Plenty to talk about during today’s webcast; here is an article from today’s Washington Post:
Congressional efforts to impose stringent restrictions on executive compensation appeared to be evaporating yesterday as House and Senate negotiators worked to fine-tune the compromise stimulus bill.
Provisions to impose a penalty on banks that paid hefty bonuses and to cap pay at $400,000 for all employees at firms applying for additional government funds did not survive the compromise, sources said.
The situation was in flux last night, but provisions in the Senate bill that called for a ban on bonuses for all companies receiving government funds also appeared to be headed to the chopping block, congressional sources said.
The provisions would go further than those announced by the Obama administration last week. They would target the 359 banks that have received government aid and essentially prohibit companies from paying anything other than a base salary, analysts said. The 25 highest-paid executives at each company would be subject to the ban.
The White House restrictions, which capped executive pay at $500,000, apply only to institutions that receive government funds in the future and under limited circumstances. The White House version also allows companies to award company stock to executives that could be redeemed once the government investment was repaid.
Excessive executive compensation has received increasing scrutiny as the pay gap between executives and average workers widened in recent years. Public outrage has reached a boiling point with news that billions of dollars in bonuses were paid to Wall Street employees last year even as the banks took billions in taxpayer bailout money.
The provisions in the Senate bill were part of a flurry of efforts by legislators to curb executive pay. While similar proposals remain in Congress, their elimination from the stimulus package highlights the difficulty of passing such measures.
Several compensation analysts said yesterday that many of the measures that were in the Senate bill would have faced legal hurdles because they applied retroactively to banks that received government funds under rules agreed to last fall when Congress passed the Troubled Assets Relief Program’s capital repurchase plan.
“It was not part of the original agreement,” said Laura Thatcher, head of the executive compensation practice at Alston & Bird. “If they’re going to retroactively change playing rules, it would seem to me that, in fairness, they would have to give the institutions an opportunity to back out of the deal altogether.”
Now that the Senate has passed a bill with executive compensation restrictions that are dramatically different than the new set of Treasury guidelines that were just adopted last week, confusion reigns (within the 780-page “American Recovery and Reinvestment Act” is the Senate’s own set of executive compensation standards in Title VI of Division B; I could only find the bill on “Thomas“).
Try reading the Senate’s executive compensation provisions (here’s a memo outlining them; Mark Borges has provided an outline in his blog) – and you’ll get the feeling that various Senators got to insert their own random provisions because they don’t seem to work together. Hopefully this will get fixed during the House-Senate conferencing before this hodge-podge becomes law.
The U.S. Senate’s economic stimulus bill, which is expected to be put up for a Senate vote today, includes a raft of new executive compensation restrictions that would apply to financial institutions receiving TARP assistance. Most of the restrictions would apply retroactively to any institutions that have received any amount of TARP funds and are significantly more severe than both the existing TARP restrictions as well as the restrictions announced by the Obama administration last week.
While the Senate bill is expected to pass with these restrictions, it is uncertain whether the restrictions will be modified as the House and Senate stimulus bills are reconciled by the conference committee. Learn more from this Davis Polk alert. And remember that the panel will describe all these new changes during Thursday’s webcast – “TARP II: The Executive Compensation Restrictions.”
We have posted the transcript from the second part of our popular two-part CompensationStandards.com webconference: “The Latest Developments: Your Upcoming Proxy Disclosures—What You Need to Do Now!”
A new Towers Perrin survey shows that the vast majority of U.S. companies are making multiple adjustments in their pay programs for executives and other employees in response to the deepening economic crisis. Overall, the modifications will mean lower – or no – 2009 salary increases and bonuses for 2008 performance for many U.S. employees, along with reductions in the value of 2009 equity grants for many executives.
The survey was conducted online from January 6th-14th and targeted U.S.-based midsize and large companies. A total of 513 companies participated in the survey. Nearly 65% of the participants had experienced stock price declines of 30% or more in 2008, with 28% down 50% or more.
This survey found that most companies are holding the line on salaries by cutting their 2009 merit increase budgets, freezing salaries or cutting base pay. Merit budgets for the overall survey group averaged 2.4% for most levels, and were lower at 1.9% for executives. When companies that froze or cut salaries were removed from the sample, the budgets grew to nearly 3.0% on average.
Compensation committees are struggling to set incentive plan performance targets in light of 2009 budgeted/planned results that are significantly below 2008 levels, coupled with considerable uncertainly about how quickly the economy will rebound. Almost three-quarters (73%) of the survey respondents say the financial crisis has had an impact on their approach to setting 2009 performance targets under annual incentive plans. The most common considerations among companies reporting changes in their approach to goal-setting are greater use of discretion or judgment in determining awards, setting lower threshold performance levels and greater use of relative performance measures instead of absolute measures (e.g., setting a revenue growth target at 10% above median performance for the industry, rather than a fixed growth rate).
The survey also shows that many companies are rethinking their approach to determining the size of their 2009 long-term incentive grants. Three key elements of a long-term equity award, number of shares, price per share and total grant value are all being examined, both individually and in combination, for potential change. Regardless of methodology, the research indicates these total long-term incentive grant values will decline between 15% and 20% on average. Our recent consulting experiences indicate the decline may be even greater.
A growing number of companies are also wrestling with questions about how to deal with underwater stock options and whether or not to reset performance goals on outstanding awards under long-term performance plans. The survey responses suggest that relatively few companies have fully addressed these issues thus far, although more are beginning to focus on the issue. To date, just over a quarter (26%) of the companies either have addressed underwater options or are currently reviewing the issue. If the market downturn is prolonged, we would expect to see more companies consider the issue of underwater options.
Even fewer of the companies surveyed appear to be moving toward adjusting the performance goals for outstanding cycles under their long-term performance plans to reflect the current business climate. Only a few companies (2%) have recalibrated performance goals or plan to thus far, although 11% of the respondents are now considering such steps. Once again, the longer the market downturn lasts, the more we would expect companies to consider actions like option exchanges to help retain and motivate key talent and recognize some value from the expense associated with past grants.
A strong concern of a majority of companies in the survey was the potential for losing their best performers and those in pivotal roles during this market downturn. The data indicate the more limited dollars available for compensation awards, or adjustments, will go to these individuals through retention awards, bonus payments and individual salary increases, increasing the differential between the best performers and the remainder of the staff.
We’re now in the equity grant season for calendar year companies. Most clients are on dollar-based LTI grant guidelines, which means that, if prices are up, new shares granted decline, and vice versa.
Commonly, compensation professionals argue that, if it’s fair to cut shares when prices increase, then it’s likewise fair to increase shares when prices decline, to preserve LTI grant values. For the most part, Compensation Committee members agree with this “fairness” argument.
But, what few seem to recognize is that there is an asymmetrical relationship between share increases when prices decrease and share decreases when price increases. Thus, as shown in this first graph (see this PDF for the first graph), if the price declines, e.g., 50%, the number of shares do not go up 50% – they double. But if price increases 50%, the shares only decrease by a third.
Note that, as the grant price approaches zero, the shares needed to maintain constant value approach infinity. The second graph illustrates the math even better (see this PDF for the second graph).
With average year-over-year stock price declines of 40-50%, advisors and compensation committees need to be aware of this math in approving new grant recommendations. If the price has declined significantly, consideration needs to be given to either (1) using a price higher than current market price to convert dollars to shares, (2) applying a discount to intended grant values, particularly if it is stock options that are being granted, or (3) applying a run-rate cap or cap on value transfer to the total shares granted. Otherwise, the share dilution just becomes too great and executives benefit excessively just for getting stock prices back to last year’s levels.
Yesterday, I blogged a story about a conversation with a cabdriver about the Wall Street bonuses and how the environment has been altered so much that boards absolutely must change their thinking about executive compensation practices or else face potential societal implications (see this NY Times article).
Recognizing the need for this change, President Obama yesterday announced a new set of Treasury guidelines for those companies seeking government funds. The fact that the President made the announcement and held a press conference on the topic highlights the importance of this matter. Rather than repeat these new restrictions, read the bullets in this press release.
To explain these new restrictions – and how they impact both companies seeking government funds and all companies generally – we are holding a webcast – “TARP II: The Executive Compensation Restrictions” – next Thursday on CompensationStandards.com. Tune in to learn these new developments!
How to Fix the Latest Treasury Guidance
Jesse Brill lays out below how the latest Treasury guidance still needs to be tweaked to accomplish its goals of reining in excessive executive compensation:
The biggest change under the new Treasury guidelines is a $500,000 salary cap. One key aspect of the new $500,000 cap that has not gotten sufficient attention is the unlimited amount of restricted stock and stock options that still can be granted under the latest “restrictions.” Equity compensation is the pay component that has gotten most out-of-line over the past 20 years. It (as well as severance/retirement/ golden parachutes) has caused the greatest disparity between CEO compensation and that of the next tier of executives (and employees generally).
The new $500,000 cap provision does prevent executives from realizing the gains in their equity compensation until after the government is paid back. But there are two major problems with how this applies:
1. It does not apply to past equity compensation. Warren Buffet imposed a similar cap on Goldman Sachs’ executives, but his restriction applies to all the equity held by the top executives. It is not limited just to future grants, as is the case with the new government restriction. So Buffett’s provision wisely requires that the key decision-makers keep all their “skin in the game” until he gets paid off.
2. Although it may help protect the government’s investment, it is short-sighted and fails to protect the shareholders’ best long term interests. The holding period should be the longer of age 65 or two years following retirement. That will ensure that the key executives make decisions that truly are in the long-term best interests of the company (as opposed to decisions aimed at a shorter period – after which an executive could depart, taking all his marbles with him).Note that holding-through-retirement also addresses the major concern about top executives’ unnecessary risk taking.
Holding equity compensation through retirement is perhaps the single most important—and fundamental – fix to getting executive compensation back on track because it also addresses all the past outstanding excessive option and restricted stock grants. And, by requiring CEOs to keep their skin in the game for the long term, it will go a long way to restoring public trust in our companies and our market, which is so important to restoring stability to the markets.
Needless to say, the fundamental hold-through-retirement fix should apply to all companies – not just TARP financial institutions—and can be adopted at the same time that Congress adopts say-on-pay legislation (if such legislation is adopted). (It will have much greater impact and do more good than say-on-pay.) Learn how to implement hold-through-retirement in our “Hold-Through-Retirement” Practice Area on CompensationStandards.com.
Here are three additional points about the $500,000 cap:
1. Just as the $1 million cap was a major cause for the runaway increase in equity compensation over the past decade, the new unlimited opening for restricted stock will further exacerbate the problem. As an example, the typical time vested restricted stock grant does not qualify for the $1 million cap “performance-based” compensation exemption, thus more companies and shareholders will suffer the cost of the lost tax deductions as these very large amounts vest. (So, once again the top executives will benefit at the expense of shareholders.)
2. One reasonable fix to the tax deductibility problem would be to require real performance conditions (in addition to time vesting) upon the vesting of the equity.
3. To address the “unlimited “ new grants problem, do not permit additional grants in situations where the CEO’s total accumulated equity grants exceed the company’s own historic internal pay equity ratios compared to the next tiers of executives within the company.
Just back from a long cross-country business trip and what a week it was. Kicked off by this article last week in the NY Times (both Jesse and I talked to Ben White and Jesse is quoted), the issue of the great pay divide in this country has come to the fore. Last night, my cab driver talked for the entire ride about how he couldn’t understand how Wall Street is paying bonuses after they killed our economy.
Smartest guy in the room? On the one hand, I do understand how the Wall Street firms had contractual obligations and that some of these people weren’t “to blame” for the financial meltdown. On the other hand, I am in touch with reality and recognize that our society potentially is in the balance if things don’t change. When more than 99% of the population looks at a set of practices and says they can’t comprehend the logic, maybe there’s something to it?
I sure hope our business leaders – CEOs and boards – are really listening. If they are, I sure hope they are acting. I still don’t see much action nor am I hearing that necessary action is forthcoming through the grapevine. President Obama is seriously considering the drastic restriction of a pay cap for a reason (as an aside, I don’t agree with pay caps). There needs to be real change in executive compensation practices and it needs to happen fast.
This op-ed by Maureen Dowd from Sunday’s NY Times gives us food for thought:
Disgorge, Wall Street Fat Cats
The president’s disgust at Wall Street looters was good. But we need more. We need disgorgement. Disgorgement is when courts force wrongdoers to repay ill-gotten gains. And I’m ill at the gains gotten by scummy executives acting all Gordon Gekko while they’re getting bailed out by us.
With the equally laconic Tim Geithner beside him, Mr. Obama called it “shameful” and “the height of irresponsibility” for Wall Street bankers to give themselves $18.4 billion worth of bonuses for last year. They should know better, he coolly chided. But big shots — even Mr. Obama’s — seem impervious to knowing better. (Following fast on Geithner’s tax lacunae, Tom Daschle’s nomination hit a pothole when he had to pay $140,000 in back taxes he owed mostly for three years’ use of a car and a driver provided by a private equity firm.)
At least the old robber barons made great products. When you make money out of money, unmoored from morality and regulators, it must unhinge you. How else to explain corporate welfare queens partridge hunting in England, buying French jets and shopping for Lamborghinis?
Mr. Obama was less bracing than during the campaign, when A.I.G. executives were caught going to posh retreats after taking an $85 billion bailout. He called for them to be fired and to reimburse the federal Treasury. Now that he has the power to act, Mr. Obama spoke, as his spokesman Robert Gibbs put it, “like that disappointed parent that doesn’t embarrass you in the mall, but you feel like you’ve let somebody down.”
That’s not enough, not with the president and Geithner continuing to dole out what may end up being a trillion dollars to these “malefactors of great wealth,” as Teddy Roosevelt put it. USA Today wrote about “the A.I.G. effect:” executives finding ways to spend more discreetly, choosing lesser-known luxury hotels and $110 pinot noir instead of the $175 variety.
More than a disappointed parent, they need a special prosecutor or three. Spare the rod, spoil the jackal. Anyone who gave bonuses after accepting federal aid should be fired, and that money should be disgorged to the Treasury.
Claire McCaskill popped out a bill to limit the pay of anyone at firms taking federal money to no more than the president makes — $400,000. “These people are idiots,” she said on the Senate floor. “You can’t use taxpayer money to pay out $18 billion in bonuses. … Right now they’re on the hook to us. And they owe us something other than a fancy wastebasket and $50 million jet.”
One Obama official said her idea is catchy, but it won’t work “because no one would come to Treasury to participate, and that means our economy would continue to stumble downward.”
Senator Chuck Grassley urged the administration to snatch back the bonuses. “They ought to give ’em back or we should go get ’em,” the Republican told me. “If this were Japan and a corporate executive did what is being done on Wall Street, they’d either go out and commit suicide or go before the board of directors and the country and take a very deep bow and apologize.”
He was shocked to learn that the Office of Management and Budget, insistent on following the Paperwork Reduction Act, was dragging down a special inspector general’s investigation of what banks are doing with taxpayer money. (After complaints, the O.M.B. yielded on Friday.)
“Once in a while, some C.E.O. comes and talks to me and I wonder if they’re laughing under their breath at having to talk to someone who makes 1 percent of what they make,” he said. Treasury officials and Barney Frank are dubious about recouping bonuses. “Paulson let the cat out of the bag,” Frank said of Henry Paulson, Geithner’s predecessor, “and it can’t be gotten back.”
But aren’t taxpayers shareholders in these corporations now, and can’t shareholders sue or scream “You misspent my money!” like Judy Holliday? “In ‘The Solid Gold Cadillac,’ ” said Frank, who knows the movie. “We got some preferred shares,” he mused, “but I don’t think we could sue on that basis.”
Rudy Giuliani resurfaced Friday to defend corporate bonuses, telling CNN that cutting them would mean less spending in restaurants and stores. Stupid. Even without bonuses, these gazillionaires can still eat out. It’s like Rudy’s trickle-up Make Work Program: Make Leisure.
Some Obama policy makers still buy into the notion that if they’re too strict, these economic royalists, to use F.D.R.’s epithet, might balk at the bailout, preferring perks over the prospect of their banks going belly-up.
The president needs to think like Andrew Cuomo. “ ‘Performance bonus’ for many of the C.E.O.’s is an oxymoron,” he said. “I would tell them, a) you don’t deserve a bonus, b) where are you going to go? and c) if you want to go, go.”
“Malus” is a new word being tossed around in executive compensation circles to mean “negative bonus.” At UBS, starting next year, only 1/3 of any cash bonus will be paid out in the year it is earned. The amount held in reserve can be reduced by a “malus” if results are poor.
A recent article in Business Week on reforming executive pay also referred to the “bonus / malus” system (as well as this DealBook article). I suspect the new word is someone’s attempt to combine the Latin word “malus” (evil or wicked) with “bonus” (which comes from the Latin word for good). We’ve seen nifty neologisms in the executive compensation area before – the immediately understandable “clawback” is a good example. It will be interesting to see if the more erudite “malus” catches on.
The headlines are coming. “CEO pay rises while stock prices decline sharply.” Investors will be outraged, the compensation committees will be targeted, and critics will ask “where’s the pay for performance?”
The short answer is that for equity awards, and options in particular, the SEC requires disclosure of the cost of equity to the company rather than the benefit of the award to the employee. Of course, the value of what the employee would actually receive from the award fluctuates with the stock price, and this is the missing performance link rarely discussed in news articles.
For many executives, equity compensation makes up the majority of total compensation as reported in the Summary Compensation Table, and the value of equity compensation that is reported is the FAS 123R accounting charge. The Associated Press formulation substitutes the grant date fair value of equity awards granted during the year, but this too is an accounting charge. For most time-based options, the accounting charge is set when the option is awarded and does not fluctuate with changes in the company’s stock price. This is where the performance link breaks down, because the SEC and the media rely on accounting estimates (cost) that are not influenced by performance.
Let’s look at an example that, unfortunately, will be fairly common this proxy season. At the beginning of 2007, ABC Co.’s Compensation Committee determines their CEO’s compensation as follows: salary of $1 million, a cash bonus target of $3 million, and stock options with a FAS 123R value of $6 million for a target total compensation of $10 million. At the beginning of 2008, the Compensation Committee reviews ABC Co.’s results: revenue and net income both increased 10%, the stock price rose 20% and the CEO earned 100% of his targeted bonus amount, so the Summary Compensation Table shows the CEO received $10 million in total compensation for 2007.
Because of the solid performance for 2007, the Compensation Committee elects to increase the CEO’s target 2008 compensation by 10% to $11 million as follows: $1.1 million salary, $3.3 million cash bonus target, stock options with a FAS 123R value of $6.6 million. At the beginning of 2009, the Compensation Committee reviews the grim 2008 results. Revenue and net income are flat, the stock price is down 25% (which is slightly better than its peer group). Based on the cash bonus formula, the CEO receives only 75% of his targeted bonus ($2.5 million). In the proxy statement, the CEO’s total compensation for 2008 is $10.2 million, an increase of 2%. How can this be?
Because the accounting charges that are reported in the Summary Compensation Table are static. For stock options with time-based vesting, the values reported in the option award column will not reflect the impact of stock or financial performance. To see pay for performance in action, you need to look at the intrinsic value of the CEO’s option award. Let’s assume that at the beginning of 2008, the CEO’s $6.6 million FAS 123R cost consists of one option for 1 million shares with a strike price of $10.
If the stock price declines by 25% over the course of 2008, and now trades at $7.50, the intrinsic value of those options is now zero. In fact, the stock price would have to rise 33%, back up to at least $10.01, for the option award to have any intrinsic value at all, let alone $6.6 million of value. If you look at the impact to the CEO’s pocketbook, the total compensation is closer to $3.6 million (salary of $1.1 million, bonus of $2.5 million, options with an intrinsic value of zero) rather than the reported $10.2 million. Here is where the impact of performance becomes vividly clear; the CEO will only receive value from his option award to the extent the stock price increases.
Recent History of Reporting Equity Award Values
In 2006, the reporting of equity awards was addressed by the SEC on multiple occasions. In January, the proposing release would have included the grant date fair value of awards granted during the year in the Summary Compensation Table and included the original grant date fair value of equity awards in the Option Exercises and Stock Vested Table so stockholders could see how the initial estimate differed from the ultimate outcome. In August, the requirement to report the grant date fair value in the Option Exercises Table was removed due to concerns that it would be confusing and could lead to double counting.
Then in December, the SEC replaced the grant date fair value of equity awards granted during the year with the FAS 123R compensation expense for all outstanding equity awards incurred during the year. The original grant date fair value was included as an additional column in the Grants of Plan-Based Awards table, so both accounting measures are readily available to stockholders and the media.
How to Demonstrate the Pay for Performance Link
Unfortunately, there is no consensus on the best way to show the impact of stock price on the value of the named executive officers’ outstanding equity awards. Measuring the year over year stock price change is the easy part; the difficult part is what do you multiply it by? All outstanding equity awards? What about grants made during the year? Or exercises? And what about previously vested awards that are reported in the beneficial ownership table? Should those count? For Intel’s 2008 proxy, we attempted to capture realized and unrealized gains/losses on outstanding equity awards in the CD&A. We also showed the market value of options and restricted stock units in the “Outstanding Equity Awards Table” for directors and officers.
While I believe these measures are helpful, I would like to see more discussion and debate on this topic, with the goal of establishing an accepted methodology that crisply shows the pay for performance link for equity awards, focusing on the benefit of equity awards to the employee rather than the cost to the company.
At this point, I am not arguing that the equity costs included in the Summary Compensation table should be replaced with a benefit value based on the intrinsic value based on the current stock price, but rather, how do we come up with a benefit value to serve as a companion to the accounting charges? How do we report a number (or numbers) that shows how stock price performance influences what the employee may ultimately receive? By developing a benefit-based measure of equity awards, we can demonstrate the pay for performance link that exists.