A while back, we conducted a study of IPO compensation and financial data that shows that over the past seven years, founder CEO equity holdings in companies going public have plunged. As a result, there is very little difference between ownership levels of founder and non-founder CEOs at the time of IPO (as noted in this WSJ article). This data came from our new IPO Pay Reporter™.
The study reveals that median founder CEO ownership at IPO fell to under three percent of total shares outstanding in 2008. This is down sharply from a high of over 10 percent in 2002. Conversely, non-founder CEO ownership has remained relatively consistent at slightly greater than one percent of total common shares outstanding at IPO.
Our analysis finds investors are returning to a more rational financial expectation of companies looking to raise public capital. This has forced a change in the financial profile and compensation strategies of IPO companies. In 2008, median company revenue, market capitalization and net income at IPO were at the highest levels since Presidio Pay Advisors began collecting IPO data in 2002.
In an effort to meet a more sustainable financial profile, companies are taking an additional two to three years to file for IPO. The most pronounced result is the dilution of founder CEO ownership; this is likely due to less favorable term sheets or additional rounds of financing required to reach IPO.
Our analysis also found that the mix between options and common stock ownership among all executives has undergone a transformation. In 2002, executive officers had a stronger link to investor success, with over 85 percent of their ownership in the form of common stock and less than 15 percent in stock options. By 2008, nearly 40 percent of executive officer ownership was stock options, which have no downside risk for executives, creating a potential disconnect between the financial interests of executives and company investors.
Other major findings include:
– Companies in 2008 awarded and reserved fewer shares for grants to employees; median stock option overhang was at its lowest level in seven years.
– Since 2005, a 24 percent rise in median CEO base salary has been offset by a 25 percent decrease in annual cash bonuses, leaving total cash compensation essentially unchanged for both founder and non-founder CEOs.
– What are the Fed Reserve’s new guidelines?
– What is your own experience in implementing guidance from the Fed?
– What do you recommend that financial institutions do in response to the Fed’s guidelines?
I think most of us see at least one media story per week (or per day) about executive pay which so severely misinterprets the data that we cringe. I have ranted a couple of times on this blog and others on this topic.
A few years ago, I was speaking at the NASPP Silicon Valley Chapter annual conference when a media story that morning had concluded that (1) a certain Valley CEO had received a 90% pay cut from the previous year and (2) this was a clear indicator that CEOs across Silicon Valley would be taking massive pay cuts. It was a bit awkward to cite that story in the introduction to my presentation knowing that another writer from that publication was in the audience, but it was a great and timely example of my topic that day.
Since then, the changes in proxy disclosure rules led some media organizations to rethink their executive pay interpretation and reporting policies and practices in the interest of responsible reporting. There, I thought, was hope.
But a couple of weeks ago, it was déjà vu all over again. The story reported that a Silicon Valley technology company “cut” its CEO’s compensation “by about half.” Well, that’s a story that I’m not only going to read, but am going to research for myself. In the ongoing crisis-fueled executive pay frenzy, this is critical because next week I’ll be in some boardroom and some director will ask me about those big pay cuts that CEOs are receiving and the CEO in the corner will be waiting eagerly for my response.
True, “pay” as measured by this media organization was in fact lower this past year in comparison to the previous year. But the truth of the article ends there. All three facets of executive pay interpretation – collection, valuation, and reporting – were seriously flawed.
The collection issue was easy to discern. The CEO had been promoted in January 2008 in a company with a fiscal year ending on July 31. That gets ugly right away. So base salary went up, as reported in the Summary Compensation Table, but that was a full-year CEO salary compared to a half-year CEO salary the year before, and his salary amounts received were not increased by the 5% reported; it was not increased at all last year after the 33% base salary increase as a result of the promotion in January 2008.
Annual incentive earned and paid for the year did indeed go down “by about half” but the CEO had received a substantial additional discretionary bonus the year before, almost doubling the amount versus his target, by discretion of the Compensation Committee. Was this related to his promotion? Difficult to discern, but his 2009 bonus was only about 14% below target. Whether he’s feeling that year-to-year change was a “pay cut” is questionable.
But here’s the kicker. The proxy disclosure clearly states that the individual received an additional equity grant relating to his promotion last year with a grant date fair value of $6.2 million. How should such promotion grants be treated in pay analysis? Did he get a “pay cut” because he was promoted to CEO last year and didn’t get a promotion this year? Where would he go from here? (One thing that did not complicate this analysis was that the Company’s stock price on the grant dates in the two years was virtually the same, so we don’t get into that debate.)
Another pay action that didn’t fit into the pay tables, and could be deemed a pay “increase” that year was the Compensation Committee’s decision to make changes to the performance goals for the performance RSUs . This is the performance share equivalent of an option repricing. The goals were missed, so the goals were lowered. Where do we put that? It’s shown as the “new” grant for the second year. This highlights both the collection and the valuation issue. Would that have been captured in a survey or proxy database? Doubtful. Given that this is a repriced grant from the prior year and no other equity grants were made in the past year, it could be deemed a 100% pay cut in equity.
Finally, two grants of RSUs were missed in the calculation. Oops. A little $4.1 million data collection oversight there.
This media organization did avoid what they said they wouldn’t do, which is to simplistically report the SCT numbers. But where they ended up may have been worse. Collection, valuation, reporting. Reporting a pay cut resulting from a comparison year of a promotion (or new hire), and then missing a significant portion of LTI awards, is an interpretation problem. If you accept their general approach, the CEO really received a 70% pay cut, not “about half.” But nothing was cut.
A friend of mine often cites the line used by construction contractors: “You can have it good, fast, or cheap. Pick any two.” But in executive compensation, we can’t opt out of the collection, valuation, reporting troika – getting two out of three right won’t do. People often have gripes about an experience with a contractor, and executive compensation professionals are quickly headed to that same status if we don’t get better and force the media and pay critics to do the same.
These issues are rooted in the continued practice of reporting year-over-year changes in executive pay as if executive pay were an orderly annual event, which it is not. More on that in the next posting.
In this podcast, Greg Taxin discusses Soundboard Review Services’ activities, including:
– Why was Soundboard founded?
– What opportunities for boards does Soundboard provide? How does it differ from what advisors do today?
– What is the diligence process that Soundboard undertakes to understand a company’s executive compensation processes?
– What is the “opinion letter” that Soundboard provides at the end of its evaluation?
The latest issue of Fortune magazine has an article that begins with this provocative opener:
Here’s a strong opinion right upfront: High pay for outside directors of corporations guts the whole idea of these representatives of the shareholders making independent judgments. How does a board member challenge a CEO when the director is being paid oversize amounts likely to be important to his or her lifestyle?
The article goes on to note that data from executive recruiter Spencer Stuart’s study of 491 large and important companies reveals that average director pay for non-employee directors was $213,000 in 2008. Moreover, proxy statements companies in the survey whose average salary, in Fortune’s words, “exceeded the nosebleed level of $400,000,” revealed director compensation packages ranging from $713,500 to roughly $1.5 million. Does this kind of compensation gut the idea of director independence?
To be sure, it might give one pause, particularly when considering compensation levels at the higher end. In certain sectors, the average director compensation package tops $300,000. Then too, according to the Spencer Stuart study, for S&P companies with nine independent directors, “the annual price tag for board-related compensation tops $1.9 million.” That seems like a pretty hefty tag. On the one hand, even this kind of compensation may not approach the level of what has been termed excessive executive compensation. On the other hand, to the extent that financial ties to a company may undermine independence, these levels of compensation may be a cause for concern. Indeed, one (though not the only) rationale for increasing the number of independent directors, and thereby decreasing the number of inside directors on a board, has been that inside directors draw a salary from a company and hence may be hampered in their ability to make independent judgments with respect to that company. In this regard, high levels of board compensation pose problems for the independence rationale.
Of course, it may not be as dire as the Fortune article suggest. As an initial matter, we are increasingly expecting our directors to take on significant amounts of responsibility, and one would expect that they would be compensated in light of that fact. This triggers the all-important question: what exactly is “excessive” or “oversized” compensation in this context? Then too, given the spotlight on directors and increased concerns about liability, being an independent director has become a risky business and that risk likely needs to be factored into the equation when considering compensation. Moreover, the current director compensation story is much more nuanced. Indeed, the Spencer Stuart study not only reveals that, across all industries, the average total director compensation package represents a 2% decline from last year, but also that the annual cash retainer only rose 1% from last year the smallest annual increase since Spencer Stuart began tracking compensation data in 1998. Then too, the number of boards paying per meeting fees has steadily declined. It is now at 43%, as compared to 78% in 1999. Finally, there is a significant trend away from stock options and towards restricted stock. This additional data suggest that board compensation has changed not only to account for market conditions, but also to seek a better alignment with long-term growth.
Viewing all the data together paints a different picture, and may reduce worries (to the extent you had them!) about director compensation and its impact on director independence. However, as Fortune notes, it seems to be an issue worthy of a second look, and worthy of keeping in our radar, especially given the kind of responsibilities we increasingly place on independent directors.
The last two years of tumult in the financial markets has generated even greater scrutiny of executive compensation practices in part because of the view that such practices contributed to the on-going global financial crisis. Much has been discussed and written on this topic and the federal government has openly called for market reform and has adopted/proposed various regulations to curb excessive executive compensation.
As a result, equity compensation awards have also garnered much attention. In particular, what to do with outstanding underwater stock options and how to avoid providing a windfall to executives by granting options in a depressed market such that grantees will end up being unjustly enriched simply because stock market prices return to their former higher levels without any underlying superior performance achieved by the grantee or his/her company. Indeed, a quick look at the S&P 500 Index shows its significant volatility over the last couple of years.
Until earlier this Spring, the S&P 500 Index has generally been on a precipitous decline and approximated 1,500 two years ago in October 2007, 950 in October 2008 and 700 in March 2009. However, the index has since strongly rebounded and is currently approximating 1,100 in October 2009.
Broc’s reference to Bud Crystal’s recent article, “Stock Options Winners and Losers”, touched upon the unjust enrichment concern with granting option awards in a down market. Mr. Crystal’s article states that there are stock option “winners” which are options granted at a time when the stock price is materially lower than the average price during the calendar year of grant and “losers” which are options that are granted with exercise prices that are materially higher than the year’s average price. Mr. Crystal also suggests that an option’s exercise price could be based on an average of the issuer’s stock price for the year preceding the date of grant in order to eliminate such stock option winners and losers.
In another very interesting blog, Ed Burmeister proposes the intriguing idea of underwater stock option grants automatically being canceled without consideration if their degree of being underwater reaches some prescribed depth. Granting such self-canceling stock options could benefit the issuer since it would not have to go through the typical hand-wringing ordeal of what to do with deeply underwater options and potentially going through with a costly tender offer stock option exchange program.
Mr. Burmeister’s proposal to prematurely terminate a stock option based on the relationship between stock price and option exercise price represents the flip side of my blog from last year (“Mandatory Stock Option Exercises – A Benefit for Both Employer and Executive?”) in which I commented on the potential benefits of mandating automatic exercises of a nonqualified stock option upon attaining a prescribed threshold increase in the issuer’s stock price relative to the option’s exercise price.
As noted in my earlier blog, among other things, one benefit of an automatic exercise provision is that the option holder is converted into a shareholder with respect to the exercised shares and this feature can potentially mitigate an executive’s interest in taking excessive risks that a stock option could otherwise possibly promote.
With respect to the issues regarding the timing of equity compensation grants, it is important to recognize that it is not easy to accurately predict the future of the stock market in general (or of any particular company’s stock price) absent inside information. In fact, proponents of the Efficient Markets Hypothesis (EMH) or Random Walk Theory would generally say it is not possible.
Even critics of the EMH who advocate alternative views based on Behavioral Economics/Finance or the Adaptive Markets Hypothesis would presumably acknowledge that it is difficult to routinely and consistently outperform the market over time. This should not be a terribly difficult proposition to accept as forecasting the future with precision is something that is generally not achievable on a recurring basis. This means that at the time of any equity compensation grant, one cannot know with certainty whether the grant is occurring in a down or up market or whether the underlying stock price will appreciate or depreciate after grant. What we do know, based on market and stock price history, is that there will be fluctuation of prices in the future and that in hindsight one may contend that a particular equity award potentially was a beneficiary or victim based on the timing of its grant.
Therefore, it could be beneficial to try and smooth out the effects and consequences of the timing of equity compensation grants. Along the lines suggested by Mr. Crystal, a company may want to consider using an average of stock prices for establishing an option’s exercise price. Moreover, applying the self-cancellation and self-exercising features discussed above could address some of the adverse consequences that could be created in part simply because of when the options were granted.
It is important to note though that an issuer will want to be mindful of the regulations under Internal Revenue Code Section 409A that impose certain requirements when using average prices for establishing the fair market value that underlies an option award. That is, if an option’s exercise price is going to be based on an average of stock prices, a company would likely want to structure such a grant in accordance with the 409A regulations to ensure that the option is not treated as nonqualified deferred compensation. And, option grants to named executive officers that do not simply equate the exercise price to the closing price on the date of grant would require fuller disclosure under the SEC’s executive compensation disclosure rules.
In addition, companies may want to consider having grants issued more frequently than the typical one grant per year. For example, smaller magnitude grants, incorporating some or all of the features discussed above, could be awarded on a quarterly basis during a company’s open trading window period. More frequent grants, while probably more administratively burdensome, could produce a greater smoothing out of the effects of stock price fluctuations. Furthermore, particularly when a company’s stock price and/or the market is generally rising, using smaller but more frequent option grants as compared to one larger annual grant could provide less of a conflict of interest for executives with respect to their company’s stock price.
Similar to those nutritionists who recommend “grazing” which is the consumption of more frequent smaller meals rather than fewer larger meals, smaller but more frequent equity grants (“Equity Grant Grazing”) with fenced high/low stock price boundaries on exercisability and/or averaged exercise prices could become more easy to digest by both executives and shareholders than the current typical annual grant cycle.
About an hour ago, the SEC issued nine new Compliance and Disclosure Interpretations to deal with issues posed by the new executive compensation and proxy disclosure enhancement rules adopted last month. These CDIs are in addition to the transitional CDIs already issued.
Below are links to the new CDIs, the last two of which are transitional in nature (in the alternative, we have placed all of the new CDIs in one document for your reading pleasure):
The SEC announced a moment ago that it will hold an open Commission meeting next Wednesday to consider issuing interpretive release on climate change. Here is the meeting agenda. Wonder if this guidance will apply to this proxy season?!?
The GAO’s report, “Private Pensions: Sponsors of 10 Underfunded Plans Paid Executives Approximately $350 million in Compensation Shortly Before Termination,” found that 40 executives for 10 companies received approximately $350 million in pay and other compensation in the years leading up to the termination of their companies’ underfunded pension plans. GAO identified salaries, bonuses, and benefits provided to small groups of high-ranking executives at these companies during the 5 years leading up to the termination of their pension plans. For example, beyond the tens of millions in base salaries received, GAO found that executives also received millions of dollars in stock awards, income tax reimbursements, retention bonuses, severance packages, and supplemental executive-only retirement plans.
Now it would seem to me that any company with even a partially underfunded pension plan for its workers should immediately freeze any executive pension benefits until the plan is in the black, but that sounds like a really effective way to incentivize executives to fiddle the books in a massive way, so the oversight of such legislation would have to be incredibly effective.
On the other hand, most executive retirement packages – certainly defined benefit ones – are a complete waste of shareholder resources because once you are in a position to be eligible for such a plan, you are also in a position to be eligible for enough stock awards to fund your retirement without a pension.
Why do companies bother to keep SERPs? Bebchuk & Fried’s “Pay without Performance” pointed out that while qualified pension plans (exempt from taxation) are limited to about $200,000 a year, supplemental executive retirement plans, known as SERPs are neither exempt nor limited. Yes, they are an inefficient way to compensate CEOs but they come with one great benefit – camouflage. “Neither the increase in value of the SERP plan before retirement nor the amount of payments after retirement appears in the compensation tables, the existence of SERPs, and the formulas under which payouts are made must be disclosed in the firm’s SEC filings.”
While CEOs want to keep their owned defined benefit plans, they frequently want to outlaw them for public employees. As The Corporate Library points out, when the pension plans for their own employees go south, CEOs tend to ensure they still get theirs. Fat cats apparently have no shame. Neither shareowners or the public are really mobilized around the issue, even though many seem to have pitchforks at the ready.
Our firm recently completed its 3rd annual study of stock option valuation assumptions and results under FAS 123(R).1 From 2007 to 2008, the percentage of companies disclosing option fair values decreased from 73% to 72%. The median percentage increase in stock compensation expense from 2007 to 2008 was 2.4%. There are a bunch of charts, etc. that provide more analysis in the study.
Last week, the SEC filed a second complaint in the US District Court – SDNY against Bank of America concerning an alleged lack of disclosure over extraordinary financial losses at Merrill Lynch prior to a shareholder vote to approve a merger between the two companies (here’s the SEC’s litigation release). Last year, the SEC filed a “lack of disclosure” complaint against BofA over a bonus plan related to its merger with Merrill Lynch that became headline news after Judge Rakoff had earlier refused to approve a settlement between BofA and the SEC.
A second complaint was filed by the SEC rather than amending the existing complaint because the court had denied the SEC’s motion to amend. Note that in the SEC’s litigation release announcing its intention to seek leave to amend, the SEC specifically noted that it does not allege that any individual bank executive or counsel acted with scienter and does not name as defendants, any individual. Trial is set for March 1st…
Dominic Jones notes that Judge Rakoff recently ruled that BofA cannot present expert testimony asserting that media reports should have alerted shareholders to the bonuses it planned to pay Merrill Lynch executives after the 2008 merger.