Tag Archive: executive compensation

Revisiting the Scope of Clawback Coverage

Published by

It remains appropriate for the boards of companies to prioritize discussion of the application of executive clawbacks in their compliance and compensation agendas, regardless of the initiatives in Congress to reform the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Michael W. Peregrine

Indeed, a series of public developments this year should be prompting boards to consider expanding the scope of existing “clawback” provisions listed in executive compensation agreements. When well-crafted, they can help prevent fraud, malfeasance, or damage to the corporate reputation.

A Short History

The concept of compensation recoupment as an executive sanction has its roots in the corporate responsibility provisions of the Sarbanes Oxley Act of 2002 and related enforcement actions by the Securities and Exchange Commission (SEC). Section 304 of the Sarbanes-Oxley Act empowered the SEC to compel public company CEOs and CFOs to reimburse the company for certain bonus and incentive-styled compensation that would not have otherwise been paid for misconduct.

The limited scope of Section 304 led Congress to include broader clawback rules for listed companies under Dodd-Frank. Generally speaking, Dodd-Frank provides for the exchanges to require companies to have a clawback policy as a listing condition. Pursuant to Dodd-Frank, proposed rules call for clawback policies to cover all executive officers, applied without respect to whether there has been any misconduct by the executive officer and extend to a longer look-back period. Proposed rules would also extend the clawback rule to more types of incentive compensation.

While these proposed clawback rules have not been adopted by the exchanges, shareholder advisory services like Institutional Shareholder Services and Glass-Lewis & Co. have taken a lack of a clawback policy into account when evaluating a public company’s corporate governance practices and making voting recommendations on directors. As a result, financial restatement-based clawback provisions are now accepted as a common public company practice, and increasingly so within large, financially sophisticated nonprofit organizations.

New Developments

The utility of clawbacks as a corporate responsibility measure has attracted renewed attention because of a series of corporate, legislative, and regulatory-related developments.

One of the most prominent of these was the decision by the board of a prominent financial services company to claw back in excess of $60 million in compensation benefits from two senior executives following a major corporate controversy involving certain sales practices. Yet in another development, the board of United Continental Holdings took a different position when it decided not to seek compensation clawback from a CEO who had been terminated in connection with a federal investigation of the company’s conduct, in which he had been tangentially implicated.

Additionally, the Department of Justice weighed in on clawbacks when it issued new guidelines for compliance program effectiveness. Under these guidelines, the use of financial incentives (such as clawbacks) to motivate compliant behavior is considered to be an important element of program effectiveness.

Also notable was a recent governance survey suggesting an increased willingness of boards to terminate CEOs for unethical conduct. Another development was the 15th anniversary of the Sarbanes-Oxley Act earlier this summer, which is prompting many boards to renew awareness of the tenets of corporate responsibility.

A Possible Response

These developments combine to keep clawbacks in the mainstream of current governance discourse, not only from the perspective of corporate responsibility, but also from that of effective corporate compliance—notwithstanding legislative efforts to repeal Dodd-Frank and questions on the related enforcement focus of the SEC.

Matters of clawback review could be delegated jointly to the executive compensation and audit/compliance committees, as matters of executive compensation recoupment fall within both of their respective committee charters.

The focus of the joint committee review would likely be on the expansion of clawbacks, from incidents of restatement of corporate financials, to executive misconduct which is implicated in such matters as a fraud-based governmental or internal investigation, material ethical misconduct, and damage to the corporate reputation.

In their deliberations, those committees may wish to consider two additional, important factors. One is the fact that expanded clawback provisions cannot fairly be considered a corporate best practice at this point. Enhanced media and shareholder attention to the concept of clawbacks is not the equivalent of a broadly accepted governance conduct. It may be, however, that these recent developments could accelerate the movement towards clawbacks as a best practice.

The second consideration is the effect that any expanded clawback coverage could have on board-management relationships, executive team morale, and on broader issues of talent development and retention. The board should anticipate some amount of resistance from executive leaders to the concept of expanded clawbacks, especially if it cannot yet be promoted as a best practice.

The Timing is Right

There may be no best practice available yet to guide the board or committee discussion about expanded clawbacks. And there may be no single right answer about how any one company should address the issue.  But the need for reasonable methods to incentivize appropriate executive behavior suggests that the timing is right for such a discussion. Indeed, the wrong answer might be to simply ignore it.

 

Michael W. Peregrine, a partner in McDermott Will & Emery, advises corporations, officers, and directors on matters relating to corporate governance, fiduciary duties, and officer/director liability issues.  

Do Nonfinancial Measures Have To Be Soft?

Published by

Barry Sullivan

In a recent Harvard Business Review article, Graham Kenny posits that nonfinancial measures should be included alongside financial measures in incentive plans. He goes on to say that this is leading companies to use both hard and soft performance measures—where ‘soft’ measures can be more subjective in nature. We wholeheartedly agree with the premise—so much so that we wonder if Kenny goes far enough, particularly where subjectivity is concerned. For many, however, the element of subjectivity in this context implies an arbitrary assessment of performance against goals, based on the general sense of the board’s compensation committee.  This interpretation rightly makes institutional investors and other investors uneasy. But, does this really need to be the case, especially given the abundance of data in today’s digital age?

Seymour Burchman

We think there are ways to structure subjectivity such that the compensation committee’s performance assessments and incentive determinations make sense against the backdrop of company performance. Moreover, by bringing a clear structure and hard information to the more subjective elements of the incentive system, performance assessments and incentive determinations become more explainable, more powerful internally, and more defensible externally. We suggest an approach that would work as follows.

Define the performance to be measured as precisely as possible. We have used nonfinancial measures across a wide range of clients targeting a variety of strategic and operational areas. The goal in this step is to provide enough specificity at the board level so management can operationalize imperatives into specific, measurable key performance indicators (KPIs).

For example, one company was an end-to-end, integrated furniture manufacturer which covered product development, through the supply chain, manufacturing, retail sales, installation, and after-sales servicing. This company viewed the improvement of total customer experience as a critical strategic imperative in an increasingly competitive industry.

Consider potential sources of objective evidence and data. Preferably using a cross-functional team, determine KPIs to be tracked, sources of the KPI information, and favorable and unfavorable outcomes for each KPI. The KPI data could be sourced from: internal management information systems; Internet sources such as social media sites; sensors, which are becoming ever more prevalent in household goods, vehicles, industrial equipment; or tailored surveys conducted by or for the company.

For our furniture manufacturer, the board chose to use Net Promotor Score (NPS) as a key indicator. NPS could be benchmarked against key competitors and broader industry groups, and it tracked many of the key elements of total customer experience. The company then supplemented and validated this information with data collected from its own website and social media platforms as well as a few key Internet and social media sites that track customer satisfaction. It was recognized that the quality of data on these external sites can be open to question, so composite information and judgment are needed when using them. Favorable results were considered to be in the upper quartile vs. competitors, given the company’s premium pricing.

Build a scorecard. Use the evidence and data sources identified in the prior step to build a scorecard that can be measured quantitatively or with highly structured discretion. Such a scorecard is a useful tool for communicating with employee-participants, as well as external stakeholders (generally after the fact, to safeguard the company from competitive harm).

Put a range around the committee’s adjustments. Putting a fixed range around compensation adjustments makes the process more approachable and more doable versus using open-ended ranges. It also communicates to participants the importance of non-financial metrics by virtue of their potential impact on overall awards. In this case, the company allowed for a +/- 25 percent adjustment to the award.

By using this approach, executives have a better sense of focus areas and needed behaviors—as in, they know the rules of the game. And the compensation committee are more fully ‘in the seat’ when it comes time to judge performance. The committee also knows the rules of the game and, more pointedly, the committee knows the potential impact, or swing, its discretion can drive in the incentive outcome. Where discretion is left unstructured, we often see committees shying away from hard choices either out of concern for not having enough supporting information to make an informed decision or for fear of making too big an impact on the overall incentive outcome. Other important process points include: transparency, regular reporting on progress, careful consideration of unintended consequences, and openness to experimentation (e.g., implement the softer elements on a trial basis before including them in the formal incentive decision).

Consider the furniture manufacturer: the board and management built a program based on the principles outlined above that strikes the right balance of hard and soft performance measurement. And the softer, more subjective elements of the measurement system, by virtue of careful consideration and diligent information gathering, are anything but soft. Overall, the company’s incentive program is perceived as fair by employee-participants and investors, alike. And these key stakeholders also applaud how the system makes clear the company’s strategy and priorities for execution.

Barry Sullivan is a managing director at Semler Brossy.  Sullivan supports boards and management teams on issues of executive pay and company performance. He may be contacted at bsullivan@semlerbrossy.com. 

Seymour Burchman is a retired managing director at Semler Brossy. Burchman, who has been an executive compensation consultant for over 30 years, has consulted on executive pay and leadership performance for over 40 S&P 500 companies. He may be contacted at sburchman@semlerbrossy.com.

Boardroom Implications for the New Revenue Recognition Standard

Published by

It’s all a matter of time—at least when it comes to recognizing revenue at public companies. The Financial Accounting Standards Boards (FASB) and the International Accounting Standards Board (IASB) in 2014 developed an accounting rule that is set to change how companies approach revenue recognition. The rules, available here, go into effect for public companies with fiscal years beginning after December 15, 2017, and will have major consequences for financial reporting in many industries.

To address the executive-compensation implications of the revenue recognition standard, NACD, executive compensation advisory firm Farient Advisors, and law firm Katten Muchin Rosenman cohosted a meeting of the Compensation Committee Chair Advisory Council on April 4, 2017. During that meeting and its related teleconference, Fortune 500 companies’ compensation committee chairs came together to discuss leading practices and key considerations related to the impact of the new revenue recognition standard. Jose R. Rodriguez, partner in charge and executive director of KPMG’s Audit Committee Institute, joined council delegates for the discussion. The meeting was held using a modified version of the Chatham House Rule, under which participants’ quotes (italicized below) are not attributed to those individuals or their organizations, with the exception of cohosts. A list of attendees’ names are available here.

About the New Standard

A 2014 press release from FASB explained the rationale behind the new standard, noting that revenue is an important metric that investors use when trying to understand how a company has performed and its potential for future performance. Previous accounting standards from the International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP), however, were somewhat at odds, according to the press release. Those inconsistencies between IFRS and GAAP meant that different industries that had very similar types of transactions were accounting for revenue in sometimes very different ways. The revenue recognition standard aims to bring more consistency to accounting done for similar types of transactions.

A key part of the new standard is that revenue can only be recognized—among other requirements—once customers actually benefit from the services or goods that the company has already provided them, as noted in the Journal of Accountancy. The Journal continues that if a company provides a customer with goods or services over time, such as a yearlong service contract, the company can recognize revenue as the customer receives benefits in the contract period. For more information on the standard, see this four-page overview and in-depth guide from KPMG.

Key Questions Directors Should Ask
While the level of disruption that the revenue recognition standard will cause varies by industry and company, four questions important for all boards emerged from the Advisory Council meeting:

  1. How will the new revenue recognition standard affect our company specifically?
  2. Does the board understand the key milestones for the revenue recognition standard and how the company is progressing in light of those milestones?
  3. How will compensation plans be affected?
  4. How will our disclosures need to change?

How will the new revenue recognition standard affect our company specifically?

Impact of the new standard will vary widely for a few reasons.  First, sales and service contracts can differ significantly depending on industry—consumer products, health care, manufacturing, IT, and so on. Additionally, the types of sales contracts—and, therefore, the way revenue is recognized—can differ even within a single company, depending on the types of products and services sold. The company’s suppliers and vendors are a third factor influencing change: “Even if the standard doesn’t affect our core business, we could be working with partners and vendors that are affected,” said one director. “One of my companies has hundreds of millions of dollars in service contracts,” another delegate commented. “Our whole income statement is going to change.”

“Every company’s finance department has been looking at this,” Rodriguez said. “Ask your CFO to brief the board about the major income-statement changes that will occur for the company. What will be affected across all revenue lines? How are key reporting processes changing to accommodate the new standard?”

Does the board understand the key milestones for the revenue recognition standard and how the company is progressing in light of those milestones?

Rodriguez said that a pitfall for many companies is not investing enough time upfront in ensuring compliance with the new standard. “Some companies are finding that this is a bigger lift than they thought [to adopt the standard], so they are having to scramble to coordinate.”

Rodriguez shared several steps that companies can take to prepare:

  • Forming cross-functional task forces that integrate finance, accounting, IT, legal, and HR to ensure activities are coordinated.
  • Designating a revenue group to analyze contracts in different regions and locations to ensure all jurisdictions are covered.
  • Devoting sufficient time and resources to make required changes and upgrades to IT and reporting systems, especially in companies that have multiple legacy systems in place.
  • Developing a communication plan to explain to affected employees (especially on sales teams) how the changes will impact their work. “This is actually a huge change-management process,” one council delegate said. “You have to re-train sales people about how they design contracts and agreements.”

How will compensation plans be affected?

Council delegates agreed that compensation committees need to have a clear understanding of how the new standard will affect the key metrics that drive compensation for all levels of employees, from rank-and-file to the C-suite (For more information on incentives and risk taking, please see NACD’s brief, Incentives and Risk Taking). Changes to the way revenue is reported could have a major impact on the numbers used in annual bonus plans, as well as on long-term incentive plans that are already in place.  “With multi-year incentive plans that are in mid-cycle, the effects could be quite complex,” said Dayna L. Harris, partner at Farient Advisors. “For compensation committees, it will be important to ensure incentives are paid out in a way that’s appropriate to what was originally intended to keep consistent with the compensation philosophy the board has devised.”

Compensation committees can ask the following questions:

  • Is the company adopting the new standard prospectively or retrospectively, and how will that change our revenue numbers?
  • Which compensation plans will be affected beyond the CEO and named executive officers (e.g., sales staff at multiple levels)?
  • What do we anticipate will be the impact on the peer groups we use to benchmark executive compensation?

Rodriguez suggested that compensation committees schedule a briefing session with the external auditor, audit committee chair, CFO, and compensation consultant to discuss these and other questions. Members of the audit committee can also be invited to the briefing.

How will our disclosures need to change?

As noted in the Report of the NACD Blue Ribbon Commission on Board-Shareholder Communications (p. 17), “Directors have a general responsibility to oversee the company’s disclosure programs. They also need to take special care in reviewing certain specific disclosures—notably the company’s regular financial disclosures, such as the proxy statement, 10-Ks, 10-Qs, and 8-Ks, as well as any securities registration statements filed with the [U.S. Securities and Exchange Commission (SEC)].” A director observed, “In addition to the changes to reports, we need a strategy to communicate with our major investors. They will be asking questions about why compensation payouts appear to have ‘changed.’”

The SEC will task review teams with scrutinizing public companies’ financial disclosures, 10-Ks especially, to determine if the statements include information on the revenue recognition standard, Bloomberg BNA reports. Mark Kronforst, chief accountant of the SEC’s Division of Corporation Finance, told Bloomberg BNA, “I don’t think that we will be shy about issuing comments if we don’t see the disclosures.”

“Accounting changes should not interfere with a good business decision, performance outcomes on incentives, and appropriate incentive payouts,” said Harris. “With an accounting change in the middle of a performance period, compensation committees will need to provide full transparency into incentive payout decisions, especially if they appear larger than expected under the new accounting. There’s a whole list of ramifications if that transparency is lacking, from proxy advisors’ criticisms to activist investors’ reproach.”

And there’s no time like the present to understand those ramifications and ensure that management stays on top of key milestones.