In Episode #6 of GAAP Chats, hosts Mike Walworth and Chris Brundrett take on executive pay and the executive compensation provisions within the Dodd-Frank Act, two of which were recently implemented by the SEC. Please note that the following is not a full transcript. You can listen to the episode in its entirety here.
Mike: As Lizzo sings “It’s About Damn Time!” In the aftermath of massive layoffs that began late last year and continue to this day, CEOs at some of the largest companies are taking pay cuts for 2023. Good. It’s only fair, but are they doing it out of fairness and empathy, or is there something else at play? Join Chris and I as we take on executive pay, including an overview of the executive compensation provisions within the Dodd-Frank Act.
Welcome to GAAP Chats, the podcast dedicated to all things accounting, brought to you by GAAP Dynamics. I’m your host, Mike Walworth and with me, as always, is my faithful partner, Chris Brundrett. We hope you’ll join us on our journey today as we share our passion for accounting and help change the way you train.
Chris: First of all, happy birthday, Mike!
Mike: Thanks, Chris. And thank you for drafting today’s podcast episode for me.
Chris: I didn’t draft it! By the way, what are we talking about today?
Mike: I was just kidding. I know you didn’t draft it. For those of you listening, Chris and I are actually together in our office and are recording this episode on my actual birthday. And today we’re going to talk about executive compensation.
Chris: How’d you come up with the topic?
Mike: Well, after our previous episode on layoffs, I was thinking (and perhaps in that episode I even said), that it was kind of crappy that these people were getting laid off, but that these CEOs continue to make millions of dollars a year, regardless of the company’s performance. But then I saw this headline on CNN: CEOs take pay cuts after brutal 2022.
And suddenly this topic was all over the news! Apple’s CEO, Tim Cook, is taking a 40% pay cut in 2023. CEO’s at some of the world’s largest banks - Morgan Stanley, Goldman Sachs, JPMorgan and Bank of America - will all see reductions in their compensation. And, in probably the biggest reduction, the CEO of Zoom, Eric Yuan, is taking a 98% salary cut.
Chris: Well, I wouldn’t cry too much for these guys.
Mike: Exactly! Even after taking a 40% pay cut, Apple’s Tim Cook is still going to make $49 million per year.
Chris: I know $49 million isn’t chump change, but it actually seems fairly reasonable given that Apple is the world’s most valuable company with a $2.3 trillion dollar valuation! And I don’t think Apple actually had any layoffs.
Mike: Not yet. And I agree that $49 million seems reasonable for Apple. But what is “reasonable?” According to the Economic Policy Institute, CEO pay has skyrocketed 1,460% since 1978. They estimate that a CEO at one of the top 350 firms in the U.S. was paid $27.8 million on average. A CNBC article had average CEO compensation at $20 million. Either way it’s a lot! And considerably more than the average worker.
Chris: 324 times to be exact!
Mike: That’s a very precise number. Where are you getting it from?
Chris: Well, Mike, as you know, as part of the rulemaking coming out of the Dodd-Frank Act, publicly traded companies are required to disclose the pay ratio between their chief executive and median employees. And in 2021, the average S&P 500 company’s CEO-to-worker pay ratio was 324-to-1.
Mike: Let’s back up. Can you explain what the Dodd-Frank Act is for our listeners?
Chris: The formal name is the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and it was enacted in the wake of the 2008 financial crisis. Outside of the original SEC Securities Act of 1933 and 1934, it is the most far reaching Wall Street reform in history designed to prevent the excessive risk-taking that led to the financial crisis. It has many provisions, including the fact that your personal credit card statements changed as a result, but I say that in this podcast we should stick to the ones related to executive compensation.
Mike: Agreed. And, in the essence of time, I’m going to narrow it even further to only 4 of the provisions. They are basically in the order the related rules were finalized by the SEC:
- Advisory Vote on Executive Compensation (“Say on Pay”)
- Internal Pay Equity Disclosure (“Pay Ratio”)
- Pay-Versus-Performance Disclosure
- Compensation Recovery (“Clawback”) Policy
Mike: Let’s do “Say on Pay” first. Chris, what’s that all about?
Chris: The Dodd-Frank Act requires public companies to conduct a non-binding shareholder advisory vote on their executive compensation programs (as reflected in the executive compensation disclosure in their proxy statements) at least once every three years.
This vote is non-binding on the company and its board of directors – specifically, the vote may not be construed as:
- Overruling a decision by the board of directors
- Creating or implying any change in or additional fiduciary duty for the board
- Limiting shareholders’ right to make executive compensation proposals
The final rule from the SEC was adopted on January 25, 2011.This is one of the first ones, and has been around for quite some time.
Mike: How does the SEC play into this? I thought Dodd-Frank was legislation passed by Congress.
Chris: Well, the law was passed by Congress. The Dodd-Frank Act itself really didn’t do anything. Congress essentially gave the authority to the SEC to implement it.
Mike: Got it!
Chris: Final Rule 14a-21(a) requires companies, at least once every three years, to provide a separate shareholder advisory vote in proxy statements to approve the compensation of executives, as disclosed in the proxy statement.
Mike: Does that rule actually work? I mean isn’t just a good ‘ole boys club.
Chris: Well, according to a recent PwC report recapping the 2022 proxy season, record numbers of companies failed to receive majority support for say on pay. Average support at companies in the S&P 500 and Russel 3000 hit record lows since the vote was introduced 11 years ago, at 87% and 90% respectively. In the S&P 500, 21 companies failed their say-on-pay vote, with 207 companies receiving below 70% support. The number of failed votes at Russell 3000 companies hit 71.
Mike: What’s causing this, other than CEO pay being out of control?
Chris: According to the PwC report, common issues include:
- Pay and performance alignment
- One-time awards
- Uncommon pay structures, and
- Unchallenging performance targets
Mike: Well, that’s good when a rule works as intended. Let’s move on to my personal favorite, the pay-ratio, which was adopted by the SEC beginning in 2018 in response to criticism over excessive CEO pay. What are the requirements?
Chris: The Dodd-Frank Act requires public companies to disclose in all company filings with the SEC the median annual total compensation of their employees (except the chief executive officer), the annual total compensation of their CEOs, and the ratio of the median annual total employee compensation to the annual total compensation of the CEO.
Mike: So, we’re taking the median total compensation for employees and dividing it by the CEOs compensation. Got it. I always mean, median and mode confused. Guess I was falling asleep in elementary math.
Chris: Didn’t you grow up in Florida? Let’s just chalk it up to that! The median is the middle number in a sorted list of numbers, and can be more descriptive of that data set than the average. The median is sometimes used as opposed to the mean, or average, when there are outliers in the sequence that might skew the average of the values.
Mike: Makes sense. That way the other executives' high salaries can’t skew the average employee compensation.
Chris: Exactly! Because remember, all we did was remove the CEO from that group. We want to look at real people so we exclude senior executive management.
Mike: So in our company, we have 16 people on the website (or 15 excluding me). We’d just list out the 15 people’s compensation for the year and take what, the 8th person on the list, meaning there are 7 people above and 7 people below that person?
Chris: The SEC rule would allow companies to select a methodology based on their own facts and circumstances. There are some instances where that is not the best method to use. Plus, there’s a whole lot of guidance associated with the rule that we can’t get into in this show. But, for us, we’d probably take out the 3 subcontractors from our list. Then, for the part-time employees, we’d probably annualize their salary.
Mike: Wouldn’t the median employee change every year, based on turnover and hiring?
Chris: It would, which is why the SEC permits companies to identify its median employee once every 3 years unless there has been a change in its employee population or employee compensation arrangements that it reasonably believes would result in a significant change to its pay ratio disclosure. We’re trying to make a balance so that companies can’t mess with that criteria every year in order to sway the results, but it also allows companies to make a change if their employee populations change.
Mike: It’s so fascinating. And for those of you who want to know the pay ratios of certain companies, it is out there! There is this really cool article published by Bloomberg, with some sweet infographics comparing various companies.
Mike: Anyways, the CEO pay ratios are staggering!
- Wal-Mart’s CEO pay ratio is 1,013-to-1
- Amazon’s CEO pay ratio is 6,474-to-1
- The Coca-Cola Co.’s pay ratio is 1,791-to-1
Chris: Makes sense. Those are big companies whose CEOs make big bucks, while their average employee is more blue collar. What about banks?
Mike: Not much better!
- JPMorgan’s CEO pay ratio is 917-to-1
- Goldman Sachs CEO pay ratio is 238-to-1
- Citigroup’s CEO pay ratio is 372-to-1
Chris: I’m getting depressed. Can we move on?
Mike: Sure. Let’s talk about the Pay-Versus-Performance Disclosure. This headline from Bloomberg Law may provide some insight into why those say-on-pay votes we talked about earlier were failing: Investors Challenge High Executive Pay as SEC Requires More Data
The article talks about the SEC’s recently finalized rules requiring companies to report more detailed pay-versus-performance data in their proxy statements.
Chris: The Dodd-Frank Act requires public companies to present a graphic (or narrative) description of the relationship between the company’s financial performance and the compensation paid to the named executive officers in the proxy materials for their annual shareholders meeting. So it’s beyond just the CEO. There are certain named executive officers that fall into this infographic.
Mike: Although it is in the Dodd-Frank Act, didn’t the SEC rule recently get finalized?
Chris: It did! On August 25, 2022, the SEC adopted final rules requiring public companies to disclose the relationship between the executive compensation actually paid to the company’s named executive officers (or NEOs) and the company’s financial performance.
Mike: Whoa! If Dodd-Frank was enacted in 2010, why did it take the SEC 12 years to enact the rule?
Chris: The SEC initially issued proposed pay-versus-performance rules in 2015 and reopened the comment period on the proposed rules in January 2022. Let’s just say that politics plays a role. Remember, the SEC Chairman is appointed by the President of the United States.
Mike: Got it. There was a change in administration between 2015 and 2022.
Chris: At least for another couple of years.
Mike: OK. Let’s talk about the last provision. It’s the compensation recovery policy or “clawback” provision.
Chris: The Dodd-Frank Act here requires that stock exchange-listed companies to adopt a compensation recovery policy that:
- Requires disclosure of the company’s policy on incentive-based compensation that is based on financial information required to be reported under the securities laws; and
- Provides that, in the event the company is required to prepare an accounting restatement because of its material noncompliance with any financial reporting requirement under the securities laws, the company will:
- Recover from any current or former executive officer
- Any incentive-based compensation (including stock options) received during the three-year period preceding the date on which the company is required to prepare the accounting restatement
- Based on erroneous data that is in excess of what would have been paid to the executive officer under the accounting restatement.
So let’s simplify that here for a minute. What we are saying is if an executive receives stock options or bonus pay based on net income, and in a couple of years there is a restatement of financial statements that drops that net income, that company has provisions in place that can “clawback” the amount of those bonus payments. Essentially, it sets the financial statements where it should be.
Mike: So, this rule requires them to have a “clawback” policy. Didn’t companies already have such policies?
Chris: They did. The final rule was adopted in October 2022 and requires listed companies to adopt a clawback policy.
Chris: These final rules largely track the proposed rules originally released in July of 2015, although there are some important differences. First, even some “little r” restatements that did not involve a material misstatement in past years may trigger a clawback under the final rules, and the new rules require more detailed disclosures about how a company’s policy was implemented in the most recent fiscal period.
Chris: There are some other changes too, so companies might want to revisit their existing clawback policies to make sure you are in compliance with the final rules.
Mike: There are a ton of rules with these four provisions. We encourage our listeners to look at the final rules. If you do have clawback policies already in place, just make sure that the existing policies are in line with the new rules.
Mike: So, just to wrap it up, Chris. What is your opinion on these rules? Do you think this is something that should be in the SEC’s purview?
Chris: Honestly, I have some conflicting feelings about this. I feel that compensation is something that you do not discuss with other people in general. So, I struggle with that. However these are public companies. They have a duty to report information to their shareholders and potential investors. So, the world is a little different when you work for a public company. On the surface I am okay with disclosure about compensation. I think it’s important. And, I like the clawback idea. Fair is Fair. I also like the disclosure about Pay vs. Performance. I do struggle with some things. I struggle with the pay ratio. I struggle because all companies are different. A company that has a lot of manufacturing, or a blue collar workforce vs a professional services firm, it’s going to be very different. I just feel like when you see those numbers it is going to be a headline. It creates negativity in an already divided world. So, I like parts of it, but I struggle with others. Either way, this is really important stuff.
Chris: What about you, Mike?
Mike: Although I believe that this gets close to SEC activism. Perhaps we could have an entire podcast on that. I think the “clawback" is one of those things that protects investors. As you said, that pay ratio is getting into more activism. That said, I do think that it is a good ‘ole boys club up there. I think it is important that we “little guys” (and I’m looking at our height here), should understand what these public company CEOs are being paid and some data points to determine whether or not it is deserved!
Chris: That’s all for this episode of GAAP Chats, your source for all things accounting. Notes and resources from today’s episode are linked in the description and as always you can find us online at GAAPDynamics.com, and @gaapdynamics across social media. It’s never too late to become a GAAPologist! Head over to our website and subscribe to our blog so that you’re the first to know what’s new with GAAP Dynamics.
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