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.
As Mike Melbinger detailed in his blog yesterday, the FDIC and the Obama Administration have combined for a historic one-two punch that would have made Muhammad Ali blink to batter financial institutions doing business in the US. Here are Paul Hodgson’s thoughts on the FDIC’s actions.
But it’s not just the government acting against banks. As noted in this BusinessWeek article, Goldman Sachs has been sued by a shareholder – in Ken Brown v. Goldman Sachs, NY Supreme Ct (1/5/10) – over its bonus payouts. The bottom line is that citizens all over this country are extremely mad that things are tough for them but rosy for bailed out banks – and until boards and senior managers understand this, the consequences will continue to get worse. Just adopting a plan to give a percentage of earnings to charity won’t dent this anger.
I’m firmly in the camp that many of these regulatory responses don’t make sense – or may even make things worse. And I also have blogged that problems with executive pay practices are a different animal than issues related to paying bankers generally. But boards and senior managers of Wall Street firms need to understand the circumstances that they are living in. I still think they don’t “get it” – and it reminds me of Gilbert Arenas spending the day with enforcement authorities and the NBA and then later that night, playfully pretending to shoot his teammates. Gil was just fooling – but most basketball fans didn’t see it that way…
On Tuesday, after a sharply divided vote of 3-2, the FDIC Board voted to request public comment on whether compensation policies should be incorporated as a factor in the risk-based insurance premiums charged to insured depository institutions. The premise is that compensation systems that encourage excessively risky behavior pose a risk to the depository institution and its stakeholders, including the Deposit Insurance Fund, and the FDIC’s goal is to provide incentives for depository institutions to align employee and other stakeholders’ interests.
The FDIC joins a crowded field of regulators in this area. For example, the Federal Reserve announced in October 2009 a new regulatory framework intended to address risky incentive compensation practices at financial institutions. Additionally, just last month, the SEC finalized its rule to require all public companies to disclose more information about how they compensate their employees, including disclosure on how risks arising from a company’s compensation arrangements are reasonably likely to have a material adverse effect on the company.
The two FDIC Board members that opposed the proposal were the Comptroller of the Currency John Dugan and OTS acting director John Bowman. They voted against the proposal stating, among other things, that the FDIC is acting prematurely because other regulatory or legislative bodies, including the Federal Reserve and Congress, were looking to address banker compensation using different standards. The FDIC indicated that its proposal would not be inconsistent with other proposals being considered because it is meant to incentivize good behavior, such as good risk management practices, and not set limits on compensation.
While there is nothing in the rulemaking process that establishes a specific timeline for the final rule, there is speculation in the press that it will take the FDIC until the end of this year to put the final rule in place. Ultimately the timing will be up to the FDIC; however, issuing an advance notice of proposed rulemaking is an uncommon preliminary step available to the regulators which usually reflects an agency’s view that more information is necessary in order to issue a proposed rule. This indicates that the FDIC is not ready to issue a rule on this matter anytime soon.
As an example of how the criteria would be used in practice, the FDIC suggested that if a depository institution could attest that its compensation program contained the features below, it would pay a lower risk based assessment rate than a firm that could not make such an attestation. The compensation program features being considered are the following:
– A significant portion of compensation for employees, including senior managers, whose business activities present significant risk to the institution and who also receive a portion of their compensation based on performance goals, should be comprised of restricted, non-discounted company stock.
– Restricted, non-discounted company stock that becomes available to the employee at intervals over a period of years should be subject to a look-back mechanism (e.g., clawback). Additionally, the stock would initially be awarded at the closing price in effect on the day of the award.
– The compensation program should be administered by a committee of the Board composed of independent directors with input from independent compensation professionals.
Request for Comments
The FDIC has requested comment on all aspects of the proposal, including comments on the FDIC’s stated goals and the features of compensation programs that could meet such goals. For example, the FDIC invites comment on:
– Whether the size or types of activities of a depository institution should be taken into account in applying the criteria or whether compensation should be used as a criteria to decrease or increase deposit insurance fees across all types of institutions;
– How large of an adjustment to the initial risk-based assessment rate would be required to influence the practices of a depository institution;
Whether compensation systems of holding companies or affiliates should be considered as well; and
– Any other alternatives that would be effective in aligning the interests of employees with the firm’s stakeholders.
The release is subject to a 30-day comment period beginning upon its publication in the Federal Register. There are alternatives for the submission of comments in this advance notice of proposed rulemaking.
We have posted the transcript to the popular webcast: “The Latest Developments: Your Upcoming Compensation Disclosures – What You Need to Do Now!” As we do every year, we have updated our “SEC Rules” Practice Area – including posting these memos & checklists that raise considerations for this proxy season.
We have also posted a new sample D&O questionnaire – anonymously donated by a NYSE company member – updated for the new rules in our ” “D&O Questionnaires” Practice Area. To make sure you haven’t missed anything, you will still want to review the sample model D&O items that Dave Lynn and Mark Borges wrote as part of the Winter 2010 issue of “Proxy Disclosure Updates.”
As noted in this WSJ article from yesterday, a number of companies are moving away from using advisors from the larger multiservice consultants in the boardroom for advice on executive pay packages. This has been spurred by the SEC’s new disclosure requirements about conflicts (although some of these new requirements are still a little ambiguous), possible Congressional action in this area and pressure from some shareholders.
Over the past few years, key compensation consultants have left these larger consulting firms to form their own small shops. The most recent is Ira Kay, who has left the newly combined Towers Watson. It may be a matter of time before the Mercers and Towers Watsons of the world stick to general HR consultancy (ie. actuarial and other non-exec comp services) and don’t handle the much smaller practice of executive compensation consulting.
If your company is struggling with what to do in this area and is trying to decide whether to go with an “independent” consultant, please let me know and I will keep it confidential. I know other companies in the same situation who want to confer with like-situated companies.