A common theme among the Obama administration, Congress, investors, and regulators is that executive compensation must refocus on different fundamentals: Long-term value rather than short-term profits; financial stability, and management of risks. To date, the Obama administration and its Department of Treasury have not offered much help except to announce five principals:
- Compensation plans should properly measure and reward performance;
- Compensation should be structured to account for the time horizon of risks;
- Compensation practices should be aligned with sound risk management;
- Golden parachutes and supplemental retirement packages should be reexamined to determine whether they align the interests of executives and shareholders; and
- Transparency and accountability should be promoted in the process of setting compensation.
At its September 24, 2009 conference in Pittsburgh, the G-20, being pushed by the European Community, added additional items for the refocus
Clawing back all compensation, including salary, for poor performance which goes beyond the Obama administration's clawing back of incentive compensation for malfeasance;
Linking bonuses of an organization's executives more to the health of the organization's balance sheet;
Requiring an incentive pay performance period to be three or more years; and
Requiring compensation committees to be composed of independent directors with rotation of the committee chair and its members as already required in the US.
The new focus on long-term value, financial stability, and management of risks will likely apply to all industries, not just financial institutions, and to all types of organizations, not just publicly-held companies. Without the help of Congress, the Federal Reserve, FDIC, SEC and Treasury can require such new focus by regulation on banks, publicly-held companies, investment banking firms, securities dealers, and tax-exempt organizations. Similarly, state regulators will likely require a new focus by insurance companies, utilities, state and local government agencies, and other organizations subject to state regulation. The European Community is the most vocal in urging reform of the focus of executive compensation.
Properly designed long-term incentive plans (or LTIPs) may be the best tool for accomplishing this new focus.
An LTIP provides an executive with incentive-award opportunity for achievement of pre-established performance measures over a multiple-year performance period. Although LTIPs have existed, the traditional LTIP requires some redesign to accommodate this new focus:
- The performance measures traditionally have been based upon results of operation under the executive's control, such as growth in revenues, operating margins, or earnings. In the future, performance measures should include the balance sheet, especially the long term effect on liabilities and net worth (capital or surplus for non-stock companies). Compensation committees should consider economic measures used in economic value added ("EVA") models (which typically measures an organization's "economic profit" or increase in net worth, capital or surplus in excess of the organization's cost of capital) as well as non-economic measures used in balance scorecard evaluations (which typically include evaluations of improvement in customer relations, learning and growth, and internal operating processes). EVA expertise can be found at the Stern Stewart & Co website, the developer of the EVA model, and at the Eleanor Bloxham website, an Ohio-based consultant having experience with EVA models. The best source for information on the balanced scorecard is the seminal publication, The Balanced Scorecard: Translating Strategy into Action by Robert S. Kaplan and David P. Norton (1996).
- The performance period, traditionally has been two or three years, over which the performance measures were measured. In the future, the performance period should not be less than three years and may be a combination of three- and five-year periods. The Council for Institutional Inceptvestors and the European Community are urging that the performance period be coupled with 100 percent forfeiture akin to cliff vesting if the participant does not remain in service for the entire performance period.
- The incentive award opportunity based upon the level of achievement of the performance measure over the performance period. The incentive award opportunity traditionally has offered three levels of award: A "threshold" award for achievement of 75-to-80 percent of the expected level performance; a "target" award for achievement of the expected level; and a "maximum" award for exceptional performance. The Council for Institution Investors and Treasury are urging that there should be defined performance levels or floors below which there will be no incentive award. The Council for Institution Investors and the European Community are urging dollar limits on the amount of any maximum award. Finally, most investors and regulators are urging there be defined events or "stops" the occurrence of which annuls the opportunity and stops any award. Following the first rule of executive compensation of Steven Davis, CEO of Bob Evans, that "shareholders get paid first," compensation committees should define as such a stop any failure for net worth (or, for non-stock organizations, capital or surplus) to increase for any performance period.
Two new limitations also are being urged by the European Community, investors, and some regulators:
- Deferral of payment. Rather than pay the incentive award immediately after the performance period as has traditionally been done, compensation committee are being urged to defer payment for an additional two or three years to allow clawback if the executive is found to be involved in malfeasance.
- Scheduled vesting. Rather than vest the executive's rights to the incentive award upon completion of the performance committee, compensation committees are being urged to schedule vesting based upon continued service after the period. Committee's are being urged to consider scheduled vesting over two or three years after the performance period. For example, an executive would forfeit his or her entire incentive award opportunity if service is terminated prior to the performance period and would only be entitled to payment of a percentage of any actual incentive award earned based upon the number of years of service completed after the performance period.
Finally, "transparency" has become the operative word of the Obama administration, Congress, investors, and regulators as well as the G-20. The purpose of transparency is to hold the board or other managers accountable for the compensation paid. The elements of transparency include:
- Articulation of the philosophy underlying the incentive plan;
- Reporting to the entire board of the size, distribution, vesting requirements, other performance criteria and payment timing of the incentive awards. The European Community would require board approval of the compensation of senior executives
- Documentation in minutes of the adoption of incentive award plans, the granting of incentive award opportunities, any changes to opportunities after their grant, and any approvals of payments thereof; and
- Disclosure of the terms of the incentive awards by publicly-held companies in proxy materials and by tax-exempt organizations in Forms 990.
Even as LTIPs are redesigned to accommodate the new focus of the administration, Congress, the G-20, investors, and regulators, they are likely to become more popular as compensation committees eliminate non-performance-based SERPs, severance, and annual bonuses which are increasing being view as entitlements entrenching management.
NOTE: A glossary of the terms used in this and future articles on executive compensation are contained in the July 2009 issue of Acredula and are also available on the Bricker & Eckler Executive Compensation Resource Center.