They've been up, they've been down. They've been in the money and under water. And they've been all over the headlines.
Now stock options are moving from the small print to the body of financial and proxy statements, and as they do, companies across America are reconsidering their approach to compensation; revisiting the forms of payment they offer; and trying out new ideas for motivating employees, top performers and key executives.
Clearly, there's a lot at stake. The spotlight is shining on the small print of executive contracts as the FASB's financial accounting statement (FAS) 123R and new SEC disclosure regulations require publicly traded companies to treat stock options as an expense and to list not just the salaries and perquisites paid to top executives, but also the philosophy behind them. Some pay experts say all the attention will hold down salaries; others counter that the new visibility will spur competitive pressure to pay even more. One thing is certain: Finance executives will find their knowledge and skills more in demand than ever as advisors to compensation committees -- establishing compensation programs aligned with business objectives, helping guide decisions, quantifying requirements, and representing the best interests of stakeholders to senior executive management and the board of directors.
The backdated stock options scandal, outrageous severance pay packages and extravagant perquisites have forced several essential questions at U.S. companies today: What are best practices in compensation management? What are the best ways to attract and retain top management talent; align the objectives of the organization and its key stakeholders; inspire and reward performance; provide for, at minimum, the full disclosure required; and be perceived as being "above scrutiny" by a cynical investor community? For finance executives, experts agree: Consider compensation management a front burner issue for the foreseeable future.
The Background to Success:
The Financial Accounting Standards Board's financial accounting statement (FAS) 123R has been public for two years, and many forward-looking companies have gotten a jump on things and reported the details of their executive compensation already. Every company must do it now, though, in the first financial and proxy statements filed after December 15, 2006. FAS 123R replaces the previous standard, APB 25, under which companies had to expense stock options granted to their executives only if they were priced below market value. Now all options must be counted. The SEC regulations, meanwhile, say companies must detail all the compensation paid to the CEO, the CFO and the other three top earners each year and explain how these compensation plans align the goals of the top executives with those of its shareholders. Where in the past companies were required to disclose perquisites worth $50,000 or more, this year they must list anything worth $10,000 or more. Section 601 of the SEC regulations now requires CEOs and CFOs to certify that the disclosures being made are a "valid and accurate" representation of the company's compensation plan. By the end of 2007, companies will be required to disclose payments in connection with the resignation, severance, retirement or other termination of an executive officer or upon change in control of the company. To former SEC deputy chief accountant Scott Taub, the changes are "a real opportunity for companies to rethink their compensation packages" -- beginning with their use of stock options. "In the past, APB 25 gave such an accounting benefit to fixed-price, at-the-money options that that's what everyone issued, regardless of whether that was the best way to motivate people," he says. "FAS 123R gives companies an opportunity to not let accounting drive what kind of equity compensation to issue, to actually design compensation packages based solely on the best way to motivate people." |
A Change in Accounting for Options
Whether options are the best measure of the value of a CEO or CFO has been a subject of heated debate for decades. For growing companies, they certainly hold down the cost of hiring top talent and reduce the tax consequences of paying for it. But do they align stakeholders' interests? In their book Pay Without Performance: The Unfulfilled Promise of Executive Compensation (Harvard University Press, 2004), Harvard Law School professors Lucian Bebchuk and Jesse Fried argue that options are just an underhanded way for corporate boards to overpay their CEO buddies. CEO excess, they say, is curbed only by the "outrage constraint" of public opinion.
Now, the one-two punch of disclosure requirements and scandals around backdating options and severance packages is providing the outrage. As a result, companies are accelerating their search for new ways to compensate senior executive management. A survey last June by the Controllers' Leadership Roundtable found one in four companies had cut back on the stock options it offers (see A Changing Landscape) -- most usually, turning instead to cash or restricted stock options, often tied to performance.
Anticipating the increased scrutiny, many companies are taking a proactive approach to compensation, seeking to link pay and performance. General Electric Chairman and CEO Jeffrey Immelt receives no options, but instead is issued "performance share units" that pay off only if specific performance objectives are met. At the same time, Immelt is required to hold stock valued at six times his current base salary of more than $3 million. (GE senior vice presidents are given five years to build up a bank of stock worth three times their base salary.) Immelt himself asked to have his bonus paid not in cash but in performance shares instead, according to GE's 2006 proxy statement.
The Campbell Soup Co. and IBM have followed a similar tack. IBM has been cutting back on options for employees as well as executives since 2005; it now offers executives premium-priced options set at 10 percent over the market price. These are designed to more closely align the interests of shareholders and executives, says IBM spokesperson John Bukovinsky, as executives don't realize any benefit until shareholders receive at least a 10 percent gain on their investment.
According to its 2006 proxy statement, IBM has established stock-ownership guidelines for members of senior management to increase their equity stake in the company and more closely link their interests with those of the stockholders. These guidelines provide that, within a five-year period, senior executives should attain an investment position (not including unexercised stock options) in IBM stock or stock units of three to seven times their base salary, depending on the individual's scope of responsibilities, and 13 times base salary for the CEO.
For many companies, though, stock options will remain the incentive of choice. In fact, now that options must be accounted for as an expense, the market is seeking new models to set lower values on them (see New Options in Accounting for Options). According to Ted Buyniski, senior vice president at Radford Surveys + Consulting, a San Jose-based company focused on compensation and benefits for the technology and life sciences industries, 85 percent of respondents to a recent survey say they still use stock options, about 5.6 percent shortened the vesting period over the past year, and 5.9 percent shortened the exercise term.
Paul Hodgson, senior research associate at The Corporate Library, is quick to note that options, when used correctly, are both legal and effective. "The most sophisticated and effective compensation programs" offer index-linked options, in which the exercise price goes up and down in line with a general index of similar companies, so executives earn a profit only if the stock outperforms that of its peers. Alternatively, companies can follow the example of IBM, The Chubb Corp. and Yahoo! and offer options at a premium, so they become profitable only if the stock price goes up by a predetermined amount. At Chubb, for example, a "restoration feature" provides that CEO John D. Finnegan does not get an automatic renewal of his stock options, but rather can exchange them as they vest only if the stock price has increased by 25 percent.
In any event, the IBM approach of forcing executives to hold onto stock for longer periods of time is a definite trend this year, says Carl Weinberg, principal of PricewaterhouseCoopers Global HR Services. Just a blip on the radar five years ago, "it is starting to become mainstream," he says. "Shareholders want to see senior management have a long-term investment."
From Exxon Mobil to Pepsi, from Citi to GE, many top companies now have senior executives working without employment contracts. Many more executives find themselves working under short-term contracts, more in keeping with the real-time nature of modern business (and the reality that the tenure of the average of CEOs and CFOs is less than two years). It's very difficult for anyone to say what a CEO should earn five years in advance; many companies are offering one- or two-year contracts tied more directly to company objectives. Also likely are sunset clauses that say the contract must be renegotiated every two or three years, giving the board more flexibility to keep objectives aligned with strategy.
Whatever the approach companies take, the investing public surely is watching and may well take matters into its own hands. Institutional investors at about 75 companies are pushing for the right to approve executive compensation plans before they take effect, says Hodgson. That's a new concept in the United States, but it has already spread rapidly elsewhere, and executives in Britain, Australia, Sweden and the Netherlands rely on their shareholders, in part, to determine their pay packages.
Align Performance, Risk and Reward
Neither FAS 123R nor the new SEC regulations say anything at all about reducing executive pay or linking it more closely to performance; the only mandate is to be clear about what you are paying and why. Still, the trend toward less fixed and more variable pay is picking up steam in the spirit of good corporate governance and in the light of public scrutiny.
One of the most important outcomes of the "FAS 123 revolution," says Radford Surveys' Buyniski, is the growing emphasis on long-term incentives and the focus on answering the central question, "How do we know we're winning?" Compensation committees are seriously considering whom to compare executives against in setting performance goals, asking who their real business competitors are and how executive pay compares. "Increasingly, I'm seeing compensation committees hold management's feet to the fire and say, 'If you perform, we'll pay you very well. But you really have to win.' "
As a key member of the executive team, the CFO should be part of the team that sets performance objectives for executives, experts agree. Stock prices are too far removed from the control of any single executive -- even the CEO -- to be a useful measure of performance. The best practice is to look for objectives that really matter, that can be measured and over which executives have real control.
The general concern about performance metrics is that too often underperforming executives are not penalized, but when they perform well they get all the credit -- a "heads I win tails you lose" phenomenon that turns performance goals into gifts. "In terms of a best practice, it makes sense to be symmetric with regard to bonus practices and to reward on the up side and penalize on the down side with a balanced view," says Joseph A. Grundfest, Franke Professor of Law and Business and co-director of the Rock Center on Corporate Guidance at Stanford Law School.
More than ever before, companies are pushing the pay-for-performance theme down to the front lines. Towers Perrin managing principal and global practice leader Ravin Jesuthasan says he's seeing "a veritable explosion in the use of variable pay throughout the workforce" and bonus opportunities of up to 10 percent of annual salary being offered even to union employees. In the retail and travel industries, many companies are using merchandise or loyalty points in lieu of cash because they deliver perceived value that's greater than the cost of the program, help the employee understand the customer experience and minimize the taxes the company has to pay.
But most companies simply don't have the processes in place for setting organizational objectives and cascading them down to the individual level. Stock options are just "an excuse for creating a compensation program without really creating strategic alignment," notes Mark Stiffler, CEO of Synygy, a performance improvement consulting company. A much better measure for the CFO, for example, might be to reduce the cost of capital by 0.5 percent -- a move that would positively impact the value of the company and is directly connected to the CFO's direct responsibilities.
For finance, all this means a huge change -- and a new need to build alliances with HR, Buyniski says. The two groups must pull together as never before to design and administer plans "so that ultimately that whole 'mom-and-apple-pie' of pay for performance actually makes sense and works."
The 90-Day PlanThe search for the perfect compensation program is a never-ending trek, and this first year of disclosure will surely give life to the devils lurking in your details. The way to get started is to divide the task into small steps -- and then to take the first one. If you are still working on your Compensation Disclosure and Analysis, consider having it approved by the HR, legal and accounting departments before you certify and file your Form 10-K. Take the time to get comfortable with the information. Look for details likely to raise red flags. If you are not including actual performance targets, benchmarks and peer groups, be prepared to justify why doing so would result in competitive harm to the company. Read over your compensation committee report and proxy statement with an outsider's eye. Think like a shareholder. Consider whether it meets the spirit of full disclosure. Be prepared to justify every detail. Take an especially close look at termination and retirement contracts, which are attracting a lot of attention this year and must be made public next year. Remember that nothing is more certain than change. Set regular times throughout the year to sit down with your CEO and the heads of HR and the compensation committee to revisit the overall goals of your compensation strategy and the structure for attaining them. When you do, start from scratch. Challenge all your underlying assumptions regarding executive compensation. As the compensation plan comes together, do a reality check. Plug the numbers into your business plan to see how your executives and financials would have fared had the program been in place two years ago and how they are likely to look next year. Rethink your contracts with outside compensation experts to avoid conflicts of interest. By the end of 2007, companies will have to make public the details of compensation arrangements that contain a deferral feature. Begin now to assess the impact. |
CFOs Step Up
For CFOs, the public scrutiny of executive compensation brings more good news than bad. As executive officers, they now are seeing their own names and salary details on compensation tables in the proxy statements. But at the same time, their role as key players in the process of setting compensation has increased.
CFOs are important providers of information to the rest of the management team and the board in terms of the metrics investors are watching, what can be measured, how much the compensation strategy is costing and how the organization is performing, says Diane Doubleday, worldwide partner at Mercer Human Resource Consulting.
CFOs are "stepping up and assuming a leadership role around equity plans in general," says a senior executive at a fund management company that administers roughly 1 million stock plans. CFOs need to make sure that robust internal controls are in place to comply with reporting standards and that the plan is aligned with corporate goals. "Where in the past more HR people assumed responsibility," she says, "now it's more likely that the CFO is heading up the effort."
Just as Sarbanes-Oxley energized the audit committee, the disclosure requirements are going to energize compensation committees this year, says Glenn Davis, who heads the corporate governance services practice of J.H. Cohn LLP, an independent accounting and consulting firm with offices in New Jersey and New York. According to Davis, they have a long way to go. In a recent study he cites, less than half of corporate boards feel that their compensation committees have the necessary skills and background to do a good job.
Now is the time to prepare a clearly delineated company policy defining compensation objectives and plans against the company's strategic objectives, experts say. Anthony Zecca, partner-in-charge of Cohn Consulting Group and a member of parent company J.H. Cohn's management committee, suggests that compensation committees lay out all the disclosure requirements and track all the various components of the compensation plan in one place -- including not just the compensation of the CEO, the CFO and the next three highest-paid executives, as the new regulations require, but the top 10. "There's going to be a lot more robust discussion at shareholders meetings, and the committee needs to be prepared with a document that has all the different components of how you compensate executives and the rationale behind how you decided to do what you decided to do," he says.
Documentation is particularly important for CFOs, who could find themselves needing to explain and perhaps defend compensation policies and plans even though they may not have been physically present at the discussions that led to their implementation, notes Pete Lupo, managing director of Pearl Meyer & Partners, executive compensation consultants in New York City.
One important point: Punting the ball to a paid outside consultant is no guarantee of shareholder support this year. Those contracts are also under fire -- and the disclosure regulations of the SEC. Consultants with compensation engagements are precluded from providing other services to their client companies, just as Sarbanes-Oxley bars auditors from other engagements with their audit clients.
No matter what compensation plan your company chooses, the very best advice -- this year and every year -- is to "be open and honest in your disclosure and management discussion and in all your filings," recommends FASB chair Robert H. Herz. "That's by far the best policy, and it gets you a lot more credit than trying to hide things or write them in a way that obfuscates the truth."
Herz also underscores the fact that the SEC has specifically asked for feedback on the new executive compensation disclosure requirements, even though they already have taken effect. Both the FASB and the SEC "encourage CFOs to try to participate in our process through comments," he says, "and whenever you have the opportunity to comment on rulemaking that affects you, you should take it."
Tips from the TopSEC Commissioner Roel C. Campos offered the following best practices at the 2007 Summit on Executive Compensation in January. Do your homework before the executive is hired. Investigate and do due diligence on the front end. Many boards don't understand the ramifications of their executive compensation decisions, particularly as they relate to severance pay, pensions and golden parachutes. Set up a negotiation team, working for the board and the compensation committee, led by a neutral professional whose objective is a fair compensation package. The team should commit itself to not paying an outrageous amount in total compensation. Focus on long-term compensation, not just quarterly or yearly stock price. Get investor buy-in with respect to whatever package has been tentatively negotiated. Look to international norms when making recommendations. Carefully consider giving shareholders an advisory vote on executive compensation. |
New Options in Accounting for Options:
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