What Is the Real Value of an Incentive Compensation Award When It Is Made?

Joseph E. Bachelder is special counsel in the Tax, Employee Benefits & Private Clients practice group at McCarter & English, LLP. The following post is based on a column by Mr. Bachelder which first appeared in the New York Law Journal. Andy Tsang, a senior financial analyst with the firm, assisted in the preparation of this post. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).

The value of an incentive compensation award to an executive often is significantly less than the award’s “target value.” Target value for this purpose means the amount “targeted” for payout at the end of an award period if conditions to which the award is subject are satisfied. These conditions may be based on achievement of performance targets or simply based on continued employment during a stipulated period of time.

Delay in payment and accompanying risk factors over the period the award is to be earned out may reduce or eliminate that target value. Understanding the real value of such an award at the time it is made to the executive is very important. It impacts on the negotiation of pay packages and is reflected in executive pay information included in proxy statements and in reports in the media regarding executive pay. [1]

In April and May of this year, six federal agencies issued proposed rules under Dodd-Frank Section 956 (Proposed Rules) that would further reduce the value of incentive compensation awards at the time of grant for many executives at large financial institutions by requiring deferrals beyond the date they are earned and by adding to the risk factors. The Proposed Rules were published jointly in the Federal Register on June 10, 2016. [2]

This post first explains why incentive compensation awards, when granted, are often worth significantly less than their target value. Second, it discusses how the Proposed Rules under Dodd-Frank Section 956 further reduce value at the time of grant by increasing risks accompanying incentive compensation awards in the financial services industry. Finally, a chart is provided summarizing approximate discounts in value attributable to the factors discussed in Parts I and II. The discount percentages shown are rough estimates, reflecting a combination of survey data, commentary and the author’s own experience.

Part I: Value Applicable to Incentive Compensation at the Time Awarded

Following are several factors that cause an incentive compensation award at the time of grant to be worth less than its target value.

  1. A discount must be made for delay in payment. A dollar (i.e., the target award) to be received one year or several years from today obviously is worth less than a dollar received today.
  2. Risk of loss due to termination of employment must be taken into account. The discount for this factor is based on the likelihood that an executive’s employment will terminate prior to vesting of the award and, if so, whether the award will be forfeited in whole or in part.
  3. Risk of loss due to failure to attain performance goals must be taken into account. The discount for this factor reflects the attainability of the award’s performance goals, the length of the performance period and the variation of the payout amounts based on performance results. This factor does not apply, of course, to awards that are time-vested only.
  4. Value must be discounted for stock market risk during periods of deferral for those awards that are equity-based. The discount depends on the company’s stock price volatility. A company with a high stock price volatility generally will indicate a higher discount than a company whose stock price has a lower volatility (i.e., grows more consistently). This factor does not usually apply to annual bonuses, which typically are awarded in cash.
  5. A discount must be made for risk of clawbacks. This discount factor takes into account clawbacks required by statutes as well as clawbacks imposed by companies under policies that go beyond statutory requirements. (A “clawback” for this purpose refers to the requirement that an executive pay back to the employer the full, pre-tax amount previously paid to the executive if certain circumstances occur.) Statutory clawbacks include those imposed by Sarbanes-Oxley Section 304 on the CEO and the CFO of a public company in certain circumstances in which a financial restatement has been required. [3]

Part II: Proposed Rules under Dodd-Frank Section 956 Would Further Reduce Value of Awards at Certain Financial Institutions

The Proposed Rules under Dodd-Frank Section 956 impose additional restrictions on “incentive-based compensation” awarded to many executives at large banks and other financial institutions. The Proposed Rules define “incentive-based compensation” as “any variable compensation, fees, or benefits that serve as an incentive or reward for performance.” [4]

The rules create three levels of “covered institutions”: Level 1—those with consolidated assets of $250 billion or more; Level 2—those with consolidated assets of $50 billion or more but less than $250 billion; and Level 3—those with consolidated assets of $1 billion or more but less than $50 billion. [5]

The Proposed Rules begin by requiring that incentive-based compensation of “covered persons” at all three levels of covered institutions must balance “risk and reward,” must not be “excessive” in amount, and must be subject to good risk management and controls and to effective corporate governance practices. [6]

The most significant of the new rules in terms of risk and its impact on value are those implementing the requirement that there be a balance of “risk and reward.” They would require (i) deferral of payment beyond the earn-out date of a portion of an incentive-based compensation award, (ii) forfeiture of the award, in whole or in part, for violation of certain risk-related requirements and (iii) special clawback rules. These new rules would apply to “senior executive officers” and “significant risk-takers” at the larger covered institutions.

These two categories of covered persons are defined as follows:

  • “Senior executive officer” means a covered person who holds the title (or, without regard to title, performs the function) of one or more specified positions at a covered institution for any period of time during the relevant performance period. Over a dozen positions are listed in the Proposed Rules, starting with the president and the chief executive officer. For more detailed discussion, see FDIC Proposed Rule Section 372.2(gg).
  • “Significant risk-taker” means any other covered person whose incentive-based compensation equals 50 percent or more of base salary and who (i) is “highly compensated” (among the top five percent (Level 1 institution) or top two percent (Level 2 institution) in base salary plus incentive-based compensation) or (ii) has the authority to commit or expose to risk a specified level of capital of the covered institution as set forth in the Proposed Rules. For more detailed discussion, see FDIC Proposed Rule Section 372.2(hh).

In addition, each federal agency is given discretion to add other covered persons to the category of significant risk-taker at the covered institution over which it has jurisdiction.

Following is a further discussion of the three new rules, noted above, relating to “risk and reward.”

Deferral of Awards. Deferral of incentive-based compensation awards to a senior executive officer or a significant risk-taker would be required as follows:

Only a portion of an incentive-based compensation award could be paid out at the end of the performance period in respect of which the award is earned. The portion that could be paid out would vary between 40 and 60 percent of the award depending on circumstances described in the Proposed Rules. [7] The other portion must be deferred as noted in the next paragraph. [8]

In the case of an annual bonus (or other short-term award) payment of the deferred portion must be delayed for another three or four years (depending on the size of the institution) following earn-out at the end of the performance period. (There is a limited exception noted at the end of this paragraph.) In the case of a long-term incentive plan (LTIP) award (defined in the Proposed Rules as one with a performance period of three years or more) payment of the deferred portion must be delayed for another one or two years (depending on the size of the institution) following earn-out at the end of the performance period. The Proposed Rules do permit a limited acceleration of the deferred portion of any award (short or long term) by permitting payout on a pro rata annual basis during the deferral period.

Forfeiture or Reduction in Award Amounts Due to Failure to Comply with Risk Avoidance Requirements. The Proposed Rules impose a number of requirements relating to the avoidance of financial and operational risks at the covered institution. Failure by a senior executive officer or a significant risk-taker to comply with these requirements would cause forfeiture, or at least reduction in payout, of the award. These consequences would apply only if the failure occurs during the performance period (or, if later, through the end of the deferral period). Failures to comply include (i) taking inappropriate financial risks and (ii) taking actions that result in poor financial performance due to deviation from risk parameters established by the covered institution’s policies and procedures. For other requirements to be taken into account, see FDIC Proposed Rule Section 372.7(b).

Clawbacks for Misconduct, Fraud or Misrepresentation. The Proposed Rules require that incentive-based compensation paid to a senior executive officer or a significant risk-taker be “clawed back” in the event that the applicable covered institution determines that the senior executive officer or significant risk-taker engaged in “(1) misconduct that resulted in significant financial or reputational harm to the covered institution; (2) fraud; or (3) intentional misrepresentation of information used to determine the senior executive officer’s or significant risk-taker’s incentive-based compensation.” Under the Proposed Rules, the clawback period applies for seven years following payment of an award. [9]

In addition to the requirements noted in this Part II, the Proposed Rules contain numerous other provisions relating to incentive-based compensation. These other provisions would not impose time and risk elements on incentive-based compensation to the extent of those relating to “risk and reward” discussed above in this Part II. [10]

Examining the Gap

The following chart summarizes the gap between award-date value and target value (expressed as percentage discounts) for incentive compensation awards. As already noted, the discounts shown are only estimates and may vary significantly in particular situations.

Summary of Discounts in Incentive Compensation Award Values at the Time Awards Are Made Reflecting Estimated Reductions for Time and Risk Factors

Discount Factor Annual Bonus LTIP Award*
A. Discounts Generally
1. Opportunity cost for time value of money due to delay in payment during applicable period 4% 12%
2. Risk of forfeiture (or reduction in value) due to termination of employment during applicable period 5% 15%
3. Risk of forfeiture (or reduction in value) due to failure to attain performance goals 5% 10%
4. Stock market risk during applicable period 0% 15%
5. Risk of clawback 1% 3%
Aggregate Discount ** 14% 44%
B. Additional Discounts for Certain Executives at Large Financial Institutions Subject to Proposed Rules under Dodd-Frank Section 956
1. Additional opportunity cost for time value of money due to additional delay in payment during deferral period under Proposed Rules 6% 3%
2. Additional stock market risk due to deferral-related requirements under Proposed Rules 5% 0%
3. Additional risk of forfeiture (or reduction in value) during performance period and deferral period due to failure to comply with the risk-related requirements under Proposed Rules 10% 15%
4. Additional risk of clawbacks under Proposed Rules during 7-year clawback periods 5% 5%
Aggregate Discount** 24% 22%
Aggregate Discount (all discount factors)** 35% 57%
* An LTIP award is assumed to have a 3-year earn-out period.
** Each of the “aggregate discount” figures is calculated by applying the preceding individual/aggregate discounts on a cumulative basis.

The chart was compiled by the author and senior financial analyst Andy Tsang.

Conclusion

The chart explains the components of the significant gap in value between the target value of incentive compensation awards and their worth to executives at the time the awards are made (i.e., the time at which the award opportunity is communicated to the executive). This gap, represented by the discount percentages shown in the chart, is due to time (the period between the date on which the executive is informed of the award opportunity and the date on which the award is paid out) and risk factors as summarized in the chart.

The chart indicates that annual bonuses are generally worth, at the time the executive is informed of the award, approximately 85 percent of the amount that will be paid out (approximately one year later) if the target is achieved. (This reflects the 14 percent aggregate discount for an annual bonus shown immediately below line A.5 of the chart.) After taking into account the Proposed Rules under Dodd-Frank Section 956, the relative value of the original award is substantially less—approximately two-thirds of target value—for annual bonuses of many executives at large financial institutions. (This reflects the 35 percent aggregate discount for an annual bonus shown at the bottom of the chart.)

The chart indicates that the gap between award value and target value is greater for LTIP (three-year) awards than for annual bonuses. LTIP awards, for example, tend to be worth, at the time of grant, in the range of 55 percent of their target value. (This reflects the 44 percent aggregate discount for an LTIP award shown immediately below line A.5 of the chart.) After taking into account the Proposed Rules under Dodd-Frank Section 956, the grant date value for many executives at large financial institutions will drop to below one-half of target value. (This reflects the 57 percent aggregate discount for an LTIP award shown at the bottom of the chart.)

It is important that parties to the negotiation of executive compensation packages be aware of these differences between value at the time an award is made and the target value. Otherwise the parties may assume a value at the time of award that does not exist. Likewise, unless these differences are recognized, the reporting on executive pay in filings with the SEC and in commentaries in the media may be inflated over actual values at the time of award.

Endnotes:

1 The discussion in this post is made in the context of public companies. Incentive compensation awards, of course, are made in private as well as public enterprises. Risks directly associated with enterprise value itself (reflecting operating and/or financial circumstances) generally impact on such awards, especially equity-based awards, more directly and significantly at a private company than at a public company. Discussion of operating and/or financial risk is beyond the scope of the post. Accordingly, incentive compensation awards made to management of private enterprises are not directly addressed in the post.(go back)

2 81 Fed. Reg. 37669. The agencies issuing the Proposed Rules are the Federal Deposit Insurance Corporation (FDIC), the Board of Governors of the Federal Reserve System (Federal Reserve), the Securities and Exchange Commission (SEC), the Office of the Comptroller of Currency, Department of the Treasury (OCC), the Federal Housing Finance Agency (FHFA) and the National Credit Union Administration (NCUA). The six sets of Proposed Rules are very similar. Because of this similarity, citation to a Proposed Rule, unless otherwise noted, is to the rule as proposed by just one of the agencies—the FDIC.(go back)

3 Another statutory requirement is imposed by Dodd-Frank Section 954 (not the subject of this post). That section provides that, in the event of a financial restatement, stock exchanges must require a listed company to claw back from its senior executives’ incentive compensation amounts paid to them that exceed the amounts that would have been paid absent such financial restatement. (The proposed rule issued under Dodd-Frank Section 954 on July 1, 2015 was discussed in a prior NYLJ column (Sept. 18, 2015).) The clawback requirements of the proposed rulemaking under Dodd-Frank Section 956, applicable to covered financial institutions, are discussed in Part II of the text.(go back)

4 See FDIC Proposed Rule Section 372.2(r). Commentary has varied as to whether this definition includes awards that are time-vested only. Presumably this point will be clarified in the final version of the rules.(go back)

5 For purposes of the Proposed Rules, each of the six agencies provides its own definition of “covered institution”—identifying those financial institutions over which it has jurisdiction. For each of these respective definitions, see FDIC Proposed Rule Section 372.2(i), Federal Reserve Proposed Rule Section 236.2(i), SEC Proposed Rule Section 303.2(i), OCC Proposed Rule Section 42.2(i), FHFA Proposed Rule Section 1232.2(i) and NCUA Proposed Rule Section 751.2(i).(go back)

6 For discussion of these general requirements, see FDIC Proposed Rule Section 372.4. “Covered person” means “any executive officer, employee, director, or principal shareholder who receives incentive-based compensation at a covered institution.” FDIC Proposed Rule Section 372.2(j).(go back)

7 See FDIC Proposed Rule Section 372.7(a)(1)-(2)(i).(go back)

8 The Proposed Rules require that deferred incentive-based compensation amounts contain a “substantial” portion of equity and a “substantial” portion of cash. The Proposed Rules do not define what “substantial” means. See FDIC Proposed Rule Section 372.7(a)(4)(i).(go back)

9 See FDIC Proposed Rule Section 372.7(c). An incentive-based compensation award that is paid out in two or more installments will have a separate seven-year clawback period as to each installment.(go back)

10 For discussion of these other provisions, see FDIC Proposed Rule Sections 372.5, 372.7(a) and 372.8-11.(go back)

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