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.

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 CompensationStandards.com 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...

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

Fred Whittlesey

Compensation Venture Group, Inc.

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 25^th 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

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.

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.

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!

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.