In my experience, relative financial comparisons become very complicated and lose credibility with the compensation committee and senior management team when the results are skewed by unusual items. For example, if a peer company had an asset impairment last year, this year’s ROIC may be at the top of the peer group. Why? Not because of improved financial performance, but because its capital has been largely written-off. Thus, even a modest profit makes the company look like it is batting .400.
Do you adjust for this, or simply use the “as reported” figures? Same goes for companies that have unusual gains or losses, severance costs associated with a plant closing, etc. If you decide to adjust for these items, you often end up having to restate the financials for the entire 15-20 company peer group. If you decide to “play it where it lies” you may unjustly penalize or reward your executives.
My Preference: Generally, I prefer to use relative TSR based on the same peer group used for compensation purposes and three-year budgeted financial goals (like cumulative EPS or 12% ROIC). That way, management is being rewarded based on both a shareholder friendly measure (i.e., TSR) and a measure that they can more directly influence (e.g. a three-year internal goal). Although this approach has its own set of challenges and issues, it has served my clients and their shareholders pretty well over time.
When hiring – or evaluating the performance of – a compensation consultant, one area of focus should be time availability. The committee needs to know its consultant will be available to discuss issues when needed – and the consultant should expect the same of committee members. From the committee’s standpoint, the consultant should not be overloaded with other client work and be reasonably available for in-person, and not just telephonic, meetings with the committee.
A senior consultant is usually the lead person on an account, but the committee should be aware of the extent to which assignments will be undertaken by a more junior person. While the latter may be competent to respond to most factual questions, the committee needs assurance that the most experienced consultant will respond when an opinion is needed regarding a particular course of action.
In turn, the consultant should explain to committee members that doing a good job requires candor from and accessibility to the committee – not just when the compensation committee chair requests a meeting, but also when the consultant believes there is an issue that deserves further consideration.
Recently, Senator John McCain has been speaking out against excessive executive compensation and has now joined Senator Obama in calling for mandatory “say on pay.” Here is a Business Week article about this – and here is an excerpt from McCain’s June 10th speech:
“Americans are right to be offended when the extravagant salaries and severance deals of CEOs … bear no relation to the success of the company or the wishes of shareholders,” says McCain, adding that some of those chief executives helped bring on the country’s housing crisis and market troubles. “If I am elected president, I intend to see that wrongdoing of this kind is called to account by federal prosecutors. And under my reforms, all aspects of a CEO’s pay, including any severance arrangements, must be approved by shareholders.”
The proposals that both Senators Obama and McCain support not only would provide shareholders an annual non-binding vote on executive pay, they would also provide shareholders with a separate non-binding vote when a company gives a golden parachute to executives while simultaneously negotiating to buy or sell the company.
With H&R Block joining the list, there are now nine companies that have agreed to a non-binding vote on pay.
Last Days: Early Bird Discount for Our Conferences
I would like to offer a little different perspective on the blog from last week about “The Price of CEO Protection.” This analysis overlooks two important variables – the wealth and the public profile, and resulting risk to the CEO of that wealth and profile, regardless of explicit threats. Some of these individuals have been very aggressive in their business dealings. One was Time Magazine’s Man of the Year. Another introduced a revolutionary and disruptive business model. All three of these examples are multi-billionaires.
A useful approach would be to analyze security costs in a multivariate model considering personal wealth (an objective number), public profile (subjective), and the how-many-you-might-have-ticked-off-along-the-way metric (probably quantifiable but not available) and then the numbers might make more sense.
Having worked directly for six of the most famous and wealthiest CEOs in the country, I can tell you that most people cannot imagine the intensity of the security issues they face. Travel to a foreign country often involves the State Department, Secret Service, and/or CIA. Their children are assumed to be kidnapping targets. Their security staff are not rent-a-cops but former Special Forces, SEALs, and CIA operatives. Not something Joe Schmoe CEO really needs to think about or pay for.
This leads to the question of whether the company should be shouldering these costs. If you note that Steve Jobs looked so skinny during his keynote last week that rumors about his health took 6% off of Apple’s stock price in two days, we note that the markets consider the well-being of “celebrity CEOs” to be a shareholder value issue, despite tax code trivia, and a valid use of company funds.
A few weeks ago, I blogged about the challenges in pciking relative financial measures. This entry follows up with thoughts about picking a peer group:
Most of my clients struggle with determining the right peer group for performance comparisons. You might say: what do you mean? Don’t you already have a peer group you use for compensation purposes? What’s wrong with those companies? As I have learned, in some – but very limited – cases, the compensation peer group is reasonable for relative financial performance comparisons. For example, it might be reasonable for a specialty chemical company to use a relatively broad chemical group for pay comparisons – but since it only has two true competitors, relative performance comparisons to the entire peer group may be unreasonable as the demand for their products, cost of goods, etc. can be vastly different than the broader peer group.
Similarly, an oilfield services company might have a well-defined peer group, but relative financial performance comparisons should probably be limited to just the capital intensive peers, rather than the entire peer group.
And what about companies with a unique niche or conglomerate status? These companies often defy categorization, and trying to build a relevant peer group can be quite difficult. Some companies might default to a broad index, like the S&P 500, but I think such broad market comparisons are relevant only if you are using relative total shareholder return (as opposed to an earnings, return or growth measure).
RiskMetrics is not the only entity seeking comments on a paper. Stephen Davis is looking for input on this Millstein Center paper: “Board-Shareowner Communications on Executive Compensation.” The 17-page paper – which is an executive summary and initial findings – presents findings of a six-month research project that included interviews with directors, senior managers and investors on their views of dialouge regarding executive pay. A final paper will be published once more input is received.
Logically, the “say on pay” movement is addressed in the paper. Given that the media contains reports that some investors are now rethinking their views on “say on pay,” some of the research might be dated already, even though it’s not that old. I personally talked to some investors who now find themselves on the other side; and I find myself leaning against it for now (as I have blogged about). So please send Stephen your comments.
On pages 6-7 of the paper, there is this finding related to say on pay:
Compulsion, through crisis or other acute events, is the foundation under most current US corporate initiatives to foster governance dialogues with institutional owners.
Evidence suggests that scandals over executive compensation – whether payouts for failure or backdating stock options – were key contributors in 2007 in motivating certain boards to increase their interaction with shareowners. Exercises in board dialogue on governance have generally not come about in the United States as a product of proactive, long-term strategic outreach by untroubled corporations. This reality has contributed to growing investor conviction that regular dialogue will not spread widely in the absence of compulsion, even where companies are troubled. As a result, many funds back a UK-style annual advisory vote on executive pay policies, a measure that helped open channels of communication between UK boards and their equity owners.
A manifesto is defined as “a written statement declaring publicly the intentions, motives or views of its issuers.” While most of my experience with the term is related to the Unabomber and his manifesto, it was nonetheless the word that came to mind as I read the draft white paper – “Explorations in Executive Compensation” – by RiskMetrics Group (formerly known as ISS). RiskMetrics is seeking comments on this draft.
The paper focuses on a number of subjects, and takes turns being educational, informational and editorial in content. Specific subjects covered include:
– Evaluating Executive Pay Components;
– Key Considerations in Executive Pay;
– Equity Compensation Plans;
– Peer Group Benchmarking; and
– Executive Compensation Risk Modeling.
It is the last two areas that I found the most interesting. I will dive a bit deeper into the peer group modeling piece in this post, and potentially take up the risk profiles piece later—unless someone beats me to it. [Note: The entire paper is worth reading by anyone who wants to get up to speed on executive compensation, as well as those who want to know where RiskMetrics is headed.]
Number of Peer Companies
The ISS research suggested that most S&P 500 companies have between 11 (20th percentile) and 23 (80th percentile) companies in their peer group, and goes on to suggest that any company with a group smaller than 11 or larger than 23 should raise red flags. I guess I agree with half of that statement. If a group is too small, then the practices of one or two companies can have a dramatic effect on the median or average, which may or may not reflect a valid change in the marketplace. On the other hand, companies that do not have a clear set of peers may be well served by using a broader sample—perhaps well beyond 23 companies.
Ways to Define Similar and Dissimilar Companies
In defining similarity, RiskMetrics focused on three measures—revenues, market capitalization, and industry (2 digit GICS code), though they did acknowledge that financial companies might want to use assts instead of revenues. They then went on to scrutinize the peer group used by Ford Motor Company. It turns out that virtually all of the companies are from a different industry, and/or outside the revenue or market capitalization boundaries—they defined 0.5-2.0 as an acceptable boundary, though they also acknowledged that companies may need to stray outside in some cases.
I am not here to defend the Ford peer group—after all, the group includes both Exxon Mobil (market cap of $463 billion) and General Electric (market cap of $305 billion), while Ford’s market capitalization as of today is about $14 billion. According to RiskMetrics, 22 of the 22 peer companies have a higher market capitalization.
However, I was interested in seeing what companies might fit the RiskMetrics definition of “similar” defined above. I ran a screen using industry (2 digit GICs code), sales (0.5-2.0x Ford) and market capitalization (0.5-2.0x Ford). I only found one U.S. public company that met all three criteria–General Motors. While no one would argue that GM is a good peer company for Ford to use, it also illustrates that finding 11 companies that fit like a glove can sometimes be challenging.
So, Who Could Ford Use as Peer Companies?
We used our proprietary Peer Group Analyzer to try to answer the above question (the Peer Group Analyzer uses more than 20 factors across the dimensions of industry, size, valuation, and performance in an attempt to address the question of similarity). The model suggested that the best fit was companies such as Archer Daniels Midland, Johnson Controls, and Dell, as well a number of retailers and wholesalers—mostly companies with a sales to market capitalization ratio of greater than one, and almost all companies with sales below Ford’s $172 billion.
Are these companies perfect?—clearly not. Are they better than Exxon Mobil and General Electric?—that is a distinct possibility. If Exxon Mobil gave away 1% of the company to executives ($4.63 billion of $463 billion), Ford would have to give away about one-third of the company ($4.63 billion of $14 billion) in order to be competitive in terms of dollar value delivered.
In any event, I had better stop writing before someone accuses me of creating my own manifesto.
We recently completed a study on security spending at some of the largest U.S. companies over the past two years (see this recent WSJ article). Security spending is generally a small-ticket perquisite. However, in some rare cases the disclosed values can be quite high, even running into the million-dollar range. What is most interesting is the wide diversity of spending within the same industry, spending that does not necessarily relate to company size.
Most companies spend nothing, or report very little, on security expense for the CEO. We reviewed proxies for the largest 300 companies, which as of the end of April 2008 totaled 247 filers. Of these companies, 156 (62%) indicated they had no CEO-related security spending. Of the 91 reporting security costs, 60 companies reported spending $10,000 or less. Only 31 companies disclose security spending in excess of $10,000, the threshold for disclosing spending, of which 21 companies spent more than $50,000.
Four companies reported expenditures in excess of $1 million—Oracle, Limited Brands, Amazon, and Dell:
– Oracle disclosed $1.7 security spending on CEO Lawrence Ellison in each of the last two years. The disclosure states that these were security-related expenses for Mr. Ellison’s residences. This is all part of a residential security program for Mr. Ellison which was adopted by the Board of Directors.
– Leslie Wexner at Limited Brands has received $1.25 million in security services in each of the past two years, with no explanation other than “Security Services Paid by the Company”.
– Jeffery Bezos at Amazon has personal security arrangements in addition to security arrangements at business facilities and for business travel with a value of $1.2 million.
– Michel Dell’s disclosure indicates $1.05 million in ”company-paid expenses relating to personal and residential security” as part of a Board-authorized security program.
We believe these vast differences in security amounts typically reflect either a) risk assessments by outside security advisers, b) a CEO’s tenure and c) whether or not a company is involved in a high-risk industry or region. The tax rules may also provide insight as to the disparity in security expenditures. Specifically, Treasury Regulations Section 1.132-5(m) provides that an executive would not include as part of his/her taxable income, expenditures related to security if these expenditures demonstrate a “bona fide business-oriented security concern”, and are part of an “overall security program”, and/or recommendations implemented as from an “Independent Security Study.”
The regulations are explicit that a generalized concern for an employee’s safety is not a bona fide business oriented concern. Examples provided in the regulations that are bona fide security concerns are death or kidnapping threats, as well as recent history of violent terrorist activities. If we assume that the security perquisites listed in our study were not included as part of the executives’ taxable income, it is likely these expenditures were in response to security risks in connection with the executives employment.
Please note that the proxy disclosure does not require or provide whether the perquisite is taxable to the employee. Lastly, if we assume that these expenditures are not includible in the executives’ income, the driving force behind the appropriate level of expenditure is likely to lie with those experts who were engaged by the companies to make such determinations.
The media has had a field day ever since Delaware Chancery Court’s Chancellor Chandler unsealed this amended complaint filed against Yahoo, particularly because Carl Icahn is involved as he pressures Yahoo to sell; see this DealBook post which includes a recent Icahn demand letter (its not even the latest; there is a new one nearly every day – scroll down here for links to all of them). The lawsuit charges that Yahoo’s directors breached their fiduciary duties by their actions, including failing to negotiate a deal with Microsoft and enacting a broad employee severance plan.
Yesterday’s NY Times ran this article about a brief filed Monday by the plaintiffs to unwind the severance plan. Professor Steven Davidoff describes the tin parachute in quite some detail – and analyzes the arrangement, plus links to two other blogs that do the same – in his “DealBook” blog. Here is an excerpt from his blog:
The plan provides that if an employee with Yahoo is terminated by Yahoo without “cause” or by the employee for “good reason” within two years after Microsoft acquires a controlling interest in Yahoo, the employee will receive (among other things):
(1) his or her annual base salary over a designated number of months ranging from four months to 24 months, depending on the employee’s job level; and
(2) accelerated vesting of all stock options, restricted stock units and any other equity-based awards previously granted.
Under the plan, good reason means any “substantial adverse alteration” in an employee’s duties or responsibilities during the two years following the change of control.
As a measure of the market, the argument that this plan is “egregious” seems primarily related to the cash severance component, not the equity acceleration. The latter feature is quite common even on a single-trigger basis (in which the equity is accelerated immediately upon a change of control or on a modified basis, permitting the executive to leave the company after one year and benefit from this provision).
But single-trigger provisions are becoming much less common. And under the Yahoo plan, both these payments have a double trigger: There must be an acquisition by Microsoft and then a subsequent termination of the employee. This is what you would expect for a tin parachute — slang for a change-in-control plan that covers all employees.
Still, it is less common to permit rank-and-file employees to benefit under the plan if they decide to leave the company for “good reason.” Typically, they only get a benefit if they are terminated without “cause.” But here, the definition of “good reason” is narrower than you would typically see for a corporate executive, though it still gives some rights to the employees to walk away. This is the part of the plan that is most aggressive. And the complaint is right that the definition of good reason could provide substantial leeway for Yahoo’s employees to walk.