If you haven’t heard, The Corporate Library has launched a new blog. They’ve launched them in the past but they didn’t “take.” Based on the frequency of entries for this one already, I think this one will have staying power. Below is an entry from Nell Minow worth reading:
In yesterday’s Wall Street Journal, Princeton economist Alan Blinder wakes up to the fact that the problem with excessive compensation is not the absolute levels but the incentive structure. Incredibly, he says that “the ruckus has been over the generous levels of compensation, or the fact that bonuses were paid at all, not over the dysfunctional incentives that inhere in the way many compensation plans are structured.”
I’m not sure which ruckus he has been referring to as pretty much everyone commenting on this subject, from the institutional investors to the financial press and our own testimony and reports (see especially the testimonies dated October 6 and 7, 2008 in our online store), has been focused on problems like rewarding executives based on the number or size of transactions rather than their quality. We welcome Blinder to the debate but wish he had come up with a stronger proposal than suggesting boards do better. Without some incentives like a better pay-performance link for directors and disincentives like the risk of removal by shareholders, we are unlikely to see much improvement and a homus economicus like Blinder should know that.
Below is some important reading that has recently been brought to our attention that we commend to each of you. It shows that this country has some pretty amazing leaders:
1. Pepsi’s CEO Indra Nooyi, who was educated in India and then the Yale Business School, recently gave these impressive remarks about corporate values (you can watch Ms. Nooyi deliver them on this video).
2. JPMorgan’s CEO Jamie Dimon annual letter to shareholders is a “must” read, particularly starting on page 13. Note what Mr. Dimon says about compensation: “It also is clear that excessive, poorly designed and short-term oriented compensation practices added to the problem by rewarding a lot of bad behavior.” And see the steps he has taken at JPMorgan (at pg 26). When I saw the bullet about no special severance provisions, I remembered that he had a huge severance provision in his contract when he went from BankOne to JPMorgan in 2004. Well, I did a little research and sure enough, it turns out that he voluntarily gave it up in ’06 without any fanfare.
3. Roger Martin, Dean of the Rotman School of Management at Toronto puts a fresh lens on compensation and metrics in “Undermining Staying Power: The Role of Unhelpful Management Theories.” His important observations recently were summarized in this Financial Times article.
4. Finally, one of this year’s best media articles is this one entitled “The Executive Pay System is Broken” by Alistair Barr of MarketWatch. It explores possible solutions to fix executive pay and answers why it’s important to do so…
With ARRA’s prohibition on “any compensation plan that would encourage manipulation of the reported earnings to enhance the compensation of any of its employees” there’s finally a legislative impetus to deal with one of the real problems with executive pay. This has received scant attention, however, given the media focus on simpler and politically-sexier provisions such as the $500,000 pay cap. Who really wants to read about financial performance measures when we can debate whether $500,000 is a lot of money?
As a consultant, it’s easy to shoot at the simplistic knee-jerk TARP and ARRA pay provisions but I have to say that I appreciate the government’s institutionalization of an idea that many of us have been harping about for (I hate to admit) decades. While we don’t yet know exactly what that sentence in the legislation really means, allow me to speculate on the potential it holds.
Much research and a basic knowledge of financial accounting indicate the potential issues with a large percentage of executive incentive programs using earnings per share (EPS) and other potentially flawed measures as a primary measure of company performance. Many research studies show no relationship between EPS and shareholder value creation so we must ask why such a measure should be the basis for short-term cash-based awards to senior executives. The lack of relationship between some measures and value creation should be enough to end the use of such, but it has not been. The far bigger problem is the ease with which such measures are manipulated. Now these programs may be in direct violation of the new prohibition for TARP companies and raise questions for all companies as other TARP provisions have.
This blog posting could easily be a chapter and that chapter could easily be a book. It’s a deep and difficult aspect of compensation design that has been given too little attention for three reasons:
1. It’s a deep and difficult aspect of compensation design. It takes more analysis, more understanding of both accounting and finance, and a thorough understanding of the firm’s business strategy. That’s a lot harder than looking in a survey. Peter Drucker was not exaggerating in his comment that “fundamentally, businesspeople are financially illiterate.” There are some Compensation Committee members in that category. Why, EPS is right there at the bottom of the income statement. The FASB requires reporting it. It must be good. Next slide please.
2. The most “popular” measures are the most easily manipulated. Surprise! Anyone with a basic understanding of accounting knows that the accrual-based income statement is nothing more than one possible and very subjective version of business performance resulting from hundreds of decisions. It’s the set of numbers that the company chooses to report. LIFO or FIFO? Black-Scholes or binomial? Exactly when it that piece of machinery going to wear out? Is all that inventory in the warehouse really saleable? What about all that goodwill on our balance sheet, it’s still valuable, right? Let’s do a value-for-value option exchange. There we go, a nice big fat EPS number. Bonus time!
3. The survey says. How can a company be wrong if it’s doing what 70% of the peer group is: determining incentive compensation based on EPS. Well, I think we have seen an answer to the “everybody’s doing it” rationale.
It has always annoyed me that there are surveys, and annoyed me more that companies reference those surveys, measuring “what other companies do” in terms of prevalence of performance measures. That’s about as meaningful as deciding what to have for dinner based on a survey of what other people on my street are eating tonight.
A few years from now we’ll look back on this economic crisis and likely try to ferret out the good that came from the economic devastation, misguided government efforts, and associated effects. I am hopeful that a survey will show that this period created a new attention to short-term and long-term performance measurement and that no one got in trouble for manipulating reported earnings to enhance their compensation.
Although I count myself among those who believe that say-on-pay will impose business burdens that outweigh the benefits, this Financial Times article about Royal Dutch Shell’s 59% “no” vote last week has me thinking. The front page article focuses on the “right” concerns in my estimation – holding boards accountable for paying bonuses when financial targets are not met. Here is a related WSJ article.
The financial downturn certainly places a premium on cogent explanations for executive compensation decisions, and the FT article suggests the increasing importance that shareholders attach – globally – to both corporate disclosures and the input of proxy advisory firms such as RiskMetrics.
Note that in response to our generous early bird offer for the “4th Annual Proxy Disclosure Conference” (whose pricing is combined with the “6th Annual Executive Compensation Conference”), we are on pace for a record number of attendees (despite the economy). A true reflection of how important executive compensation is this year! These Conferences will be held at the San Francisco Hilton and via Live Nationwide Video Webcast on November 9-10th.
Act now, as this tier of reduced rates will not be extended beyond the end of today! With the SEC intending to propose new executive compensation rules in the near future – and Congress looking to legislate executive compensation practices this year, these Conferences are a “must.” Register today. If you’re in need of a few days to get a check cut, email me today to hold this rate.
Recently, the SEIU Master Trust – the pension funds managed on behalf of the SEIU – sent letters to the boards at 29 major financial services companies, demanding that they investigate more than $5 billion in compensation to their NEOs that may have been tied to derivatives and other instruments that are now worthless. The SEIU argues that if the payments – including cash and equity – are shown to be based on false economic metrics, they may be subject to clawbacks. They further demand that the boards overhaul their executive compensation practices so that the NEOs don’t reap bonuses and other incentivized pay regardless of corporate performance. A list of the 29 companies is at the bottom of this press release.
In this podcast, Mike Barry of Grant & Eisenhofer and Stephen Abrecht of the SEIU explain this movement by SEIU’s Master Trust to seek clawback of excessive pay, including:
– How did the SEIU choose the targeted 29 companies?
– What legal theories are being used to seek recovery of excessive pay?
– What did the letters request? Do they seek responses from the boards of the companies?
Those of you who have concerns about the continued value and effectiveness of stock options as an employee incentive device may be interested in an alternative by reading an article written by a colleague, Kathryn Neel, and me in the May-June issue of WorldatWork’s Workspan. It describes a new equity device, which we call Market Stock Units, or “MSUs” for short. It is a market-leveraged RSU grant that has the following characteristics:
– More market leverage than RSUs; less than options
– Symmetrical market leverage, not asymmetrical like options
– Uses average period market pricing for measurement purposes, unlike single-day pricing with options
– Avoids the alluring but risky feature of options that allows employees to cash in at will after vesting
– Is performance based without requiring goal setting
– Eliminates situation that leads to pressure to reprice options when they go underwater
– Includes dividend equivalents, hence aligning to total shareholder return, unlike options which align to stock price growth only
We want to alert compensation advisors to MSUs in case you are asked about them by clients. And we want to engage those of you with a technical interest so that you can ferret out the accounting 162(m) and 409A implications of MSUs in advance if you wish.
Schumer’s “Shareholder Bill of Rights”: Why, What, When and If
– Broc Romanek, CompensationStandards.com
Yesterday, Senator Charles Schumer – along with Senator Maria Cantwell – finally introduced the “Shareholder Bill of Rights Act of 2009” (this is the final proposed bill). Here is my ten cents on your burning questions:
1. Why? – Typically, it would be expected that this type of legislation would originate in Rep. Barney Frank’s House Financial Services Committee. So why did Senator Schumer begin frontrunning his own bill a few weeks ago. The likely answer is that influential parties wanted governance reform as part of the discussion over Obama’s “First 100 Days” to keep these issues in the spotlight. And Frank was too busy with financial regulatory reform to drum up something as a placeholder.
2. What? – As noted in this blog before, the bill is a virtual “wish list” for investors interested in reform (eg. CII’s press release and Nell Minow’s observations in “The Corporate Library Blog”) as it tackles every hot governance there is today (with the notable exception of CEO succession planning).
3. When? – The big question: “What are the odds of this bill getting passed?” I think the odds are fairly slim that this bill becomes law because it includes too many items that potentially contravene state law and open it up to a Constitutional challenge. However, if another big scandal suddenly surfaces, Congress could push this through unexpectedly (just as WorldCom’s implosion pushed Congress to adopt Sarbanes-Oxley).
The fact that only one other Senator placed her name on this bill is a “tell” that there might not be a lot of momentum for it. My guess is that Sen. Schumer wanted to make a mark within the first 100 days of the Administration – and that he wanted this bill to influence what Rep. Frank produces later in the year as well as influence the financial regulatory reform that is being crafted now. In the end, I think the chances of certain provisions of this bill becoming law by the end of the year is fairly high, including say-on-pay and shareholder access – just not as part of this bill.
4. If? – What if this bill gets passed? Wow…
Looks like the parameters of today’s proxy access proposal have been made available to the mainstream media since this NY Times’ article states: “The proposal would permit large shareholders — typically institutional investors like pension funds or hedge funds — or alliances of shareholders to nominate as many as one-quarter of the directors. For the 700 largest public companies, the proposal would require approval by 1 percent of the shareholders for a dissident slate to be nominated. For smaller companies, it would be either 3 percent or 5 percent, depending on the size of the business.
One of those things I’ve been meaning to blog about – and no one else was blogging about until Mark Borges covered it this morning in his blog. A few weeks ago, Ed Durkin and the United Brotherhood of Carpenters Pension Fund has submitted a new shareholder proposal to 20 companies seeking a triennial vote on pay rather than an annual one.
The rationale is that this would help shareholders by reducing the number of companies they would have to analyze each year – and would help companies as they wouldn’t have to face an annual battle over their pay practices.
As Mark notes, the triennial executive pay (known as “TEP”) proposal would require:
– In addition to an overall vote on named executive officer compensation, separate votes on a company’s (i) annual incentive plan, (ii) long-term incentive plan, and (iii) post-employment benefits (including retirement, severance, and change-in-control payments); and
– A “forum” between the compensation committee and shareholders on at least a triennial basis to discuss senior executive compensation policies and practices.
In talking to company representatives, they obviously find a vote every three years more palatable – although I think they have overlooked the fact that the Carpenter’s forum idea is something that could be much more frequent (eg. Intel recently launched a stockholder forum leading up to tomorrow’s annual shareholders meeting).
I agree with Mark that this idea’s weakness is how to deal with corporate implosions between the triennial votes. My solution would be a safety valve where shareholders could gather and trigger a vote, much like the idea of triggering proxy access. In other words, if a group of shareholders got together that met a ownership threshold and filed some type of certification with the SEC that states they seek a say-on-pay vote (with the filing made by a particular deadline), the company would be forced to put say-on-pay on the ballot.
But note that I’m still dubious whether say-on-pay is really meaningful anyways. I would rather rely on votes “against” compensation committee members as the signal to the board that shareholders are unhappy over pay practices. In a say-on-pay world, I worry that board will routinely get their pay packages blessed (see yesterday’s WSJ article) and that excessive pay practices won’t change.
Since the collapse of the financial markets last spring, regulators, politicians, the media, and a wide range of stakeholders have been assailing the financial-services industry for its compensation practices. Few practices have caught more flak than executive bonuses. Examples of outsized executive compensation packages have been well documented: billions of dollars in bonus pay to executives for their performance in 2008—just when their institutions were in crisis and when the US government stepped in to staunch the bleeding with a federal bailout.
Understandably, the main focus has been on the sheer size of bonus awards paid to executives at organizations already hurtling toward financial disaster. Specifically, the sector’s critics turned their wrath on three aspects of bonus-plan design:
– Performance measures out of line with the realities of the business (that is, not taking into account risk-adjusted performance).
– Dominance of annual bonus payouts based on an employee’s performance over 12 months, in businesses where the economic value of an individual’s performance might take years to realize.
– Timeframe when awards are paid out. Most banks pay at least half of the annual bonus in cash and the balance in restricted stock or restricted stock units. These deferred bonuses are not usually tied to future performance goals; individuals receive the balance of their bonus provided they remain employed for a two or three-year holding period, regardless of their performance during the period.
In January, troubled Swiss bank UBS announced its response to these criticisms. In a move closely monitored across the industry, UBS revised its entire approach to rewarding staff in its institutional and investment-banking businesses. A key plank of the new compensation model: the introduction of bonus banking, a concept now being touted by some as the holy grail of incentive structures.
Bonus banking is an incentive plan where part of the bonus earned in a year is ‘banked’ in a bonus account, to be paid out in subsequent years. It differs from recent practice by allowing for the declaration of a negative bonus (sometimes called a ‘malus’) where the amount in the bonus bank is reduced if subsequent corporate or individual performance declines, or if the initial assessment of performance upon which the bonus was based turns out to be wrong. It’s closely related to a bonus ‘claw-back’ (where the company demands the repayment of a bonus that has already been paid to an individual), but has the benefit of providing the company with some security for repayment. The deferred portion of the bonus is held in escrow on the organization’s balance sheet, so it’s easier to recover funds in the future if the measure becomes necessary.
In essence, bonus banking allows companies to balance short-term and long-term value creation, satisfy stakeholders’ demands for accountability, and succeed in attracting, motivating, and retaining the talent needed. Initial reaction from regulators, such as the US Securities and Exchange Commission and the Financial Services Authority in the UK, has been favorable.
Unfortunately, bonus banking is far from a complete answer to the issues surrounding incentives in financial services. While it has some attractions, bonus banking is difficult to implement, unpopular with employees, and ineffective at driving performance.
An appealing idea, in theory
Bonus banking has an obvious appeal to compensation committees searching for an acceptable approach to offering incentives to top executives. It reduces the much-criticized reliance on annual performance measures, creating stronger alignment of incentives with medium-term or long-term creation of shareholder value. Depending on the measures used, it can lessen the opportunities for gaming the system by focusing exclusively on meeting bonus targets at the expense of overall corporate performance. And it reassures shareholders, regulators, and the wider community that the company has some leverage should it turn out that bonuses were earned by producing numbers that were later found to be less than solid.
Stern Stuart, the firm that created ‘Economic Value Added’ (EVA), the financial-performance measure that attempts to capture an organization’s true economic profit, has been advocating bonus banking for years. In fact, bonus banking has worked with the EVA concept in some companies that have stuck to that measurement year after year. For these companies, the practice of bonus banking smoothes out the payouts. Typically, an employer will bank an individual’s full bonus and offer a withdrawal opportunity each year. The employee can usually withdraw from 33 to 50 percent of the balance in the bonus bank. As time goes on, the employer has a better understanding of how the employee’s actions impact the organization. This mitigates a windfall in any one year, and in doing so, addresses some of the skeptics’ major concerns.
Harder than it looks
The primary challenge with bonus banking, in our experience, is the difficulty of managing and communicating the plan while maintaining its effectiveness as a performance incentive. A cardinal rule of incentive plans is that the more remote the payout, the weaker the incentive. Employees may feel their bonus payouts are less secure and may be unsure about the conditions for the receipt or adjustment of the portion of the bonus that has been banked. Complex multi-year performance measures can dilute the focus on maximizing performance in the current year, without setting clear long-term performance goals.
What’s more, bonus-banking plans often have an unintentionally punitive tone. Bonuses can usually only be adjusted down, which can lead employees to feel that failure will be punished, but sustained success will go unrewarded. This is one of the primary reasons for the limited popularity of bonus banking, with consequent risks to retention and performance. In the recent bull market, where talent was scarce, it was not in an organization’s best interest to consider adopting bonus-banking, proving the market is often the final determinant of incentive compensation practices.
Even where company leadership succeeds in overcoming these issues, bonus banking has other limitations. Depending on how it is structured, it can lead to bonuses paid out in years where overall corporate performance is down – one of the criticisms of bonuses paid to investment bankers this year, or to former employees who have not contributed to this year’s performance – a result that could be difficult to communicate to shareholders. Performance measures can be difficult to construct, so plans are often based on rolling annual targets, which are less effective in driving a focus on long-term performance. In the face of these obstacles, compensation committees faced with a challenging environment may opt for more conventional approaches.
The alternative
Of course, there are other options available. Deferring a part of the annual bonus into restricted stock or restricted stock units ties the final value of the bonus to the share price – useful for focusing top-executive attention on long-term shareholder value, though less effective for those employees without a line of sight to the share price. Basing some incentives on two- or three-year timeframes – for example, risk-adjusted returns based on cash returns rather than profit estimates – can reduce the danger of fostering a short-term focus. Bonus banking can work in some cases, but only as part of an overall strategy that focuses the organization on long-term value creation. In and of itself, however, bonus banking cannot guarantee the achievement of a responsible reward program.
This article is reprinted from Directorship’s April/May 2009 issue with permission.
We recently posted the Spring Issue of the Compensation Standards Newsletter. Please note that we also have posted all the archives of this publication for CompensationStandards.com members to access.
If you can’t wait until next week to see the final version of Senator Schumer’s proposed “Shareholder Bill of Rights,” here is a draft and Mark Borges posted a brief summary in his “Proxy Disclosure” Blog this morning.
“Early Bird” Rates: Expire Next Friday, May 22nd
Note that in response to our generous early bird offer for the “4th Annual Proxy Disclosure Conference” (whose pricing is combined with the “6th Annual Executive Compensation Conference”), the conference hotel is close to being “sold out.” These Conferences will be held at the San Francisco Hilton and via Live Nationwide Video Webcast on November 9-10th.
Act now, as this tier of reduced rates will not be extended beyond next Friday! With the SEC intending to propose new executive compensation rules in the near future – and Congress looking to legislate executive compensation practices this year, these Conferences are a “must.” Register now.