Early Reviews on 2010 Proxy Disclosures

For any company wondering what grade it may have received for the proxy disclosures it made this spring, listen up.

Patrick McGurn, special counsel to RiskMetrics’ ISS Governance Services, gave an early review of proxy disclosures this past season at Compliance Week 2010. This year’s proxy statements had to include a flock of new disclosures about executive pay, corporate structure, and risk management, and McGurn shared some examples of the good—and not so good—disclosures made in five major areas that continue to resonate with most investors.

“The stakes are growing,” he said. Issues like mandates for majority voting, proxy access, say-on-pay, and more, “make disclosures even more important than they have been in the past.”

Board Leadership. Starting this spring, companies had to disclose whether they split the role of board chairman and CEO, why or why not, and why the model they chose works for them.

McGurn

The best disclosures, McGurn said, go beyond that basic boilerplate and get to “the why question.” At companies that still combine the chairman and CEO roles, the majority of proxy statements essentially say, “We’ve always done it this way, and we’re going to continue to do it this way,” McGurn said. But investors want specificity to this argument: What is the nature of the company’s operations, the scope of the business itself, and how does that interrelate with the decision to combine the chairman and CEO roles?

In addition, McGurn recommended adding insight about the future. Is this a permanent structure, or something you’d like to change from time to time? Are there circumstances under which you’d combine the chairman and CEO jobs, and if so, would there be a lead director? What would that director’s responsibilities be?

One step further would be to provide the job description of the independent chairman position, as well, “so investors can understand how they interrelate with the senor executives and the CEO of the firm,” said McGurn. Without that juxtaposition of where one role ends and the other begins, “you really only have one side of the story,” he said.

And for companies that face a shareholder resolution asking to separate the two positions, these disclosures are likely to determine the outcome. “To the extent that you’re not making your case or not making a compelling fact, I think it can, and will, be held against you in the future,” McGurn said.

Diversity. The new rules from the Securities and Exchange Commission also order companies to disclose whether and how the board’s nominating and governance committee considers diversity when it recruits nominees, and whether the company has a boardroom diversity policy. If a policy does exist (and the rules don’t require a company to have one), the SEC further wants to know how that diversity policy has been implemented, as well as how the nominating committee assesses the effectiveness of it.

Issues like mandates for majority voting, proxy access, say-on-pay, and more, “make disclosures even more important than they have been in the past.”

—Patrick McGurn,

Special Counsel,

RiskMetrics ISS Governance Series

Many companies do say in their disclosures that the nominating and governance committee has integrated diversity into its selection process, McGurn said, but they “provide no evidence to back this up whatsoever.” The best disclosures carry the discussion through, not only integrating it into the discussion, but also backing it up with evidence, he said.

McGurn also warned against the approach of one small construction company, which stated that, “The diversity in the boardroom was that one of their directors was from California.”

EQAS (experience, qualifications, attributes, and skills). Companies have long had to provide some basic description of board candidates, McGurn said, but most only provide a thumbnail sketch. Now—at least in theory—companies must also disclose the specific skills each board nominee possesses that make him or her a good candidate. “This is probably from an investor perspective the most meaningful of the new additions in the proxy statements,” McGurn said.

Unfortunately, McGurn said, no company really nailed that level of disclosure this year. The best efforts, he said, would include discussion of what continuing education your directors are receiving, or what projects they have worked on in the past. Most new directors are retired, which raises questions about whether the experience they have is current and useful.

“Don’t save paper here,” said McGurn. “I’d much rather see an expansive discussion of this and perhaps less on the other issues.”

Pay Risk. Good disclosure of “pay risk”—that is, how much the prospect of a big pay-off might tempt an executive to be reckless with company resources—explains who is involved in setting pay policies, and what issues are considered. A better disclosure, McGurn said, describes what steps the company takes to mitigate that risk and any provisions such as clawbacks. McGurn noted that nearly half the disclosures ISS has examined this year conclude that there weren’t any risky pay practices at all.

EXEC COMP EVALUATION

The following excerpt is from RiskMetrics’ 2010 Corporate Governance Policy Updates and Process:

Currently, RiskMetrics’ evaluation of executive compensation affects its analysis of equity plan proposals, compensation committee and board elections, as well as Management Say-on-Pay (MSOP) resolutions. The likely advent of MSOP in the US underscores the need for a coherent approach to evaluating executive pay, involving a variety of factors that may affect this analysis.

In order to more holistically evaluate compensation and provide clearer guidance to the market, the new Executive Compensation Evaluation policy incorporates and unifies RiskMetrics’ existing Pay for Performance, Options Backdating and Poor Pay Practices policies, together with the existing guidelines on evaluating MSOP proposals. The five global principles on executive and director pay, which were introduced in 2007 as part of the MSOP policy, now underlie the comprehensive US Executive Compensation Evaluation Policy and align it

with overarching best practices at a global level while recognizing local market distinctions.

The updated policy provides a framework for determining the appropriate voting outcome in cases where pay practices raise shareholder concerns. As supported by a majority (52 percent) of Policy Survey respondents, the MSOP proposal (if present) will be the primary communication avenue to initially address problematic pay practices, with additional or alternative negative recommendations on Compensation Committee members (or the board) in especially egregious situations. If these concerns are not sufficiently addressed in the following

year, the policy would recommend votes against Compensation Committee members.

Within this reorganized evaluation framework, there are two notable updates to RiskMetrics policy guidelines:

(1) The Pay-for-Performance evaluation will additionally consider the alignment of the CEO’s total direct compensation (TDC) and total shareholder return (TSR) over a period of at least five years. The new consideration will be an evaluation of long-term pay alignment through a 5-year historical trend of CEO TDC and company TSR.

(2) Given regulatory and market focus on the relationship between executive pay and excessive risk-taking at financial services firms, RiskMetrics’ evaluation of problematic pay practices will include consideration of whether incentive practices may motivate inappropriate risk-taking by executives. This evaluation will also assess the extent to which techniques such as clawback policies or stock ownership/holding requirements may mitigate this risk.

Source

RiskMetrics Executive Summary of 2010 Updates (Nov. 19, 2009)

Risk Oversight. The SEC had been expecting companies to report how the board administers its risk oversight function, and the effect that has on the board’s leadership structure, McGurn said. In practice, however, few companies made that connection.

“I think best practice may be in the future to put those right next to one another in your disclosure, and to carry that transition into how your board leadership structure plays in to your board risk oversight,” McGurn said. “Many proxy statements did not touch upon that even in passing mention.”

Companies that handled this disclosure well explained where risk oversight resides in the company, which typically tends to be in the audit committee, he said. Yet even better disclosures identified who is involved both inside and outside the company. Some companies seemed to farm out risk oversight to their auditor, he said.

Best practice is to talk about risk oversight substantively, such as stating risk appetites or tolerance levels. One example may be to state, “We apply COSO standards,” or any other ERM processes that may be in place, McGurn said.

Other Issues

McGurn also reviewed what issues companies can expect to confront in the future, both from a regulatory and legislative standpoint. They include:

Compensation, Discussion, and Analysis. As shareholder votes on executive compensation packages become more prevalent, companies should confront possible tensions over compensation directly, ideally in the executive summary of the proxy statement, McGurn said. “Make the argument upfront about CD&A—about how pay ties into performance, about how you look at peer groups, how you deal with issues like perquisites, and other hot-button issues.”

Hedging. Does your board have a policy regarding senior executives using hedging instruments? “With all the focus on derivatives and other issue these days, you cannot afford to be without one of these polices,” McGurn said. It’s likely you’re going to have to disclose what your polices are. “The best policy from our standpoint is zero tolerance,” said McGurn.

Internal pay equity. Under the Senate’s financial reform bill, companies would need to state internal pay equity: the CEO’s annual total compensation, the median compensation for all other company employees, and the ratio of the two amounts. (CEOs currently make hundreds of times more than the median worker’s salary.) If that pay equity disclosure becomes law, “this could end up being the most inflammatory number that’s ever been in the proxy statement … so just start getting ready for it,” McGurn said.