– Ed Hauder, Senior Attorney and Consultant, Exequity, LLP
Following up on last week’s Part I, here is some advice for folks looking at their employees and worrying about retention:
1. If you haven’t already done so, identify your high potentials, those employees whose loss would hurt your business. Think about the different areas of your company and which people in each area whose loss would be difficult on the company. Keep in mind that high potentials typically are no more than 10% of your employees and are easily identifiable as such by almost everybody who knows what these individuals do and how. Having a limited number of folks identified as high potentials makes the company’s special treatment of them easier for everybody else to accept and understand.
2. Communicate to your high potentials that they are viewed as such (though that evaluation may change over time if they do not continue to display the same qualities and efforts that got them placed on the list in the first place) and challenge them to live up to that assessment.
3. Assess what motivates your company’s high potentials and determine whether they perceive those motivating factors as existing at your company. If not, take steps to develop such motivating factors and effectively communicate the existence of these motivating factors to your high potentials.
4. Assess whether your high potentials have a sufficient long-term stake in the company to ensure that they will have to think twice about leaving and that they’ll have to walk away from a significant amount of compensation (on a relative basis compared to their regular total compensation) if they do leave. Assess the quality of your high potential’s equity stake in the company. Is it mainly in stock options that are largely underwater? Is it in the form of performance shares the past few cycles of which have not paid out? Is the stake sufficient “glue” to keep your high potentials?
5. Assess the state of your business and the economic realities that are confronting it. If your business is going through a tough business cycle right now, what do you need from your high potentials? What would happen if some of them left? Are your high potentials fully engaged in their work and with the company? Do they have sufficient opportunities to grow, develop and pursue their passions?
6. Monitor the turnover rates for both your broader employee population and your pool of high potentials.
7. Do not take the easy way out and implement a retention program that treats all employees equally based on level or position. Sure, such a solution is quick and easy to implement and you don’t risk angering too many folks. But this “peanut butter approach” may not be terribly effective and could end up wasting scarce company assets – money and equity – on individuals who are not key to the company’s success. The peanut butter approach also might not be all that effective in retaining your high potentials. Avoid the urge to take the easy path and instead embrace the more difficult path of identifying high potentials, evaluating what motivates these folks and using a retention plan, if needed, to target your high potentials to ensure they stay focused, engaged and at your company.
8. While you need to consider the reaction of media and shareholders to any potential retention effort, you should also consider the likely consequences if no retention efforts are made and you lose high potentials. How would the media and shareholders react if they learned that the turnover rate of your high potentials was greater than your turnover rate for all employees? What if you could state that that the turnover rate for high potentials was lower? Would that change how these constituencies might view retention efforts?
9. To help with your retention efforts, you might want to explore a portfolio approach to equity grants, i.e., a mix of equity grants that together can address multiple goals. For example, if your company has decided to be solely focused on pay for performance and has instituted performance plans, you might also want to consider also granting restricted stock or restricted stock units with longer vesting provisions to your high potentials to act as “glue” to keep them at the company.
10. Periodically review and re-assess your list of high potentials to ensure that all the employees who should be on the list are on it and that all those who were on the list from your last assessment should continue on the list.
– Gross-ups: “Senior executives should not receive gross-ups beyond those provided to all the company’s employees.”
– Severance Pay: “Executives should not be entitled to severance payments in the event of termination for poor performance, resignation under pressure, or failure to renew an employment contract. Company payments awarded upon death or disability should be limited to compensation already earned or vested.”
Recently, I blogged about our implementation guidance in the latest issue of The Corporate Executive. It was heartening to see that Warren Buffett agrees with this concept – forcing senior Goldman Sachs executives to agree to such provisions before he invested $10 billion in the beleaguered bank. Below I repeat a WSJ article from Wednesday:
Buffett Insists Goldman Executives Are Also Owners (by Yogita Patel)
In exchange for his $5 billion investment in Wall Street firm Goldman Sachs Group Inc., Warren Buffett is due a hefty dividend and an equity kicker, but he also got something else: a commitment from top company insiders that they will continue to hold a substantial stake in the firm. Chief Executive Lloyd C. Blankfein and three other top executives agreed that they won’t part with more than 10% of their common-stock holdings until October 2011, unless the company first redeems Mr. Buffett’s perpetual preferred shares.
In a tumultuous period in which executive pay at financial companies is under close scrutiny, the four executives’ commitment sends a strong signal to Mr. Buffett and to the market in general, said Reena Aggarwal, a professor of finance at Georgetown University. “There is so much anger at Wall Street executives right now that they end up making their money and everybody else is left out there with empty pockets,” Ms. Aggarwal said. “By doing this, [the Goldman Sachs executives] are kind of sending a signal to the market that they are not just going to run out and cash their stock holdings.”
On Sept. 23, Goldman Sachs announced that Mr. Buffett had agreed to buy $5 billion of perpetual preferred stock with a 10% coupon. Goldman Sachs has the right to redeem the preferred shares at any time, but the firm must pay a 10% premium to do so. Mr. Buffett’s investment vehicle, Berkshire Hathaway Inc., also got the right to buy $5 billion in Goldman Sachs shares at $115 a share, the price they were trading at in 4 p.m. composite trading on the New York Stock Exchange Tuesday after falling $9.00, or 7.3%.
Thursday, Goldman Sachs disclosed that Mr. Blankfein, Chief Financial Officer David A. Viniar and Chief Operating Officers Gary D. Cohn and John Winkelried had agreed to hang onto at least 90% of their current stock holdings for the term of the agreement. Their spouses and estate-planning vehicles are similarly restricted under the deal. Representatives of Goldman Sachs and Berkshire Hathaway declined to discuss the agreement.
Ben Silverman, research director at InsiderScore.com, said the agreement was necessary to show that the executives are committed and will work to create value at the company, which recently converted to a commercial bank. “The purpose of the agreement is simply to ensure that top management continues to have their interests aligned with that of shareholders, including Berkshire Hathaway,” said Mr. Silverman, whose firm tracks and rates insider stock transactions. According to Goldman’s most recent proxy, as of Feb. 11 Mr. Blankfein had beneficial ownership of 3.4 million shares, Mr. Cohn of about two million shares, Mr. Winkelried of 2.8 million shares and Mr. Viniar of 1.9 million shares.
Mr. Silverman said it is important for this type of agreement to leave executives with some wiggle room for estate planning and personal liquidity — hence the permission for the insiders to sell up to 10% of their current holdings. Ms. Aggarwal said the Goldman Sachs executives made a bold move by agreeing to the limits. “Any time you put a restriction, you’re taking away an option,” Ms. Aggarwal said. “If they didn’t want to sell, they didn’t have to, but now they definitely can’t sell.”
During our upcoming Conferences, some of the most respected compensation consultants will describe how companies can implement internal pay equity as an alternative to peer group benchmarking (see the Conferences’ agendas). With so much attention right now on excessive executive compensation, we predict that this methodology will really take off over the next year given how existing peer group surveys are comprised of inflated data.
Some companies have already taken the leap. In its 2008 proxy statement for Cerner Corporation, the company discloses that it uses internal pay equity guidelines that provide that its “CEO’s total cash compensation shall not be more than three times that of the next highest total cash compensation (the company’s board must approve any exception to these guidelines).” The flaw in Cerner’s internal equity methodology is that the company fails to include all compensation – including equity awards, which is where the real disparities in pay reside. Companies must be mindful to avoid giving the appearance of good governance when the realities are quite different (eg. clawbacks without teeth).
My Ten Cents: Overcoming Objections to Internal Pay Equity
To the extent there is pushback from compensation consultants about clients using internal pay equity as an alternative benchmark to peer groups, I can understand it – because internal pay likely will reduce the level of the consultant’s role in the pay-setting process. With internal pay, consultants can advise clients about how to implement internal pay equity methodologies, but they wouldn’t make money for the use of their peer group database. This is because internal pay equity is an “internal look” at the company’s own pay scale.
But for the life of me, I can’t understand why lawyers would advise their clients not to consider internal pay equity. Over the past few years, peer group benchmarking has been criticized by many quarters. It’s not that peer group analysis is not useful per se, it’s just that the current batch of CEO pay data is tainted because most boards sought to pay their CEOs in the top quartile for 15 years – thus driving CEO pay inflation through the roof.
Given that most boards rely on peer group benchmarks as the paper trail to show that they were informed when exercising their fiduciary duties – and given that peer group benchmarking is now widely discredited – shouldn’t lawyers be advising boards to find another source of documentation for their files? Or urging them to obtain at least an additional layer of protection by balancing peer group benchmarking with internal pay equity?
The old adage that “everyone else is doing it” simply doesn’t work anymore with regulators and courts. Imagine a courtroom where several experts are brought in to show how peer group data is tainted and that everyone “should have known” it. It’s easy if you try…
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A number of members emailed me some of their reactions to Peter Hursh’s recent blog about restricted stock. Below I repeat Peter’s four thoughts (which I have italicized) followed by reactions sent to me – and then that is followed by further thoughts from Peter:
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%.
Reactions from members:
– This is true from the executive’s viewpoint but neglects to point out that the employer correspondingly gets a lower deduction to the extent the executive realizes capital gain and while this may or may not affect the size of the award it should clearly be known and considered by the committee.
– Both restricted stock and RSUs are taxed as ordinary income, restricted stock when the vesting restrictions lapse and RSUs when paid, which of course can be structured to be when the restrictions lapse. If RSUs are paid in stock, which is typical, they will also be subject to capital gains treatment.
Peter’s further thoughts:
The point is that the executive gets capital gains treatment while holding the stock, on all gains that occur after the restrictions lapse- – hence the words in my point 4: “locking in capital gains treatment from the date of grant.” The executive can never get capital gains treatment while holding the RSU’s. And, since RSU’s are typically held until termination of employment, ordinary income tax applies the entire time the RSU’s are in effect.
Regarding the last thought of this comment – “If RSUs are paid in stock, which is typical, they will also be subject to capital gains treatment” – my reply is: “Yes, but only the stock gains that occur after the individual receives the stock are subject to capital gains tax. Although RSU’s can be designed to pay out before termination of employment, they seldom are.”
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.
Reactions from members:
– This a particularly confusing comment since while it is true that the settlement obligation reflected by RSUs are not protected from the claims of creditors in the event of the employer’s bankruptcy, the creditor status claim of the RSU holder will come ahead of the equity status claim of the restricted stockholder.
– If a company goes bankrupt, I agree that the restricted stock is not subject to the claims of creditors, but the stock is worthless anyway.
Peter’s further thoughts:
On the last point, I agree but that’s assuming the executive still owns the stock. The executive could have sold the stock while still employed, while he or she probably has the RSU’s until termination of employment. That is, long before any signs of bankruptcy, the executive could have sold the stock sometime after the restrictions lapsed and the stock went up in price, so that he or she cashed in at the more favorable capital gains tax rate.
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.
Reactions from members:
– In many, many cases pre-409A and I suspect in even more cases post-409A RSUs will settle upon vesting thereby permitting the shares to be sold so the difference this comment is based on will not be as prevalent as the comment would lead the reader to believe.
– RSUs can be designed to work exactly like restricted stock–he is criticizing the vehicle assuming a certain design.
Peter’s further thoughts:
Most RSU’s are designed to be held until termination of employment, especially under the new and complex rules on deferred compensation.
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.
Reactions from members:
– Section 83(b) elections are very rare. If an executive leaves the company during the restriction period, the stock is forfeited even though taxes have been paid. There aren’t a lot of executives who want to take on that risk.
– 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.
Peter’s further thoughts:
The person responding is “criticizing the vehicle assuming a certain set of facts,” to borrow the words above. Yes, there is that risk of forfeiture – but only if the executive leaves voluntarily without “good reason” or is fired for “cause,” neither of which happens very often at all, and both of which are minimal risks from the executive’s standpoint.
– Ed Hauder, Senior Attorney and Consultant, Exequity, LLP
I had a conversation with a client recently about retention issues. The company’s past several performance and bonus cycles had not paid out and are unlikely to do so and most stock options that remained outstanding after the company switched to performance shares were granted at prices far in excess of the current stock price. A top executive recently left as well as one of the executive’s direct reports. The client was concerned about the potential loss of employees across his organization. We talked more and it turned out that he believed while his Board of Directors would be concerned about the loss of key talent, they would first want to see evidence that employees were leaving before addressing the issue.
There is definitely a concern that you don’t want to address an issue that doesn’t exist, i.e., grant retention incentives where none were needed. This is especially true given the general take of the media and reaction of certain shareholders when retention efforts are disclosed. But companies also need to consider what would happen if they did lose employees. An ounce of prevention is worth a pound of cure (and is generally cheaper).
So what should a company in this type of situation do? I discussed analyzing the compensation packages (i.e., equity holdings and bonus potential) of key employees – those employees whose loss would cause alarm or the loss of key institutional memory or impact the company’s ability to achieve its strategic objectives or shareholders’ view of the company (“high potentials”). If these employees didn’t have a sufficient “at risk” stake that they’d have to turn their backs on to leave, then it might be appropriate to ensure that they were granted such a stake.
Of course, you could look at the situation from the point of view that the economy is bad in general. Therefore, employees are less likely to change jobs and put themselves at risk for down-sizing, etc. at a new employer. You might then think you should just wait and see whether there is a significant jump in turnover of employees before acting. While this approach has a certain appeal, the problem with it is that if high potentials leave, it will be too late to address the situation. In good and bad economic times, it is often a company’s high potentials who will be most able to secure new positions outside the company.
During troubling economic times, every company wants to hire high potentials to help weather the storm and improve their businesses. Thus, even if the employee turnover rate itself remains constant, if the make-up of the employees who leaves is largely high potential employees, then a company that relies on the talents of its employees will be left a hollow shell of what it once was.
So, I asked my client if they had looked at their high potentials and I heard a fairly familiar refrain, “We haven’t seen any list of high potentials, and if such a list exists, it may only be in the head of our CEO.” Well, at least the CEO knows, right? While true, it makes it difficult to monitor the turnover of high potentials and to manage them like the valuable assets they are. What would happen if others had a chance to see and react to such a list or even assist in its creation? What if a high potential employee was told that he or she was on the list? Might not that recognition alone coupled with the challenge of seeing the company through these difficult economic times be enough to reenergize and recommit the employee to staying the course with the company? It might.
As well as being able to look at the group of key employees whose loss could hurt the company, knowing who is a high potential can enable a company to make rational decisions regarding which employees it should encourage to stay through recognition, greater assignments, compensation and other opportunities and, if needed, retention grants. That strikes me as a prudent way for a business to make decisions regarding the potential loss of a valuable asset. And make no mistake about it, high potential employees are a valuable asset who can help make a good company great or whose disappearance can condemn an “ok” company to remain mired in mediocrity and not develop into what it might otherwise have become.
In my experience, employees generally are not solely driven by compensation (heresy, I know, with me being a compensation consultant). Instead, after some base amount of compensation, high potentials look for career challenges – opportunities to learn, develop and grow – and recognition that their contributions are seen and appreciated by higher ups (which could be accomplished through something as simple as a personal note from the CEO – the type of low cost, high impact action that can help motivate your high potentials and keep them engaged and focused on your business). Another thing I’ve noticed is that most high potentials make their decision to stay at a company based on the people they work with and the challenges and opportunities they perceive they have.
Businesses usually make decisions regarding threats to other business assets without waiting to see a loss. Sure, some companies need to experience a huge data theft before IT security becomes a hot-button issue, but normally companies take prudent steps to protect their valuable business assets – they hire security services to protect their offices, plants and equipment or they file patents and trademarks to protect their intellectual property from others. So why can’t companies look at high potentials in the same way from a business perspective? If companies looked at high potentials the same way as any other valuable business asset, many would find that discussions and decisions concerning compensation, while likely initially more difficult, could in fact do a better job of helping the company achieve its strategic objectives.
However, let’s recognize that this is not an easy thing to do. Not everyone can be above average (or a high potential). Not all companies are headquartered in Lake Woebegone. That isn’t to suggest that all employees don’t contribute to the company’s success. Most of them do in some form or fashion. Instead, it simply recognizes the truth that some employees have a bigger impact on a company and should be treated as the valuable asset they are. Companies should at least be in a position to decide what to do with such valuable assets and be able to protect their investment of time, effort and resources in such individuals rather than allow them to slip away due to lack of knowledge or neglect. So why not identify your high potentials so you know who is critical to your organization, and then work out how to keep these folks engaged and committed to the long-term efforts of your company?
In the furious activity of the past few days, it’s easy to understand why many in Congress have demanded salary caps on Wall Street executives as a condition of approving the Bush administration’s bailout of the financial system. After all, in the eyes of the American public, many of the same people who will be leading the effort to get the the diversified financial industry sector back on its feet were the very same “masters of the universe” whose greed and myopia brought the sector, and, subsequently our country, to its knees in the first place.
Nonetheless the decision of Congress to impose some form of still unspecified executive pay limits, a demand reluctantly accepted by Hank Paulson and the Bush administration last week, is a mistake. At this very moment, it’s a valiant struggle to keep a straight face when you read the words “talent” and “Wall Street” in the same sentence. And yet, precisely because Wall Street is currently a trainwreck, the financial system will desperately need scores of simply brilliant and hard working executives and key employees, if it is to return to a state of financial health that benefits the rest of the economy.
The sort of sums that would satisfy Congress as a cap may be far above the income levels of average Americans, but if artificial caps are put into place, there will be no surer way of driving the financial services industry sector offshore, or into private equity or hedge funds where it will be beyond the gaze of regulators. Besides, if ever there was a time when executive pay in financial services, investment banking, and in general industry overall is likely to be depressed by the market, it is now. The financial bubble didn’t only inflate asset and stock prices, but, as a result of executive pay plan design that was largely equity-based, it also inflated pay. Now the bubble has burst in an ugly way, and hundreds of thousands want work.
U.S. politicians have a lamentable record of intervening in setting executive pay. In the early years of the Clinton administration, Congress imposed IRS 162(m), a salary cap of $1 million, beyond which companies faced a tax penalty for any pay above the cap that wasn’t “performance-based”
Executive pay rose as CEOs beneath the cap, realized that they might be “underpaid”, and another set of executives gained from an outpouring of creativity, as companies, with a great deal of help from (mea culpa) executive pay consultants invented myriad types of short- and long-term incentive plans get around the limit. This not only complicated an already confusing situation, it also made it harder for shareholders to know who was getting what, when, and most importantly, why.
If the “deja vu all over again” foolishness of Congress trying to set and regulate executive pay levels is an old lesson, the financial crisis is teaching some new lessons to shareholders. Forget the conventional wisdom that paying executives in large grants of stock options or restricted stock their own companies ensures “skin in the game”, thus driving sensible risk-taking and maximum shareholder value decision-making.
In recent collapses of Lehman Brothers and Bear Stearns, senior management did not just take reckless gambles with other people’s money. Dick Fuld and Jimmy Cayne took reckless gambles with their own, still failed to do the right things, consequently ended up losing everyones money, as well as most of their own fortunes. Public company shareholders and institutional investors, and watchdogs should remember that loading up top executives with shares can certainly be an aid to corporate governance, but not a substitute for it.
For executives and employees alike, the tales of Lehman Brothers, Washinton Mutual, Countrywide, and other catastrophic corporate failures, especially after meltdowns like Enron, Tyco, Global Crossing, the whole “.com bust”, is a reminder of the danger of having too much capital tied up in the company where you work.
Additionally, it clearly magnifies the need for a “balanced portfolio” of executive pay vehicles that are both operationally and market driven. Many more truly talented executives and key employees will now demand their short- and long-term incentives in cash, and perhaps ask for even more shares. That surely will have an effect on the way that companies recruit key employees and on equity-based executive pay in general. And, hopefully, the concept that forcing significant equity-based stakes on executives in their own companies as a means to stop bad decision making has finally been put to rest.
A strong message to Congress – the design and payout structure of executive pay programs is far more important than the amount – especially in the financial services industry sector. For Wall Street executives, foolish short-term risk-taking could be discouraged by matching the timing and payout of executive compensation to the achievement of performance metrics for the companies and portfolios they are responsible for. And, if we’re going to collect capital from the taxpayers, we ought to insure that there is adequate return on invested capital to them, as well as any of our stakeholders, and link those successes directly to executive pay – without guarantees of wealth in spite of failure at the detriment of employees and shareholders.
Congress can certainly ask that financial institutions put up more capital if their executive pay structures appear to be dangerously risky. That makes far more sense than capping executive pay. In the end companies, their Boards of Directors and their shareholders are far better at setting executive pay than government bureaucrats will ever be.
Lastly, there will never be adequate fixes to executive pay in any industry sector – public or private – as long as there are guaranteed “Golden Parachutes” that allow executives to bail out of a crashing company while both employees and shareholders go down with the ship. Candidly, what has created the highest degree of recent outrage in executive pay has been the captains of those sinking ships paddling away in their own comfortable lifeboats, while women, children, and all remaing souls went under.
– Pearl Meyer, Senior Managing Director, Steven Hall & Partners
In response to last week’s blog on mandatory stock option exercises, I would respond that the technique is useful, but for purposes other than those outlined. Requiring exercise and limiting appreciation without a clear corporate objective appears to contradict the grant’s purpose of motivating and rewarding the creation of shareholder value – and the more, the better.
I’ve used this technique, but to achieve a specific corporate purpose – such as to provide employees with the opportunity to earn the negative spread on underwaters while preventing double dipping and to limit the charge to earnings for an option grant.