April 29, 2015
Thank you, Chair White. And thank you to the staff from the Division of Corporation Finance who worked diligently on today´s proposing release, in particular Keith Higgins, Felicia Kung, and Eduardo Aleman. Thanks as well to staff from the Division of Economic and Risk Analysis and from the Office of the General Counsel.
It will come as no surprise that I wish we were all gathered here today for some other purpose. The Division of Corporation Finance has much important work to do on top of its day-to-day duties, including its review of corporate disclosure requirements and hopefully someday a much-needed review of the shareholder proposal system. The last thing we need is to spend precious time thrusting ourselves into corporate governance matters best left to state law. Unfortunately, the Dodd-Frank Act gave us certain rulemaking mandates to do just that, and unless the law can be changed we must at some point implement the mandates.
But that does not mean that we need to be doing the rulemaking now, and it does not mean that we need to be doing it in this way.
We have other, more germane congressional mandates to complete. And, better yet, there are pressing, complex issues in the equities and fixed income markets that desperately need our attention Instead of focusing our resources on those critical areas, we are taking another trudging step on the path towards completing Dodd-Frank´s — and thus the federal government´s — intrusions into the realm of corporate governance.
With respect to pay-versus-performance, we could have pursued a more rational approach. We could be proposing a performance standard requiring large registrants to disclose how they evaluate the executive compensation actually paid to the principal executive officer, versus the financial performance of the issuer. And, smaller reporting companies would be exempt. What this approach lacks in comparability, it makes up in its simplicity and in its alignment with the philosophy of our compensation disclosure and analysis requirements. Investors would be able to evaluate whether they agree with the company´s determination of what "pay" and "performance" mean, as well as the company´s assessment of the relationship between the two.
Instead, the proposed rule takes a far more prescriptive approach. "Pay" is defined in detail, with specified adjustments to existing, prescriptive compensation disclosures we mandate, to reach a calculation of "compensation actually paid." It is dubious whether that´s the most meaningful definition for every company across the board.
Today´s rule would require disclosures to be provided with respect to all named executive officers. But disclosures for named executive officers other than the principal executive officer may be unnecessary, given that the compensation "tone" for top executives is typically set by the principal executive officer´s compensation.[1] Principal executive officer-only disclosure would also obviate the problem of heterogeneous populations of named executive officers — a problem that the release seeks to address through an averaging approach that has its own issues. Finally, principal executive officer-only disclosure would be less burdensome for companies and would not sacrifice important information for investors.
The proposed rule also specifies that "performance" is to be understood as total shareholder return, or TSR, both taken on its own and as compared to a peer group TSR. To be clear, this is not because pay-versus-performance is sufficiently measured by use of TSR.[2] As a stock price-based measure, TSR may be gamed by any of the usual corporate strategies for boosting stock prices in the short term — for example, cutting spending on R&D projects to inflate net profit, or focusing resources on a corporate strategy that pays off in year 3, at the expense of one with a much larger payoff in year 10.[3] Thus, the Commission´s chosen metric risks exacerbating the current overemphasis on short-term performance at the expense of long-term shareholder value creation.[4]
Moreover, a simple TSR-based comparison is likely to produce an excessive number of false positives. It will show companies where pay seems to be out of alignment with performance, based on this simplistic metric, but where a more nuanced evaluation would show that pay is actually well-aligned with performance. In fact, ISS used to use a single TSR-based metric as an initial screening device for alignment of pay with performance.[5] But ISS recently moved to more sensitive alignment tests, noting that while 30% of companies failed the initial TSR-based screening, more than two-thirds of those companies actually exhibited alignment of pay with performance when analyzed more closely.[6] And I know that quite a few companies would even disagree with the two-thirds figure because they believe it is too low.
This means a substantial number of companies will not be able to simply make the required disclosures and move on. Rather, they will need to make a number of supplemental disclosures to explain why the required disclosure seems to show a lack of alignment. Yet even with this additional context, I worry that retail investors — the people most likely to be consuming the new disclosures given that institutional investors have access to more sophisticated metrics — will misunderstand. Specifically, I worry they will think the Commission believes TSR is the best way to measure performance, and that they will not appropriately credit the company´s explanations for why TSR has produced a false positive in the company´s particular circumstances. They will view them as excuses, rather than essential supplements to the Commission´s mandated standard.
Based on this, I believe that the release brings the wrong philosophy to bear. The fact that TSR as a measure is relevant, and that there´s nothing better that we could mandate, does not mean that we should therefore mandate its use. Rather, the more appropriate path forward would be to admit that we have not solved the very difficult question of how to align executive pay with performance. Perhaps because we shouldn´t be involved in that determination in the first place. But if we are forced to take it on, then we should give issuers the flexibility to determine how best to communicate their compensation story to investors, provided they meet the general principles set out in the statute.
I also strongly object to the inclusion of smaller reporting companies in this proposed rule. It would have been quite simple to scope them out.[7] Thankfully, emerging growth companies are not included — but only because the JOBS Act specifically carved them out. Otherwise I´m sure today´s proposal would have heaped additional disclosure requirements on them as well. We on the Commission frequently talk about facilitating capital formation for smaller companies, but sadly our actions to the contrary are shouting us down.
For these reasons, I cannot support today´s rule proposal, but I hope and expect that we will receive robust public comment on how we could have done better.
[1] See, e.g., Carol Bowie et al., ISS, Evaluating Pay for Performance Alignment: ISS´ Quantitative and Qualitative Approach (Nov. 2014) at 5 ("ISS focuses on the CEO´s pay because that package sets the "compensation pace" at most companies; also the compensation committee and board are most directly involved in and accountable for the decisions that generate the CEO´s pay."). But cf. Glass Lewis & Co., LLC, Pay-for-Performance Analysis, at http://www.glasslewis.com/issuer/pay-for-performance/ (noting that Glass Lewis looks at the top 5 executives).
[2] See also supra note 1 at 7 (stating one of the core principles for a revised method for assessing pay-versus-performance as "Use multiple measures to assess alignment. No single quantitative measure can conclusively indicate that pay and performance are aligned.").
[3] See, e.g., Roland Burgman & Mark Van Clieaf, Total Shareholder Return and Management Performance: A Performance Metric Appropriately Used, or Mostly Abused?, Rotman Int´l J. Pension Mgmt v. 5 i. 2 (Fall 2012) ("There may be situations in which TSR is positive yet there is a declining or negative return on invested capital (ROIC) and economic profit (EP), resulting in the destruction of underlying shareholder value. The reverse can also be true, such that there is negative TSR (e.g., during the most recent global financial crisis) yet the underlying business has positive and increasing ROIC and EP. TSR as a measure is not always aligned with underlying shareholder value creation."). This is not to say that the two measures advocated by these authors are the right ones either, but rather illustrates that TSR standing on its own appears to be insufficient to adequately capture firm "performance" across the board.
[4] See, e.g., Lars Helge Hass et al., Measuring and Rewarding Performance: Theory and Evidence in Relation to Executive Compensation (Oct. 2014) (report prepared for CFA Society UK, describing a difference between "value generation" and "return generation," and that measures of return generation such as TSR and EPS growth "do not necessarily align perfectly with long-term value creation"). The report highlights that UK practice shows a predominance of performance metrics capturing return generation, such as TSR and EPS growth, and a "dearth of metrics such as residual income (RI) that benchmark periodic performance against the cost of capital"; this practice "supports concerns expressed by a range of corporate stakeholders that UK corporate managers and boards may be failing to recognise the crucial distinction between paying for performance and compensating management for strategic success." The report further notes that "[t]he unintended consequences of over-reliance on narrow, simplistic performance measures that align poorly with value creation are well documented and include: investment myopia, earnings manipulation, excessive risk taking, and threats to organisational culture."
[5] See supra note 1 at 4 (noting that the "approach has utilized a quantitative methodology to identify underperforming companies — i.e., those with both 1- and 3-year total shareholder return (TSR) below the median of peers in their 4-digit Global Industry Classification Standard (GICS) group").
[6] See id. at 7 ("The current pay-for-performance screen is a binary pass/fail performance-oriented screen that is triggered for close to 30 percent of companies — less than one-third of which are ultimately determined to have a pay-for-performance disconnect of immediate concern to shareholders. The new screen is designed to provide more robust information about pay-for-performance alignment by evaluating and reporting the degree of alignment found."). As noted supra note 5, ISS´s approach is short-term in nature, focusing on one and three-year alignment; others have noted that over a three-year period TSR aligns only moderately with financial performance, but that alignment increases significantly over longer periods. See Frederic W. Cook & Co., Inc., Relative Total Shareholder Return Performance Award Report (Oct. 2014), at 1 & n.1 (noting also that "[C]ritics assert that relative TSR is not without its drawbacks. They highlight that TSR outcome is not entirely within management´s control as external factors often affect stock price and that TSR and financial performance are not always strongly correlated, particularly over shorter measurement periods."). While the 5-year period proposed to be covered by the rule is more costly than a rule that aligns with the 3-year period presented in the summary compensation table, I am cautiously optimistic that this slightly longer period may be beneficial in terms of exhibiting a greater alignment of TSR with financial performance, and generally promoting longer-term thinking.
[7] I do appreciate that the release does at least scale the proposed disclosures for smaller reporting companies, but this is more a function of the interaction of these disclosure proposals with our existing disclosure rules than any sort of solicitude for small companies.