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Corporate governance in the post Sarbanes–Oxley period: Compensation disclosure and analysis (CD&A)

Dan R. Dalton ⁎, Catherine M. Dalton

Kelley School of Business, Indiana University, 1309 East 10th Street, Bloomington, IN 47405-1701, USA

Abstract

In recent years, the entire fabric of corporate governance, certainly in the United States, has dramatically changed. With the passage of what has colloquially become known as SOX (the Sarbanes–Oxley Act of 2002), US-based corporations have operated under stricter governance guidelines than at any previous time, especially as regards the structure of boards of directors and financial oversight of the corporation. A now perennial governance “hot button” issue not addressed by SOX is concern over continually rising executive compensation. Until the 2006 adoption of new compensation disclosure guidelines by the Securities and Exchange Commission (SEC), it had been nearly 15 years since federal attention had been devoted to compensation guidelines or regulations. Beginning with 2007 filings, US corporations must now include a Compensation Disclosure and Analysis (CD&A) section. The intent behind the CD&A is to provide investors access to clear explanations of executive compensation and the philosophy that underlies compensation. As often happens, this good intent is accompanied by several unintended risks that may mitigate the effectiveness of the CD&A. © 2008 Kelley School of Business, Indiana University. All rights reserved.

KEYWORDS Corporate governance; Executive compensation; Compensation disclosure and analysis (CD&A)

1. Sarbanes–Oxley: A background

Under the tutelage of Senator Paul Sarbanes (D- Maryland) and Representative Michael G. Oxley (R- Ohio), the Public Company Accounting Reform and Investor Protection Act (Pub. L. No. 107-204, 116 Stat. 745) was passed into United States federal law in 2002 (see AICPA, 2005). This legislation, com- monly referred to as “SOX” or “Sarbox,” was adopted with an imposing bipartisan and bicameral

mandate, a vote of 423–3 in the House and 99–0 in the Senate (see, for example, Bradley & Wallen- stein, 2006; Gourevitch & Shinn, 2005).

SOX has been enthusiastically endorsed by a number of observers and has been referred to as the top “legal milestone of the last ten years” (Myers, 2005, p. 1), the “most comprehensive public com- pany legislation since the 1930s” (Green, 2004, p. 19), and “the most significant piece of legislation in the history of federal securities regulations” (Bradley & Wallenstein, 2006, p. 67). Much of that enthusiasm may be the result of a series of high- profile corporate misadventures. Table 1 provides a

Available online at www.sciencedirect.com

⁎ Corresponding author. E-mail address: [email protected] (D.R. Dalton).

www.elsevier.com/locate/bushor

Business Horizons (2008) 51, 85–92

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partial list of corporations, many of which enjoy[ed] market capitalizations in the $10–$100 billion range, that have been involved in settlements with the Securities and Exchange Commission (SEC) and/or have restated their earnings (Boogle, 2007). It was errors/omissions of these and other types, in part, that SOX was designed to address.

The guidelines promulgated by SOX have two critical, and unprecedented, aspects in common. Prior to SOX, much of the framework for the regulation of US corporations was the jurisdiction of the individual states. Many of those state privileges, preempted under the auspices of SOX, are now federal prerogatives. Pre-SOX, federal regulations primarily addressed corporate disclo- sure requirements. SOX, however, sets forth a series of specific requirements regarding the internal

governance structures and functions of public cor- porations (Bradley & Wallenstein, 2006; Monks & Minow, 2004; Romano, 2005).

SOX is not the only impetus for improved corporate governance to emerge in this period. Devoid of any formal association with SOX, but largely in parallel with its spirit of disclosure, transparency, and inde- pendence, were the corporate governance guide- lines set forth by the listing exchanges (see NASDAQ, 2006; New York Stock Exchange, 2007). In these guidelines, too, are a host of regulations designed to ameliorate the corporate misadventures of the pre- SOX period. The current compliance, particularly with regard to independence of boards of directors and board committees, under both SOX and the listing exchanges guidelines is impressive. Indeed, 100% of S&P 500 boards' audit, compensation, and nominating/governance committees are comprised of independent directors. Derivatively, all of these committees are also chaired by independent direc- tors. Also, the listing exchanges' guidelines state that listed companies must have a majority of indepen- dent directors. The current rate is 81%, well above the enumerated standard (Spencer Stuart, 2006a). More critically, however, may be the deft observation:

“While these data demonstrating an increase in board independence are important, even more intriguing is the evidence suggesting…a new genera- tion of governance reform” (Spencer Stuart, 2006b, p. 3).

Indeed, among the more “intriguing” of the current foci on corporate governance not addressed by SOX or the guidelines of the listing exchanges, but a focus that may nevertheless promise to forever change the fabric of governance best practice, is executive compensation. As we will develop in succeeding sections, many of these changes, ardently sought by their advocates, seem sensible. Under a bit more scrutiny, however, that perspective may seem less certain. We find exam- ples of both actual and proposed interventions of this type in CEO compensation.

2. CEO compensation

It would be an epic understatement to suggest that CEO compensation remains in the forefront of cor- porate activists' agendas and as a staple of the business/financial press. Despite this attention, CEOs of the 500 largest US firms received a col- lective 38% increase in their 2006 pay. On average, this is an annual rate of $15.2 million per person (Anonymous, 2007).

Table 1 Companies restating earnings and/or involved in settlements with the Securities and Exchange Commission a

Adelphia Kodak American International Group (AIG)

Krispy Kreme

Avon Legato Systems

Boeing Lernour & Hauspie

Bristol-Myers Squibb Lucent Technologies

Cendant Marsh McClennan

Ceridian MBIA

Citibank Merrill Lynch

Coca-Cola MGIC

Computer Associates Microsoft

Conseco MicroStrategy

Critical Path Network Associates

Dynergy Oxford Health Plans

Enron Peregrine Systems

Fannie Mae PNC Financial Services

Fleming Companies Quest Communications

Freddie Mac Raytheon

Gateway Reliant Resources/ Energy

GemStar - TV Guide International

Rite Aid

General Electric Royal Dutch Petroleum

Global Crossing Safety Kleen

Halliburton Shell Transport

Hanover Compressor Silicon Graphics

HBO McKesson Robbins Spiegel

HealthSouth Sunbeam

Homestore Symbol Technologies

Household International

Time Warner

Informix

Trump Hotels & Casino Resorts

Interpublic Tyco

Kimberly Clark Warnaco Group

Kmart Waste Management WorldCom

a For the companies involved with settlements with the SEC, not all included an admission or a denial of guilt.

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Actually, we would argue that concern over CEO compensation is often misspecified. Many observers are largely indifferent about, or at least uncritical of, the amount of compensation that others receive. Consider, for example, an author with a dozen or so bestselling books, translated into 50- plus languages worldwide, and with a resultant nine-figure net worth. Few of us are concerned about that. He or she wrote the books; they were well received; a large income was the result. By contrast, what disquiets most people is when performance is not related to compensation. A CEO who has realized a nine-figure net worth over several years, yet whose company's market value has decreased by half, is an example of the latter scenario. In that spirit, on two occasions the SEC and Congress have intervened with regulations designed, in part, to both quell the rapid increases in executive compensation and establish a protocol whereby the relationship between compensation and performance must be established and publicly reported.

3. The SEC, Congress, and executive compensation

Despite a whirlwind of controversy, in 1992 the SEC adopted the Executive Compensation Disclosure Exchange Act (57 Fed. Reg. 48126, 48138).1 Among other elements, the compensation report to be provided in companies' federal filings pursuant to this Act should disclose the “specific rationale for the executive compensation paid, as well as the relationship of the compensation paid to the company's performance” (Mobley, 2005, p. 120). This objective was largely unmet as reports were often perfunctory. Indeed, it was noted that “much [of the] disclosure…is just boilerplate and is not very informative” (Mobley, 2005, p. 120).

Shortly after the adoption of the executive disclosure act, the US Congress amended the Internal Revenue Code (Section 13211: The Disal- lowance of Deduction for Certain Employee Remu- neration in Excess of $1,000,000 of the Omnibus Budget Reconciliation Act of 1993, Pub. L. No. 103- 66, 107 Stat. 312 [1993]). The essence of this amendment was that executive compensation in excess of one million dollars would not qualify as a deductible expense for the company providing this compensation. “Performance-based” compen- sation, however, was an exception. In principle,

then, the amendment was designed to encourage companies to adopt performance-based compen- sation under penalty of losing their federal tax deduction. Given the increasingly upward trend of executive compensation from 1993 to the present, it would be fair to say that this intervention was largely futile.

Recently, however, the SEC has adopted the most comprehensive guidelines in its history for disclo- sure requirements for executive and director compensation, related party transactions, equity ownership, and other corporate governance matters (SEC, 2006). Commonly known as Compensation Disclosure and Analysis (CD&A), it addresses an expansive array of compensation matters that are, in concert, intended to provide investors with a clearer and more complete overview of the com- pensation earned by company CEOs, CFOs, three other of its highest paid executive officers, and members of its board of directors. As emphasized, these disclosures must be “provided in plain English….[and are] intended to make proxy and information statements, reports and registration statements easier to understand” (SEC, 2006, p. 1). Table 2 provides a summary of select elements that comprise the CD&A requirements. We apologize for its detail, but point out that the SEC enabling document release is 436 pages in length.

Notably, however, there are aspects of the early application of the CD&A guidelines that some observers will find to be troublesome, both in the near term and as the CD&A unfolds over the next few years.

4. Plain English?

As highlighted, part of the spirit under which the CD&A was developed included the notion that it would be accessible to its readers, absent impene- trable text and arcane – if not obfuscating – footnotes. On this point, the early returns are disappointing. SEC Chairperson, Christopher Cox (2007), recently addressed this issue:

“I have to report that we are disappointed with the lack of clarity in much of the narrative disclosure that's been filed with the SEC so far. Based on the early returns, the average Compensation Disclosure and Analysis section isn't anywhere close to plain English. In fact, according to objective third-party testing, most of it is as tough to read as a Ph.D. dissertation.”

Moreover, thus far the CD&A has typically proven unwieldy. The median length for a CD&A is 5472 words, some 1000 words longer than the US

1 See Mobley (2005) for an outstanding history of federal regulation addressing executive compensation. See also Elson (1993) and Perry and Zenner (2000).

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Constitution; the longest submitted is more than 13,500 words.2 According to Chairperson Cox (2007, p. 4), “…we have far to go before we can say that legalese and jargon have truly been replaced by plain English.” In fact, he concludes that the average CD&A is less readable than a standard insurance contract. Another observer has referred to the compensation disclosures as “clear as mud” (“Comp Disclosure,” 2007, p. 1). In fairness, it should be noted that the SEC documents presenting the CD&A guidelines are even more difficult to understand (“Comp Disclosure,” 2007, p. 9).

5. CD&A: A standard or a primer?

A foundation of the CD&A is that a requirement for a comprehensive public reporting will result in some abeyance in the excesses of many aspects of corporate compensation. It is in that spirit that Justice Louis Brandeis (1914, p. 92) famously observed: “Publicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the best of disinfectants…”

There is, however, an alternative view. In the near past, corporations would engage compensation consultants who, among other things, would provide presumably comparable data about compensation practices in the industry, or for a group of companies

2 A double-spaced page of text is about 300 words; 13,500, then, would be approximately 45 pages.

Table 2 Summary of compensation disclosure and analysis (CD&A) requirements a

The CD&A must describe: The objectives of the company's compensation programs; What the compensation program is designed to reward; Each element of compensation; Why the company chooses to pay each element; How the company determines the amount (and, where applicable, the formula) for each element to pay; and, How each compensation element and the company's decisions regarding that element fit into the company’s overall compensation objectives and affect decisions regarding other elements.

Additionally, the new regulations include the following non-exclusive list of examples of material information that companies may also need to disclose in the CD&A:

The company's policies for allocating compensation between: • Long-term and currently paid out compensation, • Cash and non-cash compensation (and among different forms of non-cash compensation), and • Different forms of long-term compensation awards (for example, the relationship of the award to the achievement of company long-term goals, the executive's exposure to downside equity risk, and costs and benefits to the company);

How the determination is made as to when awards are granted, including awards of equity-based compensation such as options; What specific items of corporate performance are taken into account in setting compensation policies and making compensation decisions; How specific elements of compensation are structured and implemented to reflect company and individual performance, including: • Whether discretion can be or has been exercised either to award compensation even if performance targets are not attained or to change the size of an award, and

• Company policies regarding the adjustment or recovery of awards if such awards are reduced because of a restatement or other adjustments to performance measures;

Factors considered in any decision to materially change compensation; Whether the company has stock ownership guidelines and policies regarding the hedging of its stock; How compensation or amounts realizable from prior compensation are considered in setting other elements of compensation (for example, how gains from prior option or stock awards are considered in setting retirement benefits); The company's reasons for selecting certain triggers for severance and change of control arrangements (for example, single trigger vs. double trigger); The impact of accounting and tax treatments on the form of compensation used (for example, equity-classified awards vs. liability-classified awards under FAS 123(R)); Whether the company engaged in any benchmarking of total compensation, or any material element of compensation identifying the benchmark and, if applicable, its components (including component companies); and The role of executive officers in determining executive compensation.

a These materials abstracted from a much larger document provided by Goodwin Procter LLP, available at www.goodwinprocter. com/publications.aspx.

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similar to the focal corporation. Inasmuch as many compensation practices were considered to be proprietary and were actively protected as a competitive advantage, these data would often be incomplete or estimated, or both. Not now.

Instead, a CD&A actually amounts to a primer for all firms to determine what, exactly, other firms are doing regarding the compensation of their CEO, CFO, NEOs (named executive officers), and board of directors. This has two potential ef- fects, one at the enterprise level and the other at the individual level, both of which are presumably unintended.

From the perspective of the enterprise, there is now access to the many elements of (for example) base compensation, bonuses, employment con- tracts, separation agreements, equity programs, and deferred compensation relied on by other firms. As novel approaches are developed, their diffusion will be efficient, essentially a free good. The risk, of course, is that this “sunlight” will not necessarily discourage resourceful compensation practices, but illuminate them in full relief.

At the individual level, the CD&A may have established a metaphorical leader board whereby everyone can see exactly where they stand. CEOs, CFOs, NEOs, and board members will now know, on an annual basis, whose compensation is higher than theirs and whose perquisites are grander. None of us will be surprised when some of these newly educated/updated folks will argue that they de- serve the same consideration (Bureau of National Affairs, 2007a; Nocera, 2006). Thus, we will revisit – but writ larger – the Ratchet, Ratchet, & Ratchet, LLP venerable approach to compensation/perqui- sites; that is, just keep moving everyone to the 80th percentile, year-after-year-after-year.

6. Shall I compare thee to a summer’s day? The linkage between performance and compensation

William Shakespeare (1564–1616), in his 18th Sonnet, lyrically observed: “Shall I compare thee to a Sum- mer's day? Thou art more lovely and more temperate” (Folger Shakespeare Library, 2004). A delicate met- aphor, to be sure, but tactically bankrupt. With tongue only slightly in cheek, to assure a favorable comparison one must select a far less favorable com- parator. Some might contest that Shakespeare's friend was, in fact, more lovely than a summer's day. Few, however, would disagree that his friend was more lovely than a calamitous whirlwind.

In that spirit, then, we often find that people will seek a favorable comparison rather than an accu-

rate/fair one. Consider, for example, that J.C. Penney includes AT&T and Alcoa in its CD&A compensation/performance peer group. Let's just say that the basis for such a comparison is not intuitive. Consider, also, Timberland and its selec- tion of Nike in its comparisons. First, Nike enjoys approximately 10 times Timberland's revenue ($15 billion vs. $1.5 billion, respectively). More no- tably, however, we see that Timberland's CEO made $5.6 million while Nike's CEO made $5.7 million (Boyt & Mercado, 2007). That is a very favorable comparison to the benefit of Timberland. Obvious- ly, the choice of CD&A benchmarks will impor- tantly affect both performance and compensation outcomes.

There is another aspect of CD&A performance/ compensation linkages that promises to be awk- ward. Under the guidelines, the CD&A should provide benchmarks for corporate performance such that readers can determine if CEO, CFO, NEO, and board compensation is actually related to performance. This is admirable, in principle. For many firms – most, really – these comparisons will not truly be possible. Let's focus on CEO compensa- tion. Companies filing CD&As will likely rely on five- year windows. This, in and of itself, is not necessarily problematic. We all are aware of the criticisms leveled at corporations for their short-term perfor- mance perspectives, a focus to appease the analysts and others by attention to quarterly and annual performance indicators.

This five-year window, however, provides a substantial obstacle. The vexing issue is the escalation of CEO turnover rates. A recent Booz Allen Hamilton study, adding some perspective to this trend, referred to CEOs as “The World's Most Prominent Temp Workers” (Lucier, Schuyt, & Tse, 2004). The current CEO turnover rate tops 16% annually (Lucier, Kocourek, & Habbel, 2006), repre- senting an increase of over 300% in the last decade. Today, the average CEO tenure is approximately six years. Thus, we have the irony of a five-year per- formance window. On average, this performance window is moot because the company may have replaced its CEO during that period. Accordingly, the performance/compensation clock will have to be reset. Darn.

The establishment of performance/compensa- tion linkages is also compromised by other organi- zational transitions. CFO turnover, too, is at its zenith, with the current rate hovering over 17% (http://liberum.twst.com). Consider, also, the trends in boards of directors' turnover. In 2001, one year pre-SOX, the turnover rate for indepen- dent directors was 5%. For the first three years post-SOX (2002–2005), the annual turnover rate

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increased to 11.3% (Spencer Stuart, 2004, 2005a,b, 2006a,b). Now, however, the current turnover rate for independent directors is a daunting 35.7% annually (“Director Departures,” 2006). Given the specter of these accelerating transitions, the linkages between performance and compensation become difficult, if not impossible, to establish. As well, this muddies the issue of responsibility: Which CEO? Which CFO? Which NEOs? Which combinations? Against which set of performance standards? For which year(s)?

7. Trading one excess for another?

Revisiting the aforementioned “sunshine/disinfec- tant” principle, one objective of the CD&A is to facilitate a reconsideration of outsized perquisites or other financial enablements. At least in princi- ple, boards may decide that the public reporting of enablements of this kind is not in the best interests of the enterprise. There is some evidence that this conjecture is not well placed. Instead of discarding these entitlements, they are traded, presumably for others that are less in disfavor.

Some boards do seem comfortable with abandon- ing executive perks (e.g., Fortune Brands, United Technologies, Lockheed Martin), but they then increase the cash compensation of these executives “to make up the difference in value” (“Boards Purge,” 2007, p. 1). Marsha Johnson, a director for Office Depot, Lehman Brothers, and Weight Watch- ers, nicely captures this trend: “We've decided to pay the people a dollar amount, and if they choose to pay for a country club membership, then so be it”(“Boards Purge,” 2007, p. 9; see also Sasseen, 2007).

There exists yet another tactic to maintain the current value of perks for executives. Countrywide, for example, recently adopted a revised policy whereby new executives will not be reimbursed for country club memberships and fees. Extant execu- tives who are already eligible for these perks, however, will be unaffected by this policy (Hegarty, 2007).

We should also note, in defense of some boards that might otherwise be more proactive, that many elements of executives' compensation/perquisite packages are part of a formal employment contract, or severance agreement, or related documents. In these cases, without the tacit approval of those executives, these contracts may not be unilaterally revised (Sasseen, 2007). There is yet another issue that complicates the relationships between boards and executives as regards the negotiation of compensation, presently or in subsequent periods.

Often, the same compensation consultant is en- gaged by both the board and the firm's executives. Obviously, in such cases there is a moral hazard: a textbook conflict of interests (Lublin, 2007).

8. Is detailed information about compensation proprietary?

In a recent study by Watson Wyatt Worldwide (2007), it was noted that only about half of the companies reported the financial targets on which some elements of compensation are based (“Boards Torn,” 2007). They declined to disclose this infor- mation because such detailed information is, in fact, proprietary and public disclosure (especially when easily accessed by competitors) would place their companies at a competitive disadvantage. Suppose, for example, that a company's board has tasked the CEO with seeking a suitable merger/acquisition and that part of her/his compensation will depend on its successful implementation. Should such a company voluntarily disclose this information? Should the company, under the authority of the SEC's CD&A guidelines, be mandated to disclose such informa- tion? The answer to the latter question is no. In fact, the SEC has provided an exception whereby compa- nies do not have to disclose information of this type if such disclosure could lead to a competitive disadvantage. Having said that, where is the line? Who will draw it? Who will cross it?

Frankly, we wonder what performance targets would not have this character. A commitment to increase market share, for example, suggests reliance on particular strategies. Pursuing market share, for example, would not usually include increasing prices. A commitment to pursue organic growth, too, implies certain strategies. It may, for instance, suggest attempts to introduce known products into alternative markets or new products into existing markets. A commitment to enter a heretofore neglected international market would have high signal value to competitors, as well.

Another entirely rational response to the contro- versial guidelines of CD&A is interesting, and perhaps does reflect the markets in which large- scale enterprises conduct their business. Some firms (e.g., Black & Decker, Whirlpool, Centene, Anheu- ser-Busch, Northern Trust, Waddell & Reed) have essentially included a defense of their existing perquisite programs in the recent proxy statements (“Boards Purge,” 2007). The basic argument is that firms operate in a hyper-competitive market, par- ticularly given the previously mentioned increases in CEO, CFO, and boards of director turnover. A crucial element in the competitiveness of that

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marketplace includes the compensation and per- quisites for high-ranking executive officers and members of their boards. In order to obtain, incent, and retain officers and directors with experience, expertise, and reputation, certain levels of com- pensation/perquisites are an expectation without which firms will not remain competitive. Also, much of this is magnified by the insatiable appetite of private equity firms for outstanding executives to manage not only their focal firms but their acquisi- tions, as well.

9. A view from on the fence

When discussing the seemingly schizophrenic, dis- associative elements in these compensation initia- tives, we are reminded of one of the best known openings in English literature, the timeless obser- vation introduced by Charles Dickens' (1859) A Tale of Two Cities:

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had every- thing before us, we had nothing before us….” (Dickens, 1859, p. 1; see also Hauder, 2007).

For the advocates of CD&A specifically, and of disclosure and transparency more generally, these are good days. Its critics, however, are not without robust defenses. That being said, this matter is on the threshold of further controversy. The SEC, for example, has promised even higher levels of compensation disclosure oversight; among the areas of emphasis will be performance/compensa- tion goals and linkages (“SEC Prepares,” 2007). Beyond that, there is some expectation, absent reasonable attention to disclosure, that the SEC will adopt amendments that will make the requirements even more stringent.

Shareholder advocacy groups have also entered the compensation fray and have recently enjoyed some success. A proposal seeking to establish an annual advisory shareholder vote on executive compensation at Blockbuster received a majority vote (57%). It should be noted that this is a non- binding proposal; nevertheless, this is the first clear majority vote for this issue (Walton, 2007). Subsequently, a similar resolution was passed (50.18%) at Verizon Communications that also approved a non-binding advisory vote on executive compensation (Cheng & Sharma, 2007). While neither Blockbuster nor Verizon is under any

obligation to implement these resolutions, these majority votes may well be the harbinger of increased activism. Indeed, it has been estimated that some 60 shareholder proposals of this type are currently pending (Bureau of National Affairs, 2007b).

In yet another development, the US House Financial Services Committee has approved a bill (Shareholder Vote on Executive Compensation Act – H.R. 1257) allowing shareholders to have a non- binding vote on executive compensation for publicly traded companies (Bureau of National Affairs, 2007b). This bill will be sent to the Senate, where a companion bill (S. 1181) awaits.

The last chapter of this CD&A saga has not been written; indeed, it may not have been adequately outlined. Representative Ron Paul (R-Illinois), in addressing the House bill, has clearly anchored one side of the debate (Bureau of National Affairs, 2007b, p. 1):

“Giving the SEC the power to require shareholder votes on any aspect of corporate governance, even on something as seemingly inconsequential as a nonbinding resolution, illegitimately expands Fede- ral authority into questions of private governance.”

There is much yet to be said… and yet to be done. Earlier, we noted that the compliance rates for many aspects of SOX and the guidelines of the listing exchanges are near 100%. Compliance with the CD&A guidelines are nowhere near that standard. So, are we in the age of governance wisdom, or the age of governance foolishness?

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