There’s a lot being said about the new CEO pay ratio disclosure rules, most of it far better than anything I could write myself, so today, as a fill in for Jenn Namazi who is on vacation, I continue my new tradition of “borrowing” other blog entries on this topic.
Today’s entry is a nifty “to do” list for preparing for the CEO pay ratio disclosure that Mike Melbinger of Winston & Strawn posted in his August 6 blog on CompensationStandards.com. Given that the disclosure isn’t required until 2018 proxy statements, you might have been lulled into thinking that this isn’t something you have to worry about yet. While it’s true that there’s no need to panic, there is a lot to do between now and 2018 and it is a good idea to start putting together a project plan now to get it all done. Don’t let this turn into another fire that you to put out. Here are Mike’s thoughts on how to get started:
1. Brief the Board and/or the Compensation Committee as to the final rules and the action steps. Press coverage of the rules has been extensive. They are likely to ask.
2. Each company may select a methodology to identify its median employee based on the company’s facts and circumstances, including total employee population, a statistical sampling of that population, or other reasonable methods. We expect that the executive compensation professionals in the accounting and consulting firms very soon will be rolling out available methodologies (they began this process when the rules were proposed, two years ago). The company will be required to describe the methodology it used to identify the median employee, and any material assumptions, adjustments (including cost-of-living adjustments), or estimates used to identify the median employee or to determine annual total compensation.
3. As I noted yesterday, the rules confirm that companies may use reasonable estimates when calculating any elements of the annual total compensation for employees other than the CEO (with disclosure). Assess your ability to calculate precisely all items of compensation or whether reasonable estimates may be appropriate for some elements. The company will be required to identify clearly any estimates it uses.
4. Begin to evaluate possible testing dates. The final rules allow a company to select a date within the last three months of its last completed fiscal year on which to determine the employee population for purposes of identifying the median employee. The company would not need to count individuals not employed on that date.
5. Consider tweaking the structure of your work-force (in connection with the selection of a testing date). The rules allow a company to omit from its calculation any employees (i) individuals employed by unaffiliated third parties, (ii) independent contractors, (iii) employees obtained in a business combination or acquisition for the fiscal year in which the transaction becomes effective. Finally, the rule allows companies to annualize the total compensation for a permanent employee who did not work for the entire year, such as a new hire. The rules prohibit companies from full-time equivalent adjustments for part-time workers or annualizing adjustments for temporary and seasonal workers when calculating the required pay ratio.
As I noted yesterday, the rules permit the company to identify its median employee once every three years, unless there has been a change in its employee population or employee compensation arrangements that would result in a significant change in the pay ratio disclosure.
6. Determine whether any of your non-U.S. employees are employed in a jurisdiction with data privacy laws that make the company unable to comply with the rule without violating those laws. The rules only allow a company to exclude employees in these countries. (The rules require a company to obtain a legal opinion on this issue.)
7. The rules only allow a company to exclude up to 5% of the company’s non-U.S. employees (including any non-U.S. employees excluded using the data privacy exemption). Consider which non-U.S. employees to exclude.
8. The rules allow companies to supplement the required disclosure with a narrative discussion or additional ratios. Any additional discussion and/or ratios would need to be clearly identified, not misleading, and not presented with greater prominence than the required pay ratio.
The rules explicitly allow companies to apply a cost-of-living adjustment to the compensation measure used to identify the median employee. The SEC acknowledged that differences in the underlying economic conditions of the countries in which companies operate will have an effect on the compensation paid to employees in those jurisdictions, and requiring companies to determine their median employee and calculate the pay ratio without permitting them to adjust for these different underlying economic conditions could result in a statistic that does not appropriately reflect the value of the compensation paid to individuals in those countries. The rules, therefore, allow companies the option to make cost-of-living adjustments to the compensation of their employees in jurisdictions other than the jurisdiction in which the CEO resides when identifying the median employee (whether using annual total compensation or any other consistently applied compensation measure), provided that the adjustment is applied to all such employees included in the calculation.
If the company chooses this option, it must describe the cost-of-living adjustments as part of its description of the methodology the company used to identify the median employee, and any material assumptions, adjustments, or estimates used to identify the median employee or to determine annual total compensation.
Companies with a substantial number of non-US employees should seriously consider the ability of apply a cost-of-living adjustment to the compensation measure used to identify the median employee.
Risky Behavior and Stock Options The study, which is summarized in the article “The Making of a Daredevil CEO: Why Stock Options Lead to More Risk Taking,” published by Knowledge@Wharton, looked at companies that had recently experienced an increased risk and evaluated which companies took steps to mitigate that risk based on the percentage of their managers’ compensation that is in stock options and the in-the-moneyness of the options.
The researchers found that firms where managers held more stock options took fewer mitigating actions. They felt that this is because once stock options are underwater, the value of the options can’t get any lower. When you think about it, with full value awards, there’s always upside potential but there’s also always downside potential–until the company is just about out of business, the value of the stock can always drop further. But once an option is underwater, it doesn’t matter how low the stock price drops, the option can’t be worth any less. As a result, managers in the study that held more options were less incented to take actions to keep the stock price steady.
Risk and In-the-Moneyness
Interestingly, and in line with this theory, the study also found that when managers’ had in-the-money options they took more mitigating action than when their options were underwater. If there was some spread in the options, the managers were motivated to preserve that spread and thus took action to keep the stock price from dropping. But where there was no spread, the managers were more incented to take risks (presumably in the hopes that the risks would pay off and the stock price would increase).
This is all very interesting; I’ve often wondered (probably here in this blog even) why the media and investors have a bias for full value awards over stock options–I think this is the first plausible explanation I’ve heard for that bias. But here in the NASPP Blog, we view studies like this with a healthy level of skepticism–it’s odd but I’ve never seen a study that didn’t prove the researchers’ initial hypothesis–so I wouldn’t scrap your option plan in favor of full value awards just yet (if you haven’t already done so).
A Nail in the Coffin for Premium-Price Options
I’ve never been a fan of premium-priced options because the reduction in expense is less than the premium, which, to my mind, makes them an inefficient form of compensation. I prefer discounted options, which provide a benefit that exceeds the additional expense to the company.
If this study can be believed, premium options would also discourage executives from taking steps to mitigate risk (whereas discounted options would presumably have the opposite impact). Maybe regulators and investors need to reconsider their bias against discounted options (although, in the case of the IRS, this bias may have less to do with concerns about risk taking and more to do with tax revenue–see my March 16, 2010 blog, “Discounted Stock Options: Inherently Evil or Smart Strategy“).
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
This week I look at a section of the NASPP’s 2011 Domestic Stock Plan Administration Survey (co-sponsored by Deloitte) that came as a big surprise to me–the design and usage of stock ownership guidelines.
Trends in Stock Ownership Guidelines Maybe I haven’t been paying attention, but the significant increase in companies that have ownership guidelines was a big surprise for me. 73% of respondents in the 2011 survey report having ownership guidelines, up from only 54% of respondents in the 2007 Domestic Stock Plan Design and Administration Survey (also co-sponsored by Deloitte), a 35% increase. Back in 2007, we also asked how many respondents were considering implementing ownership guidelines in the next two years. Based on the responses to that question, I would have expected around 65% of respondents in the 2011 survey to have ownership guidelines, quite a bit less than 73%.
In case you are wondering, 25% of respondents to the 2011 survey that don’t currently have ownership guidelines said they are considering implementing them in the next three years. That would add around 35 companies to those that have guidelines, so I’d expect the percentage of respondents with ownership guidelines in 2014 (the next year the survey is planned for) to be close to 80%. All the cool kids are doing it, is your company one of them?
What Counts?
Everyone counts shares owned outright, whether purchased on the open market or through some type of compensatory or private arrangement. Of the respondents that offer the following types of arrangements, here’s the percentage that count them toward their guidelines:
70% count unvested restricted stock
60% count unvested phantom stock and RSUs
93% count vested phantom stock and deferred RSUs
Only 31% count unvested performance shares
72% of respondents indicated that they offer stock options but don’t count them toward the guidelines.
We asked about a bunch of other types of arrangements in the survey, but the ones I list above are the most interesting.
Who Counts?
Ownership guidelines are largely applied only to top executives–98% of respondents said that the guidelines apply to their CEO and CFO and 95% apply the guidelines to their other NEOs. Only 71% apply the guidelines to other senior executives. From there, application of the guidelines drops off sharply, with only 12% applying the guidelines to other management.
How and When to Count
Most, or 78%, of respondents base required ownership levels on a multiple or percent of compensation. 68% allow up to five years to meet the guidelines; another 13% percent require guidelines to be met in three years.
How Much to Count
For CEOs, required ownership levels are pretty high. 74% of respondents require the CEO to own stock equal in value to five or more times his/her compensation (49% of respondents require exactly five times compensation). That is perhaps reflective of how much CEOs get paid in stock. For the CFO and other NEOs, the requirement is a little lower, with 78% of respondents indicating that their requirement for these positions falls in the range of two to four times their compensation.
See You in San Francisco in Two Weeks! It’s hard to believe, but the 19th Annual NASPP Conference is just two weeks away! I hope to see all of my readers at the Conference, which is scheduled for November 1-4 in San Francisco. The last Conference in San Francisco sold out a month in advance–and that was without the reality of Dodd-Frank and mandatory Say-on-Pay hanging over our heads. With Conference registrations going strong–on track to reach nearly 2,000 attendees–this year’s event promises to be just as exciting; register today to ensure you don’t miss out (and make your hotel reservations, because the hotel is close to selling out).
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
October 20 is a popular day for local NASPP chapter meetings; the Chicago, Los Angeles, Phoenix, and Twin Cities chapters are all meeting on this day (separately, not one big meeting). Make sure you attend your local meeting!