Recently, the WSJ had an article by Phred Dvorak on the complexity of the recent proxy disclosures on Executive Compensation : "(New Math) x (SEC Rules) + Proxy=Confusion". The article cited examples of comically complex compensation formulas. The proxy for Novel
tosses around such terms as "assigned weighted quantitative performance objective achievement percentage," and describes a two-step process for calculating executive bonuses: First: "Bonus Funding Percentage x Weighted Quantitative Performance Objectives Achievement x Qualitative Performance Factor = Performance Factor." Then: "Performance Factor x Target Bonus Percentage x Base Salary = recommended Bonus Amount."
Anyone who works on executive pay issues is painfully aware of the convoluted language in proxies; we have to wade through hundreds of them annually. Overly complex descriptions of company compensation programs is not a new issue. In 1992, the SEC started requiring the tables currently found in proxies describing, in quantitative terms, every element of executive compensation. The idea was that since the previously required narratives were practically unreadable, the tables would at least give an investor some idea of the magnitude of the compensation numbers.
Maybe some of the good government-types thought that the new executive compensation rules published by the SEC in late 2006 were going to simplify things. According to the rules, companies are to use plain English to provide investors with a clear idea as to how executive compensation is set. The fact that the SEC has to devote a page or two of its regulations to define what they mean by plain English is a clue that, perhaps, the natural inclination of preparers of financial information is not always towards illuminating the investor on company affairs.
I give the companies a bye on the sheer amount of information they have thrown into the proxies related to executive compensation. My unscientific survey shows that companies take an average of twelve single-space pages to explain its executive compensation approach, philosophy and pay practices. And why not. From a company's perspective, there is no incentive for providing a concise version. The SEC is never going to bring a company up on charges of violating its rules by disclosing too much information. But there is a real risk of leaving something out that is deemed material now that the CD&A is considered part of a company's formal financial reports and subject to CEO/CFO Sarbanes-Oxley Certification.
What concerns me is not the length of the descriptions but the complexity of many of the compensation programs I have reviewed. I can see two reasons for this, neither of which shines a positive light on management:
- The Plans are, in fact, so complex that an experienced compensation professional has to read them multiple times to understand what they pay out and under what circumstances. If that is the case, can the executives themselves understand what they are supposedly being incented to do?
- Management purposely obscures its executive compensation plan through lengthy and convoluted proxy language because it is embarrassed by its practices.
Based on my experience, the first rationale is the primary reason for complex language. Despite all the compensation consultants hired by management and despite the fact that some of the brightest people I have ever met run large public companies, executive compensation programs are often a mess; poorly thought out, communicated and executed.
Beyond complexity, the major flaw I see in executive compensation design is too much emphasis on short-term profit sharing. Many, if not, most annual incentive plans primarily reward a measure related to corporate- or division-wide profitability. But, at the executive level, profits are created over a period of time by making the right decisions and through actions aligned with a strategic plan. And that period of time does not always coincide nicely with the annual accounting cycle. Short-term incentive plans are best designed to reward actions and behaviors that can be monitored in an annual period. Not results.
In the end, results are all that count but they are best left to rewarding over a three to five year period through stock option, grants of restricted stock and performance unit plans.
We cannot blame the SEC for poor executive compensation design. Yes, if it makes all the lawyers feel better, throw the kitchen sink into your proxy. But an effective compensation program is simple to understand and will reward short-term what can be measured short-term and long-term what can be measured long-term.
