U.S. corporations are growing more concerned that federal lawmakers and regulators have hijacked the traditional corporate disclosure process to fulfill a social agenda. Investors, meanwhile, are being smothered with volumes of data, much of it virtually useless for making investment decisions. How did we get here?
In no way am I arguing that companies should be excused from fulfilling their obligation to provide truthful, complete information—in plain English—so shareholders can make sound investment decisions. Instead, I simply raise the question: What kind of information is relevant to investors, and what isn’t?
For example, the Dodd-Frank Act will require companies to provide the ratio of the CEO’s total compensation to the median salary of all other employees in executive compensation disclosures. Called the “internal pay equity ratio,” the Securities and Exchange Commission is expected to publish this rule for comment sometime next April. OK—but what does that number really tell investors?
A U.S.-based retail firm like Wal-Mart or a restaurant chain like McDonald’s, with operations all over the world using mostly low-paid hourly employees, will likely have a huge ratio. On the other hand, a U.S.-based retail bank, with higher-paid employees and fewer of them, will have a lower ratio. Yet, the CEOs of each could be paid about the same. How does that ratio help an investor make sound investment decisions, unless the investor is making decisions based on social value rather than investment value?
For some time now, some in Congress and some in the regulatory realm have believed that CEOs make too much money, particularly in relation to their employees. And, when that ratio is published in a company’s proxy, probably no figure will be more likely to grab the attention of the media. Some corporate accountants call this “social engineering by way of disclosure.”
Harvey Pitt, a former SEC chairman (and a fellow Compliance Week columnist), says that instances of Congress legislating new disclosures to change corporate behavior are not new. For example, various provisions of the Sarbanes-Oxley Act did just that. New compensation disclosure, Pitt says, “is minimally an issue about how much CEOs make, although that’s the real agenda of many in Congress and many corporate activists. In reality, the issue is not what CEOs are being paid, but what they are being paid for, and how boards are monitoring and assessing whether they’re receiving bona fide performance for the dollars they are paying.”
Pitt goes on to say that if the goal of executive pay is to get performance (which it should be) then boards have an obligation to identify what it is they expect their senior managers to achieve, what the compensation is for each facet of performance, and how they will measure whether they’ve received sufficient performance for the expense they’ve paid. But, Pitt adds, “very few boards perform this exercise. Had they been performing the exercise as I’ve described it, there would have been no support for the compensation provisions of Dodd-Frank.”
Institutional investors share Pitt’s perspective. Fred Speece, a partner in Speece Thorson Capital Group in Minneapolis and a former chairman of the CFA Institute’s board of governors, says his group reviews executive pay “in terms of the success of the business. We look at measures that management can control, such as return on invested capital, margins, and working capital. We tend to discount earnings per share, and least important is the share price of the company’s stock, as these are things CEOs can’t control and often create the wrong incentives.”
Sam Jones, former chief investment officer for Trillium Asset Management, looks for context. “If I see a company’s stock is relatively underperforming its peer group or a benchmark index at the same time that the top executive’s compensation package is rising significantly, I would tend to take a dim view of the corporate governance situation there. What is the justification, and how could the board compensation committee allow such generous payouts under the circumstances?”
The board needs to fulfill its fiduciary duty to provide greater clarity on the performance goals for its senior executives and on the metrics it uses to evaluate whether the investors are getting their money’s worth.
And James Allen, head of capital markets policy at the CFA Institute, also called for more information on the link between pay and performance, when he testified before a congressional committee in April. “We support greater transparency about both the metrics used to determine executive compensation and the actual pay awarded during a given fiscal year. Unfortunately, we have found companies less than forthright in their compensation disclosures, employing legal boilerplate language that may satisfy the letter of the law but falls short of the intent to offer meaningful insight into management incentives,” he said.
Some individual investors have acknowledged that they don’t look at their proxies, whether they’re on paper or computer screen. And since notice-and-access proxy delivery went into effect in 2008, the percentage of retail investors who vote their proxies has plummeted to about 5 percent. Is that an indicator that as long as the company is making money for investors, they don’t care about detailed disclosure?
Now the Dodd-Frank Act requires companies to give shareholders a non-binding vote on executive pay packages, starting in January 2011. At least every six years after that, shareholders will be able to vote on a one-, two-, or three-year cycle to renew say-on-pay. (Smaller reporting companies get a three-year reprieve from the requirement.) Roughly 650 companies offered say-on-pay votes to shareholders voluntarily in the first half of 2010; if they are any barometer of what we’re likely to see in 2011, almost all enjoyed affirmative votes above 90 percent. Only three executive compensation plans were rejected. Say-on-pay has been on the agenda of proxy reformers for years. Now that it will be in effect for most public companies, 2011 will tell how much this really means to investors.
Shareholder access to the proxy statement is the other big reform that has critics complaining about social engineering through regulation. The SEC finally published its rule allowing for some shareholders to nominate directors in the proxy statement at the end of August; it then suspended the rule in early October when business groups filed a lawsuit to block its implementation.
Should proxy access survive the courts, it will not be some democratic opportunity for all shareholders to participate in the nominating process. Instead, it is limited to (large) investors with at least 3 percent ownership for three continuous years. Mutual funds representing the majority of individuals or plan participants generally don’t hold a company’s stock for that length of time. That leaves a few big public pension funds or labor unions that are likely to nominate director candidates who will approach the boardroom with an agenda, rather than those who play the traditional director role of providing oversight to ensure management is enhancing shareholder value. Since the proxy access issue was brought before the SEC in 2003, activist investors and some activist pension funds have largely driven the initiative.
The lesson we can take from all of this is that if corporations want to keep the social engineers in Congress at bay, they should go beyond the letter of the law and pursue better disclosure of meaningful information to investors without a rule forcing them to do so. Opaque disclosure suggests something to hide. Another lesson is that boards must provide the kind of oversight that investors expect and deserve. The board needs to fulfill its fiduciary duty to provide greater clarity on the performance goals for its senior executives and on the metrics it uses to evaluate whether the investors are getting their money’s worth.
Then the amount CEOs are paid will take a back seat, when shareholders are making money.
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