Transcript Executive and Director Compensation Update

THE ASSOCIATION OF EXECUTIVE
SEARCH CONSULTANTS
The Brave New World of
Executive Compensation
Daniel J. Ryterband
Managing Director
Frederic W. Cook & Co., Inc.
April 10, 2003
Today’s Discussion
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Current State of Executive Compensation
Timeline of Reform Initiatives
The Clear Messages
Summary of Major Trends
I.
II.
III.
IV.
V.
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Voluntary Expensing of Options
Changes in CEO and Top Executive Compensation
Redesign of Long-Term Incentives
Redesign of Non-Executive Director Compensation
Redesign of Executive/Director Stock Ownership
Policies
The Key to Reform - The Decision Making
Process
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Current State of Executive
Compensation

Numerous scandals with significant executive compensation
implications:
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Widespread practices on the “slippery slope”
—
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Enron
Global Crossing
Tyco
WorldCom
Option repricings without shareholder approval
Equity grants from plans not approved by shareholders
Change in control severance pay to executives not severed
Loan forgiveness following stock price declines
Special “retention” awards in conjunction with declining operating
results and share price depreciation
The result – widespread shareholder and public skepticism
—
Perception of executive compensation perhaps never lower
3
Timeline of Executive
Compensation Reform Initiatives
12/21/01
SEC releases disclosure rules applicable to equity compensation plans
5/24/02
Nasdaq approves new corporate governance rules
6/27/02
SEC requires certification by CEO/CFO of financial statement accuracy
7/16/02
IASB announces decision to develop global option expense rules
7/30/02
Sarbanes-Oxley Act
8/1/02
NYSE approves new corporate governance rules
9/17/02
Conference Board releases “best practice” guidelines
9/18/02
FASB announces intention to revisit option expensing
3/12/03
FASB announces new options expensing requirement likely effective for 2004
Overall Depth and Scope is Expansive and Comprehensive
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The Clear Messages
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Constrain executive compensation
Increase executive/director accountability
Shift control over dilution to shareholders
Improve transparency and reliability of
financial disclosures
Disable insider ability to profit from non-public
information and fraudulent financial results
Increase independence of executive
compensation decision making
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I. Voluntary Expensing of Options

GAAP currently allows choice between two standards:
—
—
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Historically, only a small handful of companies had
elected FAS 123
Now, however, over 200 companies have voluntarily
elected to expense options
—

APB Opinion 25 – intrinsic value
→ Generally no expense for traditional options
FAS statement 123 – fair value
→ Expense generally equal to “Black-Scholes” value at grant
But, group includes virtually no high technology
companies
Mandated expensing highly likely in near future
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I. Voluntary Expensing of Options
(cont’d)
High Profile Company Sample
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American Express*
American International Group
AT&T*
Boeing*
Citigroup*
Coca-Cola*
ConocoPhillips
DuPont*
Emerson Electric
Ford
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General Electric*
General Motors*
Home Depot*
JP Morgan Chase*
Lowe’s Companies
Merrill Lynch
Morgan Stanley
Procter & Gamble*
United Parcel
Wal-Mart Stores*
* Component of the Dow Jones Industrial Average
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II. Changes in CEO and Top
Executive Compensation

CEO and top executive compensation has peaked and
is declining
—
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Greatest decline in area that exhibited fastest rise
→ Long-term incentives - stock options in particular
Little change in salaries and bonus opportunity
→ But some companies paying low or no bonuses
Some increases, however, attributed to special “retention”
grants and other one-time awards
Factors driving decline
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Falling share prices, which affect Black-Scholes values
Growth in “overhang” and resulting inability to increase
grant sizes
Cost considerations applicable to option substitutes
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III. Design of Long-Term
Incentives
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During 1990s, many companies used stock
options as sole or predominant long-term
incentive
—
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In some cases, options constituted 80% or more
of senior executive compensation opportunity
Drivers behind 1990s trend:
—
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Absence of P&L charge for traditional options
Highly leveraged nature – substantial wealth
creation opportunity in bull market
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III. Design of Long-Term
Incentives (cont’d)
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Companies reducing reliance on options and replacing
opportunity with “full-value” cash and/or equity
grants
—
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Restricted shares: time vesting, perhaps with performance
acceleration
Performance shares: performance-based, 2 to 5-year cycle
Performance units: cash-denominated multi-year bonus
Rationale for “full-value” movement:
—
—
Market volatility – underwater options create a
retention/performance disincentive
Option accounting – voluntary or mandated option
expensing eliminates financial efficiency options have
historically enjoyed
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III. Design of Long-Term
Incentives (cont’d)
—
Institutional investors – pressure to constrain
growth in “overhang”
→
—
Challenges in securing approval to replenish
exhausted share reserves
Public criticism – options in “disgrace”
→
General belief that options foster a short-term
focus
−
—
In worst cases, may encourage falsified financial
statements
Regulatory initiatives – pending rule changes at
NYSE/Nasdaq require shareholder approval of
virtually all equity awards
→
Also prohibits “repricing” without shareholder
approval
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III. Design of Long-Term
Incentives (cont’d)
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Bottom line:
—
All companies will continue to use options (or
their equivalent)
→
—
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But at reduced levels and for less employees
Stock price declines unlikely to be addressed
through repricings or higher award levels
Attempt to better balance overall program
through “full-value” awards
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IV. Redesign of Non-Executive
Director Compensation
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Widespread recognition that:
1.
Purpose of director pay different than executives:
—
—
2.
Foster independence and objectivity, as opposed to
retention
Protect shareholder interests, as opposed to
increasing shareholder value
Attraction of directors more difficult due to:
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Increased financial exposure and risk to reputation
Greater demands and expected level of
commitment
Specific credentials required to serve in various
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IV. Redesign of Non-Executive
Director Compensation (cont’d)

Resulting trends:
1.
Increased compensation at many companies
—
2.
Particularly small to mid-sized companies
Enhanced fees for directors serving in critical
roles
—
Higher retainers/meeting fees for chair/members
of key committees
→ For example: audit and compensation
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IV. Redesign of Non-Executive
Director Compensation (cont’d)
3.
Replacement of stock options with deferred or
restricted share awards
—
4.
Elimination of service-based and non-businessrelated perks
—
5.
Short (e.g., 1-year) or immediate vesting, versus
longer schedules
Such as life insurance, pension and medical plans
Adoption of stringent stock ownership guidelines
—
Often more onerous than those applicable to
executives
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V. Redesign of Executive/Director
Stock Ownership Policies

Historic programs based on a multiple of salary
(executives) or annual Board retainer (directors)
—
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Short-term reaction to investor pressure to retain
outsized option profits in 1990s bull market
Historic standard not well designed
—
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Too easy in bull market
Too tough in bear market
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V. Redesign of Executive/Director
Stock Ownership Policies (cont’d)

Investor concerns over management ownership
escalated due to recent corporate scandals
—
The “Winnick” factor – perceived management abuse of
inside information
→ Capture profit attributable to temporary appreciation or
insulate from downside risk
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Developing trends
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Increased use of guidelines incorporating “retention
ratio”
→ Requirement to hold all or a portion of after-tax profits
−
—
Option gains or vesting/earn-out of other long term incentives
Minimum absolute standards replaced with continuous
accrual models
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V. Redesign of Executive/Director
Stock Ownership Policies (cont’d)

Application to executives
A.
Coupled with minimum salary guidelines
—
For example, CEO salary multiple of 500%
→ Until 500% guideline met, retention ratio is 100%,
dropping to 50% thereafter
B.
Salary guideline plus mandatory holding period
—
C.
For example, CEO salary guideline of 500%;
mandatory 1-year hold on equity gains
Stand-alone retention ratio
—
For example, CEO retention ratio is 75%,
irrespective of total ownership level
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V. Redesign of Executive/Director
Stock Ownership Policies (cont’d)
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Application to non-executive directors
—
—
In some cases, programs mirror those of
executives
In others, a more substantial standard
→
→
Delivery of greater portion of compensation in fullvalue equity (e.g., deferred stock units)
“No sale” requirement applicable until first
anniversary of retirement or termination from
Board
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The Key to Reform – The Decision
Making Process
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Good behavior and high ethical standards
cannot be mandated
—
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Must be embraced on a widespread basis
Factors critical to reform
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Informed and interested decision makers
Less reliance on competitive precedent
Reduced attention to entitlement attitude
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The Key to Reform – The Decision
Making Process (cont’d)
“Principled Decision” making framework
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Best Practice Principles
1.
2.
3.
4.
5.
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Action supported by business
rationale
Action is reasonable, fair and
appropriate to circumstances
Action can be disclosed without
embarrassment
Action is easily understood
Action aligns management interest
with shareholders
Common Historic Standards
1.
2.
3.
4.
5.
Action is competitive based on
external precedent
Action is legally permissible
Action need not be disclosed or
can be camouflaged
Action can be complicated to
avoid scrutiny
Action is needed to keep
management satisfied
Conclusion: Impact of reform and resulting new
standards won’t be fully known until at least Spring
of 2004
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Frederic W. Cook & Co., Inc. provides management compensation consulting services to business clients. Formed in 1973, our
firm has served over 1,200 corporations in a wide variety of industries from our offices in New York, Chicago, and Los Angeles. Our
primary focus is on performance-based compensation programs which help companies attract and retain key employees, motivate and
reward them for improved performance, and align their interests with shareholders. Our range of consulting services encompasses the
following areas:
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Total Compensation Reviews
•
Strategic Incentives
• Executive Ownership Programs
Specific Plan Reviews
• All-Employee Plans
Restructuring Services
• Directors’ Compensation
• Equity Instruments
Competitive Comparisons
Incentive Grant Guidelines
•
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Performance Measurement
Globalization
Privatization
Compensation Committee Advisor
Stock Option Enhancements
Our offices are located:
New York
90 Park Avenue
35th Floor
New York, New York 10016
212-986-6330 phone
212-986-3836 fax
Chicago
One North Franklin
Suite 910
Chicago, Illinois 60606
312-332-0910 phone
312-332-0647 fax
Website address:
www.fwcook.com
Los Angeles
2029 Century Park East
Suite 1130
Los Angeles, California 90067
310-277-5070 phone
310-277-5068 fax