Tag: Executive Compensation

Executive Compensation: Realized Option Pay

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The October 2010 study of executive compensation, “What do CEOs Realize from Option Pay?” by Mark Anderson and Volkan Muslu of the School of Management, the University of Texas at Dallas, looks at the estimated fair market value versus realized value of CEO options pay relative to incompleteness of option transfer rights and tenure with company. The study considers the incompleteness of the transfer of option rights to the CEO at grant date due to performance vesting conditions, black-out and minimum equity holding restrictions, and forced exercise or forfeiture provisions upon resignation. Also, the authors discuss the flaw in relying on values derived from option pricing models since they do not factor in the performance vesting contingencies, and the distribution of outcomes is not as balanced as is anticipated in the models (e.g., Black Scholes), resulting in an asymmetrical option payout structure. The study also looks at externally versus internally hired CEOs, as well as how this factor influences the cash realization of option pay.

Using pay data of 1,403 CEOs who began and ended their tenures at all S&P 1500 companies between 1992 and 2007, their findings include the following:

• 29% of CEOs stayed in their positions for less than two years and realized only 16% of their nominal option pay.

• 31% of CEOs stayed between two and four years and realized 40% of their nominal option pay.

• 20% of CEOs stayed between four and six years and realized 57% of their nominal option pay.

• 12% of CEOs stayed between six and eight years and realized 77% of their nominal option pay.

• CEOs with eight years or longer tenure realized proceeds equal on average to their nominal option pay.

• Similar relationship exists between firm performance, CEOs’ tenure, and realized option pay.

For more details on this study, see http://business.gwu.edu/accountancy/files/effect-mandatory-ifrs-adoption.pdf.

Executive Compensation: Reporting Equity Values

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Executive compensation is almost synonymous with equity compensation given that 60% or more of executive pay is aligned with equity instruments. The two most prevalent pricing models used to value equity compensation are Black Scholes and Binomial (Lattice). Understanding the fundamental design of these models can aid the executive compensation practitioner to manage the information requirements for disclosure, to assess effective equity plan designs, and to enhance compensation communications.

Since 2005, the accounting regulations Financial Accounting Standard (FAS) 123R and its subsequent replacement, ASC 718, in 2009, have required companies to report the fair value (FV) of all equity-based compensation which becomes an expense that directly affects the income statement. The Black Scholes or Binomial models are used by most (if not all) publicly traded corporations to report the FV of equity compensation.  These models take into consideration plan design characteristics, allow for sensitivity analysis with volatility assumptions, and reflect exercise behavior realities. The standard inputs to both models are:

Current stock price

Exercise price

Risk free interest rate

Expected dividends on stock

Expected stock price volatility

Expected term of option

Companies are required to disclose in Annual Reports / 10-K filings the assumptions and input values used in these valuation models. Determining the value for expected term relies on the behavior of employees who hold options and is less predictable. For private firms (who tend to use Black Scholes), the expected volatility of their stock is also less predictable since they have no trading history like public firms. The stock price, exercise price, risk free interest rate, and expected dividends tend to be more stable inputs to the models.

According to a June 2010 Radford Survey, the number of companies adopting the Binomial model for FV calculations has increased over 1149% since 2003 (see http://www.radford.com/home/ccg/valuation_services/Binomial_Model.pdf). The Binomial (Lattice) model is more dynamic, lends itself to simulation techniques, and allows for a range of values for volatility, risk free interest rate, and expected term. Becton Dickinson adopted the Binomial model in 2004 and its recent Annual Report disclosed sets of 3-years of assumptions and inputs used in the valuing its stock appreciation rights (SARs).

For both models, there is a generic version plus several variations that capture granular assumptions to make the models more predictive, albeit more complex. Depending on the complexity of the equity programs, the business model in which the organization operates, and the cost/benefit trade-off of adopting a more complex pricing model, it can incorporate one or more of these additional variables:

  • Expected holding period and exercise history (both pre- and post-termination).
  • Vesting period and company-specific exercise rules.
  • Termination rate or forfeiture rate (the probability of a vested option being canceled).
  • Blackout periods and arrangements for automatic exercise.

Plan Ahead for Executive Compensation Consultant Independence

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Additional Dodd Frank rules related to executive compensation will likely be approved before the end of 2011. One of the rules is disclosure of compensation consultant independence. The rule will likely require disclosing answers to the following questions:

  • Did the compensation committee retain a compensation consultant?
  • Was a risk assessment conducted to determine if there is a conflict of interest with the work performed by the compensation consultant?
  • What was the outcome of the assessment, and how were any identified risks addressed/mitigated?

This rule is similar to the legislation enacted in 2000 regarding independence of auditing firms and the non-audit services they provide which may impair independence. A similar thought process will be needed to demonstrate independence by reviewing and disclosing the following:

  • Other services provided by the compensation consultant’s employer
  • Compensation consultant’s ownership of stock of the company
  • Relationship between the consultant and a member of the compensation committee
  • Policies/procedures of consultant’s employer designed to prevent conflicts of interest
  • Fees paid to the compensation consultant’s employer as a % of employer’s total revenues

Executive compensation consulting firms typically offer supplemental services which may compromise independence and create potential conflicts of interest. Figuring out how independence should be addressed may require prohibiting other services to be provided by the consulting firm. A common practice used by some organizations to diffuse the independence concerns is to not use a compensation consultant every year but rather every two or three years, allowing for some trending for the new plans and pay programs. Another solution is to define a process establishing “arms length distance” for services received or rendered by the consulting firm or client organization to ensure no conflict of interest. Some supplemental services that may impinge on the consulting firm’s independence are:

  • Market pay survey databases and related salary administration services
  • Non-qualified deferred compensation consulting
  • Actuarial and valuation services
  • Insurance brokerage and investment advisory services
  • Tax financial planning and/or investment advisory services
  • Human resource outsourcing services
  • Executive search and individual executive advisory services

To further illuminate this independence concern, there was a recent study, “Compensation Consultant Independence and CEO Pay,” published January 2011 suggesting that compensation consultants that also provide “other services” positively correlated to compensation consultant recommending higher executive compensation pay levels. (For additional information, use this link and click on “one-click” download: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1735506).

An outgrowth of this independence requirement is the increased use of “boutique” executive compensation consulting firms that do not “sponsor” executive compensation surveys/data and exclusively use third party surveys. Many of the principals of these boutique firms are former executives of the global HR Consulting firm that offer services in executive compensation:

Quiksilver Executive Compensation Disclosures in 2011 Proxy Statement Filing

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Let’s take a closer look at the disclosures related to executive compensation in the Compensation Discussion & Analysis (CD&A) section of Quiksilver’s recent proxy statement, filed February 9, 2011 for its upcoming annual meeting on March 22, 2011. Some of the key highlights are as follows:

  • The compensation committee did not use a compensation consultant or any professional third party consulting services for fiscal year 2010 to evaluate their executive compensation programs.
  • Annual Base Salary: Philosophy is to pay a base salary that is at or above the midpoint of the applicable salary range for “similarly situated” companies; the compensation committee has not identified a specific or consistent group of companies that is similarly situated.
  • Annual Discretionary Cash Bonus: This is paid out based on financial and operating performance, as well as the executive officer’s individual performance in the prior fiscal year. Quiksilver recently announced that it adopted a formal incentive cash bonus plan.  The compensation committee intends to establish specific financial targets and personal objectives for each named executive officer under this plan with respect to the 2011 fiscal year; a Form 8-K was also filed in this regard.
  • Long Term Incentive Plan (LTIP): The LTIP pays a percentage of base salary based on EPS growth with a maximum of 200% of the salary. There were no payments for the fiscal year ending October 2010. The board has no plans to issue new awards and it currently has no awards outstanding.
  • Equity Based Compensation: Quiksilver has a Discretionary Stock Option Grant and Restricted Stock Program. Although discretionary, it restricts the administrators from being able to set the grant date price lower than the fair market value of stock on the day of grant. Grant size and vesting triggers are completely discretionary.There were no grants of restricted stock made to an executive in the fiscal year 2010.
  • Perquisites: This includes health and group term life insurance benefits, supplemental long-term disability benefits, 401(k) matching, and a clothing allowance. The committee eliminated a component of the COO’s expatriate allowance, which previously provided him with a monthly stipend to cover educational and other general cost-of-living expenses.
  • Severance/Change in Control: Each named executive officer has an agreement in place for five possible termination scenarios: with cause, without cause, good reason, retirement, and change in control. The Golden Parachute 280G excise taxes are not triggered based on these agreements.

Compared with the prior year filing, the severance agreement reported this year increased significantly (i.e., from 80%, up to 148%).

After highlighting these disclosures, it is worth reviewing the company’s overall stock price history.

Stock Price History: 
http://www.marketwatch.com/investing/stock/ZQK 

It appears Quiksilver has been struggling for the past two years.  In the event they are a possible target for acquisition, perhaps this can explain the severance agreements being adjust proactively. For additional information, see a Wall Street Journal article by Brendan Conway as well as a Seekingalpha.com article by Brian Sozzi.

Restricted Stock Awards: Changing Executive Compensation

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Top executives often receive equity in the company as a large proportion of their total compensation. Which equity instruments corporations use to make those equity awards has changed significantly over the past decade. The use of Stock Options (SOs), where executives have the right to purchase company stock at a certain price after vesting, has dropped dramatically, being replaced with Restricted Stock Awards (RSAs), where, after vesting, ownership of the stock is automatically transferred to executives.

ERI Economic Research Institute has documented changes in top executive compensation since 1997, when RSAs comprised about 10% of the average top executive compensation, and SOs represented 43%. By the end of 2010, the picture was dramatically different. RSAs accounted for 31% of total compensation, while SOs were only 27%. There are some good reasons why RSAs are often a more attractive form of equity compensation for both employers and executives.

The Executive Perspective:

When companies issue SOs and business performance doesn’t improve, executives have options that are worth nothing. Even if the stock price is higher than the award price, executives have to take action to realize a benefit. RSAs, on the other hand, are never underwater and, when vested, do retain value, even if the value is less than the stock price when awarded. Also, there are some tax rules where executives can have a more favorable effective tax rate once the RSA is vested by filing certain information with the IRS and the employer within 30 days of the grant. (See http://www.fairmark.com/execcomp/sec83b.htm for more information on this Section 83(b) election.)

The Employer Perspective:

Equity compensation is intended to motivate executives to stay with the company and make decisions from an owner’s viewpoint. The accounting cost of SOs are less than RSA, so organizations will award more SO than RSAs.  The larger grant sizes coupled with lucrative upside, SOs can foster more risk taking where executives can artificially inflate the stock price for personal gain. On the other hand, since RSAs tend to be smaller grants, they are less dilutive and are preferred among executive populations that have conservative business practices.

Example:

An SO is granted at $20 per share but trades at $10 when the option vests. The stock option is worth $0.00. However, an RSA granted at $20 that trades at $10 when vested is still worth $10. The SO is underwater and has no value, while the RSA has retained 50% of its value.

Executive Compensation: Which Companies Are Proactive with Say-On-Pay?

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With the heightened sensitivity toward executive compensation pay levels, there have been recent announcements indicating that companies are adjusting pay decisions relative to their organization’s performance and overall economic conditions. Some announcements related to executive compensation show that companies are proactively adapting.

  • Bank of America kept the base salary of CEO Brian Moynihan flat at $950,000, but his pay package will include $9.05 million in restricted stock units.  No senior executives will receive cash bonuses.  Three other senior executives at the Charlotte, N.C.-based bank are getting salary increases of 6.25 percent, to $850,000 from $800,000, in addition to stock awards.
  • In January 2011, Citibank reported a $10.6 billion profit for 2010 and announced that the base salary of its CEO, Vikram Pandit, was adjusted to $1.75 million.  In 2008, Citibank received a $45 billion bailout from taxpayers and soon after, in February 2009, the CEO reduced his pay to $1.00 until the firm returned back to profitability.  Pandit declined a bonus for the 2010 performance year.

Also encouraging, some companies recently took say-on-pay requirements into consideration during their annual shareholders meetings:

  • Becton, Dickinson held its annual shareholder meeting on February 1, 2011, and its shareholders approved management’s say-on-pay proposal regarding executive compensation and voted to hold say-on-pay votes annually.
  • At Monsanto’s annual meeting on January 25, 2011, the agriculture company’s investors voted for an annual advisory vote on executive compensation: 62.2% for annual, a 35.9% for triennial, 1.4% for biennial, and 0.5% abstentions.  The Board announced they would implement the annual advisory vote on executive compensation although it was non-binding.

With the advent of say-on-pay requirements, we will continue to see more collaboration between Boards of Directors and shareholders, as well as alignment of executive compensation decisions with shareholders and pay-for-performance relative to external market conditions.

Executive Compensation: Say-On-Pay

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This week the SEC approved the non-binding Say-On-Pay rule. This is one component of the executive compensation provision of the Dodd Frank Act, a comprehensive financial regulatory reform enacted due to the collapse and near demise of many industry giants, like Lehman Brothers and AIG. The executive compensation provisions are intended to discourage companies from awarding lucrative packages that encourage risky behavior. Other components of the executive compensation provision include clawbacks (e.g., recouping executive compensation in the event of an accounting restatement), compensation committee and adviser independence, enhanced compensation disclosures, and corporate governance.

Shareholders can now vote on executive compensation packages, at minimum, once every three years. They also will have separate nonbinding votes on golden parachutes, which are compensation arrangements with executive officers in connection with merger transactions. The timeline for implementing the new rules is set for 2011 annual meetings for public companies with public investors owning greater than $75 million worth of shares. Smaller companies will have until 2013.

Although the Say-On-Pay rule is nonbinding, companies must disclose in public filings whether they followed the shareholder vote. If the Board does not make adjustments to executive compensation based on the shareholder vote, it may face negative repercussions like dissension between the Board and shareholders, the wrath of major shareholder advisory firms, a negative impact on investor confidence and public image, and directors may not get re-elected. In the UK, a similar rule has been in place since 2002 and, as a result, has more effectively linked pay to performance, improved communication among boards, management, and institutional investors, and aligned shareholders and management.

Currently, there are some 80 companies that have already implemented Say-On-Pay prior to this recent SEC approval. To date, shareholders at only three companies — Motorola, Occidental Petroleum, and KeyCorp — have voted against executive compensation packages.  Shareholders have voted against tax gross-ups, in which executives receive compensation to reimburse them for taxes on perquisites.

How should companies prepare to implement say-on-pay?

  • Establish formal communication plans
  • Proactively identify potential executive pay issues and concerns in advance
  • Make transparent the rationale behind their executive pay programs in the proxies’ Compensation Discussion and Analysis section
  • Partner with proxy advisors
  • Work with key institutional shareholders