– Ira Kay and Steve Seelig, Watson Wyatt Worldwide
We understand that at least some companies are discussing or considering special off-cycle equity grants for top executives in response to the recent decline in share prices. Such grants may pre-emptively address concerns that executives will “self re-price” by forfeiting options at their current employer in exchange for large new hire option grants with a relatively low exercise price at another company. While off-cycle grants were made by some companies during the last broad-based market decline in 2001, we believe that fewer companies will do this in today’s environment.
Our colleague Tom Kelly pointed out the reasons why this market is different:
1. Several companies who did this in 2001 found they made the special grants too early, and continued declines in share prices meant that the additional grants simply compounded the retention problem of underwater options.
2. Off-cycle equity grants are criticized by many investors as a form of “spring loading” or “market timing.”
3. With the new accounting rules, more companies have transitioned to viewing annual equity grants in terms of grant date value and as part of “total compensation.” Making off-cycle equity grants in response to a share price decline weakens the argument that equity grants are a key element of regular direct compensation.
4. The new proxy disclosure rules require companies to discuss in more detail their methodologies and processes for awarding equity-based compensation. This includes timing of awards as well as how the size of grants is determined.
5. Making an additional round of option grants just because the share price is considered to be at a low is not something most companies want to put into their proxy statement.
6. Companies are more judicious about managing their authorized pool for equity awards and Compensation Committees have become more diligent in managing things like overhang and total annual grant size. Accelerating 2009 grants into late 2008, which some companies did in 2001 and others did in 2005 (in advance of the change to FAS 123R), is similar to taking an advance on a line of credit. Using too much in one year can result in constraints on grant capacity in future years.
7. Fears about executives “self-repricing” by leaving their job and underwater options at one company for a large new hire grant at another company do not seem to be holding up in 2008 as compared to 2001. This time, the decline in share prices is more broad-based and the outlook for recovery is more uncertain.
8. Option grants are only one part of most companies’ long-term incentive program. Although other vehicles could be impacted by declining share prices, a primary reason why many companies shifted to restricted stock after 2001 was to provide a retention cushion in the event of share price declines.
While outstanding restricted shares have also declined in value since the time of grant, they still have some higher perceived value as compared to underwater stock options. Companies that have unvested restricted shares are less likely to feel the need to restore retention hooks through special grants of options.
– Pearl Meyer, Senior Managing Director, Steven Hall & Partners
I really love Fred Cook – and not just because he’s an icon – but rather because he’s tall, gray and handsome. And I absolutely agree that Say on Pay will be another costly blight on the community brought on by a few bad corporate actors and overzealous activists. It will serve only to further empower and enrich the proxy services who will now issue annual voting advisories on corporate executive pay, rather than when plans are up for approval every few years.
Fred’s suggestion is a reasoned one, but I would require a higher withhold of at least 20% on compensation committee chairs (who, of course, will be reluctant in the future to serve as targets in the catbird seat). If I had my druthers, I would also limit the vote to committed owners, as outlined in my earlier blog.
My suggestion was made after listening to Reps. Frank, Waxman, other politicos and advocates, such as Rich Ferlauto, note that mandatory Say-on-Pay legislation is inevitable. Like Fred, my purpose is to recommend a sane approach to any proposals put on the table. With best wishes for the Holiday Season and New Year!
We have just posted the first 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.” We are pleased to announce that Mark Borges has agreed to keep us all updated on the newest best practices and guidance through our new Disclosure Updates newsletter.
Subscribers to the Treatise will receive this quarterly Updates newsletter (as part of the Annual Service that accompanies the Treatise at no charge), in which Mark and I will keep you abreast of all the latest guidance that you need to know.
This first issue focuses on key new disclosures all companies will need to address in the wake of EESA and other regulatory responses to the crisis. Subscribers will receive the second issue of Updates in early January, with plenty of last-minute critical pointers for your proxy disclosures.
Act Now: To receive a non-blurred copy today, try a No-Risk Trial to the “Lynn, Romanek & Borges’ ‘Executive Compensation Service'” today. Subscribers can access the full issue here.
Here Come the EESA-related Shareholder Proposals
Ted Allen of RiskMetrics Group recently noted on the RiskMetrics Risk & Governance Blog that shareholder proposals seeking compensation reforms are being submitted to financial institutions participating in the Treasury’s bailout program. The proponents are the Laborer’s International Union and the International Brotherhood of Teamsters. Ted’s blog indicates that the proponents expect that some institutions will seek to exclude the proposal on a “substantially implemented” argument, but the unions will fight any such efforts at the SEC.
Ted notes: “The proposal calls for directors to adopt the following reforms:
– Limit annual incentive compensation to an amount not exceeding one times the senior executive’s annual salary;
– Require that a majority of long-term compensation be awarded in the form of performance-vested equity instruments;
– Freeze new stock option awards to senior executives, unless the options are indexed to peer group performance so that relative, not absolute, future stock price improvements are rewarded;
– Require senior executives to hold for the full term of their employment at least 75 percent of the shares of stock obtained through equity awards;
– Prohibit accelerated vesting for all unvested equity awards held by senior executives;
– Limit all senior executive severance payments to an amount no greater than one times the executive’s annual salary; and
– Freeze the accrual of retirement benefits under any supplemental executive retirement plan (SERP) for senior executives.
The labor unions urge directors to adopt all of these reforms unless barred by existing executive employment agreements. ‘At this critically important time for the Company and our nation’s economy, the benefits afforded the Company from participation in the TARP justify these more demanding executive compensation reforms,’ the funds argue in their supporting statement.”
It’s Not Too Late
There is still time for all companies – and not just financial institutions – to take another look at their compensation programs in light of recent events. With a great deal of attention focused on the CD&A in next year’s proxy statement, now is the time to consider comparing existing compensation policies and practices with the emerging standards coming out of the EESA and the fallout from the financial crisis. While it is likely that many companies will already have appropriate policies and practices in place, it may be necessary now to revisit things like the company’s clawback policy or whether a hold-through-retirement policy should be adopted or amended.
Further, in light of the most recent economic events, including significant layoffs, cost-cutting and an increasing trend toward CEOs foregoing bonuses, it may be necessary to pay close attention to bonus decisions that have already been made – as well as upcoming bonus decisions – for senior executive officers. Justification for why bonuses are warranted (and the level of bonuses) in light of a company’s financial situation will likely be a principal focus of investors in upcoming CD&As.
All of these actions should be considered in the coming weeks, so that any changes can be implemented in time to be disclosed in the upcoming CD&A. You can find out more about these critical considerations in the inaugural issue of “Proxy Disclosure Updates” Newsletter Fall 2008.
Recently, New York Attorney General Andrew Cuomo subpoenaed Bank of America, demanding a list of every executive that received a bonus of more than $250,000 over the past two years. The subpoena is part of the AG’s investigation into bonuses paid out to banking executives during the run-up to the industry’s meltdown.
Last month, Cuomo’s office asked nine banks (including BofA) to voluntarily turn over information on executive pay and bonuses, as well as plans for awarding bonuses in 2008. All nine banks sent at least some information, but apparently Cuomo’s office wasn’t satisfied with BofA’s response, which included little of the data sought. Among other things, the subpoena seeks information about how the company awards bonuses, who makes the decisions, who gets them and the size of the anticipated bonuses for 2008.
Cuomo and AIG
Also notable is that Cuomo wrote AIG’s board last month demanding that the company recover bonuses and the cost of other perks from current and former executives – and AIG freezed some payments. According to this article in the NY Times, New York law allows creditors to challenge company payments for which value was not received in return. Some believe that if the Attorney General is successful in his pursuit of AIG, other creditors may use it to pursue other firms such as Lehman Brothers.
And Cuomo’s strategy seems to have worked. On Monday, AIG issued this press release indicating that AIG’s CEO will receive a $1 salary and no annual bonuses through ’09. In addition, AIG’s next top six executives will not get year-end bonuses. Here is AIG’s letter responding to Cuomo’s letter. Mark blogged about this development last night…
For your assistance as you are preparing to meet the year-end deadline for finalizing the documentation required to avoid excise taxes under IRC Section 409A, my partner Jeff Banish and I have prepared a one-page quick reference guide on 409A. It comes with the caveats that you would expect for a one page summary, but still provides a quick overview of what is – and is not – exempt, as well as the core requirements to qualify for the exemptions.
My strong advice: There were enough changes between everyone’s read of the initial law and what the final regulations provide, that if you have not looked at your compensation arrangements subsequent to the final rules, you need to. This includes not just employment agreements and severance plans, but all bonus plans, equity compensation arrangements, SERPs and any other plan or program that you have that could provide a post-termination benefit to an employee, independent contractor or director. If you have any comments on the guide, contact me at brink.dickerson@troutmansanders.com.
I love Pearl Meyer. I really mean it. She’s a pioneer, an icon, and a free spirit. And she speaks her mind, but not frequently. So when she does, attention must be paid. But I have a different idea for Say-on-Pay than the one she expresses in her recent blog.
I believe that a mandatory vote on Say-on-Pay vote each year for all public companies is overkill. There are approximately 10,000 US public companies. Pay practices that investors and the public regard as abusive are likely limited to a tiny fraction of these. So why impose an annual burden on the whole of private enterprise that is publicly owned?
My idea is to use a rifle rather than a shotgun to target the companies that have abusive practices. Let’s have the stock exchanges require that any company whose compensation committee chair receives 10% or more WITHOLD votes must submit its pay program to a advisory Say-on-Pay vote the following year, and every year thereafter until the negative vote drops under 10%.
That way shareholder activists and watchdog groups can target those companies with poor practices for Say-on-Pay, while leaving the vast majority of American businesses that have perfectly defensible executive pay practices alone.
Raise your hand if you have been throwing away memoranda concerning the October financial bailout legislation, officially named the Emergency Economic Stabilization Act of 2008, because your company is not a financial institution?
Don’t worry, we suspect you are not alone.
As you begin to prepare for December board and compensation committee meetings, you may want to keep in mind three key issues arising from the financial bailout legislation and recent national elections of particular concern to U.S. public companies that are not financial institutions:
1. Executive Compensation and Risk Management — Executive compensation decisions may increasingly be second-guessed for the risks they encouraged executives to take.
2. Clawback Policies — Anticipate increased scrutiny of clawback policies and campaigns for adoption of policies with more stringent recovery features.
3. Say on Pay — Plan for it to soon be a reality for your company.
See our alert for a “board-level” overview of these issues. One additional piece of information that was released after the date of this alert (which supports the first issue identified above) is the fact that executive compensation emerged as a key concern coming out the meeting this past weekend of the G-20 nations in Washington DC. See Dave Lynn’s recent blog on this topic.
– 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.