We recently completed a study on security spending at some of the largest U.S. companies over the past two years (see this recent WSJ article). Security spending is generally a small-ticket perquisite. However, in some rare cases the disclosed values can be quite high, even running into the million-dollar range. What is most interesting is the wide diversity of spending within the same industry, spending that does not necessarily relate to company size.
Most companies spend nothing, or report very little, on security expense for the CEO. We reviewed proxies for the largest 300 companies, which as of the end of April 2008 totaled 247 filers. Of these companies, 156 (62%) indicated they had no CEO-related security spending. Of the 91 reporting security costs, 60 companies reported spending $10,000 or less. Only 31 companies disclose security spending in excess of $10,000, the threshold for disclosing spending, of which 21 companies spent more than $50,000.
Four companies reported expenditures in excess of $1 million—Oracle, Limited Brands, Amazon, and Dell:
– Oracle disclosed $1.7 security spending on CEO Lawrence Ellison in each of the last two years. The disclosure states that these were security-related expenses for Mr. Ellison’s residences. This is all part of a residential security program for Mr. Ellison which was adopted by the Board of Directors.
– Leslie Wexner at Limited Brands has received $1.25 million in security services in each of the past two years, with no explanation other than “Security Services Paid by the Company”.
– Jeffery Bezos at Amazon has personal security arrangements in addition to security arrangements at business facilities and for business travel with a value of $1.2 million.
– Michel Dell’s disclosure indicates $1.05 million in ”company-paid expenses relating to personal and residential security” as part of a Board-authorized security program.
We believe these vast differences in security amounts typically reflect either a) risk assessments by outside security advisers, b) a CEO’s tenure and c) whether or not a company is involved in a high-risk industry or region. The tax rules may also provide insight as to the disparity in security expenditures. Specifically, Treasury Regulations Section 1.132-5(m) provides that an executive would not include as part of his/her taxable income, expenditures related to security if these expenditures demonstrate a “bona fide business-oriented security concern”, and are part of an “overall security program”, and/or recommendations implemented as from an “Independent Security Study.”
The regulations are explicit that a generalized concern for an employee’s safety is not a bona fide business oriented concern. Examples provided in the regulations that are bona fide security concerns are death or kidnapping threats, as well as recent history of violent terrorist activities. If we assume that the security perquisites listed in our study were not included as part of the executives’ taxable income, it is likely these expenditures were in response to security risks in connection with the executives employment.
Please note that the proxy disclosure does not require or provide whether the perquisite is taxable to the employee. Lastly, if we assume that these expenditures are not includible in the executives’ income, the driving force behind the appropriate level of expenditure is likely to lie with those experts who were engaged by the companies to make such determinations.
The media has had a field day ever since Delaware Chancery Court’s Chancellor Chandler unsealed this amended complaint filed against Yahoo, particularly because Carl Icahn is involved as he pressures Yahoo to sell; see this DealBook post which includes a recent Icahn demand letter (its not even the latest; there is a new one nearly every day – scroll down here for links to all of them). The lawsuit charges that Yahoo’s directors breached their fiduciary duties by their actions, including failing to negotiate a deal with Microsoft and enacting a broad employee severance plan.
Yesterday’s NY Times ran this article about a brief filed Monday by the plaintiffs to unwind the severance plan. Professor Steven Davidoff describes the tin parachute in quite some detail – and analyzes the arrangement, plus links to two other blogs that do the same – in his “DealBook” blog. Here is an excerpt from his blog:
The plan provides that if an employee with Yahoo is terminated by Yahoo without “cause” or by the employee for “good reason” within two years after Microsoft acquires a controlling interest in Yahoo, the employee will receive (among other things):
(1) his or her annual base salary over a designated number of months ranging from four months to 24 months, depending on the employee’s job level; and
(2) accelerated vesting of all stock options, restricted stock units and any other equity-based awards previously granted.
Under the plan, good reason means any “substantial adverse alteration” in an employee’s duties or responsibilities during the two years following the change of control.
As a measure of the market, the argument that this plan is “egregious” seems primarily related to the cash severance component, not the equity acceleration. The latter feature is quite common even on a single-trigger basis (in which the equity is accelerated immediately upon a change of control or on a modified basis, permitting the executive to leave the company after one year and benefit from this provision).
But single-trigger provisions are becoming much less common. And under the Yahoo plan, both these payments have a double trigger: There must be an acquisition by Microsoft and then a subsequent termination of the employee. This is what you would expect for a tin parachute — slang for a change-in-control plan that covers all employees.
Still, it is less common to permit rank-and-file employees to benefit under the plan if they decide to leave the company for “good reason.” Typically, they only get a benefit if they are terminated without “cause.” But here, the definition of “good reason” is narrower than you would typically see for a corporate executive, though it still gives some rights to the employees to walk away. This is the part of the plan that is most aggressive. And the complaint is right that the definition of good reason could provide substantial leeway for Yahoo’s employees to walk.
Despite the contention of pay critics that Delaware’s “business judgment rule” all but requires compensation committees to hire an “independent” compensation consultant, at least one esteemed jurist thinks otherwise. As part of a recent ruling in the ongoing Northwest Airlines bankruptcy case, U.S. Bankruptcy Court Judge Alan L. Gropper provided his views on whether use of a compensation consultant providing other services to management would be grounds for rejecting the company’s compensation plan for key executives. His views should be considered by compensation committees in conjunction with the study Broc cited in his post last week, which concludes that full-service firm consultants do not have clients who provide higher pay.
As background, section 1129(a)(3) of the Bankruptcy Code, sets forth the requirement that a plan be “proposed in good faith and not by any means forbidden by law.” This standard is similar to that under Delaware law that “in making a business decision the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company.” In re Walt Disney Derivative Litigation, Case No. 411, 2005 (Del. June 8, 2006) at 39. Under Delaware law, directors are protected by the “business judgment rule” absent a showing they had either breached their duty of care or had not acted in good faith.” In re Walt Disney Derivative Litigation at 39.
In considering whether the Northwest Board acted in good faith in their creation of a management equity plan (MEP) to retain key executives through the Bankruptcy proceedings, Judge Gropper observed:
“The objectors contend the consultants were not entirely independent because the firm, [name omitted] has worked for the debtors on unrelated pension matters. There is no evidence or indication that [name omitted] advice was colored in any way by its other work, and no citation has been provided to any rule of law or ethics that was violated.” (In re Northwest Airlines Corp., Case No. 05-17930 (ALG) (Bankr. S.D.N.Y. May 18, 2007).
This case demonstrates two important points that make it premature to conclude Delaware law requires boards to hire a consultant that performs no other services for a company.
First, the only standard to be met in making a decision to hire a consultant – as the Delaware court also opined in Disney – is for that person to have the requisite expertise in their field. Judge Gropper stated, “As a matter of process, there is no evidence that [name omitted] could not be relied on as experts in their field, or that they did not do an adequate job.” at p. 522.
Second, not only did the use of this consultant not cause the adoption of the MEP plan to fail to meet the good-faith requirement of section 1129(a)(3) of the Bankruptcy Code, the court also found “[T]he board’s procedures and decision easily satisfy the business judgment rule, assuming that it was required by applicable law.” at p. 529.
As consultants who work for a full-service firm, it is our humble reading of this case, and our view of Delaware law, that the key question boards and compensation committees ought to focus on in hiring a consultant is: “What is their expertise in advising companies of similar size, in a similar industry and in similar circumstances?”
We also would advise committees to document their reasoning in hiring their consultant, and cite directly to these factors in that document. We also recommend to committees to annually review the work of their consultant, and to document how the consultant rated in their review. We believe that it is far more likely the issue of expertise would be raised in future litigation than would the question of perceived conflicts of interest.
Many thanks to Peter Friedman of Cadwalader, Wickersham & Taft, who co-authored a fine article on “Management Equity Plans in Bankruptcies,” for alerting us to this case.
As the Corp Fin Staff has nearly finished uploading the 350 comment letters from its executive compensation review project last Fall, we have put the finishing touches on providing links to all the comment letters and responses in the CompensationStandards.com “SEC Comments” Practice Area. Thanks to Dave for the heavy lifting on this one. Note that it might be missing one or two…
Okay, you now know why Dave and I haven’t been making silly videos lately – we have been busy jamming on a comprehensive treatise of executive compensation disclosures – Lynn & Romanek’s “The Executive Compensation Disclosure Treatise & Reporting Guide” – so that we can get it into your hands by Labor Day. This thing will be massive: over 1000 pages and is full of explanations, annotated sample disclosures, analysis of possible situations that you may find yourself in, etc.
After you order the Treatise, you will also receive quarterly Update newsletters – so that we can give you the latest practice tips at the crucial moments you need them. And once the Treatise is done, those that order the hard copy also get access to an online version of the Treatise (and newsletters). We haven’t yet figured out the URL for the online version – suggestions are welcome. Here are FAQs about the Treatise.
Order your Treatise now so we can rush it to you right after Labor Day; 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.
RiskMetrics’ “Explorations in Executive Compensation”
Recently, RiskMetrics has put out a draft – and lengthy – set of white papers entitled “Explorations in Executive Compensation.” The project is intended to spark constructive dialogue about executive pay issues and I really encourage you to read their papers and provide comments.
The first white paper – “Considerations” – defines and puts into context the basic elements of U.S. executives’ pay packages, with special attention paid to emerging key considerations for investors in evaluating pay and equity plans in particular. The second one – “Innovations” – offers a pair of new methods of looking at critical issues in executive pay: peer group benchmarking and and the degree of alignment between the risks borne by investors and by shareholders.
SEC Petition: Disclosure about Consultant Conflicts
As I prepare to speak at a director’s college next week on executive pay, I read this recent petition from a group of 21 large institutional investors to the SEC that seeks to require companies to disclose all fees associated with consultant engagements for a single company and any ownership interest a consultant working for the compensation committee may have in the parent consulting firm. This disclosure would be made in proxy statements.
I’m still not convinced that consultant conflicts routinely impact CEO pay levels – and I definitely believe there are many other areas in the CEO pay process that are in greater need of fixing, with a much higher priority. Here is some food for thought – a recent study that concludes that potential conflicts of interest between companies and consultants are not a primary driver of excessive CEO pay (note there are studies that have opposite findings).
Last week, Dave Schmidt blogged about the challenges of disclosing metrics. Based on my experience, trying to establish a three year financial target to be used in a long-term incentive plan (LTIP) can be very challenging. Some companies will use – or consider – using relative financial performance, figuring “if we perform at least as well or better than our peers, we deserve to be paid our LTIP award.” While the use of relative financial performance is very appealing – as it avoids the need to (a) establish three year financial targets and (b) disclose targeted financial results in the CD&A – there are many practical challenges, including:
1. What measure(s) should be used?
2. Who is the relevant peer group?
3. Do we rely on reported results or make adjustments for unusual items?
Relative financial measures – such as EPS and revenue growth, 3-year average ROIC and ROE, etc. – may all provide a useful gauge about how well the company is doing relative to peers. However, depending on a company’s particular strategy, relative results may fall below the peer group median.
For example, a company may be willing to give up a little ROIC to attain higher revenue growth. Similarly, a bottom quartile ROIC performer may need to focus on profit improvement to exit the profitability cellar. As a result, revenue growth may be negative. Thus, the selection of the right relative financial measure must support the company’s business objectives.
Also, relative performance – particularly EPS growth – can be significantly impacted by your starting point. For example, if a company barely broke-even last year, any improvement will yield a large percentage increase in EPS, vaulting the company to the upper quartile of its peers. Not many compensation committees are willing to pay maximum incentives for an increase in EPS of $.03 to $.06, even though it represents 100% growth and 90th percentile relative performance. More thoughts to come…
As investors seek to rein in “pay for non-performance”, change in severance benefits payable after involuntary termination has become more commonplace. A review of the Fortune 250 found that one in ten changed their severance benefits in the past 12 months.
One creative tool for change in severance is a “sunset provision”. As the name implies, sunset provisions are designed to reduce benefits from a potentially high level and have them settle at a lower level at a set time in the future.
I have found sunset provisions in executive severance programs useful, not as a severance policy in and of themselves, but rather as an effective way to deal with special cases, while preserving the integrity of the existing, or planned, severance guidelines.
There is potentially a sound logic to this approach which recognizes that an individual executive’s greatest income risk from involuntary termination is during the early period as an executive, before he/she has an opportunity to accumulate wealth and/or build saleable skills in the executive role. That risk is presumed to go down over time.
However, in my experience, if applied as a policy to a large group of executives, a sunset provision will over time create a sense of inequity and confusion. Few, if any, can remember the different circumstances that created the different levels of individual severance benefits, and with a significant number of similarly-leveled executives covered at more than one level of severance there is a mixed signal on what is the intended level of severance benefit.
Two examples I have experienced where a sunset provision has worked well for a client include:
– A large employer, who had an assortment of individual severance agreements, was targeting to establish a guideline of 1 times salary for its executive leadership team, while retaining a benefit of 2 times salary for the CEO. At the same time, a COO was being recruited from outside the organization and sought a 2 times salary severance benefit, similar to his contract with his current employer. The organization offered the candidate a sunset severance program, with 2 times salary as his severance benefit during his first two years of employment, followed by a decline to a 1 times severance after that time. The sunset provision helped in resolving the potential conflict between the candidate’s requested severance protection and the Company’s planned severance guidelines.
– The Compensation Committee of a public company that had been criticized by institutional investors for providing generous severance payments during a time of poor stock price performance, decided to move forward with a reduction in its executive severance guidelines from 2 times salary and bonus to 1 times salary and bonus. However, in light of its difficult business climate and risk of unwanted turnover, they used a sunset approach and stepped the benefit down over two years, first to 1.5 times and then to 1 times salary and bonus. This sunset approach allowed them to establish the longer term standard for severance of 1 times cash pay, but not increase the risk of voluntary turnover while the company improved its business performance.
The level of executive severance benefits for involuntary performance will likely remain under pressure to decline. A sunset provision may be one tool for companies to use in attracting or retaining talent during a period of transition.
As noted in the memo, Senator Clinton’s bill is a broad response to concerns over executive pay, and it is currently unclear if it will be voted out of Committee (there are no co-sponsors so far). However, it’s realistic to expect that similar legislation will be introduced next year under a new Administration.
The “bottoms up” approach is indeed a useful starting point for assessing directors’ pay at small and large organizations. But the potential liability and exposure fall virtually all on the outside professional advisors, who always run some risk of being sued successfully for malpractice and who therefore build the costs of that risk into their hourly rates.
The potential liability and exposure of directors have been badly overexagerated. As long as directors do these four things – (i) make decisions on a rational basis, (ii) use a rational process for making these decisions, (iii)act in good faith, and (iv) have no conflicts of interest – the business judgment rule will insulate them from liability. Of course, anyone can sue anyone for anything – and that’s why directors need D&O insurance to cover the costs of litigation.
But I do not know of a court decision where the court found that the directors met this four-part test and still were found liable. The business judgment rule gives directors the right to be wrong. Outside professional advisors do not have this right.
Our recently released study of 2006 performance metrics at the top 300 public companies – now being updated for 2007 data – revealed that 37% of companies with long-term incentive plans used total shareholder return (TSR), a market measure. All but five of these companies based their payouts on TSR relative to a peer group. On the other hand, for the majority of plans using a performance-based or internal financial measure, relative designs were the exception. Indeed, of the performance-based long term incentive plans, less than 20% used relative measures. To be compliant with Item 402(e)(1)(iii), disclosure of the measures, including threshold, target and maximum values, would be required.
Short-term incentive plans rarely use relative measures. This same study estimated just 8% of companies with short-term incentive plans used relative measures as part of these plans. Moreover, the reporting of metrics in 2006 was woefully short of expectations with just 16% of these top companies providing complete information on short-term goals and accomplishments. Clearly, there was great hesitation in disclosing this information.
For companies that would prefer not to disclose this information for competitive reasons, an easy solution would be to base payouts on performance relative to a set of peer companies. As with a TSR design, payouts could be based on percentile performance over a multi-year period. Reporting would consist of listing the applicable measure(s) and the percentile performance that triggers vesting/payouts. Equity-based plans would retain all the features of any other performance-based plan such as fixed expense per share and reversible expense for sub-threshold performance.
Using a relative design is also a better way to measure performance. With a relative measure, changes in the economy and industry are reflected in the performance of comparator companies. Consequently, if a company is falling short of its EPS goal, it is possible that the company can outperform its competitors and be rewarded accordingly. Alternatively, if the company goal is more easily achieved as a result of external factors rather than astute management, a relative goal can prevent an unwarranted windfall.
Of course, one downside to relative measures is the potential payout of incentives in cases of poor company performance but strong relative performance. Having minimum financial hurdles can be designed to prevent ill-timed payments.