Compensation Committees

2014 Trends in Executive Compensation and Governance

Posted by Jeff McCutcheon on January 20, 2014 / Posted in Compensation Committees

The following represents our assessment of executive pay, governance and how these factors impact the role of the board member in 2014.

Our Environment in 2013

Pay. In 2013 the S&P 500 total return was 31.9%, the strongest since 1997. The rapid climb in value resulted in substantial wealth gains by investors as well as many CEOs and directors. The S&P gains also highlight two longstanding issues with executive pay that directors must confront. First, that pay plans often fail to differentiate relative performance, where “all ships rise with the tide”, second, and related, that a single measure such as total return may measure results, but the results may be unrelated to management’s actual contribution and success in their roles.

In 2013 we saw generally conservative executive pay actions. The average CEO salary increased by roughly 1%, with 2 of 3 CEO’s seeing no increase at all. Option usage declined slightly, offset by a corresponding increase in the use of performance-based restricted stock or stock units. Perhaps the result of modest economic growth and the maturity of the Say-on-Pay regulation, restraint was evident. It will be interesting to see how this general trend is affected by the equity market escalation; I expect 2014 pay disclosures will reflect more aggressive pay actions.

Regulation. Regulatory and pseudo-regulatory bodies were more reserved than prior years. Heavyweight pay influencers such as ISS and Glass-Lewis refined benign issues such as peer group methodologies and danced around more volatile issues such as pay-for-performance standards.

The SEC, with 4 major regulations outstanding from the 2009 Dodd-Frank legislation, effectively told the market they would address the CEO pay ratio and punt on the remaining issues (i.e., pay-for-performance disclosure, hedging and claw-backs[1]). SEC changes announced in 2012 becoming effective in 2013 and 2014 such as Compensation Committee member and advisor independence, were generally not disruptive to most companies.

The IRS established no new landmarks. Taxation of carried interest plans as ordinary income (currently treated as capital gain) remains a target. The IRS refine its thinking on the timing of deductibility of annual bonus plans. Similarly, no new accounting changes impacting executive pay were implemented in 2013.

In all, it was a quiet year for the traditional players in executive pay.

Investors. For many compensation committee members 2013 distinguished itself as a year of change in the role of the shareholder. In 2013 we saw continued evolution of the role of shareholder litigation in executive pay, where the derivative litigation industry used failed Say-on-Pay votes, 162(m) disclosures, as well as minor pay reporting errors as grounds for derivative suits against the company and the board. While very few of the fiduciary-based derivative lawsuits were successful, companies and Compensation Committees were often involved in prolonged, expensive and distracting efforts to defend themselves.

Takeaway from 2013. In 2013 we saw what is likely the waning of relative influence of ISS and Glass-Lewis[2]. Several large institutional investors such as Vanguard, Fidelity and Blackrock developed their own proxy analysis/governance groups, with some explicitly stating they no longer followed ISS recommendations. In addition, statements from both Canadian and US securities regulators indicate a willingness to regulate[3] the proxy advisor industry in reaction to what was perceived as heavy-handed practices by the industry leaders.

Also in 2013, as mainstream institutional investors proved they were willing to join, or sometimes lead, shareholder efforts to drive change in companies[4], compensation committee members found themselves much more involved in shareholder outreach programs. For 2013 Georgeson reported 58% of large public companies undertook a formal outreach effort[5]. The single most “popular” reason for the effort was to explain CEO pay, followed by company strategy.

Looking Into 2014

At the macro level, it is reasonable to believe several trends will be of consequence to compensation committee members and their companies in 2014.

Pay. Since 2008 we have seen a steady shift away from stock options, primarily to performance-vested RSU’s (at least for post-TARP organizations). This aversion to stock options was driven by a number of sources, arguing that the asymmetric risk characteristics of an option were conducive to excessive risk taking and placed the executive in a market-timing conflict with other investors. These arguments coincided with a major market correction which at least temporarily wiped out nearly all option gains held by executives, resulting in little desire to contest the conclusions of pay critics. With the market now restored to pre-recession levels, a gradual return to stock options is likely. We can expect a shareholder-endorsed “Stock Option 2.0” will be granted with share retention requirements as well as potential limitations on exercise timing, directly addressing prior investor and pay critic concerns.

In addition, we believe that companies will increasingly rely on some form of realized pay in addressing pay-for-performance concerns from investors. Compensation committee members are reminded that we still generally define “competitive” executive pay in terms of SEC reporting standards, where pay opportunity (e.g., Black-Scholes), not value received (realized pay), is the comparator. Committee members need to be mindful of the difference, and be certain this distinction is communicated to investors and other stakeholders.

Proxy Advisors. There is a good chance the SEC will withdraw the original 2003 no-action letter that provided institutional investors with fiduciary “cover” when they relied upon a recommendation from a proxy advisor[6] for voting their shares. Such a change, coupled with individual institutional investors fighting to directly establish their own agenda in the boardroom, may mean multiple standards for acceptance of pay actions and the end of what was previously an ISS “safe harbor”.

Institutional Investors. We expect that “problematic pay practices” will remain a point of contention with institutional investors. However, we should expect they will address the problem with companies directly – and expect compensation committees to respond personally. Fortunately, the institutional investor approach is typically a negotiation, not a disruptive “no” campaign.

Regulation. The SEC has clearly shifted to the recalcitrant regulator with respect to public company executive pay. However, recent statements indicate the final three regulations dictated by Dodd-Frank will finally be introduced over the course of 2014, five years after the act was passed[7]. The pay-for-performance regulation (Section 953(b)) is potentially the most controversial of the three. It is our belief the SEC will follow the emerging trend of describing pay in terms of company performance over an extended period of time, consistent with contemporary realizable pay methodologies[8]. Independent of the SEC’s eventual rule-making, we see an increasing number of companies embracing realized pay as a means of assessing long-term compensation committee effectiveness and as a tool for direct communication and justification of pay decisions with investors.

At this point there is little controversy surrounding the claw-back and hedging policies, particularly in light of the “problematic pay practice” standards of ISS, Glass-Lewis and certain institutional investors[9]. While we expect any additional regulations to be burdensome, we do not expect the eventual rules to reflect any change in the current evolutionary path of executive pay and employment terms.

Board Tenure and Board Refreshment. While not new, discussion surrounding director independence is increasing, particularly relating to age and tenure. A number of institutional investors have determined that an exceptionally long tenure of a director may jeopardize the independence of the director. The EU recommends terms no longer that 9-12 years. The UK considers directors with more than 9 years of board service no longer independent.

We do not expect any action on this subject in the US yet, but we believe continued discussion in governance circles will result in several leading companies reinvigorating prior retirement programs and considering new board refreshment programs. Institutional investors appear to endorse the board refreshment concept[10], in conflict with the general view of companies. However, it is unknown whether institutional investors will be willing to force a key director out or whether they will simply endorse the program as a tool to weed out lower-contributing directors. Independent of the outcome of the board refreshment issue, we believe board succession and diversity will remain a visible issue for 2014.

Litigation. We see no change in the pace of derivative shareholder litigation in 2013. Despite the relative failure of plaintiffs to win judgments, the industry remains profitable for certain law firms to conduct a form of economic extortion on those companies failing Say-on-Pay voting, failing to adhere to disclosure standards, and failing to adhere to their own shareholder-approved plans and Committee charters.

What This Means for the Compensation Committee

Our principal concerns for Board compensation committees in 2014 are the following.

The relative economic weakness on Main Street and its contrast with the success of the equity markets highlights an economic divide within the economy and provides popular support for arguments to address perceived inequities and abuses arising from executive pay. The level of discussion is now working its way into preliminary political statements as we prepare for mid-term elections, and will likely maintain social pressure on perceived executive pay abuses and potential future regulation. Committee members are advised to remember that only executives like executive compensation.
Committees will come under increased scrutiny if realized executive pay over a 3-5 year period is not correlating with investor outcomes. The data necessary for any analyst to perform the calculations is publicly available and is likely to become a vehicle for activists to tell their story. Committees are advised to be prepared by understanding their CEO’s realized pay relationship to performance.
Boards will see increased scrutiny from institutional investors to explain company strategy, and compensation committees (and their advisors) must be prepared to explain precisely how the existing pay arrangements advance that strategy. Quoting a “pay-for-performance” philosophy may be insufficient. Compensation Committee members should be prepared as investors will be seeking clarification of strategy and how pay relates.
Good management of compensation committee processes will remain important as the derivative litigation industry continues to thrive. Committees are advised to consider audits of plans and processes[11].

That said, we are optimistic about executive pay and its related governance in 2014 for a number of reasons.

The increased attention of institutional investors in understanding unique business strategies can support more rational pay decisions. Perhaps we are seeing an end to “data slavery” and the disproportionate focus on pay comparisons based on present-value methodologies.
The decreased emphasis on homogenizing executive pay and elimination of the one-size-fits-all governance model can help companies who are willing to differentiate themselves.
Greater sophistication of institutional investors in understanding executive pay arrangements will support concepts such as realizable pay being used to support good committee decision-making, and to protect committee members who commit to longer-term pay strategies.
SEC recalcitrance to issue regulations has created a void that is being filled by institutional investors who have a direct interest in value creation rather than a shifting political agenda.

Jeff McCutcheon

[1] The outstanding claw-back regulation involved compensation erroneously earned, as opposed to the specific financial services industry regulations finalized in 2011 impacting claw back liability in the instance of failed financial institutions.

[2] For example, of the 261 “no” recommendations on Say-on-Pay from ISS, only 18% failed. In general, 2013 ISS recommendations tended to correlate with votes, but by no means dictate voting (source: Wachtell, at http://www.wlrk.com).

[3] There have been a number of statements, including statements by David Gallagher (SEC Commissioner) indicating potential SEC action (at NASDAQ request) to withdraw a no-action letter from 2003 that provided a fiduciary safe harbor to investment companies relying on proxy advisor counsel for voting shares. The Canadian Securities Administration has announced possible regulation of the industry.

[4] In 2013 Blackrock announced they are no longer following ISS recommendations regarding the voting of shares, and Fidelity’s governance group initiated discussions directly with companies as a result of sending letters to 350 companies asking for direct information regarding problematic pay practices.

[5] Georgeson 2013 study of client companies.

[6] There have been a number of statements, including statements by David Gallagher (SEC Commissioner) indicating potential SEC action (at NASDAQ request) to withdraw a no-action letter from 2003 that provided a fiduciary safe harbor to investment companies relying on proxy advisor counsel for voting shares. The Canadian Securities Administration has announced possible regulation of the industry.

[7] The Dodd-Frank legislation required agencies to establish 398 separate rules. As of July 2013, over half remain unresolved with 29.4% in pending form (since then, the CEO pay ratio was finalized) or not yet issued (32.2%). See DavisPolk, Dodd-Frank Progress Report (June 3, 2013), http://www.davispolkportal.com

[8] Voluntary disclosure of realizable pay calculations were presented by a minority of companies in 2013, including large cap companies. ISS began using a variant of realizable pay in assessing companies where there is “high or medium concern” regarding the relationship of pay and performance.

[9] Over half of public companies already disclose policies prohibiting executives and directors from hedging. SEC rules dating back to Sarbanes-Oxley (2002) require the SEC to pursue the claw back of compensation earned through fraud. As a result, most companies also have claw-back policies within their various incentive plans.

[10] In 2013 ISS surveyed investors and companies regarding exceptional board tenure. 74% of investors viewed long tenure as problematic, whereas 84% of companies said it was not problematic.

[11] See BoardMember Magazine, Q4 2013, “See the Forrest and the Trees” P. McConnell and J. McCutcheon.

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Executive Compensation: See the Forest and the Trees

Posted by Jeff McCutcheon on January 20, 2014 / Posted in Compensation Committees

For executive compensation, achievement of corporate strategy is the destination; pay levels, pay programs, and metrics provide the route. As inevitably as the Cubs missing the playoffs, the end of the year swiftly approaches and compensation committees must reflect on the year’s actions and re-check their route. With media scrutiny, regulatory oversight and the specter of derivative litigation ever-increasing, we all need to ask ourselves some pointed questions about our compensation strategy.

Consider the environment:
• Executive compensation represents one of the Board’s principle responsibilities in executing company strategy. Mistakes are costly. Pay-for-performance alone is insufficient for driving successful strategy. Investors expect more.

• Derivative litigation continues to plague companies. Even the most specious claims require extensive board time, distract management, and represent wasted profits in the form of direct and indirect legal expense. This growing litigation shark tank feeds on seemingly minor compliance errors, obliging committees to conduct their own independent audits. (If in doubt as to the potential scale of this problem, ask counsel to brief your committee on the Clorox1 case.)

• As executive pay regulation accumulates such as the expected 2016 CEO pay ratio disclosure, committees need to anticipate public and investor reactions to pay actions through the lens of current disclosure regimen. In 2013 we saw an increase in activism from historically quiet institutional investors. As many large institutional investors have brought their proxy analysis in-house the relative reach of ISS and Glass-Lewis have diminished, also diminishing the assumed “safe harbor” found with the proxy advisors’ formulaic approval process. Committees that overstep expectations may find themselves suddenly initiating investor outreach programs, directly explaining their actions to key institutional investors.

There are no clear-cut answers to every issue, and no one-size-fits-all approach that will automatically place a company beyond reproach. Instead, compensation committees must reflect on both the exigencies and opportunities facing their company, and act accordingly.
By following a methodical approach to committee compliance, compensation committees will equip themselves to make informed, careful, strategic decisions that will serve their companies well in 2014 and beyond.

We suggest an internal review along three major themes:

Pay Strategy.
(How the Compensation Committee uses pay and employment terms to advance the company’s strategy.)

• “The Compensation Story” – Is there a succinct narrative that can consistently and compellingly be used by each board member and affected management?

• Value Creation – Is it readily apparent to all that your executive pay plans promote shareholder value creation in a manner consistent with investor presentations and your investors’ expectations?

Pay Effectiveness.
(The degree to which the actual value delivered supports the strategy.)

• Simplicity – Are the various plans understood and embraced by executives? How do we know? (“I don’t understand all that stuff” = Low ROI.)

• Wise Risk – Does the overall program encourage appropriate risk? Discourage unwise risk?

• Impactful – Is it suitably motivational and does it promote retention?

• Defensible – When described in the media, are you proud or embarrassed?

Compliance.
(Safeguarding the company from nuisance litigation through disciplined compliance.)

• Achievement – Did the committee complete all responsibilities laid out in its charter?

• Compliance – Is the company in full regulatory and exchange compliance with plans and filings?

• Advice – Are external advisors competent? Do we have sufficient confidential contact with them?

1 Mancuso v. The Clorox Co., No. RG12-651653 (Cal. Super. Ct. Alameda Cnty.).

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Annual Executive Compensation Levels: Where We Veered Off the Road

Posted by Paul McConnell on August 30, 2013 / Posted in Compensation Committees

[Originally published in Board Member Magazine 2013 Q3.]

In our last article, we noted that somewhere along the way, executive compensation veered off the road. Executive compensation plans became too complex, isolated from true performance and downside risk, and in many cases, total compensation was just too high. While there is no shortage of blame to go around, we find one obvious flaw is the prevailing practice of treating executive equity as annual compensation.

Assume that you had money to invest in a business and I was going to run it for you. I’d get a salary and bonus for my labor. You might also give me shares of the company to align our interests and ensure I was fully “bought in” to the venture. It would be clear between us that the stock was my “share of the deal” and would remain invested with the company until we parted ways.

As an unintended consequence of the thirty-year effort by the SEC to improve the oversight of executive pay, we have effectively created a bias against the “share of the deal” approach to equity. To provide greater transparency and comparability, the SEC requires companies to report all remuneration in annual terms – even if it is not an annual event. Consequently, we stopped thinking about executive equity as a “share of the deal” and we fell into the mindset that it was all annual compensation.

Obviously, equity awards have a compensatory effect, and are a key part of an executive’s total pay. The best talent will seek opportunities where they can share in the value they help create. However, by seeing executive equity as a piecemeal annual reward rather than as one’s share of the deal we have created the perception that the equity is indeed a cash equivalent, to be exchanged for cash when needed.

From an owner’s perspective, the critical issue should not be the annual increment of equity, but the total equity commitment necessary for each key executive role to achieve the following investor objectives:

• Providing an attractive package to recruit and retain the management talent needed;

• Matching executive performance and wealth more closely to the company risk horizon; and,

• Aligning executive wealth proportional to investor gains or losses.

Unfortunately, in the current “tail wagging the dog” scenario, we find companies think about equity in annual terms because we report it and compare it on annual terms. This has the perverse impact of:

• delaying the formation of a substantial equity position for several years in order to comply with annual compensation practices;

• rewarding volatility by granting more equity (as a percent of outstanding stock) when the company does poorly and fewer shares when the company is highly successful; and,

• thinking of equity as a cash equivalent that can be sold during the term of employment.

It makes far more sense to manage equity decisions using established target equity levels for each of the key executive roles. Achieving the target ownership may be accomplished in one step (e.g., in a turnaround), or parsed out over time. The key difference, however, is that executives and investors know the annual grant is not a bottomless pit of investor dilution. Periodic grants would represent the execution of a strategy rather than an attempt to chase some market median practice.

With this approach companies, executives, and investors benefit three key ways:

• We answer the question “how much is enough?” — the elephant in the room nobody currently wants to talk about;

• We simplify pay by distinguishing an illiquid career investment from annual cash pay. This change in perspective removes much of the concern driving the Dodd-Frank pay-ratio debate; and,

• We assure all parties that executive management is a long-term investor in the company, with upside and downside risk, and full accountability for the economic consequences of risks through a sizeable stake held throughout their career.

It is time we begin to think and act like owners and treat equity as if we were making partners out of management – by granting them a piece of the enhanced value of the business over time, not doling out shares simply to reach a “competitive” amount of annual compensation.

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Are Relative Total Shareholder Return (TSR) Plans “The Answer”?

Posted by Paul McConnell on May 06, 2013 / Posted in Compensation Committees

[Originally published in Board Member Magazine 2013 Q1.]

There has been a great deal of recent interest in performance share plans that use Total Shareholder Return (TSR) relative to a peer group as a measure of performance. Clearly, these plans usually look good in a pay for performance comparison and can help secure favorable say-on-pay votes, but the additional questions Compensation Committees should be asking are:

Do they motivate executive performance?
Are they right for this particular company?
Does TSR reflect true executive performance?
Is this the only performance-linked program we should use?

Any discussion of total shareholder return must start with the understanding that TSR is a result of good management performance, not the performance itself. The desired management performance is the production of great products/services, properly priced for consumer value, that deliver consistent financial returns commensurate with the riskiness of the required investment. If the market sees this performance, share prices are bid up relative to peer companies and positive relative TSR results, assuming of course, other, exogenous events do not occur.

From a motivational perspective, the strongest incentives are those where a clear line of sight exists between the desired behaviors (performance) and the reward. TSR plans may not provide as clear a linkage as plans tied to measures of operating performance. Even though it may be very hard to do, executives know what it takes to raise net income by 10%; it is less clear what it takes to raise the stock price by 10%. And the market is not necessarily rational, certainly not in the short term but also seemingly for the long term as well. Thus plans tied to operating metrics more clearly convey performance expectations and behaviors. However, executive pay is not just about incentives and motivation. It’s also about sharing the risk and reward of ownership. What then are the situations where risk sharing is more important than communicating performance expectations? Although the following list is not exhaustive, it shows the areas where we think these plans have value.

Shareholder Relations Issues: In cases where there have been historical issues with the pay for performance relationships, relative TSR plans alleviate that problem – in fact, better than outright share ownership. By definition, the change in the value of executive shares owned has a 1 for 1 alignment with TSR. TSR performance plans have a more exaggerated relationship, due to the fact that the value of the shares awarded as well as the number of shares themselves vary with TSR. The value of these shares typically climbs faster and drops more quickly than total shareholder return itself does.

Change in Strategy/Turnarounds: In these situations, it is difficult to set reasonable performance goals. Success will likely be much different than current expectations. But a successful turnaround will likely have a dramatic impact on TSR, as the market builds new expectations into the market price. These kinds of awards are also useful in justifying the kind of above market grants that are typically required to attract new management required to effect the change in strategy/performance.

Technology/Life Sciences: These industries are known for high risk/high reward – particularly in the pre-IPO stage, where large equity grants are the rule. These grants are either very valuable or worthless. (Executives that have worked in these industries often have enough worthless stock option certificates to wallpaper their office.) Relative TSR plans can replicate this highly leveraged reward practice in the public company stage. Very successful strategies produce high relative TSR, which these plans magnify into even larger reward.

In Conjunction with Other Plans: When other long-term plans are in place that use other metrics, a TSR plan can be good for balancing the total plan so that a company doesn’t create negative perceptions that management gets very generously rewarded when shareholders don’t.

Are relative TSR plans “the answer”? No, they are “an answer” that can be very appropriate in the right situations.

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CEO and Executive Pay Plans: Help for a Broken System

Posted by Paul McConnell on May 06, 2013 / Posted in Compensation Committees

[Originally published in Board Member Magazine 2013 Q2.]

Somewhere along the way, executive compensation veered off the road. It became too complex, isolated from true performance and downside risk, and in many cases, too high. The original idea of executive compensation was to pay an adequate and fair wage and good benefits. Any additional pay was intended to place executives in the same position as owners. However, with high base salaries, equally powerful short-term incentives, long-term incentives that are treated as income rather than investment and often protect against downside risk, and the potential for golden parachute payments that reward executives when they fail, something went wrong. The good news is that it can be fixed. The bad news is that it will require some bold new thinking on the part of boards and management.

Performance. Before discussing pay, let’s examine performance.

More often than not we reward CEOs for luck and good timing rather than for leadership, stewardship and good strategy. Research has shown that as much as 80% of total return may be based on macro-economic factors and industry trends unrelated to company behavior.
Performance against internally-developed goals is important, but may be unrelated to actions that build long-term value for investors. If a CEO is truly operating at a strategic level, the real impact of their leadership may not be evident for 5-10 years, and in some industries with long development or capital cycles, perhaps 15 years. Yet for the most part we define CEO performance in terms of annual financial results rather than on more broad indicators of long-term value creation.
Current year plan-based targets, ROIC (return on invested capital) and share price are all great dashboard measures, indicating directional progress, but these measures should not be confused with actual success of a strategy or long-term value creation within an organization. Boards need to think long and broad when it comes to assessing performance.

If we are to improve the pay model, we must first be willing to commit to a longer-term view of performance and articulate exactly what success looks like.

Pay. Much of the current executive compensation thinking is a product of the 1980’s and 1990’s. Many of today’s practices are influenced by the SEC efforts to standardize disclosure in an effort to bring more transparency and comparability to executive pay. Unfortunately, as with many things, there were unintended consequences.

We think about and communicate pay in annual terms rather than in long-term outcomes. If in doubt, read the “compensation philosophy” section of the typical CD&A.
We emphasize annual bonuses that pit CEO’s self-interest against investors when negotiating performance targets.
We claim that equity is an incentive to create alignment and balance risk, but we allocate it on the basis of “competitive pay” like cash; we too rarely acknowledge an intended career allocation or a targeted ownership objective.
We rationalize equity programs as putting executives in the same position as owners, but, in our experience executives rarely lose money. Annual equity awards are typically based on dollar-denominated “target values”, protecting executives from stock price changes, and executive stock holdings are often sold to the extent they exceed minimal ownership requirements.
We use “competitive practice” as a synonym for minimum requirement, whether dealing with salary and incentives, terms of employment, or severance. As a board we seldom exercise leadership in crafting employment arrangements directly supportive of the company’s mission.

To say that executive pay is “broken” may seem overly harsh, but we should at least acknowledge that executive pay often falls far short of delivering on its objective of rewarding executives for long-term value creation. The first step in the cure is admitting you have a problem.

In later articles, we will examine several solutions to these problems.

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Pitfalls in Executive Loans: Stock Purchase and Loan Plans

Posted by Jeff McCutcheon on March 28, 2013 / Posted in Compensation Committees

Last week (March 20^th, 2013) Baker & Hostetler, LLP[1] received guidance from the SEC regarding the use of arms-length loans within an executive stock-purchase-and-loan plan (SPLP) for a client company, RingEnds Partners[2]. Of significance here is not the design of the plan or the ability of employers to effectively arrange credit for executives, but that complicated executive pay arrangements are being developed to circumvent tax policy to the potential detriment of companies and investors – with limited positive effect for the executives.

The RingsEnd Partners executive compensation program consists of:

The company transfers stock award shares into an independent trust on behalf of the executive.
The executive elects to recognize the grant value of the shares upon receipt by electing 83(b) treatment
The trust immediately borrows money at arm’s length from a bank, securitized by (and only by) the shares it holds, distributing cash to the executive approximating the income taxes owed

At this point, the executive’s basis in the security is the grant value of the award, with all subsequent gains or losses subject to capital gains treatment. The executive’s tax/vesting risk is effectively transferred to the trust and the company; if the shares do not vest, the executive is not liable for the loan used for tax payments or the interest on the loan. Assuming the shares vest, the trust will withhold shares at the vested value to repay the loan and interest, transferring the remaining shares to the executive without any further taxation until sale of the stock.

The executive benefits from two features of the plan. Assuming the rate of appreciation exceeds the rate of interest on the loan obtained by the trust, the executive benefits from the spread between the tax-effected loan interest rate and the equity growth rate, plus,

The effective deferral of taxation on appreciation in shares from grant date through vesting date until eventual sale on the shares.

But for all the complexity of the arrangement, economic benefits are limited. In contrast:

We believe there is a potential shareholder issue if, in fact, the employer is underwriting the financial risk associated with an executive’s 83(b) election.
We question whether an 83(b) election is even appropriate when an employer is effectively underwriting the risk.

And (notwithstanding this caveat), there is little the plan provides that an executive could not achieve under the existing tax and regulatory framework. An 83(b) election to recognize income upon receipt of a stock award is already available. The only unique feature with RingsEnd is that, through a rather complicated trust arrangement, the company is underwriting the risk that the shares will not vest, relieving the executive of paying taxes on shares never received. Strangely, this effectively reduces the executive’s negative consequences of leaving the company prior to vesting.

We believe that encouraging executive shareholding, particularly with limited liquidity during the term of employment, is good public policy. When executives hold a considerable portion of their total net worth in the form of illiquid shares of company stock, they are more inclined to have a balanced view of investor risk. However, we find nothing in the RingsEnd plan to support an ownership objective and find it may undermine other incentive objectives such as retention, solely for the benefit of incremental executive tax efficiency.

Companies are advised to be wary of programs that are inordinately complex, and avoid falling into the trap of allowing design elegance to distract you from actual program effectiveness.

Jeff McCutcheon is a Managing Director at Board Advisory, LLC, an independent consulting firm exclusively serving boards of directors, their compensation committees, and investor groups.

[1] Prominent in the Baker & Hostetler, LLP request was Michael Oxley, the former Congressman and Chairman of the House Financial Services, and co-author of the Sarbanes-Oxley legislation, now Of Counsel with Baker & Hostetler, LLP.

[2] http://www.sec.gov/divisions/corpfin/cf-noaction/2013/ringsend030413.htm

Reconciling U.S. Tax Policy on Executive Equity with the Public Interest

Posted by Jeff McCutcheon on March 28, 2013 / Posted in Compensation Committees

There is substantial agreement between academics, policy makers and behavioral experts that executive ownership of company shares, particularly when those shares are held for an entire career (e.g., retirement plus 2 years for successor transition), is good for investors and the public. Long-term equity ownership on the part of executives is viewed as a mitigant for excessive risk taking, providing financial accountability for risks taken over the course of a career that may not be reflected in annual bonus or salary decisions. However, current tax law does not effectively extend to executives the same tax treatment afforded investors, nor does it encourage the type of ownership that can retard events such as those leading up to the recent financial crisis.

Gaps and inconsistencies in tax policy have contributed to much of the complication, obfuscation and negative unintended consequences in current executive pay arrangements. Companies seek, often through overly-complex arrangements, to provide executives with the same tax treatment afforded investors.

The IRS Code has provided some opportunity for alignment between tax policy and good governance dating back to 1964 through employee stock purchase plans (ESPP’s)[1] and since 1981 with Incentive Stock Options (ISO’s)[2]. These provisions allowed, in certain circumstances, for employee equity to be treated consistent with investors with respect to capital gains treatment. An Incentive Stock Option (ISO), established in 1981, provides employees with capital gains treatment for the gain on any qualifying option award under certain exercise and holding period requirements. Unfortunately, the original $100,000 award limitation remains unchanged from 1981. On a pay-inflation-adjusted basis alone, this limit would need to be over $1M in 2013[3].

We propose that through minor modification to the existing tax code we can increase the transparency of executive equity/compensation arrangements, provide greater alignment of executive rewards with societal goals of balanced risk taking, and increase the actual net revenue to Treasury. We propose the following simple changes to existing tax code:

Eliminate the $100,000 limit on Incentive Stock Option awards. The definition of a qualified award would include full-value shares as well as stock options.
Where there is a discount element (e.g., restricted or performance shares), the discount at grant would be treated as ordinary income to the executive, taxed upon sale of the shares. The corresponding employer tax deduction would also be deferred until sale.
To qualify for capital gains treatment, shares must be held for the longer of ten years from the date of grant 2 years following termination of employment. Shares sold prior to the time limit would be disqualified and subject to immediate ordinary income taxation of the entire amount.

These proposed tax rules create a strong incentive for executives and Boards to design equity plans utilizing hold–till-retirement provisions. This will result in more net shares remaining in the hands of executives, presumably providing a more significant incentive for delivering long-term results for investors and the public at large.

Curiously, although the executive would receive favorable tax treatment, the tax revenue gains to the government would actually increase. Currently, upon share vesting or option exercise, income tax paid by the executive is generally offset by the compensation deduction of the employer. On a net basis, the only revenue received by Treasury now is the capital gains tax received upon sale of the shares. Under our scenario, the employer loses the tax deduction for gains from grant through exercise/vesting (further delineating between income and investment), leaving the government with effective taxation, albeit at a lower rate, of a greater portion of the award.

Under our proposed approach[4], the executive’s capital gains would be measured from the grant date price – as is the case with an investor purchase – with no offsetting tax deduction by the corporation for subsequent gains. While this results in a lower tax rate for the executive, the effective Treasury revenue is increased by elimination of the employer’s tax deduction. Furthermore, the combination of hold-till-retirement covenants and supporting tax policy better aligns the executive performance incentive with the interests of investors and the public over time, rather than allowing an executive group to be rewarded for short term results. With a broad definition of equity incentive plans (i.e., including nonpublic company equity and equity-like vehicles), this approach can successfully apply regardless of company size or ownership structure (e.g., small businesses, joint ventures, subsidiaries, private equity and start-ups).

The individual & corporate taxation, as well as federal revenue, can be summarized in the following example where an executive is granted 3,000 restricted shares at $10 per share, vesting in entirety at the end of three years, with the shares eventually sold at the end of 10 years, assuming a constant 10% CAGR in share price.

Treating executive pay consistent with investors is good public policy. Creating an effective tax penalty for executives choosing to liquidate shares prior to retirement achieves a sensible balance for executive risk-taking and provides greater long-term skin-in-the-game that provides additional accountability for executives and corporations within our economy. We believe this is an easily-achievable step toward aligning federal tax policy with public policy interests, and can immediately provide increased federal tax revenues through improved public policy. Lastly, it would eliminate the need for complex plans, where any benefits to investors or the public are negligible at best.

Jeff McCutcheon is a Managing Director of Board Advisory, LLC, an independent consulting firm exclusively serving boards of directors, their compensation committees, and investor groups.

[1] The Revenue Act of 1964 provided the tax treatment for options contained in ESPPs through IRC Section 421(a)(1), providing that “no income shall result at the time of the transfer of such share to the individual upon his exercise of the option with respect to such share.”

[2] The Economic Recovery Tax Act of 1981 established ISOs. P.L. 97-34. Senate Report 97-144 states the intended tax treatment for ISOs: The bill provides for “incentive stock options” where there are no tax consequences when an incentive stock option is granted or when the option is exercised, and the employee will be taxed at capital gains rates when the stock received on exercise of the option is sold. Similarly, no business expense deduction will be allowed to the employer with respect to an incentive stock option.

[3] IRC Section 422(d)(1). The $100,000 limit on ISO value was established in 1981 and has not changed. Based on compound growth rate of executive pay for S&P 500 CEOs from the period 1989 through 2011, the $100,000 limit established in 1981 would need to be over $1M for 2013 based on the average growth rate in S&P 500 CEO compensation of roughly 7.5% per year.

[4] See Aligning Tax Policy with Sound Executive Pay Practices, Board Advisory, LLC, (Issue 3, 2009).

Facebook’s Multi-Billion Dollar Tax Break on Executive Stock Options

Posted by Paul McConnell on February 18, 2013 / Posted in Compensation Committees

There has been a lot written recently about Facebook’s multi-billion dollar tax break from the tax deduction for the cost of executive stock options and share awards. Stock awards such as these are taxed to executives as compensation based on their value at the time of exercise (options) or vesting (shares), and the employer gets a corresponding deduction for the compensation expense, even though no cash was expended. Facebook’s phenomenal growth in value from its private company days (when most of these grants were made) makes the resulting deduction very large, particularly compared to its operating income. The publicity regarding this little understood section of the tax code will likely lead to calls for limiting or eliminating these deductions. In our opinion, this is treating the symptom, not the disease.

The fundamental problem is that in the eyes of the IRS, stock grants are treated as compensation by the employer rather than as an investment by the executive. In the example below we contrast tax treatment of a warrant issued by a company as a “sweetener” in a stock offering to a identical situation where a stock option is issued by the same company to an executive. In both instances, we assume the option is priced at $10 (strike price), exercised at $20, and with the underlying share sold after one year at $24. For simplicity, we assume corporate tax of 35%, individual tax of 40% and capital gains of 20%.

Comparison of IRS Treatment: Investors vs. Employees
	Employer Treatment		Investor/Executive			IRS
	Deduction	Tax Impact	Ordinary Income	Capital Gains	Total Taxation	Net Taxation
Investor Model	$0	$0.00	$0	$14	$2.80	$2.80
Employee Model	$10	($3.50)	$10	$4	$4.80	$1.30

The company does not receive a deduction with warrants, and the warrant holder does not recognize any income. Upon exercise of the warrant (share purchase), the capital gains holding period begins. Upon sale of the share after completing the holding period for capital gains, their tax bill would be $2.80 per share (i.e., $14 gain x 20%). In contrast, under the current IRS employee model, the employer realizes a $10 tax deduction for compensation expense (the gain at exercise), the employee recognizes the same amount as ordinary income. Upon a later sale the employee qualifies for capital gains on the additional $4 gain. Thus the Treasury nets only $1.30 per share in revenue in the employee model compared to the investor model, where the IRS realizes $2.80 per share in revenue.

As we noted in an earlier blog entry treating corporate executives as shareholder/ investors for tax purposes would be beneficial to the Treasury by increasing revenue and simplifying taxation. More importantly, it would align tax policy with social and economic objectives of encouraging long-term stock ownership as a deterrent to excessive risk taking and of making corporate and individual taxation more transparent.

– Paul McConnell is a Managing Director of Board Advisory, LLC

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Executive Leadership Transitions: “PAVE” the Way to Success

Posted by board-advisory on December 04, 2012 / Posted in Compensation Committees

We’ve been involved in Transition Coaching more than ever before because of the importance rightfully being placed on improving the assimilation of new leaders into organizations. In recent years, the failure rate of transitioning leaders (whether external hires or internal promotions) has been surprisingly and unacceptably high—anywhere from 30%-60%, depending on who’s research and metric you’re using. And the cost of a mistake at senior levels typically runs 10-15X salary. Indeed, Boards and Executive Teams are “owning” this crucial challenge, as they should.

Executive transitions are complex affairs, so we try to simplify things with a few basic concepts and a guiding framework. The foundational concepts are (a) transition success is a function of followership; (b) followership stems from trust, and (c) trust comes from two types of credibility—professional credibility and personal credibility. Professional credibility means that people will trust and therefore follow a leader because they believe she knows what she’s doing… she has the experience, the credentials, the track record that gives others confidence that they will be led to the right place. Personal credibility means that people will trust and therefore follow a leader because he cares about me… he behaves in a manner that gives me confidence that I matter and will be led in the right way. In the transition window, the leader can take steps that are primarily transactional or activity-based to build professional credibility, and steps that are primarily relational or behaviorally-based to build personal credibility.

Furthermore, transition steps can be targeted to four (4) primary “targets”—Boss, Team, Colleagues and Self. Most transitioning leaders pay attention the first two, at the expense and peril of the second two. But all four need concerted attention. The boss tends to believe they’ve solved a big organizational problem when the new leader takes the reins, so they turn their attention elsewhere. That’s why they’re paying them the big bucks, right? Compounding that erroneous assumption is that the new leader wants to prove her independence. But if the new leader and the boss aren’t fully lock-step not only on exactly how success is defined in the leader’s role, but also how the two of them will operate, with frequent check-points on both, the new leader is driving this change blind-folded at best.

The team dynamic could be the most intense. After all, the new leader landed in their lap, and possibly in the role a few of them wanted and thought they deserved. While making quick change in this space is tempting, due diligence and patience could be what’s most needed. The new leader will only be as good as his team, so getting this right is paramount to a successful transition.

As alluded to above, many transitioning executives are vertically oriented, paying attention to the boss and taking care of the team. Yet lateral and diagonal relationships in the rest of the organization could well be the most important of all, since multi-faceted support is required in today’s complex organizations, and lack thereof can torpedo things fast. Besides, the new leader’s peers are the bearers of the current culture, which often has a strong immune system and thus by design rejects foreign bodies. Deliberation and considerable finesse is often required to navigate this minefield.

Last but by no means least is oneself, as neglect here can be an easy and very costly mistake. If the new leader is not at the top of her game—mentally, emotionally, and physically—her odds of failure increase exponentially. Conversely, attention to self will ensure the new leader has the sharpness, stamina and fortitude to effectively lead potentially the biggest challenge of her career through to fruition.

The acronym and action matrix below is one way to be mindful and purposeful in the transition window.

Prime yourself.

Align with your boss.

Vector your team.

Engage the organization.

Executive Transition Matrix

	ACTIONS
	Transactional (activity based) *Professional Credibility*	Relational (behaviorally based) *Personal Credibility*
TARGET
Self	What you do with Self Health & Wellness Coach and/or Mentor Other	How you conduct Self Integrity Authenticity Other
Manager	What you do with your Boss Scorecard Work Plan Other	How you align with your Boss Communication Accountability Other
Team	What you do with the Team Assimilation Talent Review Other	How you affect the Team Motivating Others Building Talent Other
Organization	What you do Organizationally Networking Stakeholder Input Other	How you influence Culture Collaboration Relationship Building Other

We find that being deliberate in this manner can help transitioning leaders bolster credibility, build trust, and gain the followership required for a successful transition.

– Kevin R. Hummel, Ph.D.

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Keeping Dodd-Frank in Perspective: Lame Duck Session for the SEC

Posted by Jeff McCutcheon on October 31, 2012 / Posted in Compensation Committees

As the election approaches and candidates swap jibes at each other, we’re curious to see how the results affect executive compensation regulations. Up to now, the SEC has been sluggish—to the point of inertia—to adopt final rules for the “gang of four” regulations outlined in the Dodd-Frank act. Troubling though it is, their inaction has not slowed us down a bit.

Some background: Enacted in July 2010, Dodd-Frank is a behemoth of a law, registering at a whopping 2319 pages. The table of contents alone sprawls to fifteen pages. As you can imagine, the thicket of financial regulations are dizzying in number and complexity. And yet…the devil is in the details. Congress left it to the Security and Exchange Commission to sort out the nitty-gritty, including the more controversial issues. As of July, only a third of the rulings had been issued.

With respect to executive compensation, the act provided for a number of executive pay “reforms” of clawbacks, independence standards and increased company disclosure. The SEC has adopted final rules for “say-on-pay,” golden parachutes, and compensation committee independence standards. But the SEC appears to have run out of steam. Specifically, the whole “gang of four” is still up in the air (pay-for-performance, hedging policy, clawbacks and internal pay ratio.)

In a presentation to the NACD in July, Commissioner Troy A. Paredes said he was “troubled” that the Dodd-Frank regulatory regime went “too far.” His comments recognize that the legislation, if acted upon by the SEC, could have regrettable consequences not envisioned by the drafters. We agree with the Commissioner’s conclusions and share his concern regarding the executive pay regulation. However, we are less comfortable with the executive branch’s passive resistance to legislative action.

In our view, the SEC is playing “wait-and-see” until the election results come in, reticent to sift through the remaining Dodd-Frank executive pay issues in case a change in the political winds means a repeal (unlikely) or incremental reform of the problematic legislation (hopefully).

Still, we’re not holding our breath. Though we’re more than ready to help our clients navigate the murky waters of Dodd-Frank whether the political tides change in November or not, we hardly need to wait around to act on our experience and knowledge to devise winning compensation strategies. Politics aside, we’re on firm ground as far as that’s concerned. When all is said and done, we believe that executive compensation should be driven by the needs of the company and the desire to enhance shareholder interest, not what is coming out of Washington.

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