The PCAOB has proposed standards requiring auditors to assess whether compensatory arrangements held by executive officers create risks of material misstatements. According to Steve Seelig in Towers Watson’s Executive Pay Matters blog (“Does New PCAOB Proposal Really Eliminate the Risk of Auditor Involvement in Executive Compensation Design?,” May 30, 2013), the focus is on “the potential for incentive compensation program structures to create incentives for executive officers to exaggerate gains or minimize losses.”
This a re-proposal of a proposal from 2012. According to the PCAOB, the redraft is designed to make it clear that the auditor isn’t required to assess the reasonableness of the compensation. Steve, however, doesn’t see much difference between the two proposals and based on the comparison he includes in his blog, I don’t see much difference either. To be honest, they both seem fairly inscrutable to me.
Are You Going to Get to Know Your Auditor Even Better?
While there’s the potential for any type of compensation to incent executives to make the company’s financial condition look better than it is, this is particularly a concern with stock compensation, where the value delivered to the exec is driven by the stock price, which, in turn, is driven by the company’s financial performance. Thus, this is potentially something new that auditors will be focusing on when they review your stock compensation programs. The PCAOB proposal calls for auditors to read the related compensation contracts (this would be the grant agreements and any other related documentation for stock awards) and also to read the disclosures in the company’s proxy statement and other public filings.
My first thought is “aren’t the auditors already reading those things?” Probably they are (aren’t they?), but maybe not with a focus on whether the arrangements create risk that execs will be incented to misstate the company’s financials.
But given what many stock plan administrators have told me about their auditors–i.e., their auditors are often fresh from the CPA exam with little to no understanding of stock compensation–I also have to wonder whether the auditors are really capable of making this assessment. It seems unlikely that someone who doesn’t understand what the exercise price of an option is will understand the nuances in financial risk inherent in, say, an option vs. restricted stock, and how clawback provisions and holding requirements might be used to mitigate that risk. Steve is concerned that auditors “may develop bright-line rules on what compensation programs are risky or not,” which seems like a reasonable concern to me.
Light Reading
If you are looking for some light summer beach reading, well, this PCAOB proposal sure isn’t it (however, I do recommend “Let’s Pretend This Never Happened” by Jenny Lawson–perfect summer reading and nothing to do with stock compensation). The whole thing (the PCAOB proposal, not the Jenny Lawson book) clocks in at 203 pages and includes sentences like “In the fourth bullet, delete the period (.) and add a semicolon (;) at the end of the bullet.” Seriously?
On the other hand, if you can wade through the proposal, (1) you are a better person than me, and (2) you have until July 8 to submit your comments to the PCAOB.
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.
According to the NASPP’s 2010 Domestic Stock Plan Design Survey (co-sponsored by Deloitte, with survey systems support provided by the CEP Institute), 68% of respondents report that their stock compensation programs are not subject to a clawback provision. I’m hearing predictions that this will change, with more companies implementing clawbacks for executive level employees in the future.
Clawback Provisions A clawback provision enables the company to recover, or “clawback” previously paid or realized compensation upon the occurrence of specified events or behavior. Historically used to enforce noncompete provisions, we are now seeing clawbacks for financial restatements due to misconduct or compliance failures, inaccurate financial reports, and fraud or ethical misconduct (whether or not it results in financial restatement). I’ve even heard of a company including a clawback on performance awards if the board later determined that the way the performance goal was achieved wasn’t quite the behavior they were looking for. Clawbacks can apply to bonuses and various types of stock awards, including stock options, restricted stock/units, and performance awards.
Why Clawbacks Now?
Clawbacks are hot now in part because several recent pieces of legislation have required them, including SOX, the Emergency Economic Stabilization Act, and, most recently, Dodd-Frank. Although the requirements are fairly limited in each case (for example, EESA only applies to TARP companies), regulator interest in clawbacks is likely indicative of the public and media support for them. And now clawbacks are viewed as an effective tool for mitigating risk in compensation programs.
In addition to the obvious questions that must be addressed when implementing clawbacks–who should the clawback cover, what compensation should it cover, what events should trigger it, and how long it should be in effect–there are a number of more sophisticated matters to address:
Should the clawback be a provision in the plan or award agreement or should it be a more general policy?
Will the clawback be enforceable? State laws can be a particular hindrance to enforcement, so this question is not always as easy to answer as you might think, given that federal laws require clawbacks in some circumstances.
How will the clawback be communicated to executives and what level of consent will be required from them (for example, executives have to indicate consent by signature)? If the clawback policy covers previously granted awards, what will the consequences be if executives don’t consent?
What level of discretion to enforce (or not enforce) the policy will be provided to the board?
If a company has a clawback policy or provision in place, one tip from the “Risk Mitigation for Stock Compensation” panel is to discuss the policy prominently in the Executive Summary of the CD&A in your proxy statement. Clawbacks are exactly the type of risk mitigation strategy that ISS and shareholders (and other shareholder advisory groups) are looking for; having a clawback policy could offset other problematic compensation practices.
The panel also included a detailed discussion of the tax treatment that applies when a clawback is triggered–information that is likely to be very useful in the future as we see more enforcement of these provisions.
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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.
The writing is on the wall; risk management through effective compensation practices is a hot topic right now. Recent regulatory developments and government initiatives indicate that all pubic companies may eventually need to explain to shareholders and investors how their compensation practices help align employee performance with shareholder interests and safeguard the company against excessive risk. I’m not just talking about your executive compensation, either. Now is the perfect time to take another look at your company’s equity compensation practices and decide if they are motivating employees to take reasonable risks that will help your company grow without encouraging excessive risk-taking behavior.
This Senate Bill, introduced on May 19th of this year, would require companies to create a board committee to oversee company risk management. Specifically, it calls for companies’ risk management committees to be independent of their audit committees. While this bill does not call for publication of risk management in compensation practices, it does put a focus on the importance of managing risk.
On June 10th of this year, Treasury Secretary Tim Geithner made a statement outlining the measures the Treasury Department will be promoting to help create financial stability. Among the focal points in this press release are several statements about how companies should be dealing with risk management. First, the Treasury encourages all company compensation committees to not only conduct, but also publish risk assessment of pay packages. Additionally, it calls for companies to ensure that compensation is structured in a way that fixes an appropriate time horizon for risks. To do this, the Treasury asks that companies provide their risk managers with the “appropriate tools and authority to improve their effectiveness at managing the complex relationship between incentives and risk-taking.”
On July 1 of this year, the SEC submitted its proposal on changes to compensation disclosures. In particular, this proposal includes requiring companies to discuss how they are managing risk-taking through compensation practices. The proposal doesn’t necessarily require this discussion for all companies; it is only required if the risks may have a “material effect” on the company.
Get Involved!
This trend of focusing on risk management encompasses your company’s broader compensation practices. It is important for your company to review its compensation practices (especially in light of the current economic situation) and stock plan administrators should be getting involved in what this will mean for equity compensation.
When it comes to managing risk, the most obvious way to tackle the issue is through performance-based incentives. Effective performance grants are good for everyone, and the economic conditions have made it clear that a review of performance metrics is warranted. Make sure that your stock plan team is involved in conversations on how to improve your performance metrics; not only to help make them more effective, but also to make sure you will be ready to administer the grants when they are awarded.
One of the most important points to make about performance grants is the need for a well-balanced mix of performance goals. When awarding performance grants to your executives and other key employees, using just a single metric (like share price or revenue) puts too much emphasis on just one target and potentially increases inappropriate risk taking by key employees. A good mix includes both short-term and long-term goals so that strong performance must be met and maintained. Even better, including both internal and external goals helps promote behavior that not only meets your company’s internal targets, but also keeps it competitive in the marketplace. For ideas on how to create effective performance-based compensation, check out our Performance Plans Portal.
Another great way to encourage sustained growth and effective risk taking is to put a long-term focus of at least a portion of equity compensation for your key employees. This can be done by requiring key employees to maintain a meaningful position in your company’s stock. What we’ve seen recently that has shareholders (and employees) in an uproar are executives who can leave the company and cash-out on huge equity compensation packages, but leave behind a company that is poised to fail because of ineffective risk management on the part of those executives. Companies are dealing with this by establishing hold-through-retirement policies, ownership guidelines, and claw-back or forfeiture provisions. Be sure to check with your risk manager, compensation committee, or head of compensation to see if any of these strategies are in store for your company’s equity compensation program.
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