Those of you who have concerns about the continued value and effectiveness of stock options as an employee incentive device may be interested in an alternative by reading an article written by a colleague, Kathryn Neel, and me in the May-June issue of WorldatWork’s Workspan. It describes a new equity device, which we call Market Stock Units, or “MSUs” for short. It is a market-leveraged RSU grant that has the following characteristics:
– More market leverage than RSUs; less than options
– Symmetrical market leverage, not asymmetrical like options
– Uses average period market pricing for measurement purposes, unlike single-day pricing with options
– Avoids the alluring but risky feature of options that allows employees to cash in at will after vesting
– Is performance based without requiring goal setting
– Eliminates situation that leads to pressure to reprice options when they go underwater
– Includes dividend equivalents, hence aligning to total shareholder return, unlike options which align to stock price growth only
We want to alert compensation advisors to MSUs in case you are asked about them by clients. And we want to engage those of you with a technical interest so that you can ferret out the accounting 162(m) and 409A implications of MSUs in advance if you wish.
Schumer’s “Shareholder Bill of Rights”: Why, What, When and If
– Broc Romanek, CompensationStandards.com
Yesterday, Senator Charles Schumer – along with Senator Maria Cantwell – finally introduced the “Shareholder Bill of Rights Act of 2009” (this is the final proposed bill). Here is my ten cents on your burning questions:
1. Why? – Typically, it would be expected that this type of legislation would originate in Rep. Barney Frank’s House Financial Services Committee. So why did Senator Schumer begin frontrunning his own bill a few weeks ago. The likely answer is that influential parties wanted governance reform as part of the discussion over Obama’s “First 100 Days” to keep these issues in the spotlight. And Frank was too busy with financial regulatory reform to drum up something as a placeholder.
2. What? – As noted in this blog before, the bill is a virtual “wish list” for investors interested in reform (eg. CII’s press release and Nell Minow’s observations in “The Corporate Library Blog”) as it tackles every hot governance there is today (with the notable exception of CEO succession planning).
3. When? – The big question: “What are the odds of this bill getting passed?” I think the odds are fairly slim that this bill becomes law because it includes too many items that potentially contravene state law and open it up to a Constitutional challenge. However, if another big scandal suddenly surfaces, Congress could push this through unexpectedly (just as WorldCom’s implosion pushed Congress to adopt Sarbanes-Oxley).
The fact that only one other Senator placed her name on this bill is a “tell” that there might not be a lot of momentum for it. My guess is that Sen. Schumer wanted to make a mark within the first 100 days of the Administration – and that he wanted this bill to influence what Rep. Frank produces later in the year as well as influence the financial regulatory reform that is being crafted now. In the end, I think the chances of certain provisions of this bill becoming law by the end of the year is fairly high, including say-on-pay and shareholder access – just not as part of this bill.
4. If? – What if this bill gets passed? Wow…
Looks like the parameters of today’s proxy access proposal have been made available to the mainstream media since this NY Times’ article states: “The proposal would permit large shareholders — typically institutional investors like pension funds or hedge funds — or alliances of shareholders to nominate as many as one-quarter of the directors. For the 700 largest public companies, the proposal would require approval by 1 percent of the shareholders for a dissident slate to be nominated. For smaller companies, it would be either 3 percent or 5 percent, depending on the size of the business.
One of those things I’ve been meaning to blog about – and no one else was blogging about until Mark Borges covered it this morning in his blog. A few weeks ago, Ed Durkin and the United Brotherhood of Carpenters Pension Fund has submitted a new shareholder proposal to 20 companies seeking a triennial vote on pay rather than an annual one.
The rationale is that this would help shareholders by reducing the number of companies they would have to analyze each year – and would help companies as they wouldn’t have to face an annual battle over their pay practices.
As Mark notes, the triennial executive pay (known as “TEP”) proposal would require:
– In addition to an overall vote on named executive officer compensation, separate votes on a company’s (i) annual incentive plan, (ii) long-term incentive plan, and (iii) post-employment benefits (including retirement, severance, and change-in-control payments); and
– A “forum” between the compensation committee and shareholders on at least a triennial basis to discuss senior executive compensation policies and practices.
In talking to company representatives, they obviously find a vote every three years more palatable – although I think they have overlooked the fact that the Carpenter’s forum idea is something that could be much more frequent (eg. Intel recently launched a stockholder forum leading up to tomorrow’s annual shareholders meeting).
I agree with Mark that this idea’s weakness is how to deal with corporate implosions between the triennial votes. My solution would be a safety valve where shareholders could gather and trigger a vote, much like the idea of triggering proxy access. In other words, if a group of shareholders got together that met a ownership threshold and filed some type of certification with the SEC that states they seek a say-on-pay vote (with the filing made by a particular deadline), the company would be forced to put say-on-pay on the ballot.
But note that I’m still dubious whether say-on-pay is really meaningful anyways. I would rather rely on votes “against” compensation committee members as the signal to the board that shareholders are unhappy over pay practices. In a say-on-pay world, I worry that board will routinely get their pay packages blessed (see yesterday’s WSJ article) and that excessive pay practices won’t change.
Since the collapse of the financial markets last spring, regulators, politicians, the media, and a wide range of stakeholders have been assailing the financial-services industry for its compensation practices. Few practices have caught more flak than executive bonuses. Examples of outsized executive compensation packages have been well documented: billions of dollars in bonus pay to executives for their performance in 2008—just when their institutions were in crisis and when the US government stepped in to staunch the bleeding with a federal bailout.
Understandably, the main focus has been on the sheer size of bonus awards paid to executives at organizations already hurtling toward financial disaster. Specifically, the sector’s critics turned their wrath on three aspects of bonus-plan design:
– Performance measures out of line with the realities of the business (that is, not taking into account risk-adjusted performance).
– Dominance of annual bonus payouts based on an employee’s performance over 12 months, in businesses where the economic value of an individual’s performance might take years to realize.
– Timeframe when awards are paid out. Most banks pay at least half of the annual bonus in cash and the balance in restricted stock or restricted stock units. These deferred bonuses are not usually tied to future performance goals; individuals receive the balance of their bonus provided they remain employed for a two or three-year holding period, regardless of their performance during the period.
In January, troubled Swiss bank UBS announced its response to these criticisms. In a move closely monitored across the industry, UBS revised its entire approach to rewarding staff in its institutional and investment-banking businesses. A key plank of the new compensation model: the introduction of bonus banking, a concept now being touted by some as the holy grail of incentive structures.
Bonus banking is an incentive plan where part of the bonus earned in a year is ‘banked’ in a bonus account, to be paid out in subsequent years. It differs from recent practice by allowing for the declaration of a negative bonus (sometimes called a ‘malus’) where the amount in the bonus bank is reduced if subsequent corporate or individual performance declines, or if the initial assessment of performance upon which the bonus was based turns out to be wrong. It’s closely related to a bonus ‘claw-back’ (where the company demands the repayment of a bonus that has already been paid to an individual), but has the benefit of providing the company with some security for repayment. The deferred portion of the bonus is held in escrow on the organization’s balance sheet, so it’s easier to recover funds in the future if the measure becomes necessary.
In essence, bonus banking allows companies to balance short-term and long-term value creation, satisfy stakeholders’ demands for accountability, and succeed in attracting, motivating, and retaining the talent needed. Initial reaction from regulators, such as the US Securities and Exchange Commission and the Financial Services Authority in the UK, has been favorable.
Unfortunately, bonus banking is far from a complete answer to the issues surrounding incentives in financial services. While it has some attractions, bonus banking is difficult to implement, unpopular with employees, and ineffective at driving performance.
An appealing idea, in theory
Bonus banking has an obvious appeal to compensation committees searching for an acceptable approach to offering incentives to top executives. It reduces the much-criticized reliance on annual performance measures, creating stronger alignment of incentives with medium-term or long-term creation of shareholder value. Depending on the measures used, it can lessen the opportunities for gaming the system by focusing exclusively on meeting bonus targets at the expense of overall corporate performance. And it reassures shareholders, regulators, and the wider community that the company has some leverage should it turn out that bonuses were earned by producing numbers that were later found to be less than solid.
Stern Stuart, the firm that created ‘Economic Value Added’ (EVA), the financial-performance measure that attempts to capture an organization’s true economic profit, has been advocating bonus banking for years. In fact, bonus banking has worked with the EVA concept in some companies that have stuck to that measurement year after year. For these companies, the practice of bonus banking smoothes out the payouts. Typically, an employer will bank an individual’s full bonus and offer a withdrawal opportunity each year. The employee can usually withdraw from 33 to 50 percent of the balance in the bonus bank. As time goes on, the employer has a better understanding of how the employee’s actions impact the organization. This mitigates a windfall in any one year, and in doing so, addresses some of the skeptics’ major concerns.
Harder than it looks
The primary challenge with bonus banking, in our experience, is the difficulty of managing and communicating the plan while maintaining its effectiveness as a performance incentive. A cardinal rule of incentive plans is that the more remote the payout, the weaker the incentive. Employees may feel their bonus payouts are less secure and may be unsure about the conditions for the receipt or adjustment of the portion of the bonus that has been banked. Complex multi-year performance measures can dilute the focus on maximizing performance in the current year, without setting clear long-term performance goals.
What’s more, bonus-banking plans often have an unintentionally punitive tone. Bonuses can usually only be adjusted down, which can lead employees to feel that failure will be punished, but sustained success will go unrewarded. This is one of the primary reasons for the limited popularity of bonus banking, with consequent risks to retention and performance. In the recent bull market, where talent was scarce, it was not in an organization’s best interest to consider adopting bonus-banking, proving the market is often the final determinant of incentive compensation practices.
Even where company leadership succeeds in overcoming these issues, bonus banking has other limitations. Depending on how it is structured, it can lead to bonuses paid out in years where overall corporate performance is down – one of the criticisms of bonuses paid to investment bankers this year, or to former employees who have not contributed to this year’s performance – a result that could be difficult to communicate to shareholders. Performance measures can be difficult to construct, so plans are often based on rolling annual targets, which are less effective in driving a focus on long-term performance. In the face of these obstacles, compensation committees faced with a challenging environment may opt for more conventional approaches.
The alternative
Of course, there are other options available. Deferring a part of the annual bonus into restricted stock or restricted stock units ties the final value of the bonus to the share price – useful for focusing top-executive attention on long-term shareholder value, though less effective for those employees without a line of sight to the share price. Basing some incentives on two- or three-year timeframes – for example, risk-adjusted returns based on cash returns rather than profit estimates – can reduce the danger of fostering a short-term focus. Bonus banking can work in some cases, but only as part of an overall strategy that focuses the organization on long-term value creation. In and of itself, however, bonus banking cannot guarantee the achievement of a responsible reward program.
This article is reprinted from Directorship’s April/May 2009 issue with permission.
We recently posted the Spring Issue of the Compensation Standards Newsletter. Please note that we also have posted all the archives of this publication for CompensationStandards.com members to access.
If you can’t wait until next week to see the final version of Senator Schumer’s proposed “Shareholder Bill of Rights,” here is a draft and Mark Borges posted a brief summary in his “Proxy Disclosure” Blog this morning.
“Early Bird” Rates: Expire Next Friday, May 22nd
Note that in response to our generous early bird offer for the “4th Annual Proxy Disclosure Conference” (whose pricing is combined with the “6th Annual Executive Compensation Conference”), the conference hotel is close to being “sold out.” These Conferences will be held at the San Francisco Hilton and via Live Nationwide Video Webcast on November 9-10th.
Act now, as this tier of reduced rates will not be extended beyond next Friday! With the SEC intending to propose new executive compensation rules in the near future – and Congress looking to legislate executive compensation practices this year, these Conferences are a “must.” Register now.
Facing pressure by Congress and others who are impatient to see action (e.g. recent introduction of the “Authorizing the Regulation of Swaps Act” in the Senate), the Treasury Department outlined plans yesterday to regulate derivatives. Under these plans, the Commodity Futures Modernization Act of 2000 would be rolled back. The plans are detailed in this letter by Treasury Secretary Geithner to Congress and in this Treasury Department statement.
This action followed remarks by President Obama that he intends to rein in pay practices at all financial institutions, not just those receiving TARP money. It’s unclear yet what form these restrictions would take, although a few alternatives are posited in this WSJ article.
In this WSJ video, Joann Lublin does a great job explaining the futile consequences of past efforts by the government to rein in pay. Takes the words right out of my mouth…
– Ira Kay and Steve Seelig, Watson Wyatt Worldwide
We read with interest Broc’s post about the “debate” on whether CEO pay went up or down during 2008, and the have a very short answer to that debate: Our research finds that CEO pay levels have declined no matter how you measure it.
Oh, were there not apples and oranges. We’ve blogged here before on how we think equity values should be measured. Not based on the grant date value for accounting purposes used by the Associated Press in their reporting (and soon to be required by the SEC per Mary Schapiro’s most recent comments) and most certainly not based on the number the SEC currently requires to be shown on the Summary Compensation Table (the value recorded for the year on the financial statement). Either of these measures is just the opportunity being granted to the executive for the year. We think the real equity value earned for the year is what the executive gained or lost based on how the stock price changed for the year on outstanding grants and those vested for the year, something we call “realizable pay.” We’ve written about this concept in a recent Watson Wyatt Insider article and intend to ask the SEC to consider using this approach on the Summary Compensation Table as it revisits the disclosure rules.
Any study that measures CEO pay levels based on grant date values from the start of the year, but then measures whether they match the value delivered to shareholders as of year-end must be viewed with some skepticism. Stock values need to be measured on an apples to apples basis. This is not to say there’s no room for criticism if there are higher pay opportunities granted for the 2009 fiscal year or when 2008 year-end discretionary bonuses are paid when the company performed poorly.
So what does the data say about 2008 realizable pay and 2009 pay opportunities?
1. 2008 Realizable Pay: In a soon to be released study, we looked at pay levels of 80 CEOs and found the typical CEO saw a decline of $39 million or 53 percent in value for pay realizable in 2008, with a drop in annual bonuses alone of 24 percent. These declines in pay opportunity and realizable pay are proportionate to the companies’ stock price declines. The analysis also found that despite a moderate stock market rebound in recent months, the typical CEO lost an additional 21 percent in equity value for existing holdings in the first three months of 2009.
2. 2009 Pay Opportunity: Based on a review of Form 4 filings during the first quarter of 2009, we found the long-term incentives granted to CEOs for 2009 declined 17 percent in dollar value from values granted in 2008, even though there was an 25 percent increase in the number of shares granted to account for stock price declines. This reflects that companies did not stick with a pure economic value approach to equity grants and recognized a need to cut back on grants to recognize poor performance during 2008 and to mitigate potential gains should the market rebound.
In a separate survey of corporate directors just released, more than a third (34 percent) of directors said their companies had already reduced salary, target bonus and/or long-term incentive award levels. Six percent plan to make those changes in the next six months and another 48 percent are considering making them.
Our research reflects that the so-called “ratchet effect” for CEO pay, whereby pay levels only increase as companies chase the illusive ever-rising median, does not exist in our current down market. If and when the stock market recovers over the next few years, we think we will see an uptick in pay opportunity and realizable pay.
As the proxy season progresses, we are starting to see the results from efforts by activist investors to move Say on Pay forward through the shareholder proposal process. Not surprisingly, proposals asking companies to implement an advisory vote on executive compensation have been garnering significant levels of support this season, as the outrage over pay levels continues largely unabated.
Last week, AFSCME issued a press release noting “[w]ith 29 Say on Pay proposals voted on since the start of the 2009 shareholder season, ten have received a majority of the votes cast (out of FOR and AGAINST votes). These 29 proposals have averaged more than 46 percent support, and this level of support is expected to increase as companies release their final voting numbers. Approximately 80 Say on Pay shareholder proposals are expected to be voted on this year.” Generally, the level of support this year has been higher than the support received for similar proposals in the very short history of the Say on Pay shareholder proposal.
Ted Allen of RiskMetrics Group recently provided some additional insights in the RMG Risk & Governance blog, noting “[t]he best showing so far this season was 62 percent support for a shareholder proposal at Hain Celestial; the lowest were 30 percent votes at Eli Lilly and Burlington Northern Santa Fe, according to RiskMetrics data. The two votes appear to reflect the firms’ ownership mix. At Lilly, a family endowment holds an 11.9 percent stake; at Burlington Northern, Berkshire Hathaway owns a 22.6 percent stake. In the coming weeks, ‘say on pay’ proposals are scheduled for a vote at Chevron, ConocoPhillips, Exxon Mobil, Home Depot, McDonald’s, Qwest Communications, Raytheon, Target, UnitedHealth, and Yum! Brands.”
For at least one company that has already implemented Say on Pay, apparently not all shareholders are on the warpath – as noted in this Washington Post article, last week shareholders overwhemingly supported executive pay at Verizon Communications with a 90% vote in favor!
CalSTRS Calls for Pay Reforms at 300 Companies
Say on Pay features prominently in a new initiative announced by CalSTRS last week. CalSTRS is calling on 300 of its portfolio companies to develop executive compensation policies and to allow shareholders advisory votes on those policies.
As part of the initiative, CalSTRS has published model executive compensation policy guidelines, as well as some broad executive compensation principles for the targeted companies to follow. CalSTRs plans to step up its engagement with the 300 targeted companies on executive pay issues, and in the event that the companies are unresponsive, the pension fund will ultimately vote against or withhold votes in directors’ re-election.
Below is the second in a series of blogs exploring the different approaches to say-on-pay that companies can take (here is the first blog on this topic):
Broad Retrospective Model – The Aflac Model
Aflac’s 2008 proxy statement states that Aflac adopted a say-on-pay policy voluntarily following interest expressed by a shareholder in November 2006. The company originally intended to put executive compensation to a shareholder vote in 2009 after three years of comparable compensation data was available. Aflac concluded, however, that the two years of data available in 2008 was sufficient. Accordingly, Aflac put the following resolution to a shareholder vote in that year:
“Resolved, that the shareholders approve the overall executive pay-for-performance compensation policies and procedures employed by the Company, as described in the Compensation Discussion and Analysis and the tabular disclosure regarding named executive officer compensation (together with the accompanying narrative disclosure) in the Proxy Statement.”
This resolution seeks approval of Aflac’s “overall executive pay-for-performance compensation policies and procedures.” Shareholders are referred to two sections of the proxy statement for a description of these policies: first, the Compensation Discussion and Analysis section, and second, the compensation tables, which generally appear after the CD&A.
Aflac’s approach to say-on-pay is broader than the “Narrow Retrospective Model” since it contemplates shareholders voting on both the amount of compensation and the policies underlying it.
As a result, shareholders could vote against the prior year’s executive compensation because they disagree with the policy underlying it rather than the amount (or even if they approve of the amount). This could occur, for example, if shareholders consider the amount of compensation attributable to long-term incentives to be insufficient and believe the company’s compensation policies are overly-focused on short-term returns.
Furthermore, the vote is not limited to the SCT, but covers additional tables included in the proxy statement. This would include the table showing “Grants of Plan-Based Awards” during the prior fiscal year. It might also include those tables that merely summarize “Outstanding Equity Awards at Year End”, “Option Exercises and Vested Stock”, “Pension Benefits” and “Non-Qualified Deferred Compensation.”
There is also a potential pitfall for companies adopting the “Broad Retrospective Model.” CD&A is intended to provide an explanation of a company’s overall compensation policies and practices in order to provide a context for compensation “awarded to, earned by, or paid to” named executive officers.
As a result, the CD&A largely provides the rationale for the prior year’s compensation. However, by its nature, a discussion of overall compensation policies and practices has general application and will often also apply to future compensation decisions. In addition, the SEC has provided comments to the CD&A sections of companies’ proxy statements seeking disclosure of prospective targets for bonuses.
Companies have generally resisted these requests by undertaking to provide prospective targets only to the extent they are relevant to the discussion of historical targets. However, the breadth of the Aflac resolution gives shareholders a vote both on historical amounts and policies, and on prospective policies and targets if they are included in the CD&A.
In what I believe is a reflection of the sheer complexity of executive pay packages, a number of well-respected compensation consultants differ on whether executive pay levels went up or down last year. If the experts can’t even agree on something as basic as whether pay is up or down, I am dubious that boards can fully understand how all the various complex components that make up most pay packages work together. Over the past few decades, the area of executive compensation has become rocket science!
Recently, Bill Gerek of the Hay Group blogged about pay appearing to be going down, according to their joint survey with the WSJ. Jim McRitchie recently posted notes from a panel that dissected this survey.
In comparison, Bud Crystal recently wrote this article about how executive pay levels are going up. Similarly, a preliminary analysis by The Corporate Library suggests that generous incentive compensation will drive an increase in total CEO compensation in 2008 (it’s the April 7th report).
In addition, a recent Financial Executives International survey on CFO compensation – which interviews the executives themselves – revealed that 31% of financial executives didn’t receive a salary increase in 2008 – and an estimated average base salary increase of all respondents of 3.7% (which was down a percentage point compared to the previous year – but still amazing that salaries went up and not down! – while 94% of survey respondents reported receiving a 2008 bonus. Here is FEI’s press release regarding the survey. Note how they emphazize “no salary increase for one-third” – the real headline should be “two-thirds still got salary bump despite crap economy”…
As a “thank you” to members – and due to the importance of the analysis included in it – we have decided to share a complimentary copy of the March-April issue of The Corporate Executive with you. This issue includes pieces on:
– Grant Guidelines and Declining Stock Prices
– Excessive Windfalls in Compensation Once Stock Prices Recover
– Two Fundamental—and Very Relevant—Considerations for High Level Executives
– Executives Surrendering Underwater “Mega” Grants
– Important, Timely Guidance on the Accounting Treatment of Acceleration of Vesting—Including Ramifications for Underwater Options
– Important, Timely Suggestions from a Respected CEO
In addition, you should read this supplement as it contains our recommended key fixes to the SEC’s executive compensation rules.
Act Now: To continue receiving the practical guidance imparted in The Corporate Executive, try a no-risk trial now.
Congrats to Jesse Brill for appearing on “The Today Show” this morning during a piece on executive pay. Here is a video archive of the segment.
SEC May Reverse “December Surprise”: Equity Compensation Disclosure Methodology for the Summary Compensation Table
In her AP article, Rachel Beck notes how the SEC may be considering reversing the rules from the December ’06 “surprise” – this relates to equity compensation disclosure methodology for the Summary Compensation Table.
Here is some commentary from Cleary Gottlieb on this development:
Many of you will recall that when the SEC comprehensively revised the executive compensation disclosure rules in August 2006, equity awards were to be presented in the Summary Compensation Table based on the full grant date fair value of each year’s awards, computed in accordance with FAS 123R. This was the methodology set forth in the proposed rules in February 2006, and there was full consideration of the approach as part of the comment process before the final rule was adopted.
In an unexpected release on December 22, 2006, the SEC changed the rules to require that the grant date fair value of an equity award be reflected in the Summary Compensation Table based on the recognition of accounting expense in the reporting company’s financial statements as required by FAS 123R in respect of the award, typically over an amortization schedule that corresponds to the award’s vesting period. That revision was adopted without a public meeting, without notice and comment and without any adequate explanation as to why the change was being made. Beyond the procedural concerns, many considered that the revision undercut the purpose of the Summary Compensation Table by obfuscating the value of equity-based grants, which are of course a principal element of executive compensation, and led to unnecessary last-minute changes to the composition of the named executive officers, primarily because amortization under the accounting rules was typically not permitted for “retirement eligible” executives.
Fast forward two-plus years, and we learn that the SEC is considering a reversal back to the original August 2006 rule. Press reports on Friday stated, based on an interview with SEC Chairman Mary Schapiro, that the SEC “is considering changing a formula that critics say often allows public companies to low-ball in regulatory filings just how much top executives are paid.” If the reversal happens, it in fact should be a welcome development for critics and reporting companies alike. The inclusion in the Summary Compensation Table of the grant date fair value of equity awards granted in each year to named executive officers presents a clearer picture of compensation decisions in a given year, and makes the determination of the named executive officers more predictable and sensible.
If the press reports are correct, interesting questions arise as to the transition from the current rule to the new rule. Will unamortized awards from prior years be entirely excluded from the Summary Compensation Table? Will companies be required or permitted to recompute the amounts disclosed for prior years, as if the changed rule had been in effect in the past? Could the basis of disclosure for 2009 (if that is the first fiscal year for which the change is effective) equity awards be different than the basis for the amounts set forth in the Table for earlier years? We would expect the SEC to address these and other transition issues as part of any rule change or in accompanying guidance. Stay tuned.