United States: Executive Compensation Outlook For 2012

Last Updated: March 21 2012
Article by Bill King

The boards of directors at U.S. companies enter 2012 with no shortage of executive compensation challenges. Some of the most significant issues include new requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act or Act), a difficult political and regulatory environment, public dissatisfaction with executive pay and global economic uncertainty.

Dodd-Frank Act

The Dodd-Frank Act was enacted in 2010, and many of the most significant executive compensation provisions became effective for the first time in 2011, including:

  • shareholder "say on pay,"
  • shareholder "say on frequency" of "say on pay" vote,
  • shareholder "say on golden parachutes," and
  • elimination of broker discretionary votes.

These provisions gave shareholders the right to vote directly on executive compensation for the first time, but the effect may not have been as profound as many people expected. Nearly 99 percent of the 2,900 public companies that took votes received majority shareholder support on their executive compensation programs. Only 37 of the 2,900 companies failed to achieve majority support, with some leading to shareholder lawsuits. However, shareholders did overwhelmingly vote to hold these say-on-pay votes annually (76 percent), despite the fact that nearly 45 percent of companies recommended a vote only every three years.

In addition, several notable companies made changes in anticipation of the say-on-pay vote. For example, Disney sent shareholders supplemental proxy materials disclosing that it had amended the executive employment agreements for its top four officers, including the CEO, by eliminating the obligation to pay tax gross-up on a change-in-control. GE changed its CEO compensation by adding conditions that tied the vesting of stock options to prespecified performance targets. As noted by these examples, the say-on-pay provisions have provided another avenue for corporate governance firms like Institutional Shareholder Services (ISS) and Glass Lewis to assert influence beyond the share authorization vote. In the past, the share authorization vote was used to express general dissatisfaction with executive pay at certain companies.

The business community is still waiting for the regulations for many other Dodd-Frank Act executive compensation provisions — meaning that the new law's overall impact on executive compensation remains an open question. One of the most significant outstanding issues is how the Dodd-Frank Act's "clawback" of executive pay will operate. Unlike the Sarbanes-Oxley clawback requirements, the Dodd-Frank Act clawback covers more than just CEO and CFO pay, and is not restricted to misconduct resulting in a restatement of the company's financial statements. Instead, the policy provides for recovery of any incentive compensation received (including stock options) from former and current executive officers during the three-year period prior to an accounting restatement resulting from erroneous financial data.

Without final rules, planning for compliance will be a challenge for 2012, and many companies have delayed adopting a clawback policy. Others have voluntarily adopted clawback policies that are much broader than the Dodd-Frank Act requirements. These policies often provide for the recovery of incentive compensation if the executive engages in misconduct (regardless of whether the misconduct resulted in a financial misstatement). As with many other provisions of the Dodd-Frank Act, the clawback requirements are ambiguous, and Congress deferred to more-detailed rules that will be issued by the SEC. Among the areas that will require clarification:

  • Does the triggering period commence with the occurrence of the decision to file the restatement, the work on the restatement or the restatement?
  • How are "executive officers" defined? Without guidance, this presumably refers to individuals as defined by Exchange Act Rule 3b-7 (president; any vice president in charge of a principal business unit, division or function; and any other officer who performs a policy-making function) or to Section 16 officers.
  • How does the policy apply to an individual who became an executive officer after the grant of options, but before the restatement?
  • How is "incentive-based compensation" defined? Does such compensation apply to short-term and long-term plans, and does it apply to other forms of equity besides stock options?
  • How is the recouped compensation determined if it was not tied to specific performance metrics?
  • Is the clawback based on the award or payment of compensation?
  • How does the three-year look-back period apply to stock options granted, vested and/or exercised during the previous three-year period?

Another key issue to consider is the accounting implications of the clawback provisions. The general thought is that the clawback would be accounted for if and when the contingent event triggering the clawback occurs. The company would recognize the value of the compensation returned by the individual. If shares are returned, the shares would be treated as treasury stock, while income would be recognized to the extent of compensation expense previously recognized for that particular award, and any excess would be recorded as an increase to additional paid-in capital.

The problem occurs when a company adopts a policy that allows for discretion regarding when the triggering event of the clawback provision occurs. Such discretion could result in a conclusion that there is no grant date for accounting purposes at the time the award was issued if there is not a mutual understanding between the company and employee regarding the terms and conditions of the clawback provisions. If there is no grant date for accounting purposes at the time the award was issued, the result could be variable accounting for the fair value of the award until either the settlement date or the date of mutual understanding of the terms and conditions. If the company adopts a performance-type clawback linked to individual or company performance, the metrics need to be clear and determinable when the award is granted in order to establish a grant date.

Another issue is that if the performance condition triggering the clawback affects the vesting and or retention of the award, this could alter the period over which the related compensation expense is recognized. In other words, the compensation expense may need to be recognized from the grant date through the performance measurement date versus the specified vesting date. If the performance condition is tied to something other than vesting, it could affect the fair value of the award. For example, if the performance metric affects the exercise price or number of stock options issued, the grant date fair value of each potential outcome would need to be determined. Compensation expense would then be based on the most likely outcome of the performance metric for each reporting period.

Pending the final rules, companies should assess the potential accounting implications as well as the other issues previously cited when they amend their incentive compensation plans to incorporate the clawback features as required by the Act. Most large public companies (more than 75 percent), have already adopted clawback policies for their named executive officers, and many have included a broader group generally in line with Dodd-Frank Act guidelines.

Under Section 953(b) of the Act, companies may be required to disclose the ratio of CEO pay to the median of employee pay. For this disclosure, the company must calculate the annual total compensation of all employees worldwide using the rules for total annual compensation figure in the summary compensation table of the proxy statement. When all of the compensation components and the diversification of the workforce are factored in, the complexity of the calculation has led many companies to call on Congress to repeal the law in 2012. At this time, the SEC has yet to propose any rules under Section 953(b), because Dodd-Frank has set no deadlines for SEC rulemaking. However, given the current political atmosphere on corporate governance, the prospect of repeal appears remote.

Section 957 of the Act requires national securities exchanges to preclude a broker from granting a proxy to vote shares in the case of a vote on the elections of directors, executive compensation or any other significant matter (as determined in the rules of the SEC), unless the beneficial owner of the shares has specifically instructed the broker on how to vote. Although the New York Stock Exchange (NYSE) eliminated brokerage discretionary voting for director elections beginning with the 2010 proxy season, Section 957 of the Act extends the prohibition to say-on-pay votes as well as other significant matters.

Many other Dodd-Frank Act executive compensation provisions are expected to take effect some time in 2012, including:

  • disclosures regarding chairman/CEO roles,
  • disclosures of hedging policy,
  • pay-for-performance disclosures, and
  • independence requirements for compensation committee members and advisers.

In anticipation of the new rules, most companies have already begun taking steps to comply with these provisions.

Institutional Shareholder Services

ISS has released new guidance that companies will need to use to determine whether their 2012 executive pay plans align with shareholder interest. One of the most significant updates for 2012 is the ISS's revised U.S. pay-for-performance policy. During the policy process, both clients and issuers indicated that pay-for-performance alignment should be viewed long term rather than for the most recent year. Accordingly, the ISS's new approach will provide clients with a more robust view of the relationship between executive pay and company performance over a sustained time horizon. Specifically, the ISS will consider the relative alignment between the company's total shareholder return and the CEO's total pay rank within a peer group, as measured over one and three years, as well as absolute alignment (the alignment between CEO pay and a company's share return over the prior five years). If alignment appears weak, further in-depth analysis will determine if there are mitigating factors.

Two years ago, the ISS launched the Governance Risk Indicators (GRID) as a new measure of governance-related risk. The GRID was designed to help institutional investors understand high-level areas of concern across a portfolio and provide analytical tools to help analyze the governance practices of individual companies. It also provided companies with a basis for aligning their corporate governance structure and practices with shareholder interest. The GRID evaluates company's governance practices on four dimensions: audit, board, shareholder rights and compensation. At the core of the GRID methodology for each market is a set of 60 to 80 questions that collectively examine a company's practices across the dimensions. GRID questions and the weightings applied to the responses are tailored to the governance dynamics of each market covered.

The GRID therefore provides a comprehensive screen of governance-related risk, regarding both data and universe coverage. For 2012, the ISS has released updates and enhancements to the GRID methodology including additional questions incorporating the ISS's new pay-for-performance quantitative methodology, additional information on related-party transactions and board relationships, and a more comprehensive evaluation of takeover defenses. As a result, companies may need to prepare carefully as the 2012 proxy season approaches and as the ISS begins to publish its analyses of compensation reflecting the new policies. Executives may want to review the 2012 GRID updates to determine the risk factors on which the ISS is focused.

Another key policy update includes boards of directors' responsiveness to earlier say-on-pay votes. Pursuant to the ISS, if a company receives less than 70 percent shareholder approval on its previous vote, the ISS will analyze the company to see if negative vote recommendations are warranted. Specifically, the ISS will analyze:

  • how the company responded to the previous advisory vote, including:
    • disclosure of engagement efforts with major institutional investors regarding the issues that contributed to the "low" level of support,
    • specific actions taken to address issues contributing to the low level of support, and
    • other recent compensation actions;
  • whether the issues raised are recurring or isolated;
  • what kind of ownership structure the company has; and
  • whether the support level was less than 50 percent, which would warrant the highest level of responsiveness.

For companies that received less than 70 percent approval in their say-on-pay vote, the messaging in the proxy statement around the board of director response to the shareholder dissatisfaction will be critical.

Another important change affects newly public companies seeking shareholder approval on the material terms of their equity plans when their private-to-public exception under Section 162(m) expires. This often happens in the fourth year after an initial public offering. In 2010 and prior years, the ISS generally supported such proposals without much comment. Under the new guidelines for 2012, however, the ISS has codified its position that there is no "free pass" for newly public companies regarding such proposals. Instead, if a company's equity plan is being approved by its public shareholders for the first time, the plan will be subject to a full-blown ISS analysis of its equity plan.

Alignment of risk management and executive compensation

Compensation committees will continue to face challenges designing executive pay strategies that allow companies to recruit and retain management talent while creating a disincentive for managers to increase the company's risk exposure to meet short-term compensation targets. To mitigate excessive risk, greater emphasis will be placed on aligning executive compensation with the company's long-range objectives.

As we move into economic recovery, attracting and retaining executive talent will also become important in the executive compensation planning process. Executive turnover makes it more difficult to align shareholder value creation with executive compensation based on long-range performance. Research by the ISS (Risk Metrics Group at the time the study was completed in 2008) found that short-term profit pressures have rapidly decreased CEO tenure. Management succession is a strategic business risk and impairs the company's ability to smoothly execute its long-range strategic plans. To address this issue, boards of directors will need to reexamine the compensation packages offered to executives to determine if they are competitive and appropriate to retain and focus executive behavior toward the long-range objectives of the company.

Risk oversight will continue to be a high priority for today's boards of directors. Many boards are reconsidering the risk governance structure and which committees have the expertise to oversee particular risks. The SEC now requires disclosure of the board's role in risk oversight including whether the entire board is involved in or whether risk oversight is executed by a particular committee, and whether the employees responsible for risk management report directly to the board. The SEC continues to consider risk oversight a key responsibility of the board and believes that this disclosure will improve investors and shareholders' understanding of this role.


This year will clearly be another challenging one for executive compensation planning. As with 2011, corporate governance and the change in the regulatory environment will play a key role in executive compensation design. Compensation committees will face the challenge of designing effective executive pay programs aligned to shareholder interest while managing risk and executive retention. It's important to begin addressing these challenges now.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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