The Impact of the Dodd-Frank Act on Executive Compensation

Proceedings of The National Conference On Undergraduate Research (NCUR) 2012 Weber State University, Ogden Utah March 29 31, 2012 The Impact of the Dodd-Frank Act on Executive Compensation Sam Liu Department of Accounting Temple University Fox School of Business and Management Philadelphia, Pennsylvania 19122 USA Faculty Advisor: Dr. Steven Balsam Abstract Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) on July 21, 2010, which became effective for shareholder meetings held on, or after January 21, 2011. The Dodd-Frank Act requires U.S. public companies to conduct an initial advisory, non-binding vote on executive compensation called say-on-pay and a subsequent vote on the frequency of say-on-pay. This study investigates the voting pattern of the say-on-pay and the say-on-frequency and examines the impact of the Dodd-Frank Act on the amount and structure of executive compensation. The say-on-pay and say-on-frequency patterns of over 1,700 companies from the ExecuComp database are investigated using the U.S. Securities and Exchange Commission Forms DEF 14A, 8-K, and 10-Q. A further study of S&P 500 companies, from 1992 2009, found in the Wharton Research Data Services is used in the regression analysis to forecast executive compensation. Results show that 98% of the sample firms are supported by a majority of shareholders who voted on executive compensation, while 2% of the sample firms failed the say-on-pay. Preliminary results show that 60% of companies initially recommended every three years as the preferred say-on-frequency, while the shareholders voted in favor of every one year (90% of the companies). However, company recommendations for say-on-frequency have grown from 60% in favor of every three years in March 2011 to 63% in favor of every one year in December 2011, suggesting that companies are responding to shareholder pressure. Further results indicate that executive total cash compensation (salary plus bonus) has been decreasing since 2006. Additional analyses, comparing 2010 to 2009 total cash compensation, show that firms reduced total cash compensation in 2010 prior to the advisory vote on executive compensation. Keywords: Executive Compensation, Dodd-Frank Act, Say-on-Pay 1. Introduction Executive compensation is widely believed to be the cause of our economy s turmoil. 10 Despite the financial crisis in the United States, executive pay has continued to rise over the years. To address the public outrage in executive pay and the lack of transparency in compensation packages, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) on July 21, 2010 which, among its many provisions, mandates a series of compensation reforms. 9 Say-on-pay, a provision of the Dodd-Frank Act, entitles the shareholders of public companies to have a non-binding, advisory vote on executive compensation and the frequency of votes on executive pay. In addition to the say-on-pay provision, the SEC requires an advisory vote and additional disclosure regarding golden parachute compensation arrangements that would occur when a company is engaged in merger transactions. 15

2. Purpose of Research and Background My research examines the impact of the Dodd-Frank Act on the amount and structure of executive compensation and examines over 1,700 companies using data from the United States Securities and Exchange Commission (U.S. SEC) after the Dodd-Frank Act to investigate the say-on-pay and the frequency of the say-on-pay voting patterns. 2.1 Say-On-Pay, Frequency Of Say-On-Pay And Golden Parachute Compensation The Dodd-Frank Act requires U.S. public companies to conduct an advisory vote on executive compensation called say-on-pay, the frequency of say-on-pay, and the golden parachute compensation. 14 Say-on-pay became effective for shareholder meetings held on or after January 21, 2011. However, smaller companies, defined by the SEC as having a market capitalization under $75 million, are exempt from holding a say-on-pay vote until their first annual meeting held on or after January 21, 2013. Furthermore, public companies receiving funds from the Troubled Asset Relief Program (TARP) were already required to allow shareholders to vote on executive compensation; however, TARP recipients are exempt from holding a shareholder vote on the frequency of say-on-pay. Instead, they are required to hold say-on-pay annually. In addition, the advisory vote and additional disclosure on golden parachute compensation became effective for all public companies with proxy statements and other acquisition related filings on or after April 25, 2011. 2.2 Audit In Compliance With The Dodd-Frank Act With greater legislative scrutiny and increasing investor concern about executive compensation practices, it is important that auditors stay educated in compliance with the Dodd-Frank Act and understand the disclosure requirements in many provisions of the law. For example, the SEC s 2006 rule change requiring more extensive disclosures and plain English discussion of executive compensation to improve transparency and comparability was enhanced by including compensation and disclosure provisions of the Dodd-Frank Act. 4 In addition, the Dodd- Frank Act requires additional disclosure on golden parachute compensation. There are also more requirements of the Dodd-Frank Act to increase the accountability and transparency of executive compensation that have not yet taken effect. Although the SEC will adopt these rules in the near future, further requirements include mandating public companies to disclose the relationship between executive compensation actually paid and the company s financial performance. Companies will also need to disclose the CEO pay ratio which compares the total annual compensation of the CEO to the median total annual compensation of all employees. This can be a complex issue in determining the CEO pay ratio for multinational corporations, particularly because of the vague terms of considering the status of employees part-time or full time and calculating total annual compensation. 13 Additionally, similar to the Sarbanes-Oxley rules on audit committee independence, the Dodd-Frank Act will require companies to have independent compensation committee members as well as advisers to those committees. Disclosures on independent compensation committee members will be needed in the proxy statements for annual shareholder meetings held on or after July 21, 2011. Shareholders will be affected by the company policies based on the information in these disclosures. For example, a company that fails to adequately disclose sufficient information can influence the decision making of a prudent investor. A company in compliance of the Dodd-Frank Act will also need stronger internal controls and require internal auditors to review issues that can have material misstatements in the disclosures. According to the Journal of Accountancy, auditors of public firms may need to assess management s compliance with new procedures on executive compensation, accountability and governance. 8 For example, the Institute of Internal Auditors (IIA) is becoming more involved in the internal review audit of executive compensation plans. The IIA Director of Standards and Guidance Beryl Davis said: The highly complex executive pay programs of large corporations contain inherent risk. Poor design could trigger a wide range of unintended consequences ranging from management fraud, to inadvertent over- or under-payments, to a drain of organizational talent Internal auditors can add value to the organization by continually monitoring related risks and controls and bringing their findings and recommendations to the attention of management and the board to avoid a crisis. 11 199

Internal control auditors are needed to attest to these provisions in the proxy statements and additional disclosures required by the law. 2.3 CEO Pay Trends Although the United States is in the midst of an economic recession and many large corporations have been bailed out, executive pay continues to increase. In 1978, according to the Wall Street Journal, the average American CEO earned 35 times more than the average worker. Since then, however, this ratio grew to 71 in 1989 and by 2000 the ratio had soared to 300. 12 In 2010, a typical CEO earned $11.4 million in total compensation 343 times the workers median pay. 1 The gap in pay disparity between executive officers and the rest of the work force continues to widen. 2.4 United Kingdom Say-On-Pay Model One solution to improve executive compensation practices is to give shareholders say-on-pay. In 2002, the United Kingdom introduced the Directors Remuneration Report (DRR) Regulations to increase accountability, transparency, and performance linkage of executive pay. 2 It became the first country mandating a say-on-pay, giving investors a voice on CEO pay. Research by Professors Conyon and Sadler found that less than 10 percent of shareholders abstain or vote against the UK say-on-pay. For example, Conyon and Sadler found that firms with higher CEO pay attract greater voting dissent while lower CEO pay remains less controversial. 5 In addition, a Harvard study by Ferri and Maber found that there is no evidence of a change in the level and growth rate of CEO pay; however there is an increase in the sensitivity of CEO pay to poor performance, particularly in firms with controversial CEO pay practices. 6 Ferri and Maber conclude that the 2002 UK say-on-pay effectively reduces rewards for failure. Further research has found some evidence that executive boards curb excess salary and dilution of stock option grants as well as improving pay-performance link. 4 Although the UK and the United States are two separate entities, these studies of the UK say-on-pay are good examples of how shareholders would react to say-on-pay in the United States and how investors can influence executive pay. The UK say-on-pay serves as a model for the United States and other countries considering the introduction of a vote on remuneration. 3. Sample and Data The sample used in this study consists of 1,744 companies found in the ExecuComp database with non-zero CEO compensation for 2009. Using these sample firms, the data collection was done manually using public sources available from the U.S. Securities and Exchange Commission Forms DEF 14A, 8-K and 10-Q. For shareholder meetings held on, or after January 21, 2011, the effective date of the say-on-pay provision, shareholder votes on executive compensation of approval or against and the frequency of future advisory votes on executive compensation of every 1 year, 2 years, or 3 years can be found using SEC Forms 8-K and 10-Q. Prior to the annual shareholder meetings, company recommendation of the frequency of the say-on-pay can be found using the annual proxy statement in SEC Form DEF 14A. Based on the data collection, this study investigates the patterns of the company recommendation and shareholder votes on executive compensation and the frequency of the say-on-pay. From the initial 1,744 companies, 186 sample companies were deleted that are not subject to the say-on-pay provision, did not have annual meetings or did not report results of the shareholder vote by the cut-off date of March 6, 2012, leading to a sample of 1,558. I additionally completed a further analysis of the executive total cash compensation (salary + bonus) using the ExecuComp database in the Wharton Research Data Services. The structure and amount of executive compensation prior to the Dodd-Frank Act was investigated, using a sample of 100 companies from the S&P 500. A regression analysis was used to forecast the executive total cash compensation of each company and to investigate the impact of the executive compensation prior to the Dodd-Frank Act. The difference between the actual and predicted executive total cash compensation was the residuals from the regression analysis. Then, this residual was divided by the actual executive total cash compensation for each year from 1992 2009. This showed the increase or decrease in executive total cash compensation for each year. Using the regression analysis model for each company, the forecasted executive total cash compensation in 2010 was compared with the actual executive total cash compensation in 2009 to see if there were any changes in the amount of executive compensation. 200

4. Empirical Analysis 4.1 Analysis Of Voting Patterns Of Say-On-Pay And Say-On-Frequency As of March 6, 2012, research results indicate that 98% of all companies were supported by their shareholders on executive pay: shareholders approved the pay for 1,529 companies and 29 companies failed to receive a majority vote in favor. Table 1. results on approval or rejection of shareholder advisory vote on executive compensation Date For Against Total Jan-11 8 1 9 Feb-11 47 1 48 Mar-11 48 2 50 Apr-11 178 5 183 May-11 784 13 797 Jun-11 216 4 220 Jul-11 33 0 33 Aug-11 52 0 52 Sep-11 29 0 29 Oct-11 24 1 25 Nov-11 49 1 50 Dec-11 27 0 27 Jan-12 26 1 27 Feb-12 8 0 8 Total 1,529 29 1,558 For those 1,529 companies that received an approval on executive compensation from their shareholders, the average approval percentage was 91.11%. More than 50% of the companies received at least 95.34% support from their shareholders. However, for those 29 companies that received a rejection on executive compensation, more than 50% of those companies received between 44.2% to 48.9% support from their shareholders with an average of 42% shareholder support for rejected company. The lowest approval rate was 32% and the highest was 100% while the overall shareholder support for the 1,588 companies was 90.20%. In the same sampling, 974 companies recommended annually, 492 companies recommended triennially, 33 companies recommended biennially and 37 companies had no recommendation. However, contrary to the company recommendation, shareholders were overwhelmingly in favor of annually 1.391 companies received a majority shareholder vote for annually, 142 companies received a majority shareholder vote for triennially and 4 companies received a majority vote for biennially. 201

Graph 1. company recommendation vs. shareholder recommendation on the frequency of advisory vote on executive compensation, March 6, 2012 Further results show that up until the 8-K filing date of March 24, 2011, since the effective date of the say-on-pay on January 21, 2011, 57 companies recommended triennially, 34 companies recommended annually, 5 companies recommended biennially and 5 companies had no recommendation. Therefore, if no recommendation is excluded from the analysis, the preliminary results indicate that about 60% of companies initially recommended every three years as the preferred say-on-frequency. However, 83 companies received majority vote from shareholders to have reporting annually while 17 companies received triennially and one company received biennially, leading to an 82% preferred vote for annually. The 82% increased to 90% by the end of April 2011 and has remained at 90% since then. Table 2. results on company recommendations of the frequency of advisory vote on executive compensation from January 2011 to February 2012 (TARP recipients are required to hold annually) 202

Table 3. results on shareholder recommendations of the frequency of advisory vote on executive compensation from January 2011 to February 2012 (TARP recipients are required to hold annually) By the end of December 2011, 63% of companies recommended the say-on-frequency of every one year instead of every three years. This 63% has remained the same since then and the latest results as of March 6, 2012 still show that 63% of companies voted for every one year as the preferred say-on-frequency. The Board of Directors believed that a frequency of every two years or every three years is most appropriate, providing sufficient time to evaluate the effectiveness of the overall compensation philosophy, policies and practices. 3 On the other hand, the Board of Directors also believed that a frequency of every one year will allow shareholders to provide timely, direct input on the executive compensation philosophy, policies and practices. 3 Based on the shareholder voting results, shareholders are in favor of an annual advisory vote on executive compensation because, according to the Institutional Shareholder Services, annual say-on-pay provide[s] the most consistent and clear communication channel for shareholder concerns about executive compensation. 7 4.2 Analysis Of Executive Compensation Prior To The Dodd-Frank Act In comparing the actual with the predicted executive total cash compensation, results indicate that executive total cash compensation (salary plus bonus) has been decreasing since 2006. Based on the regression analysis of a sample of 100 companies from the S&P 500 in 1992 2009, 59 companies actual was below predicted executive total cash compensation every year from 2006 2010. Additionally, 15 companies experienced the same decrease in expected executive total cash compensation in the period since 2007 and 16 companies experienced a decrease in expected executive total cash compensation, with the exception of one year in either 2007, 2008, 2009 or 2010 where actual exceeded expected executive total cash compensation. Table 4. results on actual vs. predicted executive total cash compensation using a sample of 100 companies Every Year (2006 to 2010) Actual was Below Predicted Executive Total Cash Compensation Every Year (2007 to 2010) Actual was Below Predicted Executive Total Cash Compensation Except 2006 Every Year (2006 to 2010) Actual was Below Predicted Executive Total Cash Compensation Except One Year (2007, 2008, 2009 or 2010) Two or More Years (2006 to 2010) Actual was Above Predicted Executive Total Cash Compensation 59 15 16 10 100 Total 203

Further results indicate that more companies had reduced executive total cash compensation since 2006. For example, 79 companies in 2006 had actual executive total cash compensation below the predicted executive total cash compensation, 89 companies in 2007, 89 companies in 2008, 94 companies in 2009 and 89 companies in 2010. Table 5. number of companies below predicted executive total cash compensation, 2006 2010 Actual was Below Predicted Executive Total Cash Compensation 2006 2006 2007 2007 2008 2008 2009 2009 2010 2010 79-68.47% 89-66.85% 89-75.07% 94-84.20% 89-84.59% Based on those 79 companies in 2006, actual executive total cash compensation was below the predicted executive total cash compensation by an average of 68.47%, 66.85% for those 89 companies in 2007, 75.07% for those 89 companies in 2008, 84.20% for those 94 companies in 2009 and 84.59% for those 89 companies in 2010. Using the same sample of 100 companies, comparing 2010 to 2009 actual executive total cash compensation, show that 48 firms reduced executive total cash compensation in 2010 prior to the advisory vote on executive compensation. For example, the Dow Chemical Company decreased executive total cash compensation as high as 70%. For those 48 companies that decreased the compensation, executive total cash compensation decreased by an average of 14.35%. 5. Conclusion While the say-on-pay provision of the Dodd-Frank Act may not be a solution to the financial crisis, it has significant implications in the structure of executive compensation. The advisory vote of say-on-pay, say-on-frequency and the golden parachute compensation allows shareholders to express their concerns on executive pay. Although the shareholder vote is nonbinding, under the SEC rule, additional disclosures such as the golden parachute on mergers and future disclosures mandating firms to disclose CEO pay ratio, increase transparency, comparability and accountability in public companies. In addition, internal audit control is needed to review compliance procedures with the Dodd-Frank Act. Prior research on UK say-on-pay shows that there is an impact on executive compensation. Shareholders of poor performance firms and firms with high CEO pay are more sensitive to the sayon-pay. Further research shows that annual say-on-pay is the preferred vote from shareholders. More than 90% of companies received a vote for annual say-on-pay by shareholders. Pressure from shareholders appears to have led to a change in company recommendations from a preferred say-on-frequency of three years to a preferred frequency of one year. Findings also show that executive total cash compensation has been decreasing since 2006. 6. Acknowledgements The author wishes to express his special thanks and appreciation to his faculty advisor, Dr. Steven Balsam, for his guidance and individualized attention throughout this research. He also would like to thank the entire McNair Scholars community and the McNair Scholars Program for giving him the opportunity and support to conduct his research. 204

7. References 1. AFL-CLO. 2010. Why CEO Pay Matters. Retrieved from http://archive.aflcio.org/corporatewatch/paywatch/ 2. Baird, J. and P. Stowasser. 2002. Executive Compensation Disclosure Requirements: The German, UK and US Approaches. PracticalLaw.com, PLC Document 4-101-7960. 3. Brill, J. M. 2011. Our Model Say-on-Pay Disclosures. Compensation Standards: The Executive Compensation Newsletter for Directors and Advisors. Executive Press, Inc. 4. Carter, M. E. and V. Zamora. 2009. Shareholder Remuneration Votes and CEO Compensation Design. Working paper, Boston College. 5. Conyon, M. and G. Sadler. 2010. Shareholder Voting and Directors Remuneration Report Legislation: Say on Pay in the UK. Corporate Governance: An International Review 18(4): 296 312. 6. Ferri, F. and D. Maber. 2009. Say on Pay Votes and CEO Compensation: Evidence from the UK. Working paper, New York University. 7. Institutional Shareholder Services. 2010. 2011 U.S. Proxy Voting Guidelines Summary. Retrieved from http://www.issgovernance.com/files/iss2011uspolicysummaryguidelines20101216.pdf 8. Lamoreaux, M. G. 2010. Financial Regulatory Reform: What You Need to Know. Journal of Accountancy. 9. Larcker, D. and B. Tayan. 2011. Seven Myths of Executive Compensation. Working paper, Stanford University. 10. Kelly, K. 2009. Populist Rage Over CEO Pay Clouds Judgment. Harvard Business Review. Retrieved from http://blogs.hbr.org/hbr/how-to-fix-executive-pay/2009/07/populist-rage-over-ceo-pay-clo.html 11. McCallum, S. C. 2010. Internal Auditors Can Help Boards Assess Appropriateness of Executive Compensation and Benefits. The Institute of Internal Auditors. 12. Mishel, L. 2006. CEO-to-worker pay imbalance grows. Economic Policy Institute. Retrieved from http://www.epi.org/economic_snapshots/entry/webfeatures_snapshots_20060621/ 13. PricewaterhouseCoopers. 2010. A Closer Look at the Dodd-Frank Wall Street Reform and Consumer Protection Act. Retrieved from http://www.pwc.com/us/en/financial-services/regulatoryservices/publications/assets/closer-look-executive-compensation.pdf 14. U.S. Securities and Exchange Commission. 2010. Shareholder Approval of Executive Compensation and Golden Parachute Compensation. Release No. 33-9153. Retrieved from http://www.sec.gov/rules/proposed/2010/33-9153.pdf 15. U.S. Securities and Exchange Commission. 2011. Shareholder Approval of Executive Compensation and Golden Parachute Compensation. Release No. 33-9178. Retrieved from http://www.sec.gov/rules/final/2011/33-9178.pdf 205