Below is a letter to SEC Chairman Mary Schapiro from Senior Research Associate Paul Hodgson sent last week.
Dear Chairman Schapiro,
Lessons from past experience: Not squaring the circle – apples and oranges in the
Summary Compensation Table
The Commission has indicated it will soon hold hearings regarding modifications to the rules for mandatory disclosure of compensation information. I am writing to share some thoughts that may be helpful to you during these deliberations. For eight years, I have served as the lead researcher on executive compensation at The Corporate Library, an independent corporate governance firm. Our work is based primarily on data derived from SEC filings, so the matter you are considering is of particular importance to us.
As you are aware, the SEC introduced new compensation disclosure requirements in 2006. During the SEC’s open meeting on 17 January 2006 which premiered the new compensation disclosure proposals, one of the commissioners questioned why retirement benefits would not be included in the Summary Compensation Table. In response, Alan Beller, the chief architect of the proposals, said he did not want “to try and square the circle and include future compensation in the Summary Compensation Table.”
Unfortunately, the regulations eventually ended up doing precisely this by including in that table the “expensed cost” of equity awards, rather than any actual amounts that have been realized, or profits that were made, during the fiscal year in question. These latter figures, the true present compensation from equity awards, are disclosed in a different table.
Simply put, the SEC’s Summary Compensation Table currently includes a mix of both current, actual compensation and future, unrealized compensation.
It has been reported that that the Commission is now considering including the “grant date present value” of equity awards rather than the expensed cost in this table. If this is true, then we will still have a mix of apples and oranges – it will just be a different variety of orange. The Commission will still be trying to square the circle with future compensation continuing to be included in the Summary Compensation Table alongside earned compensation. This is at best a sideways step and not a forward move.
Such a proposal is all the more difficult to understand because the Commission clearly understood from the beginning that the Summary Compensation Table was largely intended to present compensation paid currently, current earnings from other compensation plans, and “the dollar value of all other amounts earned during the fiscal year pursuant to incentive plans.” Why, then, should it also include amounts “expensed” in the year but not earned, or the estimated value of grants made in the year?
Summary Compensation Table should include only realized compensation
As far as the Summary Compensation Table is concerned, it would seem that the best way forward would be to have two such tables: one that indicates monies received in the year – Realized Compensation; and another that discloses the target, future level of compensation aimed at by present grants and awards – Realizable Compensation.
The two tables would therefore include the following items for each named executive officer. All amounts are dollar amounts:
|
“Realized Compensation”: Compensation received in fiscal year |
“Realizable Compensation”: Target compensation |
|
Base salary |
Base salary rate (the rate set during the year, not the amount paid) |
|
All other compensation (itemized in supplemental table, but see below) |
Expected cost of all other compensation (itemized in supplemental table, but see below) |
|
Annual cash bonus |
Target annual bonus |
|
Value of any vested time-restricted stock |
Grant date value of any time-restricted stock award |
|
Value of any exercised stock options |
Grant date value of stock options |
|
Value of any other LTIP payout – Cash amount in one column/equity amount in another |
Target payout of any other LTIP – Cash amount in one column/equity amount in another |
|
Actual increase in pension value and non-qualified deferred compensation earnings |
Expected cost of increase in pension value and non-qualified deferred compensation earnings |
|
Total realized compensation |
Total realizable compensation |
“In this way, all the “apples” will be in one table, and all the “oranges” (whether they be Navel or Seville) will be in another. Such an arrangement would also negate the need for the Grants of Plan-based Awards Table.
You will note that I have suggested that the Bonus and Non-equity Incentive Compensation amounts are conflated into a single Annual Cash Bonus column. The distinction between Bonus and Non-equity Incentive Compensation is often not clear and has caused immense confusion among shareholders and some commentators. In addition, it is not sufficient distinction that some companies have bonus plans that set targets at the beginning of the year and others assess performance at the end of the year. Truly discretionary bonuses such as signing payments and guaranteed bonuses should be recorded under All Other Compensation, not the bonus column.
I have also suggested that long-term cash compensation be disclosed separately. This is another area that has caused immense confusion for shareholders when the Non-equity Incentive Compensation amount includes two or even more types of compensation that can represent payouts from multiple plans each measuring different kinds of performance over different time periods. This combination is again not helpful to shareholders trying to understand where compensation has originated
While these two suggested tables would negate the need for the Grants of Plan-based Awards Table, I would suggest retaining the Options Exercised and Stock Vested Table for a number of reasons. Firstly, this will allow shareholders to see how many options were exercised and how many shares vested, as they do now. I would like to make some suggestions for changes and additional disclosure to this table, however. Like the separation of short and long-term cash bonuses, I would also suggest that time-restricted and performance-restricted stock be separated – as they are in the current Grants of Plan-based Awards Table. This will allow shareholders more clearly to see how much compensation has been earned based on performance and how much on merely remaining in post – a valuable distinction. Finally, additional disclosure should be required in this table that details the grant dates of these awards and the original exercise price in the case of options. In almost every case I have examined companies have very carefully explained how and when future compensation might be earned, but in most cases there is no information as to where the long-term awards that are described in this table originated. You would have thought companies would volunteer such information as it would go a long way to justifying what are often very substantial amounts of compensation, yet I have found none do. On the other hand, those companies to whom I have suggested this voluntary disclosure have reacted very positively, understanding that it might improve their shareholder relations substantially.
A shareholder who can see clearly that a CEO has waited nine and a half years to exercise an option and who has overseen a considerable increase in the stock price rise can readily understand where such option profits have originated, and that if they had bought stock at the same time as the option was granted would have benefited from the same appreciation in value.
Perquisite disclosure
To turn to the disclosure of perquisites, there are also problems associated with this area of the regulations; it is relatively easy to see, for example, how companies can circumvent the law to avoid proper disclosure. The rules require “that each item of compensation included in the All Other Compensation column that exceeds $10,000 be separately identified and quantified in a footnote.” The original “Request for Comment” that was sent out in 2005 asked:
• Should all compensation no matter how de minimis be required to be disclosed?
• Will companies be able to track this information without undue burden?
• Is $10,000 the appropriate threshold for separate identification and quantification?
The answers to these questions were and still are: yes, yes and no, respectively.
There is no real justification for any threshold, companies already track these expenses, and there is very little likelihood that the information is not readily available. Therefore there should be no additional burden involved in disclosing even de minimis amounts. Furthermore, the $10,000 threshold for separate identification is clearly open to abuse. Given that the threshold was reduced because investors were interested in the “what,” not necessarily the “how much,” this lack of a requirement to identify separate perks is not even logical.
Furthermore, it takes no time at all to discover how to get around the rule. The only thing companies would need to do is break perks down into tiny, smaller than $10,000 increments in order to evade disclosure. In this way, an executive could receive 10 separate, equally valued perks worth a total of $90,000 and not have to disclose any of them. Or, instead of disclosing a car allowance, the company breaks this down into a car leasing allowance, and a petrol allowance, and a car insurance allowance, and a chauffeur’s uniform allowance, and a chauffeur’s uniform cleaning allowance, and a car valet allowance, and a travel allowance per trip…. Pretty soon, you have all other compensation of $800,000, comprised of 880 separate items, none of which needs to be disclosed individually. Furthermore, with the threshold in place, the absurd situation is still in place where a tax reimbursement on a perk has to be disclosed, but not the perk on which the tax is reimbursed. This clearly does not make sense.
Disclosing golden parachutes
SEC rules currently state that severance benefits be disclosed in a narrative, requiring that companies give the estimated payments and benefits that would be provided in each termination circumstance. It is very important that disclosure covers each termination circumstance; even before the implementation of the new proposals we had an example of a company – Morgan Stanley – volunteering such information, but selectively. So, when a termination actually occurred, its cost bore no relation to anything that had been disclosed.
Morgan Stanley’s 2005 compensation committee report indicated that then CEO Philip Purcell did not have any agreements entitling him to base salary, cash bonus, perquisites, or new equity grants following a termination. In the company’s narrative disclosure of “termination scenarios” in the report, termination was discussed as a result of a voluntary termination, a change in control termination, or a “for cause” termination. The eventual outcome, the board’s termination of his employment, was neither discussed nor disclosed; therefore what looked like great disclosure was actually selective and obstructive disclosure.
Mr. Purcell’s eventual termination led to severance payments of two times salary and annual bonus along with the immediate vesting of all equity awards. Mr. Purcell also received a cash payment of $250,000 per year in lieu of benefits, full retiree medical benefits, administrative assistance, and $250,000 per year in charitable contributions. All of these benefits were to be provided for the rest of Mr. Purcell’s life.
In other words, there was no agreement entitling Mr. Purcell to severance payments, but when it came time to terminate him, one was drawn up, instituting the very things the compensation committee report said were not entitlements. In addition, the eventual amount paid out to Mr. Purcell did not resemble any of the amounts disclosed either in aggregate or in detail as part of the narrative disclosure. As you can see, this is obfuscation not disclosure
The SEC’s “alternative narrative disclosure” did not improve matters to the fullest extent possible, and it would have been far more effective to mandate these disclosures in tabular form. Where figures are involved, it is an invariable rule that a tabular format is both easier to understand and easier to present, and should be adopted for every such disclosure. That many companies adopted tabular disclosure is proof of this maxim.
Unfortunately, however, as there was a general free-for-all as to what should and should not be included in any voluntarily-provided table, we have completely inconsistent results from company to company. Therefore, any changes to the disclosure rules should mandate a specific table, with mandated column headings as in every other instance of compensation disclosure. It is difficult to see why severance should have been treated any differently from other forms of future compensation (such as pensions and deferred compensation). A survey of the very best examples of disclosure, including those that disclose the cost of excise and other tax gross-up payments as well as any retirement and other benefits that vest on termination, should be taken so that the SEC can adopt corporation-defined best practices and impose these on all corporations.
We would be most grateful if you could take these comments into consideration if any changes to executive compensation disclosures are contemplated in the coming months. If you would like to receive any further detail regarding these suggestions or would like to discuss these issues further, we would be happy to arrange a meeting.
Yours sincerely,
Paul Hodgson
Senior Research Associate
The Corporate Library
