Behind the Veil: How Well is Compensation Disclosure Working?

During the past two years, many senior bank executives and directors may have fretted over the vastly more extensive compensation disclosure that the Securities and Exchange Commission has implemented for officers and directors. But at least one bank executive says the greater degree of transparency is proving beneficial.

John J. Dickson, CEO of Everett, Washington-based Frontier Bank, says the greater openness has helped defuse tensions with vexed shareholders after the companyu00e2u20acu2122s stock plummeted to $16 per share in early May. Thatu00e2u20acu2122s a decline of nearly 50% compared with the $30 per share stock price the bank recorded in late December 2006. u00e2u20acu0153I was bracing myself for the worstu00e2u20ac as the annual shareholders meeting approached, Dickson admits.

But, he says, several factors tempered investorsu00e2u20acu2122 criticism. Having delivered positive returns to shareholders over the past 30 years, the $4.1 billion bank had built up a residue of goodwill. Moreover, the downturn in the banku00e2u20acu2122s fortunes was largely attributable to the countryu00e2u20acu2122s overall economic climate and not faulty management or risk taking. Frontier, for example, did not engage in subprime mortgage lending. Indeed, among corporate rankings, such as one reported last year by Bank Director using data from investment banking firm Sandler Ou00e2u20acu2122Neill & Partners, Frontier had the highest return on assets of any bank in the country in 2006.

In addition, Frontier executives and directors, while well paid, canu00e2u20acu2122t be accused of gluttony. Dickson, for example, had total 2007 compensation of $890,388, according to SEC filings. Thatu00e2u20acu2122s a respectable six-figure pay package, but itu00e2u20acu2122s not in the same league with Fortune 500 CEOs whose yearly earnings, at 25-50 times that amount, make them as well paid as Hollywood superstars or top professional athletes.

Perhaps most important to tamping down criticism, however, was Frontieru00e2u20acu2122s pay-for-performance compensation formula. With the clearer SEC rules in effect, the read-it-and-weep information in the proxy statement was more readily available. u00e2u20acu0153If you multiplied the number of shares the directors and officers owned times the stock price,u00e2u20ac Dickson says, u00e2u20acu0153youu00e2u20acu2122d see that our net worth had decreased by about $69 million over the last year.u00e2u20ac

Indeed, as spelled out in the proxy statement, Dicksonu00e2u20acu2122s own wallet had taken a serious hit. At $29.83 per share, the 3,600 shares in Frontier stock granted to Dickson in 2007 were originally valued at $107,388. But by late May 2008, when the company stock price had tumbled to $14.3 per share, his grant was worth $51,480, roughly half as much. u00e2u20acu0153Shareholders are upset with the drop in prices,u00e2u20ac he says, u00e2u20acu0153and weu00e2u20acu2122re in it with them. We feel their pain.u00e2u20ac

Embedded in Dicksonu00e2u20acu2122s discussion with his shareholders are two important compensation principles advocated by shareholder groups, corporate governance activists, governmental policymakers, and other interested parties. A significant portion of compensation, these groups say, should be u00e2u20acu0153risk-basedu00e2u20acu00e2u20ac”that is, paid out in equity payments and stock option awards, thus aligning a corporationu00e2u20acu2122s management and directors with its shareholders. And the entire compensation program should not only be clearly outlined and meaningfully explained but the disclosure should describe the companyu00e2u20acu2122s overall compensation objectives by spelling out not only what is paid out but why.

To that end, the SEC promulgated a new round of disclosure rules in December 2006. Although the new rules first went into effect last year, it was only this year that proxy statements governed a full calendar year.

Among other things, the SEC insists that a public companyu00e2u20acu2122s proxy statement include a summary compensation table for each of the top five executive officers. In tabular form, the proxy statement should list the dollar values of base salary, bonuses, and stock and option awards granted during the previous year; nonequity incentive compensation; changes in pension value and deferred compensation earnings; u00e2u20acu0153all other compensationu00e2u20ac; and total compensation for the fiscal year.

In addition, the proxy statement requires a new section known as the Compensation Discussion and Analysis, or CD&A. In it, companies must now lay out in plain English the companyu00e2u20acu2122s overall compensation objectives and the rationale behind its compensation formula.

JPMorgan Chase & Co., for example, writes the following under the heading u00e2u20acu0153Philosophy and approachu00e2u20ac: u00e2u20acu0153Our compensation system plays a significant role in our ability to attract, retain, and motivate the highest quality workforce. The principal underpinnings of that system are an acute focus on performance, shareholder alignment, a sensitivity to the relevant marketplace, and a long-term orientation.u00e2u20ac

Paula Todd, a compensation expert at consulting firm Towers Perrin in New York, says simply by insisting that companies spell out how they pay their top people, the SECu00e2u20acu2122s narrative requirement is having a salutary effect. u00e2u20acu0153With 10 to 15 pages now given over to CD&A,u00e2u20ac she says, u00e2u20acu0153you have to write about why you do things, which means that you have to give it a little more thought.

u00e2u20acu0153So now people are rethinking things like pensions, perquisites, deferred compensation, and severance payments that are not aligned with performance. People are asking, u00e2u20acu02dcWhat happens if the CEO is fired or dies?u00e2u20acu2122 Those are things that people werenu00e2u20acu2122t thinking about as much before. I think thatu00e2u20acu2122s healthy.u00e2u20ac

The SEC has proven a stern taskmaster. After the regulations had their first run last year, the agency sent out letters rebuking some 350 companies for their inadequacies. And companies have responded, says Derrick Neuhauser, a senior manager in the executive compensation practice at accounting firm BDO Seidman, who notes the voluminous growth in pages at some companies to as many as 30 to 40 pages, up from just four to six pages a couple of years ago. u00e2u20acu0153The SEC was disappointed in what [some companies] disclosed last year. But I really think that companies are putting a lot of effort into this now.u00e2u20ac Stock option awards in particular are more understandable, Neuhauser says. Before last year, he notes, it was necessary to move between the proxy statement, where the stock option rewards were cited, and the 10-K, where their value was explained, in order to gain a full picture.

Yet for those shareholders and corporate governance activists who had hoped the new disclosure rules would put a dent in bloated executive compensation, most experts say that such expectations are mostly wishful thinking. In early April, New York-based compensation consulting firm Pearl Meyer & Partners issued a study of the effects of the SEC disclosure rule on 124 public companies, along with a press release bearing the telling headline, u00e2u20acu0153More Proxy Disclosure Wonu00e2u20acu2122t Mean Less Pay.u00e2u20ac

Essentially, the consultancy found that the SECu00e2u20acu2122s rules were hastening the trend toward linking compensation with corporate performance and shareholder value. Yet the disclosure policies were not u00e2u20acu0153dramatically transforming the compensation landscape.u00e2u20ac

Says Towers Perrinu00e2u20acu2122s Todd: u00e2u20acu0153Companies have to disclose and describe more, but I donu00e2u20acu2122t think thatu00e2u20acu2122s radically changed compensation programs. Youu00e2u20acu2122re seeing small adjustments, but nothing radical. I donu00e2u20acu2122t think disclosure rules have changed compensation levels, although companies might have pulled back on some things.u00e2u20ac

Director compensation seems little influenced as well. In a statement to Bank Director, a media relations manager at BB&T in North Carolina reported: u00e2u20acu0153Our approach to director compensation has not changed because of the new rules. In 2007, each nonmanagement director of the corporation received a $50,000 annual retainer, $50,000 in equity awards, and $1,500 for each board and assigned committee meeting attended by the director.u00e2u20ac A chairu00e2u20acu2122s fee of $10,000, $5,000, and $2,500, respectively, was paid to the chairs of the audit, compensation, and corporate governance committees for service during 2007.

Despite the added pages of charts, extra verbiage, and promises of u00e2u20acu0153plain English,u00e2u20ac the chore of making sense of the proxy reports has actually gotten harder. Pearl Meyer reported that the reading comprehension level required to evaluate the 2008 proxy reports rose to that of a college junior, up from a college sophomoreu00e2u20acu2122s reading level last year.

u00e2u20acu0153The SECu00e2u20acu2122s goal was for the proxy statements to be clearer,u00e2u20ac says Susan Ou00e2u20acu2122Donnell, a managing director in Pearl Meyeru00e2u20acu2122s Boston office and a banking industry compensation expert. u00e2u20acu0153But while there is more information, itu00e2u20acu2122s just not easy for people to get a handle on what it all means. It really requires further analysis.u00e2u20ac

By all accounts, however, the new SEC rules have had one significant impact: They are sounding the death knell for many perquisites. Country club memberships and other privileges that were once naturally accorded are fast disappearing. u00e2u20acu0153Old School perquisites like club dues, which are completely indefensible, and cars and driversu00e2u20ac”unless they are for security purposesu00e2u20ac”[have definitely] been impacted the most by the additional layer of transparency,u00e2u20ac asserts Patrick McGurn, special counsel at RiskMetrics Group, a consulting and research firm based outside Washington, D.C. that advises shareholders. u00e2u20acu0153A lot of companies either curtailed or limited the perquisites they had offered.u00e2u20ac

Under the new rules, companies are required to disclose perquisites of $10,000 or more. But proxies are now filled with statements abjuring all such u00e2u20acu0153alternate compensation,u00e2u20ac which seem to be acquiring a certain taint. BB&T of North Carolina declared in an e-mail statement to Bank Director magazine: u00e2u20acu0153BB&T does not provide executive management with perquisites such as personal club memberships, vacation houses or apartments, personal travel on corporate aircraft, or similar perks.u00e2u20ac

But McGurn reports that while u00e2u20acu0153a lot of the low-hanging fruit has largely disappeared,u00e2u20ac some perquisites persist. Corporate aircraft, he says, remains u00e2u20acu0153the most problematic.u00e2u20ac JP Morgan Chase & Co., for example, offers this declaration: u00e2u20acu0153The CEO is required to use firm aircraft and automobiles whenever feasible for business and personal travel and the firm augments other security measures for the CEO.u00e2u20ac

Says McGurn: u00e2u20acu0153Companies will argue the issue of security, [but] I think investors are seeking some level of reimbursement.u00e2u20ac

For her part, Towers Perrinu00e2u20acu2122s Todd says the disclosure rules are prompting companies to think twice about appearances. Aircraft privileges, for example, are a prime area. u00e2u20acu0153A company Iu00e2u20acu2122m familiar with had a board meeting planned in China and they planned to invite spouses,u00e2u20ac she relates. u00e2u20acu0153But then there was the question of including children and whether the nannies could come, too. And suddenly the company realized they would have to disclose tens of thousands of dollars in travel in the proxy. So they decided to make it u00e2u20acu02dcdirectors only.u00e2u20acu2122 The disclosure rules really opened their eyes.u00e2u20ac

Other perquisites increasingly drawing fire are u00e2u20acu0153gross-ups,u00e2u20ac in which the company provides an executive or director an allowance to cover taxes on compensation or perquisites. u00e2u20acu0153It has that Leona Helmsley scent that u00e2u20acu02dconly little people pay taxes,u00e2u20acu2122 u00e2u20ac McGurn says. And consultants and compensation critics alike agree that golden parachutesu00e2u20ac”officially referred to in proxy statements as u00e2u20acu0153severanceu00e2u20ac payments and u00e2u20acu0153change-of-control arrangementsu00e2u20acu00e2u20ac”are increasingly a target for shareholder disgruntlement.

So far, however, efforts at curtailing golden parachutes havenu00e2u20acu2122t fared too well, says David Pardys, a partner in the Philadelphia law office of Reed Smith. u00e2u20acu0153There are several places in the tax code on limitations of change-in-control payments, and yet that doesnu00e2u20acu2122t stop people from getting [them],u00e2u20ac he says.

Even if perquisites are vanishing from view, compensation experts note thereu00e2u20acu2122s a certain amount of sleight of hand occurring. Says Pardys: u00e2u20acu0153Shareholders can grab on to things like the use of airplanes and other perquisites worth $50,000. But while eliminating the perquisite, the company may raise the base pay to $800,000 from $750,000. Itu00e2u20acu2122s easier to just pay cash than provide a perquisite that you have to disclose.u00e2u20ac

Still, cash payments remain one of the more recognizable areas. Ou00e2u20acu2122Donnell, the Pearl Meyer consultant, stresses that even with the new disclosure rules, the promise of transparency is far from realized. Consider, for instance, the proxy statementu00e2u20acu2122s compensation disclosure for James (Jamie) Dimon, CEO and chairman of JPMorgan Chase.

Perusing the 18 pages of compensation disclosure in the latest proxy statement on Dimon, his four top lieutenants, and 11 fellow directors, the reader finds the company compares its own pay formula with the SECu00e2u20acu2122s new requirements. Doing it the old-fashioned way, JPMorgan Chase reckons that Dimon got a pay hike in 2007 of 11% to $30 million, compared to $27 million in 2006.

But computations using the SECu00e2u20acu2122s u00e2u20acu0153summary compensation tableu00e2u20ac finds Dimon earning about $2.2 million less moneyu00e2u20ac”$27,797,275u00e2u20ac”in 2007 than did JPMorgan Chaseu00e2u20acu2122s own calculations. Footnotes in the proxy statement indicate that different accounting treatments account for much of the disparity.

Ou00e2u20acu2122Donnell says, among the differences, the SEC figures represent the expense to the company in accounting terms for fiscal years 2006 and 2007. She also notes that the SEC figures give consideration to the vesting schedule of restricted stock grants and whether stock options are actually exercised. u00e2u20acu0153When you vest in a stock option, [that] doesnu00e2u20acu2122t mean it will show up in your W-2.u00e2u20ac

Whatever the calculations, the move in the direction of a performance-based metric is generating friction between shareholders and executives and directors in the banking and finance sectors. In the wake of the subprime mortgage crisis and a general economic slowdown marked by weakening consumer demand, higher food costs, and $4-a-barrel oil, the financial services sector is among the industries experiencing the most pain. Witness the heavy financial losses and resignations at the top of Merrill Lynch and Citigroup, as well as the total collapse of Bear Stearns.

Last year financial institutions performed well until summer, which entitled top executives at many banks and thrifts to stock and stock options awards, notes Bruce Brumberg, editor-in-chief of mystockoptions.com., a Boston-based educational source on stock option and equity plans. u00e2u20acu0153And now itu00e2u20acu2122s coming out in proxy statements that they were vested and made money. Shareholders are taking a hard look at that and saying thereu00e2u20acu2122s incongruence there.u00e2u20ac

In mid-April, shareholdersu00e2u20acu2122 ire bubbled over at the annual meeting of Washington Mutual, the countryu00e2u20acu2122s largest savings-and-loan association, whereu00e2u20ac”following losses of $1.14 billionu00e2u20ac”the thriftu00e2u20acu2122s stock price nosedived from $44.66 a share last May to a low of $8.72 this spring. Angry shareholdersu00e2u20acu2122 forced the resignation of Mary Pugh, the chair of WaMuu00e2u20acu2122s finance committee. Aggrieved shareholders also confronted Kerry Killinger, CEO and chairman, accusing him and his team of running the bank into the ground and, by a 51% nonbinding vote, demanded that he surrender his position as chairman. In early June, Killinger acceded to shareholder pressure and, while remaining CEO, gave up the title of chairman (a position he had held for 17 years) to WaMuu00e2u20acu2122s lead director, former utility-industry executive Stephen Frank.

Following the tumultuous meeting, Killinger agreed that u00e2u20acu0153credit-related targetsu00e2u20ac would be included in the metrics used to construct executive compensation in 2008, according to the Wall Street Journal. After viewing the conflict at Washington Mutual on a webcast, one close industry observer remarked: u00e2u20acu0153It was an emotional scene. And I really think the disclosure of executive compensation fueled the anger.u00e2u20ac

With more compensation at risku00e2u20ac”BB&T, for example, says 75% of its senior executivesu00e2u20acu2122 compensation is u00e2u20acu0153tied to corporate performanceu00e2u20acu00e2u20ac”the combination of punishing market forces and spirited shareholder engagement are having an effect after all. u00e2u20acu0153Pay packages are down in general,u00e2u20ac says Ou00e2u20acu2122Donnell of Pearl Meyer, u00e2u20acu0153but that has to do with [the] performance of the banking industry. Stock prices are down. And when the industry is down, the incentives are down as well. Stock option and equity awards are not being granted.u00e2u20ac

u00e2u20acu0153More disclosure means more shareholder focus on directorsu00e2u20acu2122 behavior and more accountability,u00e2u20ac asserts Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware. Hailing the SECu00e2u20acu2122s reforms, Elson adds: u00e2u20acu0153Now shareholders will be able to take their concerns straight to directors.u00e2u20ac Only time will tell what the overall influence these actions will have on board decisions in the months to come. One thing is for sure, however: Those decisions will be transparent in next yearu00e2u20acu2122s proxies for the world to see.