Recently, I blogged about a new survey we were conducting regarding long-term incentive practices. We have collected responses and posted this summary of the responses.
In a nutshell, it looks like 2009 LTI grant values will decline in total by more than 10%. Of those companies changing their values, the median decrease (at the time of the survey) was 20%, but a number of companies have not yet gotten Compensation Committee/Board approval, and those companies are contemplating cuts of 30% at median.
It will be interesting to see how companies respond if the 2009 LTI grant data shows such decreases. If they stick to trying to deliver a market competitive value, one would expect that 2010 LTI grant values would erode further. However, if companies respond to all of this by rejecting a value-based approach to LTI grants (which many companies appear to be doing in 2009), then they would be likely to stick with a set number of shares for their grants, and the value would change then only as a result of stock price movement.
Late Friday, Congress finished its conferencing and passed the “American Recovery and Reinvestment Act” – and law firms went to work drafting their memos analyzing this stimulus package (we’ll be posting all these memos in our “Rolling Back Compensation” Practice Area). The final text of the legislation is posted on the White House’s site in five parts, along with the ability for anybody to post comments!
The most relevant part of the legislation for our members is the tax provisions in Division B, which includes the controversial executive compensation restrictions among others (eg. see this Hodak Value commentary) – even President Obama is not happy (as noted in this article) with what Senator Dodd inserted as the final exec comp language. Oddly, the stimulus legislation went from no new executive compensation restrictions on Friday morning to more restrictive than previously contemplated by the end of the day. More coverage to come…
Populism Over Bankers’ Pay
I thought this piece from the Financial Times’ Blog by Martin Wolf made good reading:
Populism is breaking out, not surprisingly, over bankers’ pay. When an industry has played a huge role in creating what may well be the first depression since the 1930s, that is hardly surprising. Even Lloyd Blankfein, chairman of Goldman Sachs, has admitted the industry screwed up comprehensively. That is pretty obvious now.
The response to the pay curbs is that the high pay is needed to obtain and reward talent. I think that’s nonsense. Do we really want to reward the “talent” that has just brought down the world economy?
So what makes sense here? I suggest there are four questions.
First, does the government have an interest in how bankers are paid?
Answer: yes, of course. Since the government is, on behalf of the taxpayer, the ultimate risk-bearer in banking, it has a profound interest in the structure of pay or, as Lex puts it more precisely, incentives. We have seen the impact of incentives to destroy the bank. Do we really want to go there again?
There are obvious collective action problems in all corporate payment systems. But in the case of banking the consequences are very severe. In any case, if governments are shareholders, they must have a role in setting pay, as owners.
Second, Is banking an exceptionally difficult job or one that demands exceptional talent not required by brain surgery, fighting in Afghanistan etc?
Answer: of course not. It is a gross misallocation of resources to pull the most talented people into a business whose true value added is modest and many of whose activities are zero sum. For the UK it has surely been a catastrophe.
The more energetic and “talented” bankers are, the bigger the risks they will take. I no more want bankers to have such characteristics than I want those who run the electricity grid to have these characteristics.
The reason even junior bankers make so much money is that they sit on the money flow, which is the result of the licence given by the state to create money. We should not give any support to the ridiculous idea that bankers really do deserve their pay in some objective sense. Even Hayek would not have supported that idea.
Special talent really isn’t needed in commercial banking. What is needed is trustworthiness, caution, scrupulousness and organisational ability. Everybody knew this until a couple of decades ago. They were right. Investment banking may be different (I doubt it), but then they can’t rely on government money.
Third: what sort of pay structures should the government seek?
Answer: I agree that a simple pay cap is distorting. It is well-known that this leads to all sorts of ways of disguising incomes, as happened when we had pay policies. So the intervention has to be more subtle. It needs to focus on the structure of incentives and particularly whether there is any tendency to increase risk-taking.
Finally, are current circumstances exceptional?
Answer: yes. If taxpayers are putting trillions of dollars into these ghastly institutions, do they really have no right to decide how their employees are paid? Do we not accept that they have a right to decide how the doctors they employ are paid?
Until banks are free of the need for massive government subventions, they have to accept such interventions. This is the price of failure. I would certainly agree that 500,000 dollars is too low, though it is at least double what Ben Bernanke is paid and he is at least as intelligent as – and doing a far more important job than – any banker I have ever met.
Unfortunately, there’s plenty of examples of CEOs that “just don’t get it.” However, Wells Fargo took this concept a step further by purchasing full-page ads in several national papers this past Sunday to defend its poor decision to continue a Vegas junket for employees.
In this press release, the company defends itself. And CEO John Stumpf further defends the decision because the money for the recognition event came from profits, not the $25 billion in TARP money the bank received. Here is what my mailman told me: “If so, why don’t you just take some of those profits and pay the taxpayers back now?”
Or as I like to put it: “okay, we get it Wells Fargo – you’re just not into us taxpayers.”
Right now, it’s clear that optics matter. And there is no difference between a business trip and a junket in the minds of many. I wonder how long it’s gonna take until these CEOs “get it.” For some, I imagine they won’t until their mansions are surrounded by people with pitchforks.
It’s still too soon to tell if the executive compensation restrictions stimulus bill died in conference as the reports have been mixed so far on that. Even if they were cut from the stimulus bill, Jesse’s piece about key fixes to the new Treasury guidelines still is timely and his points were recently picked up by Joe Nocera in the NY Times’ “Executive Suite Blog.”
We encourage you to forward Nocera’s blog to key members of Congress and Treasury and other decisionmakers. We each have a responsibility to help the government “get it right.”
Plenty to talk about during today’s webcast; here is an article from today’s Washington Post:
Congressional efforts to impose stringent restrictions on executive compensation appeared to be evaporating yesterday as House and Senate negotiators worked to fine-tune the compromise stimulus bill.
Provisions to impose a penalty on banks that paid hefty bonuses and to cap pay at $400,000 for all employees at firms applying for additional government funds did not survive the compromise, sources said.
The situation was in flux last night, but provisions in the Senate bill that called for a ban on bonuses for all companies receiving government funds also appeared to be headed to the chopping block, congressional sources said.
The provisions would go further than those announced by the Obama administration last week. They would target the 359 banks that have received government aid and essentially prohibit companies from paying anything other than a base salary, analysts said. The 25 highest-paid executives at each company would be subject to the ban.
The White House restrictions, which capped executive pay at $500,000, apply only to institutions that receive government funds in the future and under limited circumstances. The White House version also allows companies to award company stock to executives that could be redeemed once the government investment was repaid.
Excessive executive compensation has received increasing scrutiny as the pay gap between executives and average workers widened in recent years. Public outrage has reached a boiling point with news that billions of dollars in bonuses were paid to Wall Street employees last year even as the banks took billions in taxpayer bailout money.
The provisions in the Senate bill were part of a flurry of efforts by legislators to curb executive pay. While similar proposals remain in Congress, their elimination from the stimulus package highlights the difficulty of passing such measures.
Several compensation analysts said yesterday that many of the measures that were in the Senate bill would have faced legal hurdles because they applied retroactively to banks that received government funds under rules agreed to last fall when Congress passed the Troubled Assets Relief Program’s capital repurchase plan.
“It was not part of the original agreement,” said Laura Thatcher, head of the executive compensation practice at Alston & Bird. “If they’re going to retroactively change playing rules, it would seem to me that, in fairness, they would have to give the institutions an opportunity to back out of the deal altogether.”
Now that the Senate has passed a bill with executive compensation restrictions that are dramatically different than the new set of Treasury guidelines that were just adopted last week, confusion reigns (within the 780-page “American Recovery and Reinvestment Act” is the Senate’s own set of executive compensation standards in Title VI of Division B; I could only find the bill on “Thomas“).
Try reading the Senate’s executive compensation provisions (here’s a memo outlining them; Mark Borges has provided an outline in his blog) – and you’ll get the feeling that various Senators got to insert their own random provisions because they don’t seem to work together. Hopefully this will get fixed during the House-Senate conferencing before this hodge-podge becomes law.
The U.S. Senate’s economic stimulus bill, which is expected to be put up for a Senate vote today, includes a raft of new executive compensation restrictions that would apply to financial institutions receiving TARP assistance. Most of the restrictions would apply retroactively to any institutions that have received any amount of TARP funds and are significantly more severe than both the existing TARP restrictions as well as the restrictions announced by the Obama administration last week.
While the Senate bill is expected to pass with these restrictions, it is uncertain whether the restrictions will be modified as the House and Senate stimulus bills are reconciled by the conference committee. Learn more from this Davis Polk alert. And remember that the panel will describe all these new changes during Thursday’s webcast – “TARP II: The Executive Compensation Restrictions.”
We have posted the transcript from the second part of our popular two-part CompensationStandards.com webconference: “The Latest Developments: Your Upcoming Proxy Disclosures—What You Need to Do Now!”
A new Towers Perrin survey shows that the vast majority of U.S. companies are making multiple adjustments in their pay programs for executives and other employees in response to the deepening economic crisis. Overall, the modifications will mean lower – or no – 2009 salary increases and bonuses for 2008 performance for many U.S. employees, along with reductions in the value of 2009 equity grants for many executives.
The survey was conducted online from January 6th-14th and targeted U.S.-based midsize and large companies. A total of 513 companies participated in the survey. Nearly 65% of the participants had experienced stock price declines of 30% or more in 2008, with 28% down 50% or more.
This survey found that most companies are holding the line on salaries by cutting their 2009 merit increase budgets, freezing salaries or cutting base pay. Merit budgets for the overall survey group averaged 2.4% for most levels, and were lower at 1.9% for executives. When companies that froze or cut salaries were removed from the sample, the budgets grew to nearly 3.0% on average.
Compensation committees are struggling to set incentive plan performance targets in light of 2009 budgeted/planned results that are significantly below 2008 levels, coupled with considerable uncertainly about how quickly the economy will rebound. Almost three-quarters (73%) of the survey respondents say the financial crisis has had an impact on their approach to setting 2009 performance targets under annual incentive plans. The most common considerations among companies reporting changes in their approach to goal-setting are greater use of discretion or judgment in determining awards, setting lower threshold performance levels and greater use of relative performance measures instead of absolute measures (e.g., setting a revenue growth target at 10% above median performance for the industry, rather than a fixed growth rate).
The survey also shows that many companies are rethinking their approach to determining the size of their 2009 long-term incentive grants. Three key elements of a long-term equity award, number of shares, price per share and total grant value are all being examined, both individually and in combination, for potential change. Regardless of methodology, the research indicates these total long-term incentive grant values will decline between 15% and 20% on average. Our recent consulting experiences indicate the decline may be even greater.
A growing number of companies are also wrestling with questions about how to deal with underwater stock options and whether or not to reset performance goals on outstanding awards under long-term performance plans. The survey responses suggest that relatively few companies have fully addressed these issues thus far, although more are beginning to focus on the issue. To date, just over a quarter (26%) of the companies either have addressed underwater options or are currently reviewing the issue. If the market downturn is prolonged, we would expect to see more companies consider the issue of underwater options.
Even fewer of the companies surveyed appear to be moving toward adjusting the performance goals for outstanding cycles under their long-term performance plans to reflect the current business climate. Only a few companies (2%) have recalibrated performance goals or plan to thus far, although 11% of the respondents are now considering such steps. Once again, the longer the market downturn lasts, the more we would expect companies to consider actions like option exchanges to help retain and motivate key talent and recognize some value from the expense associated with past grants.
A strong concern of a majority of companies in the survey was the potential for losing their best performers and those in pivotal roles during this market downturn. The data indicate the more limited dollars available for compensation awards, or adjustments, will go to these individuals through retention awards, bonus payments and individual salary increases, increasing the differential between the best performers and the remainder of the staff.
We’re now in the equity grant season for calendar year companies. Most clients are on dollar-based LTI grant guidelines, which means that, if prices are up, new shares granted decline, and vice versa.
Commonly, compensation professionals argue that, if it’s fair to cut shares when prices increase, then it’s likewise fair to increase shares when prices decline, to preserve LTI grant values. For the most part, Compensation Committee members agree with this “fairness” argument.
But, what few seem to recognize is that there is an asymmetrical relationship between share increases when prices decrease and share decreases when price increases. Thus, as shown in this first graph (see this PDF for the first graph), if the price declines, e.g., 50%, the number of shares do not go up 50% – they double. But if price increases 50%, the shares only decrease by a third.
Note that, as the grant price approaches zero, the shares needed to maintain constant value approach infinity. The second graph illustrates the math even better (see this PDF for the second graph).
With average year-over-year stock price declines of 40-50%, advisors and compensation committees need to be aware of this math in approving new grant recommendations. If the price has declined significantly, consideration needs to be given to either (1) using a price higher than current market price to convert dollars to shares, (2) applying a discount to intended grant values, particularly if it is stock options that are being granted, or (3) applying a run-rate cap or cap on value transfer to the total shares granted. Otherwise, the share dilution just becomes too great and executives benefit excessively just for getting stock prices back to last year’s levels.
Yesterday, I blogged a story about a conversation with a cabdriver about the Wall Street bonuses and how the environment has been altered so much that boards absolutely must change their thinking about executive compensation practices or else face potential societal implications (see this NY Times article).
Recognizing the need for this change, President Obama yesterday announced a new set of Treasury guidelines for those companies seeking government funds. The fact that the President made the announcement and held a press conference on the topic highlights the importance of this matter. Rather than repeat these new restrictions, read the bullets in this press release.
To explain these new restrictions – and how they impact both companies seeking government funds and all companies generally – we are holding a webcast – “TARP II: The Executive Compensation Restrictions” – next Thursday on CompensationStandards.com. Tune in to learn these new developments!
How to Fix the Latest Treasury Guidance
Jesse Brill lays out below how the latest Treasury guidance still needs to be tweaked to accomplish its goals of reining in excessive executive compensation:
The biggest change under the new Treasury guidelines is a $500,000 salary cap. One key aspect of the new $500,000 cap that has not gotten sufficient attention is the unlimited amount of restricted stock and stock options that still can be granted under the latest “restrictions.” Equity compensation is the pay component that has gotten most out-of-line over the past 20 years. It (as well as severance/retirement/ golden parachutes) has caused the greatest disparity between CEO compensation and that of the next tier of executives (and employees generally).
The new $500,000 cap provision does prevent executives from realizing the gains in their equity compensation until after the government is paid back. But there are two major problems with how this applies:
1. It does not apply to past equity compensation. Warren Buffet imposed a similar cap on Goldman Sachs’ executives, but his restriction applies to all the equity held by the top executives. It is not limited just to future grants, as is the case with the new government restriction. So Buffett’s provision wisely requires that the key decision-makers keep all their “skin in the game” until he gets paid off.
2. Although it may help protect the government’s investment, it is short-sighted and fails to protect the shareholders’ best long term interests. The holding period should be the longer of age 65 or two years following retirement. That will ensure that the key executives make decisions that truly are in the long-term best interests of the company (as opposed to decisions aimed at a shorter period – after which an executive could depart, taking all his marbles with him).Note that holding-through-retirement also addresses the major concern about top executives’ unnecessary risk taking.
Holding equity compensation through retirement is perhaps the single most important—and fundamental – fix to getting executive compensation back on track because it also addresses all the past outstanding excessive option and restricted stock grants. And, by requiring CEOs to keep their skin in the game for the long term, it will go a long way to restoring public trust in our companies and our market, which is so important to restoring stability to the markets.
Needless to say, the fundamental hold-through-retirement fix should apply to all companies – not just TARP financial institutions—and can be adopted at the same time that Congress adopts say-on-pay legislation (if such legislation is adopted). (It will have much greater impact and do more good than say-on-pay.) Learn how to implement hold-through-retirement in our “Hold-Through-Retirement” Practice Area on CompensationStandards.com.
Here are three additional points about the $500,000 cap:
1. Just as the $1 million cap was a major cause for the runaway increase in equity compensation over the past decade, the new unlimited opening for restricted stock will further exacerbate the problem. As an example, the typical time vested restricted stock grant does not qualify for the $1 million cap “performance-based” compensation exemption, thus more companies and shareholders will suffer the cost of the lost tax deductions as these very large amounts vest. (So, once again the top executives will benefit at the expense of shareholders.)
2. One reasonable fix to the tax deductibility problem would be to require real performance conditions (in addition to time vesting) upon the vesting of the equity.
3. To address the “unlimited “ new grants problem, do not permit additional grants in situations where the CEO’s total accumulated equity grants exceed the company’s own historic internal pay equity ratios compared to the next tiers of executives within the company.