Executive Compensation New Proxy Disclosure Rules Enhance the Pay Role of HR
As human resources executives take the lead in the proxy disclosure process under the SEC's new executive compensation rules, they are entering a new era of responsibility and engagement with the board of directors.
As head of human resources for the Hudson Highland Group, Margaretta Noonan was on the bleeding edge for submitting new proxy statements under the Securities and Exchange Commission’s executive compensation disclosure rules.
“No one has done these before, so there are no models, and it’s all new work,” she says of Hudson, which operates along a calendar year.
Like other top HR executives across the country, Noonan took the lead in drafting the required compensation discussion and ana¬lysis (CD&A) narrative and pulling together data for the tables. Hudson’s proxy statement weighs in at 39 pages. In many ways, Noonan produced the statement under optimal conditions, and Hudson is well positioned to withstand the scrutiny of shareholders who pore over the proxy of the Nasdaq-traded recruitment and talent management company. Noonan has an excellent relationship with the com- pany’s compensation committee, and Hudson’s executive compensation policies and practices are clear and easily defensible.
But other HR executives are struggling to draft the statements and are bracing for the new wave of criticism that will rain down on executive compensation as companies reveal the details of their executive pay packages, the total compensation paid and the peer group companies they use for benchmarking.
At the same time, the most forward-looking HR executives are using the proxy statement process to solidify their work at the top of the organization and draw attention to HR’s contribution to meeting corporate objectives.
“The new proxy disclosure rules have dramatically enhanced HR’s role,” says Ira Kay, global leader of the compensation practice at Watson Wyatt Worldwide. “At most companies, HR is either driving the proxy process or partnering with the general counsel.
“Prominent SEC attorneys have told me that HR should take leadership in the disclosure process because the rules require that companies tell their story and explain why they adopted their compensation policies. Lawyers don’t know the story.”
The next step in the proxy pro¬cess will hit as employees, shareholders and the media view the statements and ask for explanations of the levels of executive compensation, the relationship between pay and performance, and the purpose of non-performance-related elements in the package. HR executives will need an action plan for addressing these issues and communicating with stakeholders about the proxy information.
Deep in the proxy process
Hudson, with $1.4 billion in annual revenue, was in the first group of companies to fall under the new SEC rules, which apply to the fiscal year ending on or after December 15, 2006. The rules require disclosure of all forms of executive compensation, ending with a total compensation dollar amount that can be compared across companies, plus a compensation discussion and analysis section written in “plain English.”
“The arduousness of the task depends on how good the company’s systems and processes are,” says Doug Jensen, vice president and U.S. executive compensation practice leader for the Hay Group. “If they are in good shape, the company can simply pull all of the information out of those files. And if the company has already clearly articulated its compensation philosophy, it will be prepared for drafting the CD&A.”
At many companies, the proxy process will now begin in HR because it has the broadest knowledge of all the elements of compensation, notes Diane Doubleday, leader of Mercer Human Resource Consulting’s global executive remuneration business. The proxy materials will then move to finance, with its expertise in performance metrics and its awareness of and contact with Wall Street, and then to legal to ensure that there are no misleading statements so the proxy statement meets the regulations.
“HR tends to have strong project management skills and basic competencies that can help in the proxy process,” Doubleday says.
Hudson followed this basic approach. As executive vice president and chief administrative officer, Noonan leads the global team of HR and legal professionals throughout all divisions of Hudson and is also the primary staff person assigned to both the compensation committee and the nominating and governance committee. Noonan wrote the first draft of the CD&A narrative.
Noonan then circulated the completed draft to the internal legal team, the CFO and accounting, then sent it to Hewitt Associates, Hudson’s independent compensation consultancy, and to outside counsel. Then, over a five-day period, Noonan met with each compensation committee member to discuss the draft and get comments. With all the comments incorporated, the draft went to the board for approval.
Noonan’s work on the proxy statement benefited from the fact that Hudson operates with a board of six members with industry expertise, and the compensation committee includes John Haley, president, CEO and chairman of the board at Watson Wyatt Worldwide. Because the company’s business line is talent management, its executives and directors are well versed in compensation issues. Also, as a relatively new company, it can set policy without legacy hangovers. Hudson spun off from TMP Worldwide, Monster’s parent company, in April 2003.
The stated objective for the compensation committee at Hudson is to target market medians for base salaries, equity grants and benefits, with cash bonuses set above market medians for above-median performance. Exec- utives do not receive some of the most controversial forms of compensation, such as pensions and private jets. The company’s performance expectations are clearly articulated in incentive pay plans and stock ownership guidelines that call for ownership equal to 100 percent of base salary.
“We set executive compensation rules from the beginning and it all flows from that,” Noonan says. “The board members have the technical knowledge to design and implement our compensation policy. It all comes down to having the right people on the board and building the best relationships you can with them.”
Noonan prepares all the materials that go to the compensation committee, works directly with the chair to construct agendas, attends all committee meetings and executes the decisions made. Her work internally is to apply the philosophy set by the compensation committee and ensure that the same thinking is pushed down through the organization.
“The new disclosure rules have made the work of HR executives much tougher, and they are putting in tremendous hours,” Jensen says. He notes that initial feedback from the SEC, which has now seen the first group of proxy statements under the new rules, is that there is still “too much lawyer” in the statements.
“We are expecting more feedback and comments from the SEC with respect to the ‘plain English’ requirement, and individual companies will be hearing from the SEC about the proxy statements they have submitted,” he says.
Experts agree that the new proxy statements will generate extensive comments from shareholders.
“A new wave of criticism of executive pay will ensue, especially when shareholders see for the first time the cost of pensions and severance plans,” Jensen says. The new proxy statement for Johnson & Johnson, for example, values the CEO’s pension and deferred compensation at a staggering $64.2 million.
“The two gorillas in the executive compensation controversy now are supplemental pensions and severance pay,” Watson Wyatt’s Kay says. “We are advising boards to protect incentive pay but make everything else open to negotiation and to consider replacing or trimming back supplemental pensions and severance.”
The new proxy statements will also revitalize the demand for clear links between pay and performance. Citigroup’s new proxy reports total CEO compensation of $26 million, including a bonus of $13.2 million, up from $12 million in 2005. The new proxy statement may fuel pressure from shareholders who watched profits drop more than 12 percent in 2006.
Home Depot and Pfizer are two examples among dozens in 2006 where the CEOs were dismissed when their high pay did not reflect strong corporate performance. Almost one-third of CEO departures are performance-related involuntary terminations, according to consultancy Booz Allen Hamilton.
Compensation committees will also be more closely scrutinizing all parts of the package. Along with shareholders, committees will be able to see the amounts at the end of the charts and make direct comparisons with peer companies. “It will give compensation committees better information to make more strategic decisions,” Jensen notes.
Because of the new proxy statements, HR leaders will have to prepare internal communications to explain executive compensation to employees, including managers that are only one level down from the top executives.
“HR executives must be thoroughly versed in all elements of the proxy disclosure and very comfortable in telling the story both internally to employees and externally to shareholder groups,” Jensen advises. “HR executives need to be the business partner with the general counsel, the CEO and the board to explain metrics and plan design.”
HR executives also need to be prepared to understand and communicate the value of a CEO with a proven track record for meeting performance targets. In addition, they will need to manage the expectations of shareholders and employees who often assume that executive compensation is excessive. For any position, setting and defending the level of compensation begins with an analysis of the supply of available talent.
Jensen advises HR executives to sharpen their understanding of the labor market for CEOs and be ready to explain why they set competitive position where it is and the reasoning behind the selection of the peer group companies. The best practice for HR executives is to use the market as a reference point, but also add to that a thorough explanation of where the leadership is trying to take the business and how the company’s executive compensation programs fit into the company’s objectives and goals.
Median CEO tenure dropped to 5.5 years in 2006, down from seven years in 2005, according to Challenger, Gray & Christmas. “The investing community is so tough on CEOs that they react very quickly to what they see as nonperformance,” Jensen notes. In addition, private equity firms are pulling more CEOs away from public companies with offers that may double or triple the CEO’s earnings.
“The labor market for CEOs is working extremely well, much better than the critics would have you believe,” Kay says. “Pay for performance is in place and working well as long as you understand it as realizable pay, which includes the in-the-money value of stock options and not pay opportunity, which is the definition used by many critics.” Realizable pay levels for CEOs correlate extremely well with company performance, according to extensive data from Watson Wyatt.
Although experts advise companies to control executive compensation costs through strong succession planning, boards may be forced to pull in outside talent for a number of reasons. In addition, research from Booz Allen Hamilton indicates that outsider CEO performance is higher than insider CEO performance for the first four years of tenure.
“Despite all the bad publicity, boards still offer large packages to new CEOs because the stakes are so high,” Kay says. “The right CEO can bring huge amounts of market cap to the company. If a Fortune 100 company needs to replace a CEO, there are probably only a dozen candidates available, and the realistic pool is probably three people.”
When Gap Inc. removed CEO Paul Pressler for poor performance in January, the company announced it would seek a replacement with deep retailing and merchandising experience in apparel and a track record for financial discipline.
“There’s no question that there is a terrible shortage of CEO talent in most sectors,” Jensen says. “The CEO position is one of the toughest jobs in the country, and people with a proven track record in the position are rare. And they can have an impact on billions of dollars.”
The real issue is pay for performance and whether the company is getting the results it wants from the executives, Jensen says. The savviest investors will put more pressure on companies to demonstrate the performance link.
As the driving force behind the new proxy statements and the “plain English” spokesperson for executive compensation policies, HR executives can perform a critical service for the board, shareholders and employees by articulating pay policies, explaining the links to company performance and educating stakeholders about the labor market conditions that ultimately determine executive pay. It’s a much larger and far more important task than HR has shouldered in the past.
Workforce Management, April 23, 2007, p. 25-29 — Subscribe Now!