Monday, November 15, 2010

Exec Comp Design in 2010 and Beyond

Executive compensation design in 2010 and beyond is not what it used to be. Sarbanes-Oxley and its stepsister, Dodd-Frank, are changing all the rules, all the standard practices, and the public's view of what's right. Here are 10 of the worst practices we see in executive compensation design and some comments on fixing them:

  1. Single trigger and gross-up on golden parachutes - For the uninformed, a golden parachute, loosely described is a special package given to an executive in the event of a change-in-control. Golden parachutes are covered in Section 280G of the Internal Revenue Code. Excise taxes on excess parachute payments are covered in Section 4999 of the Code. A single trigger is an arrangement whereby a golden parachute pays out upon change-in-control, regardless of loss of employment for the covered executive. A gross-up occurs where the company pays all the taxes on an executive's parachute payments, and these can be massive. A payout of 2.99 times pay for an executive in the event of a change-in-control and loss of employment is very sufficient.
  2. Perquisites - Perquisites, also known as perks or perqs are not inherently evil, but they have gotten way out of hand. In giving perquisites to executives, ensure that they have a business purpose. So, while use of the company airplane by the CEO may have good business reason, a chauffeur for the CEO's spouse probably does not. Special health care benefits (especially executive physicals) for the top executives may be important to the risk management processes of the organization, but multiple company-paid country club memberships likely are not.
  3. Exchange of Underwater Stock Options - Suppose you granted a whole bunch of stock options to your executives in 2007 and now the company stock is selling for much less than the strike price of the options, then those options are said to be underwater. In recent years, a number of companies have been exchanging such options for ones that may be more likely to have value to those executives. Gee, do the shareholders who bought the stock in 2007 get to similarly exchange their shares? They had nothing to do with the stock price declining, don't they deserve a deal at least as good as what the executives?
  4. Excessive Share Dilution - Authorizing too many shares for executive compensation programs may dilute shareholder value. While we would say never say never, doing this too often is a sign that your company is putting its executives ahead of its shareholders.
  5. Evergreen Employment Contracts - I've never had a rolling, self-renewing employment contract, have you? You're not sure. Perhaps the best examples of such contracts are found in college athletics. Hometown U hires Coach Goodplayer and gives him a 5-year contract to coach the football team at a salary of $2 million per year (plus perquisites of course). At the end of each year, Coach G's contract automatically resets to be a new 5-year deal, unless Hometown U decides to cut off the evergreen part. Finally, in 2013, when Coach G has a bad season and the alumni say to get rid of him, Hometown U owes him 4 years of salary and perquisites just to make him go away.
  6. Severance for Failure - The real live cases are well known. Living in the Atlanta area, the best known case here was Bob Nardelli's deal at The Home Depot. Under Mr. Nardelli's leadership, HD stock price fell precipitously. After 6 years at the helm, he resigned under pressure with a severance package valued at roughly $210 million according to
  7. Disconnects in Incentive Payouts and Timing - Incentive payouts should make sense. Executives should be expected to perform at high levels. Paying out a bonus for poor performance, for example, should be viewed as taboo. Consider a circuit breaker whereby the switch flips to off if an executive hits less than 80% of his or her target. Does that seem to harsh? If an executive is not hitting 80% of target, think about what is happening to the poor shareholder.
  8. Discretionary Incentive Designs - In days of yore, most discretion on incentive payouts was reserved for the CEO, and not the CEO's bonus. That is, the CEO had the discretion to unilaterally increase (yes a discretionary decrease was available, but rarely if ever happened in practice) the bonus of any of his or her direct reports beyond what the incentive plan design would have recommended as a bonus. In the new world of executive compensation, such discretion lies only with the Board, and the Board's discretion exists to ratchet incentive payouts downward.
  9. Poor Goal-Setting that Motivates Imprudent Risk-Taking - Be very careful how you design a set of goals or an incentive plan. Poor design might motivate behaviors that are against the goals of the organization. Think about the crisis in the financial services sector. Think Bear Stearns, Countrywide Mortgage, AIG, and others. News reports certainly suggested that executives at each of these organizations were being well-rewarded for taking incredible risks -- risks that eventually led to corporate downfall. Take steps to ensure that taking risks beyond those that the company (and its shareholders) would consider acceptable be de-motivated.
  10. Design Based on a Mis-Chosen Peer Group - The peer groups for many companies have historically been chosen by the executives at those companies. How did they choose them? Many chose them very reasonably, but some cherry-picked that peer group. In other words, they picked companies that looked somewhat like theirs, but that they knew were underperforming. The peer group should consist of high performing companies of similar size and divisional peer groups should be based on companies and their segments of similar size. Companies that are known to be underperforming should be left out.
So, there you have it ... my Top 10.

Nothing in this post or this blog should be construed to represent legal, accounting or tax advice, and while this is thought to be generally correct, nothing herein represents consulting advice for any specific organization.

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