As could be expected, the phone started ringing off the hook when it was announced that the government would be taking over Fannie Mae and Freddie Mac. These journalists posed the big question: what would the departing CEOs be taking home with them?
And they are not the only one posing the question – as this WSJ article notes, the Presidential candidates and some US Senators have weighed in by writing letters urging the Federal Housing Finance Agency to stop payment (the GSEs have their own regulator, the FHFA). Under a new law enacted in July, the FHFA has the authority to approve pay packages and prohibit or limit severance pay.
It’s too early to tell what will happen – although some outsiders have made calculations regarding what they are entitled to. According to the WSJ article, in an interview with the PBS “Nightly Business Report” on Monday, the FHFA Director James Lockhart said, “We’re not going to try to get part of the money back.” According to media reports, it seems like one CEO seems willing to rein in his own package (and has hired his own lawyer with his own money) whereas the other doesn’t appear as willing (and has hired his own lawyer with his former employer’s money).
It is noteworthy that the new Freddie and Fannie CEOs “will have salary and benefits significantly lower than the old CEOs,” which is great news since it’s the type of leadership that Corporate America has been sorely lacking. Someone stepping up and not demanding the excessive pay of peers.
And what am I telling the journalists who call me? I explain how to implement a clawback provision with “teeth” – as laid out in our Winter 2008 issue of Compensation Standards. The WSJ article cites statistics of the growing numbers of companies with clawback provisions – but I wonder how many of those really have teeth to avoid the sort of media crisis that happens when a company falls in the toilet and the CEO heads off to the links.
By the way, check out the investor relations’ home pages for Fannie Mae and Freddie Mac. Not a word – or link to something that mentions – the government takeover. And the IR profession wonders why it’s importance is diminishing…
Short-term incentive plans enhance executive performance, but very little is revealed to investors about them, according to new research by our New York-based firm. And while companies are disclosing more about their plans, they have a long way to go before reaching full compliance with the SEC’s new rules.
The SEC asserts that if executive compensation performance targets are central to a company’s decision-making process, they must be disclosed to investors. The new proxy disclosure rules require that all performance measures and goals must be released and compared with actual results. This disclosure requirement includes both short- and long-term incentive performance measures.
There is evidence that some companies are resisting the SEC. Though the SEC’s requests seem straightforward, implementation is proving to be difficult. Indeed, many companies are simply not bothering to comply. At least that’s the conclusion of a study by our firm that analyzed a representative sample of the medium-size companies in the Standard & Poor’s MidCap 400 group.
According to the most recent proxy filings, which covered 2007 results, only 47% of the companies made the required disclosures concerning short-term incentive pay. While this figure is substantially higher than the 23% that complied with the rule in 2006, it is nonetheless distressing.
On long-term incentive pay, for those companies with long-term incentive plans, compliance was a more robust 62% last year. In 2006, only 41% of companies complied. Long-term incentive compliance is generally higher than for short-term incentives as companies find it less threatening to report the relative goals typical of many long-term incentive plans.
When it devised its disclosure rule, the SEC gave companies a sizable loophole, excusing them from detailed disclosure of targets if they believed that publishing such figures would put them at a disadvantage in their industry. Many companies are using potential competitive harm from disclosure as a reason for not disclosing.
This argument of competitive harm would seem to be a pretty weak one. Is it the case that companies don’t want the bright light to be shone on their situation because it gives them the flexibility to give a bonus when it isn’t earned?
Others are disclosing the performance measures and the weights on each measure (but not the levels). Make no mistake: the SEC requires the full disclosure of goals, and performance measures, including weights and levels in comparison with actual performance and its effect on the executive’s compensation.
Even when companies have included discussion of performance goals in their proxy statements, the SEC has not been entirely satisfied with the results. That’s because after examining hundreds of proxy statements during last year’s proxy season, the SEC determined that the specifics of executive compensation decisions and policies need to be explained in clearer language for investors.
Most companies are disclosing the performance measures (but not the levels). Earnings are the number one performance measure across all industries, and companies appear to be setting more difficult goals as goal achievement declined in 2007. Thus, the new rules have more closely aligned pay and performance and have informed shareholders of important performance goals.
Companies may be choosing not to disclose specific benchmarks because those figures may be significantly different from financial targets that executives at these corporations have promised Wall Street analysts and investors — indicating that the boards in question are setting their bars too low and generating bonuses too easily.
The study also examines how often the CEO meets or exceeds goals. In proxies from both 2006 and 2007, some 60% of companies met or beat their targets, generating short-term payouts. This might be an indication that goals are often being set too low. A review of 2009 proxies will be very interesting on this point.
We are in the final stages of analyzing large cap companies with small companies to follow later.
With all the talk about the imminent, though protracted, adoption by the US of International Financial Reporting Standards (IFRS) I would think that everyone had at least heard the acronym by now. Maybe my client sample is an aberration but I’m surprised at the “huh?” response by many Directors and C-Level executives. Let’s all say it together: “iff – riss.”
There is of course plenty of time until we have to worry about IFRS conversion and any impact on executive compensation, with an SEC “roadmap” that may stretch from 2011 to 2014 or beyond. Or is there? The answer is “no, there’s not.” In this memo I recently wrote, you can learn some of the technical details about this issue.
Why does this matter? Because the rapidly increasing prevalence of equity awards with performance features means that the deemed performance against goals set years in advance has a direct impact on executive compensation levels. To the extent there is an accounting rule change mid-cycle and the plan documentation has not provided for appropriate adjustments, payment windfalls or shortfalls may occur and there may be accounting and tax (Section 162(m)) ramifications of any effort to “fix” the problem.
This may occur not only if a company converts to IFRS reporting standards but if the company has a peer-referenced performance goal and itself remains on U.S. GAAP throughout the performance period, but one or more of its peer group companies converts to IFRS during the period.
Although the required adoption of IFRS standards by U.S. companies would appear to be several years away, the increasing acceptance of such standards means that those involved in developing a company’s compensation plans — from the Compensation Director to the VP of HR to the CFO and the Board of Directors’ Compensation Committee — must become knowledgeable about how changes to financial reporting will affect these plans. Given that IFRS standards are currently mandated or permitted in all but a few countries, all companies need to assess the potential impact on their executive compensation plans.
– Peter Hursh, Managing Director, ECG Advisors, LLC
Recently, there was a blog about why companies should not issue restricted stock. While I am not a tax attorney, here is my understanding of at least four reasons why restricted stock makes sense.
1. Restricted stock gets capital gains treatment, either from the date of the 83(b) election, however infrequent, or from the date of vesting. RSUs never get capital gains treatment; they are always subject to ordinary income tax. For most executives, the federal capital gains tax is 15% through 2010, and then 20%. The highest marginal federal income tax rate is 35%.
2. Restricted shares are protected from creditors in bankruptcy. RSUs, which are nothing more than deferred compensation that tracks the performance of the company’s stock, are not protected from creditors in bankruptcy.
3. The recipient of restricted stock has the flexibility to sell his or her shares, once vested, even while he or she continues to be employed by the company or serve as a director. RSUs are often not available to cash-in until the individual terminates employment with the company.
4. The section 83(b) election should not be dismissed out of hand. The executive who truly believes in his or her company will make the election, locking in capital gains treatment from the date of grant. If the executive thinks that the stock price will go through the roof, then he or she can be a big winner. Moreover, the election sends a very strong message to shareholders abut the alignment of the executive’s interests with theirs.
By the way, the dividends and voting rights on restricted stock do not have to commence on the date of grant. The dividends can be held until vesting occurs, and the voting rights can be barred until vesting.
– Gregory Schick, Partner, Sheppard Mullin Richter & Hampton LLP, San Francisco
Yes, sadly this is yet another blog posting dealing with that infernal Internal Revenue Code Section 409A. But, my musings here are not about the intricacies of 409A and the various tax issues it presents or even the fact that the year-end compliance deadline is now less than 150 days away! Rather my focus is on whether this pervasive tax statute also has the power to complicate securities law compliance as well.
Private Company Valuation and Discounted Stock Options
As most practitioners know, 409A does not look too kindly on employee stock options that were issued at a discount from the grant date share fair market value. Whereas a typical vanilla flavored stock option is exempt from 409A, a discounted option is not. And, if a discounted option’s exercise periods are not sufficiently constrained (e.g., by limiting exercisability to a 409A permitted event) then such a discounted option could likely violate 409A.
As most of us know, this treatment has caused quite a stir with privately held companies since the determination of the fair market value of their shares cannot be gleaned simply by looking at trading prices posted on-line or in the morning newspaper as is the case for public companies. Indeed, the 409A final regulations recognize this and provide elaborate discussion (along with some guidance and safe harbor presumptions) on how private companies should determine the fair market value of their shares.
Since most stock options are generally intended to be granted with an exercise price equal to the grant date fair market value, the fear of course is that a defective undervaluing of the shares means that the company could have inadvertently awarded discounted options which then could cause a 409A violation.
Apart from altering their future option grant and share valuation practices, many private companies and their counsel/accountants have had to scurry around examining historical option grants to uncover whether they had outstanding discounted options due to low and indefensible valuations. The existing 409A guidance discusses various techniques for correcting discounted stock options. The most obvious method is to simply increase the exercise price of the discounted option up to the corrected, higher grant date fair market value. And, a number of companies have opted to follow this path.
Rule 701 Numerical Limits and Consequences of Repricing Stock Options
The potential securities law compliance issue that is the source of my musings relates to Rule 701 of the Securities Act of 1933. Rule 701 is the easiest and primary way that companies obtain exemption from the registration requirements of the Act with respect to their compensatory stock options. Rule 701 imposes numerical limitations on the magnitude of equity securities that can be issued in reliance on Rule 701 in a twelve month period.
In particular, the aggregate sales price or amount of securities sold in a twelve month period cannot exceed the greater of: (i) $1 million, (ii) 15% of total assets or (iii) 15% of outstanding securities. Moreover, if relying on either (ii) or (iii) and the aggregate sales price of Rule 701-issued securities exceeds $5 million, then Rule 701 requires that additional disclosures (in essence, a prospectus) be provided to grantees. Such additional disclosures need to have been provided to grantees before they exercised their Rule 701 options and acquired shares.
The sales price for stock options awarded for purposes of these numerical tests is computed at the time of option grant and is calculated by multiplying the number of option shares by the per share exercise price. The SEC’s April 1999 adopting release of amendments to Rule 701 provides that “In the event that exercise prices are later changed or repriced, a recalculation will have to be made under Rule 701.”
Normally, such a recalculation would be performed (with favorable results) when there is an option repricing to lower the exercise price to equal a share fair market value that has declined since the grant date. But, what about if the option is repriced upwards in order to accommodate 409A? Presumably, options whose exercise price is increased to avoid being treated as a discounted option under 409A must also be recalculated for purposes of Rule 701 using the higher option exercise price. Would the recalculation be retroactively performed for the period when the initial grant was made or would the value of the amended option be included in Rule 701 numerical analysis as of the date of the amendment?
In either case, the effect of such an upward adjustment could result in the aggregate sales price exceeding the $1 million and/or total assets thresholds of Rule 701 whereas computations applying the pre-adjusted exercise prices did not. And, perhaps even more troubling, if the Rule 701 $5 million threshold was breached as a result of the recalculation, it could be problematic or even impossible for the company to comply with the additional disclosure requirements imposed by Rule 701 since it is quite possible that some grantees may have already exercised their stock options absent the benefit of the requisite additional disclosure.
Private companies that have increased their option exercise prices in order to comply with 409A may want to also re-examine their compliance with the numerical limitations of Rule 701 particularly if they are considering going public or being acquired since their historical securities law compliance will come under closer scrutiny. While it is possible that the company may be able to avail itself of another exemption under the Act (e.g., Regulation D for certain qualifying option grants), will these recurring 409A-related headaches never end?
I think Frank Glassner’s recent post only tells one side of the independence story – the one that boutique consultants want to be told. But it fails to note that the majority of the Fortune1000 companies (61% in 2007, according to the Equilar data) continue to use full-service consulting firms in some capacity for advice on executive pay either in addition to or in lieu of a firm that consults only on executive compensation.
In virtually all cases, these companies have carefully examined the “consultant independence” issue and concluded that the depth and breadth of resources and expertise offered by full-service firms can’t be replicated in most cases by smaller, so-called independent firms. They have concluded that any potential conflicts of interest in the full-service firms can be effectively and appropriately managed. Many have speculated that even greater potential conflicts could result from smaller firm’s dependence on business from any particular client.
A more balanced perspective can be found in several recent academic studies that squarely rebut the notion that potential conflicts of interest at the leading full-service consulting firms play any meaningful role in the escalation of executive pay. Unlike the Waxman Committee’s highly partisan December 2007 majority report on the consultant independence issue, these more recent studies by researchers at The Wharton School, the University of Southern California and Stanford bring more rigor and objectivity to the analysis of consultants’ influence on executive pay decision-making.
Among other areas, the researchers examined the potential conflicts of interest inherent in all advisory firms, full-service and boutique (e.g., the need to sell repeat business as well as to cross-sell other services), and concluded that potential consultant conflicts play no significant role in companies’ decisions about executive pay.
No credible evidence suggests that full-service executive pay consultants are any less objective than the “independent” boutiques. Ultimately, the real issue is not pay consultants’ perceived “independence,” but the objectivity and overall value of their advice.
Here’s a summary of the academic studies as well as Towers Perrin’s views about consultant independence.