to move quickly after the rules are released to establish systems to complete the necessary reviews.

-Reversal of the “Christmas Surprise”. The Summary Compensation Table contained in the proxy statement is intended to reduce all compensation for the year to a single “Total Compensation” figure. To do so, very different types of compensation and benefits must be reduced to a single dollar amount. In the case of equity awards, the proxy rules look to the financial accounting standard, FAS 123R. Initially, equity awards were to be included in the SCT at their full grant date value, but shortly before they went into effect the SEC modified the rule so that only the currently expensed portion of the grant date value was included in the SCT. For example, a stock option granted in 2009 might have a grant date value of $100 and be subject to vesting over a two year period. Under current law, this option would be included in the SCT as $50 in 2009 and $50 in 2010, which aligns the SCT inclusion with the company’s financial accounting expense. The SEC is expected to reverse course and go back to its original proposal. In that event, the same option would appear only in the 2009 SCT at its full $100 value. The new rule might simplify many companies’ disclosures, although they may find it challenging to explain the new presentation in the first year under the rule.

The new rules would likely be finalized and effective for the upcoming proxy season.

On Tuesday, the Chairman of the SEC confirmed that the SEC will be revising the proxy disclosure rules to add new disclosure requirements covering, among other things, (1) risk management through compensation programs and (2) compensation programs for non-executives (including presumably the risk management aspects of those non-executive programs). I would anticipate the SEC moving quickly so that these rules will apply to next year’s proxies. Lots of practical issues will arise from the new requirements. Perhaps the most important is the issue of how should one think about risk management from a compensation standpoint. While it is easy to come up with procedures (e.g., meet with risk management personnel every quarter), it is much harder to do the substantive work (e.g., identify particular risks and modify compensation programs accordingly). There are very few precedents here, and most of them are in the financial services sector where the issues (e.g., credit default swap exposures) are unlikely to be relevant to the rest of the market.

As a possible starting point and precedent, let me suggest a recent report from a British financial industry regulator, the Financial Services Authority (or FSA). The FSA spent several months investigating and debating the relationship between compensation and risk-taking. Their report is a thoughtful and balanced discussion of the issue. It looks seriously at the arguments and counter-arguments for various approaches and tries to weigh the benefits and burdens. (You can find the report at: http://www.fsa.gov.uk/pubs/cp/cp09_10.pdf) Here are a couple of interesting tidbits from the report. First, they acknowledge that there is no proof that compensation programs in fact caused excess risk taking in the financial sector. The consensus to the contrary, they say, is based on anecdotes and circumstantial evidence. They even note that there are a variety of factors having nothing to do with compensation that were likely more important.  I think this explains the relatively mild reforms suggested by the  FSA.  Second, the report has a fascinating discussion of the way compensation programs can over-align the interests of shareholders and managers. They note that institutional shareholders often have very short holding periods, and may in fact prefer that management produce short-term gains and take lots of risks because they discount or even ignore gains that will come after they have sold their stake. In the context of “too big to fail” businesses, this alignment can be socially problematic, but in industries that do not benefit from government guarantees, the clear implication is that risk management may be contrary to shareholder interests. In all events, the report is as good an example as any of how to conduct a sober appraisal of risk and compensation.

In my last post, I noted that companies should consider using their CD&A and other proxy disclosures in a more aggressive fashion. By that I mean, instead of drafting with an eye toward checking off boxes and avoiding SEC comments, using the disclosure to tell the company’s story the way it wants it to be told. While this won’t stop an activist from cherry picking the details it needs to tell a critical story, the press tends to report on a “he said, she said” basis. The key then is to have a good “she said” story. You could choose to do so on the fly, but most reporters will not wait very long for a quote from the company and, in this day and age, “no comment” is not an attractive approach for many companies. Figuring out how best to present your compensation programs and doing so calmly and thoughtfully in advance could pay dividends.

With that in mind, consider yesterday’s WSJ story on the use of company owned life insurance policies (COLI) to fund executive compensation arrangements. The story relates how many public companies, including banks, purchase life insurance on their employees with the company as the beneficiary. Embedded within the story are the reasons for these arrangements: they enable companies to fund their existing compensation obligations in a tax and accounting efficient manner. A consultant is said to have estimated that the banks alone will receive $400 billion over the coming years from these insurance policies. Great idea, right? Wrong. The story characterizes COLI as a “little-known tactic” that, “[t]hough not improper,” is similar to other “controversial” techniques and that Congress has been (so far) unsuccessful in reining it in. In other words, these companies are to be criticized for not paying more taxes than required and for not driving down earnings. Interestingly, these arrangements are generally not mentioned in companies’ proxy disclosures and therefore they are not defended. Because they are merely a funding method and have no effect on how much is paid or payable to executives, they do not need to be discussed in the proxy. If they are discussed at all, it is in the financial statements in the 10-K.

I think there are a couple of lessons here. First, the scope of compensation issues for which you can be criticized is broader than you may suspect. Merely covering off the disclosure items required under the SEC rules will not guarantee that you have covered everything of importance. This also highlights the benefit of performing a regular 360 degree review of all compensation arrangements. Second, even a practice that seems self-evidently value-enhancing can be twisted into a sinister sounding tactic. Proactive disclosures can help frame the debate in a beneficial manner and avoid criticism of the company going unrebutted in the media.

Independent directors are increasingly being criticized for perceived compensation abuses. We see this in many forms, for e.g., press reports that focus on compensation committee members, and labor unions and pay activists that target compensation committee members for withhold the vote campaigns. We are also seeing it in the regulatory sphere. The “TARP” rules, which apply to financial institutions that received taxpayer funds, allocate many new responsibilities to compensation committees. In the broader world, the SEC has announced that proxy disclosures will be broadened in ways that require compensation committees to take a leading role in risk management. There are also some indications that legislation in Congress mandating “say on pay” shareholder votes for all companies will be taken up this year.

Ironically, most of the ammunition being fired at compensation committee members comes in some sense from the committee itself—namely, the company’s proxy disclosures. The typical proxy contains a vast amount of compensation information, and it is not difficult to cherry pick data points to construct a critical story. One of the common examples of that is the focus in the press and among critics on the “total compensation” figure in the summary compensation table (or SCT). The SCT is the keystone of the compensation disclosure. It supposedly tells us how much each named executive was paid in the prior year. Of course, if you followed the development of the proxy rules, you know that the SCT does no such thing. The SCT compiles and adds together a hodge podge of apples and oranges. In particular, equity compensation (which is often the single largest value item) is included based on the byzantine FAS 123(R) accounting rules. Under these accounting rules, an option granted in 2007 before the market crash is as valuable today as it was then. As a result of this and other oddities in the rules, many public companies are reporting 2008 total compensation levels that are essentially the same as 2007 levels, even though their executives’ personal losses may exceed, as a percentage matter, the losses of their shareholders.

When you take together the increased scrutiny of compensation committee members and the fact that run of the mill proxy disclosure is likely to provide fodder for critics and the press, it seems clear that directors should consider whether they are making the most of their proxy disclosure or whether they can do better. Many companies could make the case much more forcefully that their compensation programs are well structured and performing as expected. For example, some companies are already including a separate summary table that reflects what the committee paid in the fiscal year rather than what the accounting rules allocated to that year, with a none too subtle hint to ignore the SCT. These “restated SCTs” can help avoid the suggestion that executives received large equity paydays in down years. Similarly, the ancillary tables that follow the SCT generally indicate the magnitude of the executives’ losses on equity pay, but these losses do not appear in the SCT. You might consider noting to your investors that, contrary to what the SCT suggests, your executives shared their pain and suffered enormous personal losses—you might even quantify them. (Incidentally, when the proxy disclosure rules are changed later this year and you need to demonstrate that your compensation programs do not create excessive risks, it will be valuable to document the fact that executives are punished financially when the company’s performance and stock drops.) While these measures are not a panacea, they can persuade at the margin, provide positive talking points to the press, and set the agenda for a broader communication plan should it become necessary.

Thanks to the Wall Street meltdown, risk management has become one of the most talked about corporate governance topics of the year. Not surprisingly, the subject has been injected into the executive pay debate. As in many other cases, even though this issue derives from Wall Street, directors of Main Street companies will have little or no choice but to address it. In fact, it is very likely that legal and regulatory changes, including new SEC disclosure requirements, will make risk management a top tier concern for all public company directors, especially compensation committee members. As an example, SEC Chairwoman Mary Schapiro recently announced that the SEC will likely propose new disclosure requirements addressing how companies ensure that “compensation does not drive inappropriate risk-taking.” Unfortunately, in my view, it will be a concern that generates lots of light but no heat. 

The focus on how compensation practices interact with risk taking has a couple of sources. Early on, the press made the argument that finance industry employees had an incentive to run outsized risks because they were paid based on annual revenues and other metrics that were not accurately discounted for the risks being taken. Congress effectively ratified that view in October of last year when the first bailout bill included a requirement that the companies receiving taxpayer aid ensure that executive compensation programs not create incentives to take “unnecessary and excessive risks”. The Treasury Department then quickly released guidance clarifying that Congress meant that compensation committees needed to have periodic meetings with risk management officers to review incentive plans and whether they might be creating incentives to take unreasonable risks. In February of this year, Congress overhauled the executive pay rules for these firms but left this requirement mostly intact. Strangely, Treasury has not yet spoken about how firms are to comply with the new version of the rules.

The situation with Treasury is a good metaphor for where the issue stands in the broader world: Lots of people are talking, they’re doing lots of thinking, but no one has come up with a substantive solution to the problem. To be sure, commentators have pointed out that certain pay practices might be problematic, for e.g., paying executives entirely with stock options, but obviously these practices were not commonly used. For most companies, the recommended changes to compensation strategy to avoid excessive risk look an awful lot like the “best practices” changes recommended in 2007, 2006, etc., long before excessive risk became a buzzword.  The bottom line on most of these proposals is to increase the portion of compensation paid in equity and require employees to hold that equity for longer periods of time—all old news. That being said, there is no reason not to consider implementing clawbacks and stock holding periods or any of the other usual suspects, but it's not clear to me that any of them does more than nibble around the edges of addressing systemic or catastrophic risk.

You should be relieved to know that the courts (at least those in Delaware the laws of which govern the fiduciary duties of most public company directors) have acknowledged the reality that it is extremely difficult to manage risk prospectively and the related dangers inherent in judging boards with the benefit of hindsight. In a recent decision involving Citigroup and the subprime losses it incurred, the court ruled on the pleadings that, in effect, it was in no position to second guess Citigroup’s directors and would instead only inquire as to whether the directors were making a good faith attempt to do their jobs. From a director’s personal standpoint, this is good news. Following the procedures, talking to experts and thinking about risk and incentives (and disclosing that you did it) will likely be enough to satisfy your legal and regulatory requirements.

In closing, consider that for six months Treasury, which has a public mandate to the rescue of the financial system, has had virtually unlimited power to dictate how compensation committees (and by extension management teams) address risk taking and compensation at bailed out financial companies. It has access to every available bit of data regarding these firms as well as better data about the national and international economy than anyone in the world. The sky is literally the limit. Yet the sum total of their best advice to those firms so far is “talk about it and think it over”. This is not a particularly different standard than the one announced by the Delaware court in the case I described above, which was in turn based on the general fiduciary duty rules that have been applied to directors by Delaware courts for more than 50 years. In many respects, the right substantive answer to managing risk and related issues of executive pay (and possibly the only real answer) may be to keep doing what you likely have been doing all along—asking questions of management, having discussions with fellow directors and taking time to think about it all. 

That’s a quote from a NYU business school professor contained in an article about executive pay in yesterday’s New York Times. The real headline is “Executives Took, but the Directors Gave”, but I think the quote summarizes the piece a bit better.

The basic idea here is that directors are responsible for decisions they make about executive pay and can expect to be criticized when things go wrong—hardly newsworthy. More importantly, the article hints at a much more important issue for directors, which may be coming to a head. The issue relates to “proxy access”, which has nothing to do with compensation in the first instance. Proxy access is a complicated topic that is mostly beyond the scope of this post, but the basic idea of it is to give individual investors the ability to bring proposals to a binding shareholder vote (ie to access the company’s proxy statement in order to conduct a shareholder vote). The most important of these votes is the vote for directors. The SEC has debated proxy access for years and consistently rejected it. Now, however, the new SEC Chairwoman, who is believed to support proxy access, has announced that the SEC will take up the subject again this May. Her goal seems to be to have proxy access approved sometime this year.  Although proxy access can be structured in many different ways and we don't know what the SEC will or won't ultimately do, for our purposes the core idea is to permit shareholders to nominate their own candidates to replace incumbent directors.

Proxy access, should it occur, will be critical for compensation committee members. This will be all the more true if, as is expected, Congress imposes the “say-on-pay” vote on all public companies (one version of say-on-pay already passed the House; it did not pass the Senate, but one of its main supporters there was then-Senator Obama). As the NYT article notes, shareholder activists are strong advocates of both proxy access and say-on-pay. To see why this is important, put yourself in the position of a hedge fund or shareholder activist that wants a company to make changes that the company has already considered and rejected. Proxy access offers the possibility of direct representation in the boardroom and influence over management by voting out an incumbent director and voting in a new director that shares your views. But which incumbent directors to go after? The answer may well be the compensation committee members.

Comp committee members have an unusual role on the board. Their personal work product (i.e., what they decide to do and why they decided to do it) is the subject to extensive public disclosure, some of which (the CD&A) they are required to personally approve. Unlike audit committee members who oversee the work of inside and outside experts, compensation committee members make the ultimate decisions that investors care about. All of which makes them particularly vulnerable to challenge by dissident shareholders. Say-on-pay votes will add a potentially powerful weapon to the mix because they are susceptible to being treated like public referendums on the performance of the comp committee. This is true even though, in reality, no one knows what the vote means. (Even some of the most vocal supporters of say-on-pay have acknowledged this.) Needless to say the present political and media environment does not give the benefit of the doubt to compensation decision makers. A director quoted in the article summarized the state of play with this question: “Are we vulnerable?” The phrasing speaks volumes. If you haven’t learned about proxy access yet and what it might mean for your board, now is the time.

A final side note. In discussing the argument that incentive compensation helped to create systemic risk, an academic is quoted in the article as saying “[n]one of the corporate governance activists ever made the connection.” The point could have been made much more broadly. At their best, pay critics can have interesting ideas, suggestions and perspectives that are worth considering. But for a variety of reasons (including their lack of detailed information about any particular company), their views need to be taken with a grain of salt. They don’t have a crystal ball, particular when it comes to the unintended consequences of their proposals. In fact, the article, without recognizing the irony, makes the claim that one of the main factors behind excess CEO pay was a tax law change from the early 1990’s; this was of course viewed at the time as a “reform” that would improve executive pay practices.

The goal of this blog is to provide directors with real-time updates and insight into executive compensation and related matters.  As a partner at Cravath, I have the good fortune to be involved in an wide range of transactions and issues, whether representing individual executives, companies or directors.  My practice covers the tax code, corporate law, ERISA, securities law and even some accounting, so I hope to hit a variety of topics.  When it comes to the more technical areas, I will try to keep things as plain English as possible so that you have information you can actually use.  Topics I’ll discuss will largely be driven by current events (of which there is currently no shortage). Additionally, you should feel free to propose issues or questions—if your board is grappling with a particular problem, chances are it will be of interest to others. Obviously, these posts are intended for your general information only and do not constitute legal advice.

The Executive Compensation Topic of the Year

If you've spent much time on a compensation committee, you have no doubt heard a presentation or two (or fifty) about “hot topics” or “emerging best practices” in executive pay.  You may even have noticed that the hot topics for 2008 looked an awful lot like the hot topics for 2007, 2006, 2005....   This year looks to be a different story--there is finally something new to talk about.  The 800 lb gorilla in the room goes by the name of TARP.  TARP stands for the Troubled Asset Relief Program, and it is basically the Treasury Department's main program to spend the bailout funds appropriated by Congress. Companies that participate in TARP (think banks) are subject to a host of limitations on executive (and possibly non-executive) pay.  The press has spilled a lot of ink on some of these limits, especially the ban on severance (and whether it applies to the now infamous AIG bonuses) as well as the cap placed on the amount of bonuses paid to executives. Other provisions, though, have not received nearly as much attention, which we'll rectify in future posts.

Before we get into those details, there is the more basic question of "who cares?"  After all, if your company hasn't taken taxpayer funds and isn't subject to the TARP pay rules, then what difference do they make to you? Well, as a practical matter, you don't have a choice.  Compensation consultants, lawyers and other advisors will be giving countless presentations to boards over the coming months, and they will almost inevitably be discussing TARP, even though TARP is legally inapplicable to their clients.  So, if you sit on a compensation committee, you will probably be hearing about the TARP pay rules, like it or not.  

A less cynical explanation is that TARP provides a snapshot of where "the market" is heading.  Congress and Treasury did not pull the TARP pay rules out of thin air (or at least not all of them).  In fact, some of them, like the provision requiring the repayment or "clawback" of bonuses, go back years and years. It's not too much of a stretch to say that TARP, in broad outline, reads like a hot topics presentation from several years ago.  But now, instead of the items in those presentations representing the wish list of pay activists and critics, they have the approval of the Congress and the President.  This gives the TARP rules a kind of legitimacy and appeal that exists whether or not they make sense for a particular company.  Consequently, directors of non-TARP firms should be prepared to address them from an informed position.  Of course, the pay activists and critics have not gone away.  Quite the contrary, TARP represents an affirmation of many of their core objectives.  Directors of companies in all industries should expect executive pay to be an even bigger issue than in the past, with TARP-approved reforms being high on the list.  (In that regard, you may be interested in the interview Corporate Board Member conducted with my partner Marc Rosenberg, which you can find at http://www.boardmember.com/BRC.aspx?taxid=271&id=2315.)  

In my next post, I expect to take up the question of risk taking as it relates to executive pay, which is one of the less often discussed elements of TARP but one of the most important for directors.