– Fred Whittlesey, Principal, West Region Practice Leader, Buck Consultants
Poor stock options. How many obituaries have we now read? The post-Enron obituary. The Breeden Report obituary. The FAS123R obituary. And now the bailout/volatility obituary.
Someone once said that where you stand depends on where you sit, and from where I sit I see this a little differently. I’m sitting in California looking out at a lot of technology and life science companies that still remember the proverbial dot-com bust and are now part of the baby being thrown out with the investment banking bath water.
The notion that stock options will become more “expensive” due to recent market volatility might be true…if one measures stock option “cost” solely by FAS123R expense. Not only are lower share prices providing an offsetting factor in valuations, but an integrated financial impact analysis considering cash flow, option gain potential, and dilution can lead to a very different conclusion. In my conversations with clients, it’s become a virtual “no-brainer” that the recent market declines open the door for a mass retreat from prohibitively “expensive” full-value awards and a return, even if temporary, to stock options.
The notion that the expected volatility used for option valuation will increase as described might be true…if one assumes that thoughtful valuation experts will simply take historical volatility data, plug it into Black-Scholes, and accept the result. Much valuation work already excludes “extraordinary” periods of market activity. Companies are actively discussing with their auditors how they will treat the past few months’ data. Do we really expect 5% and 10% daily swings in the future? Probably not.
The notion that there might be limited upside after this “bear market” might be true…if we thought that the declines were completely driven by market fundamentals. The extended flat market of 1968 through 1982 was not due to panic selling but due to the fact that companies were unable to earn a return on capital that exceeded their cost of capital and stock prices reacted accordingly. As we know, much of the selling over the past few months was both forced selling and panic selling, a quite vicious circle. Panic sellers made a run on the market, money managers who didn’t want to sell had to do so to cover, driving the market down further and creating more panic selling.
There’s no question that a rebound in the markets will not be nearly as uniform as the decline. Investors’ eyes have been opened to flawed business models, inadequate cash positions, and the underlying risk of many companies, inside and outside of the financial sector. For companies with solid business models and solid balance sheets, the market downturn is a nice opportunity to deliver cost-efficient gains to employees.
The notion that options are once again deemed to be the underlying cause of risk-taking and moral hazard may be true…and then the dust will settle and we’ll remember that being in business requires taking risk, we don’t really know what excessive risk is in many industries (biotech anyone?), and stock options are a great alignment tool – as long as we don’t provide failure insurance in the form of executive severance, change-in-control agreements, and unreasonably large grants.
Some companies will inappropriately use this period to do market-timed grants – remember the discussions about “bullet-dodging” and “spring-loading” during the option backdating debate? Some companies will convince shareholders that it’s time for an option exchange and double-dip at these low prices. And a lot of companies will make their regular annual stock option grants during their normal annual period and if the market is still depressing their stock price relative to their business fundamentals, then ’tis the season to be jolly.
– Pearl Meyer, Senior Managing Director, Steven Hall & Partners
I find myself doubting whether the proposed approach to Say on Pay legislation will be effective, let alone accomplish its objectives on a practical level. I think we should consider an alternate approach of limiting participation to committed stockholders, thereby excluding empty voters (ie. those using borrowed shares) and short-term speculators, as well as those with nominal holdings who seek to influence the vote. I would propose that those voting be required to:
1. Own a meaningful stake (similar to the SEC proposal for eligibility to nominate directors such as a specified percentage of outstanding),
2. Own the shares for a meaningful period of time, such as holders for at least one year, and
3. Require actual ownership, rather than borrowed shares.
Hopefully, such owners would be informed, responsible, responsive to the needs of the company and take a constructive approach to the issues of fairness to both employee and shareholder, as well as sensitive to the competitive, retention and motivational aspects of compensation.
Also, I question whether it is necessary to hold such a vote annually – wouldn’t every two or three years be sufficient? A repetitive annual vote will surely become less meaningful and be used principally to express dissatisfaction with an entirely different aspect of the company’s performance (i.e. stock price) as evidenced by the recent votes at Aflac and Sun Microsystems.
– Ira Kay and Steve Seelig, Watson Wyatt Worldwide
As we begin to mine the lode of compensation rules begetting unintended consequences, we’ve begun to keep track of those we are seeing. Hopefully, Congress will take note before enacting additional attempts to restrict executive pay and spend some quiet reflective time to think through all the potential results.
1. Changes in 162(m) Might Cause Less Performance-Based Pay, Not More – In an attempt to reduce executive pay (or raise taxes, or both) the TARP rules now limit to $500,000 the deduction allowed for compensation earned each year by SEOs. What if Congress expands new 162(m) to the rest of corporate America? Remember, this rule eliminates the “performance-based” exception, which is blamed for the proliferation of stock options.
Putting aside whether companies will respond by continuing to reduce their option grant level under new 162(m) – a notion we question since FAS 123R has already reduced those levels significantly – we think this change could cause some companies to move toward using more discretionary bonus and performance plans. The merit of current 162(m) is that it forces compensation committees to pre-establish performance goals at the start of the 1-year annual, or 3-year LTI cycle. The SEC and shareholders certainly want to see those up-front goals disclosed; witness the controversy over companies that do not disclose their performance goals.
If 162(m) eliminates the need to have performance-based compensation, we are concerned some companies simply will decide to move to purely discretionary plans since they are likely to continue to pay executives over $500,000. Our experience is that compensation committees like having pre-set formulas in place, so we’re not sure how this change will play out.
But it is possible companies will continue to have pre-set goals in mind, but could decide they won’t need to communicate them outside of the company itself. This approach would help solve the problem for companies who don’t wish to disclose their up-front performance targets in their CD&A. Ironically, the discretionary annual plan is a feature well known at Wall Street firms. So a new 162(m) could drive companies to adopt the very plans often blamed for the financial mess we are in.
Regarding 162(m) for TARP participants, there is another unintended consequence. While the rules may tend to lower total compensation paid if there is no deduction available, it certainly would have little effect on existing compensation promised. So the immediate result will be for companies to reduce the deferred tax asset (depicting the anticipated tax deduction) listed on this year’s balance sheet, which would cause them to have even more losses for the year. This might cause them to ask Treasury for even more money to prop up their balance sheet. In effect, this rule could be causing the taxpayers to loan money to companies in the TARP to help pay for the now non-deductible compensation.
2. 409A Hastens Distributions from Troubled Firms – At least two high-profile, troubled companies are taking advantage of 409A to hasten distributions of deferred compensation. “Wait,” you say, “wasn’t this rule designed to prevent distributions of deferred compensation from troubled firms?” Well, because of a combination of a very liberal regulatory transition rule and a lengthy delay in finalizing the regulations, any company can decide to trigger deferred compensation distributions as soon as 1/1/2009 for the entire balance in an employee’s account.
While it is arguable these accelerated distributions were permissible under old law, it is clear that under 409A, these distributions are permitted now. The companies using this exception argue, using logic Congress would find perverse, they need to make distributions of large account balances to retain their executives. The notion being executives with large deferrals might decide to terminate early to get their money (the only current distribution triggering event), thereby creating a talent drain from which the company could not recover.
The desire to take the money now would be far greater in a company where bailouts are needed and bankruptcy looms. Yet we really don’t know how many employees would decide to quit to get their deferrals. Perhaps this is a valid argument, but one certainly antithetical to that which created 409A.
We’ll post again soon as we hear of more of these. Feel free to share those you see.
Personally, I’ve come to despise AIG and think that company has risen above the fray to be the poster child of this credit crunch. It’s the “Enron” of this half of the decade. It’s not just that AIG already has stuck out it’s hand for $150 billion of taxpayer money – or even the eye-popping junkets that its employees recently enjoyed.
It’s the continued poor “tone at the top” of senior management, who claim that the company is in trouble due to the government’s onerous terms. There hasn’t been any acceptance of accountability for the mess they’re in (although the compensation of the top 70 officers has been further reined in under new bailout terms with the government, primarily a limit on golden parachutes and bonus pool size has been frozen). And I don’t think I’m alone – see this recent Floyd Norris’ column about the arrogance of AIG. And you should have heard Lou Dobbs last night, whoa boy.
Anyways, check out this recent Washington Post article. Now, AIG has quietly disclosed that it’s paying $503 million of deferred compensation out early in an effort to retain 6200 employees (14 deferred compensation program were terminated; payments will be made in early ’09). My gut reaction was that this will not sit well with the general public (even though the purpose of deferred compensation typically is to defer taxes, not to retain employees) – and that many of these employees will simply take the money and run since there are no strings attached (and they may not want to continue to sully their reputation by staying at AIG if they have any chance of leaving this new “Enron”).
One helpful consultant explains what’s really going on. Most deferrals are paid upon termination of employment. So, if you were worried about the company cratering, you would be motivated to quit to secure your deferred compensation balance ASAP. So AIG’s actions likely are an attempt to stop good employees from leaving. That makes sense (although I don’t think it will work – I still think AIG employees that will take the money and run).
Another consulting friend raises this potential question that someone might ask: Were the deferred monies earned as a result of incentives based on “excessive risk” that has led to the current situation? If so, should some – or all – of that money be clawed back before it is paid out under the Treasury’s agreement with AIG? This is said without intimate familiarity with AIG, it’s plans or the agreement with Treasury – maybe the deferred money is not entirely derivived from incentives (an unlikely event).
It will be interesting to see how the AIG saga continues to play out – because I doubt this is the end of it…
Note that these 14 deferred compensation plans are not related to last month’s agreement with New York Attorney General Andrew Cuomo to not distribute $600 million from other deferred-compensation and bonus pools that AIG maintains.
Last week, I blogged over on TheCorporateCounsel.net about how some financial institutions participating in the Treasury’s TARP Capital Purchase Program might be changing their “double triggers” to single for their change of control arrangements. I clarified that blog right after it got pushed to those that have signed up for that feature (if you want to be added, just input your email address to the left of this blog or send me an email) that no bank has yet disclosed that it has taken such action (at least, as far as I know). Rather, I have been hearing that through the grapevine. So it’s hearsay at this point (a good thing because hopefully anyone thinking about it will now be enlightened).
I have also heard that some advisors are saying that (despite some apparently contradictory guidance in Q-11 of Treasury’s interim final rule release for participants in the CPP) that a move to pure “single triggers” is not required based on Q&A-16 in the IRS notice regarding the Section 162(m) and Section 280G provisions of the EESA and Section 302(e)(C)(i) of EESA itself.
In other words, some advisors are interpreting Q-11 to say that “double triggers” (or severance payments upon terminations after a change of control) may be prohibited parachute payments, even if the Treasury no longer holds any equity or debt in a company it once invested in. So some companies have been thinking that while they would have to ask executives to cut back on their “termination without cause” protection to comply with the Treasury’s program, they could modify their double trigger to make it a single trigger.
The thinking apparently is that if there is no requirement for a “termination of employment” in connection with the change of control payment, then it could never be a prohibited golden parachute. In response, tax lawyers and consultants have been pointing to Q&A-16 and Section 302(e)(C)(i) of EESA to say that a payment that is a parachute payment under the traditional 280G analysis – on account of a change of control without regard to the new Section 280G(e) – is not subject to the new prohibitions in 280G(e) and therefore not prohibited by the CPP. Clear as mud?
Even though Treasury might not particularly care if SEOs get prohibited parachute payments in connection with – and particularly, after – a change of control in which Treasury has been bought out (in the case of equity) or paid off (in the case of debt), I imagine investors certainly will care, as well as those in Congress who approved the $700 billion blank check to Treasury…
Corp Fin’s New Bag of Tricks: E-mail Your Questions!
Yesterday, Corp Fin posted this overview of its policy offices, including some organization chart information. My guess is the SEC will have trouble keeping that updated, as we have found maintaining our own “Corp Fin Org Chart” challenging ourselves – but we do keep it updated!
The big news is that these policy offices – including all your favorites like Chief Counsel’s and Chief Accountant’s – will now accept interpretive queries in writing via this online form.
Wow! It will be interesting to see if the volume of queries changes at all – my guess is it will go up, which will be a bummer for the Staff. But on the plus side from the Staff’s perspective, the queries will likely be couched more clearly when reduced to writing. Having worked myself in Chief Counsel’s office, it can be difficult to try to answer a question posed over the phone, particularly if the questioner is strangely vague or inexperienced (or drunk, but that’s a long story).
With the recent record vote of 67% support on a say-on-pay proposal at Sun Microsystems – and the high likelihood of Congress adopting mandatory say-on-pay for the 2010 proxy season – yesterday’s RiskMetrics’ “Say on Pay” webcast was interesting. So far this year, “say on pay” proposals have received majority support at 11 companies (up from 8 last year) – and 12 companies have agreed to conduct advisory votes voluntarily.
1. Schering-Plough’s New Survey – Not much new was imparted during the webcast – which was comforting in itself to hear. To me, the most interesting part of the webcast was the discussion over Schering-Plough’s unique plan to survey investors on pay practices. One panelist didn’t think a survey goes far enough (ie. not transparent enough) because the shareholder feedback only goes to the board and not other shareholders. One liked it, so long as the design of the survey was sound – and it was paired with a say-on-pay vote.
Personally, I like the idea of it – but I’m afraid the reality is that most investors don’t have the time to fill out surveys for all their portfolio companies – nor have the expertise to provide advice on compensation practices. Similar issues that arise for say-on-pay itself. It will be interesting to see how many do indeed respond to Schering-Plough.
2. Will Boards Know What an Advisory Vote Means – It sounded like the Center for Executive Compensation’s principal argument against say-on-pay is that a board wouldn’t know what a majority vote “against” would mean – and that a majority vote “for” would mean that the company wouldn’t have to worry about the structure of their pay packages (as many of you know, the “Center” is run by a group of HR professionals).
I’d look elsewhere for more cogent arguments as the other panelists were quick to make these appropriate points. If a company gets a majority vote on any proposal, it’s the job of the board to reach out to the company’s biggest shareholders and find out the true meaning of the vote. And if the board doesn’t reach out, not only will it find itself in deeper waters – but shareholders likely will speak up and tell you (directly, through the media or just voting no on the board in the following year per ISS guidelines).
On the flip side, if say-on-pay is mandatory, I’d bet that companies will work hard to refine their compensation arrangements to fall within the parameters of the major proxy advisory groups and shareholders before they put them up for a vote. So there would be dialogue about pay packages that received majority support – it would just take place before the annual meeting of shareholders. This is what happens in the United Kingdom today.
My own take on this argument is that it’s true that a majority vote “against” a company’s pay arrangements might mean something else other than dissatisfaction over pay. Today, some shareholders use the tactic of submitting proposals they don’t care about in an effort of getting a board to the table on another issue. But by engaging with the company’s major shareholders, the board will find out what shareholders want. In a nutshell, that’s what say-on-pay is all about – getting boards to do their jobs and represent shareholders.
Anyways, my own views on say-on-pay remain the same. I’m on the fence and can see the pros and cons (although my list of those are different from some others). But views on the topic don’t seem to matter much these days – it sure looks like Congress intends to adopt say-on-pay in the very near future…
Recently, I answered five questions posed to me in this USA Today article:
Q: Are business people and employees still angry about the financial debacle and rising pay to executives — especially on Wall Street?
A: The outrage is at the highest levels I’ve ever seen. There are too many non-performing CEOs whose pay does not conform to reality. Twenty years ago, CEO pay was 250 times higher than rank-and-file pay. Today, it’s 600 times, even as the country slides into a recession. Executives shouldn’t recklessly gamble with everyone’s money, then be allowed to paddle away. That’s flat-out wrong. In the words of Tony Soprano, you get paid when we get paid, you get out when we get out.
Q: Given the $700 billion financial system bailout plan, will executive pay level off or keep growing?
A: Pay won’t necessarily continue rising. People realize that trees can’t keep growing into the sky. I think pay will more closely match performance, and there will be an appropriate balance to executives’ pay and the interest of shareholders. I will say as long as there are guaranteed golden parachutes that allow executives to bail out of a crashing company while shareholders and employees go down, there will be no reform in executive pay.
Q: Is the bailout plan’s limits on executive pay for companies that receive money a wise or dumb move?
A: Congress can’t regulate this stuff. It’s too complex. The imposition of unspecified pay limits really is a mistake.
Q: Who bears responsibility for too-high executive pay?
A: It’s easy to point fingers and vilify CEOs. For every bad CEO, there are 99 good ones. Microsoft, Berkshire Hathaway, General Electric, Procter & Gamble — all are companies that clearly practice pay for performance. We need to look around ourselves to find the responsible parties, and it’s a combination: business people, boards of directors, Congress, institutional investors, mutual funds, the media — and let’s not forget executive pay consultants.
Q: What’s the easy solution to a complex problem?
A: If we had very clearly defined regulations based on the design of pay plans — rather than on caps and limits on pay — we might go somewhere. Just a few years ago, it was all the rage for companies to peg executives’ pay to earnings per share. Then, all you had to do was to issue and buy back your company stock, and all of a sudden, you were skewing earnings. If a company performs well, you get paid. If it doesn’t perform, you don’t get paid. Hopefully, the financial crisis will teach new lessons to everybody.
– Ed Hauder, Senior Attorney and Consultant, Exequity, LLP
With all the gyrations in the market lately, I couldn’t help but wonder what this might mean for stock options. Yes, stock options have already experienced a bit of a decline in popularity in recent years thanks to FAS 123(R), but will the flight from options increase? (To read a better version of this blog, see this document with four charts added.)
Not being able to let this go, I ran some quick calculations of volatility for the Dow 30 stocks. The results confirmed that volatility had increased dramatically in 2008 (through October 17th) compared to 2007, 38.99% vs. 21.80% (based on a daily volatility calculation using adjusted closing stock prices), an increase of approximately 80%.
To see how this dramatic increase in volatility might impact stock options, I then looked at volatility for the same group of companies over two three-year periods (i) 1/1/2006 to 10/17/2008, and (ii) 1/1/2006 to 12/31/2007. Not surprisingly, the rise in volatility that showed in the year-over-year comparison also echoed in the three-year volatilities, 24.11% vs. 19.84%, an increase of approximately 22%.
So, how might this impact the future use of stock options? Options are going to become more expensive to use and, if the market is in a prolonged bear market (such as that between 1966 and 1982), there may not even be much upside potential. Additionally, the new bailout-related mandates, including admonitions against incentives that encourage “excessive risk,” are also likely to have an adverse impact on the use of stock options.
However, the stock prices themselves will be depressed compared to prior periods, so wouldn’t the impact of increased volatility be offset by the decrease in the stock price? To test that I took the closing median stock price of the Dow 30 companies for each of the 3 year periods, $33.33 for 1/1/2006 to 10/17/2008 and $46.99 for 1/1/2005 to 12/31/2007, and then used the medians of the most recent FAS 123(R) assumptions disclosed by the Dow 30: risk free interest rate of 4.80%, dividend yield of 2.33% and an expected life of 6.0 years, and ran a Black-Scholes model of a “median” stock option for the Dow 30 in each three-year period.
The results confirm that the relative cost of a stock option will increase as a result of the increase in volatility for 2008. The Black-Scholes values were $8.45 (25.36% of face value/median stock price) for the 1/1/2006 to 10/17/2008 period and $10.45 (22.23% of face value/median stock price) for the 2005-2007 period, representing a 14% increase in the percent of face value/median stock price. So, even though the stock price has dropped as has the Black-Scholes value, the FAS 123(R) cost for stock options will represent a larger percent of the stock price.
Is this the death of stock options? Probably not. But, their increased cost, possible limited upside and the new mandate to avoid excessive risk in compensation programs (at least for those companies participating in the financial bailout) will cause a good number of companies to reconsider their use of stock options, and, most likely, many of them will veer further away from stock options and towards full value awards like restricted stock units and performance shares/units. In these challenging times it will be harder to justify leveraged incentives that can result in greater upside potential than is the case for shareholders whose equity participation has come the old fashioned way – by buying full value shares.
A short while ago, Corp Fin Director John White announced he will be leaving the SEC at the end of the year after working at the SEC for nearly three years. I understand that John will return to the law firm for which he spent over 30 years, Cravath Swaine & Moore. Like his predecessor, John has overseen an enormous amount of regulatory change on his watch – and we thank John for all he has done for the corporate community (and for us by speaking out about responsible executive compensation disclosures).
Last Friday, the WSJ ran this front page, top article – entitled “Banks Owe Billions to Executives” – reporting that the big financial institutions getting capital infusions from the Treasury Department owed their senior executives more than $40 billion for past years’ pay and pensions as of the end of 2007.
The article notes that “Few firms report the size of these debts to their executives. (Goldman is an exception.) In most cases, the Journal calculated them by extrapolating from figures that the firms do have to disclose.”
What the WSJ would be surprised to hear is that many companies don’t even report the size of these debts to their own compensation committees and boards – because they don’t conduct a wealth accumulation analysis! In our “Wealth Accumulation Analysis” Practice Area, we have a number of sample tables to help you get started, including this new “Wealth Accumulation/Full Walk Away Amounts Chart” courtesy of Watson Wyatt and Deloitte Consulting.