Equity and fairness

Compensation committee members are finding themselves at the center of the storm as regulators, exchanges and investors put compensation policies under the microscope, while directors are being targeted by withhold campaigns by pension funds for giving executives fat pay packets. 

Compensation committees are increasingly looking for ways to guarantee that their decisions on executive compensation will meet with shareholder approval. Institutional investors are making it clear they want awards to be fair and above all, performance-based. 

Committees at larger companies are increasingly using equity awards based on performance to motivate and reward executives, according to a survey of 50 large US companies by Pearl Meyer & Partners, a New York-based pay consultant. Performance-based incentives, including restricted stock, made up 41 percent of long-term CEO compensation in 2004, up from just 18 percent in 2003, according to the survey. The average CEO salary remained at $1.2 mn, while the average long-term incentive doubled to $2.7 mn. For example, Stanley O’Neal, CEO of Merrill Lynch, was paid a 2004 compensation of $32 mn, of which $31.3 mn was restricted stock that won’t vest until 2009. In 2003 only 40 percent of his $28 mn pay was restricted. 

Restricted stock does not vest until either a specified amount of time has passed or a target such as earnings per share is reached. Consultants say restricted stock that does not vest for many years is one way of aligning the interests of executives with those of the company, and that long vesting periods promote long-term strategic thinking. For executives, restricted stock is more valuable than options in today’s bearish market, and typically is not taxed until it vests. The main factor pushing companies to award restricted shares and move away from options is the Financial Accounting Standards Board’s (Fasb) decision to require the expensing of stock options on the income statement. 

‘For restricted stock, the shares have value on the day they are awarded, even if there isn’t a lot of subsequent appreciation, so executives get something of value they didn’t really have to pay for,’ explains Mark Borges, a principal at Mercer Human Resource Consulting. 

Getting the balance right is a new challenge for some compensation committees. ‘The issue of restricted stock awards is new for many compensation committees,’ says Thomas Desmond, an attorney at the Chicago law firm of Vedder Price who advises companies on compensation matters. ‘Many companies solely awarded stock options because there wasn’t any financial statement expense associated with them. It was viewed as a low-cost way to provide incentives and retention tools. But options sometimes motivated management to focus on short-term rather than long-term value creation.’ 

Pay for pulse

Investors, especially large public pension funds affiliated with labor unions, say without performance-based criteria for vesting, restricted stock will not promote innovation. The American Federation of State, County and Municipal Employees (AFSCME) has filed a proposal at Bristol-Myers Squibb requiring some of the drug giant’s CEO pay be in performance-based restricted stock. ‘It had poor performance with higher than average executive pay,’ says Richard Ferlauto, director of pension and benefit policy for the union. Other companies are also facing the wrath of public pension schemes with similar shareholder proposals. ‘We call restricted stock with only a time requirement ‘pay for pulse’. We want to see measurable performance-based benchmarks,’ says Ferlauto. 

Although equity-based compensation is a hot-button issue this proxy season, so are two other matters: benchmarking and fairness to other employees in the firm. Without true independence, diligence and intelligent counsel, no executive compensation plan is going to meet the stringent tests set by investors and their advisers. Committees cannot consider equity-based compensation in a vacuum – it must be part of a well-thought-out plan. 

‘When considering equity-based compensation, the committee needs to think about what it wants to accomplish: the goal might be to incentivize, retain and further align the interests of management with those of shareholders,’ observes Desmond. That means the committee must decide how much of executives’ pay should be in fixed and how much in variable, performance or time-based awards. These decisions create the core of the company’s compensation philosophy, and should guide the committee’s decisions on the amount and make-up of any executive award. Often companies hire consultants and/or lawyers to help them settle on the best policy. 

Benchmarking is usually conducted by outside consultants, who look at several factors, including sector, size and salaries in the geographic region. Only a few years ago, management typically hired the consultants and drew up a pay plan. 

‘Management now has pretty much stopped designing its own compensation program,’ says Borges. ‘In the past, the CEO or CFO would hire the consultant and the report would be presented to the committee for approval. What you are seeing now is the committee taking on full responsibility for designing the compensation program for executives.’ 

Clear disclosure

Investors and consultants say firms are falling short of clearly detailing what criteria are used for the vesting of restricted stock. ‘What I find troubling is disclosure of compensation in proxy statements – we need much more rigorous regulation,’ comments Andrew Oelbaum of executive compensation onsultancy ExecPay in New York. ‘The SEC needs to monitor disclosure more aggressively. If you’ve technically met the rules but don’t tell the full story, it amounts to a misrepresentation.’ 

Proxy Governance, an independent proxy advisory service, advocates the committee provide as much information as possible in the proxy statement. ‘Compensation committee reports have been very boilerplate,’ says Jim Melican, director for policy at Proxy Governance, adding that he expects explicit information about the targets executives have to reach for stock to vest, whether based on earnings per share, return on equity, share price gains or revenue growth. ‘Certainly in the proxy statement there’s no reason they cannot be that specific: after the fact, it’s not competitive information,’ he explains. 

Some companies are even publishing the targets and objectives at the beginning of the year, although often that level of disclosure has come as a result of shareholder actions protesting excessive pay. 

‘We think Siebel’s disclosure should be the model going forward. It disclosed details about how it will measure performance, what the criteria are and how they are weighted,’ says Ferlauto, referring to the California-based software maker. Siebel Systems now publishes detailed information in its 8K on when and how its restricted stock awards will vest. It also lists, in advance, the circumstances under which executive bonuses will be paid. 

In general, the trend is toward more disclosure. The stakes are high: consider Disney, NYSE and other recent infamous cases. If committees fail to justify and document their decisions, they could end up with their names sullied in newspaper reports, or worse – in court.