This undoubtedly will be a pivotal year for finance in all kinds of ways. It is debatable whether one issue, executive compensation, is deserving of so much attention, given the deep seismic shocks across the financial system. Still, market and governmental forces are aligning in the direction of vast change on the pay front.
Companies may break with current practices on underwater stock options, bonus calibration, golden handcuffs, and the mix of long-term and short-term elements of compensation packages, among others. They likely will be pressed to make greater disclosure of executive comp programs, and they may even be required to give shareholders an advisory vote on top managers’ pay.
At stake is nothing less than the public perception of their business acumen — a pretty important asset in the current shaky climate. “We’re going to see companies either applauded or criticized based on how they respond to these challenges,” says Mark Poerio, a compensation and benefits partner at the law firm Paul Hastings.
This year will see more than half of U.S. companies (54 percent) paying smaller bonuses for 2008 performance than for the prior year, according to a survey of 513 companies released today by Towers Perrin. And 4 in 10 expect executive bonuses to be 25 percent or more below last year’s levels. Almost three-quarters (73 percent) say the financial crisis has affected their approach to setting 2009 performance targets.
Paul Hastings held a media briefing this week to outline the array of shifts in the executive compensation arena that are already under way or expected to take shape in 2009.
The vast majority of stock options — at least 85 percent, according to published reports — are under water and likely to stay there for a long time.
At one time, it was common for companies to simply reprice options during economic downturns in order to hang onto their top talent. But a wave of repricings in the early 1990s led to the Securities and Exchange Commission issuing strict disclosure rules and a surge in shareholder activism on the issue that has not quelled to this day. Right now, sentiment against repricings is so deep that very few companies have taken that route. Others, at most, are weighing the costs and benefits of such a move very conservatively.
There was, though, a recent major exception: Google, which replaced all of its employees’ worthless options with new ones at current market value carrying a one-year vesting period. Poerio sees that move as a likely harbinger of a thaw in companies’ cold shunning of repricings.
“I think we’re going to see companies straightforwardly wrestling with it, and some other leaders like Google will come out, and there will be an escalation of repricings, despite the last 15 years of shame that goes with them,” he says. “In this cataclysmic downturn, you might have to rethink your prejudices and acknowledge the value of repricing if you want your people to stay.”
In the Towers Perrin survey, 26 percent of responding companies have addressed underwater options or are reviewing the issue, up from just a handful of companies in the firm’s fall survey.
Options that are 5 or 10 times lower than their strike price may be worse than worthless. In Poerio’s view, they are psychologically debilitating: “It’s a thorn in your side — a constant reminder of what the company used to be worth and what it is worth now.”
The Long Haul
Even before the current crisis and the new public focus on executive compensation, companies were giving long-term and performance-based awards greater weight in pay portfolios. That shift promises to accelerate markedly now.
But it will raise a significant issue: What happens if there is a three-year cycle for an award, and it is clear at the end of the first year that the goal cannot possibly be achieved — for market reasons, say — regardless of an executive’s performance over the next two years? Here too, retention would be jeopardized. Some boards are already saying they may keep the discretion to recalibrate long-term awards every year, or even every six months. Poerio calls such a strategy “quicksand.”
It does smack of an attempt to do an end run around shareholders’ preference for performance-based awards. Smart boards won’t make that mistake. “There will be a real premium on very, very careful design of long-term incentives, working in both performance and adjustments based on the market, as well as peer-group performance,” Poerio says. “That complexity is worth it, if you really want to have incentives that work.”
Give It Back
Borrowing a page from the Troubled Assets Relief Program for bailed-out financial firms, many companies will be rethinking their clawback provisions. Also expect changes to severance-and-control benefits.
Currently, many companies either have no forfeiture provisions for someone leaving to join a competitor — the traditional meaning of “golden handcuff” — or they have inconsistent ones that evolved individual by individual. That will change in 2009, but the discussion won’t end with disloyalty scenarios. More companies will institute clawbacks that will kick in if an executive is guilty of fraud or abuse, if there is a financial restatement, and even if the company miscalculated the award.
Theoretically, the more clawback provisions there are, the less appealing the award is. But, Poerio points, out, loyal executives who do their jobs properly are not at risk. He mentions one client that was talking about having a clawback for financial restatements that would apply to the past three years’ awards. “At that moment the executive team jumped up and said, ‘No way we’ll agree to that!’ And everyone else in the room was thinking, ‘Something must be wrong here.’ “
More companies may make clawback provisions retroactive, though trying to get back money paid three years earlier could pose some legal challenges. Paul Hastings favors designing provisions under which the company holds most of the money for a year; if the payout is $100,000, the executive will get $25,000 immediately and the rest after a year if he hasn’t left the company or not fulfilled his obligations.
For many years the typical severance for a CEO has been three times annual salary, with CFOs and others one level down getting two years’ or at least one year’s pay. But there generally has not been a performance-based component to that equation.
Now, with so many companies performing poorly, there is great sentiment against huge severance for their departing executives. “You’re going to see much more accountability in severance,” Poerio says.
Executives who get larger-than-normal golden parachutes may have to give up some of the cash.
Under IRS rules, a payout greater than three times annual salary is hit with an additional 20 percent tax on top of ordinary income taxes. Many employment contracts include “gross-ups” — an agreement that the company will pay that penalty.
Now, though, a movement is afoot to do away with gross-ups — not only for newly hired executives, but also when existing executives’ contracts are up for renewal, notes Paul Hastings partner Eric Keller.
An Open Book
A year ago, there was a lot of talk about how some companies were still being slow to expand the analysis of executive compensation in their proxy statements, as the Securities and Exchange Commission required in 2006. By this year, though, most will have begun to give the SEC at least some of what it wants.
In fact, because of the financial crisis and the consequent effects on executive pay programs, many proxies will reflect changes made after the close of their fiscal year. As with the Management Discussion and Analysis section, the Compensation Discussion and Analysis section is required to be up to date as of the document’s filing.
One item that likely will receive more attention in CD&As is risk assessment — the relative riskiness that the executive compensation structure will create. Short-term, profit-based incentives typically carry greater risk than longer-term, growth-based incentives, for example.
Hewlett-Packard recently gave a jolt to activist shareholders’ efforts to push Say on Pay measures by announcing that it was voluntarily adopting the measure. While only a handful of companies have approved the advisory vote on executive compensation packages, this year more than 100 resolutions calling on companies to do so have been filed for 2009 proxy consideration.
But according to the Paul Hastings attorneys, these efforts are likely to become moot this year. That’s because legislation introduced by Rep. Barney Frank in the House and co-sponsored in the Senate by then-Senator Barack Obama, which would mandate Say on Pay for public companies, stands a good chance of passing.
“We’re hearing from our Washington sources that it has a lot of traction and is very likely to pass,” says Poerio. HP, meanwhile, has thrown its weight behind the bill.
But in some cases, meanwhile, institutional shareholders are using the threat of Say on Pay as leverage. Keller tells of a client that was approached by TIAA-CREF, a major institutional shareholder, which said it planned to propose a Say on Pay initiative — unless the company agreed to proactively address a list of 10 other issues.
Unrelated to Say on Pay, Poerio tells of another client that had a compensation policy that denied incentive awards to the top five executives in the event of a financial restatement. An institutional shareholder pressed the company to apply it to the top 100 executives. “They wanted greater protection against what they perceived as their No. 1 threat,” he says.
This Shall Not Pass
Is there anything that won’t happen on the executive comp from this year? Yes, according to Paul Hastings banking partner John Douglas: Barney Frank’s aggressive legislation that, among other things, would prohibit any incentive compensation for the top 25 officers of companies that accepted government-bailout funds.
“That is an amazing thing, when you think about it,” says Douglas, who was general counsel for the Federal Deposit Insurance Corp. 20 years ago during the savings-and-loan crisis. “My sense of Congress is that there’s almost no idea that’s a bad idea. Whether you need your airplane or not, sell it. No bonuses for your top 25 officers? Sure. But then how do you compensate the next 25 officers? Banks already have a hard time competing for talent, and this would just exacerbate the difficulty.”
But he adds that for those reasons, the bill stands little chance of passing. “I just think [Frank] wanted to make a statement,” Douglas surmises.