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As the SEC shines a light on executive compensation, will companies clean up their acts or find new ways to hide excess?
Don Durfee, CFO Magazine
October 1, 2006
As Pfizer Inc. shareholders assembled in Lincoln, Nebraska, last April for the company's annual meeting, there was a buzz in the air — literally. A small plane circled overhead, pulling a banner that read, "Give It Back Hank!"
The sign captured the mood of investors who had raised angry questions after reading in the March proxy statement about CEO Henry McKinnell's $83 million retirement package. Why was such lavish treatment warranted when the share price had fallen 43 percent over his five-year watch? Besides, hadn't he already earned $65 million during those years?
A withhold-the-vote campaign failed to unseat two of the Pfizer board's compensation-committee members, but did garner an embarrassing 20 percent of the shares voted. And when anti-McKinnell pressure continued to mount, the board finally announced in July that the chief executive would step down.
But one question probably did not occur to shareholders: Why was the drug maker disclosing the value of the retirement package in the first place? The Securities and Exchange Commission had made a proposal in January for new compensation disclosure rules, but had called for them to be reflected in proxy statements next year. Pfizer directors, though, decided that their company would be among the first to include the array of details the SEC proposed requiring — one of them being a calculation of the present value of McKinnell's pension.
The SEC stresses that its new rules, which apply in 2007 to companies that have a fiscal year-end of this December 15 or later (Pfizer's is December 31), aren't meant to influence pay practices. "Our job is not to regulate compensation," says John White, director of the SEC's Division of Corporate Finance. "We just want to make sure disclosure is out there so that the marketplace can make its own judgment."
As McKinnell discovered, though, disclosure has a way of forcing changes that companies might not otherwise make. Compensation experts, in fact, expect the new rules to spur big changes both in how companies set executive pay and in the resulting pay packages themselves. Shareholder activists, among others, are betting on it. "This will mean an absolute quantum leap in the quality of disclosure," says Patrick McGurn of Institutional Shareholder Services. "Compensation committees are now in the hot seat."
Machete and Pith Helmet
The last overhaul of disclosure rules came in 1992, ushering in the compensation tables that are still in use today. The tables, too, were meant to give shareholders a plain view of the amount of money that management was making. Not long after that rule change, however, companies developed and began installing forms of pay that did not have to be disclosed in the tables. These include deferred compensation, supplemental executive retirement programs (SERPs), golden-parachute payments, and a variety of perquisites.
Many investors dislike these forms of pay, of course. Such methods allow firms to grant executives a great deal of money or other benefits — often unrelated to their performance — without clearly detailing it in financial reports.
Consider one common perk: the guaranteed postretirement consulting contract. After Gerald Levin resigned as CEO of AOL Time Warner Inc. in 2002, he was granted a consulting deal with the company that paid him $1 million a year in exchange for making himself available for five days each month. The arrangement, which expired last December, didn't appear in the tables, because Levin was no longer an employee by the time the money was paid. Instead, it was described in the footnotes.
In some cases, compensation is even more opaque. In its 1997 proxy, General Electric Co. noted that Jack Welch would receive "continued lifetime access to Company facilities and services comparable to those which are currently made available to him by the Company." The disclosure gave no further details about what turned out to be tens of millions of dollars in company-paid benefits ranging from the grand (free use of the company's Boeing 737 and use of a GE-owned Manhattan apartment) to the petty (free dry cleaning). It wasn't until Welch's heavily publicized divorce in 2002 that investors saw the full picture.
Compensation-committee reports are often woefully inadequate, consisting of little more than vague pronouncements about linking pay to shareholder value. "In the past, it's been very difficult to judge the rationale behind executive compensation and whether it fits in with the strategic plan of the company," says John Wilcox, head of corporate governance for TIAA-CREF.
The SEC has grown impatient, too. "No shareholder should need a machete and a pith helmet to go hunting for what the CEO makes," chairman Christopher Cox told New York financial writers in a speech this past summer.
The new rules aim to clear away the underbrush. Among other things, they require companies to show the dollar value of such hard-to-measure benefits as stock options, SERPs, and severance terms. Companies will have to provide a total compensation figure for each executive, and file a compensation discussion and analysis, or CD&A, to detail and explain why the company pays what it pays. The CD&A will have to be filed with the 10-K, meaning that the CEO and CFO need to certify it.
CFOs should expect strict enforcement by the SEC. "The SEC is very focused on getting people to make these disclosures in a good-faith way," says White. "In company reviews, the staff will be looking in particular at the new disclosures required by these rules."
McGurn puts it more bluntly: "I think the SEC is going to wait for the first good example of someone who has lived up to the letter, but not the spirit, of the law and go after them like a horde."
A 404 for Compensation
Some fear the reaction so far to these proposals has been lax. "Most companies are vastly underestimating the amount of work that needs to be done," says Mike Savage, senior vice president of Aon's compensation consulting practice. "If you wait until November to start this, you're too late."
In some cases, assembling the information needed for the new compensation tables — including data for the total compensation figure — will be arduous. To calculate the present value of each executive's SERP, for example, a company may have to find papers for an enrollment from a decade ago. And time-consuming Black-Scholes analyses and actuarial valuations may have to be done for various severance or change-in-control provisions.
The CD&A section is a bigger worry. Any misrepresentations — intentional or otherwise — could bring legal complications. Consider the boilerplate assertion often made in proxies: "Compensation is designed to link the executive's interests with the shareholders'." Such language could now bring a compensation-committee challenge.
Companies may be on the spot for using earnings per share to determine a cash bonus, for example. "EPS is very susceptible to manipulation," says Andrew Liazos, a partner with Boston-based law firm McDermott Will & Emery. "The danger is that you say your objective is X, but you pick a compensation vehicle that does Y. If that causes large payments when the stock price is going down, that could expose you to litigation." In such cases, Liazos advises boards to collect evidence to support their decision, perhaps by hiring a statistician to demonstrate how certain metrics correlate with shareholder value.
Using peer groups to determine pay could also be treacherous. Now, boards often assemble lists of similar companies and use them as a basis for CEO pay decisions, typically targeting the median or 75th percentile. "The rules suggest that you need to document how you chose that group," says Savage. "Can you show that you built an unbiased peer group? Can you prove that the CEO didn't lean on the scale and exclude some company that would have lowered the median?"
If all this sounds familiar, it may be because it mirrors the kind of work most companies put into the management discussion and analysis (MD&A) section in current filings. A similar approach will now be needed in the compensation area. CFOs should become more auditorlike, argues Liazos, and consider where numbers came from and who was responsible for them. "The SEC really doesn't want boilerplate in these documents," he says. It wants people to "think about and sweat over" the CD&A, as they do the MD&A.
The extra work may be a minor hassle for many larger companies. Delray Beach, Florida-based Office Depot already discloses many of the things the SEC is calling for, such as dollar values for stock-option grants. "This is a notch up in complexity, but it's just something we will work through," says CFO Patricia McKay, adding that the company likely will add to its disclosure committee to handle compensation-related issues.
For smaller companies, the burden will be considerably greater. "Large companies have an HR staff and a corporate secretary," says Derrick Neuhauser, senior manager of BDO Seidman's executive-compensation group. "In small and midsize companies, all this work is going to fall directly on the CFO."
Inevitably, the new rules inspire comparisons to the Sarbanes-Oxley Act's Section 404. "For compensation committees, this is as big as 404," notes Savage. "Only this time, companies don't have the army of people to implement it."
A Rise in Pay Envy?
The new rules will do much more than create busywork and add some liability for compensation committees. Stockholder feedback should ensure that the committees will think harder, as well, about what they pay executives.
The test will come in next spring's proxy statements, when total compensation numbers appear for the first time across the corporate horizon. Compensation consultants report that clients have been creating mock proxies to see how the company's pay structure will look under the new rules. Some committees are finding that because of the inclusion of the likely value of benefits such as deferred compensation and severance, the reports may contain some very large numbers.
"When companies report that single compensation number in the first year, it's going to be shock and awe," asserts Neuhauser.
Even directors may be taken aback. "In many cases, boards will be getting this information for the first time," says McGurn. "They've been approving individual elements of the packages and never getting the full picture." Some renegotiations of pay packages may result, and attorney Liazos says that some companies have already begun that process. In one case, the board negotiated a cut in the CEO's total payout by $20 million after seeing the total compensation figure.
Similarly, compensation consultants predict that such staples of past contracts as country-club dues, free sports tickets, and financial advisory services may disappear at some companies. "Instead of giving you a car or money for a lease, it's a lot easier to just say, 'Here's $10,000,'" says Mark Rosen, managing director of compensation consulting firm Pearl Meyer & Partners.
Skeptics believe that better disclosure could spark some pay envy among executives who come up shorter, perhaps causing average compensation to rise, not fall. This happened after the SEC's first overhaul of proxy rules in 1992 and 1993.
But to a greater extent this time, pay increases will be linked to performance. Liability associated with filing the CD&A, in particular, should force boards to explain just how pay practices help the company. And, of course, the increased transparency raises the prospect of Pfizer-style shareholder outrage against boards that grant executives large pay packages with only a slight link to performance.
Rosen already has observed some companies examining their practices. "We're seeing compensation committees asking themselves, 'Are our programs appropriate? Do they incentivize the right thing? Are we, in fact, independent of management?'" he says.
Furthermore, the CD&A will turn the spotlight on consultant relationships, often criticized when the firms work both for management and the compensation committee, creating a conflict of interest. CEOs themselves sometimes work with consultants to determine a package, then present it to their own board, which more often than not approves it. Now, says Aon's Savage, boards will have to explain the process and will take control.
Certain companies may actually benefit from transparency. "We have a high percentage of employee stock ownership and have never had poison pills, severance, or change of control payments," says Rene Jones, CFO of Buffalo-based M&T Bank, an early adopter of many of the SEC's proposals. "In the past, we didn't talk much about it. But as corporate watchdogs start comparing companies next year, I think we'll get some credit for our practices."
It's unlikely that compensation disclosure rules will permanently fix problems plaguing executive remuneration. If future proxies reveal most of what companies now pay, new approaches will emerge, presenting new charges of concealment.
"Never — and I mean never — underestimate the creativity of corporate lawyers, accountants, and compensation consultants to find loopholes," says McGurn.
Still, the SEC's action inspires some rare optimism about the future of compensation. "We're very enthusiastic about the new rules," says Wilcox. "Will it lead to higher or lower pay? I can't say. But I do think pay will be better designed."
Don Durfee is research editor of CFO.
Show and Tell
Highlights of the SEC compensation disclosure rules taking effect in 2007 for companies whose fiscal year ends this December 15 or later.