Our firm recently surveyed over 400 board members, executives and human resources professionals in regard to what modifications they’re contemplating to executive pay programs in response to recent market turmoil. The results of the survey – entitled “Executive Pay in the New Economy” Quick Poll – offer important insights into companies ‘ year-end pay decisions, the awards provided for performance in 2008 – as well as a useful preview of compensation planning for 2009.
Overall, executive pay appears certain to face significant upheaval in 2009. Nearly nearly 90% of survey respondents said the economic downturn will affect their decisions about executive compensation during the next six months, with nearly one in five predicting the impact will be “significant.” They said annual bonus and stock-based awards for executives will decline , while salary growth slows. Nearly 18% said their companies are “strongly considering” a salary freeze, while 36% might consider paying a year-end bonus below formula. Additionally, about 1 in 5 respondents said their companies’ severance or change-in-control arrangements will be revised in the next 12 months.
Since the survey was completed, the economy has officially been declared a recession and even more leading companies have sought governance assistance. There seems no question that companies will need to significantly increase the extent to which executive compensation, particularly variable components such as annual bonus awards and stock grants, are put at real risk when performance stumbles. Whether the program changes they make will end up satisfying shareholders who are feeling the pain in their own paychecks, and portfolios, is less certain.
As I blogged this morning on TheCorporateCounsel.net, the SEC adopted mandatory XBRL yesterday. From the remarks at the open Commission meeting, it doesn’t appear that the SEC adopted XBRL for executive pay data. However, as Dave wrote up below, some service providers have taken action to place pay data in XBRL format:
Recently, a company by the name of Xtensible Data announced that its recently released interactive data website now includes 2006 and 2007 executive compensation data reported in XBRL for more than 4000 companies. This is a significantly greater data set than the SEC provides in its own executive compensation viewer, which only includes 2006 data for 500 large companies.
Like the SEC’s viewer, Xtensible Data’s Corporate Pay interactive tool focuses on the information provided in the Summary Compensation Table. The data is based on information from public filings, and the company has converted the data from HTML or standard text into an interactive XBRL format. The database can be searched based on company name and ticker, stock index, and industry, and the results can be sorted by each column of the Summary Compensation Table, and filtered by executive type and fiscal year. The method used to determine the value of stock and option awards may also be selected by the user. The Corporate Pay tool also allows users to graph the executive compensation information (including comparative graphs) and the data may be downloaded into Excel.
A new RiskMetrics Group study – “Gilding Golden Parachutes: the Impact of Excise Tax Gross-Ups” – that I authored sheds light on a long obscured aspect of executive pay. The SEC’s new 2006 compensation disclosure rules lifted the veil on such benefits by requiring companies to estimate potential severance payments, including any tax gross-ups, in their annual proxy statements. These gross-ups are designed to eliminate the impact of a 20 percent penalty (excise) tax that is levied on change-in-control related severance payouts to executives that are deemed to be “excessive.”
Congress enacted the tax in 1984 in an attempt to put the brakes on what were then considered unjustifiably large payouts (though paltry by today’s standards) being made to top executives who lost their jobs after takeovers. But RiskMetrics’ study of S&P 500 companies found that, in fact, the regulation has likely spurred the growth of severance packages, as more and more companies have agreed to pay the penalty tax – and pass that expense onto shareholders. Key findings from the study include:
– A substantial two-thirds of the S&P 500 disclosed they would provide excise tax gross-ups to one or more top executives. That’s in spite of the fact that excise tax gross-ups are a costly benefit, since it generally takes at least $2.50 and as much as $4 to cover each $1 of excise tax that must be “grossed-up.”
– At 80 percent of these companies, the tax would have been triggered if the executives had received change-in-control severance at the end of the prior fiscal year–in other words, the company disclosed its estimates of the tax hit. The aggregate potential gross-up payments for all named executive officers at those companies averaged $13.9 million. And their total estimated severance, including tax gross-ups, averaged a staggering $78.4 million.
– The story was different for the one-third of companies not providing excise tax gross-ups–average total potential severance payouts to the “top five” executives at these firms was $43.9 million.
The huge gap ($34.5 million) between the average value of top executive severance packages at companies that do provide tax gross-ups, versus those that don’t, cannot be explained by the average value of the gross-ups alone ($13.9 million). This finding suggests that companies providing such gross-ups tend to pay higher change-in-control-related severance generally, likely not what Congress intended back in 1984.
Shareholders have been generally tolerant of these arrangements, but that might change now that more details are available on a regular basis. And, although the government may appreciate the revenue stream from the penalty tax, Congress may also take note of the unintended consequences of that attempt to control executive pay.
To get a window on what may happen if say-on-pay legislation is enacted in the US, look no further to the results from the recent annual shareholder meeting for Jackson-Hewitt Tax Services. As noted in the company’s Form 10-Q filed last week, 37.5% of the votes cast were voted against the company’s pay package (see Proposal III) – the highest level of opposition so far for an advisory vote in the U.S. market. This is only the fifth company in the US to allow say-on-pay on the ballot – once more companies allow it, I imagine the levels of opposition will grow given the environment out there today.
Congrats to Dave Lynn for getting quoted in this front-page article yesterday in the Washington Post. The article is entitled “Executive Pay Limits May Prove Toothless.” And more importantly, the article mentions our new treatise! I find it hard to believe, but someone told me they heard Alex Bennett review the treatise during his Sirius radio show yesterday…
As a possible harbinger of eventual extension of Section 162(m) to all Principal Financial Officers, it should be noted that the “Emergency Economic Stabilization Act” adds new subparagraph (5) to Section 162(m), which limits to $500,000 the deductibility of certain compensation paid to executives of those financial institutions participating in the Treasury’s TARP. Although this was an opportunity for Congress to amend Section 162(m) to bring the “Principal Financial Officer” (as defined by the SEC) into the definition of “covered employee,” the EESA only does this with respect to participants in TARP. Meantime, the “Principal Financial Officer” continues to be excluded from Section 162(m)’s scope (as first reported in the Sept-Oct 2006 issue of The Corporate Executive and formally accepted by the IRS in Notice 2007-49).
Careful readers will note that the EESA refers to the “chief financial officer” without defining the term, but Section 101(c)(5) of the EESA authorizes the Treasury Secretary to promulgate regulations defining terms in the EESA so the likely result will be 162(m) regulations defining ” chief financial officer” as the person who is the “Principal Financial Officer” for purposes of disclosure of executive compensation under the SEC’s rules.
The county of San Mateo, California, which lost $150 million in the recent bankruptcy of Lehman Brothers, has sued officers and directors of Lehman to recover some of their losses. The county is also suing Ernst & Young, Lehman’s auditors. The complaint – which is posted in our “Compensation Litigation” Portal – alleges that Lehman executives, in its public filings, during investor calls and at investor conferences, implied that the risks of its “Alt-A” mortgage business were adequately hedged. The executives’ public statements were not consistent with their more pessimistic internal memos, and of course, they look remarkably bone-headed now that the company has collapsed.
Since the county knew that Lehman was involved in a risky business, it essentially has to argue that Lehman’s disclosures didn’t scare them enough, which seems like a long shot.
Lehman executives recently had to appear before Congress to explain to skeptical lawmakers why Lehman’s failure wasn’t their fault. That’s part of the emotional appeal of this case, along with CEO Fuld’s huge compensation ($300 million) and vast personal fortune, which is mentioned several times in the complaint. The case bears watching to see if it survives summary judgment.
As noted in our recent paper, opponents of say-on-pay have cited a survey done for the Center on Executive Compensation of 20 of the largest investors that found only 25 percent of large institutional investors support say-on-pay.
Proponents of say-on-pay found the survey to be disingenuous. It was narrowly targeted to primarily poll institutional investors that have recognized conflicts of interests associated with the marketing their services to corporate executives. Few people were surprised to learn that large institutional investors with conflicts of interest were more reticent to support say-on-pay than shareholders generally.
We already know that 42–43% of shareholders support say-on-pay from voting results on resolutions over the last two years. From a CFA Institute survey, we also know that 76 percent of investment industry professionals support say-on-pay. What the largest and most conflicted few institutional investors might think about say-on-pay tells us more about how conflicts influence their judgment than it says about shareholder support for the concept. The fact is that nearly half of voting shareholders have consistently supported say-on-pay. Given market events of the past few months, we expect the level of support to grow.
– Jack Dolmat-Connell, CEO, DolmatConnell & Partners
We recently conducted a study on trends in executive compensation and long-term incentives (LTI) for 2008 in both the top 100 NYSE and Nasdaq firms. Despite fierce media, investor, and government claims to the contrary, the study conclusively finds that executive pay is related to firm performance. Both sets of firms have strong links between company performance and short-term and long-term incentive payouts, especially when long-term incentives are considered in a new light – that of realized and unrealized value.
The study looked at top 20 performing and bottom 20 performing companies in each index. It found that the elements of executive compensation that are the most correlated to performance (actual bonus paid, bonus payouts as a percentage of target, and the value of realized and unrealized equity), top performing CEOs far outpace their lower performing peers, both in absolute dollars and change from the prior year.
Actual total direct compensation at top performing companies for the CEO saw greater increases (up 16%) over the last year than bottom performing CEOs, who saw either little growth or slight reductions in total pay (between +3% and -3%).
More importantly, realized and unrealized equity compensation was vastly different between top and bottom performers, both in absolute amounts and year-over-year change. For example, unrealized equity compensation was at $63.4M in the NYSE top 20, up 77% from the prior year, and only $18.5M in the bottom 20, down 34.1% from the prior year. This is truly where pay for performance can be seen.
The study also revealed a direct relationship between real ownership (shares owned outright) and company performance in both indices. Top performing NYSE CEOs hold approximately eight times as much equity than their bottom performing counterparts, and top performing Nasdaq CEOs hold approximately ten times as much equity as bottom performing CEOs. Such high levels of ownership show a symbiotic relationship between ownership and performance, and give executives “skin in the game” to align their own personal wealth accumulation with the financial success of the company.
In going through Notice 2008-113 over the weekend, I found myself working out the effect of correction in the same year of a payment of deferred compensation made to a “specified employee” prior to the end of the 6-month delay as follows:
Under Section IV.B.2(b) (p.16) the employee is to repay the “amount that was erroneously paid….”
Under Section III.E (pg. 6) the “amount erroneously paid” is defined as the “gross amount paid…before…any withholding….”
Thus, it appears that if an employee in California receives approximately $65,000, net of federal and state income and employment tax withholding (at the minimum required rate and assuming any applicable wage base for employment taxes has already been exceeeded) of a $100,000 gross payment, the employee must pay back $100,000. While the employee will eventually receive $100,000 back from the employer, there is the obvious loss of use of the additional money during the time until repayment can occur, not to mention any transaction costs associated with raising the additional sum.
It also appears that while the employer can make an adjustment for employment taxes withheld under Sec. 6413 (pg. 17) the same is not to be true of withheld income taxes. Thus, part of the tradeoff for avoidance of the 409A taxes may be early payment of the income tax to be withheld.
A topic that we have been writing about much recently is hold-through-retirement provisions. Not only does this type of provision provide a fairly easy fix to the “excessive compensation” concerns raised by Treasury (and Corp Fin Director John White) – as we have blogged about before – it’s something that major investors also have recognized as a key safeguard against irresponsible pay.
Recently, the AFL-CIO, Connecticut Retirement Plans and Trust Funds and AFSCME have submitted shareholder proposals to a number of companies (eg. Citigroup), urging them to extend the minimum period that senior executives must hold onto shares obtained through equity awards. These investors plan to file about 12 proposals that seek to address the risk alignment between executives and shareholders with a hold-through-retirement provision.
As an example of these, here is the proposal submitted to Dow Chemical last week that urges the company’s compensation committee to adopt a policy requiring that senior executives retain a significant percentage of shares acquired through equity compensation programs until two years following the termination of their employment. The proposal also recommends that the committee not adopt a retention requirement lower than 75 percent of net after-tax shares.
In their supporting statement, the investors note that requiring executives to retain their company stock for extended periods prompts them to focus on the company’s long-term performance: “In the context of the current financial crisis, we believe it is imperative that companies reshape their compensation policies and practices to discourage excessive risk-taking and promote long-term, sustainable value creation.”
In addition, the Laborers’ International Union of North America, International Brotherhood of Teamsters and United Brotherhood of Carpenters and Joiners have submitted shareholder proposals to 25 of the financial companies that sought TARP funds (originally, they planned to target 50 companies but ran into deadline issues). These proposals also contain a request for hold-through-retirement by seeking a “strong retention requirement that mandates that senior executives hold for the full term of their employment at least 75% of the shares obtained through the exercise of options or the award of restricted shares.” For an example of this shareholder proposal, see page 22 of this exclusion request from SunTrust Banks.