Economic downturn shines spotlight on compensation packages (April 24, 2009)

The public outcry over outlandish bonuses and pensions paid to senior executives at financial institutions in the United States and the United Kingdom could start to spill over into other industries as executive compensation comes under greater scrutiny in the wake of the greatest financial crisis since the 1930s.

The fury reached a fever pitch in the U.K. earlier this year when the chief executive of the Royal Bank of Scotland, which suffered the greatest loss in British corporate history, walked away from his job with an annual pension of US$1.02 million.

Debate over runaway pay in the now much-reviled financial sector is unlikely to be as heated in other industries. But in countries like the United States, where the average pay of a chief executive was 531 times that of the average hourly worker in 2000, according to Business Week magazine, well-heeled executives across all sectors should take note that the paradigm has shifted when it comes to how much they earn and how clearly it is disclosed.

“Even in industries whose senior executives played no role in the credit crisis, any payment of special considerations will need to be carefully and credibly explained, or risk a rough reception from shareholders, the public, and the media,” Hugessen Consulting, an independent executive compensation consulting firm, penned in a note to clients last October. “The rules of the game may be changing and the pressure on boards to manage pay in a more performance-sensitive and shareholder-friendly manner will inevitably increase.”

Alexander Cwirko-Godycki, a research manager for Equilar, an information services firm in Redwood Shores, California that tracks executive compensation, says he believes companies will be more cautious about how they design pay packages going forward. “The burden of proof is squarely on companies,” he says. “If performance is good and increases in compensation are merited, companies will probably still give out big bonuses. But if they do, they will need to back up those decisions with clearer explanations for how pay is directly related to that performance.”

According to data from Equilar, median CEO compensation at S&P 500 companies was US$8.45 million in 2008, while average CEO compensation reached US$10.17 million.

Potash Corporation of Saskatchewan (POT-T, POT-n) is one of the first companies in Canada to accurately size up the mood. On March 23, the world’s largest fertilizer producer agreed to introduce a non-binding advisory shareholder vote related to executive compensation at its annual meeting in 2010. (Last year the company paid total compensation to its chief executive, William Doyle, of C$17.02 million.)

“Executive compensation is increasingly a top-of-mind issue and shareholders in many companies have recently expressed their support for ‘say on pay’ resolutions,” Dallas Howe, chair of Potash Corp’s board said in a prepared statement. “Given such sentiment, this is an appropriate and timely action for us to take.”

It may be too early to call it a trend. But in late March the Canadian Coalition of Good Governance or CCGG, which represents the interests of institutional investors, adopted a policy recommending that boards voluntarily add to each annual meeting agenda an advisory shareholder resolution on the report of their human resources committee, their compensation plan, and the prior year’s awards, according to Janne Duncan, a mining lawyer with a special interest in executive compensation at law firm Macleod Dixon’s Toronto office.

“Although it is premature to say whether more mining companies will introduce non-binding advisory shareholder votes on executive compensation,” she says, “I expect that most companies, especially mid- to large-cap companies that are closely followed by institutional investors and their advocacy groups, will carefully consider the CCGG’s model policy and shareholder resolution when deciding how to proceed on this hot-button issue. Say-on-pay has certainly become a trend in the U.S., and companies based in Canada may see it as inevitable.”

But it’s not just the amount of money that chief executives and senior managers are being paid that is coming under the microscope. It is the way in which pay is determined and perhaps just as importantly how clearly it is broken down and explained in company documents.

In January 2008 the CCGG reported that a study of the executive compensation disclosure of 208 companies on the Toronto Stock Exchange by the Clarkson Center at the Rotman School of Management found that 169 of them “still had substantial work to do” in adopting better disclosure policies.

“We have seen some improvement in disclosure but we need to see more,” the CCGG’s then managing director, David Beatty, said in a statement in January 2008. “Setting senior executive compensation is the toughest ongoing job a board has to do and investors want, and should know how they arrive at their judgments.”

New reporting requirements may bring some relief to shareholders and the general public who find it nearly impossible to decipher the actual dollar value for an executive’s annual compensation.

In September 2008, the Canadian Securities Administrators, a forum for the 13 securities regulators in Canada including the Ontario Securities Commission, released its new executive and director compensation disclosure requirements known as Form 51-102F6.

The form came into effect on Dec. 31, 2008 and applies to all proxy circulars issued on behalf of companies with financial years ending on or after that date.

The new rules, largely based on U.S. rules that came into effect in 2006, were crafted over a two-year period and are geared to improve transparency and the way in which public companies disclose what, how and why executives are paid.

Under the new rules, proxy circulars must include a new section called “Compensation Discussion and Analysis” or CD&A to enable people to better understand the dizzying combination of annual salaries, performance and non-performance related bonuses, and long-term incentives they receive in the form of stock option grants.

“It has been a time-consuming and challenging exercise for companies to re-evaluate and explain to their shareholders for the first time how they came up with the absolute values of executive compensation,” explains Duncan of Macleod Dixon. “Not only do they have to include the total amounts earned by executives, based on additional information that is required by the new disclosure tables, but they also have to explain what their compensation program includes, and how the different elements fit together to achieve performance.”

Duncan notes that although Canadian securities laws do not require chief executive and chief financial officer certification of the CD&A, and do not require the CD&A to be approved by a company’s board of directors or compensation committee, a company that fails to comply with the new disclosure rules risks exposure for secondary market liability.

For example, if a company has failed to properly quantify what its payout obligations would be in a change of control situation, and a golden parachute is triggered by a change of control, the company’s shareholders could come after the company (and possibly its board of directors) for misrepresentations in the company’s executive compensation disclosure. “The threat of secondary market liability may have a significant impact on how diligent companies will be in policing their disclosure in their proxy circulars,” she says.

Catherine McCall, an executive compensation expert at Hugessen Consulting in Toronto, notes that there has been a great variety in the level of disclosure and compliance with the new rules so far this year.
For example, the new rules require that issuers disclose specific performance targets used in incentive plans unless to do so would seriously prejudice the issuer. “We have noticed that not all issuers are doing so – they don’t disclose targets and they don’t cite serious prejudice as the reason,” she says.

“It will be interesting to see how the Securities Commission responds when it does its expected review of executive compensation disclosure in coming months,” she says. “Will they send letters to the issuers requiring that further information be filed?”

Among the new rules is a requirement that companies have to include the identity of any companies they use to benchmark pay for their top management. They also expect that every element of compensation be assigned a dollar value including stock grants and options and benefits under all pension plans. Compensation from all sources is to be shown and totaled.

Indeed, a summary compensation table will require a total compensation column and termination scenarios will require disclosure of all payments. The new rules also mandate that specific performance targets be identified and there must be an analysis of performance factors supporting compensation decisions.

In order to stress the connection between performance and pay, the new rules also mandate a discussion of how the trend in compensation paid to executive officers relates to the company’s total shareholder return over five years (a trend that must be shown in a performance graph that also shows the returns from a broad equity index over the same period.)

In February this year, Potash Corp. became one of the first companies to file its proxy circular under the new rules. The company’s executive compensation committee and board reviewed chief executive William Doyle’s performance relative to his 2008 performance goals in order to determine his 2009 base pay level and 2008 short-term incentive bonus award.

Under the column for total 2008 compensation, for example, the chief executive earned $17.02 million. But that figure is then broken down into six categories: an annual salary of $1.09 million; stock awards ($2.91 million), option awards ($6.50 million), non-equity incentive plan compensation ($2.07 million), change in pension and nonqualified deferred compensation earnings ($4.17 million) and all other compensation ($257,984).

“Not all of the reported $17 million compensation was a cash payment,” explains Bill Johnson, the company’s director of public affairs. “The $1,092,000 base salary is obviously a cash payment, but many other components of the compensation are either valuations of performance based options and incentives, deferred compensation and pension contributions, and “other” compensation, which is essentially the cash value of items such as Mr. Doyle’s club memberships and travel expenses for Mr. Doyle’s wife if she accompanies him on company business.”

Johnson added that the $2.07 million in non-equity incentive plan compensation was “a cash payment for the company’s performance over the previous years in the short-term incentive plan. The other payments were not immediate cash payments, but rather deferred compensation.”

But even under the new rules that are designed to clarify executive compensation for people who may not work in the financial or legal industries, the Northern Miner was forced to ask for further clarification of what the various components actually mean and how and when they are paid out.

Tauna Staniland, a lawyer at law firm Macleod Dixon’s Toronto office, explains that the share- and option-based awards represent the grant date fair value of an award so that the amount reported represents the anticipated dollar value of the awards when they vest or that the board thinks they will be worth when the officer actually becomes entitled to them.

“Non-equity incentive” Staniland adds, is the annual cash bonus plan or the cash amount received for performance in 2008, while the change in pension amount represents the increase in an officer’s pension amounts over 2008, but which they won’t be entitled to until they retire.

The “all-other compensation” column “is a catch-all to capture any amount not caught somewhere else,” she explains. “It specifically includes benefits such as health benefits and perks such as car allowances and parking.”