Saturday, April 13, 2013

Whatever Happened to the CEO Pay Ratio?
Fred Whittlesey

Compensation Venture Group

I just returned from the Conscious Capitalism 2013 Conference. There was scant discussion of compensation other than occasional references to the CEO pay ratio. Then I spent a few hours catching up on email and links to the endless stream of online commentary on compensation and there it was. The CEO Pay Ratio.

It’s amusing to me that almost 3 years after the passage of Dodd-Frank Act which requires the disclosure of the CEO Pay Ratio – the ratio of a company’s CEO pay to the median pay of that company’s employees - some commentators (I resisted the temptation to link) are just now writing about all of the complex technical implementation difficulties with the CEO Pay Ratio disclosure requirement. I addressed that in a WorldatWork Journal article in July 2010 and there’s been ample coverage since. It’s a tired issue, covered extensively and now repetitively.

The definitional and implementation complexities are indeed overwhelming and over-debated, no doubt the reason for the SEC’s continued avoidance of the issue. (The SEC seems to have decided in response that the best way to avoid missing deadlines, which they have repeatedly done with respect to Dodd-Frank requirements, is to stop setting deadlines, which they have done. As many of us know, a project without a deadline is a project that may never be completed.)

But while the SEC has not acted, it has not stopped their discussing it. In February of this year, SEC Commissioner Aguilar in a speech touched on this issue, identifying it as a risk management and disclosure issue: 

“...risks relating to compensation go beyond the immediate incentives of a particular compensation plan or policy. The relative pay of different classes of employees, such as the ratio between CEO compensation and median pay, can also create risks to an enterprise, including the risk of employee, customer, and shareholder discontent.”

But the populist anti-pay movement is extending beyond the C-suite. On April 1, 2013 (why does any organization issue any significant information on that day?) the IRS issued proposed regulations for Section 162(m)(6). Section 162(m) is the “million dollar cap” (cap that is not-a-cap) on CEO pay. Subsection 6 now imposes a new “cap” of $500,000 on ALL employees of certain health insurance providers. It’s an extremely complex rule but an extremely simple concept – legislators and regulators worldwide are looking for opportunities to impose constraints on highly-paid people. So far, we have on the list CEOs, bankers, and healthcare insurance employees. More to come, to be sure.

In the US, we’re focused on Dodd-Frank and the SEC, but the movement is global. In Switzerland, citizens voted for additional limits on executive pay, beyond the recent approval of strict say-on-pay rules. As Broc Romanek noted, in his blog, “The Young Socialists, the youth wing of the left-leaning Social Democratic Party of Switzerland, have collected more than 100,000 signatures--the threshold needed to call a vote--in support of a referendum to limit executive salaries to 12 times those of a company's lowest-paid employee. The campaign, dubbed the 1:12 Initiative for Fair Pay, is named for the organizers' belief that no one in a company should earn more in one month than the lowest-paid employee makes in a year. “

In the meantime, those in the US more concerned with the concept than the regulatory details have forged ahead, much as other organizations and companies have done with the Pay for Performance requirement which the SEC has similarly failed to determine. For example:

· Whole Foods Markets states in their 2013 proxy discusses their salary cap by saying “we have placed a cap on executive and other leadership members’ salaries and equity grants…in an attempt to balance our competing objectives of fairness to all stakeholders.” They publish a table showing that the cap is a multiple of 19 times the average annual wage since 2008.

· DuPont in their 2013 proxy discloses the concept of a “pay equity multiple” comparing CEO pay that of other executives which is roughly 3x.

Interestingly, there are several large companies that in the past disclosed positions described as “internal pay equity” which no longer do so. It is a difficult concept to manage.

Outside the US, a longer-term example of the concept exists in Mondragon Corporation in Spain which determines pay ratios between executives and other workers that range from 3x to 9x, averaging 5x. Mondragon has been in business for over 55 years, and has more than 80,000 employees working for more than 250 companies.

Paraphrasing Arlo Guthrie in Alice’s Restaurant, if one person does it they’ll think he’s really sick; if two people do it in harmony, they’ll think they’re (censored) and they won’t take them; if three people do it they may think it’s an organization; and if fifty people a day do it, they may think it’s a movement. The CEO Pay Ratio is a movement, and one to watch. With or without the SEC.

The problem with most of these ratios, though, is that they only capture base salary or granted pay; the real story is in realized pay. Next week I will be quoted in another article in the Boston Globe citing CVG’s research that a CEO was granted approximately $5 million in pay in 2012, but actually realized over $16 million that year. The big story is that he has accumulated an estimated future $83 million over his tenure at this company including 3 different pension plans, a deferred compensation plan, and the outstanding equity awards still unvested or unexercised.

Some would say that pay levels like this are not “fair”. I always tell clients (and the media) that I never use the “F word” when discussing compensation because I don’t know what “fair” is.

What I do know is that if suppliers are being pressured to lower prices, customers are paying higher prices, employees’ pay is stagnant relative to inflation, employee ownership plans have been axed because of institutional shareholders’ and proxy advisers’ arbitrary policies, and the impact on society and community is of concern in a company that provides tens of millions of dollars of compensation to a CEO running an auto-pilot business…in a capitalistic free-market society the collective stakeholder groups - suppliers, customers, employees, the community - will change things.

That society can wait for a misguided Congress to legislate irrational laws that securities regulators balk to implement, or the society can wait for its youth to trigger still more legislation. Or that society can awaken to some conscious, rational approaches to paying executives, board members, and employees that rebalance the current stakeholder hierarchy where shareholders rule at the expense of all other stakeholders. We have collectively allowed the latter to occur and now have the opportunity for the former.

Conscious Compensation ® raises these questions and proposes solutions to support Conscious Capitalism © and the progress of global society. The CEO Pay Ratio dialogue is the door to making progress on this. Don’t be fooled by the consultants, like me, who in the course of our professional roles debate the mechanics of such a concept. Just like granted pay, realized pay and accumulated pay, the regulated Pay Ratio requirement may make be complicated and make no sense, but the concept is not an Arlo Guthrie organization, it is an Arlo Guthrie movement.

Tuesday, December 04, 2012

Year-End Dividends, TSR Havoc, and CEO Pay - Isn't That Special?

Fred Whittlesey
Compensation Venture Group, Inc.

What do Costco, Oracle, Tellabs, Whole Foods Markets, Las Vegas Sands, Movado and National Beverage have in common?  They don't make a very good peer group given their disparate GICS codes.  

They are pursuing a tax-driven (and somewhat political) tactic in the name of "returning capital to shareholders" that may come back to bite them, or their peer companies, when it's time to look at executive compensation.

An increasing number of companies are rushing to declare and pay a "special dividend" prior to the end of 2012 to hedge shareholders against the prospect of a large increase in tax rates in 2013.  I can't help but think of Church Lady when I hear "special" used.

While this would seem to be an all-around positive move - returning cash to shareholders, improving the shareholders' aftertax gains, assuaging the corporate finance critics who believe that investors are better at allocating capital than companies flush with cash who are incented to acquire other companies - there is an interesting aspect to this going unnoticed by those who may be most affected by it.

One commentator has outlined the alternative scenarios that these dividend actions will produce on the dividend-paying companies' stock prices, this month and then throughout 2012. A stock price spike in December, then a sudden drop after the ex-dividend date.  And then, an exit by income funds from those shares - that is, investors who buy the shares for the dividend, that (in the case of Oracle) has just seen 2013 dividends "accelerated" into 2012 and thus zeroes out most of 2013.

As often happens, the taxation tail is wagging the strategy dog.  As Boards of Directors attempt to optimize shareholders' single-year tax outcome (and bash President Obama and maybe even Congress a little), they may be digging a hole for themselves with their executive and equity compensation programs.

The extreme short-term stock price volatility introduced by the announcement of a special dividend will be fueled by both high-frequency traders that can nab the share on the ex-dividend date then get out faster than can you or I, and options traders that profit from the volatility alone. As investors change their view of a company from a dividend payer to one that is not, more price pressure is introduced.

What does this have to do with executive compensation?  Are any of these companies in your executive compensation peer group?  Do you use TSR (total shareholder return) as a performance measure in your incentive compensation programs?  Do you care about what ISS and Glass Lewis think of your executive compensation pay-performance "alignment?" Ah, so there's the connection.

For those who have run the numbers for ISS's CEO pay-for-performance model, you know that 1-year stock price performance has a disproportionate impact on the results.  With sudden spikes or dives in a company's stock price resulting from a special dividend tactic in December 2012, and the point-to-point measurement of most TSR models, a company may have just bought itself a big shareholder and proxy adviser battle come proxy season, for the sake of short-term tax optimization for shareholders. This is an even greater problem given the combined volatility and flatness of equity markets over the past few years.  Relative TSR has become a lottery system and the special dividend of your company and/or your peers just made things even more random.

(And shame on you, Whole Foods Markets, who promote your mission and values, especially those regarding "increasing long term shareholder value."  Those of us focusing on Conscious Compensation©  know that a short-sighted tax-driven tactic like this is most certainly not supportive of that..and that TSR really stands for "Total Stakeholder Return" now doesn't it?)

So, watch your peer group companies for these special dividends, and watch how your relative TSR ranking bounces around between now and December 31, your incentive plans malfunction, and your pay-for-performance analysis blows up. That might be really "special" for your Compensation Committee.

Thursday, November 08, 2012

What I Say on Say-on-Pay Will Pay, I'd Say

OK, maybe I read a few too many Dr. Seuss books to the three little ones over the past 10 years.

As we enter what will be an extremely busy November-December executive and equity compensation season, one theme will dominate:  say-on-pay.  This is not just an executive compensation topic.  It has impact on every equity compensation plan and professional.  I've had a lot to say about it to hundreds (maybe thousands) of equity compensation professionals over the past few months.

Even before the busy September-October conference/webinar season, I posted my blog of 26-June, reblogged on 23-July by Broc Romanek of titled "33 Reasons Why Your Company's Say-on-Pay Vote May Go Sub-50% in 2013."  Read it. It's a fast read. You will see your company's compensation practices on that list.

Then, I was pleased to be on a panel with Seth Rosen of KPMG and Jack Marstellar of Pay Governance at Global Equity Organization's National Equity Compensation Forum on 20-September.  Our topic:  Looking Back and Forging Ahead.  The full title was way longer.  It was about say-on-pay.

Next, I presented "The Effects of Global Say-on-Pay:  Coming to Your Stock Plan in 2013" to the Pacific Northwest Chapter of GEO on 25 September.  This references my book chapter in GEOnomics 2012 "Say-On-Pay's Impact on Equity Compensation Design:  Horse or Camel?." (free download)

Then, my webinar for Equity Administration Solutions, Inc. (EASi) on 18-October, with the same title as the recent GEO presentation, took the topic further and explored how fast-moving trends outside the US will drive US practices in the coming year. So much had happened in the 3 weeks since, that there was a new dimension.

Interestingly, all of this ties into the presentation I've been doing with Terry Adamson of Aon Hewitt, "Value and Valuation: Understanding Long-Term Incentive Data." We presented at WorldatWork's Annual Conference in Orlando in May, again at NASPP's Conference in New Orleans last month (with Billy Vitense of Starbucks), and now headed to  do the presentation later in November for a joint meeting of NASPP's and GEO's Boston Chapter on 16-November.

I am pleased to send the presentation from any or all of these to you if you are interested. If you deal with equity compensation (which if you're reading this you probably do) you will need to know this stuff, in the coming months.  It will pay to know it, even if I do say so myself.  Oh, the places you'll go...

Tuesday, June 26, 2012

33 Reasons That Your Company’s Say-on-Pay Vote Might Go Sub-50% in 2013

Fred Whittlesey

News of companies that failed their say-on-pay vote is in the headlines almost daily this time of year.  What don’t make the headlines are stories of the companies that barely passed (in the 50% to 70% range) or that passed but plummeted from their 2011 approval levels.  Many in the former category last year failed this year.  Many in the latter category this year may fail next year.

While additional data will continue to trickle in over the summer, my firm has completed research on the first 54 failed say on pay votes in 2012, finding:
  • Only four of the companies that failed this year’s SOP vote also failed last year. The other 50 companies that failed this year had an average approval rate of 78% last year with approval levels ranging from from 50% to 99%.
  • 13 companies that passed the 2011 SOP vote with percent approvals in the 90’s – probably feeling like the issue was over – failed in 2012, averaging a 38% approval – no different from the average of other failing 2012 companies that had 2011 approval levels of 50% to 89%.
  • Votes on replenishment of shares in equity incentive programs among the failing SOP firms ranged from 100% down to the one company that failed the additional shares request (37%) as well as SOP (33%).
  • Increasingly, the Compensation Committee members are failing to attract a strong majority “for” vote – if SOP and equity votes don’t get their attention, a personalized message typically does.   Many that were re-elected did so with an approval level in the 60s and 70s. We have seen how that can trend.
  • In one company that has a triennial, rather than annual, SOP vote the shareholders who couldn't vote against executive pay instead voted against all three Compensation Committee members, who failed to get majority support.
  • The moral to the story: Don’t be complacent about an SOP success – even at 99% - in any given year.  Several companies whose programs received ISS’s blessing last year saw that opinion reversed on the identical pay program this year, because ISS changed the rules which they may do again next year.
Do You See Your Company's Equity Program Features on This List of 33?

There has emerged a consistent set of issues that have led Institutional Shareholder Services, Glass Lewis, and others to recommend an “against” vote and these are central to the steep decline in approval experienced by the companies failing. Most of these apply to executive awards, but some apply to broader programs. Here they are, in no particular order:
  • Grants of stock options (not performance-based pay!)
  • Grants of time-vested RSUs
  • Large “retention” awards (2 or 3 times normal annual grant size)
  • Time-vested stock options granted with a strike price at current fair market value
  • Performance-vested awards without sufficient “rigor” of the goals
  • Lack of disclosure needed to assess the rigor of goals
  • Performance awards that payout at the maximum level several years in a row, indicating a potential lack of rigor
  • Granted pay (per the Summary Compensation Table, the majority of which is equity) that is not aligned with total shareholder return in previous years…even though “realized pay” is aligned
  • Performance measures for equity awards that are qualitative (e.g., synergy, leadership)
  • Performance measures for equity awards that are quantitative but use nonfinancial measures (e.g., safety, quality) which are not externally auditable and verifiable
  • Using the same performance metrics for  both the annual and the long-term incentive plans
  • Using non-GAAP performance measures (e.g., adjusted EBITDA) that are not clearly reconciled to GAAP numbers
  • Overlapping goals in performance awards
  • Unreasonably low performance thresholds and targets for performance awards that assure payout
  • Payout opportunities for performance below the peer group median performance (e.g., performance at the 25th percentile that pays 50% of target)
  • Use of subjectivity or discretion in determining award payouts, as an element of the plan design
  • Modifying performance goals mid-cycle when the goals will certainly be missed
  • After-the-fact discretionary override of missed goals to provide a performance award payout due to external circumstances
  • Use of “either-or” performance measures that appear to ensure a payout
  • Short-term (e.g., annual) performance periods within a multi-year plan
  • Carryforward and/or carryback features in a performance plan
  • Payment of dividends/dividend equivalents on unearned or unvested awards
  • Inclusion of equity awards in pension or SERP calculations
  • Tax gross-ups
  • Lack of stock ownership guidelines or retention requirements on equity awards
  • Large grants of RSUs in the same year that stock ownership guidelines are implemented, assuring that upon time-based vesting the aftertax shares will be sufficient to meet the guideline
  • Lack of a clawback policy (even though the SEC hasn’t met their deadline for issuing clawback rules)
  • Inadvertent timing of grants and the recognition of an accounting grant date, creating the appearance of a large “pay increase” year-over-year
  • Single trigger, or modified single trigger, change in control provisions for equity grants
  • No disclosure of holding periods for shares from exercised options and RSU/performance RSU awards
  • Excessive “concentration” of equity grants in the year among the NEOs (NEO combined grant value as a percent of total grant value to all employees)
  • Inadequate disclosure regarding the equity compensation program when requesting additional shares - which led to a judge prohibiting the vote at one company that reconvened the meeting later and received only 59% support
  • And finally, ignoring last year's criticisms of the equity compensation program because the SOP approval rate was satisfactorily high
Of course, some of your company's equity program features are on this list. This is the problem.  It is impossible to design an equity compensation program to meet all investors' and proxy advisers' policies and standards, include design features that make sense from strategic, financial, behavioral, and governance points of view and reflect sound business judgment by the Compensation Committee but nevertheless may be the trigger for a "no" recommendation on SOP, the equity plan, and/or the Committee members.

And the best plan design in the world may not be enough if your total shareholder return is negative or below that of your peers, and your investors are grumpy about that.

There are many other executive compensation issues that are not specific to equity compensation but are potential triggers of a negative recommendation from proxy advisers and institutional shareholders.  This brief list above is limited to those that directly affect equity compensation practices.

I’ll be discussing these issues in depth in the next "Ask Fred" EASi webinar on 19-July: 

Say-on-Pay 2012:  The Effects on Equity Plan Design

With much of the 2012 shareholder meeting season having passed, we have the opportunity to review how the second year of say-on-pay in the US is influencing equity compensation program design. While often discussed as an executive compensation issue, one of the central themes in shareholder voting influences continues to be equity compensation.  In fact, the approval rates for new equity plans and additions of shares to existing plans are declining compared with previous years.  In some companies, voting outcomes are revealing more dissatisfaction with the equity plan than with executive pay.  This session will review what companies experienced in 2011, how that changed in 2012, and what will continue to evolve as companies are already preparing for the 2013 season.

Register here for this session

Thursday, June 14, 2012

She Said She Said

Fred Whittlesey
Compensation Venture Group, Inc.

"She said, you don't understand what I said

I said no, no, no, you're wrong"

She Said She Said

The Beatles (John Lennon)

A new research study published in the Journal of the American Medical Association concludes that female physicians are paid less than male physicians by about $12,000 per year, enough of a difference over a 30-year career that one of the study's (female) authors claims "here in Michigan...buys a house" and "Anywhere...sends a kid to college" because "Even Women Doctors Can't Escape the Pay Gap."

When I read this, $12,000 didn't seem like a significant difference given what I know about physician pay levels.  I also know that it's quite difficult to measure the earnings of physicians, for many reasons, and that if you just ask what a doc's "salary" is you probably aren't getting his or her real income number.

The research concluded that the $12,000 - by my calculations equal to about 6.3% of the weighted-average salary of the 800 doctors responding to the survey - is a genuine gender pay gap after twenty (yes, 20) variables are factored into the analysis. It is "statistically significant" which as we all know may or may not be significant. Knowing that it is possible to make statistics tell you just about anything you would like to hear, I looked at the actual research, which was based on a self-report survey of doctors.

In fact, the average male doctor pay level in the survey is 19.5% higher than the average female doctor pay level, and the data confirm that male doctors choose (or are chosen for) higher-paying specialties (like surgery) rather than lower-paying ones (women, children), work in higher-paying settings, work more hours per week (8.8% more hours/week on average), and have conducted and published more research.  I may be missing something but that sounds more like pay-for-skills-and-performance to me than a gender pay gap.

Even after accounting for these other variables, the researchers conclude that the 6.3% pay difference is indeed a gender-driven pay difference attributable to the lack of a Y chromosome.   Or maybe it's because those more highly-paid doctors are researching medical issues, saving lives, and improving patients' health rather than crunching self-reported salary data.  That probably sounds like my Y chromosome talking.

I'm not saying that there is no gender discrimination in the workplace, including healthcare settings, or that there is no gender-based pay discrimination anywhere.  I'm saying that compensation professionals need to be aware of and knowledgeable about these research studies and the resulting pop media headlines. We know how research and media can lead to legislation and regulation, with unintended consequences.

Maybe I should call the neurosurgeon (one of the highest-paying specialties) who performed my daughter's brain surgery last week at Seattle Children's Hospital and find out if she is underpaid.  I think she is the best of the dozen or so neurosurgeons performing the dozen or so brain surgeries over the past 7 years, and I think she should be the highest-paid of the bunch despite her apparent lack of the Y chromosome possessed by all of the other neurosurgeons there.  I wonder what she would say about this research.

Thursday, June 07, 2012

Bullet-Proof Vest(ing)

Fred Whittlesey
Compensation Venture Group

"And it seems these days that everybody wears a bullet-proof vest"

- Colbie Caillat, "Bullet Proof Vest"

In the current compensation governance environment, many (perhaps most) companies are seeking the bullet-proof vest to fend off criticisms of proxy advisers and institutional shareholders in the say-on-pay process.

One of the key components of the bullet-proof vest strategy is...the vesting schedule - and this is getting little attention in the media, compensation surveys and databases, and some consultants' analyses.

My firm's analyses of executive compensation include a detailed analysis of vesting schedules. Why?  Because over the past few years this has escalated from the analytically-interesting to the essential.  While vesting schedules are indirectly recognized in accounting fair value calculations (and we can debate whether that is really true) there are much larger issues with vesting schedules.

The days of simple decisions about 3 years versus 4 years, incremental versus cliff, are long-gone.  We now have, of course, both time and performance-based vesting (with a remarkable variety of the latter) applied not only to full-value awards (RSUs and PSUs) but options and increasingly-prevalent cash LTI plans.  We just completed an analysis of a client's 25 peer companies, and found 72 (yes, seventy-two) unique vesting schedules being applied to the past year's equity grants to the named executive officers in those companies. We have a methodology for rationalizing that diversity of vesting schedules into a few normalized metrics but it still is a lot for a Compensation Committee to digest when they ask a question like "what is the typical vesting schedule?"

In the extreme cases, companies are adding performance-based vesting to previously-granted awards due to say-on-pay pressure.  Other companies are proactively adding performance vesting to stave off future threats (given the number of companies that had comfortably-high say-on-pay approval ratings last year and failed this year). Yet in any given peer group we will still find a company that is granting all equity in the form of RSUs with a 3-year graded vesting schedule, or options with 25% vesting in the first year and the monthly vesting in the three years thereafter.

There is good news and bad news in the 72 vesting schedules.  Perhaps the say-on-pay process has forced companies to be more thoughtful about the conditions that should be applied to the earning of multi-million dollar equity awards.  That would be the good news.  The bad news?  That these are knee-jerk reactions to threats from self-anointed corporate governance pundits like ISS and Glass-Lewis, over-engineering of award design that might lead to reduced perceived value by recipients, and confusion for all.

Finally, it's important to note that surveys or proxy databases are not capturing the complexity of LTI vesting schedules and when LTI comprises more than half of executive pay, ignoring a critical design feature in reporting pay "values" renders that data less than valuable, perhaps useless.  For example, let's say that:
  • Fair value of an option award with 3-year incremental vesting (33.3% per year) is $5 million.  
  • Fair value of restricted stock units (RSUs) with 5-year cliff vesting schedule is $5 million.  
  • Fair value of performance-vested stock units (PSUs) with a 1-year performance period and a 2-year subsequent time-based vesting period is $5 million. 
  • Fair value of PSUs with a 3-year cliff performance period is $5 million. 
And the answer is:  $5 million.  But it's not.  That is merely the valuation firms and accountants' opinions of the value of each, under accounting rules. There are vastly differing strategic, financial, behavioral, and governance implications of those awards. One thing we do know about accounting for equity compensation is that the least likely pay outcome for each of those awards is $5 million despite what the actuaries tell us.

Colbie's song lyrics in "Bullet Proof Vest" imply that wearing an emotional one may not be optimal in the game of love.  Defaulting to a perceived bullet-proof vesting schedule may not be optimal in the game of executive compensation and say-on-pay.  Blindly following a consultant's statement of purported "best practice" without understanding the incredible complexity of equity award design may lead to the pattern we're seeing over the past few years: annual changes in equity grant design because last year's just didn't work.  It took a bullet, despite the vest.

Maybe we need to find the Titanium of equity award vesting.

Tuesday, January 31, 2012

The Executive Compensation Controversy: What it Means for Equity Compensation in 2012

As we approach the 2012 proxy season - the months of March, April, and May when about 70% of public companies file their proxies for this year's shareholder meeting - we provide an update on a number of significant developments. Over the past few months, a series of changes in proxy adviser policy, regulatory timelines, media coverage, and the political landscape are converging to ensure another controversial year for equity compensation.

The headlines will focus on the topic of "executive compensation" but in fact many of the issues are driven by equity compensation and will have a direct impact on companies' equity compensation granting practices in 2012.

On February 2 at 10:00 AM PST, I will be hosting a webinar covering various issues related to executive compensation, including:
  • Why the second year of "say on pay" may pose more problems for companies than the first year, and how #1 issue in investors' minds is not executive pay - it's equity compensation
  • How a new focus on pay-for-performance "alignment" for the CEO - a calculation driven by, and distorted by, equity compensation valuation - will force some companies to redesign their plans
  • Why the headlines about "CEO pay cuts" and "record CEO pay" are rooted in misunderstanding of equity compensation values and provisions and will require proactive communication to investors...and employees
  • Why the carefully constructed peer group you use for compensation comparisons may have just become irrelevant for equity compensation purposes
  • How the SEC's delay in implementing the Dodd-Frank "CEO Pay Ratio" and "CEO Pay for Performance" rules has led the private sector to forge ahead with the concepts
  • Why companies will need to develop more sophisticated grant allocation methods and systems to balance increasing pressure on dilution and the growing complexity of plan design
This webinar is hosted by Equity Administration Solutions, Inc. (EASi)

Register today to participate in this informative session!

Monday, January 02, 2012

Another CEO "Pay Cut" That Isn't

I understand that stock options are difficult to understand.  And I understand that some journalists seem to have a keen interest in reporting how "overpaid" CEOs are, and others a similar interest in gleefully reporting that a CEO took a "pay cut."

The problem is, CEOs rarely have their compensation reduced through a direct action by the Compensation Committee of the Board of Directors, just as most employees in most organizations rarely have their compensation reduced. Usually these reported pay cuts are inaccurately reported and, more often than not, represent a pay increase.

The latest misunderstanding comes from The Wrap (which I only noticed because so many major media outlets distributed the story) in reporting that Reed Hastings, CEO of Netflix, received a $1.5 million reduction in his "stock option pay" for 2012 compared to 2011.  It is true that a certain number reported in an 8-K filing in December 2010 was $3 million, and the comparable number in an 8-K filing in December 2011 was $1.5 million, leading to the conclusion that the CEO was "paid" $1.5 million less as a result.

For those interested in the true story, keep reading here.  For those that choose to believe that Mr. Hastings is truly being paid $1.5 million less in 2012 than in 2011, just left-click on that link above, rather than right-click.  I won't get into the long-term multi-year nature of the value of options, or vesting schedules, or the complete reliance on stock price as a basis for what the ultimate "pay" really will be. There's something much simpler and, to me, more interesting here.

Netflix uses a dollar denominated approach to determine stock option awards.  It works like this:  In December 2010 the Compensation Committee of Netflix decided to grant to Mr. Hastings stock options with a "fair value" (i.e., hypothetical value as determined by accountants and actuaries) equal to $3 million.  To do this, the company determines the value of one stock option and then simply calculates how many of those it takes to hit the $3 million target.  This was done at a time when Netflix stock was trading around $184 per share.

They took the same approach this year, but determined Mr. Hastings should receive a grant with a fair value of only $1.5 million.  At a time when the stock was trading around $70 per share.  Aha.

To do the calculation, companies typically take the calculated value of the options and do a straightforward division.  So if Netflix stock trading at $70 produces, under the option pricing model, options worth, say, 50% of that amount, each option would be "worth" $35 and, extending this calculation, they would grant $1,500,000/$35  = 42,857 options.  Whereas last year each option would have been worth 50% of $184, or $92 per share, yielding $3,000,000/$92 = 32,609.  Hmm, this year he would have received around 10,000 more options at a lower strike price. (Illustrative numbers not actual, but close.)

I wish someone would give me a pay cut like that.

But wait, there's more.  Netflix doesn't use their accounting-based option valuation to determine the number of options as I describe above.  They specifically disclose in their 10-K footnotes that they use the binomial model instead of Black-Scholes:

"The Company believes that the lattice-binomial model is more capable of incorporating the features of the Company’s employee stock options than closed-form models such as the Black-Scholes model."

Despite their belief in the binomial-based numbers, they do not use these numbers to determine stock option awards.  Instead of a value of about 50% of the stock price resulting from that model, they use an arbitrary 20%.  The result?  An option award that is 250% the size of an award that most companies would make using the same methodology. "Size" being number of options, not hypothetical fair value.

I have no problem with Netflix or their executive compensation practices.  Despite the criticism Mr. Hastings received this year, my family is a loyal customer. Their service keeps two 7-year old girls riveted to Sesame Street videos each morning and the whole family entertained every Friday for Movie Night.

I do have a problem with journalists who know little or nothing about a topic engaging in so-called journalism - which by definition requires fact-checking and making an effort to understand the topic.  Perhaps worse are journalists who do understand the numbers and choose to misrepresent and distort them to make a point.  That belongs in the Opinion section, not the business section.  But the latter is much more difficult to prove while the former is evidenced in the numbers.

Reed Hastings got a great stock option grant this year which should make him feel better about his now-underwater options granted last year.  I'm just glad I bought their service but not their stock.

Tuesday, December 20, 2011

The Pressured Mandate of the Compensation Committee/RemCo

I was thrilled to be invited to co-author a piece with David Creelman (Canada) and Andrew Lambert (UK) of Creelman Lambert  as we collectively continue to explore how to improve the linkage between Board-level governance processes and the necessary focus on human capital.

Our key point is this:

What’s the solution? There are three things we need: a committee with a mandate to take
a broad look at human capital; members who have time to fulfill this mandate; and
executive teams that can communicate human capital issues in succinct dollar-denominated
metrics. The obvious place for the mandate has been the comp committee.
Yet we know many are struggling to handle their current workload. It may be necessary to
create an HR committee with a broader role, freed from the minutiae of the exec pay wars.

I believe this will get worse before it gets better, as the current disjointed process with "independent" consultants to Compensation Committees further distances the Committee and the consultant from an integrated view of compensation issues in the organization and the business.

If the comp committee is pre-occupied with avoiding trouble, it can leave the topic of
human capital an orphan. The best boards integrate human capital considerations into all
of their discussions, but not everyone is blessed with such a truly “HR-capable” board.

Wednesday, November 30, 2011

The Most Wonderful Time of the Year (Peer Groups)

Fred Whittlesey
Compensation Venture Group

"There'll be scary ghost stories
And tales of the glories of...
Long, long ago"

-Edward Pola and George Wyle
as performed by Andy Williams (1963)
"It's the Most Wonderful Time of the Year"

Yes, it's the most wonderful time of the year - Compensation Committee season!

As Committees gather to review 2011 and plan for 2012, we have a record number of scary ghost stories this year - with the first year of say-on-pay, several dozen failed votes, and a handful of lawsuits, all rooted in ghosts of decisions of Compensation Committee meetings past.  With that comes the inevitable yearning for the glories of long, long ago.  Not so long ago, really.  Maybe five years since Compensation Committee decisions starting getting really complicated, with the past year attaining a new level of complexity.

These discussions typically commence with the topic of the peer group.  Is the peer group still relevant?  Did we lose many peers over the past year due to M&A activity?  Have we considered the peer group criteria of external parties?  Have we used the "right" industry codes and metrics to define the group? Did we use a defensible process for determining our peer group?

We've moved from a time of shareholders and proxy advisers merely opining on pay versus peers, to one of their opining on the peers themselves.  The media have caught on to this topic, with the Tootsie Roll story in the Wall Street Journal back in 2009, and more recently the Washington Post "Cozy Relationships" article.

Thank goodness, Institutional Shareholder Services has come along with their annual holiday treat, their 2012 Policy Updates.  The U.S. policy updates are a particular treat, with ISS informing us that they are going to extend their helpfulness by not only critiquing companies' peer groups as disclosed in the proxy statement, but now creating a personalized peer group for them:

"The peer group is generally comprised of 14-24 companies that are selected using market cap, revenue (or assets for financial firms), and GICS industry group, via a process designed to select peers that are closest to the subject company, and where the subject company is close to median in revenue/asset size. The relative alignment evaluation will consider the company’s rank for both pay and TSR within the peer group (for one- and three-year periods) and the CEO’s pay relative to the median pay level in the peer group."

This will purportedly help ISS to assess "peer group alignment" for the pay-for-performance assessment. The magic number of "14-24 companies" must be a scientifically-derived improvement over the range of "15-25 companies."

We also have on our holiday wish list the proposed guidance from the SEC on clawbacks, the CEO pay ratio, and the CEO pay-for-performance analysis.  They never let us down with these year-end pronouncements.

These rules will put still more pressure on the peer group process as various parties - including the media - opine on the CEO pay ratio versus other companies and the CEO pay-for-performance analysis versus other companies (and maybe yet another peer group).  We'll see companies publish supplemental tables to push back on the SEC's required disclosures, all of this rooted in the peer group issue.

That is the ghost of Compensation Committee meetings future.  Happy Holidays.

Saturday, November 19, 2011

Fixing the Executive Pay Problem, 1990-2011

Every week I receive a Giga Alert, pointing me to where I have been posted, cited, or referenced.  Some of these represent a chain going back quite far.  Today I received one citing an article published by Rutgers University in 1992 that mentions an editorial I wrote for the Sunday Los Angeles Times in 1990.  I hadn't read that piece, or even thought of it, for quite some time.  21 years later, not much has changed.  See the original here, or keep reading.

Fixing the Executive Pay Problem : Compensation: Improvements must come in incentive programs that link pay to performance, with an emphasis on long-term stock benefits instead of quick cash.

EXECUTIVE PAYCHECKS. California's Rising Sums: First in a series.

May 27, 1990|VINCE TAORMINA and FRED E. WHITTLESEY | VINCE TAORMINA is a principal and FRED E. WHITTLESEY a senior manager in compensation and benefits consulting at the accounting firm KPMG Peat Marwick in Los Angeles
What should be done, if anything, about the seemingly excessive executive pay in U.S. corporations? The answer, while technically simple, is difficult to implement.
Most economic and financial theorists agree that a senior executive's job is to maximize long-term shareholder value. If this is correct, then the executive's pay should be maximized when shareholder value is maximized.
If boards of directors are to design such programs, then the improvements must come in so-called incentive compensation programs--such as annual bonus plans and stock options--that link pay to performance. It is these programs--not salaries, benefits and perquisites--that are creating the highest compensation levels. These incentive programs deliver two forms of compensation: cash, mostly from annual programs, and stock, mostly from long-term programs.
Unfortunately, most annual cash incentive plans are based on such measures as pretax profit, return on equity and other financial measures that encourage short-term maximization and are easily manipulated by savvy executives. A large body of financial research indicates that better measures are available that ensure that shareholders' capital is earning an adequate return. Incorporating these measures into annual incentive plans will improve one element of the total executive compensation situation.
The current use of stock options and stock-related compensation programs is consistent with the goal of increasing shareholder value. If structured properly, stock-based compensation should not ruffle shareholders' feathers because their fates will be linked with that of executives. When an executive's share holdings far exceed any benefit or risk derived from cash compensation programs, shareholders' interests will be maximized.
The abuses tend to come when various "bells and whistles" are added to already potentially lucrative stock programs. And these are easily remedied:
* Eliminate stock appreciation rights. SARs allow an executive to get a cash bonus when the stock price goes up. While this objective seems noble, the cash payment allows an executive to profit from temporary rather than long-term stock price increases.
* Require executives to hold stock options for a longer period before cashing out. Most plans allow executives to begin exercising stock options as soon as one year after receiving them and continuing over a three- to five-year period. By extending these schedules, the executive has a true long-term incentive to maximize share price.
* Require the executive to continue holding shares acquired through stock option and stock award plans. This would truly align executives' interests with shareholders' interests. These holding periods can allow for some cashing out along the way, but only when stock value is maintained or increased. Without holding periods these stock plans can become just "quick cash" programs.
* Eliminate the cancellation and reissuance of options. When an executive receives an option and share price drops soon after, an option may not be "in the money" for some time. Most options usually give an executive the right to buy stock at a price close to the market price when the option is granted. So if the stock price then goes up, the option becomes more valuable, in effect allowing the executive to purchase stock at a discount. But if the price goes down instead, the option is essentially worthless.
Many companies have solved this problem by canceling the old option and reissuing it at the lower price. Unfortunately, a shareholder who bought a share at the higher price does not have the same opportunity. It is difficult to imagine a situation in which a cancel or reissue is truly warranted, particularly if companies follow rational option-granting policies.
* Grant large options at the beginning of a period and eliminate annual grants. If on the day a senior executive is hired or promoted, he or she received 10 years' worth of stock options and the options could not be exercised for 10 years, the executive's perspective would be much longer term. The practice of making annual option grants encourages a short-term cash-out mentality.
* Consider paying executives only in stock, with special arrangements to provide the necessary cash flow for living expenses. If all other compensation is in stock, then dividends, selective liquidation programs and company loans can eliminate the need over time for any base salary or bonus plan. In the transition, a well-designed annual incentive program should provide all the cash necessary for a well-funded executive lifestyle.
The obstacles to implementing these shareholder-oriented compensation programs are not technical in nature. The obstacles are timid boards of directors, relationships between consultants, and executives that prevent objectivity and objections by executives who benefit from the current programs.
With improved board scrutiny and timely redesign of compensation programs, the executive compensation controversy will end to all parties' satisfaction, with the exception of those poorly performing executives who were excessively paid under the old schemes. In absence of such action, there is the risk that the government will step in to curb the perceived excesses.

Saturday, November 12, 2011

About Four Years Ago

Fred Whittlesey
Compensation Venture Group, Inc.

I was updating my website this weekend, and revisited some "old" articles I had authored.  Way back in late 2007 through early 2008.

The field of equity compensation has gone through such tremendous upheaval over the past four years, I was ready to delete these links until I pondered for a moment the titles, that could have been written and be relevant just this week:

Because these were all written at the time for (now Kenexa) where I was a Fellow, whatever that is or was, I can't update them, per se.

Then I read them, and realized they hardly need updating.  In fact, the premise of each has been strengthened over the past 4 years and there are even more pressures on the three topics. Sure, the data references need to be recent and there are more inputs to the issue - primarily the new Dodd-Frank disclosures (CEO pay ratio and CEO pay-for-performance).

Consider, since 2007/2008:
  • Investor, proxy adviser, and SEC scrutiny has extended from how executives are paid versus peers, to which companies are actually in the peer group and how that peer group was determined.

  • Performance plans, somewhat avant garde back in 2007, are fast becoming a mandated approach in the US as we are now in the say-on-pay era - exactly the pattern we saw in the UK with the advent of say-on-pay.  Now this solution has become yet another problem, as I have written and presented on.

  • And cash long-term incentives, still under the radar due to compensation survey firms' and proxy data services' inadequate tracking of them, are growing in prevalence faster than reported, due to the odd combination of shareholder concerns about dilution and many companies with large amounts of cash on their balance sheet.
Taken together, these issues create chaos for trying to understand how much an executive was "paid" so that everyone can chime in on whether the number is just too big, too big relative to the average worker, and/or too big relative to company performance.  When very different forms of compensation are awarded, we run into the issue of "granted" vs. "earned" vs. "realizable" vs. "realized"...and more.

Each of these three written pieces deserves an update, I mean a fresh authoring, which I will do over the next few weeks.  While I'd like to pat myself on the back for being prescient on these issues, I think we all should have seen these three things coming and now we have even more to discuss.

Anyone want to predict what we'll be discussing in 2015?  Yikes.

Monday, September 26, 2011

Equity Plan Design: "How It Works"

Steve Jobs said that “It’s not just what it looks like and feels like.  Design is how it works.” He of course was talking about things like Macs and iPods (and, later, iPhones), but the same applies to equity compensation program design.

The current governance environment has drawn excessive attention to how equity compensation programs “look” and “feel.”  And the ever-increasing number of professionals labeling themselves as plan “designers” often focus on the look and feel of plan design.

The “look” part is features like types of award vehicles used, methods for allocating grants to employees, determining and reporting accounting expense, and dilution to shareholders. Increasingly, companies want their plans to look not too different from other companies’ plans.  Many would say that these characteristics, and the process of mimicking other companies’ programs, comprise “plan design” and the work that goes into this must then be the result of the efforts of plan designers.

The “feel” part is the arbitrary standards imposed by various proxy advisors, institutional investors, and other external parties:  overhang of 10% “feels” OK but overhang of “15%” “feels” too high. RSUs feel OK for non-executive employees but do not feel OK for executives.  These external forces have become significant factors influencing the design of compensation programs, becoming indirect plan designers.

It’s time to return our focus to “how it works” not just how it “looks and feels.” That requires a focus on strategy and behavior, not survey data, run rates, and accounting expense.

Since I introduced the concept of behavioral economics to equity compensation professionals during the 2008-2009 financial crisis and as a keynote session at GEO’s 2009 Annual Conference in Paris, I’ve continued my exploration of these ideas and how they can improve the effectiveness of equity compensation programs.  My book chapter in GEOnomics 2009 spurred a global discussion on the topic and resulted in some companies redesigning their program accordingly.

While many have focused on the communication and perception aspects of the behavioral economics concepts, I believe there are proven applications for equity compensation plan design as demonstrated around the world in the design of pension plans, savings plans, and healthcare benefits.

I will be doing a two-part webinar for GEO in September and October; the first on 28-September presents the key concepts of behavioral economics in easy-to-understand ideas and discusses how these concepts have been implemented. Attendees will learn how some program design features that we take as a “given” should be questioned in light of the ongoing research in the field of behavioral economics.  

This discussion will lay the groundwork for Part II of the series on 26-October in which we’ll look at specific program features and discuss both how these influence behavior and how employee behavior actually affects the value of the equity instrument - producing a direct effect on the return on investment (ROI) to the employer.

With the continued and increasing scrutiny of equity compensation as a result of concerns about executive pay, it’s time to understand what plan design is, and is not, and how to understand how to make it work. Maybe we can turn equity compensation from a perceived source of risk and abuse into something cool.  Like an iPhone.