Executive Compensation: What Will 2012 Bring?

This post comes to us from John J. Cannon, a partner in the Executive Compensation and Employee Benefits Group at Shearman & Sterling LLP, and is based on a memorandum by Linda Rappaport.

Executive compensation continues to command the center stage in public discourse about corporate governance. In the context of a troubled worldwide economy, the focus on pay in the financial services industry— most prominently evidenced by the Occupy Wall Street movement— has led to increased scrutiny of executive compensation at all companies.

As 2011 draws to a close, boards of directors of U.S. public companies are subject to conflicting pressures in making executive pay decisions for this year and in designing compensation programs for 2012. There is a widespread public sentiment that senior executives of large U.S. corporations are paid too much, and there are newly enacted laws and regulations that emphasize the importance of paying for performance and guarding against excessive risk-taking. Corporate directors, however, continue to have an obligation to foster the future profitability of their corporations, and they see compensation as a key motivating tool.

Against this backdrop, it is helpful to look forward to major legal themes that will be likely to affect incentive compensation in 2012 and the effect those themes may have on decision-making in U.S. corporate boardrooms.

Risk and Compensation Practices

The key role that incentive compensation can and should play in controlling unnecessary and excessive risk-taking behavior is one legacy of the 2008 financial crisis that is taking hold in corporate America. Companies are refining tools that allow them to understand (1) which individuals are in the position to expose the company to significant risk and (2) how the pay programs applied to those individuals should be designed to ensure that they do not encourage unnecessary or excessive risk-taking. For several years, the SEC has required companies to disclose in their proxy statements compensation programs that are found to promote excessive risk-taking.

Looking at compensation through a lens that focuses on risk-taking raises important issues about compensation plans that, partly in response to shareholder concerns, have to date been focused on paying for performance. Compensation plan structures that motivate robust performance by, for instance, setting aggressive or highly leveraged goals, may inadvertently encourage inappropriate risk-taking. Finding the balance between reasonable performance goals and business-appropriate risk-taking will be a developing theme in incentive design. Financial services companies have been responding to this design challenge for several years. 2012 may mark a year when other industry sectors begin to see this issue as a central challenge.

A possible response to this challenge will be to redesign executive pay packages to place greater emphasis on the creation of long-term corporate value rather than the attainment of short-term goals. Long-term incentive plans, which, for instance, pay in corporate equity premised on reaching multi-year targets, serve to tie wealth creation for the corporate executive to long-term wealth creation for the corporate shareholders. This result is enhanced when the program requires executives to hold the equity they receive through their retirement. These plans also promote retention of the individuals. Annual bonuses will continue to play a role in executive compensation, but may be more variable, as bonuses were historically intended to be, and may constitute a relatively smaller component of pay.

In 2012 we will also likely see the development and refinement of compensation scorecards which assess, with the benefit of hindsight, whether a company’s pay programs had the desired effect on risk-taking and corporate performance. The “rear-view mirror” perspective may begin to take hold as a meaningful tool in compensation design.

Will Dodd-Frank Really Have an Impact?

The impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act on executive compensation practices continues to be an open question. In part this is due to delays in promulgating the regulations required to put the law’s provisions on clawbacks and CEO pay disclosures fully into effect. The final rules implementing these provisions are now expected in mid to late 2012.

Clawbacks. Pay recovery policies, or “clawbacks”, came to the attention of the public with the Sarbanes-Oxley Act in 2002. Sarbanes-Oxley required that in the event of any accounting restatement based on misconduct, public companies must recover incentives paid to the CEO and Chief Financial Officer that were paid within 12 months preceding the restatement. The application of clawbacks expanded when the U.S. Troubled Asset Relief Program (commonly referred to as “TARP”) required participating financial service companies to recover incentive bonuses paid to senior executives, even if no misconduct was involved.

Dodd-Frank further expands the use of clawback policies by requiring the Securities and Exchange Commission to direct the national securities exchanges and national securities associations to amend their listing standards to mandate, among other things, that every listed company adopt a clawback policy. Under the law, the clawback policy must provide that following an accounting restatement due to material non-compliance with a financial reporting requirement, a company will seek repayment from any current or former executive officer of incentive compensation paid during the three-year period preceding the date when the company must prepare the accounting restatement. The clawback is calculated as the excess amount paid on the basis of the restated results. It is significant to note that the law only requires clawbacks in situations where a financial statement is required to be restated.

While many companies have delayed adoption of a clawback policy, waiting to see what the enacting regulations will require, some companies have voluntarily adopted clawback policies that are in many cases broader in scope than the Dodd-Frank rule. For instance, many clawback policies allow for recovery of incentive compensation when an executive is found to have engaged in misconduct, regardless of whether or not the misconduct resulted in a restatement. It will be interesting to see which evolves as the predominant practice — clawbacks that adhere only to the Dodd-Frank requirement, or a broader approach which is also triggered by individual wrongdoing, regardless of whether a restatement is required.

The scope of the final Dodd-Frank clawback rules will be important for another reason: many bonus programs are not formulaic in nature, but allow for discretion in determining amounts to be paid, typically on the basis of subjective, non-quantitative goals, such as leadership. Consequently, boards of directors may have leeway to avoid clawbacks, even in the face of a material accounting restatement, if they determine that the amount of the bonus would have been the same notwithstanding the accounting adjustment, due to the discretionary elements that were taken into account in determining the bonus amount. Whether the clawback rule will address — or in its operation over the course of time will influence — the structure of bonus programs to be more or less formulaic in their design is an open question.

Disclosure of the Ratio of CEO to Median Employee Pay. Much ink has been spilt urging Congress to repeal the Dodd-Frank requirement that U.S. public companies disclose the ratio of their CEO’s pay to the median level of their employee pay, on the grounds that the required disclosure could result in significant unintended consequences, such as the outsourcing of lower-paying jobs, will not provide meaningful additional information, and will be costly to comply with. There had been hope that Congress might repeal the law in 2012. Given the current political atmosphere, the prospect of repeal now seems remote, and the SEC has recently announced that it is preparing a recommendation for a proposed rule to enact the disclosure requirement. The agency’s website calls for a draft of the proposed rule by the end of 2011, with 2013’s proxy season being the first requiring disclosure. In any event, in 2012, companies will have to begin the burdensome task of collecting the information required to comply and to consider the consequences of the potentially incendiary disclosure.

Say-On-Pay and Pay for Performance. Say-on-pay, perhaps the most significant compensation-related element of Dodd-Frank that was in effect for 2011, may well have an increased impact on compensation design in 2012.

Dodd-Frank requires public companies to provide shareholders with a non-binding vote to either approve or disapprove their executive compensation as disclosed in their proxy statements. The 2011 proxy season was the first time the Say-on-Pay rules were in effect, and the majority of public companies sailed through with in excess of 90 percent of their shareholders’ approval. These results seemed to uncover an apparent split between shareholders who support their companies’ compensation programs and the public at large which seems to think that the Occupy Wall Street movement has the right idea.

As we enter 2012, however, there are warning signals against complacency. The increasing focus in the political and public arena on the pay disparity between corporate CEOs and rank-and-file employees may well affect 2012 Say-on-Pay votes. Even more to the point, some shareholder activist groups and institutional shareholders are indicating that companies that received less than 70 percent approval in their 2011 Say-on-Pay vote will be taken to task in 2012 if they do not make meaningful changes to their pay practices. In order to ensure passage in 2012, corporate boards will need to be vigilant that bonuses are sensitive to the total shareholder return received by shareholders on their investment over a one-year, three-year and longer-term time horizon, and will have to be able to argue convincingly to their shareholders that their pay for performance program does, in fact, pay only when the company’s performance warrants payment.

Just as important, communications between companies and their shareholders about pay practices and the board’s philosophy on their implementation will continue to improve and become more frequent in 2012. Timely shareholder engagement, with a premium placed on listening as well as on clear and convincing explanation, will play an increasingly important role, while compliance with the SEC rules against selective disclosure of non-public information will require a nuanced approach and sophisticated attention.

The challenges involved in shareholder engagement serve as a reminder that the corporate governance paradigm has been changing in significant ways in the U.S., with the balance of power continuing to shift away from corporate management and toward boards and shareholders, not only in questions of executive compensation but in all significant issues facing corporations. 2012 will not be likely to bring resolution to these broader, central issues, but it will undoubtedly be another year in which these governance trends and the related changes in the law will call for increased effort, diligence and decision-making on the part of boards of directors in the sensitive area of executive compensation.

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