Trouble Over Performance Targets

The big sticking point for disclosure of executive compensation seems to be emerging: performance targets.

As Corporate America hacks through its second year of compensation disclosure under amended rules from the Securities and Exchange Commission, the agency is pushing hard for companies to be more forthcoming about what performance goals their top executives must meet to get their pay. It is not something companies are eager to do.

“The issue of performance goal disclosure is causing companies the most agony” in drafting their proxy statements, says Steve Seelig, executive compensation counsel for consulting firm Watson Wyatt. “They are struggling with the decision of whether to disclose this information.”

Under the letter of the rules, companies are not required to disclose executives’ performance goals—but they’d better have a compelling reason why, SEC officials have said repeatedly in the last several months. The Commission published a study in October of 350 large companies’ pay disclosures, and poor disclosure of performance targets was a recurring theme in its comments.

Companies can cite only two reasons not to disclose a performance target: because it’s immaterial, or because disclosure would result in competitive harm.

White

Summing up the SEC’s view in a speech last October, John White, director of the Division of Corporation Finance, said: “Far too often, an analysis of how the targets were used in setting compensation was missing,” which made it difficult to understand how companies used targets or considered qualitative individual performance to set compensation and make decisions.

Still, in a survey of 135 large companies conducted in mid-December by Watson Wyatt, 31 percent of respondents said they had no plans to reveal the specific goals used in their executive compensation plans for 2007 and 27 percent were unsure. Compensation experts are quick to note that what a company says in a survey is not always what it does in practice, but most also believe companies will indeed resist the calls for more disclosure.

Borges

“There are companies that continue to believe that the disclosure of that information is going to cause competitive harm, and until they get specific instruction from the SEC to disclose and have had a chance to make their argument, they’re not going to make that change based on the fact that the staff told another company that they didn’t have persuasive argument,” says Mark Borges, a principal at compensation consulting firm Compensia.

Borges expects more companies to disclose those targets than did last year, but “not a pronounced increase.” Roughly half of companies are believed to have disclosed performance targets last year; Borges says that number should climb to somewhere near 60 percent this year.

Julie Bell, a former SEC lawyer now with the law firm Hogan & Hartson, says most companies plan to disclose.

“In my experience, most companies have either fought the battle and lost, or they’ve heard loud and clear from the SEC what the hurdle is for competitive harm” and don’t think they can meet it, she says. Those planning to claim competitive harm would be wise to heed advice offered informally by some SEC staffers in recent public comments, she adds.

Bell

“Companies need to be specific and tailor the argument to their company,” she says. “They need to explain exactly how a competitor or third party could use the performance targets with specific examples, and they have to explain how it would be detrimental to the company.”

Even companies that do believe they can meet the competitive harm standard are struggling with whether they should go through the process and risk disclosure if the SEC disagrees, according to Ron Mueller, a partner at the law firm Gibson Dunn & Crutcher.

For instance, a company that uses three performance targets for each named executive officer (the top five executives at the company) would have to convince the staff that it satisfied the standard for competitive harm on 15 goals. “That’s lot of time and effort,” he says.

DETAILS, DETAILS

Below is an excerpt of the SEC report last year reviewing companies’ disclosure of executive compensation, which focuses particularly on disclosure of performance targets.

We found that a substantial number of companies alluded to using, or disclosed that they used, corporate and individual performance targets to set compensation policies and make compensation decisions. We found that corporate performance targets ranged from financial targets such as earnings per share, EBITDA, and growth in net sales, to operational or strategic goals such as increases in market share or targets specific to a particular division or business unit. Most companies we reviewed disclosed that their compensation committees considered individual performance in making executive compensation decisions, although few companies disclosed how they analyzed individual performance or whether they focused on specific individual performance goals as part of that analysis.

We issued more comments regarding performance targets than any other disclosure topic in our review of the executive compensation and other related disclosure of the 350 companies. We often found it difficult to understand how companies used these performance targets or considered qualitative individual performance to set compensation policies and make compensation decisions. In making these comments, we do not seek to require companies to defend what may properly be subjective assessments in terms of purely objective or quantitative criteria, but rather only to clearly lay out the way that qualitative inputs are ultimately translated into objective pay determinations.

Where it appeared that performance targets were material to a company’s policy and decision-making processes and the company did not disclose those targets, we asked it to disclose the targets or demonstrate to us that disclosure of the particular targets could cause it competitive harm. We reminded companies of Instruction 4 to Item 402(b) which requires them to discuss how difficult it will be for the executive or how likely it will be for the company to achieve undisclosed target levels or other factors. Where a company omitted a performance target amount but discussed how difficult or likely it would be for the company or individual to achieve that target, we often sought more specific disclosure that would enhance investor understanding of the difficulty or likelihood.

Where a company presented a non-GAAP financial figure as a performance target and the company did not disclose how it would calculate that figure, consistent with Instruction 5 to Item 402(b)(2), we asked it to disclose how it would do so. For example, where a company disclosed total shareholder return as a performance target, we asked the company to disclose how it would calculate total shareholder return and describe how it would influence compensation decisions.

Source

Securities and Exchange Commission.

Even if the SEC accepts a company’s reason for not disclosing their performance targets, Bell says, “It’s not a free pass.” The company still must describe the difficulty of meeting performance targets, explain how the targets were set, and provide historical context, including whether the targets were met in the prior year, she notes.

The Alternative Strategy

Faced with disclosure of such sensitive information, some companies reportedly are considering changes to the performance targets themselves, such as to metrics that are already publicly available. Paula Todd, managing principal at Towers Perrin, says she’s heard companies talk about stripping strategic measures out of their plans rather than divulging them. “That would be an unfortunate, unintended consequence of the new disclosure requirements.”

Bell agrees: “Some companies that … are still waiting to hear back from the staff have said if the SEC stands firm on the disclosure of the performance targets, they’re going to change what they do.”

Todd

Companies could switch to generic performance targets, or they could “go the opposite approach and say everything is discretionary,” Todd says. “Neither is a very good outcome.”

Borges and others, however, say compensation committees are unlikely to let disclosure drive their approach.

“At the end of the day, most companies won’t change their plans,” he says. “They’ll just get comfortable with the fact that they have to disclose the information, like everyone did with stock option accounting.”

Mike Melbinger, an executive compensation lawyer with the firm Winston & Strawn, says the top headache for companies is “describing performance criteria at all.” A significant percentage of companies “don’t have a hard and fast formula” for determining performance-based pay, he says. Companies often use “a lot of individual performance criteria and other internal criteria that aren’t really objective.”

Melbinger

For instance, he says, a new CFO’s performance target might be to develop a better relationship with the company’s auditor, making it difficult to explain how discretion was used.

Todd has told some companies to start by simply writing down, in plain English, “how you got to the answer you got to,” without concern about what is confidential. Then, she tells them to go back and determine what parts are too confidential to disclose. “Clients usually find they can tell more than they thought they could,” she says.

Disclosures related to benchmarking, another source of staff comments, are also causing companies discomfort, experts say. Borges says the SEC takes talk of benchmarking at face value: If a company states that it benchmarks against other companies, the staff wants it to identify those companies, “no matter how many or few.” That means that if a company says it benchmarks compensation against a survey of 500 companies, the SEC wants disclosure of all 500.

Bell says the onus is on companies “to make it clear how they use the information.” Companies should explain what the compensation committee considered and what it predicated its decision on, she says. For example, if the compensation committee considered the median CEO salary at Fortune 500 companies regardless of which companies are actually in the group, that point needs to be disclosed clearly.

Borges expects disclosure of severance packages—a flashpoint with investors these days—to be a focus of the SEC staff this time around.

“I think the CD&A and severance disclosures will be the two big areas staff will pay attention to, and are where companies will want to devote the most attention,” he says. Companies should expect to be “put to proof on why their severance programs operate the way they do, and how they arrived at the formula they used.”

For example, companies may be asked to explain why they use a multiple of twice base salary for severance payouts, rather than a multiple of one or three.

Finally, while companies that were reviewed last year should expect to be scrutinized closely to ensure that they followed through on staff comments, Borges stresses that “nobody’s immune from getting a comment letter … Companies that weren’t reviewed in 2007 can’t sit back and assume they won’t get one in 2008.”