– Ed Hauder, Senior Attorney and Consultant, Exequity, LLP
I had a conversation with a client recently about retention issues. The company’s past several performance and bonus cycles had not paid out and are unlikely to do so and most stock options that remained outstanding after the company switched to performance shares were granted at prices far in excess of the current stock price. A top executive recently left as well as one of the executive’s direct reports. The client was concerned about the potential loss of employees across his organization. We talked more and it turned out that he believed while his Board of Directors would be concerned about the loss of key talent, they would first want to see evidence that employees were leaving before addressing the issue.
There is definitely a concern that you don’t want to address an issue that doesn’t exist, i.e., grant retention incentives where none were needed. This is especially true given the general take of the media and reaction of certain shareholders when retention efforts are disclosed. But companies also need to consider what would happen if they did lose employees. An ounce of prevention is worth a pound of cure (and is generally cheaper).
So what should a company in this type of situation do? I discussed analyzing the compensation packages (i.e., equity holdings and bonus potential) of key employees – those employees whose loss would cause alarm or the loss of key institutional memory or impact the company’s ability to achieve its strategic objectives or shareholders’ view of the company (“high potentials”). If these employees didn’t have a sufficient “at risk” stake that they’d have to turn their backs on to leave, then it might be appropriate to ensure that they were granted such a stake.
Of course, you could look at the situation from the point of view that the economy is bad in general. Therefore, employees are less likely to change jobs and put themselves at risk for down-sizing, etc. at a new employer. You might then think you should just wait and see whether there is a significant jump in turnover of employees before acting. While this approach has a certain appeal, the problem with it is that if high potentials leave, it will be too late to address the situation. In good and bad economic times, it is often a company’s high potentials who will be most able to secure new positions outside the company.
During troubling economic times, every company wants to hire high potentials to help weather the storm and improve their businesses. Thus, even if the employee turnover rate itself remains constant, if the make-up of the employees who leaves is largely high potential employees, then a company that relies on the talents of its employees will be left a hollow shell of what it once was.
So, I asked my client if they had looked at their high potentials and I heard a fairly familiar refrain, “We haven’t seen any list of high potentials, and if such a list exists, it may only be in the head of our CEO.” Well, at least the CEO knows, right? While true, it makes it difficult to monitor the turnover of high potentials and to manage them like the valuable assets they are. What would happen if others had a chance to see and react to such a list or even assist in its creation? What if a high potential employee was told that he or she was on the list? Might not that recognition alone coupled with the challenge of seeing the company through these difficult economic times be enough to reenergize and recommit the employee to staying the course with the company? It might.
As well as being able to look at the group of key employees whose loss could hurt the company, knowing who is a high potential can enable a company to make rational decisions regarding which employees it should encourage to stay through recognition, greater assignments, compensation and other opportunities and, if needed, retention grants. That strikes me as a prudent way for a business to make decisions regarding the potential loss of a valuable asset. And make no mistake about it, high potential employees are a valuable asset who can help make a good company great or whose disappearance can condemn an “ok” company to remain mired in mediocrity and not develop into what it might otherwise have become.
In my experience, employees generally are not solely driven by compensation (heresy, I know, with me being a compensation consultant). Instead, after some base amount of compensation, high potentials look for career challenges – opportunities to learn, develop and grow – and recognition that their contributions are seen and appreciated by higher ups (which could be accomplished through something as simple as a personal note from the CEO – the type of low cost, high impact action that can help motivate your high potentials and keep them engaged and focused on your business). Another thing I’ve noticed is that most high potentials make their decision to stay at a company based on the people they work with and the challenges and opportunities they perceive they have.
Businesses usually make decisions regarding threats to other business assets without waiting to see a loss. Sure, some companies need to experience a huge data theft before IT security becomes a hot-button issue, but normally companies take prudent steps to protect their valuable business assets – they hire security services to protect their offices, plants and equipment or they file patents and trademarks to protect their intellectual property from others. So why can’t companies look at high potentials in the same way from a business perspective? If companies looked at high potentials the same way as any other valuable business asset, many would find that discussions and decisions concerning compensation, while likely initially more difficult, could in fact do a better job of helping the company achieve its strategic objectives.
However, let’s recognize that this is not an easy thing to do. Not everyone can be above average (or a high potential). Not all companies are headquartered in Lake Woebegone. That isn’t to suggest that all employees don’t contribute to the company’s success. Most of them do in some form or fashion. Instead, it simply recognizes the truth that some employees have a bigger impact on a company and should be treated as the valuable asset they are. Companies should at least be in a position to decide what to do with such valuable assets and be able to protect their investment of time, effort and resources in such individuals rather than allow them to slip away due to lack of knowledge or neglect. So why not identify your high potentials so you know who is critical to your organization, and then work out how to keep these folks engaged and committed to the long-term efforts of your company?
In the furious activity of the past few days, it’s easy to understand why many in Congress have demanded salary caps on Wall Street executives as a condition of approving the Bush administration’s bailout of the financial system. After all, in the eyes of the American public, many of the same people who will be leading the effort to get the the diversified financial industry sector back on its feet were the very same “masters of the universe” whose greed and myopia brought the sector, and, subsequently our country, to its knees in the first place.
Nonetheless the decision of Congress to impose some form of still unspecified executive pay limits, a demand reluctantly accepted by Hank Paulson and the Bush administration last week, is a mistake. At this very moment, it’s a valiant struggle to keep a straight face when you read the words “talent” and “Wall Street” in the same sentence. And yet, precisely because Wall Street is currently a trainwreck, the financial system will desperately need scores of simply brilliant and hard working executives and key employees, if it is to return to a state of financial health that benefits the rest of the economy.
The sort of sums that would satisfy Congress as a cap may be far above the income levels of average Americans, but if artificial caps are put into place, there will be no surer way of driving the financial services industry sector offshore, or into private equity or hedge funds where it will be beyond the gaze of regulators. Besides, if ever there was a time when executive pay in financial services, investment banking, and in general industry overall is likely to be depressed by the market, it is now. The financial bubble didn’t only inflate asset and stock prices, but, as a result of executive pay plan design that was largely equity-based, it also inflated pay. Now the bubble has burst in an ugly way, and hundreds of thousands want work.
U.S. politicians have a lamentable record of intervening in setting executive pay. In the early years of the Clinton administration, Congress imposed IRS 162(m), a salary cap of $1 million, beyond which companies faced a tax penalty for any pay above the cap that wasn’t “performance-based”
Executive pay rose as CEOs beneath the cap, realized that they might be “underpaid”, and another set of executives gained from an outpouring of creativity, as companies, with a great deal of help from (mea culpa) executive pay consultants invented myriad types of short- and long-term incentive plans get around the limit. This not only complicated an already confusing situation, it also made it harder for shareholders to know who was getting what, when, and most importantly, why.
If the “deja vu all over again” foolishness of Congress trying to set and regulate executive pay levels is an old lesson, the financial crisis is teaching some new lessons to shareholders. Forget the conventional wisdom that paying executives in large grants of stock options or restricted stock their own companies ensures “skin in the game”, thus driving sensible risk-taking and maximum shareholder value decision-making.
In recent collapses of Lehman Brothers and Bear Stearns, senior management did not just take reckless gambles with other people’s money. Dick Fuld and Jimmy Cayne took reckless gambles with their own, still failed to do the right things, consequently ended up losing everyones money, as well as most of their own fortunes. Public company shareholders and institutional investors, and watchdogs should remember that loading up top executives with shares can certainly be an aid to corporate governance, but not a substitute for it.
For executives and employees alike, the tales of Lehman Brothers, Washinton Mutual, Countrywide, and other catastrophic corporate failures, especially after meltdowns like Enron, Tyco, Global Crossing, the whole “.com bust”, is a reminder of the danger of having too much capital tied up in the company where you work.
Additionally, it clearly magnifies the need for a “balanced portfolio” of executive pay vehicles that are both operationally and market driven. Many more truly talented executives and key employees will now demand their short- and long-term incentives in cash, and perhaps ask for even more shares. That surely will have an effect on the way that companies recruit key employees and on equity-based executive pay in general. And, hopefully, the concept that forcing significant equity-based stakes on executives in their own companies as a means to stop bad decision making has finally been put to rest.
A strong message to Congress – the design and payout structure of executive pay programs is far more important than the amount – especially in the financial services industry sector. For Wall Street executives, foolish short-term risk-taking could be discouraged by matching the timing and payout of executive compensation to the achievement of performance metrics for the companies and portfolios they are responsible for. And, if we’re going to collect capital from the taxpayers, we ought to insure that there is adequate return on invested capital to them, as well as any of our stakeholders, and link those successes directly to executive pay – without guarantees of wealth in spite of failure at the detriment of employees and shareholders.
Congress can certainly ask that financial institutions put up more capital if their executive pay structures appear to be dangerously risky. That makes far more sense than capping executive pay. In the end companies, their Boards of Directors and their shareholders are far better at setting executive pay than government bureaucrats will ever be.
Lastly, there will never be adequate fixes to executive pay in any industry sector – public or private – as long as there are guaranteed “Golden Parachutes” that allow executives to bail out of a crashing company while both employees and shareholders go down with the ship. Candidly, what has created the highest degree of recent outrage in executive pay has been the captains of those sinking ships paddling away in their own comfortable lifeboats, while women, children, and all remaing souls went under.
– Pearl Meyer, Senior Managing Director, Steven Hall & Partners
In response to last week’s blog on mandatory stock option exercises, I would respond that the technique is useful, but for purposes other than those outlined. Requiring exercise and limiting appreciation without a clear corporate objective appears to contradict the grant’s purpose of motivating and rewarding the creation of shareholder value – and the more, the better.
I’ve used this technique, but to achieve a specific corporate purpose – such as to provide employees with the opportunity to earn the negative spread on underwaters while preventing double dipping and to limit the charge to earnings for an option grant.
In Proposed Regulations issued July 29, 2008, the IRS has made a restrictive, and, in my view, unjustified interpretation of the $25,000 limit for ESPPs set forth in Code Section 423(b)(8). This view, if sustained, will require many companies with purchase periods overlapping calendar years to revise their approach to the $25,000 limit, as reasonably interpreted under the statute and existing regulations. It will likely also require reprogramming by service providers who track the $25,000 limit.
What does Section 423(b)(8) provide? There are three concepts in the statute as follows:
1. The $25,000 limit is an annual limit that applies per calendar year (or any part of a calendar year) in which the option is outstanding (no mention of exercisability).
2. The rate (not amount) of accrual of a right to purchase shares is regulated per calendar year the option is outstanding.
3. The right to purchase stock is deemed to “accrue” when it first becomes exercisable.
The first concept is easily understood. If an ESPP “option” is granted December 1, 2008 (i.e., that is the start of an offering period) and expires 24 months later on November 30, 2010, then (leaving aside for a moment the rate and accrual concepts) it is possible for the employee to be given the right to purchase up to $75,000 in fair market value of shares (determined based on the grant date fair market value of the shares), because the option is outstanding in three different calendar years – 2008, 2009 and 2010. No problem so far.
However, Section 423(b)(8) puts a cap on the rate of accrual of the option by calendar year – namely, the rate of accrual may not exceed $25,000 per calendar year the option is outstanding. Here, it is clear that if the ESPP in question had a purchase date on May 31, 2009, it could not permit the employee to purchase $75,000 in shares, because that would reflect an accrual of $37,500 per calendar year the option was outstanding. Again, no problem so far.
Here is the problem. The IRS takes the third concept of 423(b)(8), that an option accrues when it first becomes exercisable, and then concludes that this must mean that no amount of the option can “accrue” (i.e., no purchase date can permit a purchase) in excess of $25,000 in any calendar year – regardless of how long the option has been outstanding.
Hence, in the above example, on the May 21, 2009 purchase date, only $25,000, not $50,000 of shares could be purchased, since the first “exercisability” of the 12/1/08-granted option accrued in 2009.
The IRS by its own admission – see preamble to Proposed Regulations – was trying to interpret 423(b)(8) in a manner consistent with the ISO $100,000 limit. This is, to put it bluntly, absurd, because the statutory language is entirely different. The ISO limit regulates simply the value of shares that can first become exercisable in any calendar year. The ISO language makes no reference either to the period the option was outstanding or to the rate of the option becoming exercisable.
The IRS, to reach its conclusion under 423(b)(8), had to read into the statutory language the phrase “and exercisable” after the phrase “for each calendar year in which such option is outstanding at any time” and read out of the statute the word “rate” of accrual. An option which is granted in 2008 but first becomes exercisable in 2009, and which permits $50,000 in shares to be purchased in 2009, simply does not reflect a rate of accrual in excess of $25,000 per calendar year the option is outstanding, even though there is an actual accrual of $50,000 in 2009.
This seems so obvious to me it makes me doubt my Stanford Law School and public high school English class education.
I am commenting on the Proposed Regulations to the IRS. If you share my view, please feel free to send your own comments to:
CC:PA:LPD:PR (REG-106251-08)
Room 5203
Internal Revenue Service
PO Box 7604
Ben Franklin Station
Washington DC 20044
– Mike Andresino and Tom Brennan, Posternak Blankstein & Lund LLP, Boston
Have looked at posts on numerous blogs – plus the non-stop CNBC squawk – here’s a question we are not seeing answered: We assume that some executive compensation limits and corporate governance reforms will be included as a condition of an entity participating in the bailout by selling assets to the government (or its new RTC II). The disconnect we have observed is that every commentator seems to assume that the bailout participants will be publicly traded financial institutions. But it’s clear from both the House and Senate bills that public companies will not be the only “financial institutions” to be bailed out.
There could be all sorts of other sellers that are not publicly traded – mutual savings banks and insurance companies, credit unions, small broker/dealers, and in the case of the Senate bill, if Treasury so determines, big pension funds and private equity partnerships. Some of these are not even corporate entities. No one is complaining about executive compensation at most of these privately-held entities, and at the ones where people are, such as hedge funds, the reforms on the table (no severance, say on pay, proxy access) make no sense. We wonder whether the bill will be qualified to the effect that the executive comp and governance provisions will only apply to the extent that a participating seller or its parent holding company or affiliate has a class of stock registered under the ’34 Act?
Oddly enough, in the discussion draft of the Senate bill, an appropriate distinction is made between public and private sellers when it comes to the equity position the government intends to take. However, the bill leads into its executive compensation limitations this way:
“The Secretary shall require that all entities seeking to sell assets through a program established under this Act meet appropriate standards for executive compensation and shareholder disclosure in order to be eligible.” (emphasis supplied).
That obviously won’t work, unless appropriate means “none”…
– Michael Segal, Jeannemarie O’Brien and Ian Levin of Wachtell Lipton Rosen & Katz
By December 31, 2008, nearly every compensation arrangement maintained for any employee subject to U.S. income tax – regardless of his or her title, compensation or position – must be amended to comply with the deferred compensation rules of Section 409A of the Internal Revenue Code. Operational compliance alone will not suffice; each arrangement subject to Section 409A (and in some cases those that are not) must contain certain technical provisions that reflect Section 409A. If the written arrangement does not comply, each affected employee may face immediate income taxes and a 20% penalty tax (even if the payment has not been received or is ever received), and the employer may have reporting and withholding obligations (the long-awaited guidance on reporting, withholding and income inclusion has not yet been issued and will present a separate compliance and administrative challenge).
Although companies have had since the issuance of the final regulations in April 2007 to amend their arrangements to comply with Section 409A, the regulations are massive in breadth and scope and even the most basic principles continue to be debated among practitioners and, we believe, within the government itself. It is apparent that most companies do not have the resources to review every compensation arrangement, identify the issues, find solutions, obtain the approval of senior management or their boards and have the changes reduced to writing and explained or consented to by the affected employees by December 31, 2008. As corporate America faces its most significant financial challenges since the 1930s, its ability to allocate financial and legal resources, and senior management and board attention, to this daunting and possibly futile effort is significantly compromised in ways not contemplated even weeks ago, and clearly must take a backseat to more pressing matters.
Section 409A has achieved one of its primary goals – a six month delay rule prevents executives of public companies from “jumping ship” to get paid their deferred compensation ahead of others (recent events show that deferred compensation’s perceived tax benefits come with a very significant and real credit risk). Whether Section 409A’s other objectives warrant the costs and resource allocation needed to satisfy the overly technical documentary requirements is questionable, since its fundamental requirements have been successfully implemented by companies in operation without regard to the written terms of the arrangement. Ironically, in the current environment, for many U.S. taxpayers, the immediate payment of deferred amounts with a 20% tax penalty may be a more rational choice than continuing the deferral and living with the risk of non-payment and incurring a future penalty tax under Section 409A.
At this point, it is clear that the government’s mandate of complete and error-free documentary compliance by year end (or ever) is unattainable and unnecessary to achieve its original goals. Treasury and the IRS must take action to delay the documentary compliance requirements of Section 409A. In the absence of a delay, the burden on companies would be significantly eased if the application of the 2008 deadline was limited to the executive officers of public companies (i.e., the Section 16 officers). Moreover, the IRS should announce that good faith efforts to comply with the final regulations, both in form and operation, will be acceptable. America’s corporate resources should be focused on business matters in this critical and uniquely difficult time, without the worry that a vast portion of its workforce will be subject to a punitive and draconian tax on New Year’s Day.
Broc’s recent blog and the September-October 2008 issue of The Corporate Executive on stock ownership guidelines and hold until retirement (HTR) policies for equity awards prompted me to proffer the following concept for consideration by public companies and practitioners.
More specifically, the concept is for public companies to consider implementing a policy of requiring its senior executives to exercise vested nonqualified stock options which have an intrinsic spread value (i.e., the difference between employer stock price and option exercise price) that exceeds a specified threshold percentage or value. Such a policy could be adopted whether or not the company has stock ownership or HTR requirements.
So, the basic idea is that vested in-the-money nonqualified stock options would be automatically exercised once their spread value exceeded a predetermined amount established by the employer. The threshold amount that would trigger the automatic exercise could be expressed either in relative or absolute terms. And, the threshold value could of course be specified as a historical average (e.g., ten day trading price average of employer shares) if desired to avoid hair-trigger option exercises resulting from a temporary upward spike in prices. While in today’s generally bearish stock market, a mandatory option exercise policy may not be as apt to currently trigger many option exercises, let’s nevertheless examine the potential benefits of a mandatory option exercise policy (which could be more applicable upon a return to a bullish or even normal stock market in which prices typically rise over time).
Potential Benefits to Employer
1. Greater alignment of executives’ interest with shareholders since executives’ equity holdings would inevitably be weighted more to stock, rather than option, ownership. Option holders, while generally in alignment with the interests of shareholders are nevertheless in a different class of securities than shareholders and an option holder’s capital is not truly at risk until the option is exercised. Until option exercise, an option holder arguably is viewing the option purely as a compensatory instrument whereas post-exercise, he/she really has become an investor with respect to his/her acquired shares in the same way as other shareholders who are not service providers.
2. Executives, by virtue of their option exercises, would arguably be more invested in their employer since their capital (even if the executive’s holdings were only comprised of after-tax shares obtained from option exercises) would now be at risk. Executives would perhaps be less likely to engage in overly risky business strategies to maximize their option spread (as might be the case if options constituted the bulk of their holdings since options can provide a leveraged opportunity to maximize returns without risking capital).
3. In the tax year of the option exercise, the employer would receive an income tax deduction for the amount of option spread value at the time of option exercise. This can provide a nice cash flow benefit for the employer since the tax deduction can create a direct positive cash inflow with no corresponding direct cash outlay.
4. If the option contained a “net exercise” provision and if this feature was utilized, then there could be a reduction in shareholder dilution and, assuming a share recycle provision in the underlying stock plan, more shares would become available for future grants to other employees. Of course, one drawback for the employer if a net exercise is effected is that the employer must make a cash outlay to cover the tax withholding that is due under the option exercise.
5. While I am not an accountant, the FAS 123r expense amount for a stock option with a mandatory exercise feature upon attaining a specified spread value would perhaps be reduced because the assumption for the expected life of the option could have a shorter time span than an option that did not contain such a feature. Ceteris paribus, this would result in lower FAS 123r amounts which translate to lower financial accounting costs for the employer’s option compensation program.
6. As discussed below, the employer can end up better preserving the income tax deductibility of change in control contingent payments that are made to executives that could be otherwise lost as a result of the federal golden parachute excise tax rules.
Potential Benefits to Executive
While normally an option holder wants maximum flexibility as to when he/she can exercise his/her stock option, there are some potential benefits for executives too.
1. The exercise of the in-the-money nonqualified stock option will mean that the executive has a higher amount of compensation reflected in his/her year-end Form W-2. This can be beneficial to both employer and executive in the event that the employer experiences a change in control thereby triggering potential application of golden parachute exercise taxes under Internal Revenue Code Sections 280G/4999.
In particular, the executive’s “base amount” (which is an average of the executive’s prior five year compensation) under section 280G would be higher (due to the option exercise(s)). A higher base amount will reduce or even eliminate the imposition of parachute excise taxes. Moreover, an executive who does not have excise tax gross-up protection will presumably be more apt to be supportive of a potential change in control transaction if he/she believes that there will be minimal or no excise taxes imposed on his/her change in control payments.
And, avoiding or reducing excess parachute payments also helps the employer since excess parachute payments cause the loss of income tax deductibility that result from such parachute payments. Furthermore, higher base amounts means that employers who provide excise tax gross-up protection can presumably report lower estimated parachute values in their annual proxy statement disclosure of potential change in control payments to named executive officers.
2. A pre-arranged mandatory option exercise coupled perhaps with a related sale/share withholding net exercise of the acquired shares could be implemented through a Rule 10b5-1 trading plan or program. This can provide the executive with an affirmative defense to allegations of unlawful insider trading.
While a mandatory nonqualified option exercise program presumably would represent a new arrangement at most, if not all, public companies and would likely be met with resistance by executives who would prefer unfettered control as to when/whether they exercise their stock options, such a policy can potentially generate benefits to both employer and employee. With sufficient education on the merits of a mandatory option exercise policy, employers can potentially benefit from such a policy and executives can recognize that such a policy can be consistent with their employer’s best interests similar to other executive compensation policies.
The latest version of the House “bailout” legislation includes provisions for a “say on pay” vote, limits on severance, clawbacks and shareholder access to the proxy for those companies involved in the bailout. See Section 9 on pages 11-13. The Senate version of a bailout bill contains the executive compensation provisions (see Section 17 on pages 30-31), but not the shareholder access one.
Bear in mind that both of these are just drafts and that they likely are just the Democratic versions of a bill. Media reports indicate that the bailout plans changes from hour to hour. In fact, I can’t even be sure I have linked to the latest drafts…
The World is Changing: Why Can’t CEO Pay?
With the very real possibility of executive compensation constraints being part of the Congressional bailout legislation, it seems like a good time to examine why executive compensation practices haven’t changed – even though 99% of this country believes they should. With Wall Street and our financial markets undergoing a complete transformation and the regulatory framework certain to be reformed in ways we never imagined, why does CEO pay remain “untouchable” for many boards and their advisors?
Here are a few of my thoughts:
1. Lots of Lip Service – Personally, I am tired of having conversations with colleagues who tell me that compensation committee meetings really have changed. I believe that. The problem is it’s just the committee processes that have changed – to pass judicial muster after Disney – but the committee’s actions remain the same. When I have these conversations, it’s telling how perfunctory committee meetings used to be!
2. When There is Responsible Change, It’s Driven by the CEO – Most often when I talk to someone who regularly advises boards, I hear that the few companies that really make responsible changes are the ones where the CEO speaks up and voluntarily asks for the change. Sadly, boards and compensation committees are not the ones driving responsible change.
3. Debunking “Everyone Else is Doing It” – How often has this justification lead us down the garden path? Just because everyone is using peer group benchmarking instead of alternative benchmarking – like internal pay equity – doesn’t make it right. In fact, some plaintiff lawyers may argue that it’s now widely known that 15 years of broken peer group benchmarking has made that methodology unreliable – and that boards that continue to heavily rely on that broken database are not fulfilling their fiduciary duty to be reasonably informed. (And remember that today’s excessive CEO pay packages are a relatively new phenomenon, only about 15 years old as I’ve explained before).
4. You Won’t Lose Your CEO If You Trim $10 Million – Probably the most frequent justification to maintain the status quo is that the CEO will walk if the pay package is cut from $20 million to $10 million. I find this an empty argument in most cases (and for the many really hurting in today’s economy, even the $10 million produces anger). Sure, the grass is always greener – but the reality is the grass is brown all over right now.
I realize that having a pay-cutting conversation is hard – but there are baby steps that can be taken to bring executive compensation back in line. Start with implementing a clawback provision with teeth, eliminate severance arrangements that have no purpose and require executives to hold-til-retirement. Use better tools to ensure a fairer process, like internal pay equity and wealth accumulation analyses.
5. Congressional Solution Not Preferred, But Perhaps Inevitable – I don’t believe Congressional intervention into pay practices is a sound idea, but the failure of boards to fix pay practices on their own has brought us to where we are today. And it shouldn’t be a surprise that Congress is now focusing on this topic – the House has held hearings on CEO pay repeatedly this year and both Presidential candidates have stated their intention to pass “say on pay” legislation next year. I believe we are at a “last chance” stage for boards to truly get their act together or else we will wind up with laws that do it for them.
What Can You Do? You can be informed and learn as much about responsible practices as possible. Our upcoming “5th Annual Executive Compensation Conference” can help you get started by providing a roadmap of practical tools and processes that you – and your board – can use to make things right. If you can’t make it to New Orleans on October 21st-22nd, you can still catch this important conference by video webcast.
If times are tight and your company doesn’t have the budget to cover the full cost of registration, send me an email and we’ll accommodate you. We are far more interested in getting CEO practices back on the right track than making money from the Conference. Note that when you register for the “5th Annual Executive Compensation Conference,” you also get access to the “Tackling Your 2009 Compensation Disclosures: The 3rd Annual Proxy Disclosure Conference” as these two practical Conferences are bundled together. The Conferences are being held on successive dates.
Dave and I are more than excited to be finally done with our comprehensive treatise of executive compensation disclosures: Lynn, Romanek and Borges’ “The Executive Compensation Disclosure Treatise & Reporting Guide”. This thing is massive, over 1000 pages long and it wouldn’t have been possible without the help of our new co-author Mark Borges and our two co-editors, Julie Hoffman and Dan Greenspan.
It’s great to have Mr. Borges as part of our Treatise team since he was able to lend his well-known experience and wisdom to the project. And of course, we thank the many of you that have sent us encouraging words (and ordered a copy).
We hope to have the online version of the Treatise up over the next week or so and it will take about a month to typeset and print the hard copy of the book. Remember that when you order the Treatise, you not only get the hard copy of the book – but you also get access to an online version of the Treatise. We’ll let you know when the Treatise is online – as well as when we mail. Here are FAQs about the Treatise.
Order your Treatise now so we can rush it to you right after it’s printed; remember there is a reduced rate if you are attending any of our Conferences.
Order online – or here is an order form if you want to order by fax/mail. If at any time you are not completely satisfied with the Treatise, simply return it and we will refund the entire cost.
– Ira Kay and Steve Seelig, Watson Wyatt Worldwide
We read David Schmidt’s recent post on disclosure of performance targets with interest, and agree that companies have not done a great job (if they are doing any job at all) of disclosing “degree of difficulty” when actual goals are not disclosed. And Corp Fin Director John White himself was similarly unimpressed when he stated after the end of the 2007 proxy season: “Without more, identifying a target simply as ‘challenging but achievable’ or as ‘designed to promote excellence and motivate management’ seems an empty disclosure that I would not think is useful to investors.”
While the use of such catch-phrases is not what the SEC is looking for, part of the blame for them not seeing a better analysis must rest on the SEC’s lack of guidance in this area. The rules simply don’t provide sufficient guidance for how companies should assess “degree of difficulty” in order to “discuss, in a meaningful way, how difficult it will be for the executive or how likely it will be for the company to achieve that target.”
We’ve made this point to the SEC in a comment letter earlier this year, and are hopeful it takes the time to provide more guidance on this issue. In our letter, we detail a methodology we first developed when advising Compensation Committees who asked us to help assess the “degree of difficulty” of performance goals being presented to them by management for their approval.
It works something like this, assuming for this example a company has established an annual sale growth target of 10 percent in its bonus plan:
1. Review goal against historical company and peer median performance – Whatever the metric chosen (e.g., annual sales growth), determine the extent to which the company has performed versus its peers. To illustrate, assume the company has outperformed the peer group for many years, with a mean over 10-years that was 13 percent versus 10 percent for the peer group.
2. Review goal against historical probabilities based on a peer group performance – Calculate descriptive statistics on the data set (e.g., mean, median, mode, standard deviation) to show historically how likely hitting certain targets would be. For example, 20% of the time companies achieved a 0-5% annual growth in sales, while only 6.7% percent of the time did they achieve 20-25% annual growth, etc.
3. After observing the shape of distribution and various descriptive statistics, examine how a specific goal fits within the distribution – For a targeted sales growth goal of 10 percent, there would be an approximate 50 percent probability of achieving this based on historical peer performance.
4. Review analyst estimates – Markets are inherently forward-looking. However, many companies set goals based on prior performance only. We think historical data is helpful but can be enhanced significantly by incorporating forward-looking estimates into the process. By incorporating consensus analyst estimates, we provide an additional lens to view performance.
5. Consider stock price to understand long-term expectations – This balances with the use of short-term (2-3 year) analyst expectations compiled in Step 4 by taking a longer term view. We use a discounted cash flow model to gauge long-term expectations. For example, to gauge the stock market’s expectation for sales growth, we use market-based assumptions (from Value Line or other sources) for all inputs except sales growth. We then modify the sales growth rate to determine the sales growth that generates the current stock price.
While we do not necessarily advocate disclosing a probability percentage in the CDA, due to the potential that the plaintiff’s bar would seize on these disclosures in future litigation, we would strongly advocate companies disclose the methodology they used in concluding their goals are “challenging” etc. Remember, John White did not say the words themselves are inadequate, he said using words “without more” is problematic. Our approach gives companies the “more.”
One other point in David’s post gave us pause, which was the notion that:
Companies may be choosing not to disclose specific benchmarks because those figures may be significantly different from financial targets that executives at these corporations have promised Wall Street analysts and investors — indicating that the boards in question are setting their bars too low and generating bonuses too easily.
Actually, we think the issue is the other way around. We believe companies tend to provide forward looking guidance to analysts that is conservative or attainable, whereas the goals within the bonus plans more accurately reflect the actual targets Boards expect management to attain. We believe part of the reason companies are reluctant to disclose the higher goals in the bonus plan is precisely because they are harder to attain, and that analysts might increase their forecasts – and downgrade the companies if they were not hit.