For investors, total shareholder return is a valuable metric because it means one thing: When the company succeeds, so do they.
Can that same metric be used to validate—or discredit—how much a company compensates its CEO and executives? The Securities and Exchange Commission says yes; compensation experts are far from sold on the idea.
“TSR” is at the heart of the SEC’s proposed pay-for-performance rules, which would require public companies to disclose the relationship between the compensation paid to each named executive officer and TSR for the company. The proposed rule requires a company to disclose executive pay and performance information for itself and a corporate peer group in a table or graph, and to tag all that data in the XBRL interactive data format.
Disclosures will be based upon “realized pay”—that is, compensation data already disclosed in Summary Compensation Tables required for proxy statements, with adjustments for pensions and equity awards. Companies will also need to benchmark their TSR to that of their peers, to allow comparisons.
The concern, voiced at the time the rule was proposed and amplified since, is that TSR is a flawed metric as a compensation incentive measure, one that could reward short-term risk taking or hold executives accountable for market volatility that has nothing to do with their leadership. The problem isn’t so much TSR itself, but how it may be used as a metric for pay disclosure.
“In term of the metric that is being used in those tables, I think TSR is actually a fairly reasonable metric,” says Greg Arnold, a principal at compensation consulting firm Semler Brossy. “It ought to align well with the value that people are realizing from their equity. From that perspective, I don’t have much of an issue, but I do think, from an extended plan design perspective, there are all sorts of problems with TSR.”
“At first blush it’s intuitive: executives should win as shareholders win,” says Barry Sullivan, managing director at Semler Brossy. “The challenge is the vagaries and fickleness of the market. There may be exogenous factors that you have absolutely no control over in your management seat that whipsaw your share price and the share price of your peers up, down, and sideways. That is not a sustainable model by which to motivate and or retain high level talent.”
Sullivan appreciates the challenge the SEC had in finding a foundation metric upon which to build its rule. “What were they going to do? Build a robust performance assessment with a scorecard across key financial results, operational indicators, and market measures? That would, arguably, be a step too far,” he says. “The question is whether dipping a toe in the water and stopping short of that comprehensive assessment is worthwhile.”
He fears that the SEC may have “mucked things up more than clarified anything” and that investors will be no better off.
“The problem is that the SEC had a statute that they needed to interpret and determined it needed to somehow take into account stock price.”
Andrew Liazos Partner, McDermott Will & Emery
“It is going to be very hard for people to interpret in a meaningful way, because of the way that the time period and the pay elements are mixed and matched,” Arnold says. “There is a disconnect between the period you are evaluating performance for and the period that the pay covers. At the same time, you are not comparing the same option grants from the Summary Compensation Table to the value that is eventually realized from that option grant in the actual pay column. The whole thing is gong to be really hard and companies are going to have to write a ton of narrative around it to explain what is going on.”
Consistency of data could be problematic from year to year. “The next year you are going to have a different TSR performance period and, because it is all based on the same starting point, you could have wildly different outcomes,” Arnold says. “And then, you are trying to tell a completely different story with different data in the table.”
The problem is that the SEC had a statute that it needed to interpret, “and determined it needed to somehow take into account stock price,” says Andrew Liazos is a partner at the law firm of McDermott Will & Emery and head of its executive compensation group. “It appears that was a significant factor in the SEC proposing a TSR metric. Another significant factor was to have a rule that would apply across the board to facilitate comparisons as opposed to having sort of a principles-based kind of disclosure.”
While many believe the SEC’s proposed rule isn’t necessary for shareholders to be able to vote on executive pay, Liazos says the approach was reasonable, because companies can provide supplemental disclosures. His advice: while disclosure requirements may not be in effect for a year or two, use last year’s compensation data as the starting point for a trial run of crafting the additional disclosure narrative and charts needed to best tell your story to shareholders.
“If you don’t use TSR in your program, and the table on its face doesn’t suggest alignment, then what approach are you going to use that doesn’t mislead or give the supplemental disclosure more prominence than the regular disclosure? You want to tell your story without it becoming four to five pages of mish-mash that no one can figure out,” Liazos says.
IF NOT TSR, THEN WHAT?
The following, a selection from a client alert authored by Greg Arnold and Barry Sullivan of Semler Brossy, looks at the use of TSR for incentive compensation.
For many companies, performance-based equity has become the principal component of executive pay.
Roughly 65 percent of large U.S. companies grant performance-based equity today and half of those use relative total shareholder return (TSR) as a performance measure. At first blush, relative TSR has strong conceptual appeal — executives earn grants only when they create more shareholder value than other companies. Upon deeper review, however, relative TSR has flaws as an incentive measure.
Relative TSR rewards volatility more than steady performance. As they say, every dog has its day, and this is certainly true with relative TSR. We measured TSR for hundreds of companies over the recent 20 years and found that even long-term, bottom-quartile TSR performers can reach top-quartile heights in a given three-year measurement period—generally by ‘bouncing’ from a low share price. Further, relative TSR does little by way of focusing executives’ attention or driving behavior. Executives respond positively to incentive measures that reflect their day-to-day responsibilities. Rewards based on relative TSR are an affirmation of company success but do little to set the path to performance at the outset of a measurement period.
What then to measure? The way forward is simple: measure the clear and controllable drivers of TSR. For many companies, this will mean top- or bottom-line growth and returns on capital. Our analysis demonstrates companies that grow and do so while returning a premium above their cost of capital create superior shareholder value over time.
Source: Semler Brossy.
Although only a handful of comment letters have been received by the SEC so far on its proposed rule, many of those criticisms address the application of TSR.
Mary Maloney, associate general counsel for NACCO Industries, urged the Commission to “reconsider the burdensome and rigid approach adopted in the proposed regulations in favor of a principles-based approach.”
“Requiring the inclusion in the proxy statement of a new [pay-for-performance] table, with strictly prescribed compensation information … will potentially mislead investors and may encourage behavior designed to inflate TSR over the short-term (both in terms of earnings and the price-to earnings-ratio),” she wrote. “This is exactly the type of behavior the Dodd-Frank Act was meant to discourage and is inconsistent with growth in long-term shareholder value.”
Another complaint is one specific to her company, a publicly traded holding company whose subsidiaries are as diverse as mining companies and household electronics maker Hamilton Beach. “The incentive compensation of the employees of the NACCO parent company is based on the performance of the entire company, including all of the subsidiaries,” Maloney wrote. “However, the incentive compensation of the employees of our subsidiaries is based solely on the performance of the subsidiary that employs them.”
As a result, she said, the identity of the named executive officers in the proxy statement varies from year to year depending on the performance of the various business units. She added that the company’s diverse business lines make the selection of an appropriate peer group nearly impossible.
Maloney also pointed out that the proposed rule does not address how a registrant should address the clawback of an incentive award from a prior period.
While companies await the final pay-for-performance rule—and the forthcoming pay-ratio disclosure rule; still no word on when that might show up—Semler Brossy’s Sullivan warns about the bigger picture around compensation.
“The pace and scale of regulatory change in and around executive pay is unprecedented,” he says. “It’s a natural ebb and flow with larger economic conditions. At some point, however, we have to get back to some sort of a steady state: ‘Here is the rulebook, now go play the game.’ Generally speaking I think executive pay continues to move in the right direction. I just wonder, 10 years out, what will be the unintended consequences of these regulations be?”