Dodd-Frank: First Impressions

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Expert Perspective by Grahall’s Garry Rogers

Daniel J. Ryterband prepared a good summary of the compensation and corporate governance implications of the Dodd-Frank bill in his July 16, 2010 article Dodd-Frank: What It Means for Comp and Governance published in Bloomberg.com’s Business Exchange.

Ryterband says: “The Dodd-Frank law will affect executive compensation and corporate governance starting in 2011 with the “say on pay” provision. Other elements will come into play as the SEC issues new regulations.”

Until the new regulations are issued by the SEC, it is difficult to predict how broad an impact the changes will have, but this fact is telling – the SEC has plans to add 800 additional staff on top of the 375 it had already requested for the coming year. Together, this would represent a 25% increase in staff size to 5,000 employees, up from the current 3,800. 

Ryterband discusses the potential downside of the SEC’s requirement “…to disclose the ratio of CEO to the median employee total compensation” saying that it “…could become a reporting nightmare”.  For companies, particularly those with large employee populations and/or currency conversion issues, we agree some administrative headaches may result, particularly in determining annual benefits accretion as well as some challenges in converting non U.S. employee pay data into U.S. equivalents However, many companies already issue annual “total compensation” statements to employees, primarily to reinforce the value of their total rewards programs.  These statements contain most, if not all the data necessary to accurately quantify each employee’s pay (including benefits valuations) and identify the appropriate median pay level necessary to satisfy the CEO pay ratio disclosure requirement.  (And for companies who do not issue these statements now, it could be a boon for the consultants who develop and administer these reporting programs.) 

We believe that the more important consideration around this particular issue isn’t the burden of doing it, but the reasons why it is included in the bill.  Clearly targeted at appeasing the pitchfork crowd to whom CEO pay is way too high in comparison to “average employees”, this ratio has the potential to become a standard measure of a company’s pay program. .   It may, through the “embarrassment factor” have the outcome of reducing relative CEO pay.

Having said that,  the median employee pay of a company has very little to do with determining whether the CEO’s pay is appropriate given the company’s performance, and will vary wildly across industries based on the composition and depth of the applicable labor forces.  It may however, be somewhat relevant within an industry – for example, what if Exxon’s CEO ratio is 600 times median, while Chevron’s is 300? We think shareholders will take note of obvious discrepancies and together with the discussion, the ratio could result in additional useful disclosure to shareholders.  In fact, we envision the potential that each industry may develop its own “range” of ratios, similar to how Wall Street firms measure total compensation as a percentage of revenues.

That doesn’t change the fact that the things that have the most direct relevance on executive pay are found for the most part on the company’s balance sheet and income statement.  While the CEO ratio might be eye-catching, it may distract people from true financial performance analysis based on revenue growth, , stock price, EPS, etc.   

Other major changes from our perspective are the rules regarding clawbacks, which both broaden the scope and reduce the standard of culpability for executives.  First, the new clawback rules dispose of “scienter” as a requirement to implement the clawback – the existing rules (under Section 304 of the Sarbanes Oxley Act) required fraud or malfeasance for the clawback provisions to become applicable. This is a major change, as proving fraud or any intent is generally the most difficult part of a prosecutor’s case.  Second, the clawback provisions will now apply to more than just the CEO and CFO, expanding the reach of clawback provisions to many more “current and former executives”.  Finally, the recapture period of time is extended from 12 months to 36 months, which also has enormous implications for potential forfeitures by equity recipients.

We agree that “… ‘say on pay’ requirements are the next big challenge for companies and their board compensation committees.”  The bill did nothing to fix the problems that “say on pay” could engender (many of these are outlined in the article). 

As we said on our blog Say, Say, Say on Pay: Doing More Harm Than Good? one of the biggest issues with say on pay is that Boards with ‘yes’ votes get a ‘rubber stamp’ on their decision and Boards with ‘no’ votes could possibly risk civil suits if they take no action.  In the end, making “say on pay” is a defacto binding vote transfers these decisions from an informed group (i.e., the Board) who (we would hope) has made decisions based on solid data, business strategy and sound philosophy developed through direct interaction with a qualified compensation consultant, to an uniformed group (i.e., shareholders) who may make decisions based on imperfect data or a gut reaction, without any outside counseling or appreciation for how each element of the program “ties together”. One wonders whether this will continue to evolve.

At Grahall, we view “say on pay” as a referendum on the Committee/Board governance structure.  If one believes in the merits of our corporate governance system, then say on pay should not be required, since highly qualified Board members, should be able to make better, more informed compensation decisions than the shareholders.  Conversely, if you are of the mind that the “system is broken,” then say on pay could be used to impose a discipline to do what appears to be “right” (assuming that is lowering executive pay).”

Contact Garry Rogers at garry.rogers@grahall.com

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