June 8, 2015

Pay vs. Performance: Comparability vs. Reality

[Hi. It’s Randi blogging again this week so, to be clear, the views I express are my own and don’t necessarily reflect those of Broc or anyone else…] 

In the brief time since the SEC published the proposed Pay vs. Performance rule, there’s been a fair amount of criticism aimed at the proposal’s use of TSR as the sole “approved” metric by which investors will gauge the correlation between executive pay and corporate performance. In a perfect example of what one of my very seasoned and wise former board members during my GC days would likely characterize as the tail wagging the dog, investors’ desire for comparability across companies is trumping the proposal’s use of performance metrics that actually make sense given each company’s unique facts and circumstances and that drive behavior consistent with a long-term view.

In case you’ve just joined the fray, here’s just a sampling of recent, relevant critiques:

– LA Times columnist Michael Hiltzik shared his passionate critique of the rule proposal, noting (among other things) TSR’s imperfect correlation with corporate performance and its short-termism focus, i.e., tendency to drive executive behaviors that will boost TSR, but harm the company over the long-term. Hiltzik also criticizes the rule’s focus on “shareholder value” to the exclusion of everything else – a focus that ultimately distorts corporate behavior to the detriment of the broader economy.

– Based on its recently reported analysis of the link between various LTI measures and corporate performance, FEI concluded that TSR was the worst performance measure to drive positive corporate performance:

TSR, particularly on a relative basis, is a poor LTI measure. For the majority of companies granting performance-based grants, relative TSR is a commonly used performance measure. However, using TSR as a measure has a negative influence on company performance, except in the case where it has been used as a performance measure for each of the past five years. Moreover, TSR, particularly when measured against a group of companies (including a stock index), does not motivate executives, and is similar to a stock option in its nature (another form of lottery ticket), as it does not provide the line of sight necessary for oversight.

– The IRRC Institute submitted this comment letter to the SEC accompanied by recently published research on pay and performance alignment, which found a disconnect between TSR and performance:

“[T]he focus on share price appreciation through total shareholder return (TSR) obscures more than it reveals with share price as a capital markets performance metric. Factors which impact TSR such as fund flows, central bank policies, macroeconomics, geo-political risks and regulatory changes are all beyond the control of executive management.

–  In this Fortune commentary, Eleanor Bloxham describes the proposal’s use of TSR as encouraging pay incentives that “fuel crisis”:

The American Bar Association and the Center on Executive Compensation, among others, have opposed the SEC’s prescriptive approach to this rule. In choosing total shareholder return (a measure of a company’s stock market price and dividends), the SEC admits that pay disclosure may have nothing to do with the actual way in which a corporate board makes compensation decisions. The problem is that this kind of measure may now have an influence on such decisions. Boards should not reward executives based on stock performance or dividends paid. They should reward executives based on the operational measures the executives in that company should be focusing on and can control. As a basis for incentives, a company’s stock price promotes undesirable CEO behavior, the kind that can lead to volatile swings in the economy. Those incentives helped fuel both the financial crisis and the stock market rout following the misdeeds of Enron and WorldCom’s top executives. Similarly, increasing dividends is not always wise, because they can strip a firm of the assets needed to make valuable long-term investments and the liquidity required to weather rocky times. The SEC should have required that companies report on the financial performance measures they currently use to determine compensation. Then, investors could sort out which companies actually understand performance measurement and which ones are clueless.

– In this recent article, Semler Brossy identifies TSR as a “flawed” incentive measure, noting:

Relative TSR rewards volatility more than steady performance. As they say, every dog has its day, and this is certainly true with relative TSR. We measured TSR for hundreds of companies over the recent 20 years and found that even long-term, bottom-quartile TSR performers can reach top-quartile heights in a given three-year measurement period — generally by ‘bouncing’ from a low share price. Further, relative TSR does little by way of focusing executives’ attention or driving behavior. Executives respond positively to incentive measures that reflect their day-to-day responsibilities. Rewards based on relative TSR are an affirmation of company success but do little to set the path to performance at the outset of a measurement period.

– Last but not least (for now), Steve Quinlivan shared these observations about the disconnect between TSR and executive pay:

What aberrations may exist?  First, there may be no link at all between executive pay and TSR.  This isn’t necessarily a governance faux pas.  Executive pay may well have increased because of improved financial metrics the compensation committee chose wisely to reward while the stock price declined because of general market conditions beyond the executives’ control.  Sure, the SEC invites the company to explain the reasons and to submit alternative measures of performance, but that will be hard to do without making it look like an apology.  Perhaps this will engender a trend to tie incentives to TSR to make the discussion easy and that may not universally by the best thing for companies to do.

SEC Enforcement: Ongoing Choice of Forum Debate

This recent WSJ op-ed addresses the fact that the SEC’s Enforcement Staff’s recently issued guidance to forum selection in contested actions generally was not well-received by those who had criticized the apparent lack of objective criteria driving determinations about whether an action would be brought in federal district court or in an administrative proceeding before an ALJ. The authors, former director of the SEC’s Division of Enforcement and former SEC chief litigation counsel, suggest the SEC take these steps to “reclaim the high ground”:

– Develop meaningful, objective criteria for exercising its discretion to bring matters in-house that is the product of input from interested parties, including the defense bar
– Modernize the rules of procedure governing its in-house proceedings
– Avoid finding, on appeal, additional violations and imposing additional penalties beyond those assessed by the ALJs, who are independent government employees

See this recent blog discussing an ALJ’s denial of an accused’s request for more information about the Commission’s forum selection process, and memos about Enforcement’s recent guidance, which are posted in our “SEC Enforcement” Practice Area.

More on “The Mentor Blog”

We continue to post new items daily on our blog – “The Mentor Blog” – for members. Members can sign up to get that blog pushed out to them via email whenever there is a new entry by simply inputting their email address on the left side of that blog. Here are some of the latest entries:

– Investors & Directors: Understanding & Bridging the Gaps
– Bolstering Compliance Programs: Compliance & Ethics Liaisons
– Old COSO Internal Controls Framework: “Qualified Pass” for 2014
– FCPA: SEC’s Director of Enforcement Talks Compliance Programs
– Overlapping Audit & Compensation Committee Memberships: Pros & Cons


– by Randi Val Morrison