Financial services companies (among others) should consider taking proactive steps to go well beyond the minimal (and ineffective) TARP requirements to reform their executive compensation practices, including:
1. Re-set the pay mix: Financial services executives earn a very high proportion of their pay (cash compensation and restricted stock) based on short-term results. This is virtually unheard of in every other industry, where the lion’s share of compensation (60% – 75%) is based on long-term, equity based incentives. Companies need to adopt long-term incentive arrangements tied to the Company’s long-term business plan that reward sustainable, long-term improvements in financial and stock price results. Performance shares tied to earnings growth and relative total shareholder return are likely to be used far more extensively than in the past.
2. Roll-back pay levels: Pay levels at some financial institutions routinely exceeded $30 million, and were justified based on pay for performance. Boards would be well-advised to reduce pay levels to more sensible levels. A good place to start would be by targeting the median, and allowing performance to drive above or below median pay. Another important step would be to cap incentives at 200% to 300% of target levels. While these reductions could lead to the loss of some executive talent to hedge funds, private equity, and start-up investment firms, this step is essential to restoring investor and taxpayer confidence.
3. Adopt “hold backs” and “hold to retirement” policies: An important method for keeping executives focused on sustained, long-term performance is to adopt “hold back” and “hold to retirement” policies. A “hold back” provision generally applies to the annual incentive, where a portion of the earned incentive is held back for at least one year (and sometimes longer), and subjected to future performance conditions.
Thus, if one year’s financial performance funds a maximum payout, a portion of the incentive is held back and paid only if the subsequent year’s financial targets are achieved. Holdbacks may vary depending on participant’s level in the organization or size of the award, and a 25% to 40% holdback is common. “Hold to retirement” provisions require that executives retain [50%] of the after tax value of earned equity incentives. This requirement is in addition to the regular stock ownership requirements. Hold until retirement provisions help to ensure the amount of wealth the executive ultimately accumulates is, in part, tied to the Company’s total shareholder return during their career with the Company.
4. Eliminate perquisites, gross-ups and other “executive entitlements”: In order to promote internal equity and fairness, many companies treat all employees the same when it comes to benefits and some impose a higher cost burden on those that can best afford it. [Citicorp was one of the first companies to charge executives for the full amount of their healthcare benefits.]
While it is difficult to quantify the level of resentment and lost productivity resulting from the perceived injustice created when executives keep lavish perquisites and benefits while employees endure higher healthcare premiums, suspended 401(k) contributions and layoffs, it is likely substantial. Shareholder ire is also caused by tax gross-ups, with the harshest criticism leveled at tax gross-ups on executive perquisites.
5. Modify severance arrangements: In addition to modifying severance benefits to comply with TARP, consider:
– Broadening the definition of termination for cause to include poor performance.
– Eliminating excise tax gross-ups.
– Capping the severance multiple to 1x base salary and target bonus for non-change-in-control terminations and 2x for a change in control related termination.
– Adopting double trigger vesting provisions in a change-in-control (i.e., must have a CIC and lose your job).
– Linking severance protection with financial need. Thus, if an executive has accumulated significant wealth during their employment with the Company, no severance will be paid. Alternatively, phase-out severance protection within 5 years of hire or promotion to executive officer.
– Ira Kay and Steve Seelig, Watson Wyatt Worldwide
We just published a study – entitled “Executive Compensation in Uncertain Economic Times” – that shows that compensation committees had been making significant adjustments to how they compensate their CEOs even prior to the recent financial crisis.
The survey found that – for the first time in years – executives at companies that performed well were granted larger pay opportunities than their counterparts at weaker companies. Total direct compensation (TDC) opportunity for CEOs at high-performing companies was $10.7 million from 2005 to 2007, noticeably higher than the $8.1 million TDC opportunity for CEOs at low-performing companies. The lack of a historical relationship between performance and pay opportunity has been a source of significant criticism of corporate America. Total direct compensation opportunity includes base salary, annual incentives and new long-term incentive stock and cash grants.
While companies are taking steps in the right direction, challenges still remain. This year’s study also reveals that companies granting riskier compensation packages — a heavier mix of stock options with higher stock price volatility — tend to grant higher total compensation opportunity — $12.5 million versus $7.1 million for CEOs at companies granting less risky compensation.
Other findings from the survey include:
– CEOs at high-performing companies continue to earn more in realizable pay than their low-performing counterparts. At companies with above-median three-year total return to shareholders (TRS) from 2005 to 2007, CEOs earned a median realizable long-term incentive value of $5.5 million compared to $1.4 million for CEOs at companies with below-median TRS.
– Consistent with previous surveys, companies with high CEO stock ownership levels significantly outperformed companies with low CEO stock ownership levels.
– Even before the recent stock market slump, one out of three companies (34 percent) had stock options that were “underwater” in 2007, an increase of 60 percent over 2006. The average strike price among these firms was 28 percent below the current share price. These values do not reflect additional market declines of the year.
My colleague, Julie Hoffman, recently caught up with Dave Johnson, Executive Compensation Practice Leader at Ernst & Young, in this podcast to discuss putting IFRS’ impact on compensation on HR and Finance’s radars, including:
– How might IFRS impact executive compensation arrangements?
– As a result, who (besides the accounting/finance teams) needs to be conversant with IFRS at a company?
– What should companies be doing to prepare now for IFRS’ impact on compensation?
Reasons Why Folks Do “Best of” Lists
I was tempted to concoct some type of “best of” list – and then I got sarcastic about it and created this pie chart instead:
Brink Dickerson of Troutman Sanders reports that a preliminary filing of a proxy statement under Rule 14a-6(a) is required in connection with management say-on-pay proposals. While Rule 14a-6(a)(4) eliminates the filing requirement for the “approval or ratification of a [compensation] plan…or amendment to such plan,” Interpretation N.10 from the Manual of Publicly Available Telephone Interpretations makes it clear that this is a narrow exclusion and does not apply to after-the-fact approval of specific compensation (note that this set of interps may be updated any day now, per statements of Corp Fin Staff). In addition, the Corp Fin Staff confirmed for one of Brink’s colleagues that a management say-on-pay proposal would not fall within the Rule 14a-6(a)(4) exception.
A number of the companies with management say-on-pay proposals (egs. AFLAC, Littlefield and H&R Block) have filed preliminary proxy statements, but they had other proposals that would have triggered a preliminary filing in any event. Other companies appear to have overlooked this requirement.
Here is a response I received from a member in response to this blog fyi: Whether right or wrong, I believe common practice is that companies do not file preliminary proxy statements even when awards to employees are made subject to the approval by shareholders of a new plan or an amendment to an existing plan. And don’t forget this additional important nuance from NYSE and Nasdaq FAQs on Equity Compensation Plans – here is NYSE FAQ F-2 (2/18/04):
If shareholder approval of a new equity compensation plan is required, may grants be made before the approval is obtained, so long as the grants are forfeited if the shareholder approval is not in fact obtained?
No shares may be issued until the approval is obtained. This is because the Exchange requires that a supplemental listing application (“SLAP”) be filed before the shares are issued, and the SLAP will not be accepted unless any required shareholder approval has already been obtained. Grants may be made before shareholder approval, provided that no shares can actually be issued pursuant to the grants until it is obtained. For example, a listed company could grant stock options that would not become exercisable until after shareholder approval is obtained. On the other hand, restricted stock could not be issued before shareholder approval, because restricted stock is issued upon grant. Note, however, that the company could promise to issue restricted stock at a future date after shareholder approval is obtained.
Our firm recently surveyed over 400 board members, executives and human resources professionals in regard to what modifications they’re contemplating to executive pay programs in response to recent market turmoil. The results of the survey – entitled “Executive Pay in the New Economy” Quick Poll – offer important insights into companies ‘ year-end pay decisions, the awards provided for performance in 2008 – as well as a useful preview of compensation planning for 2009.
Overall, executive pay appears certain to face significant upheaval in 2009. Nearly nearly 90% of survey respondents said the economic downturn will affect their decisions about executive compensation during the next six months, with nearly one in five predicting the impact will be “significant.” They said annual bonus and stock-based awards for executives will decline , while salary growth slows. Nearly 18% said their companies are “strongly considering” a salary freeze, while 36% might consider paying a year-end bonus below formula. Additionally, about 1 in 5 respondents said their companies’ severance or change-in-control arrangements will be revised in the next 12 months.
Since the survey was completed, the economy has officially been declared a recession and even more leading companies have sought governance assistance. There seems no question that companies will need to significantly increase the extent to which executive compensation, particularly variable components such as annual bonus awards and stock grants, are put at real risk when performance stumbles. Whether the program changes they make will end up satisfying shareholders who are feeling the pain in their own paychecks, and portfolios, is less certain.
As I blogged this morning on TheCorporateCounsel.net, the SEC adopted mandatory XBRL yesterday. From the remarks at the open Commission meeting, it doesn’t appear that the SEC adopted XBRL for executive pay data. However, as Dave wrote up below, some service providers have taken action to place pay data in XBRL format:
Recently, a company by the name of Xtensible Data announced that its recently released interactive data website now includes 2006 and 2007 executive compensation data reported in XBRL for more than 4000 companies. This is a significantly greater data set than the SEC provides in its own executive compensation viewer, which only includes 2006 data for 500 large companies.
Like the SEC’s viewer, Xtensible Data’s Corporate Pay interactive tool focuses on the information provided in the Summary Compensation Table. The data is based on information from public filings, and the company has converted the data from HTML or standard text into an interactive XBRL format. The database can be searched based on company name and ticker, stock index, and industry, and the results can be sorted by each column of the Summary Compensation Table, and filtered by executive type and fiscal year. The method used to determine the value of stock and option awards may also be selected by the user. The Corporate Pay tool also allows users to graph the executive compensation information (including comparative graphs) and the data may be downloaded into Excel.
A new RiskMetrics Group study – “Gilding Golden Parachutes: the Impact of Excise Tax Gross-Ups” – that I authored sheds light on a long obscured aspect of executive pay. The SEC’s new 2006 compensation disclosure rules lifted the veil on such benefits by requiring companies to estimate potential severance payments, including any tax gross-ups, in their annual proxy statements. These gross-ups are designed to eliminate the impact of a 20 percent penalty (excise) tax that is levied on change-in-control related severance payouts to executives that are deemed to be “excessive.”
Congress enacted the tax in 1984 in an attempt to put the brakes on what were then considered unjustifiably large payouts (though paltry by today’s standards) being made to top executives who lost their jobs after takeovers. But RiskMetrics’ study of S&P 500 companies found that, in fact, the regulation has likely spurred the growth of severance packages, as more and more companies have agreed to pay the penalty tax – and pass that expense onto shareholders. Key findings from the study include:
– A substantial two-thirds of the S&P 500 disclosed they would provide excise tax gross-ups to one or more top executives. That’s in spite of the fact that excise tax gross-ups are a costly benefit, since it generally takes at least $2.50 and as much as $4 to cover each $1 of excise tax that must be “grossed-up.”
– At 80 percent of these companies, the tax would have been triggered if the executives had received change-in-control severance at the end of the prior fiscal year–in other words, the company disclosed its estimates of the tax hit. The aggregate potential gross-up payments for all named executive officers at those companies averaged $13.9 million. And their total estimated severance, including tax gross-ups, averaged a staggering $78.4 million.
– The story was different for the one-third of companies not providing excise tax gross-ups–average total potential severance payouts to the “top five” executives at these firms was $43.9 million.
The huge gap ($34.5 million) between the average value of top executive severance packages at companies that do provide tax gross-ups, versus those that don’t, cannot be explained by the average value of the gross-ups alone ($13.9 million). This finding suggests that companies providing such gross-ups tend to pay higher change-in-control-related severance generally, likely not what Congress intended back in 1984.
Shareholders have been generally tolerant of these arrangements, but that might change now that more details are available on a regular basis. And, although the government may appreciate the revenue stream from the penalty tax, Congress may also take note of the unintended consequences of that attempt to control executive pay.
To get a window on what may happen if say-on-pay legislation is enacted in the US, look no further to the results from the recent annual shareholder meeting for Jackson-Hewitt Tax Services. As noted in the company’s Form 10-Q filed last week, 37.5% of the votes cast were voted against the company’s pay package (see Proposal III) – the highest level of opposition so far for an advisory vote in the U.S. market. This is only the fifth company in the US to allow say-on-pay on the ballot – once more companies allow it, I imagine the levels of opposition will grow given the environment out there today.
Congrats to Dave Lynn for getting quoted in this front-page article yesterday in the Washington Post. The article is entitled “Executive Pay Limits May Prove Toothless.” And more importantly, the article mentions our new treatise! I find it hard to believe, but someone told me they heard Alex Bennett review the treatise during his Sirius radio show yesterday…
As a possible harbinger of eventual extension of Section 162(m) to all Principal Financial Officers, it should be noted that the “Emergency Economic Stabilization Act” adds new subparagraph (5) to Section 162(m), which limits to $500,000 the deductibility of certain compensation paid to executives of those financial institutions participating in the Treasury’s TARP. Although this was an opportunity for Congress to amend Section 162(m) to bring the “Principal Financial Officer” (as defined by the SEC) into the definition of “covered employee,” the EESA only does this with respect to participants in TARP. Meantime, the “Principal Financial Officer” continues to be excluded from Section 162(m)’s scope (as first reported in the Sept-Oct 2006 issue of The Corporate Executive and formally accepted by the IRS in Notice 2007-49).
Careful readers will note that the EESA refers to the “chief financial officer” without defining the term, but Section 101(c)(5) of the EESA authorizes the Treasury Secretary to promulgate regulations defining terms in the EESA so the likely result will be 162(m) regulations defining ” chief financial officer” as the person who is the “Principal Financial Officer” for purposes of disclosure of executive compensation under the SEC’s rules.
The county of San Mateo, California, which lost $150 million in the recent bankruptcy of Lehman Brothers, has sued officers and directors of Lehman to recover some of their losses. The county is also suing Ernst & Young, Lehman’s auditors. The complaint – which is posted in our “Compensation Litigation” Portal – alleges that Lehman executives, in its public filings, during investor calls and at investor conferences, implied that the risks of its “Alt-A” mortgage business were adequately hedged. The executives’ public statements were not consistent with their more pessimistic internal memos, and of course, they look remarkably bone-headed now that the company has collapsed.
Since the county knew that Lehman was involved in a risky business, it essentially has to argue that Lehman’s disclosures didn’t scare them enough, which seems like a long shot.
Lehman executives recently had to appear before Congress to explain to skeptical lawmakers why Lehman’s failure wasn’t their fault. That’s part of the emotional appeal of this case, along with CEO Fuld’s huge compensation ($300 million) and vast personal fortune, which is mentioned several times in the complaint. The case bears watching to see if it survives summary judgment.
