26 July 2006
SEC requires single figure disclosure of remuneration
In the United States, the Securities and Exchange Commission (SEC) has decide to go ahead with new regulations to increase the transparency of executive pay.
Currently American companies publish a huge amount of detail about what they pay their various directors, but because of the complexity of the pay, the difficulty of valuing stock options and the difficulty of attributing the value of deferred compensation to specific periods, it is very difficult to determine from the reports how much in total is actually being paid to each director. In future the SEC will require companies to publish, for each director, a single figure (in US dollars) that best indicates how much in total the director was paid in the financial year.
This is a big step forward and it will significantly increase the transparency of executive pay in the US. However the technical difficulty in determining the total value of pay cannot be overlooked. There are two main difficulties in determining the total value:
1) When compensation is given in the form of options there is the difficulty of appropriately valuing the option. How do we know that the valuations are given in a fair and consistent way?
2) When compensation is deferred, or conditional, there is the difficulty of knowing in which year it should be shown.
Click here to link to spreadsheet which displays an executive pay report layout. The proposed layout addresses both of the problems identified above. This is done by including an estimate of the present value of compensation in the year in which the compensation is awarded. That estimate is then revised in each subsequent year until the compensation is finally unconditional transferred. The changes in value of past compensation are added or subtracted to each year's compensation.
This approach ensures that poor valuation methodologies can have limited long term impact. It also ensures a consistent and realistic treatment of deferred compensation.
The layout forms appendix 2 of my book "Performance and Reward". See link "View the book" in the left hand column.
This suggestion was made to the SEC via their website on 26th July 2006. Unfortunately the SEC online facility was not able to upload the attached spreadsheet, so the comment posted on the SEC site is incomplete.
Currently American companies publish a huge amount of detail about what they pay their various directors, but because of the complexity of the pay, the difficulty of valuing stock options and the difficulty of attributing the value of deferred compensation to specific periods, it is very difficult to determine from the reports how much in total is actually being paid to each director. In future the SEC will require companies to publish, for each director, a single figure (in US dollars) that best indicates how much in total the director was paid in the financial year.
This is a big step forward and it will significantly increase the transparency of executive pay in the US. However the technical difficulty in determining the total value of pay cannot be overlooked. There are two main difficulties in determining the total value:
1) When compensation is given in the form of options there is the difficulty of appropriately valuing the option. How do we know that the valuations are given in a fair and consistent way?
2) When compensation is deferred, or conditional, there is the difficulty of knowing in which year it should be shown.
Click here to link to spreadsheet which displays an executive pay report layout. The proposed layout addresses both of the problems identified above. This is done by including an estimate of the present value of compensation in the year in which the compensation is awarded. That estimate is then revised in each subsequent year until the compensation is finally unconditional transferred. The changes in value of past compensation are added or subtracted to each year's compensation.
This approach ensures that poor valuation methodologies can have limited long term impact. It also ensures a consistent and realistic treatment of deferred compensation.
The layout forms appendix 2 of my book "Performance and Reward". See link "View the book" in the left hand column.
This suggestion was made to the SEC via their website on 26th July 2006. Unfortunately the SEC online facility was not able to upload the attached spreadsheet, so the comment posted on the SEC site is incomplete.
22 July 2006
Cable and Wireless - Long Term Cash Incentive
It seems that Cable and Wireless have secured shareholder support for their controversial long term incentive plan, despite the many problems with the scheme:
Firstly the size of rewards on offer are extremely large. It would appear that 10% of any growth in the value of the business over the four year performance period will go to the executives who manage the business. Why does this need to be such a huge amount? Are the executives really working for the best interests of shareholders, or are they primarily seeking to reward themselves at the shareholders expense? Very high executive pay, such as this, makes it hard for shareholders to believe that their best interests are really being perused. Suspicion and mistrust inevitably follow.
Secondly the scheme lacks consistency over time. There will be a big push to maximise the value of the business at 31st March 2010. There is nothing in the scheme to ensure that the value created will be sustainable or will endure over any meaningful period of time. Certainly, towards the later part of the performance period the executives will have massive incentives to cut all expenditure on research, long term development, long term marketing and customer satisfaction. Their attention will be completely tied up with short term valuation issues and all focus on the longer term will be lost. This is a very bad incentive to give, and their is no need for it. All advice on long term incentive plans says that awards should be phased over time so the incentive to grow value is consistent over time and not lumpy.
There is a particularly uncomfortable provision that allows for up to 75% of all awards to be paid out a year early in such a way that they cannot be clawed back. This provides even greater opportunity for a short term grab and run approach to the rewards.
The third area of concern is the complexity, particularly of the valuation process. The good thing is that the valuations are always tied back to real stock price values. However the separation into two business units creates complications. In particular there appear to be some circumstances in which the "Group Costs" which do not lie in either business unit might get ignored. When a process is complicated it often becomes politically necessary for those who manage it to manipulate it to their own advantage in ways that others will never realise. This has to be a concern in this case.
A four concern is that the flexibility of the corporate structure is reduced going forward. The scheme vests in full if either business unit is bought out, so this might become unduly attractive to managers. Corporate reorganisations that do not fit comfortably with the two business unit approach would become unthinkable in the business because of the reward structure. Is there any really synergy between the two units? If there is synergy, then Group level co-ordination should add value, but is strongly disincentivised by the new arrangement. If their is no real synergy, why are we not looking for an immediate demerger?
So why did shareholders approve the scheme? I think they approved it because they felt it was the best deal that they were likely to get out of the management. This is a long way short of it being the best thing that the management could do for the shareholders.
My comments on the scheme are based on the scheme set down in Appendix 1 of the Notice of AGM available through the C&W Investor Relations website.
Firstly the size of rewards on offer are extremely large. It would appear that 10% of any growth in the value of the business over the four year performance period will go to the executives who manage the business. Why does this need to be such a huge amount? Are the executives really working for the best interests of shareholders, or are they primarily seeking to reward themselves at the shareholders expense? Very high executive pay, such as this, makes it hard for shareholders to believe that their best interests are really being perused. Suspicion and mistrust inevitably follow.
Secondly the scheme lacks consistency over time. There will be a big push to maximise the value of the business at 31st March 2010. There is nothing in the scheme to ensure that the value created will be sustainable or will endure over any meaningful period of time. Certainly, towards the later part of the performance period the executives will have massive incentives to cut all expenditure on research, long term development, long term marketing and customer satisfaction. Their attention will be completely tied up with short term valuation issues and all focus on the longer term will be lost. This is a very bad incentive to give, and their is no need for it. All advice on long term incentive plans says that awards should be phased over time so the incentive to grow value is consistent over time and not lumpy.
There is a particularly uncomfortable provision that allows for up to 75% of all awards to be paid out a year early in such a way that they cannot be clawed back. This provides even greater opportunity for a short term grab and run approach to the rewards.
The third area of concern is the complexity, particularly of the valuation process. The good thing is that the valuations are always tied back to real stock price values. However the separation into two business units creates complications. In particular there appear to be some circumstances in which the "Group Costs" which do not lie in either business unit might get ignored. When a process is complicated it often becomes politically necessary for those who manage it to manipulate it to their own advantage in ways that others will never realise. This has to be a concern in this case.
A four concern is that the flexibility of the corporate structure is reduced going forward. The scheme vests in full if either business unit is bought out, so this might become unduly attractive to managers. Corporate reorganisations that do not fit comfortably with the two business unit approach would become unthinkable in the business because of the reward structure. Is there any really synergy between the two units? If there is synergy, then Group level co-ordination should add value, but is strongly disincentivised by the new arrangement. If their is no real synergy, why are we not looking for an immediate demerger?
So why did shareholders approve the scheme? I think they approved it because they felt it was the best deal that they were likely to get out of the management. This is a long way short of it being the best thing that the management could do for the shareholders.
My comments on the scheme are based on the scheme set down in Appendix 1 of the Notice of AGM available through the C&W Investor Relations website.
05 July 2006
Non-executive directors and shareholder interests
Below is another letter not published by Financial Times. Follow the link to see the original article referred to. Level 1 subscription to ft.com may be required.
Sir, Your article "Higgs suggests 'lite' rule regime for Aim" (3rd July 2006) suggested that the Higgs driven changes to the Combined Code entrenched independent non-executive directors as the guardians of shareholders' interests. This is a widely held misconception.
The Combined Code's philosophy is rather more that the chairman, chief executive and finance director are principally responsible for communication with shareholders (A.2, A.3.3, D.1). In contrast, "Non-executive directors should constantly seek to establish and maintain confidence in the conduct of the company" (page 63) so providing some checks and balances on the behaviour of the executive directors.
In fact a closer study of the Combined Code 2003 shows that it does not envisage that the non-executives have any specific responsibility to represent the ownership interest. Further, non-executives who have a significant shareholding in the company, or who have any longstanding relationship with the company are unlikely to be considered as independent in accordance with the codes criteria (A.3.1). A non-executive who is not independent cannot serve on the remuneration committee (B.2.1) or on the audit committee (C.3.1) and can only be in a minority on the nomination committee (A.4.1) and on the board as a whole (A.2). Non-executive directors who are not independent therefore have very limited scope in their role, and consequently can have only limited influence.
Unfortunately therefore the Combined Code has the, perhaps unintended, consequence of marginalising rather than increasing ownership representation on company boards. This is a serious problem because the natural incentives of company ownership are essential to the efficient working of capitalism.
Yours faithfully
Patrick Gerard
Sir, Your article "Higgs suggests 'lite' rule regime for Aim" (3rd July 2006) suggested that the Higgs driven changes to the Combined Code entrenched independent non-executive directors as the guardians of shareholders' interests. This is a widely held misconception.
The Combined Code's philosophy is rather more that the chairman, chief executive and finance director are principally responsible for communication with shareholders (A.2, A.3.3, D.1). In contrast, "Non-executive directors should constantly seek to establish and maintain confidence in the conduct of the company" (page 63) so providing some checks and balances on the behaviour of the executive directors.
In fact a closer study of the Combined Code 2003 shows that it does not envisage that the non-executives have any specific responsibility to represent the ownership interest. Further, non-executives who have a significant shareholding in the company, or who have any longstanding relationship with the company are unlikely to be considered as independent in accordance with the codes criteria (A.3.1). A non-executive who is not independent cannot serve on the remuneration committee (B.2.1) or on the audit committee (C.3.1) and can only be in a minority on the nomination committee (A.4.1) and on the board as a whole (A.2). Non-executive directors who are not independent therefore have very limited scope in their role, and consequently can have only limited influence.
Unfortunately therefore the Combined Code has the, perhaps unintended, consequence of marginalising rather than increasing ownership representation on company boards. This is a serious problem because the natural incentives of company ownership are essential to the efficient working of capitalism.
Yours faithfully
Patrick Gerard
