Recently, we started using this “Board Dashboard” as a wake-up call to our clients. Our Dashboard provides an independent review of executive compensation based on these four “Fairness & Risk Tests”:
1. Defensible and business relevant peer group
2. Defensible job matching for compensation benchmarking
3. Pay-for-performance (including proper strategic performance metrics and risk horizons)
4. CEO and enterprise internal pay equity
Here is an anecdotal story about one client for whom we conducted a comprehensive executive compensation and incentive risk review:
Upon review, we found that:
– The company’s peer group was fine after we adjusted and removed outliers as compared to previous peer group used in the past – so we ranked “Green Light” on the Dashboard
– The job match for each role for compensation benchmarking also needed to be adjusted because it was a privately-held company with material ownership by one large shareholder who sat on the board. So that was fixed by benchmarking COO roles at other companies – a ” Green Light” on proper CEO job matching for benchmarking purposes. In the past, they had benchmarked CEO roles which led to ratcheting up the comparable CEO pay benchmarks.
– On pay-for-performance, the board was provided a cautionary “Yellow Flag” as the 3-year return on invested capital (ROIC) was in the second quartile and thus below median of the agreed business relevant peer group; yet CEO and executive pay was in the upper end of the third quartile (about 70th percent) – so clearly pay-for-performance alignment was out, but not at an extreme level. A LTIP re-design would fix much of the problem and move them into the “Green Flag” zone for next year.
– Internal pay equity was the big “Red Flag” for the board. Both the CEO role to the Named Executive Officers and the CEO role to the 3rd management layer down pay differentials which was over 8x (should have been 6x max). This suggested there was something wrong with the management structure and/or pay-delivery design.
The board asked us to look at the management enterprise structure and its internal pay equity from top to bottom. We put their data into our proprietary management structure analysis and internal pay equity database and the resulting output was fascinating. The company had 53% of manager-to-direct reports in the “Green” internal pay differential zone – the good news – as they fell within the optimal zone of 1.4 to 2.4x target range.
BUT the company had 24% of “manager-to-direct report” pay differentials less than 1.4x – a proxy indicator of a possible organizational jam up and overlayering and to everyone’s surprise, we identified 23% of manager-to-direct report pay differentials that were too big with over 150 managers who were identified on the Internal Pay Equity Differential report with large pay differentials of 6x, 10x and 20x+. These large differentials for 23% of managers are all in the Moody’s “Red Flag” risk zone of greater than 3x.
The board, CEO and HR head had no reporting systems to identify that they had 9+ layers of management (where only only 5 value-adding management layers are required) as well as the distribution of internal pay equity differentials which were far out of normal distribution.
So by reviewing the enterprise management structure and the internal pay equity and pay delivery review process, it was determined for this one client that:
– The CEO was overpaid by about 30%
– The Head of HR is overpaid by 2x-plus
– Overall enterprise compensation was excessive by 17% of the Total Cost of Enterprise Management (TCEM)
Now, the Board has asked for an offsite presentation regarding all the Red Flags and risks we found. Since the CEO is only 24 months from retirement, the board has set a plan to fix these management structure, over-layering and equitable pay delivery design problems and realize over $50 million+ of cashflow increase opportunity for shareholders upon CEO succession.
Below is an excerpt from my recently submitted comment letter to the SEC regarding its proposed change in the reporting of stock awards in the Summary Compensation Table (here is my full comment letter, you may want to read my oncluding paragraphs with more details on the approach that uses realized values and how this is taking more of a tally sheet approach to the SCT):
Current Approach: Report the “fair value” of stock option and stock awards to executive officers and directors that are expensed during that year for financial reporting under FAS 123R.
Proposed Change: Report instead the grant date “fair value” of the full awards made/granted that year under FAS 123R, not what was expensed for the prior grants.
I think the proposed approach will only continue investor confusion and the media’s uncertainty on how to report compensation that executives receive. It perpetuates the misunderstanding about whether the SCT is providing an accurate picture of what an executive (or director) “makes.” Instead of proposing to go back to the approach the SEC originally adopted in the summer of 2006 for stock options and stock awards in the Summary Compensation Table, the SEC should consider using in the SCT the “Values Realized” numbers from the table for Options Exercised and Stock Vested.
Below are seven reasons why the SEC should reconsider its proposed change and re-propose for comment the approach that requires disclosing realized values in the SCT:
1. Investors, other than institutional investors and others schooled in accounting, do not think about stock compensation in terms of the accounting rules and valuation models. Investors think about what is actually realized and received. The SCT should be a tally of how much an executive “made” in the past year according to the tax code definition of compensation, assuming no deferral of income.
2. All the other numbers in the SCT are amounts of actual compensation that the senior executive/reporting person actually received/was paid in the prior year (or could have if not deferred). The dollar numbers for all other compensation items are real amounts that executives could spend or put in the bank. This is not true with the grant date FAS 123R value, as grants must first vest, and then (for options) be exercised.
3. FAS 123R involves theoretical numbers based on assumptions. No other compensation numbers in the SCT are theoretical or based on assumptions. All the other numbers are actual amounts that executives have received. The severe stock market downturn shows that these assumptions and the models used for employee stock option valuation often prove to be unintentionally flawed or inaccurate.
4. For compensation-planning purposes, FAS 123R does not represent the way all companies value stock grants for determining the size of the grants or their value at grant, whether options , restricted stock, or performance shares. Many companies use either different methods or modifications to FAS 123R valuation models for setting grant sizes and their compensation guidelines.
5. FAS 123R and the models used for valuing options and performance-based equity awards for accounting purposes were not developed for comparing the value of stock compensation to the value of cash. By using it in the SCT, it represents to regular investors that this is a guaranteed, fully transferrable, certain amount, similar to the salary or bonus amounts appearing in the SCT.
6. For annual cash bonuses and long-term cash incentives, companies report only what is actually received/paid in that year, not the value of bonuses offered or some value for potential long-term cash incentives. For stock grants it should be the same in that the amount actually realized is what should appear in the SCT.
7. FAS 123R value will often not represent actual value realized, which is the concern of investors. In rising markets, it will underestimate, potentially by large amounts for stock options, the actual gains from stock grants. In falling markets, it will overestimate the value, particularly with stock options that go underwater. The rulemaking petition submitted by Ira Kay and Steven Seelig (May 26, 2009, File No. 4-585) clearly explains the dilemma in using a fixed date for FAS 123R valuation. We support their petition proposing an approach to SCT valuation for stock and option awards focused on the “pay realizable” as an alternative to using the actual realized value.
As expected, the G-20 Summit ended with the release of these implementation standards that were developed by the Financial Stability Board in conjunction with the G-20 and provide the greatest degree of detail to date on global compensation regulation that could impact global financial institutions. These implementation standards build upon the principles that the FSB issued back in April.
The implementation standards focus on what the FSB considers the critical topics to be addressed first: Pay Structure and Risk Alignment; Governance; Compensation and Capital; Disclosure; and Supervisory Oversight. The Standards state that
“[f]irms and supervisors should ensure the process of implementation is begun immediately and pursued rigorously in their respective jurisdictions.” In a joint statement issued by the UK Treasury, the five largest UK banks – Barclays, HSBC, Lloyds, Royal Bank of Scotland and Standard Chartered – said they welcome the new rules and expressed hope that “there is parity both nationally and internationally on these issues.”
Perhaps not the best online organization, but I have been posting related content in our “Bonuses” Practice Area…
As we commence work on our umpteenth (more than 50th) option exchange, I am struck by a few thoughts:
1. It seems like a colossal waste of resources to have to go through the tender offer process in order to replace, for example, 1000 underwater options with a new 100 share option grant.
2. The motivation for these option exchange programs is principally to get rid of the dilution effects, and simply the bad morale effects, of having significantly underwater options hanging out there year after year, disclosed in financial statements, etc.
3. Many companies doing these exchanges add these shares back to the share pool, thus prolonging the use of the pool. Even if they do not due to institutional shareholder resistance, the exchange has the effect of eliminating the outstanding options. The new grants are a necessary add-on, otherwise employees would not voluntarily relinquish their underwater options, although they probably see little or no value in them.
Mulling all this over, I was wondering whether a new form of option grant might solve some of these problems down the road, should we have a similar situation where vast number of companies have significantly underwater options at the point of vesting. Here is how this would work. A company would make a normal option grant (for example, current fair market value grant with a 10-year term, vesting annually over 4 years). However, the terms of the grant initially would provide that if, at the end of the full vesting period (4 years), the options were underwater by more than a specified amount (this could be a percentage of the exercise price or it could be made with reference to the prior 12-month high trading price or other measure), the option would simply be forfeited at that point.
Because the option expense would have been amortized over the vesting period, I am assuming that there would be no significant accounting effect of this (other than perhaps the impact of such a provision in the original valuation of the option on the grant date, which, if anything, would decrease the fair value for accounting purposes).
The self-cancelling or forfeiture clause in the option would remove any need for a tender offer since there would be no employee consent involved and no consideration for the forfeiture/cancellation. Moreover, the options would no longer be outstanding for dilution purposes.
Whether the company chooses to return these shares to the share pool in the plan would be up to them. If resistance from institutional shareholders to a provision that would add all of them back to the share pool, is anticipated and they are not added back, this would still have positive effects. I would think, moreover, that the company could at least project forfeitures for these options and add that number of shares back to the pool. For example, if, at the 4-year vesting point, it is estimated that 40% of those options would be forfeited, then I would assume it would be acceptable to add back 40% of the cancelled shares to the share pool.
Because I am a lawyer and not a compensation consultant, I am sure that I have overlooked many reasons why this is a bad idea, but I thought I would stick my neck out and throw out this idea for others to comment on. I do know that if such a provision had been included in the grants of all the companies now doing option exchange programs, none of them would be doing these programs, with significant attendant savings.
Anyway, perhaps this will stimulate some discussion.
Recently, Mike Melbinger blogged about the potential importance of an upcoming US Supreme Court case – Jones v. Harris Associates. Here is the SEC’s amicus curiae brief for the case.
In this podcast, Bill Wright of Fisher & Phillips describes how this case may have implications for executive compensation practices, including:
– How does the US Supreme Court’s decision to hear Jones have potential implications in the executive compensation area?
– What is the importance of Judge Posner’s dissent from the 7th Circuit’s denial of rehearing en banc?
– When should we expect the US Supreme Court to deliver an opinion in this case?
Recently, we wrapped up our annual review of total director compensation at Fortune 500 companies. We found that 2008 pay packages rose by a median of just 3% from 2007 rates, a modest increase compared to the median annual pay increases near 10% seen in recent years.
Total remuneration for nonexecutive directors at the companies studied rose to $199,949 in 2008, up from a median value of $193,965 in 2007. While cash compensation rose by a median of 5% (to $83,875, up from $80,000 in 2007), falling stock prices brought down the value of equity awards by a median of 1% overall from 2007 rates. For 2008, median equity values in director pay packages fell to $103,963 from $105,000 the year prior. This decrease in equity pay reverses a trend of rising annual equity award values for directors over the past four years, when values increased at rates between 5% and 13% annually. We expect to see even more of an impact from the economic and market downturn in the data for 2009.
The 3% median increase in total 2008 director remuneration reflects a general salary stability – and in some cases, stagnancy – seen across employees and executives at many companies during the current recession. In fact, more than half of all companies
included in the study made no change to their directors’ compensation package at all in 2008. Further, 17 companies in the 2008 study decreased the value of some element of their director pay programs, from cash compensation to equity grants.
We also also focused on the compensation premium placed on the role of nonexecutive chairmen and lead directors. At the median, a lead director receives $20,000 in additional annual compensation compared to a typical director. Nonexecutive chairmen receive a median of $150,000 in additional total compensation compared to a typical director.
Now that we have seen the SEC’s proposals and Congress’ say-on-pay legislation – that will force you to radically change your executive compensation disclosures and practices before next proxy season – we are wrapping up the ’10 version of Lynn, Borges & Romanek’s “Executive Compensation Disclosure Treatise and Reporting Guide,” which we will deliver to subscribers in October.
Act Now for $100 (Or More) Discount: To obtain this hard-copy ’10 Treatise when its printed in October (as well as get online access to the ’09 version right now on CompensationDisclosure.com, as well as the valuable quarterly “Proxy Disclosure Updates”), you need to try a no-risk trial to the Lynn, Borges & Romanek’s “Executive Compensation Service” now.
If you order by this Thursday, October 1st, you can take advantage of a $100 or more discount. The many of you that currently subscribe can renew by October 1st to also receive this discount. Get the new Treatise hot off the press when it comes out!
I want to put into context a quote of mine that you may have seen in this Reuters article relating to the G-20 summit discussions on bankers compensation. The quote does not all at represent my attitude or point of view about pay in general.
While the quote was accurate, it was in reply to a question about a list of 18 of the largest banks in the world (by market cap) and the reported 2008 compensation of their CEOs. My comment to the reporter related to comparing the compensation of the CEOs among that group of banks. I was remarking that there is a stark contrast between the $230,000 CEO pay at the named Chinese banks and $35+ million at two of the U.S. banks and the $5-13 million at the listed banks in Australia, Argentina, Canada, Italy and Spain.
In comparison, the $230,000 seemed “basically nothing” (less than 1% in some cases) and I was questioning whether the reported compensation numbers were comparing apples to oranges. It seemed to me that the Chinese compensation numbers were so far off the mark in terms of the peer group of banks that it was hard to imagine that we were looking at the whole picture. At the time, I did not realize (as the article points out) that the Chinese banks operate on an entirely different system – i.e., that their bank CEOs are government appointees, whose pay is capped at that level (exclusive of other benefits).
I am in no means an apologist for excessive compensation. Clearly something needs to be done to avoid pay systems that encourage excessive risk, regardless of the dollar amount. Nor, of course, do I think that $230,000 is “nothing” in compensation. However, as a pay cap for the world largest banks, that level is quite a far cry from the current compensation levels in the global peer group. This sharp contrast illustrates the difficulty in pursuing a universal pay cap strategy, as advocated by some in the G20. According to unofficial reports from last Thursday’s summit, the call for absolute caps on pay apparently has softened in favor of reforms that are designed to focus on controlling risks and safe-guarding the long-term health of the institution, which is in line with the recommendations of the Obama Administration.
CEO of Goldman Sachs Lloyd Blankfein’s remarks at the Handelsblatt Banking Conference recently were reported by a number of commentators. Breaking Views, for one, indicated that they were worth repeating.
Well, only if they have been changed, and it’s hard to tell precisely whether they have. Focusing yet again on compensation in the latter part of the speech he said: “There is little justification for the payment of outsized discretionary compensation when a financial institution lost money for the year.” But isn’t that exactly what Goldman did in 2008? Net income of $2.3 billion and bonuses of $4.8 billion, according to Andrew Cuomo’s report that I wrote about earlier. Don’t those bonuses wipe out that net income? Well, not really, but it’s worth thinking about anyway.
Let’s have another look at those compensation principles. He reiterated them:
“In short, we believe:
– The percentage of compensation awarded in equity should increase significantly as an employee’s total compensation increases.
– For senior people, most of the compensation should be in deferred equity. Only the firm’s junior people should receive the majority of their compensation in cash.
– An individual’s performance should be evaluated over time so as to avoid excessive risk taking and allow for a “clawback” effect. To ensure this, all equity awards should be subject to future delivery and/or deferred exercise over at least a three-year period.
– No one should get compensated with reference to only his or her own P&L. Compensation should encourage real teamwork and discourage selfish behavior, including excessive risk taking, which hurts the longer term interests of the firm and its shareholders.
– To avoid misaligning compensation and performance, multi-year guaranteed employment contracts should be banned entirely. The use of these contracts, unfortunately, is a common practice in our industry. We should all recognize that they are bad for the long-term interests of our industry and the financial system.
– And, senior executive officers should be required to retain the bulk of the equity they receive until they retire. In addition, equity delivery schedules should continue to apply after the individual has left the firm.”
With almost all of this we have absolutely no quarrel at all. But the key here is: “An individual’s performance should be evaluated over time….”
According to the Wall Street Journal article on the same remarks, the Dutch have now understood along with the British, the Germans and the French as the article notes that the Netherlands Bankers’ Association has indicated that it expects banks to have long-term targets.
Now Mr. Blankfein betrayed a basic misunderstanding of multi-year performance periods earlier in the year when these principals were first announced. Measuring performance over the long-term does not mean measuring it over 12 months and paying it out over the long term, even if the amount is subject to clawback. It means measuring it over the long-term. So it’s hard to say whether he actually means it when he says “evaluated over time.” I guess we’ll have to wait until the next proxy season and Goldman’s new compensation discussion and analysis to find out.
During the month leading up to today’s G-20 summit in Pittsburgh, there have been continuous developments as the various countries have worked behind the scenes to deliver a plan to control bankers’ bonuses. Reportedly, a number of compromises have been made among the Finance ministers from the Group of 20 as there has been disagreement about what is an acceptable approach (see this NY Times article about an agreement among the 27 EU countries). This front-page article from the NY Times last week explains how the US’ Federal Reserve has been preparing broad compensation rules, partly to stave off even more restrictive limitations from the G-20. In our “Bonuses” Practice Area, we have posted some documents noting some of the earlier positions taken this month.
My Ten Cents: Should the Government Restrict Banker Bonuses?
I’ve talked to a number of reporters who have asked the question “should the government restrict banker bonuses?” For what it’s worth, this has been my answer:
No, the governments shouldn’t get involved for these reasons:
1. Change Won’t Happen Until Boards Want Change – Unfortunately, the sad truth is that even if the legislated/regulated pay fixes were perfectly set so that pay would be aligned with performance, etc., the fixes still wouldn’t work until boards and their advisors wanted them to work. They always seem to find a “work around” to keep the excessive practices flowing.
Part of the problem is a culture of “all CEOs are deities and couldn’t possibly be replaceable” as well as a failure to recognize that the client is the company, not the CEO. The current state of executive pay remains a huge corporate governance problem – as pay has unintentionally racheted up over the past two decades – and needs to be rolled back.
2. Setting Compensation Beyond Senior Management Level is Not a Primary Board Duty – The reason why executive compensation (ie. compensation for the top officers) is so important is because its the truest window into whether the board is a tough one and willing to rein in a CEO and act forcefully. Setting pay for senior managers is the most sensitive duty a board has – and one of it’s most important. It’s at the heart of corporate governance.
In comparison, how a company decides to pay its general workforce is more of a corporate strategy issue – what types of assets should our company have? Paying a talented mid-level executive big bucks is akin to deciding to buy a fancy new machine for a factory. Should the government be telling companies which machines to buy? Banker bonuses isn’t a governance issue; it’s an operational one.
The board does indeed play a role in helping setting the company’s strategy – but in this case, management would inform the board of its proposed strategy and the board should help tweak it, etc. Unfortunately, because “pay” is involved – and there is a lot of justifiable anger over CEO pay – the issue of banker bonuses has become a big concern for the man on the street. But it’s apples and oranges with what should be the real concern – true executive compensation.
So the two reasons above are quite different one – the real answer to the query is #2 – but #1 plays a role too because “bonuses” could become “salary” if the government places artificial barriers on companies. And thus the unintended consequences make the situation even worse because the money is then truly guaranteed. It’s notable that investment banks – at least in the US – have been leaders in placing clawback provisions with teeth in their contracts with bankers, as we’ve covered in past issues of The Corporate Executive, available in our “Clawback Policies” Practice Area.