Just back from a long cross-country business trip and what a week it was. Kicked off by this article last week in the NY Times (both Jesse and I talked to Ben White and Jesse is quoted), the issue of the great pay divide in this country has come to the fore. Last night, my cab driver talked for the entire ride about how he couldn’t understand how Wall Street is paying bonuses after they killed our economy.
Smartest guy in the room? On the one hand, I do understand how the Wall Street firms had contractual obligations and that some of these people weren’t “to blame” for the financial meltdown. On the other hand, I am in touch with reality and recognize that our society potentially is in the balance if things don’t change. When more than 99% of the population looks at a set of practices and says they can’t comprehend the logic, maybe there’s something to it?
I sure hope our business leaders – CEOs and boards – are really listening. If they are, I sure hope they are acting. I still don’t see much action nor am I hearing that necessary action is forthcoming through the grapevine. President Obama is seriously considering the drastic restriction of a pay cap for a reason (as an aside, I don’t agree with pay caps). There needs to be real change in executive compensation practices and it needs to happen fast.
This op-ed by Maureen Dowd from Sunday’s NY Times gives us food for thought:
Disgorge, Wall Street Fat Cats
The president’s disgust at Wall Street looters was good. But we need more. We need disgorgement. Disgorgement is when courts force wrongdoers to repay ill-gotten gains. And I’m ill at the gains gotten by scummy executives acting all Gordon Gekko while they’re getting bailed out by us.
With the equally laconic Tim Geithner beside him, Mr. Obama called it “shameful” and “the height of irresponsibility” for Wall Street bankers to give themselves $18.4 billion worth of bonuses for last year. They should know better, he coolly chided. But big shots — even Mr. Obama’s — seem impervious to knowing better. (Following fast on Geithner’s tax lacunae, Tom Daschle’s nomination hit a pothole when he had to pay $140,000 in back taxes he owed mostly for three years’ use of a car and a driver provided by a private equity firm.)
At least the old robber barons made great products. When you make money out of money, unmoored from morality and regulators, it must unhinge you. How else to explain corporate welfare queens partridge hunting in England, buying French jets and shopping for Lamborghinis?
Mr. Obama was less bracing than during the campaign, when A.I.G. executives were caught going to posh retreats after taking an $85 billion bailout. He called for them to be fired and to reimburse the federal Treasury. Now that he has the power to act, Mr. Obama spoke, as his spokesman Robert Gibbs put it, “like that disappointed parent that doesn’t embarrass you in the mall, but you feel like you’ve let somebody down.”
That’s not enough, not with the president and Geithner continuing to dole out what may end up being a trillion dollars to these “malefactors of great wealth,” as Teddy Roosevelt put it. USA Today wrote about “the A.I.G. effect:” executives finding ways to spend more discreetly, choosing lesser-known luxury hotels and $110 pinot noir instead of the $175 variety.
More than a disappointed parent, they need a special prosecutor or three. Spare the rod, spoil the jackal. Anyone who gave bonuses after accepting federal aid should be fired, and that money should be disgorged to the Treasury.
Claire McCaskill popped out a bill to limit the pay of anyone at firms taking federal money to no more than the president makes — $400,000. “These people are idiots,” she said on the Senate floor. “You can’t use taxpayer money to pay out $18 billion in bonuses. … Right now they’re on the hook to us. And they owe us something other than a fancy wastebasket and $50 million jet.”
One Obama official said her idea is catchy, but it won’t work “because no one would come to Treasury to participate, and that means our economy would continue to stumble downward.”
Senator Chuck Grassley urged the administration to snatch back the bonuses. “They ought to give ’em back or we should go get ’em,” the Republican told me. “If this were Japan and a corporate executive did what is being done on Wall Street, they’d either go out and commit suicide or go before the board of directors and the country and take a very deep bow and apologize.”
He was shocked to learn that the Office of Management and Budget, insistent on following the Paperwork Reduction Act, was dragging down a special inspector general’s investigation of what banks are doing with taxpayer money. (After complaints, the O.M.B. yielded on Friday.)
“Once in a while, some C.E.O. comes and talks to me and I wonder if they’re laughing under their breath at having to talk to someone who makes 1 percent of what they make,” he said. Treasury officials and Barney Frank are dubious about recouping bonuses. “Paulson let the cat out of the bag,” Frank said of Henry Paulson, Geithner’s predecessor, “and it can’t be gotten back.”
But aren’t taxpayers shareholders in these corporations now, and can’t shareholders sue or scream “You misspent my money!” like Judy Holliday? “In ‘The Solid Gold Cadillac,’ ” said Frank, who knows the movie. “We got some preferred shares,” he mused, “but I don’t think we could sue on that basis.”
Rudy Giuliani resurfaced Friday to defend corporate bonuses, telling CNN that cutting them would mean less spending in restaurants and stores. Stupid. Even without bonuses, these gazillionaires can still eat out. It’s like Rudy’s trickle-up Make Work Program: Make Leisure.
Some Obama policy makers still buy into the notion that if they’re too strict, these economic royalists, to use F.D.R.’s epithet, might balk at the bailout, preferring perks over the prospect of their banks going belly-up.
The president needs to think like Andrew Cuomo. “ ‘Performance bonus’ for many of the C.E.O.’s is an oxymoron,” he said. “I would tell them, a) you don’t deserve a bonus, b) where are you going to go? and c) if you want to go, go.”
“Malus” is a new word being tossed around in executive compensation circles to mean “negative bonus.” At UBS, starting next year, only 1/3 of any cash bonus will be paid out in the year it is earned. The amount held in reserve can be reduced by a “malus” if results are poor.
A recent article in Business Week on reforming executive pay also referred to the “bonus / malus” system (as well as this DealBook article). I suspect the new word is someone’s attempt to combine the Latin word “malus” (evil or wicked) with “bonus” (which comes from the Latin word for good). We’ve seen nifty neologisms in the executive compensation area before – the immediately understandable “clawback” is a good example. It will be interesting to see if the more erudite “malus” catches on.
The headlines are coming. “CEO pay rises while stock prices decline sharply.” Investors will be outraged, the compensation committees will be targeted, and critics will ask “where’s the pay for performance?”
The short answer is that for equity awards, and options in particular, the SEC requires disclosure of the cost of equity to the company rather than the benefit of the award to the employee. Of course, the value of what the employee would actually receive from the award fluctuates with the stock price, and this is the missing performance link rarely discussed in news articles.
For many executives, equity compensation makes up the majority of total compensation as reported in the Summary Compensation Table, and the value of equity compensation that is reported is the FAS 123R accounting charge. The Associated Press formulation substitutes the grant date fair value of equity awards granted during the year, but this too is an accounting charge. For most time-based options, the accounting charge is set when the option is awarded and does not fluctuate with changes in the company’s stock price. This is where the performance link breaks down, because the SEC and the media rely on accounting estimates (cost) that are not influenced by performance.
Let’s look at an example that, unfortunately, will be fairly common this proxy season. At the beginning of 2007, ABC Co.’s Compensation Committee determines their CEO’s compensation as follows: salary of $1 million, a cash bonus target of $3 million, and stock options with a FAS 123R value of $6 million for a target total compensation of $10 million. At the beginning of 2008, the Compensation Committee reviews ABC Co.’s results: revenue and net income both increased 10%, the stock price rose 20% and the CEO earned 100% of his targeted bonus amount, so the Summary Compensation Table shows the CEO received $10 million in total compensation for 2007.
Because of the solid performance for 2007, the Compensation Committee elects to increase the CEO’s target 2008 compensation by 10% to $11 million as follows: $1.1 million salary, $3.3 million cash bonus target, stock options with a FAS 123R value of $6.6 million. At the beginning of 2009, the Compensation Committee reviews the grim 2008 results. Revenue and net income are flat, the stock price is down 25% (which is slightly better than its peer group). Based on the cash bonus formula, the CEO receives only 75% of his targeted bonus ($2.5 million). In the proxy statement, the CEO’s total compensation for 2008 is $10.2 million, an increase of 2%. How can this be?
Because the accounting charges that are reported in the Summary Compensation Table are static. For stock options with time-based vesting, the values reported in the option award column will not reflect the impact of stock or financial performance. To see pay for performance in action, you need to look at the intrinsic value of the CEO’s option award. Let’s assume that at the beginning of 2008, the CEO’s $6.6 million FAS 123R cost consists of one option for 1 million shares with a strike price of $10.
If the stock price declines by 25% over the course of 2008, and now trades at $7.50, the intrinsic value of those options is now zero. In fact, the stock price would have to rise 33%, back up to at least $10.01, for the option award to have any intrinsic value at all, let alone $6.6 million of value. If you look at the impact to the CEO’s pocketbook, the total compensation is closer to $3.6 million (salary of $1.1 million, bonus of $2.5 million, options with an intrinsic value of zero) rather than the reported $10.2 million. Here is where the impact of performance becomes vividly clear; the CEO will only receive value from his option award to the extent the stock price increases.
Recent History of Reporting Equity Award Values
In 2006, the reporting of equity awards was addressed by the SEC on multiple occasions. In January, the proposing release would have included the grant date fair value of awards granted during the year in the Summary Compensation Table and included the original grant date fair value of equity awards in the Option Exercises and Stock Vested Table so stockholders could see how the initial estimate differed from the ultimate outcome. In August, the requirement to report the grant date fair value in the Option Exercises Table was removed due to concerns that it would be confusing and could lead to double counting.
Then in December, the SEC replaced the grant date fair value of equity awards granted during the year with the FAS 123R compensation expense for all outstanding equity awards incurred during the year. The original grant date fair value was included as an additional column in the Grants of Plan-Based Awards table, so both accounting measures are readily available to stockholders and the media.
How to Demonstrate the Pay for Performance Link
Unfortunately, there is no consensus on the best way to show the impact of stock price on the value of the named executive officers’ outstanding equity awards. Measuring the year over year stock price change is the easy part; the difficult part is what do you multiply it by? All outstanding equity awards? What about grants made during the year? Or exercises? And what about previously vested awards that are reported in the beneficial ownership table? Should those count? For Intel’s 2008 proxy, we attempted to capture realized and unrealized gains/losses on outstanding equity awards in the CD&A. We also showed the market value of options and restricted stock units in the “Outstanding Equity Awards Table” for directors and officers.
While I believe these measures are helpful, I would like to see more discussion and debate on this topic, with the goal of establishing an accepted methodology that crisply shows the pay for performance link for equity awards, focusing on the benefit of equity awards to the employee rather than the cost to the company.
At this point, I am not arguing that the equity costs included in the Summary Compensation table should be replaced with a benefit value based on the intrinsic value based on the current stock price, but rather, how do we come up with a benefit value to serve as a companion to the accounting charges? How do we report a number (or numbers) that shows how stock price performance influences what the employee may ultimately receive? By developing a benefit-based measure of equity awards, we can demonstrate the pay for performance link that exists.
I wanted to bring to your attention this opportunity to influence policies being considered by congress relating to “Say on Pay.” If you want to offer your views, you can comment on Professor Jeffrey Gordon’s pre-publication draft paper – entitled ““Say on Pay: Cautionary Notes on the UK Experience and the Case for Shareholder Opt-In” – which presents a company-specific “opt-in” as an alternative to the universal approach in last years house bill.
Professor Gordon’s idea generated both corporate and investor interest when he introduced it at a December meeting of the Shareholder Forum. As both a member of the Forum’s Program Panel – and as a compensation professional whose clients are interested – I have been following this carefully and I would like to know what other compensation professionals have to say about it. It’s also important that those making policy hear from people who know what they are talking about.
The following are excerpts from the summaries Professor Gordon provided to Forum participants of his paper’s thoroughly researched review of UK and US marketplace conditions relevant to “Say on Pay” policy decisions:
The paper provides a sober look at how a theoretically attractive idea like SOP is likely to play out in the real world….
In the face of recent lessons, it seems especially unwise to mandate SOP across all 14,000 public firms in the United States. A better approach is to provide federal assurance of the shareholder right to opt-into a SOP regime. This will lead to targeting of firms with the most problematic compensation issues and will reflect commitment of genuine shareholder engagement rather than delegation of decisionmaking to a third party rater. It will also lead to testing and rethinking of compensation ideas in a more thoughtful way.
…[conditions addressed in] this draft buttress the alternative proposal to limit any mandatory SOP rules to the largest firms by showing that the UK precedent itself makes such a distinction: firms listed on the LSE Main Market (1080 firms) are subject to mandatory SOP whereas the smaller firms listed on AIM (1546 firms) are not. In comparing institutional capacity to manage SOP responsibilities, it is also noteworthy that in the UK, 82 companies account for 85% of market capitalization, whereas in the US, the S&P 500 companies account for only 75%.
Comments can be sent to the Forum’s Chairman, Gary Lutin (gl@shareholderforum.com), either for private submission or for open Forum review. Please note, by the way, that the draft is not a published paper and should be treated accordingly; anyone wanting to refer to its statements should seek permission from the author.
In our Winter ’09 issue of the Compensation Standards print newsletter, we included a short piece on “Four Key TARP Fixes.” With Congress likely to act very soon on fixing TARP – and executive compensation excesses – we hope that this short article will influence those that will be making these regulatory changes.
We have posted the article on a non-member page so that anyone can access it. Please tell your friends in Congress!
I just put together a “Quick Survey on ’09 LTI Grant Practices.” Please take a moment to complete and and I’ll share the results soon. The survey closes Tuesday, 2/3/09, at 5 pm Central.
Dave just completed a Special Supplement to the Jan-Feb ‘09 issue of The Corporate Executive. Since we expect many will be borrowing extensively from Dave’s excellent, up-to-the-moment model disclosures – inserting them into current drafts of proxy statements – we have posted the issue so that ’09 renewers can access the issue now (the full issue, including the Supplement, will be mailed to current ’09 subscribers later this week).
Renew Now: Those that renewed for ’09 received a link to the Supplement yesterday with instructions on how to access it; if you haven’t renewed yet, renew now to receive it immediately.
Try a No-Risk Trial Now: To have this Special Supplement rushed to you via email so you receive it today, try a no-risk trial for ’09 now – as the Supplement includes pieces on:
– Timely “Best Practice” Disclosures for Your Compensation Discussion and Analysis
– Implementing “Hold Through Retirement” for Equity Awards
– Our Hold-Through-Retirement Policy
– Revisiting Perquisites
– Reassessment of Our Perquisites
– Making the Most of Clawback Provisions
– Revisiting our Compensation Recovery Policy
– Evaluating the Need for Pensions and SERPs
– Our Review and Analysis of Pensions and SERPs
– Tax Implications
– Deductibility of Compensation for Tax Purposes
Given the heightened importance of executive pay right now – and the high likelihood that Congress will pass “say-on-pay” legislation, this year’s compensation disclosures will receive unprecedented scruntiny by investors, employees, customers and the media.
The rapidly escalating activity in, and debate about, “fixing” underwater equity has resulted in some public rifts. Much of the discussion centers on the technical complexity of option exchanges and performance plan resetting. Others, like our firm’s position, focuses more on Equity EffectivenessTM and the opportunity that the current market chaos presents for re-evaluating the role of equity compensation in total pay strategy.
Frankly, I think some are more interested in selling option exchange programs, and the time-intensive valuation, design, and disclosure processes that they require, though I would hope that the lucrative fee opportunities in these would not cause anyone to recommend these programs over simpler and more cost-effective strategies.
The phrase coined by our Firm – which is the name of this memo, “Stop Before You Swap” – is intended to encourage companies to step back and re-assess why they use equity compensation and, more importantly, the total financial return they are realizing from the related expenditures. While there are numerous obvious responses to this question – market practice, industry norms, financial efficiency – we believe all of these are called into a new light in this unprecedented environment.
Remember, the “cost” of equity compensation is not just FAS123R or IFRS2 accounting expense. The all-in cost of plan evaluation, design, valuation, implementation, and administration is rarely tracked but typically quite high. We believe that these cumulative costs sometimes exceed the pay delivered to plan participants, even before the recent market downturn. Equity compensation may be the sole business practice that is exempt from ROI calculations.
To suggest that underwater equity – inclusive of underwater options, RSUs with minimal value compared to values at grant date, and performance plans with little or no hope of payout – should only be dealt with through direct action on those awards is simplistic.
Similarly, in this era of heightened scrutiny to executive pay practices and the spillover to equity programs, it is irresponsible to suggest that conforming to a single proxy advisor’s arbitrary criteria as guidance for such actions is de facto “good governance.” We already have examples of companies that conformed to “the rules’ but whose programs failed as well as those who ignored the rules and proceeded with successful programs that made good business sense.
We are not in a time where programs and checklists can be the basis for good governance and good business decisions. We are in a time that requires comprehensive analysis about governance and financial issues, and not just how to optimize option exchange rates through manipulation of expected life assumptions.
Corporate governance advisors expect more and shareholders deserve more. When millions of Americans have lost one-third or more of their life savings, and some have lost their jobs and their homes too, a focus on restoring equity compensation value to “incent and retain” employees deserves critical thinking.
Dave Lynn and Mark Borges just wrapped up – and we have just posted the Winter 2009 issue of our quarterly “Proxy Disclosure Updates” Newsletter, which is free for all those that try a no-risk trial to Lynn, Romanek and Borges’ “The Executive Compensation Disclosure Treatise & Reporting Guide.”
This critical issue provides analysis, practice pointers – and model disclosures – regarding executive pay risks, a new type of disclosure that all companies will need to address in the wake of EESA and other regulatory responses to the crisis. The issue also provides new analysis regarding disclosures of pledged and hedged shares.
Try No-Risk Trial Now: Order now so we can rush a non-blurred copy of this first issue to you today – as well as a copy of the 1000-page Treatise; note there is a reduced rate if you are ’09 member of CompensationStandards.com. If at any time you are not completely satisfied with the Treatise, simply return it and we will refund the entire cost.
When you order the Treatise, not only do you get a hard copy mailed to you, you also get access to an e-version on CompensationDisclosure.com. And you also get access to the quarterly Updates newsletters that make up the “Lynn, Romanek & Borges’ Executive Compensation Annual Service.”
– Mark Poerio, Paul Hastings Law (with assistance from Michael Steele)
The financial downturn continues to swing the pendulum of public opinion further and further away from incentive-based compensation for executives. Consider, for example, an absolute prohibition on any incentives for the top-25 executives of bailed-out companies. That prohibition occurs within a TARP-governance bill (H.R. 384) passed this week by the House (and sponsored by Financial Services Chair Barney Frank (D-MA)). Although those who are bailed-out should expect greater regulation, the question for shareholders and the incoming Obama administration is nevertheless whether, at some point, the pendulum has swung too far away from motivation through proper incentives.
The reality is that well-drawn executive incentives are generally desirable, with a good litmus test being how well they promote key corporate interests, discourage excessive risk and disloyalty, and reward long-term performance. This is largely the point we make in our article entitled “Executive Insecurity—No Better Time for Employer Attention.”
Our article singles out the following general questions for employers to consider in view of the anxiety we currently face:
1. What are your most critical workforce challenges –e.g., retention, relocation, growth, reduction, or restructuring?
2. Who do you need to retain and motivate?
3. Are there opportunities to better deploy under-utilized personnel? If not, when and how will you contemplate layoffs, exit incentives, furloughs, forced vacations, reduced hours, or other temporary or permanent work force reductions?
4. Is your company perceived as being at risk of being sold, taken over, or going bankrupt?
5. Do your incentive bonuses or stock-based awards need recalibration?
6. Do you want to better discourage employees from pursuing competitive employment or improper behavior (such as unduly aggressive financial statement accounting practices that ultimately may require a financial restatement)?
7. How will you effectively communicate the actions taken to advance your workforce goals?
If you would like to see our answers and commentary on the above questions, see this article.