A recent consulting assignment highlighted the need to push back when faulty thinking threatens not only outcome but the process of executive pay determination. A CEO pushing for a renewal of his expiring 3-year contract felt ‘under-optioned” due to an odd history of Board decisions. He was requesting a 3-year front-loaded option grant and a fixed 3-year deal with all options vesting during that period. He hit a stalemate with the CC who felt something wasn’t right about his request and needed an independent viewpoint.
The outcome was one that satisfied all parties: an option grant 3x the normal number of shares in annual grant but with a 25% premium price and vesting consistent with a series of three annual grants (11-22-33-22-11%) rather than the company’s standard 3 x 33% vesting. He gets the advantage of the front-loaded grant only if the company outperforms.
The process of getting to this point was difficult. We emphasized a scenario-based tally sheet and analysis to refocus the CC and the CEO from the new option grant potential gains to the total gains from previous options plus the new one. This changed both parties’ thinking from the vesting-date based analysis to the post-vesting “tail” value of the options.
We all face the inertia of the old-school notion that “pay is annual” (reinforced by the SEC and financial reporting cycles) and that “value ends at vesting or expected life” (reinforced by FAS123R). I frequently emphasize the idea of “checkerboard pay” – every year looks different – and the cumulative uneven value of those patterns must be understood. Even more important now that the mix of SO, RS, Cash LTI, etc changes year to year and the pressure to retain options and/or shares has become an element of the pay package. The only way to understand the cumulative effects of decisions is looking back multi-year and looking forward multi-year.
With this client, I had to politely ignore both the Committee’s and CEO’s instructions to omit the previous option grants on the tally sheet because they were “irrelevant” – I guess that’s a little compensation consultant civil disobedience. When they saw the numbers with stock price projections, however, it changed everyone’s attitude and they requested that we show additional future years in the projection. Suddenly we weren’t talking about $2mm vs. $4mm but about $16mm vs. $18mm, and then $26mm vs. $30mm.
We had to emphasize a number of concepts to the Compensation Committee including:
– Truncation of option value is voluntary, not built into the option other than the term itself which is rarely a constraint. Vesting doesn’t end value accumulation, exercise only ends the tax-withheld part of value accumulation, and employment termination only affects the unvested AND unprotected (unaccelerated) part of value accumulation.
– Stock price projections are estimates, but better estimates than Black-Scholes values, and emphasize the “shareholder value commission” aspect of equity-based pay. If the projections are wrong the pay is self-correcting. The dollar value projections have to be accompanied by percent-of-outstanding analyses.
– We never, ever, ever, use accounting numbers in pay analysis. Options aren’t worth less because you paid an actuary to reduce your BS assumptions (pardon my acronym). RSUs are not worth face value at grant, they’re worth more. Conversely, performance shares are not worth the maximum payout just because you’re accruing that so you can reverse some of the expense later when EPS needs a boost. The complexity of LTI numbers require some thoughtful analysis, not FAS123R adherence.
– Despite the best efforts of “free agent” negotiators’ mentality, executive work is not professional sports and no one ever had to retire early from a knee injury sustained on a conference call with analysts. Let the sports analogy go. Shareholders should expect, and reward, continued performance-positive employment. And someone quitting at age 50 is not “retiring” they are quitting.
And yes, I’m still their consultant. Neither the CEO nor the CC fired me because I said “no”. But if they do, that’s fine too.
I recently wrote an article – “Long-Term Compensation Planning for High-Potential Employees” – whose theme is that a longer term view of rewards, focused on wealth accumulation, will be the competitive advantage companies need in competing for key or high potential talent for the future. In other words, simply providing competitive pay will not provide a sufficient advantage, and companies cannot continue to bid up wages for skills in short supply. I also observe and read that the talent management strategy of most big companies is shifting back to an internal strategy (make vs. buy). With this shift comes the opportunity to again look at levels of pay, and especially wealth accumulation, longer term. Let me know what you think.
With Aflac’s annual meeting results now in, “say on pay” is in the news. Here are five items to consider:
1. Aflac’s Pay Package Gets 93% Support – As noted in this NY Times article, Aflac’s meeting on Monday was uneventful with the company’s executive pay package getting overwhelming support.
2. RiskMetrics’ Aflac Report – ISS kindly has given us permission to post its analysis of Aflac’s “say on proposal.” It is interesting comparing that to the PIRC report that I posted last week.
3. Shareholders Not Supporting “Say on Pay” As Much This Year – As noted in this Washington Post article, the level of support for “say on pay” proposals is down this year compared to last year (bearing in mind that last year’s levels were remarkable for a “first year” type of proposal). So far, only proposals at Apple and Lexmark have garnered majority support.
Compare the Washington Post’s conclusions with those of ISS from this article. Here is an excerpt: “This year, pay vote proposals have averaged 42.1 percent support at 21 companies so far. That is in line with results for calendar 2007, when 52 such proposals received 42.5 percent average support. Surprisingly, however, the measure received less support at a number of financial companies this season, including Citigroup, Morgan Stanley, Wachovia and Merrill Lynch, where many observers expected the measure would fare better than last year given investor anger over subprime-related losses.”
As noted in the ISS piece, I’m also hearing that levels of support for proposals generally are down. I’m not sure of the reason, although some claim it’s partly due to the lower level of retail holders voting under e-proxy (I’m not sure I buy that given that relatively few companies are doing e-proxy).
4. Two More Companies Agree to “Say on Pay” – Littlefield and MBIA have joined the group of companies that have agreed to allow their shareholders to vote on executive pay, bringing the total number to seven. MBIA’s vote will occur in 2009 and Littlefield’s vote is in a few weeks, where its shareholders will vote on two management resolutions that ask shareholders whether the total compensation received by the CEO, president, and directors in 2007 “is within 20 percent of an acceptable amount,” according to its proxy statement. Hat tip to this ISS article for uncovering these two!
5. RiskMetrics’ Own “Say on Pay” Proposals – A few weeks ago, RiskMetrics Group filed its first proxy statement and it includes three separate resolutions for shareholder approval, which may become the model for future “say on pay” proposals. These three proposals are: (1) the company’s overall executive compensation philosophy; (2) whether the board executed these principles appropriately in making its 2007 compensation decisions; and (3) the board’s application of its compensation philosophy and policies to the company’s 2008 performance objectives.
Canada Revises Its Executive Compensation Proposals
Recently, the Canadian Securities Adminstrators re-published their executive compensation disclosure proposals. The original proposals were made a year ago – and interestingly, many Canadian companies have already voluntarily changed their disclosures to match the proposals. Here is a memo explaining how the proposals have changed.
While the compensation consultant is not bound by an official code of professional conduct like an accountant or lawyer, a high standard of professionalism demands that consultants serve as more than a source of black-and-white answers or even a voice independent of management.
Unlike the oversight provided by the audit committee, most decisions made by the compensation committee are not right nor wrong – but primarily matters of judgment and degree. When appropriate, the consultant must also function as a brake on the decision-making process.
Committees are well served by a consultant who will take the initiative to say to members, “There are some important issues here that you’re overlooking and should be considered before you make a decision.” It is the consultant’s duty to try to persuade members to factor in new information when needed, even if doing so may end up increasing costs or result in a delay, but to do so without being rigid or demanding.
For example, if management and the committee are overly focused on how increased earnings should be reflected in pay levels, the consultant may need to point out that the organization’s return on capital employed ranks at the bottom of its industry. So yes, the compensation consultant can serve as a “reality check” for its client.
According to a new study by our firm of Fortune Magazine’s Top 300 publicly-traded companies, a majority of 2007 proxy disclosures on annual and long-term incentive plans were inconsistent and incomplete when disclosing incentive performance metrics.
Surprisingly, many top U.S. publicly traded companies failed to disclose or explain their incentive performance metrics. Our study of 2007 proxies of nearly 300 companies revealed only 16% (46) of the companies provided complete metric and payout information for short-term incentive plans (STIP), while 19% did not provide any STIP metric values. 65% (190) of the companies had long-term incentive plans (LTIP), and of those, only 46% (88) included a reasonably complete set of metric values and corresponding payout percentages.
– TSR and EPS were the two most commonly used long-term incentive measures
– Income/profit measures and EPS were the most commonly used short-term incentive measures
– Most companies with long-term incentive plans had either one (60%) or two (32%) performance measures
– Short-term incentive plans usually included multiple performance measures
Relative performance measures to their peer groups were rarely found in short-term incentive plans (8%)
– 43% of companies with a long-term incentive plan used a relative measure
– 50% of long-term incentive plans with a relative performance measure used a total shareholder return measure with the target set at the 50th percentile of a peer group
– In all, two-thirds of companies with relative performance measures used total shareholder return
– For companies using the 50th percentile as target for a relative performance measure, over half (57%) set threshold performance at the 25th percentile
– For short- and long-term incentive plans, threshold payouts were frequently set at 0%, 25% or 50% percentile of target
– Maximum payouts were usually capped at 150% or 200% of target bonus
When reading through the Don Delves post from a few days ago, I thought about an interesting academic research paper I read recently. The paper – “The Role and Effect of Compensation Consultants on CEO Pay” -is by Brian Cadman, Mary Ellen Carter and Stephen Hillegeist. The paper uses a sample of 880 firms, and attempts to quantify the degree to which consultant conflicts of interest have an effect on CEO pay levels. Specifically, they talk about “rent extraction”, the idea that consultants with broader relationships tend to recommend higher CEO pay levels.
In reading the paper, I thought there were two interesting findings. First, the presence of a compensation consultant (ANY consultant; conflicted or not) was correlated with higher compensation for the firm’s CEO. While this may say more about the firms that don’t hire a consultant than it says about those that do, it is still somewhat troubling.
However, the authors were not able to find “widespread evidence of more lucrative CEO pay packages for clients of conflicted consultants despite anecdotal evidence to the contrary.” This is inconsistent with the findings of the Waxman committee, though the authors of this study did not have the same information available to them (the last time I checked, academics do not yet have subpoena powers). As a result, the authors had to use proxies to determine whether conflicts of interest are likely to exist.
My view is that independence is a lot more about the individual consultants providing services than it is about the firms they work for. If the sophisticated analysis from this paper was combined with the data available to Congress, perhaps the issue of consultant conflicts could be put to bed and we could all move on to talking about something else.
Last Thursday, Connecticut Treasurer Denise Nappier issued a press release stating that four companies have recently agreed to their requests for information – which were posed in the guise of shareholder proposals – on one of two issues:
– Consultant independence – specifically, how much the executive pay consultant is paid for non executive pay work, and
– The reason for the perceived pay inequity between the CEO and the other named executives.
Let’s address these issues one at a time:
1. Consultant Independence: It is certainly true that consulting firms that perform large amounts of non-executive pay work for management will have a difficult time giving independent advice on executive pay to the board – especially if that advice might not please management. However, that does not mean that non-independent consultants give bad advice. Nor does it mean that independent consultants give better advice. Some of the best consultants work for non-independent firms and there are a few independents who are not the sharpest tools in the shed.
Nappier states that, now that all of a consultant’s fees are disclosed, “Shareholders will finally have the information they need to make an informed decision on whether the company’s compensation policies and practices adhere to high standards of professional ethics and best practices.” This is a non-sequitur. Independence or non-independence (and disclosure thereof) does not equate to “high standards of professional ethics and best practices”. If Arthur Andersen had disclosed all of its fees received from Enron, would that have made their advice any more ethical?
The point here is that consultant independence, while an important issue, is a bit of a red herring. The main problem our industry (compensation consulting) suffers from is not a lack of independence, but a lack of standards. Despite Jesse’s work on Compensationstandards.com, there is no agreed on set of principles and standards defining what constitutes “high standards of professional ethics and best practices” in executive compensation design and practice, or in corporate governance over executive pay.
The accounting industry lacked standards in the 1950s and 1960s and the FASB was formed. Perhaps we need a similar industry principles setting body for executive pay. If we don’t do it, the government will, and they won’t do it well.
2. Pay Inequity: In her release, Nappier offers a very coherent argument for why we should care about pay equity or inequity. She states that when the CEO is paid three times or more the pay of the next highest paid executive, that may be a sign of inadequate succession planning. Based on my experience, that is probably true. If there is even one likely internal candidate, the company will often have to pay him or her 50% to 60% of the CEO’s pay. I think Nappier may be on to something here.
We recently updated our piece on this site – “Possible Roles of Independent Consultant to the Board Compensation Committee” – to flesh out a few more responsibilities that our firm typically fulfills for our clients, as well as list seven responsibilities that our firm expects from our client’s compensation committee, board and management. We have posted this revised document in the form of a sample agreement with a client. Let us know what you think.
With a down market, the number of companies asking what to do with their underwater options naturally increases. Looking into the crystal ball, I think it is fair to say that re-pricings will be very rare; none of my clients would even consider it (they would do cash SARs if they did not have shares).
I have had a few conversations about surrendering underwater option shares for no or nominal consideration. Participants would not be promised any replacement grant, but the shares added back to the kitty would be eligible for recycling (it appears that their plan allows an “add-back” for the surrendered options).
Some companies have accelerated their normal grant dates to try and put some incentives in place to support the needed turnaround (and take advantage of the current, low price). Some companies have granted restricted stock with continued service vesting provisions to promote retention and conserve shares. Some companies have awarded deferred cash to promote retention (in some cases, the stock is so volatile that employees prefer cash).
Also important, Risk Metrics/ISS’ allowable limits have dropped significantly the last few years, so getting a new plan or the refueling an existing plan approved by shareholders is viewed as a real challenge for underperforming companies. The bottom line is that I expect to see the use of more cash, despite the potential for liability accounting (in some cases, liability accounting is not all bad, as the charge to earnings is ultimately conditioned on what the employee realizes in value. So, a cash SAR that produces no value and ultimately results in no accounting cost; unlike a stock option, where you take the charge regardless of the value – or lack thereof – realized by the employee).
Section 162(m) of the Internal Revenue Code, the so-called “million dollar cap,” has been a failed tax law. It has been a cause of escalation in executive pay over time, rather than the deterrent it was intended to be.
When it was passed into law in 1993, it no doubt helped put performance on the table and stimulated an interest in the role of performance in executive pay. However, over time I have seen little practical impact on incentive plan design or incentive payout levels, and no end to the creative methods used to skirt (sorry, comply) with its requirements.
For most companies, Section 162(m) has resulted in creation of an additional faux incentive plan, with objective performance standards set at levels not easily missed, and handsomely rewarded when attained. The faux plan is the “umbrella” under which the actual bonus can still operate, usually unchanged. Discretion is maintained in determining payments in the actual plan, along with the tax deduction for the discretionary payment itself, so long as the actual payment does not exceed the outsized reward determined in the objective faux formula.
162(m) intended to penalize companies that exercised discretion in determining executive bonuses by ultimately making the bonus payment non-deductible. I believe that some discretion in determining executive annual incentives is necessary and a responsibility of management and Compensation Committees to exercise. And I think they should be accountable for this exercise of discretion, but accountable to shareholders, not the IRS.
The advent of the new proxy disclosure rules and the SEC staff’s push to have companies disclose how they exercise discretion and what factors they considered in determining executive bonuses now provides a process of public disclosure and accountability for the exercise of discretion in executive incentives. Today, 162(m) looms more as a potential “gotcha” if companies are forthright in their CD&A in disclosure of their exercise of discretion.
Encourage legislators who have spoken out against Section 162(m), to take the difficult political steps needed to remove this particular cap and help shareholders get the type of disclosure they deserve. You can contact: