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.
I recently saw Dave Lynn’s response to a query on this site’s Q&A Forum regarding how frequently must boards look at peer group survey data (particularly smaller companies who can’t afford it). Dave gave a great answer contrasting surveys and internal pay equity checks.
It’s important to note that internal pay equity checks are far less expensive than the flawed and distorted compensation surveys. I prefer internal pay checks that take into account a wide range of employees, from the front line manager to the CEO. I believe this is a great sanity and reasonableness check on CEO compensation fairness and we suggest this to our board and management clients. A check that can be used by anyone.
Here is an example of how this can work – let’s assume an internal pay equity multiplier of 2.52 with these additional facts:
– Average front line worker = $30,000
– Highest paid front line manager = $ 118,000
– Director of business unit – 2.52x multiplier
– VP/SVP of business unit – 6.35x multiplier
– Business Unit President – 16x multiplier
– Group CEO – 40.33x multiplier
– Global CEO – 101x multiplier (which results in annual total pay of $11.3 million)
So in this example, there are six value-adding management layers that results in the CEO’s pay being 376 times that of the front line worker or 101 times that of the front line manager. Many believe that this is excessive pay. That is true for many companies, but not all. It depends on the complexity of the CEO role and the number of value adding management layers in the enterprise.
One of the keys here is that each management layer adds unique value. Based on 30+ years of research, we know that the “Felt Fair Pay” multiplier between each value adding management layer (i.e. Work Level) is in the 2.0- 2.5x range. Some companies are overlayered so you can’t just take the number of layers and multiply each by 2.52x to get to the “Felt Fair Pay” pay differential.
To be able to ascertain what is truly fair, I use this “Felt Fair Pay” model of internal pay equity that looks at whether the task being performed are truly different and more importantly, whether the performance metrics, performance periods and decision rights identify the differential work in a role across the company’s management structure. You want to ensure you build up to the CEO’s pay multiplier from the front-line manager compensation by not just checking the CEO’s pay to the 2nd tier of management pay differential.
This all can be a little confusing when you first hear about these methodologies, so I recommend you look at my presentation from last year’s “4th Annual Executive Compensation Conference” (video archive is still up). You may also want to review this article I wrote on the topic (and this article too). This provides a great sanity and reasonableness check for boards so that they don’t get caught up in the flawed compensation surveys and wind up with pay chasing pay.
Yesterday, the WSJ ran an article entitled “Companies Cut Holes in CEOs’ Golden Parachutes” which included an example of one company that cut back on the traditional severance pay model. The company has employment agreements with top executives that were recently signed prevents the executives from getting severance in cases of “poor performance.” [Note from Broc: This WSJ article was particularly timely given the news that the FHFA intends to block severance payments to Freddie Mac’s and Fannie Mae’s ousted CEOs (but as this Washington Post article notes, they’ll still get plenty in retirement pay.]
According to the article, the top executives were just being hired by the company and they didn’t object to the board’s intent (plus, their predecessors hadn’t had employment agreements at all) – the board hired a compensation consultant and then the company’s directors and executives had a “lively discussion” on how to define poor performance. The end result was that the directors and executives agreed on performance goals, including financial targets like earnings per share and revenue growth as well as individual job objectives. Hopefully, this type of discussion has been – and will continue to be – had in many boardrooms.
In the September-October issue of The Corporate Executive – which was just mailed – the primary focus of the issue was on the need for companies to implement hold-til-retirement provisions for equity awards and how to pick what’s right for your company. With much help from Marc Trevino and Joseph Hearn of Sullivan & Cromwell, this issue contains a roadmap of the considerations you need to analyze when adopting these provisions.
In connection with this issue, we have updated our list of companies that we have identified as having hold ‘til retirement requirements and the total is now over 40 companies (thanks to Equilar for helping spot some new companies). In comparison, at least two-thirds of S&P companies have some form of traditional stock ownership guideline, whereby executives are required to acquire and retain a certain value of company stock (usually a multiple of salary).
The September-October issue of The Corporate Executive specifically includes articles on:
– “Hold ‘Til Retirement” Requirements for Equity Awards: How to Pick and Implement What’s Right for Your Company
– Forms of HTR Requirements
– Reasons to Adopt
– Addressing Potential Criticisms
– Ten Steps to Designing the Program That Is Right for You
– An Additional Comment on ExxonMobil’s Approach
– Proposed Regulations for Section 6039 Returns
– Proposed Regulations for ESPPs
– A Roadmap to Comply with the SEC’s New Regulation FD Guidance
As could be expected, the phone started ringing off the hook when it was announced that the government would be taking over Fannie Mae and Freddie Mac. These journalists posed the big question: what would the departing CEOs be taking home with them?
And they are not the only one posing the question – as this WSJ article notes, the Presidential candidates and some US Senators have weighed in by writing letters urging the Federal Housing Finance Agency to stop payment (the GSEs have their own regulator, the FHFA). Under a new law enacted in July, the FHFA has the authority to approve pay packages and prohibit or limit severance pay.
It’s too early to tell what will happen – although some outsiders have made calculations regarding what they are entitled to. According to the WSJ article, in an interview with the PBS “Nightly Business Report” on Monday, the FHFA Director James Lockhart said, “We’re not going to try to get part of the money back.” According to media reports, it seems like one CEO seems willing to rein in his own package (and has hired his own lawyer with his own money) whereas the other doesn’t appear as willing (and has hired his own lawyer with his former employer’s money).
It is noteworthy that the new Freddie and Fannie CEOs “will have salary and benefits significantly lower than the old CEOs,” which is great news since it’s the type of leadership that Corporate America has been sorely lacking. Someone stepping up and not demanding the excessive pay of peers.
And what am I telling the journalists who call me? I explain how to implement a clawback provision with “teeth” – as laid out in our Winter 2008 issue of Compensation Standards. The WSJ article cites statistics of the growing numbers of companies with clawback provisions – but I wonder how many of those really have teeth to avoid the sort of media crisis that happens when a company falls in the toilet and the CEO heads off to the links.
By the way, check out the investor relations’ home pages for Fannie Mae and Freddie Mac. Not a word – or link to something that mentions – the government takeover. And the IR profession wonders why it’s importance is diminishing…
Short-term incentive plans enhance executive performance, but very little is revealed to investors about them, according to new research by our New York-based firm. And while companies are disclosing more about their plans, they have a long way to go before reaching full compliance with the SEC’s new rules.
The SEC asserts that if executive compensation performance targets are central to a company’s decision-making process, they must be disclosed to investors. The new proxy disclosure rules require that all performance measures and goals must be released and compared with actual results. This disclosure requirement includes both short- and long-term incentive performance measures.
There is evidence that some companies are resisting the SEC. Though the SEC’s requests seem straightforward, implementation is proving to be difficult. Indeed, many companies are simply not bothering to comply. At least that’s the conclusion of a study by our firm that analyzed a representative sample of the medium-size companies in the Standard & Poor’s MidCap 400 group.
According to the most recent proxy filings, which covered 2007 results, only 47% of the companies made the required disclosures concerning short-term incentive pay. While this figure is substantially higher than the 23% that complied with the rule in 2006, it is nonetheless distressing.
On long-term incentive pay, for those companies with long-term incentive plans, compliance was a more robust 62% last year. In 2006, only 41% of companies complied. Long-term incentive compliance is generally higher than for short-term incentives as companies find it less threatening to report the relative goals typical of many long-term incentive plans.
When it devised its disclosure rule, the SEC gave companies a sizable loophole, excusing them from detailed disclosure of targets if they believed that publishing such figures would put them at a disadvantage in their industry. Many companies are using potential competitive harm from disclosure as a reason for not disclosing.
This argument of competitive harm would seem to be a pretty weak one. Is it the case that companies don’t want the bright light to be shone on their situation because it gives them the flexibility to give a bonus when it isn’t earned?
Others are disclosing the performance measures and the weights on each measure (but not the levels). Make no mistake: the SEC requires the full disclosure of goals, and performance measures, including weights and levels in comparison with actual performance and its effect on the executive’s compensation.
Even when companies have included discussion of performance goals in their proxy statements, the SEC has not been entirely satisfied with the results. That’s because after examining hundreds of proxy statements during last year’s proxy season, the SEC determined that the specifics of executive compensation decisions and policies need to be explained in clearer language for investors.
Most companies are disclosing the performance measures (but not the levels). Earnings are the number one performance measure across all industries, and companies appear to be setting more difficult goals as goal achievement declined in 2007. Thus, the new rules have more closely aligned pay and performance and have informed shareholders of important performance goals.
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.
The study also examines how often the CEO meets or exceeds goals. In proxies from both 2006 and 2007, some 60% of companies met or beat their targets, generating short-term payouts. This might be an indication that goals are often being set too low. A review of 2009 proxies will be very interesting on this point.
We are in the final stages of analyzing large cap companies with small companies to follow later.
With all the talk about the imminent, though protracted, adoption by the US of International Financial Reporting Standards (IFRS) I would think that everyone had at least heard the acronym by now. Maybe my client sample is an aberration but I’m surprised at the “huh?” response by many Directors and C-Level executives. Let’s all say it together: “iff – riss.”
There is of course plenty of time until we have to worry about IFRS conversion and any impact on executive compensation, with an SEC “roadmap” that may stretch from 2011 to 2014 or beyond. Or is there? The answer is “no, there’s not.” In this memo I recently wrote, you can learn some of the technical details about this issue.
Why does this matter? Because the rapidly increasing prevalence of equity awards with performance features means that the deemed performance against goals set years in advance has a direct impact on executive compensation levels. To the extent there is an accounting rule change mid-cycle and the plan documentation has not provided for appropriate adjustments, payment windfalls or shortfalls may occur and there may be accounting and tax (Section 162(m)) ramifications of any effort to “fix” the problem.
This may occur not only if a company converts to IFRS reporting standards but if the company has a peer-referenced performance goal and itself remains on U.S. GAAP throughout the performance period, but one or more of its peer group companies converts to IFRS during the period.
Although the required adoption of IFRS standards by U.S. companies would appear to be several years away, the increasing acceptance of such standards means that those involved in developing a company’s compensation plans — from the Compensation Director to the VP of HR to the CFO and the Board of Directors’ Compensation Committee — must become knowledgeable about how changes to financial reporting will affect these plans. Given that IFRS standards are currently mandated or permitted in all but a few countries, all companies need to assess the potential impact on their executive compensation plans.