Articles

Executive pay has been dominating the headlines of late. This should not be surprising in view of the expansion of companies' stakeholders to now include a country's taxpayers. In the case of AIG, this populist sentiment reached such intensity that there were threats of physical violence, real or perceived, against the recipients of executive bonuses. The media helped to feed this frenzy with daily reports of who made how much, who approved it, what could have been (but wasn't) done to stop it and whether or not bonuses were returned and by whom.

Implicit and often explicit in all this is that these bonuses or other components of long term salary compensation are undeserved and bear no relationship to company performance or shareholder rewards. What is also becoming clear to some in this debate is that government doesn't have an especially good record in managing businesses, where the emphasis is (or should be) more on flexibility, risk taking and creativity than on pay equity.

However, where flexibility, risk taking and creativity are unchecked then we have the existence of moral hazard which is the prospect that a party insulated from risk may behave differently from the way it would behave were it fully exposed to the risk. Moral hazard arises because individuals (i.e., company executives) or institutions (i.e., brokerage, banking and insurance firms) do not bear the full consequences of their actions, with a consequent tendency to act less carefully than they otherwise would, leaving another party (i.e., the U.S. taxpayers) to bear some responsibility for the consequences.

An atypical reprice - Google's road less traveled

Overlaying this are a growing number of option exchange proposals in the U.S., which to shareholders appear to be a classic case of a 'heads I win, tails I break even' proposition. Since the start of 2008, 114 companies have proposed or completed plans that would exchange underwater stock options, according to research firm Equilar Inc. Although the majority of these firms are in the technology sector, companies range from Williams-Sonoma to Starbucks, with Intel having just announced a program on March 23.

Perhaps one of the most prominent option exchanges of late is Google, whose stock had dropped 56 percent in 2008 prior to rising 11.7 percent through April 7, 2009. In Google's case, which is atypical of more recent exchanges, Google's employees exchanged old higher priced options for the same number of new lower priced options. Further, Google conducted the exchange without shareholder approval and allowed executives to participate in the plan. Details of the program and the results of the exchange follow.

• Each tendered option (Eligible Options are those granted prior to February 3, 2009 that have an exercise price per share greater than the last reported sale price on March 6) will be exchanged, on a one-for-one basis, for a New Option.
• Each New Option will have an exercise price equal to the closing Google share price on March 6, 2009.
• Each New Option will have a term that is equal to the Eligible Option remaining term.
• The new vesting schedule will add 12 months to each vesting date under the Eligible Option's current vesting schedule, including vesting dates that have already occurred.

As published in an Amendment to Schedule TO, filed with the SEC on March 10, Google disclosed that for the cancellation of old options, it accepted to purchase 7.6 million shares from 15,642 participants, representing approximately 93% of the total shares eligible for exchange. The exercise price per share of the options granted in the Exchange Offer is $308.57. (In its last 10-K disclosure, Google reported 9.6 million options priced between $301 and $700, representing 69% of the 13.9 million options outstanding as of December 31, 2008.)

The move by Google sparked concern that other companies would exchange options without asking investors’ permission.  However, because of rules introduced by the New York Stock Exchange and the Nasdaq in 2003, after the last round of re-pricings, companies are generally required to obtain shareholder approval prior to conducting a tender offer (Google has a clause in its options plan allowing the above offer without a shareholder vote).  “Most companies don’t have that kind of exclusion, and even those that do will likely seek investor approval,” said Patrick McGurn, special counsel at Institutional Shareholder Services, a unit of RiskMetrics Group.

The majority of recent stock option exchanges have been value neutral, meaning that the options exchanged (or tendered) are valued the same as the new options granted, usually by granting a smaller number of options and less frequently by shortening the option’s contractual term.  However, because the Google exchange is on a one for one basis, the re-pricing will cost the company approximately $460 million to be recognized over the vesting period of the new options. 

The turn towards say on pay

A countertrend to the above is the use of ‘say on pay’ in annual shareholder votes.  The Securities and Exchange Commission formally notified the 400 companies receiving “bailout” funds that they must submit their executive pay plans to an advisory shareholder vote this year.  Meanwhile, Congress is likely to extend that ‘say on pay’ requirement to all exchange-listed companies.

This ‘say on pay’ trend is also becoming evident in Canada.  According to Janet McFarlane, in a March 24, 2009 article in ReportonBusiness.com, during the past month, ten of Canada's largest companies agreed to an annual non-binding shareholder vote on CEO pay. As per McFarlane, James Baillie, who serves on the Board of Directors to Sun Life Financial Inc., which has adopted ‘say on pay’ in recent weeks, said, “it might be an advisory vote, but it would be a brave board that flouts its shareholders in this area.”

Also in the McFarlane article, Canadian corporate director and governance advocate Peter Dey says the votes may be attractive to institutional investors, but they don't convey to a company what investors specifically dislike about a compensation plan. He says direct dialogue between the institutional investors and the board is more effective.  But Stephen Griggs, executive director of the Canadian Coalition for Good Governance which represents most of Canada's largest institutional shareholders, says investors want ‘say on pay’ as a way to protest when direct dialogue doesn't work.

‘Say on pay’ in the U.S. includes newly proposed caps on bonuses as a percentage of salaries among the most highly compensated individuals at companies receiving any form of taxpayer assistance. In addition, a recently proposed “punitive” tax of up to 90% on selected bonuses is potentially leading to management by legislative fiat.

Goldman Sachs has informally begun dialogue with Treasury regulators about repaying the $10 billion in TARP funds it received.   Bank executives in general are finding the government scrutiny and potential compensation limitations associated with bailout money onerous and stifling.   “We’ve indicated our desire to repay TARP capital sooner rather than later, but obviously won’t do anything without the approval of our regulators,” Goldman Sachs spokesman Lucas Van Praag said.

However, the government may be reluctant to let banks pay back the TARP money now, because it could remove some of the leverage that the government and taxpayers have as a condition of the TARP funds and pressure other companies in a weaker financial condition to return the funds to their detriment.

Evaluating future paths

Clearly, many boards have been either asleep at the wheel on executive compensation or complicit in this race to the top, where some executives tend to overestimate their own achievements. A combination of corporate governance recommendations from the U.S. National Association of Corporate Directors and RiskMetrics guidelines regarding ‘say on pay’ proposals suggests that companies and boards will be evaluated on the following:

• Does the company use independent compensation consultants?
• Do the consultants use an appropriate peer group for performance and compensation comparisons?
• Is there a strong link between executive pay and performance, and are the performance criteria and targets appropriate?
• Are employment agreements, severance agreements and change of control provisions appropriate?
• Is there a significant pay disparity between top executives and the CEO compared to other employees in the organization?
• Is the CEO evaluated and remunerated on grooming a successor?
• Is the board responsive to investor input on compensation issues?

Time is running short, and by potentially being obstructionist, companies and their boards invite the sort of legislative mandates on executive compensation that they have so far avoided.  In other words, if they don’t do the job, someone else will do it for them.

Jim McBride
Managing Principle
Solium Equity Consulting Services Inc.

Mary is at it again and public companies should be on guard. In a recent move that furthers the distance between herself and the ‘red tape’ policies of her predecessor, former SEC Chairman, Christopher Cox, Mary Schapiro announced that the Commission is getting stricter by instituting guidelines geared to making it easier to “launch formal investigations” and get “approval for levying penalties”. Many of the changes formally outlined during her March 11th address to the Subcommittee on Financial Service and General Government had been brought to light in Senate hearings since her Dec. 18th nomination. Schapiro reiterated that in light of the financial crisis which will likely plague the global economy for a while to come, the Commission needs to send a message that “corporate wrongdoing will not be tolerated”. She has made some decisive initial steps to protect investors and bolster confidence in the markets including:

1. Ending the two-year Penalty Pilot program, streamlining the process for Enforcement staff in security fraud cases, making it easier for them to seek appropriately high penalties;
2. Increasing speed of approval procedures for formal orders of investigation to ensure subpoenas can be rapidly utilized in order to ensure witness testimony and collect needed investigation documents;
3. Hiring Robert Khuzami as the new Director of the Division of Enforcement to usher in internal reforms such as risk assessment, additional training and supervision of personnel and leveraging technology;
4. Review of tip, complaint and referral processing procedures by the Center for Enterprise Modernization to readily identify the need for potential enforcement action – an issue who’s importance was amplified through the Madoff scam;
5. Working with staff, specifically the Office of Compliance Inspections and Examinations, in order to focus on those firms identified as high-risk;
6. A revamp to the ratings process to bring greater transparency ad accountability including additional rules added to the Credit Rating Agency Reform Act;
7. Development and addition of technology to enhance the SEC’s ability to handle tips and mine data to better identify areas and companies where closer investigations are needed.

To fund these and other initiatives, Schapiro admits that the current SEC resources will be insufficient but this formal statement follows two weeks after the unveiling of Obama’s budget plan where he had asked for a 13% increase to the SEC’s 2008 budget of $974 million.

The SEC needs to act promptly, decisively, and with resolve.

- Mary Schapiro
SEC Chairman

Other changes are bound to be revealed over time, including the possible reinstatement of some form of the Uptick Rule that limits short-selling stocks, something the SEC will be looking into in greater detail during their April 8th meeting. Change is coming as Schapiro stresses that those who break the law are taking advantage of those who have invested in that company. So, with a new sheriff in town, Shapiro is cracking the whip as she threatens wrongdoers with an “unrelenting law enforcement agency in the SEC” which “needs to act promptly, decisively, and with resolve.”

As higher levels of scrutiny are being place on the evaluation of how executive salaries are being determined, the proposed amendments to the rules regarding compensation disclosures by the Canadian Securities Administrators (CSA) came into effect on December 31, 2008, for the 2009 proxy season. In order to give further clarity to investors as to the process for determining the amount awarded to executives, annual disclosures must include a Compensation Discussion and Analysis section where the following topics are presented:

• the objectives of the compensation program;
• what the compensation program is designed to reward;
• each element of compensation (instead of just salary and bonus);  
• why the company chooses to pay each element;  
• how the company determines the amount for each element (including how they are calculated);  
• how each element of compensation and the company’s decisions about the element fit into the company’s overall compensation objectives and affect decisions about other elements;
• any new actions, decisions or policies that were made after the end of the most recently completed financial year that could affect a reasonable understanding of an Named Executive Officer’s compensation for the most recently completed financial year;
• benchmark­ing data used in determining compensa­tion including the peer group and how companies were included and excluded in the selection criteria; and
• performance goals based on objective identifiable measures (or if targets are subjective, a description of the targets without providing specific measures).

The most significant change is the summary compensation table which clearly outlines the total compensation the executives receive and the more expansive definition offered by the CSA which states that compensation disclosures must include "all plan and non-plan compensation, direct or indirect pay, remuneration, economic or financial award, reward, benefit, gift, or perquisite."  

Most software providers, including Solium Capital, are responding by facilitating the production of the annual compensation table. This is available in Shareworks through the Canadian Executive Disclosure Report.

Regular Section

The Cost of GAAP to IFRS Transition

The expected cost of converting from GAAP to IFRS for US companies is from 0.1-0.7% of annual revenue according to a recent report from consulting firm Accenture. This is a far cry from the 0.05% it cost European public companies to do so in the four years of their transition.

This high cost is due in part to the SEC requirement that US firms will need to report in both GAAP and IFRS while undergoing the transition. The major costs are expected to come from technology upgrades, training accounting staff and the implementation of new internal processes. For an in-depth analysis of the impact the transition will have on stock option and incentive plan valuations and the administration of those plans, please read the related article in the next edition of KnowledgeWorks.

Option Backdating Ruling Protects Guilty Execs

The Sarbanes-Oxley Act was enacted in July of 2002, over six and half years ago, but the legalities of the clawback provision in Section 304 haven’t really been tested until recently. Sarbox Section 304 – Forfeiture of Certain Bonuses and Profits states that if an issuer is required to restate any financial reporting due to misconduct, the CEO and CFO shall reimburse the issuer for “any bonus, (profits) or other incentive-based or equity-based compensation received by that person from the issuer” in the 12 months following the misstated filing.

At the end of the last quarter, a ruling by US District Judge Jean Hamilton wiped clear the clawback requested by the SEC against Michael Shanahan, former CEO of Engineered Support Systems (ESSI). While guilt was admitted and sentences issued for the criminal charges in his role in backdating options (see The SEC Hit List), the SEC lost the civil case (which could have resulted in a repayment of $35 million by Shanahan to ESSI) because, despite the need for financial reports to be corrected, no actual filing was made. Hamilton ruled that "before penalties may be imposed, an issuer must be compelled or ordered to prepare a financial restatement, and must actually file the restatement." By this ruling, regardless if restatement of financial reports is needed and justified, if no such submission is actually made, the perpetrator(s) cannot be required by the courts to issue a repayment to the issuer under Sarbox Section 304. The initial intention may have been for Section 304 to be a serious deterrent to CEOs and CFOs but as it is now being tested in court, the bark looks to have been worse than the bite.

The SEC Hit List

Individual(s)	Title	Company	Charge	Status	Penalty
Vincent Smith	Exec. Chair	Quest Software	Stock Option Backdating from 1999-2005 of 11 million shares of common stock	Settled	Execs settled for $300K total but Quest restated $113.6 million in operating income due to backdating
John Laskey	Former CFO
Kevin Brooks	Former Controller
Michael Shanahan,Sr	Former CEO	Engineered Support Systems	Stock option backdating from 1997-2002	Pleaded guilty to criminal charges	Shanahan Sr.: 3yrs probation, $40K fine, $7.9 mil in restitution Gerhardt: 15 months jail, 2 years probation Shanahan, Jr.:1yr probation
Michael Shanahan, Jr.	Member of Comp. Committee
Gary Gerhardt	Former Finance chief

Pink Slips May be More Common but They Could also be Fatter

With layoffs typical across most industries, there is some potential light at the end of the tunnel for those hit hardest by the economic downturn. Yes, companies are looking at every aspect of business to reduce costs, but severance packages are holding their own with 65% of companies leaving the packages unchanged while 19% are actually increasing their offerings¹.

Unemployment rates reached 8.5% in the US in March, with 5.1 million jobs lost since the start of the recession. However, many companies have learned from the layoffs during the 2001 recession and are offering better severance terms including outplacement services and extended periods of pay and health insurance. In the interest of maintaining a positive brand impression, remaining an employer of choice and avoiding possible future litigation, employers may offer sweeter deals or are willing to negotiate the terms of a severance.

The tendency to negotiating the terms of a severance package is also becoming more common, with the number of employees doing so having increased threefold from 2001 to 2008. Possible areas for negotiation could include payment for unused vacation time, extension of health care benefits, unpaid bonuses and extended eligibility to hold stock options after the date of termination. It may not result in the package received by former GM CEO Rick Wagner who was allowed to keep $3.000.000 worth of stock options (although they are at prices from $20-$76, so may not go above water before they expire), $366,602 in unvested stock awards, and $534, 627 in deferred compensation, but there may be flexibility in the initial terms offered.

1. Survey conducted by Lee Hechy Harrison, released March 30, 2009. As published in: http://www.bloomberg.com/apps/news?pid=20601103&sid=aIcXwLoInGIk&refer=us

A Look at What Others are Doing with Underwater Options

As of February 2009, 72% of Fortune 500 companies have underwater options and since Q1 2008, 114 companies have taken some sort of action to address options. Let’s take a look at what actions companies are taking: