Issue Report: Carpenter Funds’ Executive Compensation Advocacy

The Carpenter Funds have been fully engaged on the executive compensation issue, closely monitoring portfolio company compensation and proactively engaging in a variety of reform initiatives. Few topics generate a more intense debate than corporate executive compensation, a debate that was energized in the aftermath of the financial crisis.  The impetus for the Funds’ activism remains the conviction that executive compensation is a vitally important ingredient in determining corporate success. A well-designed executive compensation plan is critical to focusing senior executives on the company’s strategic plan to produce long-term corporate value growth goals.

An executive compensation plan developed to meet these ends need not contain a prescribed set of standard plan features, but rather should be a distinctive combination of pay components, plan metrics, performance targets, and timelines that reflect a company’s particular circumstances and goals. The pay plan crafted by an independent and engaged compensation committee should be fully synchronized with a strategic business plan designed to deliver sustainable long-term corporate value growth.

The Core Executive Compensation Principles and Practices, outlined below, are a set of important compensation principles and related pay practices that should be reflected in a well-constructed executive compensation plan. The Funds’ Core Principles and Practices have evolved over the past three decades of activism and inform the Funds’ exercise of their Say-on-Pay (“SOP”) voting rights and guide their corporate engagements. Earlier formulations of the Funds’ executive compensation principles, such as the CommonSense Executive Compensation Principles that targeted plan design deficiencies and escalating pay levels, and the Pay-for-Superior Performance Principles that sought to strengthen plans’ pay and performance connections, guided many years of Funds’ corporate engagements on a variety of executive compensation issues.

The Funds’ executive compensation advocacy has taken varied forms including shareholder proposals, informal company engagements, shareholder-corporate work group formation, and regulatory and legislative advocacy. Fund initiatives have encouraged substantive company-specific and market-wide executive compensation reforms, and prompted many important advances in compensation disclosure ahead of regulatory action. The positive contributions of this advocacy have been significant: stock option expensing; greater pay-for-performance rigor; increases in long-term compensation relative to short-term pay; the use of a greater variety of performance-vested long-term compensation vehicles; limitations on excessive supplemental executive pensions, and expanded compensation disclosure.

Many of the enhanced compensation disclosures extracted in shareholder proposal negotiations, such as improved metric and performance target disclosure, foreshadowed later disclosure requirements in SEC rule makings, such as those included in the Compensation Discussion and Analysis (CD&A) established in 2006.

Outlined below are highlights of the Carpenter Funds’ executive compensation activism over the past three decades. During that stretch of time, shareholder rights within the corporation have strengthened, the economy has experienced recessions and a crippling financial crisis, the stock market enjoyed periods of record strong performance, and compensation practices have evolved with various forms of equity pay now delivering the largest share of compensation at most companies.

In this constantly changing investment environment, it is important that executive compensation advocacy be rooted in and guided by core principles and practices.

Carpenter Funds’ Executive Compensation Core Principles and Practices Activism (2011-present)

At the time of the passage of Dodd-Frank with its Say-on-Pay provisions, the Carpenter Funds outlined a set of core executive principles that would guide the Funds’ evaluation of the executive compensation plans at each of its portfolio companies. Strong pay practices associated with each of the defined pay principles were identified and a set of Executive Compensation Core Principles and Practices was established. The Funds have developed a Core Principle and Practices Evaluation Form to guide the  evaluation of company executive compensation plans and guide engagements with companies.

Executive compensation plans are typically complex schemes with dozens of components making plan evaluation a challenging task. The Funds’ Core Principles and Practices focus on the three key substantive plan components: annual incentive pay, long-term cash and equity compensation, and post-employment compensation, including retirement, severance and change-in-control benefits. Each Principle outlines an overarching Fund position on a specific compensation component.

Core Principle #1: Compensation Plan Goal and Structure: The Company’s executive compensation plan should be designed to motivate named executive officers (NEOs) to fulfill their key obligation; that is, to develop and implement a well-conceived strategic business plan that sustains long-term corporate value creation. The executive compensation plan should contain annual and long-term incentive plan components, which combine financial, stock-price, and non-financial strategic performance metrics with rigorous performance targets designed to reward superior (above average) performance.

Core Principle # 2: Annual Incentive Plan (AIP) Compensation: A company’s AIP should include a strategic mix of financial and non-financial performance metrics with demonstrably rigorous internal and/or peer-related performance targets that support the achievement of corporate strategic goals. AIP payouts should reward superior corporate performance in furtherance of the corporation’s long-term strategic plan.

Core Principle # 3: Long-Term Incentive Plans (LTIP):  A company’s LTIP should deliver a majority of a NEO’s total compensation, with an appropriate mix of grant vehicles/types used to achieve the goals of sustained corporate value growth and executive retention. Performance-vested equity (i.e., equity awards that vest based on satisfying performance goals should deliver a majority of a NEO’s long-term compensation, and may be complemented with performance-related (i.e., stock options) and time-based equity (i.e., restricted shares or units). The LTIP’s key performance metrics should include growth and return measures (i.e., balance sheet and capital efficiency management), linked to shareholder value creation, and include strategic value drivers, such as innovation, new products, customer loyalty, environmental protection, or employee engagement.

Core Principle # 4: Post-Employment Compensation & Benefits: Since NEOs are highly compensated and thus able to acquire a considerable level of wealth during their work tenures, extraordinary retirement benefits that exceed those provided by “qualified” retirement plans and severance pay should be limited and clearly justified. The amount of severance pay should be modest and only provided in limited circumstances. Change-in-control benefits should be strictly limited to pro-rata vesting of outstanding performance-vested equity instruments (i.e., equity awards that vest based on measured performance). In addition to the Core Principles, Core Practices that describe specific plan features for each component of compensation have also been defined. In an effort to sharpen the Funds’ pay-for-performance evaluations, a CEO Realized Compensation calculation is included with the Core Principle and Practices evaluations. The realized compensation calculation reflects the amount of annual income actually realized by a CEO and enhances performance comparisons.

The Funds’ current version of the Core Principle and Practices Evaluation Form with a CEO Realized Compensation calculation is used to evaluate  portfolio companies’ compensation plans so as to help inform the Funds’ activism and voting decisions on executive compensation issues.

Over the last six years, the UBC Funds have evaluated hundreds of companies’ pay plans and engaged in dialogue with the companies to offer feedback and suggest improvements to their executive compensation practices. The engagements generally begin with the preparation of a Core Principles and Practices evaluation of a company’s executive compensation plan, which is then shared with the company for discussion.

In 2011 for instance, the Funds undertook an executive compensation study of 120 companies over 12 industry groups. Evaluation forms were prepared for each company and then a focus on selected industries, such as pharmaceuticals, retail, utilities, transportation, and others, allowed the Funds to identify distinctive compensation practices within the respective industries.

Each company that was engaged was provided a copy of the Fund’s analysis and the compilation of industry data. The vast majority of companies have responded positively and engaged in constructive dialogue, producing positive results for the labor-intensive process. The Funds have also more recently adapted the Core Principles and Practices analysis to allow for thoughtful Say-on-Pay vote decision-making.

Carpenter Funds Executive Compensation Principles Activism (2000 – 2009)

Beginning with the bursting of the tech bubble in 2000 and continuing through the decade, Carpenter Fund executive compensation activism advanced broad compensation principles and a comprehensive set of executive compensation plan features.

The vehicles for this activism were two shareholder proposals, the CommonSense Executive Compensation Proposal and the Pay-for-Superior Performance Proposal, both of which presented broad compensation concepts and advanced multiple compensation plan features. Corporate no-action challenges to the multi-faceted nature of the proposals were unsuccessful, allowing the proposals to serve as effective mechanisms for advancing the Funds’ evolving compensation positions.

CommonSense Executive Compensation Proposal (2000 – 2005)

In 1965, the CEO-to-worker compensation ratios was 20.1-to-1 and 29.1-to-1 in 1978, but the ratio peaked at 383-to-1 in 2000, and as recently as 2012 stood at 273-to-1. By 2000, the average CEO-worker pay ratio had risen to 400-to-1, nearly ten times as large as the 1982 ratio of 42-to-1.

The combination of oversized executive stock option grants and a long-running bull market account for the escalated CEO-to-worker compensation ratios. It was in this environment that the Carpenter Funds defined a straightforward executive compensation formula that sought to moderate executive compensation.

The CommonSense Executive Compensation Proposal proposed a compensation framework that prescribed modest levels of compensation with clear and verifiable performance goals. A key CommonSense provision was the recommended substitution of performance-vested shares for stock options in the long-term incentive compensation components of the executive pay plans.

While the CommonSense principles advanced an executive pay formulation dramatically different than current practices, they received surprisingly strong shareholder support. The CommonSense proposals stimulated passionate debate and produced both substantive pay plan changes and enhanced compensation disclosure.

Pay-for-Superior-Performance Principle Advocacy (2006 – 2009)

Beginning in 2006, the Carpenter and Trades Funds focused on the pay-for-performance issue using a Pay-for-Superior Performance Proposal that challenged companies to use goal-focused stock price, financial, and non-financial performance metrics, set demanding performance targets, and focus on performance-vested instruments to deliver a majority of an executive’s total compensation. The Pay-for-Superior-Performance principle presented a straight-forward formulation for senior executive incentive compensation designed to help establish more rigorous pay-for-performance features in plans.  The Pay-for-Superior Performance principle challenged a company to establish an executive pay plan that did the following:

  • Set compensation targets for the plan’s annual and long-term incentive pay components at or below the peer group median;
  • Delivered a majority of the plan’s target long-term compensation through performance-vested, not simply time-vested, equity awards;
  • Provided the strategic rationale and relative weightings of the financial and non-financial performance metrics used in the annual and long-term incentive components of the plan;
  • Established performance targets for each plan financial metric relative to the performance of the company’s peer companies; and
  • Limited payment under the annual and performance-vested long-term incentive components of the plan to when the company’s performance on its selected financial performance metrics exceeded peer group median performance.

Both the CommonSense Executive Compensation Proposal and the Pay-for-Superior Performance Proposal stimulated dialogue on a comprehensive set of executive compensation issues with targeted companies throughout the decade.

Carpenter Fund Single Issue Compensation Activism: Stock Option Expensing Campaign (2001 – 2005)

In response to investor calls for greater correlation between executive compensation and shareholder interests, the use of stock options as a key form of executive compensation rose dramatically beginning in the late 1980’s. Stock options were a particularly attractive form of executive compensation due to the accounting treatment of options; stock options were not required to be expensed under existing corporate accounting principles, so they were considered cost-free compensation.

Authoritative market research indicated that the expensing of option grant costs would have lowered operational earnings at companies by as much as 10% in 2000. A “no-cost” executive compensation mentality produced unprecedented levels of stock option usage that encouraged reckless corporate behavior to inflate short-term stock prices and executive compensation levels.

In the early 1990’s, Congress, in part at the behest of Silicon Valley, blocked efforts by the Financial Accounting Standards Board (“FASB”) to change accounting standards to require stock option expensing.  Political forces had effectively decided the outcome of an important corporate accounting issue that had direct effect on the quality and integrity of corporate financial reporting.

With the unabated rise in the use of options fueling irresponsible and illegal corporate behavior, Carpenter and Trades Funds initiated a shareholder proposal campaign designed to put the issue of option expensing before shareholders – where it belonged. The corporate response to the stock option expensing proposal was aggressive and succeeded in securing a no-action letter from the SEC Staff that allowed exclusion of the proposal (See National Semiconductor CorporationJuly 19, 2002).

However, the Carpenter Funds successfully appealed the National Semiconductor no-action letter to the full Commission. A SEC October 18, 2002, letter to UBC General President Douglas J. McCarron stated the Commission’s new position:

“After further consideration of the issues by the Division, as directed by the Commission, the Division does not concur in National Semiconductor’s view that the United Brotherhood of Carpenters Pension Fund’s proposal relates to ordinary business matters and, in the future, we will not treat shareholder proposals requesting the expensing of stock options as relating to ordinary business matters.”

Following the SEC’s reversal, Carpenter and Trades Funds submitted over sixty stock option expensing shareholder proposals, with fifty of the proposals receiving majority vote support from shareholders in the 2003 proxy season. The following year, Carpenter and Trades Funds submitted additional option expensing proposals that received overwhelming majority vote support. At the end of 2004, in response to the clear market position on expensing, FASB issued a new accounting standard that required companies to expense stock options beginning in June 2005. The stock option expensing shareholder initiative highlighted strong investor support for option expensing and served to undercut residual Congressional resistance to FASB’s stock option expensing rulemaking.