CEO Comp Falls, Pay for Performance Needs Work
The Corporate Library released preliminary CEO compensation numbers, including salary and performance based comp data from this year's proxy statements filed through March 25. Median total annual CEO compensation fell 2.78%, down for the second straight year – the first two year drop since the survey began in 2002. Total realized compensation fell by 7%, also down for the second straight year, down to the lowest since the survey began in 2002. The realized compensation numbers reflect equity vesting and options exercises, thus a falling stock price hits realized compensation harder.
The drop in annual compensation demonstrates some resolve on the part of boards and comp committees, but not much. If the compensation objective of corporate governance is pay for performance while aligning compensation with the long term goals of the shareholder, then the two year pay declines aren't close to matching the declines in performance and the long term incentives aren't really getting adjusted as well as they could be.
Where should corporate governance be heading with compensation? Consider the following principles, the appendix from Paying For Long-Term Performance, an article by Harvard Law Professors Lucian A. Bebchuk and Jesse M. Fried scheduled for publication in the U. Penn L. Rev. I've interspersed the principles with my own italicized observations, many of which (the good ones) reflect points made in the article's text. Note, these principles deal only with equity comp (primarily restricted stock and stock options) although the performance based cash bonus raises many of the same issues. Note also, situations where the CEO and/or other top execs have both the opportunity and the lack of ethics to game the system seem rare, at least to me. Don't let the discussion persuade you that every CEO is a crook. The point is that eliminating opportunities to game the system has no real cost, why not prevent even those abuses that are relatively rare.
Appendix: Principles for Tying Equity Compensation to Long-Term Performance
Principle 1: Executives should not be free to unload restricted stock and options as soon as they vest except to the extent necessary to cover any taxes arising from vesting. Restrictions on the right to unwind, (sale, or exercise and sale, referred to generally as unwinding the position created by vested comp), that survive vesting? Why not, longer enforced holding means better alignment, the benefits of producing a good quarter or two with accounting gimmicks or high risk decisions look less attractive to the exec who owns a lot of equity that can't be sold. Limits are needed on extended holding requirements, but read on.
Principle 2: Executives’ ability to unwind their equity incentives should not be tied to retirement. Sounds good. Why give execs incentive to retire early when they need cash or see a downturn coming. Plus, the CEO nearing retirement can game the system with short term decisions that produce results just as she, or he, retires. So, say no to simple holding rules that end at a cliff on retirement.
Principle 3: After allowing for any cashing out necessary to pay any taxes arising from vesting, equity-based awards should be subject to grant-based limitations on unwinding that allow them to be unwound only gradually, beginning some time after vesting. Good, although the 20% per year following vesting that the authors suggest in the article seems unnecessarily complex when combined with a typical vesting schedule of 20% per year. The basic idea of delaying sales for two or three years following vesting works well enough in combination with Principle 4.
Principle 4: All equity-based awards should be subject to aggregate limitations on unwinding so that, in each year (including a specified number of years after retirement), the executive may unwind no more than a specified percentage of the executive’s equity incentives that is not subject to grant-based limitations on unwinding at the beginning of the year. For example, if the exec starts a year with ten million shares vested as the result of prior awards, he could sell only one million in that year. Always enough skin in the game to maintain that long-term alignment.
Principle 5: The timing of equity awards to executives should not be discretionary. Rather, such grants should be made only on prespecified dates. So you can't wait for bad news to approve the option grants and get a low exercise price (exercise price always market price on grant date).
Principle 6: To reduce the potential for gaming, the terms and amount of post-hiring equity awards should not be based on the grant-date stock price. Don't use an options grant methodology which works off dollar value awards that are converted into option grants, with the number of options calculated using Black-Scholes on grant date. The CEO can aim for a temporarily lower stock price, that will drive up the number of options granted when the formula is applied. Use of the grant date market price as the exercise price might be considered a term of the option but it is nearly universal, driven by tax and formerly accounting considerations, and I can live with it as long as other gaming avoidance measures are taken.
Principle 7: To the extent that executives have discretion over the timing of sales of equity incentives not subject to unwinding limitations, executives should announce sales in advance. Alternatively, the unloading of executives’ equity incentives should be effected according to a prespecified schedule put in place when the equity is originally granted. Ok, not as hard as it sounds. The Company could impose and disclose mandatory 10b-5(1) plans, but give the retirees a break, they won't be gaming anything.
Principle 8: Executives should be prohibited from engaging in any hedging, derivative, or other transaction with an equivalent economic effect that could reduce or limit the extent to which declines in the company’s stock price would lower the executive’s payoffs or otherwise materially dilute the performance incentives created by the company’s equity-based compensation arrangements. Right, what's the point of any limitation if you can hedge you're way around it, reestablishing the primacy of the short term.
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