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Talking Points: Executive Compensation Concerns for 2013 Proxy Season

With plaintiff law firms suing over say-on-pay and equity plan proposals, and ISS and Glass Lewis changing their policies for 2013, there’s much ado as boards and management prepare their proxies and plan for annual meetings. Boardmember.com’s web editor, Laura J. Finn, asked executive compensation attorney, James D.C. Barrall of Latham  & Watkins, about the questions his clients are asking, the big deal around realizable pay, and of course, about lawsuits and policy changes, too. Excerpts:

Corporate Board Member: What questions are you hearing most from companies as proxy statements are prepared?
Jim Barrall:The question I’m hearing most is what will be the major issue on the executive compensation front in 2013.  And the answer to that it is:  pay-for-performance alignment—whether over a period of the last three to five years the pay of the company’s named executive officers, and the CEO in particular, has been aligned with the company’s performance (and that generally means total shareholder return performance).  This was the biggest issue last year by far, and it will be the biggest issue this year.  That’s the issue that I think investors will be focused on, and that’s what needs to be addressed in proxies and in discussions with investors.

The second question I am hearing often is about the wave of lawsuits being filed by plaintiffs’ securities litigation firms that are suing to enjoin shareholder meetings and votes on say-on-pay and equity plan proposals. These firms are very active and we are receiving many calls from clients about how to deal with the threat of litigation.  So we’re spending a lot of time working on an interdisciplinary basis on the best advice we can give our clients, with compensation, corporate law and litigation inputs, on how best to defend against these lawsuits.

CBM:What do you think about ISS changing its peer group methodology, Jim?  How is that going to impact companies?
JB: It’s really too early to tell.  We saw ISS’s new peer group voting policy at the end of last year and we have their FAQs. We also know they solicited input from companies that have changed their peer groups.  But we won’t really know the impact these changes will have on their vote recommendations until we start to see their reports for 2013 meetings.  The key thing to watch is how much overlap there is with the peers the company has chosen.  While I have not yet studied any ISS reports myself, I have talked to a couple compensation consultants who have, and they are disappointed with the degree of overlap.  Whether or not the new ISS analytics will work better than those of 2012,  we’ll know in a month or two as companies start to hold their meetings.

CBM: A hot topic for 2013 proxy season is the use of realizable pay.  What’s the big deal? 
JB: The big deal is that in analyzing whether or not there is alignment between the CEO’s pay and the company’s performance over a period of years, ISS and Glass Lewis use a definition of pay based on  proxy summary compensation tables, which is not appropriate because those numbers reflect pay opportunities measured on a grant date basis, not actual pay.The problem is best illustrated by stock option valuations.  Stock options are valued in the SCT based on their Black-Scholes value at date of grant, based on numerous assumptions about volatility, dividends, etc.  ISS and Glass Lewis then take snapshots of these grant date values over the relevant period and say that is what the CEO was paid.  But that’s nonsense because that’s not what the CEO was paid. If the stock price went down and the options became worthless the CEO wasn’t paid the SCT numbers.  And it clearly is a huge disconnect to use SCT pay to judge the alignment of the CEO’s pay with the shareholders’ total shareholder return during that period, because TSR does reflect stock price movements and SCT pay does not.  Anyone who’s objective sees the disconnect. 

Last year more than a hundred companies filed supplemental proxy materials with the SEC after ISS and/or Glass Lewis issued their pay-for-performance analyses based on SCT pay opportunities.  Since last proxy season, companies, investors and their advisors have been working to develop more accurate definitions of pay to use to properly determine whether there’s alignment between pay and TSR.          

In response to all of last year’s criticism, ISS and Glass Lewis this year have said that they will take realizable pay into account in their 2013 say-on-pay recommendations,  but unfortunately not in their quantitative pay-for-performance tests. But I do think the day will come when they will have to use something other than SCT pay in their quantitative tests.  So that’s what all of the discussion of realizable pay is about.   As you said, it is a big deal.

CBM: That’s a good segue into the debate that you moderated on January 18 between Ira Kay and Charles Elson on the use of peer groups in setting executive compensation.  Elson and his student, Craig Ferrere, wrote a paper arguing that the use of peer groups inflates pay, and they had suggested that companies begin to start paying their executives on an internal market structure, which really no companies are doing right now.  How realistic do you think that idea is?
JB: Well, there are  two parts to your question.  First is whether peer group benchmarking is driving executive pay and whether benchmarking makes sense.  My personal view on this is that in the past benchmarking to aspirational peer groups rather than real peer groups had been used to “ratchet up” compensation, as Charles and Craig said at the debate.But I think that’s much less of a problem these days, in the new world of say-on-pay.  I don’t think that sophisticated compensation committees are slaves to peer groups and benchmarking, and that peer group benchmarking is just one of many factors taken into account in setting pay opportunities. So while Charles and Craig have identified something that can be bad in concept, I think in reality it’s not as big a problem now as they think it is. I also think that peer group crosschecks are important and beneficial to investors.

The second part of your question is whether it makes more sense to use internal benchmarking of the CEO’s pay to that of the company’s other executives, than to benchmark it externally. Again, I think there is truth to their thesis because CEOs who are successful are successful because they’re parts of good teams. A CEO cannot make a company successful by him or herself, and we sometimes see that when CEOs move from one company to another without their team and don’t succeed.  So I do think that boards and compensation committees need to evaluate disparities between the pay of the CEO and the company’s other officers and key executives, for morale, retention and succession reasons.   But as you say, and as Charles and Craig said, the subject of internal benchmarking hasn’t yet been studied well and they don’t have a thesis yet on how compensation should be benchmarked internally.  They did speak about DuPont where the CEO for many years had a formula tying his compensation to that of other officers, but that has not taken hold yet.    

CBM: Finally, Jim, if you could give some  advice to compensation committee members this proxy season, what would you tell them?
JB: I would encourage them to watch the video of the very good debate between Charles, Craig and Ira on CEO pay.   It was broad ranging, spirited, and addressed important issues that they will all be discussing in the years to come, and it will influence investors. 

Second,  I would encourage directors to carefully follow all the developments we expect to see this proxy season on how the ISS and Glass Lewis voting policies are being applied, how the proxy injunction lawsuits fare, what’s happening with pay–for- performance, what’s happening with the definitions of pay, and so on.   

Third, I would really encourage directors to have their companies tell their performance and pay stories in executive summaries in their proxy CD&As, which tell shareholders how the two are aligned and how the committee has responded to performance issues, investor feedback, the last say-on-pay vote, etc.  This is the first step in engaging with investors on pay matters, which is becoming increasingly important, and is becoming a year round dialogue.

Topic tags: board of directors, compensation committee, Compensation Disclosure & Analysis, corporate governance, executive compensation, proxy season 2013


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