Top News December 28, 2006, 10:05PM EST

Investor Outcry Over Exec Pay Retreat

Shareholder groups are upset that the SEC has backtracked on how some executive compensation will be reported

by Moira Herbst

Investor groups expressed outrage on Dec. 27 over a decision by the Securities & Exchange Commission to modify the rules for disclosing executive compensation at publicly held companies. In July, the SEC, investors, and companies had hammered out an agreement to make much clearer to shareholders how much top executives were getting paid, including everything from salary to stock options to perks. But late on the Friday before the Christmas weekend, the SEC reversed one component of that agreement, allowing companies to spread the cost of a stock-option grant over several years instead of counting it all in one year.

"We are disappointed that the SEC's landmark rule on exec compensation transparency has been rolled back in any way," said Christianna Wood, senior investment officer for global equity at the California Public Employees' Retirement System (CalPERS), which oversees $200 billion in assets and has long been active in shareholder rights efforts. "Shareowners have the right to know what they are paying American executives. This modification by [SEC Chairman Christopher] Cox serves to artificially understate executive compensation and reduce the transparency that shareowners fought hard to win."

Avoiding Sticker Shock?

The compromise reached in July was designed to let shareholders see at a glance all of the compensation top executives received, and it was set to go into effect for most of the proxy statements that will be sent out this spring. The central part of the effort is a Summary Compensation Table that would have added up all compensation.

Now, however, the SEC says it will allow companies to divide the value of stock-option grants over a number of years, based on how long it takes them to vest. Under the original rules, an executive who received a stock-option grant worth $10 million that vested over four years would have to report all of the $10 million the year of the grant. Under the modified rules, he will report only $2.5 million the year of the grant in the Summary Compensation Table and the same amount for the next three years. The full value of the grant will be disclosed, but it will be relegated to the less-prominent Grants of Plan-Based Awards Table.

Investor groups are upset because they believe the change was made to relieve companies of the sticker shock the original rules might have produced. "We're concerned the amendment will make the numbers look smaller than they really are," said Jennifer O'Dell, assistant director of corporate affairs for the Laborers' International Union of North America, or LIUNA, which holds an estimated $30 billion in assets and was among those pressing the SEC for the new disclosure rules. "Our No. 1 concern is transparency, and ensuring that trustees have a clear view of companies' worth. We're concerned this change will interfere with a true telling of the numbers."

Timing Stirs Questions

The timing of the rule change raised as many questions among shareholder groups as the change itself. Because the modification was announced late on Dec. 22, many were unaware of it until days later, and few feel that they have any way to mount an opposition movement in the middle of the winter holidays.

The SEC and supporters of the rule change say there's nothing nefarious going on. Rather, the commission is making the adjustment because it's a more accurate way to measure executive pay. "The object is to report accurate numbers," said SEC Chairman Cox, in an e-mail statement. "Artificially inflating executive pay, or reporting 'phantom' pay that will never be received, is just as misleading as routinely under reporting it, which was the case before we adopted the new executive compensation rules in July. The Financial Accounting Standards Board worked hard to get stock options expensing right, and insuring that the same figures are used in executive compensation tables will provide the maximum clarity and consistency for investors. The rule as adopted in July could have created confusion because it would have treated executives with vastly different compensation as if they were paid identical amounts."

Cox further explained: "Consider the case of two executives who both receive $5 million option packages that vest in four years. If one executive leaves the company five years later, she receives the full $5 million, while the other, who leaves in three years, would receive no compensation from the options. Yet under the old rule, the reported compensation for both would be the same—seriously misleading investors."

"More Realistic Picture"

Some executive compensation analysts say the amendment makes sense, as it allows the reporting of stock and option awards to conform to financial accounting practices. "I think it's a more realistic picture of what's happening on an annual basis," says Deborah Lifshey of compensation consulting firm Pearl Meyer & Partners. "Putting in bloated numbers doesn't give an accurate view of the value of these options. It's not a case of hiding compensation," added Lifshey, who said the amendment announcement was a surprise to her.

Still, powerful investor groups say they feel the amendment is against shareholders' interests. Damon Silvers, associate general counsel of the AFL-CIO, whose member unions' funds control $400 billion in assets, had not read the full report of the amendment, but said: "Most investors favored disclosure of the entire amount of an option grant at the time of the grant. The Commission correctly notes that their treatment is consistent with accounting rules. However, most investors think that the reality of executive compensation is better expressed by disclosing grants when they occur." Silvers said he could not comment further until he read the entire report outlining the amendment.

Whether investor groups will have an opportunity to have the rules changed once again remains unclear. The SEC said it would have a 30-day period for public comment. However, it also said that the rules, as modified on Dec. 22, are final. "We'd like a chance to change the amendment, but it doesn't look like we'll have one," said O'Dell.

Herbst is a reporter for BusinessWeek.com in New York.