From the SEC: Please Link Executive Pay to Performance

Sleep well sweet Prince, or perhaps Emperor. We now send executive compensation to its inevitable peaceful and infinite slumber. Shown brightly for a few decades, your glory days are over.  April 29, 2015 was officially the beginning of the end of soaring executive pay. The SEC proposed a new rule on executive pay for performance, pursuant to the requirements laid out in Section 953(a) of Dodd Frank, that will change everything we know. Essentially, the rule can be summarized thusly: “You must disclose how your executives are paid relative to company and peer performance.” With this rule, it is obvious that companies will no longer be able to justify executive pay at the levels of the past decade or more.

Who am I kidding? The new rule will just make it easier for all of your shareholders to know what your more engaged and advanced shareholders already know. Do you pay your executives in a way that aligns with total shareholder return for a three to five year period? It is an important thing to know, but it is not earth shaking new information, or even the most important metric for some companies or their shareholders.

Ok. Now that the fireworks have concluded, let’s get back to reality. The proposed new rule has several parts. I will summarize them and discuss their potential impact below.

1)     There will be a new table in the proxy. The table will show the following:

• Compensation reported in the Summary Compensation Table (SCT) and the amounts “actually paid”^(I) to the principal executive officer. Basically, this will be the information from the SCT that already exists, with some added information for the change in value to pensions and equity. Equity and pension adjustments will be shown in another new table.
• Same values, averaged for the remaining NEOs (Named Executive Officers)
• Companies’ TSR (total shareholder return) on an annual basis for the past five fiscal years (or three years for smaller companies).
• The TSR for companies’ peer group for the same periods (smaller companies will avoid this for now).

2)     Companies will be required to, “describe the relationship between the executive compensation actually paid and the company's TSR and the relationship between the company's TSR and the TSR of its selected peer group. This disclosure could be described as a narrative, graphically, or a combination of the two.”

(I) Amounts actually paid will be the amounts from the SCT with adjustments for changes to pension and equity value. Pension amounts would be adjusted by deducting the change in pension value reflected in that table and adding back the actuarially determined service cost for services rendered by the executive during the applicable year. Equity amounts will be considered “actually paid” on the date of vesting, using the Fair Value (usually Black-Scholes Value for options or Intrinsic Value for full value awards) calculated on that date.

What’s this mean to you?

1)     Private companies.  It means very little. Maybe several years from now some of this will trickle down, but for now this may be another advantage of staying private.

2)     Smaller public companies. First, look here to see if you qualify. If so, you will have at least a couple of years to transition. Even then some of the most onerous stuff won't apply to you.

3)     The rest of public companies. You will still have some time to transition, but you also have 60 days to submit a comment letter.  Will creating, managing and communicating a peer group for this be difficult? Let the SEC know. Do you think the amount “actually paid” is a reasonable method for valuing compensation? If not, send the SEC a comment letter.

4)     Do you calculate TSR differently than the SEC? If so, how will you communicate the different methods to your executives, or will you change your plan(s) definition(s) for future periods?

• (The SEC 201(e) calculation for TSR is “measured by dividing the sum of the cumulative amount of dividends for the measurement period, assuming dividend reinvestment, and the difference between the registrant’s share price at the end and the beginning of the measurement period; by the share price at the beginning of the measurement period.)

So, this is not a fun, pithy or cheeky Comp Café post, but it is an important update. How will this change the way your company looks at executive compensation (if at all)?

Dan Walter is the President and CEO of Performensation a firm committed to aligning pay with company strategy and culture. Do you want to be a better business leader? “Everything You Do in COMPENSATION IS COMMUNICATION” was written by 3/8^th’s of the Comp Café, Dan Walter, Ann Bares and Margaret O’Hanlon. It’s a practical guide to improving the communication process (with how-to worksheets). Dan has also co-authored of several other books you may find useful including “The Decision Makers Guide to Equity Compensation”and “Equity Alternatives.” Dan welcomes connections on LinkedIn. Follow him on Twitter at @Performensation and @SayOnPay.

Comments

[Jacque Vilet]

Who/how will decide what a peer company is?

[Dan Walter]

Currently each company defines their peer group for TSR purposes. It is usually a mix of industry matches and company size matches. But, this may not be enough for shareholders in the long run. They may call for some kind a rules around how a peer is determined. They may even call for prescribed peer groups.

ISS already creates their own peer groups, which almost never match the companies peers groups. This requires companies to do every calculation at least twice. Once for their own peer group and once for something they feel represents the ISS peer group.

[Trevor Norcross]

The other significant problem with TSR is that the correlation to company performance is different for every company. If you are a market mover in your industry you may have a stronger correlation between individual company performance and TSR. If you are a market follower in your industry you may have a weaker correlation between individual company performance and TSR.

Many companies blindly set their plans to TSR without understanding this and end up with awards that can be a poor reflection of performance.

Will a correlation factor of TSR to a key financial metric ever be tracked and become a part of the analysis to determine a peer group?

TSR is a great metric for shareholder alignment but is often not the right metric if you want to be aligned to actual performance. The best approach may be a balance.

[Tony Bergmann-Porter]

A further argument, were any necessary, for either remaining private, or going public offshore.

[Dan Walter]

Trevor,

You are very very on point. When looked at across hundreds or thousands of companies, TSR is a fairly stable metric. When looked in small groups or individual companies it can border on providing misinformation. This will be made even worse if a company has specific TSR goals (that may have been previously acceptable to shareholders) that do not align with the current averages that are being used to measure for the proxy.

TSR as a standalone metric and goal for long-term incentives has often been shown to provide no more of a link to actual performance than stock price. When this is the case there is very little argument that "performance-based equity" is different than normal employee stock options (and stock options provide better tax planning flexibility.)

I believe that TSR is usually best used as a thresholding mechanism than should be combined with one or two other performance metrics. Too much for this comment thread, but something I do love to talk about.

[Dan Walter]

Tony,

The topic of going or staying private has become very hot over the lest several years. And, as long as investors are willing to keep putting money into "unicorns" ("start-ups" worth more than $1Billion) I am sure we will continue to see companies hold out as long as possible.

[Jacque Vilet]

This might sound a little cynical but ID'ing peer companies is ripe for all sorts of manipulation. I would say it's done quite a bit in determining executive compensation. That aside---look at the faulty assumptions people make when comparing revenues per employee. Depends on whether a company is mfg or not----mature or start-up,type of industry,etc. Just saying I'm not sure that these new requirements will actually reveal true performance. Seems like the more we try to "clean things up " the more potential manipulation we see.

[Dan Walter]

Peer companies are one of the major concerns of this new rule (another is linking the lions share of executive pay effectiveness to a single metric...TSR). Peer groups are the ultimate game of compromise in executive compensation. Those who want to pay the executives more want larger high performing companies. Those who think executives are paid too much want smaller less volatile companies.

Then people look at the mix and hope that a company fits at least somewhere in the middle. Since high flyers and low flyers get added to most lists showing at least middling performance can be a forgone conclusion.

And, of course, the peer groups used for this exercise are unlikely to match peer groups the company or shareholders use for other measurements.

[Dan Walter]

The full text of the SCE proposal can be found here: http://www.sec.gov/rules/proposed/2015/34-74835.pdf

It's 129 pages. Fascinating what it takes to get a single page of a new rule completed.

[Don Nemerov]

good discussion, nice to have the LinkedIn alert. Think about it - there will likely now be at least 4 separate disclosures in the proxy covering CEO/NEO stock compensation (the biggest piece by far) – SCT, GPPA, PVP and supplemental realized pay summaries, and still there is disagreement on how values should be reported. Two further points – One, CEOs & their teams leading broadly held public companies control at most a third of their company’s share price change, this has been shown over & over again by studies & analyses, begs the question on TSR as the metric for PVP disclosure. (It also raises the question of whether they are paid excessively via stock-based incentives, a discussion for another day.) Two, PE capital investment far exceeds public infusions of capital via IPOs or shelf registrations, so maybe this will all solve itself one day via the ongoing decline in the number of public US companies.

[Dan Walter]

Hi Don,

You make several excellent points. It seems as if all of this will theoretically make a few investors lives easier without really changing the end game much (if at all).

While I think the IPO market will continue to remain viable, I think you are already seeing some of the fallout of the combination of readily available money and pushback against regulations. Not much else can explain the growing pool of $1BILLION+ "unicorn companies.