As noted in our previous publication, the implementation of Dodd Frank indeed slowed in the second half of 2011.  In late July, the SEC announced a second delay in implementation of four key components of the law:

1.  Pay for Performance Disclosure

This is perhaps the most meaningful of the remaining implementation issues, and the most difficult for the various constituencies to determine the best approach.  The SEC will adopt rules requiring companies to include disclosure in annual proxies showing the relationship between executive compensation and corporate financial performance.  Our opinion is that TSR (total shareholder return) will be the likely choice for the financial performance measure.

2.  Pay Ratio – CEO Pay Comparison

The Act will require companies to disclose the ratio of the median annual total compensation of a company’s employees (excluding its chief executive officer) to the total annual compensation of its chief executive officer.  This requirement will necessitate the collection of substantial compensation data. For most companies, this project will be a significant undertaking and difficult to implement.  The SEC is being lobbied to provide a more practical interpretation of the statute.  It is possible that this part of the law will not be implemented.

 3.  Clawbacks

Public companies will be required to develop and implement policies that mandate clawbacks of compensation paid to current or former executive officers if the compensation is determined to have been “erroneously awarded”.  This is effective for the three-year period preceding the date on which the company is required to prepare an accounting
restatement as a result of material non-compliance with the securities laws.

 4.  Director and Employee Hedging

The legislation calls for the SEC to issue rules requiring information regarding director and employee hedging to be disclosed in the proxy materials. This information must include whether these employees are allowed to hedge the value of any equity securities that have been granted or that are already owned by the director or employee.

The adoption dates for these components of the regulations were moved to the January-June 2012 period. This delay means that these parts of the law will not be in place for the 2012 proxy season.

Two provisions of Dodd Frank will likely be effective for the 2012 proxy season.  In March of 2011 the SEC issued proposed rules for compensation committee and advisor independence.  Final rules are expected by the end of this year.  Subsequently, stock listing exchanges will either adopt the SEC standards or further expand them.

Compensation Committee Independence

Independence standards already exist for directors of NYSE and NASDQ listed companies.  The new standards for compensation committee independence may expand from the current standards and likely follow the requirements for audit committee members imposed under Sarbanes Oxley in 2002.  “Independence” is not defined in the SEC’s proposed rules and will be left to the exchanges to define.  However, the definition adopted by exchanges and associations must consider the source of  compensation of board members, including consulting, advisory, or other compensatory fees and whether the member is an
affiliate of the company or a subsidiary.

Independence of Compensation Committee Advisors

The proposed rules would direct the exchanges to adopt standards that provide compensation committees with the authority, at their sole discretion, to retain or obtain the advice of compensation advisors (consultants, legal counsel, or other advisors).  The proposed rule would make the compensation committee responsible for appointment, compensation, and oversight of the advisor.

The rules do not require the compensation advisor to be independent, but instead require the compensation committee to consider certain factors that may affect the advisor’s independence, including:

• the provision of other services to the company by the person or firm that employs the adviser;
• the amount of fees received from the company by the person or firm that employs the adviser, as a percentage of the total revenue of the person or firm that employs the adviser;
• the policies and procedures of the person or firm that employs the adviser that are designed to prevent conflict of interests;
• any business or personal relationship of the adviser with a member of the compensation committee; and
• any stock of the company owned by the adviser.

Nothing in the proposed rule requires a committee to retain an advisor.  However, if a committee chooses to do so it must be stated in the proxy statement.  Any conflicts of interest and how they were addressed must also be outlined.

Preparing for the Upcoming Proxy Season

The first year of SOP (say on pay) advisory voting resulted in only two percent of companies receiving an unfavorable voting outcome on their executive pay practices.  ISS (Institutional Shareholder Services) and other advisory firms demonstrated significant influence in the say on pay voting based on their recommendations.  The Russell 3000 companies showed a 21% difference in the average passing vote when ISS either voted for or against the sample company’s say on pay recommendation.

This would suggest that companies need to be conscious of the most common reason for companies receiving a no vote on say on pay.  Of the 37 companies that received no votes, the most common reason was a pay for performance disconnect.  ISS views a potential pay-for-performance disconnect if CEO pay increases, remains unchanged, or marginally decreases in conjunction with below industry median 1-year and 3-year TSR.  Of the companies that received unfavorable votes, 78% had below median 1-year and 3-year TSR and 73% showed increased CEO total direct compensation.

These results suggest that the TSR / CEO pay alignment isn’t the sole issue resulting in a negative recommendation.  ISS is also undoubtedly taking a holistic view of executive compensation practices in a company.  Other issues being considered are the level
of pay that is not performance based, unaddressed problematic pay practices (option repricing without shareholder approval, excessive perquisites or gross ups, new or extended severance agreements greater than three times salary + bonus, or
severance agreements that have a single trigger).

Based on lessons learned from last year’s results, companies are advised to take the following steps to increase their chances of a favorable SOP vote:

1. Ensure that variable compensation pay opportunity is aligned to company performance and emphasize objective criteria in measuring results.  Best practices suggest that measures should be different in the annual incentive and long-term plans.
2. Avoid significant non-performance elements in the pay scheme.  Worth noting is that time vested stock options are considered non-performance pay vehicles by ISS.
3. Avoid using upward discretion when determining pay awards when results did not support the desired incentive payout.
4. Address problematic pay practices as described above.
5. Use the CD&A as a communication tool to explain the relationship between pay and performance and how decisions were made in a simple and understandable format.  Many companies are using a summary at the beginning of the CD&A to present an easy to understand overview.
6. Proactively engage with your major shareholders if issues existed in the past, or are anticipated in the upcoming proxy.  This is especially important for those receiving unfavorable votes or votes below 70% approval.

Dodd Frank will continue to influence executive pay decisions in 2012 and beyond.  Certainly some of the proposed sections of the law do not add value and may further confound rational executive pay decisions (e.g., CEO pay ratio comparison).  However, the first year of SOP voting resulted in 98% of companies receiving favorable votes.  We would suggest that this a successful outcome in that shareholders exercised their voting rights responsibly.  Companies now have a general feedback mechanism to understand shareholder beliefs on executive pay.  We hope that firms heed the feedback provided, and make changes to their pay systems to reflect pay for performance and support sound governance practices.

Say on Pay and Say on Frequency were the most significant executive compensation outcomes of the new law to impact proxy filings last year.  Publicly traded companies, with market capitalization greater than $75 million, were required to solicit non-binding shareholder votes on: (1) their executive compensation practices and procedures, and (2) the frequency of future non-binding shareholder votes on executive compensation practices and procedures.

Cogent reported the following voting results of 1,873 companies:

• Approximately 98% of the sample companies received favorable voting outcomes (50% or more) on their executive pay practices
• Approximately 84% of the sample companies received a favorable vote from 80% or more from their shareholders.

It would seem that shareholders are generally supportive of executive pay practice in the majority of companies even at a time when CEO total direct was up 11% from the previous year (2010 Wall Street Journal / Hay Study).  Strong company performance still carries the day when driving executive pay levels.

Cogent also reported on shareholder preference on future Say on Pay shareholder votes:

• Shareholders in 78% of the sample companies opted for an annual vote on the issue
• Shareholders in 21% of the sample companies preferred a triennial vote on pay
• Shareholders in 1% of the sample companies voted for a biennial vote on pay

After initial company recommendations supported a triennial vote on pay, the tide turned, and shareholders spoke loud and clear on their preference for a vote every year.

What conclusions can be drawn from these initial results?

1. Companies receiving unfavorable votes should consider a thorough review of their executive pay practices.  Although non-binding, the negative vote and the company’s response must be addressed in the next CD&A.  A disconnect between company performance and executive pay was the most common reason for a negative vote.  A disconnect might arise from rising executive pay when company performance decreased, payment of discretionary bonuses, or lack of performance goals.
2. Eighty-four percent of companies received an 80% or greater favorable vote from their shareholders.  We would suggest that 80% may become the bright line for a successful vote.  Companies that received a favorable vote (e.g., greater than 50%) but less than 80% may still have work to do in understanding shareholder perceptions and reviewing their practices with an eye towards improving their pay and performance linkage.
3. Companies that received a favorable vote of at least 80% are likely on the right track in managing an effective executive pay system.  We would suggest their focus should be on validating the pay for performance relationship.
4. Shareholders want to voice their opinions with regard to executive pay.  The prevalence of the one year vote was a minor surprise, as we believed the rationale for a triennial vote was strong.  This may be considered good news for companies, as the majority will submit their executive pay practices to shareholders annually.  The annual vote on executive pay practices provides shareholders with a frequent voice and an alternative to negative compensation committee votes and possible frivolous lawsuits.  (It should be noted that lawsuits have been filed on negative Say on Pay votes.)

As noted earlier, the implementation of Dodd Frank has slowed.  The SEC had intended to issue rules on pay-for-performance, clawbacks, and pay disparity (ratio of CEO pay to median employee pay) by July.  In late January the SEC announced a delay in issuing initial disclosure rules until August – December of this year.  This delay, the complexity of these issues, and the likely high volume of first draft comments may mean that the these rules will not be finalized in time for next proxy season.

The delayed disclosures and rules provide some additional time for companies to further review their practices in light of the upcoming legislation.  We provide additional thoughts on round two of the Dodd Frank executive pay implementation in our next blog.