Pay ratio rule in SEC chair's sights

Sullivan & Cromwell partner Jay Clayton, President Trump's nominee for SEC chairman, last week testified at his hearing before the Senate Banking Committee.  Meantime, although the commission is currently operating with only two commissioners out of the full compliment of five, several contentious issues are being revisited, with their outcomes unpredictable. 

In August of 2015, the commission adopted a final rule that requires a public company to disclose the ratio of the compensation of its chief executive officer (CEO) to the median compensation of its employees.  Based on comments received during the rulemaking process, the Commission delayed compliance for companies until their first fiscal year beginning on or after January 1, 2017.  Issuers are now actively engaged in the implementation and testing of systems and controls designed to collect and process the information necessary for compliance.

However, Acting Chairman Michael Piwowar has become aware that some issuers have begun to encounter unanticipated compliance difficulties that may hinder them in meeting the reporting deadline.  He opposed the rule in 2015 when it was approved, calling it "a provision of the highly partisan Dodd-Frank Act that pandered to politically connected special interest groups."

Part of the 2010 Dodd-Frank law, the pay-ratio rule mandates that companies disclose median worker pay - the point on the income scale at which half their employees earn more and half earn less - and compare it with CEO compensation.  The rule could put pressure on corporate boards to slow pay increases for chief executives at companies with significant or widening gaps, proponents have said.

From the outset of the debate, years before the projected start of disclosure of the data, the requirement has been controversial because it could further embroil executive pay disclosure in divisive political debates about income inequality and its causes.  Companies complain the metric, which firms are set to begin reporting in 2018 for this year's pay, is expensive to calculate and not informative to shareholders.  "Industry has fought it tooth and nail because the contrast between worker pay and CEO pay is stark," said Lisa Gilbert, a director of Public Citizen, an ardent supporter of the pay rule.

The SEC could encounter difficulty attempting to delay the rule outright, because of the commission's depleted ranks.  With just two sitting commissioners - Mr. Piwowar and Kara Stein, a Democrat - the SEC is likely politically deadlocked on most matters.  In response to the directive to reconsider it, Ms. Stein signaled opposition to efforts to ease the pay ratio rule.  "It's problematic for a chair to create uncertainty about which laws will be enforced," she said.

Congressional Republicans have indicated opposition to the pay ratio rule and are expected to try to spike it legislatively, though those efforts could be stymied in the Senate, where Democrats have more leverage than in the House.  Senator Elizabeth Warren (D, MA) said yesterday that the Acting SEC Chair may be exceeding his powers by ordering 1) the Enforcement Division’s investigative powers scaled back and 2) two Dodd-Frank Act mandated final rules, on disclosure of use of  "conflict minerals" and CEO-worker pay ratio, reconsidered.

The pay ratio rule reconsideration under way doesn't immediately relieve companies of the need to comply in the coming year.  It is somewhat unusual for the SEC chief to seek new comments on a closed regulatory matter.  Willis Towers Watson was one of myriad entities submitting suggestions to the SEC during the recently-closed comment period.  In its letter, WTW proposed:

• Narrowing the definition of “employee” and “employee of the registrant.”
• Clarifying that prior-year data can be used to identify the median employee. 
• Clarifying that companies can use base pay as a consistently applied compensation measure (CACM).
• Making clear that the disclosure can be a “reasonable estimate.”
• Allowing registrants to use readily accessible records to determine employee classifications.
• Permitting broader use of “reasonable estimates” as part of statistical sampling to greatly reduce the effort required for companies with global workforces.

We'll keep a close eye on the regulatory and legislative proceedings, which could modify the rule, perhaps postpone its effective date, or conceivably do away with it altogether.

Robert Stead

XOM in the tank, but is it half-full or half-empty?

We recently looked into the accommodation Exxon Mobil Corp. (XOM) made with its retiring CEO Rex Tillerson when he was nominated by President Trump to be the 69th U.S. Secretary of State.  The primary issue entailed compensating Mr. Tillerson for the $184 million worth of unvested restricted stock units (RSUs) awarded to him over the course of his tenure.

InvestorPlace observes that the performance of XOM common over the past decade, during which Mr. Tillerson was at the helm, appears rather unimpressive. Over that time, including dividends, XOM stock has returned 49% — total, which breaks out to an average return of just 4% per year, well below the S&P 500.  Over the past five years, the XOM common fared even worse, declining over that period.  Including dividends, XOM has averaged just a 1.8% return since 2012.

Alternatively, it could be argued that positive five- and 10-year returns for XOM stock in fact are quite impressive.  West Texas Intermediate (WTI) crude oil prices peaked at $99 in 2007 and averaged $94 in 2012.  WTI now trades at half those 2007 levels.

Owing to the consequent heavy pressure on revenues, a number of oil companies have gone bankrupt; many other oil stocks trade at a fraction of their former value.  In that context, the fact that Exxon Mobil stock has returned anything at all appears to reflect excellent performance.  After all, most oil and gas stocks have done worse – some considerably so.

Some corporate governance experts maintain that such cases illustrate that the circumstances and idiosyncrasies of particular industries, often persisting for extended periods, must be taken into account in setting and assessing executive pay.  Merely comparing a company's shareholder returns to that of broad indexes does not give the full picture of the job the CEO, and other top execs, did.  At times, it's wisest for the person at the helm to order the crew to batten down the hatches to ride out the storm.

Of course, the performance of XOM stock over the past 10 years poses a serious challenge for the company and its management going forward.  Exxon Mobil common performed much better than most peer companies in the O&G sector during a period of falling oil prices.  But it clearly didn’t perform well.  Regardless where oil goes from here, there are likely better choices than XOM.  But that's a topic to another day.

Robert Stead

AYS Report's key findings

Identifying the 100 most overpaid CEOs in the S&P 500 was the intended purpose of the As You Sow report report.  In undertaking the report the analysts focused not just on absolute dollars, but also on the practices believed to contribute to bloated compensation packages.

Of the top 25 most overpaid CEOs, 15 made the list for the second year in a row, and 10 have been on the list three years running.  The rankings are based on a statistical analysis of company financial performance using a regression to identify predicted pay, as well as an innovative index developed by AYS that considers 30 additional factors.

The companies listed in the first AYS report on overpaid CEOs have markedly underperformed the S&P 500 since that time.  Per the report, the 10 companies identified as having the most overpaid CEOs, as a group underperformed the S&P 500 index by an incredible 10.5 percentage points and actually demolished shareholder value with a negative 5.7 percent financial return.  In summary, the most overpaid CEO firms reduced shareholder value since the first report.

Many of the overpaid CEOs are insulated from shareholder votes, claims the report, suggesting that shareholder scrutiny can be an important deterrent to outrageous pay packages.  A number of the most overpaid CEOs are at companies with unequal voting structures and/or triennial votes, so shareholders did not have the opportunity to vote this year on the extraordinary packages.  While the Say-on-Pay regulations allow less frequent votes, and shareholders can decide if they can vote every one, two or three years, the vast majority of companies hold annual votes on pay.  The authors believe that the fact that the list of the top 25 overpaid CEOs includes several companies that do not hold annual votes on pay implies that such insulated companies are more willing to flaunt best practices on pay and performance.

The most overpaid CEO's represent an extraordinary misallocation of assets, posit the authors.  Their regression analysis showed 14 companies whose CEOs received at least $20 million more in 2015 than they would have garnered if their pay had been aligned with performance.

Shareholder votes on pay are said to be wide-ranging (in what way is unclear) and inconsistent, with pension funds deemed far better at exercising their fiduciary responsibilities.  The report, represented as the broadest survey of institutional voting ever done on the topic, shows that pension funds are more likely to vote against overpaid packages than mutual funds.  Using various state disclosure laws, the analysts were able to collect data from over 30 pension funds.  Per the report, the data shows some pension funds approving just 18% of these overpaid CEO packages, to others approving as many as 93% of them.

Acknowledging wide variation among entities, the report nevertheless indicates that mutual funds, on the other hand, are far more likely to approve of these overpaid CEO packages.  Of the funds with the largest change in voting patterns from last year, all of them opposed more of the pay packages than they had the prior year.  In addition to the trending votes, several funds have indicated that, at a minimum, they will be reviewing pay more closely.  Of the largest mutual funds, Dimensional Fund Advisors opposed 53% of these packages, while Blackrock opposed only 7% of them.  Some funds seem to routinely rubber stamp management pay packages, enabling the worst offenders and failing in their fiduciary duty.  TIAA-CREF, the leading retirement provider for teachers and college professors, is more likely to approve high-pay packages than almost any other institution of its size with support level of 90%.

Directors, who should be acting as stewards of shareholder interests, should be held individually responsible for overseeing egregious pay practices, urge the authors.  A number of directors serve on two or more overpaid S&P 500 compensation committees.  The report lists the companies that over-paying directors serve on, and identify individuals who serve on two or more 'overpaid' S&P 500 compensation committees.

While the report's methodology, conclusions and recommendations will be contested in some quarters of the corporate governance community, AYS formidably makes its case that an unchecked disconnect between CEO pay and company performance, as defined by shareholder returns, persists at certain companies.

3rd annual AYS study: Overpaid execs produce poor returns

In the midst of this year's proxy season, the recurrent debate over CEO pay has vigorously resumed.  But as we've previously touched upon, widening income inequality throughout the world is intensifying scrutiny and prompting renewed demands to rein in CEO compensation.  High-levels of CEO payouts are typically justified as necessary to attract and retain highly competent executives in an intensively competitive marketplace.  You get what you pay for, after all.  Moreover, shareholders by and large have seemed reluctant to oppose paying top dollar for executives, CEOs and other named executives, so long as they are perceived to have delivered adequate returns.  Are a significant proportion of CEOs overpaid and how can such instances of excessive compensation be determined?

Jumping into the fray, and not pulling any punches, As You Sow, backed by the Steven Silberstein Foundation and the Roy and Patricia Disney Family Foundation, among others, recently released its third annual report investigating the interrelationships among CEO pay, company performance and institutional investors' oversight.  The report is provocatively entitled: THE 100 MOST OVERPAID CEOs: Are Fund Managers Asleep at The Wheel?  The report opens by citing the Economic Policy Institute's assertion that, "CEO pay grew an astounding 943% over the past 37 years, greatly outpacing the growth in the cost of living, the productivity of the economy, and the stock market, disproving the claim that the growth in CEO pay, reflects the 'performance' of the company, the value of its stock, or the ability of the CEO to do anything but disproportionately raise the amount of his pay."

As You Sow forcefully makes the case that there is a pervasive and growing problem of misalignment among executive pay and performance, in some instances "devastating" shareholder returns and owing predominantly to certain institutional investors "failing in their fiduciary duty".  Although representative of a sizable portion of the corporate governance community, the report's wide-ranging findings and conclusions are not all necessarily endorsed here.

The report purportedly highlights the "100 most overpaid CEOs" of S&P 500 companies and the corresponding votes of major shareholders on their pay packages.  The report finds that executive pay continued to increase last year.  The report commends some mutual funds and pension funds for "doing better at exercising their fiduciary responsibility by more frequently voting their proxies against some of the most outrageous CEO pay packages."

The report again asserts that the system in place to govern corporations has failed in the area of executive compensation.  Like all the best governance systems, the report notes, corporate governance relies on a balance of power.  That system envisions directors representing shareholders and guarding the company's assets from waste.  It also envisions shareholders holding companies and executives accountable.

The governance system, the authors recall, comes from a time when it was assumed that unhappy investors would simply sell their stakes if sufficiently dissatisfied with the governance of a company.  It reflects a time when there were fewer intermediaries between beneficial owners and corporate executives.  However, today more and more investors own shares through mutual funds, often investing in S&P 500 index funds.  Individual investors are not in a position to sell their stakes in a specific company.  The funds themselves are subject to a number of conflicts of interest and to what economists refer to with the oxymoronic-sounding term "rational apathy," to reflect the expense of oversight in comparison to a pro rata share of any benefits.

Today, the report contends, those casting the votes on the behalf of shareholders frequently do not represent the shareholders' interests.

The report maintains that CEO compensation as it is currently structured does not work; rather than incentivize sustainable company growth, compensation plans increase increase disproportionately by every measure.  Too often CEOs are rewarded for mergers and acquisitions instead of improving company performance.  As noted in the Financial Crisis Inquiry Report, "Those [compensation] systems encouraged the big bet - where the payoff on the upside could be huge and the downside [for the individual executive] limited.  This was the case up and down the line - from the corporate boardroom to the mortgage broker on the street."  The authors note that the downside, which could include such features as environmental costs, may be limited for the individual and instead born by the larger society.

Paying one individual excessive amounts of money can lead people to make the false assumption that such compensation is justified and earned, the authors continue.  It undermines essential premises of capitalism: the robust 'invisible hand' of the market as well as the confidence of those who entrust capital to third parties.  The report alleges that confusing disclosure coupled with inappropriate comparisons are then used to justify similar packages elsewhere.  These systems perpetuate and exaggerate the destabilizing effects of income inequality, and may contribute to the stagnating pay of frontline employees, the report posits.

As the report is now in its third year, the analysts look back to see what happened to the companies in our report two years ago. We've been saying the most overpaid CEO's under-deliver for shareholders.  In examining this data from the following two years of the report, the analysts find dramatic results - not only does the group of most overpaid CEO companies of the S&P 500 underperform the S&P 500 by 2.9 percentage points, but the firms with the 10 most overpaid CEOs underperformed the S&P 500 index by an "amazing" 10.5 percentage points and actually had a negative return, reducing the actual value of the companies' shares by 5.7 percent.  In summary, according to the report, the firms with the most overpaid CEO's devastated shareholder value since our first report published in February 2015.

Shareholders now supposedly have the right, since the enactment of the Dodd-Frank financial reform act, the report notes, to cast an advisory vote on compensation packages.  However, in today's world, most shareholders have their shares held and voted by a financial intermediary.  This means that this critical responsibility is in the hands of a fiduciary at a mutual fund, an ETF, a pension fund, a financial manager, or people whose full-time job is to analyze the activities of the companies they invest in and monitor the performance of their boards, their CEOs, and their compensation.

A key element of the report was to analyze how mutual funds and pension funds voted on these pay packages.  This year the list of funds looked at was vastly expanded.  In response to excessive and problematic CEO pay packages, it should be noted that every fund manager has the power to vote against these compensation plans and withhold votes for the members of the board's compensation committee who created and approved them.  In some cases, institutional should request meetings with members of the compensation committees to express their concerns.  Institutional investors should be prepared to explain their votes on executive pay to their customers, and individuals should hold their mutual funds accountable for such decisions by expressing their displeasure directly to those that are also well compensated to protect and represent them.

Again this year, directors who serve on the compensation committees of these boards did not escape the keen eye of the AYS analysts.

If readers would excuse the length of this post, as it will serve as a ready reference for this point of view regarding executive pay v. performance.

Fmr XOM CEO already under water,...

and it's not because he fell off a drilling platform, according to a recent lengthy article in Politico Magazine.  And not long before that, Bloomberg reported that Rex Tillerson had checked into a sanitarium in Germany on his first trip abroad as U.S. Secretary of State.  All in all, it has not been smooth sailing for Mr. Tillerson since being sworn in as the nation's chief diplomat on February 1st.

Tillerson nominated for Secretary of State, retires as XOM CEO

After he was nominated in December by President-elect Trump, XOM CEO Mr. Tillerson announced his retirement from the company effective at yearend.  Having joined the company as a production engineer in 1975, Mr. Tillerson had been scheduled to retire when he reached the age of 65 in March of this year.  Prompted by this unexpected turn of events, there was the matter of what to do about unvested restricted stock units (RSUs), amounting to approximately two million underlying XOM shares then worth about $184 million.  Simply retaining them in their existing form was not an option, so to speak, because doing so most certainly would run afoul of federal conflict of interest standards and/or could give the appearance of conflicts hindering his ability to serve effectively as the 69th U.S. Secretary of State.

Agreement to mitigate potential conflicts

Consequently, on January 3rd, ExxonMobil filed an 8-K with the Securities and Exchange Commission disclosing that the company had entered into a Cancellation and Exchange Agreement (the "Agreement") with Mr. Tillerson subject to his being confirmed by the U.S. Senate and taking office as U.S. Secretary of State.  The Agreement outlines how the compensation and benefits Mr. Tillerson has earned over his 40+ year career would be handled.

The Agreement provides that Mr. Tillerson will surrender all unpaid XOM restricted stock and restricted stock units he holds in exchange for a cash payment to an irrevocable Ethics-Compliance Trust established with an independent third-party trustee (the "Trust") equal to the value of underlying XOM common stock determined under a market-based formula.  The payment will be discounted by approximately $3 million (at current market values) consistent with guidance from federal ethics authorities.

Under the Agreement, Mr. Tillerson will surrender all unpaid deferred cash bonus units (referred to as Earnings Bonus Units"), having total settlement value of approximately $3.9 million.  The surrendered Earnings Bonus Units will be cancelled without any compensating payments in exchange.

According to the filing, the net effect of the foregoing is a reduction of approximately $7 million compared to compensation and benefits Mr. Tillerson otherwise would have received.

Although unmentioned in the 8-K, Mr. Tillerson apparently would also surrender entitlement to other benefits such as retiree medical and dental benefits, and administrative, financial and tax support.

The Agreement also states that Mr. Tillerson's vested benefits under XOM's defined contribution and defined benefit plans will be paid or distributed to him in the normal course as provided under the terms of those plans, consistent with federal conflict of interest guidelines.  Mr. Tillerson's death benefit coverage under XOM's group life insurance plan for certain executives - which provides a benefit to Mr. Tillerson's survivors of approximately $13 million - will be cancelled.  The company commits to use its best efforts to obtain and, if so, pre-pay a life insurance policy from an independent third party supplying substitute coverage as comparable as possible to the terminated coverage.

Dueling tax provisions

Relying on §409A of the Internal Revenue Code, a number of tax attorneys and pay experts contend that the trust set up with the proceeds from Tillerson's RSUs creates a taxable event, to the tune of about $70 million in income plus another roughly $8 million in Medicare tax - and if Tillerson does not pay what he owes this year, he will be violating the law.  Columbia Law professor and executive compensation expert Robert J. Jackson Jr., a former Obama administration Treasury Department official, told the New York Times, “Everything in the trust is his property today, which means he must pay tax on it.”

Tax expert Robert Willens demurs, noting that §409A was never meant to apply to restricted stock units, or stock options, where the final payout is at risk.  A precipitous drop in the stock price could result in the the RSUs being worth a lot less, or nothing at all.  Under such circumstances, §83 of the tax code is implicated, stipulating that in deferred compensation arrangements, if there is a substantial risk of non-payment, then no taxes are owed until the taxpayer actually gets the money.  And RSUs are deemed to have a substantial risk of non-payment.

But in order to divest himself of his interest in XOM stock, the company is converting his RSUs and turning them into cash, and depositing the proceeds into the trust.  Because the trust preserves the same vesting schedule as the RSUs, the company and Tillerson maintain that §83 tax treatment should apply.  But with cash not RSUs in the trust, §409A could kick in, requiring Tillerson to pay upfront.

Willens, the tax expert, points out that the trust agreement, which is in place for 10 years, has a clause that requires Tillerson to forfeit whatever remains in the trust in the event that Tillerson returns to the oil and gas industry, in any capacity, even as a  consultant or lobbyist for any entity.  Since Tillerson's main expertise is in the oil and gas business, Willens argues, there is a real possibility that he will return to the industry in some capacity, which would mean that, because of the risk of non-payment, the trust still qualifies for treatment under §83.

No easy answers for company but others should take notice

Charles Elson, director of a corporate governance center at the University of Delaware, said the board of Exxon Mobil was "between a rock and a hard place.  There were no easy answers. I’m not saying they did the right thing or the wrong thing. I think they came up with what they thought was a measured answer.’’  While Elson noted the board eliminated the downside risk of continuing to hold XOM shares, the value of the stock could go up or down in the future, so Tillerson could have fared better or worse depending on when he took possession of the shares.

With more CEOs and other top corporate executives likely to be nominated for senior government positions and more CEOs considering their own suitability for the role of the nation's Commander-in-chief, this could be an issue more frequently confronting companies in coming years.

Robert Stead