New disclosure rules appear to have failed the ‘average’ reader
Investors aren’t happy, and company leaders are feeling the effects. Over the past two years one CEO after another left companies after questionable results for the shareholders, but windfalls for the managers. Robert Nardelli of Home Depot got a package reputedly worth $210 million. When Hank McKinnell was ousted from Pfizer, it was with $83 million in pension benefits. Now, shareholders are demanding greater information about exactly how much executives are getting paid. And the SEC agreed this year to new requirements for public companies to clearly set down how much top executives actually make.
As with most new SEC rules, little specific guidance was provided. And no one – including the companies – knew what to expect. Then came the first of the proxies … and the howls. So much for plain English as shareholders waded through thousands upon thousands of words that few ordinary humans could follow. The writing called for double-majors in accounting and securities – that is, when the information wasn’t plagued with unstated assumptions and critical performance goals withheld for ‘competitive’ reasons. Granted, it’s the first year for the new formats and panic is premature, but there are a lot of things that need fixing; companies have an enormous amount of work ahead of them.
But before casting into the future, companies have to look at the current situation. Going through proxies from the 2007 season, some patterns emerge. According to Institutional Shareholder Services (ISS), the median compensation discussion and analysis section ran 5,000 words, though some went up to a staggering 17,000.
Alas, quantity does not always beget quality. In March, SEC chairman Christopher Cox said the 40-odd proxies filed with the new CD&A weren’t ‘anywhere near to plain English’ and that ‘all fall short for readability standards.’ The SEC had found that the writing was more suited for the Harvard Law Review than Reader’s Digest.
In an interesting study, IRWebReport.com put 40 proxy CD&A sections (between 1,500 and 13,500 words) through the online Gunning-Fox readability analyzer. The CD&A scored 16.45, a value similar to academic papers. Keep in mind, writing understood by the average person receives a value of 12 or less. By contrast, The Wall Street Journal gets an 11 or 12 and the SEC’s touchstone, Reader’s Digest, ranks in at 8.
The most readable proxy came from Whole Foods, and that score was still pretty high at 14.02. Furthermore, the scale stops at 17. Given the number of proxies that topped out at this level, the average likely should have been even higher. The consensus? Yes, you literally need a PhD to understand the narratives.
Baffling them with details
Then, there is the data in the tables. ‘It’s great for compensation analysts and executive compensation consultants, because there’s a wealth of information in there, but it’s not necessarily quick and easy to extract,’ says Erik Beucler, a managing consultant of compensation consultancy DolmatConnell & Partners. And if you’re not an institutional shareholder or consultant, but the average investor, it is even harder to make any sense of the reports. ‘At best, they’re not any better off. In some areas the average investor has definitely lost out.’
For example, bonuses are tricky to navigate. One type of bonus goes into a column titled ‘bonus,’ while other types might go under ‘non-equity incentive.’ ‘I don’t think that helps the average investor, where the term non-equity incentive doesn’t mean anything,’ Beucler says. ‘In fact, that’s not even a compensation term. That’s specific SEC lingo.’
Even the professionals don’t necessarily find that the tables are clear. The change of control and post-termination table was vexing for both DolmatConnell and its clients. And the company started studying the newest round of proxy statements in part because its clients couldn’t handle the information and needed them to explain the contents of some of the already-filed proxies.
There is also the question of the usefulness of the information. ‘Our analysts said: We don’t know because of the lack of footnotes,’ Beucler says. ‘If the professionals can’t do it, it clearly says that something’s wrong.’
Shirley Westcott, managing director of policy at Proxy Governance, takes things a step further. She refers to some of the data that her organization’s analysts have seen as ‘funny’ numbers. While legally correct, the numbers don’t actually help the reader understand what is going on. ‘Like with the stock options,’ she explains, ‘In total compensation, [sometimes] you’d have negative numbers or the date values they’re submitting might include only what was vested from previous grants but offer no indication of what the compensation committee awarded the executive. And investors want to see both.
‘If you really want to understand what somebody is going to get paid when they retire,’ Wescott advises, ‘you have to go to a separate part of the report, read the narrative, and look at other tables. The fact that disclosures don’t seem to be standardized across companies means a lot of trying to digest and understand what you’re looking at.’
Spin city
Sometimes the companies are still trying to present things in the most optimistic way possible. ‘One thing I’ve noticed in some of the proxies is how many companies have made a change in a severance plan or their compensation plans, what type of equity awards they’re giving out or how many,’ Wescott says. Many companies also lack clarity in how they value stock options (like the Black-Scholes, binomial method or market value) or which equation coefficients they use. These values can make a dramatic difference on the reported value of the options.
It’s enough to make someone’s outrage organ work overtime. ‘There’s normally not any analysis of where these options come from and how many years of options are being exercised,’ says Mark Rosen of compensation consultancy Pearl Meyer & Partners. Also, the numbers only tell part of the story. Two executives may have exactly the same compensation and pension plan, but if one is about to retire, the company will look at the expenses over a shorter period. The outstanding part of compensation may be amortized differently, depending on prospective years of employment at the company.
‘You have to wonder if those kinds of changes, which were made particularly in the fall of last year were, made in anticipation of the upcoming disclosures,’ questions Wescott.
Poor guidance equals poor disclosure
And yet those involved – or whose clients are involved – in creating the CD&A and summary tables say that the situation isn’t so clear. ‘The guidelines are 500 pages worth of stuff you have to go through to figure out what you’re supposed to do,’ Rosen says. ‘I don’t see how the SEC expected us to create these one-page wonders. Let’s face it, any time we’re going to put together a filed document, we’re going to try to make sure we’re in compliance.’
Cox has stated that the length of the regulations or their complexity shouldn’t affect whether the disclosures themselves are in plain English. But being realistic, the SEC was still making ‘changes, and substantive ones’ as late as last December, according to Pat McGurn, ISS executive vice president and special counsel. That makes is hard to comply.
Not only were the final rules in play late, but the complicating factor was that most of the corporations had in-house counsel or HR personnel write and assemble the first drafts, says Jeffrey London, a partner at Reed Smith. That means each disclosure required a separate group of people to digest the regulations, discounting the possibility of creating an economy of scale. ‘Everyone is so conscious of how they’re drafting these things that people are being much too all-inclusive,’ London says. ‘But they’re really trying to follow the rules.’
Megan Gates, a partner at law firm Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, saw her clients start ‘earlier in the process than ever before.’ And then when the drafts are done and lawyers have had their say, the compensation committees themselves come in. ‘Compensation committee members are feeling a lot of pressure to understand these disclosures,’ she says. ‘There has been a lot of push-back from compensation committees I work with about how the companies are characterizing the decisions the committees have been making.’
Giving away the secret recipe
Often the committees are concerned that they are giving away too much detail about proprietary decisions. ‘It took some compensation committees by surprise, the amount of detail that companies think appropriate in response to the rules,’ Gates notes. ‘It’s surprising to some that the SEC wants to see what the compensation committee may have thought of as its own behind-the-scene discussions and thought processes laid out on a page for all to see.’ Though not supported by an extensive scientific study, a number of consultants have said that, from what they’ve seen, about half the companies are withholding specific performance measures and criteria.
The real irony comes when you consider who actually ends up reading the disclosure documents. Yes, average investors are probably scared off by the number of tables and narrative sections of novella proportions. But do they care? ‘Most individual shareholders aren’t reading the proxies anyway, and certainly not the CD&A sections,’ London says. ‘It’s the institutional shareholders who are most interested.’
And not even all of them. Kim Caughey is senior investment analyst at Fort Pitt Capital Group, which manages $1.1 billion in assets. She admits the compensation disclosure isn’t that important to her. ‘That’s not really why we buy companies, based on whether the CEO is richly paid or not,’ she says, ‘so I don’t spend a whole lot of time looking at them.’ She looks at the SG&A section of an income statement. ‘If you’re going to stress over these things, I guess to me it almost falls into the gossip and other column rather than the deciding factor of whether I’m going to buy this stock. I’d much rather have a little bit more in the 10K or 10Q in the management discussion of how things are going rather than how many flights in the private jet everybody is allotted.’
Yet the SEC insists it will get proxies written in clear English. Many involved expect this first year is just a bumpy ride, and that the SEC will probably come out with additional guidance. When that happens, you can figure on companies spending even more time clarifying explanations. So reserve your copy of Strunk and White’s Elements of Style while you can.
