Beneath the Hype: Notes on Key Executive Compensation Issues

This post from George R. Bason, Jr. is by colleagues Ning Chiu, William M. Kelly, Kyoko Takahashi Lin and Barbara Nims.

It’s proxy time, and business reporters are riding their favorite seasonal hobby horse: executive compensation. This year’s stories are colored by the current financial and business crisis, by the impact of various government assistance programs and by a Congressional response that has bordered on hysteria. A few compensation practices are receiving recurring attention, at times disproportionate to their actual prevalence or current impact. Here are some thoughts on a few of these practices.

Option Exchange Programs (“Repricings”)

Professors Black and Scholes have established that even underwater stock options have theoretical value, but try telling that to your employees. With so many options deeply underwater in the current market, companies are examining alternatives such as offering to exchange underwater options for new options or other compensation. Google, Intel and Starbucks are among the companies that have announced such programs. As of this month, 23 companies had completed programs this year, and over 50 additional companies have announced programs.[1] Technology companies, whose grant practices typically cover a broad employee base, have been leading the trend.

Shareholder approval is a threshold question for companies considering repricing. Most plans adopted in recent years expressly require shareholder approval for repricings. What if the plan is silent about repricings? Under NYSE rules, silence is equivalent to a prohibition. Nasdaq takes the same view as an interpretative matter, although its rules are not so explicit.

Even in the unusual instance where the plan expressly permits repricing, companies should consider the likely reaction of institutional shareholders and their advisers, like RiskMetrics Group (RMG). RMG will generally recommend a withhold vote in the following year for members of compensation committees that have implemented repricings without shareholder approval. Unless your ownership or governance arrangements allow you to be indifferent to such matters (for example, Google), shareholder approval will likely be appropriate.

If you seek shareholder approval, you should design the exchange program with RMG’s guidelines in mind. These include:

• excluding directors and executive officers from the program;• making the exchange “value for value”, meaning that employees will receive fewer options than they surrender;

• excluding options with a strike price lower than the stock’s 52-week high; and

• attaching holding periods and other restrictions to the new options to enhance retention incentives and avoid quick flips.

The benefits of any significant variations from the guidelines should be weighed against the possible risks of non-approval.

These limitations, coupled with the time and expense of obtaining shareholder approval and then conducting an SEC-registered exchange offer, have deterred some of our clients from attempting to implement option exchanges. These companies have instead looked to other tools, such as tapping more deeply into the existing equity pool, granting restricted stock in lieu of options or enhancing cash programs (including deferred cash awards).

Recoupment of Compensation (“Clawbacks”)

What happens to a bonus that is “earned” and paid, but that in light of a later restatement would not have been paid if the financial statements had been correctly stated or performance accordingly measured in the first place? Historically, the answer has usually been “nothing”. A limited form of “clawback” was included when Sarbanes-Oxley was enacted in 2002, but this provision is not privately enforceable and has had little effect.

Recent events, though, have moved clawbacks to center stage. Concern over “unearned” compensation, especially in the financial sector, is increasingly causing clawbacks to be viewed as a governance best practice. The Troubled Asset Relief Program (TARP), for example, has a clawback requirement broader than Sarbanes-Oxley. It requires participating financial institutions to recover any incentive compensation paid to senior executives based on criteria that are later proven to be materially inaccurate.

As usual, the larger companies have been pushed to be the early adopters. A 2008 survey of 428 companies in the S&P 500 showed that about 34% have adopted clawback policies, while adoption rates are much lower among smaller companies.[2]

Shareholder proposals in this area tend, in our experience, to be blunt instruments, giving little or no consideration to basic questions like:

• should clawbacks be applied to executives on a strict liability basis, or only where the executive is “at fault” or has committed fraud?• how do you enforce a clawback for historical periods if there is no contractual basis for a clawback?

• what about departed executives?

• perhaps most significantly, what if the board concludes that pursuing a particular clawback is not in the interests of the company because, for example, it will jeopardize the retention of a key executive who has done nothing wrong?

In our view, it is important for boards to retain discretion in this area, and we have had some success negotiating with activist shareholders to change sweeping unconditional proposals into a form that allows for board judgment and nuance. A policy that requires the board to consider a clawback arrangement in designing and implementing compensation programs may serve as a useful discipline. By contrast, a strict policy that could force the board to act in a way that it believes will impair shareholder value seems ill-considered.

Perquisites and Tax Gross-Ups

Executive perquisites remain an easy target. The New York Times website now features a “Perks Watch” reporting on the latest nuggets culled from proxy statements: club memberships, home security, sports tickets and that enduring favorite, the personal use of corporate aircraft. No matter that perks almost always constitute a small percentage of total compensation and a negligible expense for most companies.

This year’s twist is RMG’s increasing focus on the reimbursement of income taxes on executive perks (tax gross-ups). RMG believes that gross-ups are “poor pay practices” that can lead it to recommend “withhold” or “against” in the election of the entire compensation committee. Since RMG has a lengthy list of “poor pay practices”, the weight and import of any particular factor is unclear. Some companies have agreed, after RMG issued its draft report, to cease the practice going forward and have filed additional soliciting materials in order to avoid a negative recommendation from RMG. So, while perks continue to survive, paying the executives’ associated taxes may be going out of style.

RMG has also, although not as consistently, criticized tax gross-up provisions in change-in-control agreements. The focus here has tended to be on “single trigger” arrangements, in which payments are triggered by a change in control, irrespective of whether the executive has been terminated or has “good reason” to resign.

Advisory Votes on Executive Compensation (“Say-on-Pay”)

Say-on-pay has been hotly debated, but slowly adopted, over the past few years. Some major companies, such as Hewlett-Packard and Intel, made news this year by deciding to give shareholders an advisory vote on executive compensation, but even so, until February only about 20 companies were proposing to adopt such a proposal voluntarily this year, while over 100 companies were planning to resist shareholder proposals on this topic.

The playing field changed when the American Recovery and Reinvestment Act (ARRA), and subsequent SEC interpretations, made say-on-pay a reality this proxy season for companies that had received U.S. government assistance. In the next few months, we will see hundreds of companies subject to a say-on-pay vote. How shareholders react may prove a bellwether for the future, especially with the looming threat of Congressional or SEC action to mandate say-on-pay for all U.S. public companies. There is, of course, no empirical or logical reason to think that an up-or-down advisory vote on compensation will provide useful guidance to boards and compensation committees, or lead to improved compensation practices. But, for better or worse, say-on-pay is looking like the flavor of the month, and the momentum in favor of its adoption may be irresistible at many companies.


[1] According to Radford Underwater Exchange Portal, as of April 2009, see here.
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[2] A Corporate Library study in July 2008 found that of 2,536 companies surveyed, only 13% disclosed having adopted clawback provisions.
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