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.

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.

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.

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:

"Who are your peers?  The SEC Wants to Know"

"The New Era of Equity Compensation:  Performance Plans"

"The Return of Cash Long-Term Incentives"

Because these were all written at the time for Salary.com (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.

Equity Plan Design: "How It Works"

Webinar this week:  Behavioral Economics and Equity Compensation, Part I

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.

Music Lessons

Fred Whittlesey

Compensation Venture Group

Every Labor Day weekend in Seattle is the Bumbershoot festival.  The format varies year to year, but it’s generally 3 days and more than 100 bands.  There are a lot of other artistic activities as well, but I focus on the bands.  It draws a couple hundred thousand people each year. 

You are guaranteed to see (1) a band you’d loved forever and always wanted to  see (Bob Dylan, 2010) (2) a band you’d heard about but never listened to (Band of Horses, 2008) and (3) a band you’d never heard of and now is your new favorite after seeing them (Thee Oh Sees, 2011).  This has been going on for 11 years for me.

I love Bumbershoot because I can really escape into several days of music festival culture and not think much about work.  Ah, but I do.  There are great lessons about – you guessed it – compensation at Bumbershoot.  Here are a few from this year.

1 – Imagine if you could assemble a team of 50 or so superstar talented people and get them to perform under rigorous conditions, week in and week out.  They are so good at what they do that tens of thousands of people applaud for them every few minutes or so.  (When was the last time that happened with your work?)  As they later mingle they talk about the passion they have for their work, the great people they work with, and so on.  In casual conversation, they also volunteer information about their pay for this demanding role, just as a side comment but also as a part of the passion they have for their role:  Minimum wage.

2 – An individual begins to speak and perform and a crowd gathers.  Dozens of people watch his talents for about 15 minutes.  As he introduces his final task, he explains why the observers should pay, suggests how much they should pay, and why it is reasonable for them to pay for what they have just enjoyed.  His hat is passed and it overflows with cash.  I estimate that he’s made the equivalent of about $200 per hour.  Much better than minimum wage, even in the state of WA with the highest minimum wage in the US.

3 – Another performer quietly displays his world-class talent (he has won multiple international competitions) standing on the side of the path.  Saying nothing to the passing potential audience, and answering questions in a single phrase, he continues with his amazing work.  His hat lies on the ground with no sign or other indications.  His hat overflows with cash.   I sensed that while he surely liked the cash he was there for the adoration of his quirky talent.

4 – A well-known performer finishes up her set on one of the major stages and notes that she will be at the tent adjacent to the stage after the show, inviting the audience to come by and say hello.  The tent also has CDs, t-shirts, and other items for this artist.  People line up, shake hands, and spend.

I spoke directly with at least one person of each of the four examples above, in detail, about compensation.  (OK, I’m a hopeless compensation geek at a music festival.)  In all cases, I didn’t have to ask, the information was volunteered or obvious.  They are all extremely satisfied with their compensation model and results.

Noticeably absent from this year’s Bumbershoot lineup were the mega-acts that are making a lot of money just to play, before t-shirts and CDs, and no hat is necessary  (though Bob Dylan wore a really stupid looking hat last year). 

Much of the compensation delivered this year, like every year at Bumbershoot, was through a voluntary process, or didn’t involve cash at all. 

Pay and Performance.   Compensation plan designers:  Look into it.

#bumbershoot

Everything That Glitters May Now Be Gold

In the 1990's and into the 2000's, employee stock options glittered.  When the glitter faded due to market downturns and increasing volatility, new forms of equity compensation emerged to restore the sheen - option exchanges and repricing and restricted stock units.  This past week's market volatility, economic uncertainty, and the contributing factors took away a bit of the remaining glitter.  

With widespread concern about equity investments, what has been the newest shining light?  Gold.  But we can, and in many cases must, compensate employees with equity and we can't do that with gold...can we?

Beyond the surging price of gold in response to global economic, financial, debt, and currency issues, there are some trends underway not gaining the attention of mainstream media that point to a growing influence of gold as a currency.  Does this open an opportunity for considering gold as a form of employee compensation? 

While this may appear to be a “fringe” idea, such a view would place the world’s most prominent countries, most sophisticated investors, and a dozen US states on this fringe.

This, of course, is all intended to stimulate discussion.

• My accounting and valuation colleagues will point out the technical issues (with pay linked to a commodity)
  
•  My tax colleagues will poke holes in the court cases and cite the Code
  
•  My legal colleagues will undoubtedly identify all of the reasons that this is a poor idea and the possible liabilities resulting
  
• My equity plan administration colleagues will curse me for recommending a non-equity form of compensation (can the software platform handle a ”restricted gold” award?)
  
•  My survey and proxy data colleagues will wonder where gold would be categorized on a data input questionnaire and in the database.  A full value award?  Bonus? Other LTI?
  
• And of course, my corporate governance colleagues will cite the horrendous outcome of decoupling compensation from shareholder value. 

Not unlike issues we’ve faced with other “new” pay vehicles, like cash long-term incentive awards.

I’m providing a few links below that set the stage for what I believe will be a discussion over the next year that will move from what may appear to be a humorous alternative, perhaps even satirical, view to a central discussion point in employee compensation planning – designing, delivering, and measuring pay value if and when the bottom falls out of both the global economy and the US currency. 

Some of these links are on sites that are clearly pro-gold, anti-US currency, and even a bit anti-government, but some are a bit more credible.   All are factually true.  Sources of these excerpts are available at the links.

Winning the Tax Case in 2007…

The essence of the argument is that under the Constitution Congress is obligated by law to mint and circulate such coins as demand requires, and must establish the value of coins as they are used as legal tender, but the coins' market value, arising as valuable personal "property," is a distinct, separate attribute of such coins, and is of no legal consequence if the coins are used as legal tender.

In other words, if a worker is paid with such coins, his taxable "income" (if any) can only be the face value indicated upon the coin money paid -- i.e., $1.00 for a circulating silver dollar or $50 for a circulating gold U.S. coin. Not surprisingly, the IRS has never issued any public guidance regarding this significant issue.

But Losing the Tax Case in 2009…

(Defendant) faces up to 296 years in prison and fines of up to $14 million, Brower said. (Co-defendant) faces up to 71 years in prison and fines of up to $2.75 million.

Note:  The above cases were not just about the use of gold coins as compensation but had a number of counts of fraud and conspiracy related to hiding assets and other tax-avoidance actions.

The Technical Tax and Legal Points

The government called three accountants to testify. The defense asked each one, “What is the proper way to calculate income for purposes of the Internal Revenue Code if you are paid in a gold coin that has a $50 face value on it?” All three of them responded, “I do not know; I’ll have to research that.”  One of them had a masters degree in taxation.

No Federal Court of Appeals has ever ruled that the gold coins in question must be reported to the IRS based on FRN (Federal Reserve Note) market value.

Utah Legalizes Gold, Silver Coins as Current (22-May-2011)

Utah became the first state in the country this month to legalize gold and silver coins as currency. The law also will exempt the sale of the coins from state capital gains taxes.

Earlier this month, Minnesota took a step closer to joining Utah in making gold and silver legal tender. A Republican lawmaker there introduced a bill that sets up a special committee to explore the option. North Carolina, Idaho and at least nine other states also have similar bills drafted.

What Would Have Happened If…?

20-20 hindsight being what it is, I still find it interesting to do a what-if analysis.  For example, what if the typical Nasdaq company 12 months ago had granted gold instead of restricted stock units (RSUs) with a one year cliff vesting date? (based on Tuesday, 16-August-2011 closing prices) – with RSUs represented by the Nasdaq Composite Index and gold represented by the SPDR Gold Trust ETF (click on links to see price charts):

S&P 500 vs, Gold, 1-year

Nasdaq:  +15.66%
Gold:  +45.26%

What about a 5-year view?

S&P 500 vs. Gold, 5-year

Nasdaq:  +22.63%

Gold:  +177.341%

Hmmm.  7.8x. (The 10-year comparison is around 10x).

So What?

Will companies start using gold to pay employees?  Probably not.  Will some company somewhere do it?  Probably so.  We cannot discount the effects of political views of boards of directors, CEOs, and private company owners in the employee compensation decision process. And some people just love a new idea and being the first to try it.

Maybe a company will grant gold (or a gold derivative) as a confidence-builder when inflation returns and employees realize that meager salary increases, like current interest rates,  are really a negative number.

Or as an element of an employee choice program – bonus, stock options, or gold coins?

Or when the stock market crashes again, options go underwater, RSUs represent a fraction of their grant value, and yet another option exchange program loses its luster.

Or maybe a gold coin will replace the holiday bonus, with employers grossing-up for taxes.  Better that than a turkey, which is what the US dollar may turn out to be.

Zoellick Says China Currency To Be Global Player (14-August-2011)

World Bank president Robert Zoellick a gathering of the Asian Society in Sydney on Sunday that the renminbi and other Asian currencies may form a basket of currencies in the future that play the role as the international reserve and trade currency instead of the current US dollar-based global finance and trade system.

Just looking ahead.

A New Generation of Performance Plans?

Over the past few years we have seen performance share units and other varieties of performance-based awards grow in prevalence in response to a series of corporate governance concerns.  What concerns? Stock options, time-vested awards, executive ownership levels, and most importantly the link between pay and performance.

In this first round of say-on-pay in the US this spring, we saw these issues raised as key points in investors’ and proxy advisers’ voting policies and actions.  The new say-on-pay environment has turned the dialogue on these plans from anecdotal comments to a chorus of complaints about the manner in which these plans have been designed and operated over the past few years and the resulting impact on corporate governance.

While performance plans have been adopted to resolve some governance issues, they are creating new governance challenges which are not always apparent or easy to identify and measure.  We have identified TWENTY unique governance issues specific to performance plans and how companies can address these issues before next year’s say on pay votes.  Resolving these issues will result in the next generation of performance plans.

Equity compensation, long one of the list of items considered by investors, has become a central corporate governance issue and equity compensation professionals need to understand and be able to respond.

Here are some resources for learning more about this issue:

Performance Problems?  Addressing Emerging Issues with Performance Plans

 

Solium Transcentive Synergy Conference

12-14 September 2011, Scottsdale, AZ

Panel discussion with Fred Whittlesey, Elizabeth Dodge (Stock & Option Solutions), and Takis Makridis (Equity Methods)

This session will be videotaped for those unable to attend the Conference

The Next Generation of Performance Plans?  Fixing Governance Ups and Downs

 

Global Equity Organization - National Equity Compensation Forum

14-16 September, Scottsdale, AZ

Panel discussion with Fred Whittlesey, Elizabeth Dodge (Stock & Option Solutions), and Takis Makridis (Equity Methods)

The Governance Ups and Downs of Performance Plans (book chapter)

by Fred Whittlesey

Performance Awards

GPS:  Guidance - Procedures - Systems

Performance Awards

Fred Whittlesey, contributing author