– Broc Romanek, CompensationStandards.com

This column by Gretchen Morgenson in yesterday’s NY Times was disturbing. It reported on a recent study – “Will Disclosure of Friendship Ties between Directors and C.E.O.s Yield Perverse Effects?” – by 4 professors who found that directors who had a personal relationship were more willing to slice into a company R&D in order to pay the CEO a higher bonus. And to make matters worse, disclosing the personal relationship made the directors even more willing to forego R&D to support a higher bonus. Here’s an excerpt:

In the experiment, the directors were asked to role-play as board members of a hypothetical biotech company that was about to report earnings for the year. The company had been expected to earn $805 million, the directors were told, but its actual profits were going to be just $800 million. That shortfall would have an impact on the compensation of the chief executive, who would receive a bonus only if the company earned at least $810 million.

The directors participating in the experiment were divided into two groups. Two-thirds were told to assume that they had a personal or social relationship with the C.E.O. of the biotech company. The remaining third were told they had no such tie. Of those who were friendly with the executive, half were told that they had disclosed their relationship to the board, to company management and to shareholders. The other half were told to assume that they hadn’t made the disclosure.

The only option given to the directors to make up the shortfall — and thus help the C.E.O. get a bonus — was to cut the company’s $40 million budget for research and development. As they weighed this possibility, they were told that for every $1 million cut in that budget, there would be a 1 percent increase in the chance that the company would lose ground to its competitors.

Now for the results: Among the directors who counted the C.E.O. as a friend, 46 percent said they would cut research and development by one-quarter or more to ensure a bonus payout to their pal. By contrast, only 6 percent of directors with no personal ties to the chief executive agreed to reduce research and development to generate a bonus. That’s to be expected.

The results get more interesting when disclosure is added to the mix. Of the directors who said they would cut $10 million or more from the budget — the amount necessary to generate a bonus to the chief executive — an astonishing 62 percent had disclosed a friendship with the C.E.O. Only 28 percent of the directors who had not disclosed their relationship with the executive agreed to make the cuts necessary to generate a bonus.

Only one director with no ties to the executive agreed to cut the budget by $10 million or more.

Mr. Rose, an author of the paper, said he and his colleagues were surprised that so many directors said they’d be willing to put the company at risk to ensure a bonus for their pal, the C.E.O. “If just by mentioning that you’re friends with the C.E.O. it affects their decision-making, we think the effects going on in the real world are much, much larger than what we picked up in the lab,” Mr. Rose said in an interview last week.

Even more disturbing, he said, was that so many directors seemed to think that disclosing their friendships with the C.E.O. gave them license to put the executive’s interests ahead of the company’s. “When you disclose things, it may make you feel you’ve met your obligations,” Mr. Rose said. “They’re not all that worried about doing something to help out the C.E.O. because everyone has had a fair warning.”

– Yelena Dickerson, ISS Corporate Services

With the peak of proxy filing season behind us, fiscal 2013 chief executive pay trends are coming into sharp focus: Median CEO pay was up again in 2013, with the median Russell 3000 company CEO realizing an 8.4 percent increase in total compensation compared with fiscal 2012. The sharpest median CEO pay increases were reserved for CEOs of smaller companies. While S&P 500 companies realized an increase of 3.6 percent, and their mid-cap S&P 400 CEO colleagues earned only a median 1.4 percent increase over 2012, CEOs of smaller companies fared much better. The median small-cap S&P 600 CEO took home 10.7 percent more in 2013, and the median CEO of non-S&P 1500 companies in the Russell 3000 realized a 9 percent increase.

In the area of performance-based compensation, 2013 was a pivotal year. For the first time, CEOs in the S&P 500 had more than half (53.1 percent) of their pay granted with performance strings attached. The figure represents a 5 percentage point increase from 2012, when performance-based compensation accounted for roughly 48 percent of total pay.

S&P 400 companies are not far behind, with more than 46 percent of their compensation performance-based, a lesser increase from 2012 but still on the rise. For purposes of this analysis plain vanilla options and SARs are excluded, while equity awards granted through performance stock and performance options, as well as cash awards granted through non-equity incentive compensation plans are included.

The use of equity compensation is also revealing some interesting trends. In 2013, for the first time in several years, S&P 500 CEOs had a smaller portion of their compensation delivered through equity. Instead, we are seeing a small shift toward more cash-based performance incentives. This may show that the cash versus equity composition of CEO pay is edging toward parity, with nearly two-thirds delivered in equity and the remainder in cash.

– Broc Romanek, CompensationStandards.com

Frank Glassner of Veritas writes:

With their proliferation of plan-design alternatives and features, long-term executive compensation practices have become more and more complex over the years. Performance shares/units, stock-appreciation rights, performance cash and deferred stock units have become the preferred alternative source of compensation to restricted stock and stock options.

What’s more, the quest for better and better mousetraps has led to incentive methods that often do a worse job of actually motivating management to think and act like committed long-term owners.

For example, consider many long-term incentives now have some sort of “performance test” that determines the degree to which the award vests. One common type of performance test measures total shareholder return (TSR) in the form of dividends and share price appreciation against a list of peer companies. Typically, if TSR ranks atop the peers, 200% of the award vests with less vesting at lower TSR ranks. Bottom quartile performers often get no award.

This seems logical. If the share price performs well against peers, then management receives more shares. However, if the share price increase is caused solely by industry performance and the company is bottom quartile against peers, then the award is forfeited. This is designed so awards are not excessive for just being lucky.
As good as that sounds, there are numerous issues with TSR performance tests. Executives can earn a lot more or less based on different starting and ending points, making performance tests a bit of a lottery.

Consider United Continental Holdings, Inc. (UAL) and Delta Air Lines Inc. (DAL). A comparison of TSR over the 3 years ending January 10, 2013 shows United ahead by 94%. Comparing the very same two direct competitors 9 months later shows Delta ahead by 103%. This demonstrates just what a game of chance TSR performance tests can be. Executives just do the right things and hope the compensation works out. It’s unlikely that that motivates any desired behavior.

Perhaps more importantly, TSR performance tests do not motivate smart business-unit portfolio management and capital-allocation choices. Although a management team can move its company into areas with better growth and return on capital opportunities, if it does so, it will be compared to new peers with potentially better TSR. This may diminish the financial benefit to management and can stand in the way of motivating the right portfolio-management decisions.

Perhaps compensation committees should look to how private-equity motivates executives. Management wins if private-equity investors win and vice versa. Managements typically earn a “promote,” which is an equity participation that increases depending on how high the IRR is for the investors. They tend not to worry as much about whether the success was skill or luck; they simply reward success.

Often there is a minimum return for investors before management participates. This can be anywhere from 5% to 10% and is often described as an internal rate of return, or IRR. Any value created above that is shared between management and investors according to a formula. For example management might get 15%, 20% or 25% of any value created above the minimum IRR.

Often there is another, higher threshold of IRR, above which management will share in an even higher percentage of the value created. Though specifics vary, it is usually the case that the more money investors make, the more management earns, which forges a very strong alignment of their interests.

Public company compensation committees could reach outside their normal comfort zone and implement long-term compensation structures that work more like those in private equity. They could directly copy the private-equity arrangements or use a simplified stock-option structure designed to accomplish similar objectives.
To emulate the typical private-equity deal, a company could establish a subsidiary for the purpose of holding treasury stock that management might earn going forward. The subsidiary could be financed with, say, 10% in equity from management, either via paid-in capital or a time-vested grant. The remainder could be financed with debt or preferred stock with a pay-in-kind feature so the amount of financing builds every month to set a minimum threshold before management participates.

The value of management’s stake would increase if the value of the company grew faster than the pay-in-kind financing. That would replace the typical annual equity grants over, say, 5 years, with a single front-loaded opportunity. Thus, the size of the equity pool would need to be calibrated to deliver an appropriate high, medium and low payoff under different share-price performance scenarios.

Admittedly, implementing such a structure is fraught with all sorts of legal, accounting and tax complications, and may prove confusing for investors and proxy advisory firms.

A simplified stock-option structure can be used to mimic the private-equity approach in a way that is more consistent with normal public company practices. In place of the next 5 years of equity grants, management could be granted one front-loaded package of stock options that might come in five tranches, each with different vesting dates and exercise prices.

The first tranche might vest in 1 year and have an exercise price 8% above a benchmark share price, say the 3-month-trailing average price. The second tranche might vest in 2 years and have an exercise price 16% above the benchmark share price. And so on. Each tranche might be exercisable over 1 to 3 years after they vest.
That package would provide a huge potential payoff if management was very successful and very little payoff if they failed to create value. However, this type of plan does carry a greater potential for retention risk if the share price declines, which must be weighed against the potential for a much stronger motivation to succeed. Many companies will find that weaving some elements of this into their normal compensation approach can be beneficial even if they choose to not embrace it completely.

– Broc Romanek, CompensationStandards.com

Here’s news from this blog by McGuireWoods’ William Tysse:

On June 10, the IRS issued a revenue ruling confirming that a nonstatutory stock option or stock-settled stock appreciation right (SSAR) that is exempt from Section 409A is also exempt from Section 457A.

As most readers will know, Section 457A is a special regime for certain “tax-indifferent” entities (entities such as corporations located in offshore tax havens or domestic partnerships substantially owned by tax-exempt organizations) that generally subjects such entities’ nonqualified deferred compensation arrangements to tax on vesting, rather than on payment as under Section 409A.

Previously, despite guidance in Notice 2009-8 exempting 409A-exempt stock options and SSARs from Section 457A, the IRS’s position had been in some doubt, given language in Section 457A that exempts 409A-exempt stock rights other than any “right to compensation based on the appreciation in value of a specified number of equity units of the service recipient.” It wasn’t entirely clear how the “other-than” language in the statute and the IRS’s guidance in Notice 2009-8 could be squared, since the “other than” language appears to refer to all stock appreciation rights. The revenue ruling addresses this apparent discrepancy by citing to legislative history indicating that the “other than” language was specifically not intended to apply to stock options, and holding that if stock options are exempt, SSARs should also be exempt, given the economic equivalence between net-settled stock options and SSARs.

Thus, the only difference in coverage of stock rights between Section 409A and Section 457A is with respect to stock appreciation rights that are or may be settled in cash (CSARs), which are subject to Section 457A but may still be exempt from Section 409A if certain conditions (FMV exercise price, etc.) are met.

Some may recall that the IRS originally intended to cover CSARs under Section 409A as well. Notice 2005-1 created an exemption only for SSARs of publicly traded companies, based on concern that CSARs or private company SSARs could resemble other nonqualified deferred compensation arrangements that were not exempt. Eventually, however, the IRS recongized that all SARs, public and private, cash and stock settled, were functionally equivalent and exempted them all in the final 409A regulations. Given they produce identical payouts, it’s still unclear as a policy matter why CSARs and SSARs should be treated differently under Section 457A, but the statutory language is what it is, and the revenue ruling does at least offer a welcome confirmation of the IRS’s guidance from 2009.

– Broc Romanek, CompensationStandards.com

We have posted the transcript for the recent webcast: “Proxy Season Post-Mortem: The Latest Compensation Disclosures.”

– Broc Romanek, CompensationStandards.com

In this blog, Don Delves – now with Towers Watson – provides some interesting commentary looking at the big picture on the state of executive compensation…

– Broc Romanek, CompensationStandards.com

In this 20-second video, Cap’n Cashbags – a CEO – tries to recruit former President Bill Clinton, who would then serve on his company’s compensation committee – a subset of the board who sets his pay:

– by Broc Romanek

Here’s news from the weekly newsletter from the Society of Corporate Secretaries:

The U.S. Court of Appeals in Philadelphia upheld a federal judge’s dismissal of a shareholder derivative suit claiming Viacom’s chairman and two top executives were overpaid. In its dismissal, the appeals court cited a Delaware Supreme Court decision stating that “[T]he decision to sacrifice some tax savings in order to retain flexibility in compensation decisions is a classic exercise of business judgment.” The shareholder had argued that the Board improperly used subjective performance criteria in a shareholder approved plan to set compensation, leading the executives to be overpaid, and to a subsequent loss of tax deductibility on the purported excess.

The ruling also considered a company’s right, through its certificate of incorporation, to exclude a class or classes of shareholders from participating in a vote to approve an executive compensation plan. In addition to the derivative claim noted above, the plaintiff made a direct claim that the vote to approve the plan under which the executives were paid was invalid, given Class B non-voting shareholders did not have the right to vote on the plan. The court found the plaintiff’s “argument to be without merit: § 162(m) does not create shareholder voting rights, nor does it preempt long-established Delaware corporate law allowing corporations to issue non-voting shares. Freedman purchased only non-voting shares; he cannot now use federal tax law as a backdoor through which he may pass to obtain rights that as a shareholder he does not possess.”

– Pat McGurn, ISS

While somewhat forgotten in the rising tide of advisory votes and say-on-nay campaigns, some compensation related shareholder proposals continue to gain momentum. Notably, the 2014 season provided a breakout opportunity for opponents of accelerated vesting of equity awards following M&A transactions. For the first time since 2010 when the proposals first appeared on ballots, majority tallies were recorded. The breakthrough votes came at four firms: Boston Properties, Dean Foods, Gannett and Valero Energy. Average support based on results for 19 proposals stands at 36.2 percent, up from 33 percent (based on results on 31 proposals) in 2013.

With this break from the pack, the numbers of pro rata vesting proposals might proliferate next year. The topic might draw some proponents away from another long-standing topic – stock retention and holding requirements. Proposals asking senior executives to hold more of their equity holdings to (or thru) retirement continue to be ballot staples, but their average support (currently 23 percent of the votes cast based on 25 results) appears to have leveled off. Notably, none of these proposals urging boards to adopt more robust stock ownership guidelines for senior executives broke the 50-percent support barrier this year.

Some other pay-related topics continue to be magnets for vote support. Clawback proposals drew strong support at BB&T (34.6 percent of the votes cast) and Whole Foods Market (36.8 percent). Results at retailing giant Wal-Mart, meanwhile, came in at 14.7 percent support, or roughly 38 percent of independent support when discounting the company’s insider block. Calls to allow shareholders to approve outsized severance packages also drew high numbers at Verizon Communications (39 percent) and Kindred Healthcare (73.4 percent).

– Broc Romanek, CompensationStandards.com

Here’s an excerpt from the latest from Semler Brossy:

We have collected Say on Pay vote results for 156 additional Russell 3000 companies, bringing our total to 1,880. The average vote result for all companies in 2014 is 91%. Six additional companies failed since last week’s report; 42 companies (2.2%) have failed so far this year. Of companies with four years of Say on Pay votes, 1,321 (92.5%) have passed all four years, 92 (6.4%) have passed in three years and failed in one year, 11 companies (0.8%) have passed in two years and failed in two years, two companies (0.1%) have passed in one year and failed in three years, and two companies (0.1%) have failed all four years. Proxy advisory firm ISS is recommending ‘against’ Say on Pay proposals at 13% of companies in 2014.

Meanwhile, here’s an excerpt from this ISS newsletter:

The 2014 season posted record numbers for both MSoP ballot volume and vote support. The return of say-on-pay to agendas at hundreds of issuers that adopted a triennial vote frequency in 2011 swelled a typical large investor’s workload by more than 15 percent. At Russell 3000 firms, for example, the January 1-June 30 volume of MSoP ballot items jumped by 17 percent from 2013 levels and 23 percent from 2012’s post-Dodd-Frank Act mandate low watermark.

2014’s big ballot backlog, however, failed to translate into higher opposition. ISS Voting Analytics database shows that overall MSoP support at Russell 3000 firms for the January-to-June period actually stands at a new high-watermark of 91.6 percent of the votes cast–up from 91.5 percent of the votes cast for the same period in 2013.

Sub-majority support also failed to spike with the higher ballot volumes. As of June 12, Voting Analytics recorded only 38 sub-50 percent support votes for meeting held from Jan. 1 to June 30, which is roughly comparable to 42 and 47 for the same time-periods in 2013 and 2012, respectively, despite 2014 larger ballot volume.