What’s so scary about disclosures?
November 21 2007 by Fayazuddin A Shirazi
The new SEC rules on executive pay disclosures, are forcing companies to be more forthcoming on their disclosure statements; but many companies are disinclined to share the data fearing competitive harm to their business.
While the new requirements stipulate that companies provide information on “why” the companies pay their executives what they do, for their part companies are more inclined to provide info on “what” the pay package consists of.
Compensation experts assume that disclosing sensitive information such as the historical performance of a company and the pay packages to executives can have several knock-on effects in the form of competitive disadvantage and resounding shareholder outcry.
In its review of the new pay disclosure requirements, the SEC called for greater clarity on the reasons behind executive pay. The SEC review in mid October said that the CD&A (compensation discussion and analysis) needs to be focused on how and why a company arrives at specific executive compensation decisions and policies and not merely how much a company is paying its executives.
“Some companies focused on providing in depth detail on the “What” question: what compensation does the company grant? The SEC wants the “How” and “Why” questions to be answered. How and why did a company make the specific compensation decisions and policies? The SEC wants more disclosure about the process of compensation decisions, not just the results,” says Margaret Rosenfeld, a commentator on executive pay and a partner with law firm Smith, Anderson, Blount, Dorsett, Mitchell, & Jernigan.
According to board analysts, the biggest issues bothering companies with regard to the new SEC requirements are in the area of performance goals for business. Many claim that it is difficult for a company to decide whether it should disclose historic performance goals or whether it would face competitive harm if it did, say experts.
Another contentious issue according to board veterans is the inordinate amount of additional time and money spent on the disclosure requirement. “Companies must pay board members for attending additional compensation committee meetings. Sometimes external compensation consultants will have to be hired to provide benchmarking advice, besides also opting outside legal counsel to check on the disclosure for compliance with complicated rules, which all is a burden on the company financials,” says Rosenfeld, adding that for smaller public companies, it is all the more difficult to comply.
“For smaller public companies, as with Sarbanes-Oxley, these rules have a disproportionate impact. They must go through the same process to draft the necessary disclosure as a larger public company. In fact, sometimes smaller public companies have more unusual compensation arrangements because they need to motivate very different types of behavior in executives,” Rosenfeld points out.
Companies, Rosenfeld feels, should consider these disclosure requirements as an opportunity to explain the shareholders the reason behind paying huge sums to executives. “A company should approach the disclosure requirements as an opportunity to explain to its shareholders why it is necessary to pay the executives what they are paid. For every story of a company paying a CEO some outrageous perk, there are 100 companies making reason and market-driven decisions about executive compensation,” she says.
Board observers also contend that new disclosure requirements might upset the pay patterns in a company. “The executives and companies are reading the proxy reports of other companies and the talent will know what the CEO down the street is getting and may demand the same, which companies fear will result in unhealthy comparative practices in the company,” explains Rosenfeld, adding: “There are anecdotal stories of CEOs who marched into board rooms clutching proxy statements of competitors contending that they were being underpaid, while their counterparts in a rival company are getting a better pay package.”
However, she also feels that the requirements may as well prove helpful to companies under certain situations. She says that as annual compensation comes up for review, the compensation committees will have better information about the market they compete in for talent, so they could be in a better position to bargain a fair deal.
Corporate board commentators believe and warn that companies have to be more sensitive to the level of executive pay as compared to the shareholder wealth. Quoting an anecdote, Rosenfeld says that a company that she was working with posted poor results and it had to explain the shareholders why the company still feels the need to pay bonus to the failing executives.
“Sometimes poor results might be due to economic forces beyond the executives’ control but a company will still need to pay the executives on a level commiserate with other executives in the market to retain them and this is a hard pill for shareholders to swallow,” she remarks.
Fearing severe backlash from the shareholders, Rosenfeld reveals that some companies have decided to do away with the severance package to exiting executives. “The compensation committee of a company that I work with recently decided that severance pay for executives should be done away with, largely as a result of shareholder outrage at the amounts of potential payouts that were disclosed in the proxy statement in a new required table,” says Rosenfeld.
Bruce Ellig, advisor to corporate boards and author of “the complete guide to executive compensation” is also of the same opinion. He says that while the new reporting requirements have raised a few eyebrows about the pay of existing executives, the termination pay has shocked many. “Pay for failure” is likely to be the area of greatest cutbacks,” remarks Ellig.
Although, Ellig says, the companies are concerned about investor reaction to reported pay, especially “pay for position” (perks) and “pay for failure” (severance pay), the major issue of worry would be the internal reactions to the reported pay. “It’s not just the ordinary employees who will be surprised about the reported pay, but the middle and upper management guys are also in for a rude shock once the disclosures are made,” Ellig reiterates.
As a result, experts fear that the disclosures may trigger discontentment amongst the executives and the fixed compensation might be replaced with compensation based on performance. “I think the knock-on effect of the pay disclosures will be a greater concentration of compensation away from fixed pay elements towards performance pay,” says Paul Hodgson, senior research associate with Corporate Library, a firm dealing with corporate governance and executive compensation.
Bruce Ellig says that the reluctance of companies to reveal historical performance goals under the guise of “competitive harm” is difficult to understand, since virtually no company has explained the reasoning as required by the SEC rules. “Companies that set up goals relative to the performance of identified peers rather than absolute goals have an easier task of meeting the performance requirements. Others might find it real difficult,” he says.
While on the one hand experts consider new pay disclosure requirements has stepped up greater transparency, they say, it has fuelled confusion on the other. “Some of the observers have pointed out that, the pay tables in the proxy statements, reflect as cost to the company, and not income to the named executives. This will confuse investors as the income is reported in the business press and the same cannot be found in the proxy,” he says adding that companies could avoid this by reporting a summary compensation of income to the named executives.
Paul Hodgson says that though the new SEC requirements have opened doors for greater transparency, it cannot be achieved unless the CD&A is taken out of the hands of the corporate lawyers. “The CD&A should be undertaken by those who have always been a part of it. The compensation analysis should wrest in the hands of those who have been part of the pay decisions and amongst those who have been in regular interaction with the shareholders,” he asserts.