– Paul Hodgson, Senior Research Associate of The Corporate Library
While I was writing a new issue of “Proxy Season Foresight” on TARP and its funding recipients last week, SunTrust Banks, the recipient of $4,850,000,000 of TARP funds, filed its proxy statement. For 2008, the CEO James Wells earned just over $1.25 million with no bonus, no vesting of stock and no option profits. At the beginning of the year he was awarded equity with a grant date value of more than $6.8 million which was worth a little over $560,000 on February 17, with the stock option component of this grant worth nothing at all.
While this is somewhat reflective of the collapse in the company’s stock price, the proxy also discloses that the compensation committee has granted – subject to stockholder approval of the plan – 25,075 shares of restricted stock, 25,075 shares of performance stock based on relative Total Shareholder Return, and 852,941 stock options with an exercise price of $9.06.
This is in addition to the 50,000 shares each of restricted stock and performance stock, and 250,000 stock options already awarded to Mr. Wells on February 10th, again at an exercise price of $9.06. These awards pre-date the ARRA regulations by just a single day and are of even greater concern because typical stock option grants to the CEO in the past ranged between 40,000 and 250,000.
Mr. Wells had 953,000 outstanding, underwater stock options (not so much underwater as drowning) at the end of 2008. The combined 2009 awards would appear to be a repricing in everything but name. Using the company’s own calculations, the “grant date value” of the combined awards is less than half the grant date value of the 2008 awards, but this is not the issue. The issue is that the upside potential of these awards is huge. The highest exercise price for outstanding stock options for Mr. Wells is $85.06. If the stock price were to return to that level, the options would be worth over $89 million, with the restricted stock worth $12.8 million.
While such a rebound may seem unlikely, in a period of 10 years it is not impossible. Even if the stock price were to rise to the lowest exercise price of Mr. Wells’ outstanding options – $50.50 – the options would be worth over $45 million and the restricted stock $7.6 million. While shareholders would clearly benefit from such a return, for most it merely represents restoration of value rather than a gain and such compensation is clearly excessive for a CEO who oversaw the decline in value.
None of the expense associated with any of these awards is deductible under the amended Section 162(m) of the Internal Revenue Code. It is even likely that a Treasury review of these prior payments would find that they are “inconsistent with the purposes of… [ARRA].”
Broc recently blogged about “golden coffin” shareholder proposals. Here is a recent WSJ article on the topic – and here are a few samples of this type of proposal that we have submitted to a number of companies.
We have settled with one company, Occidental Petroleum. And a few weeks ago, Comcast filed a Form 8-K, amending the CEO’s employment agreement (and extending it for another year) and removing two of the most egregious provisions of the golden coffin (ie. pay/bonus for 5 years after death and the company-paid life insurance) – but the company kept the acceleration of vesting of stock options and equity awards.
And recently, the SEC Staff rejected Schwab’s exclusion request regarding one of our golden coffin proposals. More news to come…
Due to popular demand, we decided to prepare a cleaned-up transcript of last week’s webcast – “Say-on-Pay: A Primer for TARP Companies” – and have posted it in our “Say-on-Pay” Practice Area.
Recently, Directors & Boards re-ran this commentary from 1994 in which George Keller, forner Chair and CEO of Chevron complained about CEOs making too much. CEO pay was deemed excessive over 15 years ago – and most of the real excesses have emerged since then:
American corporate CEOs, in general, are significantly overpaid. Their job responsibilities and risks just do not justify multimillion-dollar compensation.
Let me hasten to acknowledge that I was a beneficiary of a good part of the inflation of the CEO’s income before retiring at the end of 1988.
In the past 40 years we’ve seen the introduction of modest 10% or 20% management incentive plans in the 1950s expand in scale and participation through the ’70s, and supplemented by longer-term schemes in the ’80s — stock options, restricted stock, performance shares — all incremental to normal salary progress, often adding 200% or more to salary.
Working for Their Grandchildren
Today’s typical corporate compensation profile looks like a pyramid with the Eiffel Tower poking out the top — the CEO and one or two other executive officers far above the madding crowd. At present compensation levels, most CEOs are working to generate funds for their grandchildren, their favorite philanthropies, and the IRS.
Of course, the board compensation committee is aware of the widening gap between the CEO and the rest of his organization. Practical economic considerations preclude our moving toward a more equitable relationship by simply doubling the lower-level salaries, so we pursue a sort of pseudo-equity by trying to restrain further expansion of the gap and by relating the CEO’s compensation more closely to his success in generating value for the business as a whole.
We are faced with the need to be competitive — whatever that means — in order to hire and retain qualified executives and to reward success. The question is: Competitive with whom? Movie stars? The Cubs’ second baseman? Or the true entrepreneur, the inventor, the creator, who bets his skills, imagination, and assets against long odds?
I think not! Generally speaking, these cases have few parallels in the typical career-based companies that make up the bulk of the Fortune 500. Yet, within these companies the so-called “market” analogy has spawned a self-fulfilling prophecy of increased compensation.
Data on peer CEOs is available in proxy statements, if one can decipher them, or numerous consultants stand ready to show you that your CEO is in the third or fourth quartile when his total compensation is ranked with his corporate neighbors, thus propagating the ratchet effect in which CEO salaries steadily leapfrog one another upward, ever upward.
But if I believe CEOs are paid more than the job is worth, how do I propose to do something about it? I don’t. At least as far as total target compensation is concerned. That doesn’t mean there’s no way to slow down the freight train — make that the gravy train!
An Interviewer’s Question
I was asked at one time in a TV interview if, during my last year as chairman, I was overpaid. My answer: If you rephrase the question and ask if I would have worked just as hard at my job for much less, I would say “definitely yes.”
But my senior managers and I would have been seriously embarrassed, as industry competitors with whom we dealt on a continuing basis wondered how come my board thought my job (or I, as CEO) was worth only half as much as my peers. I call this the “scoreboard effect,” and I view it as a particularly difficult impediment for compensation committees to deal with.
I believe the key objective of the committee should be “pay efficiency.” Assuming an agreed target for a total CEO compensation, and a salary component as modest as reasonable, this means that the larger part of compensation should be performance-related, primarily to his contribution to “corporate value.”
Use of the term “corporate value” rather than “shareholder value” follows my strong personal conviction that the appraisal of corporate achievement includes far more than stock price and dividend payout. Integral to its very existence and critical to its long-term success are a corporation’s employees, customers, and community.
Wall Street is a volatile short-term dealer in the shares of our corporation — an essential component in the ultimate value judgment we must make on performance. But much more significant than the stock market snapshots are steps taken to build value for the longer term.
Also, to be meaningful, our appraisal criteria must be hand-tailored to this corporation — to its strategic vision, physical and financial resources, competitive environment — and the criteria must be measurable to an acceptable degree.
The CEO as ‘Strategic Broker’
Committee members must recognize that to a large extent senior executives in the ’90s, rather than controlling organizations, are continually engaged in managing ideas. Ideally, the reward system should reflect how well these executives play the role of strategic broker — not always an easy factor to measure.
We find it simpler to relate a senior executive to measurable elements of company performance than that executive finds it possible to seriously influence these elements. Even for the CEO there are many factors more related to the economy, the marketplace for his products and services, and the resources presently available than his manipulation, where possible, of those factors.
We must recognize that the compensation of corporate leaders is not solely of interest to executives, boards, and compensation specialists. There is a much wider constituency — our American society — which is not only beginning to take notice but seems ready to react politically to the growing chasm between rich and poor.
There are signs every day that many in our country have abandoned the American Dream of a better life and, partly in consequence, are withdrawing into enclaves of special interest. This despair of progress and the new separatism it seems to have engendered is corrosive to the very concept of a democratic society.
Ripples Far Beyond the Boardroom
And, surely, it can only hasten the decline of the dream if the American people watch those at the top of the pyramid continue to pull away from all the rest.
All this is simply to suggest that the issue of executive compensation is one that sends ripples far beyond the boardroom. Words like “equity” and “restraint” touch upon a wider community of interests than those immediately connected to the corporation.
Some form of special leadership is called for here, because in this matter — as in many others — we discover that an issue of corporate responsibility is an issue of social responsibility as well.
– Don Delves, The Delves Group and Warren Batts, well-known director and former Premark CEO
Here is a column we recently wrote for “Directors & Boards”: Many companies have lost half or more of their market capitalization. The stock market has hit the proverbial “re-set” button, establishing new baseline values that capitalize a new market reality. Since the vast bulk of compensation for CEOs and other top executives is paid in the form of stock and options, it is also time to hit the re-set button on executive pay.
A little history: Back in 1993, stock options represented over 90% of stock compensation and accounted for about 5% of the outstanding stock of the typical company. Then, from 1994 to 2002, stock option grants to CEOs increased by 400% to 600%. By 2000, stock compensation – still over 90% options – accounted for 12% – 15% of the outstanding shares of the typical company. While some of this dramatic increase was market driven, some was the result of an irrational exuberance in executive pay that mimicked the irrational exuberance of the stock market.
When the bubble burst in the stock market, there was no equivalent drop in executive pay levels. While executive pay leveled off and returned to normal growth rates, stock compensation never went down in terms of the value granted to executives. The full 1990s run-up in executive pay became permanent, even though the stock market rise was not. While the stock bubble burst, no air has seeped from the pay balloon.
How does this work? Competitive long-term incentive grant values come from compensation surveys, which value the options and shares that are granted to executives. Those values are based on stock prices before the most recent market crash. In order to make new grants with equivalent values, it could easily take twice as many shares as it did a year ago. This calculation means twice the percentage of outstanding stock and twice the dilution to shareholders. We have to ask every independent board member seriously whether this mindless calculation is the right thing to do. If shareholders have taken a major hit in the value of their holdings, shouldn’t executives also receive stock compensation that has a similarly reduced value?
We are not advocating that companies grant fewer shares and options, only that they not increase the number of shares and options granted because the stock price has fallen. To be clear, we are advocating that companies maintain recent grant levels, in terms of the number of shares granted. This approach will result in much lower prospective grant values, which will look like executives are being paid below market levels. But since the market data will be based on pre-crash stock prices, even the prospective values have to be taken with a large grain of salt, a dash of good reason, and some seasoned wisdom.
These grants will return senior executives to the lofty compensation values they knew just last year – once they restore the market capitalization of their companies. This combination of values is the only way incentives ever have worked – exceptional rewards for almost impossible outcomes. Shareholders deserve no less.
One of the more disappointing aspects of this market meltdown has been the lack of leadership from the top of Corporate America. So few CEOs have spoken publicly about what can – and should be – done to fix what ails us. There has been panic in the air for over six months, and this may well accelerate if some of our biggest banks are nationalized. Where is the leadership? Hence, the “Slap a CEO” game.
Even more perplexing to me is that a few lawyers are finally speaking up about executive pay – but they are speaking up to defend past practices and urge that they be continued (in comparison, many tell me privately that they agree with our mission to rein in excessive pay). Lawyers have long ago given up the mantle of being perceived as responsible leaders in the community. This surely will not help the profession’s cause.
I’m not saying that Congress’ (and Treasury’s) latest approach to reining in executive pay is without fault. I firmly believe that Congress should not legislate executive pay and have long said that. But I don’t blame them for trying to stem the tide because those involved in setting pay have long ignored the fact that the pay-setting processes are broken (here’s my explanation for how they are).
Change Won’t Happen Until Boards Want Change
Unfortunately, the sad truth is that even if the legislated/regulated pay fixes were perfectly set so that pay would be aligned with performance, etc., the fixes still wouldn’t work until boards and their advisors wanted them to work. They always seem to find a “work around” to keep the excessive practices flowing. Part of the problem is a culture of “all CEOs are deities and couldn’t possibly be replaceable” as well as a failure to recognize that the client is the company, not the CEO. The current state of executive pay remains a huge corporate governance problem – as pay has unintentionally racheted up over the past two decades – and needs to be rolled back.
Unmasking the Myths
These pay apologists continue to argue that CEOs will run to the nearest private equity/hedge fund if they aren’t paid along the lines of the past. I say let’s see. I think most boards will find that their CEOs aren’t going anywhere fast if given the option to depart, particularly given the state of those funds.
Most of the arguments against responsible pay arrangements revolve around the fact that CEOs have amassed so much wealth that they don’t need the company anymore. Which is exactly the point. I hear the argument that hold-through-retirement won’t work because it incentivizes a CEO to retire and collect their accumulated equity now (Note that our approach encourages long-term holding until “the later of” – and Exxon Mobil has shown that it works. Here’s our analysis on how to implement hold-thru-retirement). That may be the case for this generation of CEOs who have amassed ungodly sums of money – but if pay packages are brought back to Earth, this won’t be a continuing problem because your CEO won’t have amassed $100 million in a few short years and will need to keep the job.
There has to be a modicum of common sense in negotiating these pay packages. How can one be motivated to do a better job getting paid $10 million per year versus $5 million? If you earned 5 mil, wouldn’t you give 100% of your effort? Boards need to get off the peer group survey train and do their own homework, starting from scratch and using internal pay equity as an alternative benchmark.
Now that so many responsible tools and processes have been identified, it’s time that companies start using them. Fortunately, some companies have started – as Mark Borges recently identified in his “Proxy Disclosure Blog.”
– Median total board compensation for S&P 500 firms is more than $2 million
– Median total compensation for individual directors of S&P 500 companies is just under $200,000
– In contrast to their CEO colleagues, compensation for directors in the S&P 500 did not increase by more than that for directors of smaller companies
– Company size is the greatest influence on board and director compensation
In our “Director Compensation” Practice Area, we have posted the results of a few other recent director pay studies. Here are some thoughts from a member about these surveys:
Nothing earth-shattering, just a continuation of trends noted in prior years. Larger companies pay more cash, smaller companies grant more equity. Larger companies are more likely to make equity grants in stock, while smaller companies are more likely to grant options (makes sense, since the stock price of smaller companies often has more upside potential). Stock ownership guidelines are more prevalent the larger the company.
The smaller companies that I represent liked these kinds of surveys because they at least gave boards some numerical data points. Many of the board surveys are either not available without a fee, or else heavily weighted towards large companies.
A Poll: Use of Director Pay Surveys
Please take a moment to click on an answer; all responses are anonymous. If you’re an advisor and not in-house, please answer based on how a majority of your clients act:
Below is a new memo from Wachtell Lipton that provides an interesting observation regarding the latest reiteration of TALF earlier this week and its lack of executive compensation restrictions:
The Federal Reserve and the Department of Treasury on Tuesday inaugurated the previously announced Term Asset-Backed Securities Loan Facility (TALF). The TALF is likely to prove a major step forward in jump starting consumer lending funded through issuances of consumer asset-backed securities (ABS). According to the Federal Reserve, over the past several years, approximately one quarter of all non-mortgage consumer credit – including auto, credit card and student loans – has been funded via securitizations. Since October 2008, consumer ABS issuances have remained near zero, which has adversely impacted the availability of consumer credit.
Under the TALF, the Federal Reserve Bank of New York will lend up to $200 billion in the aggregate to finance the purchase of top-rated domestic ABS backed by newly and recently originated auto, credit card, student and SBA-guaranteed loans. The loans are secured by the purchased ABS and are without recourse to the borrower. Eligible borrowers include U.S. companies (including investment firms such as private equity and hedge funds), U.S. subsidiaries of foreign companies that conduct significant activities in the U.S. and U.S. branches and agencies of foreign banks. Eligible ABS must have received the highest rating from two of the major rating agencies and no major rating agency can have rated the security below the highest rating or placed it on watch for downgrade. (Subsequent downgrades or watches, however, do not adversely affect the TALF loan.) Each ABS issuer is required to hire an external PCAOB-registered auditor to certify that information conveyed to the rating agencies is correct and that the ABS meets the TALF eligibility requirements.
The Federal Reserve will determine loan amounts by applying haircuts that depend on the ABS type. Loans will have a three-year term. If there is a payment default, the Federal Reserve will sell the collateral to a special purpose vehicle established to manage these assets. The SPV will be capitalized in part by a $20 billion equity investment by Treasury under TARP that will absorb first losses on the ABS collateral.
In a reversal, the Federal Reserve and Treasury stated that no executive compensation restrictions will apply to sponsors, underwriters or borrowers under the TALF. Previously, in order for an ABS to be eligible for TALF, the sponsor of the securitization that issues the ABS would have been required to comply with the EESA executive compensation restrictions. Eliminating the compensation restrictions, along with recent statements by banks receiving TARP funds that they intend to repay them soon, should be an indication that such restrictions may be counterproductive and merit reconsideration by policy makers.
As announced last month, the Federal Reserve and the Treasury are working to expand the TALF’s scope to up to $1 trillion in loans. As part of this effort, the government is considering accepting commercial mortgage-backed securities and other types of AAA-rated newly issued ABS for acceptance under TALF. Currently, the TALF is scheduled to cease making new loans on December 31, 2009, unless the Federal Reserve extends the termination date.
In preparation for today’s webcast – “Say-on-Pay: A Primer for TARP Companies” – I decided to hunt down the preliminary proxy statements filed by TARP companies recently. In addition, you may want to look at the proxy statements of those companies that voluntarily put “say-on-pay” on the ballot last year.
Here are two dozen recent preliminary proxy statements dealing with say-on-pay:
Yesterday, we held the prep call for this newly scheduled webcast to be held tomorrow – “Say-on-Pay: A Primer for TARP Companies” – and I know it’s gonna be a “biggie.” Our panelists have a lot to say – with much practical guidance to provide. Join these experts:
– Mark Borges, Principal, Compensia
– Ning Chiu, Counsel, Davis Polk & Wardwell LLP
– Dave Lynn, Editor, CompensationStandards.com and Partner, Morrison & Foerster LLP
– Carol Bowie, Head, RiskMetrics’ Governance Institute
Delaware Dismisses Caremark Claims Against Citigroup: CEO Pay “Waste” Claim Survives
From Travis Laster of Abrams & Laster: Delaware Chancellor Chandler’s opinion in In re Citigroup Inc. Shareholder Litigation came out last week. The complaint alleged Caremark claims against the Citigroup directors based on Citi’s subprime losses. The Chancellor dismissed all but one aspect of the case – a waste claim based on former Citi CEO Charles Prince’s exit compensation agreement. [We have posted memos regarding this case in a newly-created “Risk Management” Practice Area.]
The opinion confirms that existing principles of Delaware law apply even in the midst of an unprecedented financial crisis, and that the Delaware courts will not go looking to hold directors up as examples for the economy’s current difficulties. It provides a good summary of existing Delaware law principles governing Caremark claims, which I won’t repeat.
Here are a few nuances worth highlighting:
1. The Chancellor distinguishes between (i) a Caremark monitoring system designed to protect against financial fraud and criminal wrongdoing and (ii) the identification of and protection against business risk. He holds that Citi’s problems fell squarely under the heading of unanticipated business risk. This will be a helpful distinction for other companies faced with similar problems brought on by the current financial crisis.
2. The Chancellor makes clear that “Directors with special expertise are not held to a higher standard of care in the oversight context.” (n.63). Likewise, for directors who sit on committees with oversight responsibility, “such responsibility does not change the standard of director liability under Caremark and its progeny.” (Id.)
3. Prior experience with scandals at other companies is not sufficient to make a director “sensitive to similar circumstances” and hence susceptible to a Caremark claim. (37).
4. In a point of interest to those who litigate in Delaware and face competing litigation in other fora, the Chancellor questions whether a lower standard should apply to a motion to stay in favor of a prior pending action versus a motion to dismiss, noting correctly that both have the same practical effect. (n.16).
5. In what I view as the most noteworthy section of the opinion, the Chancellor holds that the plaintiffs stated a claim for waste based on former CEO Prince’s $68M exit package. He explains: “[T]he discretion of directors in setting executive compensation is not unlimited. Indeed, the Delaware Supreme Court was clear when it stated that ‘there is an outer limit’ to the board’s discretion to set executive compensation, ‘at which point a decision of the directors on executive compensation is so disproportionately large as to be unconscionable and constitute waste.'” (55-56). The Chancellor held that there was a reasonable doubt as to whether the exit package awarded compensation that is beyond the “outer limit.” (56).
It used to be said that waste claims were easy to plead – but difficult to prove. Then for a long time they were also hard to plead. This one survived. It’s too early to say whether the Delaware courts will now be more receptive to compensation challenges based on waste theories, but I feel safe predicting that this aspect of the decision will not go unnoticed by members of the plaintiffs’ bar. Look for more waste claims to come based on big exit comp numbers.