Executive Compensation

by Joseph E. Bachelder

This article is reprinted with permission from the
March 22, 2010
edition of the
New York Law Journal.
© 2010 NLP IP Company.


Federal Intervention in Executive Pay

For approximately 75 years (at least), the federal government has intervened in executive pay—in both direct and indirect ways. Two examples of direct intervention are Pay Controls (1971-74) and the current TARP program, introduced in 2008 in respect of financial institutions (and subsequently extended to two automotive companies) and still in effect as to many of these institutions.[1]

An example of indirect intervention is the SEC's requirement, commencing in the late 1930s, of disclosure regarding compensation of certain top executives in the annual proxy statements of publicly traded companies.[2] (Ironically, in contrast to direct controls, a major consequence of the SEC's indirect intervention through required disclosure has been an upward "tilt" to executive pay—the so-called "ratcheting effect," as discussed later in the column.)

Direct Intervention

Federal pay controls. Due to inflationary pressures, in August 1971, the Nixon administration imposed a pay and price "freeze" for a 90-day period. At the end of that period, regulations strictly limiting pay increases generally (not limited to executive pay) were introduced that generally continued until April 30, 1974. Over the period of 35 years since pay controls ended, the impact of those controls is virtually zero, and it is doubtful that pay controls have any noticeable effect on levels of executive pay today.

TARP Regulation of Financial Institutions. The economic crisis that was triggered in the fall of 2008 resulted in the enactment of the Economic Emergency Stabilization Act (EESA) on Oct. 3, 2008, amended by the American Recovery and Reinvestment Act (ARRA), enacted Feb. 17, 2009. Hundreds of banks received assistance under TARP and became subject to the TARP legislation. Limitations include prohibitions as to payments of severance and limitations in the amount of bonus that can be paid to certain levels of executives, as specified in ARRA.[3]

Seven institutions have received "exceptional financial assistance" under TARP. In addition to being subject to TARP rules generally, as noted above, the pay of top executives at an institution receiving "exceptional financial assistance" is subject to direct control by the Special Master for TARP Executive Compensation, Kenneth Feinberg.

In order to come out from under the control of the Special Master, each of the seven institutions is required first to pay back all of the "exceptional financial assistance" (including any dividends and/or interest owed). One of these institutions, Bank of America, has repaid all financial assistance, and the compensation of its top executives going forward is no longer subject to TARP. It is understood that Citigroup has repaid its "exceptional financial assistance" but has not repaid earlier financial assistance, and its top executives continue to be subject to the severance and bonus limitations noted above.

Five institutions remain subject to direct control by the Special Master. They are AIG, GM, Chrysler and their two automotive-related finance companies, GMAC and Chrysler Financial, respectively.

Apart from the institutions receiving exceptional financial assistance, the number of banks which, at the time this column was written, have received but not paid back financial assistance is approximately 670. Within the next year or two, it is quite possible that most of these banks will have paid back the amounts due the Treasury in respect of their financial assistance and TARP will cease to apply to them.

While it is difficult to forecast the ongoing influence of legislation like TARP (e.g., in the sense of what will be considered good corporate governance in the future), a reasonable forecast would be that its influence on the levels and design of executive pay will be of very diminished consequence in years after it ceases to apply.[4] Like Pay Controls (which affected most companies—not just those in one or two industries), ultimately TARP is likely to have little effect upon the pay levels of the companies now covered by it.

Thus, the two major examples of direct control of executive pay levels by the federal government in the past half century would not appear to have long-term impact on executive pay.

Indirect Intervention

Since the late 1930s, the Securities and Exchange Commission has required public disclosure of pay to top executives at publicly traded companies. Today, proxy statement disclosure includes detailed pay information as to the CEO, the CFO and the three other highest paid executives ("Named Executive Officers").

As to the covered executives, since the original rules in the 1930s, there has been an extraordinary increase in information required. (The number of executives covered increased from three to five in 1978; the rules for determining which executives are in the top five have undergone changes in the years since.) Reporting as to cash compensation (salary and bonus) has been consistently required (although prior to 1992 breakdown between salary and bonus was not required).

The biggest change in the past 75 years has been in regard to long-term compensation (especially equity-based compensation like stock options and restricted stock, as noted in the following paragraph). Other benefits as to which considerable (and monetized) information is required today (much more than was required 20 or more years ago) are retirement benefits and other forms of deferred compensation, welfare benefits not generally available on a non-discriminatory basis and perquisites (currently, if the aggregate value of perquisites is equal to or exceeds $10,000).

With regard to stock options, the most significant change occurred in 1992 with the requirement that stock options be valued at date of grant based on (a) the potential realizable value if stock were to appreciate by certain specified percentages or (b) Black-Scholes or other acceptable model of option valuation. But that disclosure was limited to a stock option grant table and not included in the Summary Compensation Table (which displayed only the number of shares under option grant). In 2006, the Summary Compensation Table was modified to require the dollar value of stock options to be included. In 2006, in addition, there was added a column totaling up the amounts shown in all the other columns. Thus, today, a single number is assigned to each Named Executive Officer as his or her "Total."[5]
In addition to tabular presentations, including several tables in addition to the Summary Compensation Table, extensive narrative is required as to a wide range of corporate policies, plans, programs, agreements and other arrangements implementing those policies. Much of this information is contained in what is described as the Compensation Discussion and Analysis.[6]

At some point, perhaps commencing before 1992 but certainly propelled by the 1992 changes, executive pay became subject to the so-called "ratcheting effect." With everybody trying to keep up with everybody else ("everybody" can see "everybody else" in detail in the proxy statement), there was an extraordinary growth in the level of executive pay in the 1990s. The ratcheting effect has been further enhanced by the addition of the "Total" pay number ("one number fits all") in 2006. The ultimate ratcheting effect of this 2006 change has not yet been felt due to the current difficulties in the economy and resulting current decrease in median incentive pay levels for top executives.
Rule changes adopted by the SEC on Dec. 16, 2009, and generally taking effect for proxy statement purposes as of Feb. 28, 2010, further illustrate how disclosure requirements introduced by the SEC can impact design and administration of executive pay programs.

Changes in Reporting of Equity Awards. Under the new rule, equity awards—including stock options and stock awards—are to be reported in the Summary Compensation Table for the year in which they are made.[7] The amount shown is to be based on the value of the award at time of grant.[8] These amounts under the new reporting rule will appear in the columns of the Summary Compensation Table for the respective forms of equity awards. In addition, of course, they are included in the total pay number shown in the "Total" column. This latter number, as noted in footnote 5, is the number typically reported by the media, a sensitive point for many companies. (Reporting of awards in the Grants of Plan-Based Awards Table continues to be based on awards made in the fiscal year being reported and based on value at the time of award.)

Comment on this new equity reporting rule. The new Summary Compensation Table rule for reporting equity awards no doubt will impact in the planning and administration of equity awards.

1. The new rule gives companies substantial discretion (subject, obviously, to other factors affecting their decision) to pick and choose the fiscal year in which they report large long-term equity awards. A company may plan to grant an executive a $1 million equity award on Dec. 31 of Year 1. By waiting one day, it can report it, in full, in Year 2.

2. For companies expecting a significant increase in stock price, the new rule may encourage large grants at today's lower price (that is, granting today rather than making grants over a period of two or more years).

3. A further consequence of the new rule will be to make it more difficult for meaningful comparisons of practices at different companies. Presumably, analysts will attempt to reconcile at least some of these differences by averaging awards over a number of years.

New Risk Management Disclosure Requirements. Under the new rules, a reporting company will be required to report on any situation in which the company's policies and practices as to compensation generally (not limited to executive pay) "are reasonably likely to have a material adverse effect on the registrant."[9] The new rules also require separately a statement as to the role of the board in overseeing management of risk at the company. See new Item 407(h).

The point being made here is that the new risk-related reporting requirements in many cases will have a significant impact on the design and administration of executive compensation (regardless of whether particular companies conclude they are not (currently) required to report). Following are two observations in this regard.

1. Reporting on the board's role in management of risk is required whether or not the company determines there is a link between compensation policies and material adverse risk so as to require reporting. This requirement of reporting as to the board's role in overseeing risk itself will raise the level of attention of boards to risks that may be involved in the design and administration of compensation. This, in turn, will result in greater attention by management to this matter. (We will call this "Trickle Down Effect Number One.")

2. The determination as to likelihood of a "material adverse effect on the company" is required to take into account not only risks existing on a company-wide basis but also risks at units under certain circumstances (e.g., reflecting, at the unit level, revenues, compensation design and profitability that may have a material adverse effect on the company).[10]

This requirement to evaluate risk as an element of compensation policies and practices and the potential adverse effect on the company should cause most public companies to give careful attention to the effects their compensation programs may have on risk. (We will call this "Trickle Down Effect Number Two.") Following are examples of specific types of issues that might arise:

a. Assume a company has an incentive plan formula based on growth in revenues and the company currently is also interested in making acquisitions (as many companies are). An incentive based on increasing revenues obviously will encourage external growth (via acquisitions) in addition to internal growth. What are the risks associated with acquisitions, and could one or more of such acquisitions have a material adverse effect on the company?

b. Assume an incentive formula based upon growth in company stock value (it could be part of a total shareholder return formula or based on a number of other stock-value metrics). Among other things, this raises the issue of management favoring short-term versus long-term performance incentives.
Even if all or a substantial portion of public companies determine there are no currently reportable risk implications, the fact that the process of designing and administering executive compensation is subject to careful review as to its impact on risk for the company is likely to have an impact on future design and implementation of executive pay.

Conclusion

Direct federal government intervention in executive compensation in response to emergencies such as inflation in the early 1970s (as part of Pay Controls) and the financial crisis late in 2008 (as part of TARP) has been immediate in its impact but of doubtful impact over the longer term. Indirect, long-term intervention, such as SEC disclosure requirements, while not itself a control over design and levels of pay, has had and will continue to have substantial impact on the planning and administration of executive pay.


FOOTNOTES

[1] The two automotive companies are GM and Chrysler. Two of their affiliated finance companies, GMAC and Chrysler Financial, respectively, also are covered by the TARP program.

[2] In setting tax rates, in establishing rules as to what is and what is not deductible and in many other ways, the Internal Revenue Code impacts on executive compensation. This aspect of federal government intervention on executive pay is not the subject of this column. Specific interventions such as the introduction of the golden parachute rules of code §§280G and 4999, the $1 million tax deduction limitation on salary and other forms of non-performance-based compensation under code §162(m) and the additional tax and interest charged against certain forms of deferred compensation under code §409A have been the subject of discussion in prior columns. See this column, Aug. 28, 1989, Aug. 30, 1993, Oct. 21, 2004, May 30, 2007.

Accounting rules also impact on executive pay. Accounting rules under generally applicable accounting principles are established by the Financial Accounting Standards Board (FASB). Because FASB is not a government agency, the impact of accounting rules on executive pay is not discussed in today's column. Of course, over time many of the actions taken by FASB are influenced by political and governmental pressures. FASB coordinates with the SEC as well as other government agencies on many of its accounting rules and rule changes.

[3] The prohibitions under TARP as to payments of severance and limitations on the amount of bonus that can be paid to certain levels of executives at TARP beneficiaries were discussed in this column on April 14, 2009.

[4] This is not intended as a forecast of what other federal agencies, bank regulatory agencies in particular, may do in the future. In October 2009, for example, the Federal Reserve announced a proposal to review compensation policies and practices at 28 large banking institutions to assess their consistency with the principles of "risk-appropriate incentives." See the Federal Reserve's Press Release dated Oct. 22, 2009. Under the proposal, the Federal Reserve also indicated that it would conduct risk-focused reviews of the compensation practices at smaller banks. In addition, in January 2010, the FDIC sought public comment on a proposal to vary the fees charged to banks to insure their deposits based on an assessment of the risks posed by the banks' compensation structures. See the FDIC's Press Release dated Jan. 12, 2010. It is understood that the Federal Reserve and the FDIC are assessing the public comments received in connection with their respective proposals.

[5] That "single number fits all" approach to executive pay gives commentators opportunity to compare total packages for CEOs based on this single number appearing in the Summary Compensation Table. These commentators generally ignore that this single number combines "apples" (cash compensation) with "oranges" (theoretical compensation such as stock options using a theoretical model like Black-Scholes).

[6] The Compensation Discussion and Analysis is described in Item 402(b) of Regulation S-K. In addition to the proxy statement, the company may also be subject to compensation disclosure in connection with a number of SEC filings, such as (a) the Form 8-K, disclosing employment agreements with certain executives, information regarding amendments or adoption of certain compensation plans, and the value of compensation required to be, but which was not, included in the proxy statement (e.g., because the amount of a bonus for the year being reported was not determinable at the time of the proxy statement filing deadline); (b) the Form 10-K, which includes the compensation disclosure required to be provided in the proxy statement (if timely provided in the proxy statement such disclosure can be incorporated in the Form 10-K by cross reference), as well as certain other information relating to compensation and benefits not required to be included in the proxy statement; and (c) registration statements, which include compensation information (or, if certain requirements are met, may incorporate such information by reference to the proxy statement).

[7] The SEC explained that it adopted the rule requiring reporting for the year of award because that "better reflects the compensation committee's decision with regard to stock and option awards." 74 Fed. Reg. 68,334, 68,339 (Dec. 23, 2009). In deciding against the proposal that reporting should be on a "when earned by the executive" basis, the SEC stated "it appears that multiple subjective factors, which could vary significantly from company to company, influence equity awards granted after fiscal year end." Id. at 68,340. The SEC expressed its concern that to attribute reporting for the year the award is earned "could result in inconsistencies that would erode comparability." Id. Ironically, as noted in the text, the discretion given to employers to report based on timing of the grant may itself impair comparability of awards.

[8] The accounting rule as to determining grant date value is contained in FASB ASC Topic 718 (para. 10-30). Regulation S-K requires that stock and option award grant date fair value be computed in accordance with the FASB rule. As of March 12, 2010, the SEC updated its Compliance & Disclosure Interpretations with regard to Regulation S-K, including issuing questions and answers with regard to executive compensation. See, in this connection, Questions and Answers concerning grant date fair value of equity awards 119.20-24. The instructions to Item 402(c)(2) of Regulation S-K require that the value of equity awards subject to performance conditions be reported "based upon the probable outcome of such conditions" as of the grant date. 74 Fed. Reg. 68,334, 68,362 (Dec. 23, 2009) (Instruction 3 to Item 402(c)(2)(v) and (vi) of Regulation S-K). If this "probable outcome" amount is less than the maximum value that could be earned out, the maximum value must be disclosed in a footnote to the Summary Compensation Table.

[9] 74 Fed. Reg. 68,334, 68,363-64 (Dec. 23, 2009) (Item 402(s) of Regulation S-K). Under the proposed rules, the disclosure requirement would have been triggered when risks arising from certain compensation policies "may have a material effect on the company" rather than it being "reasonably likely" that they will "have a material adverse effect on the company."

[10] The final rule suggests two lists of considerations (each non-exclusive) to be taken into account in determining whether reporting is required as to compensation and its impact on risk at the company. One of the lists suggests some of the situations that may give rise to reportable links between compensation and risk. The second list suggests relevant risk-related issues, or factors, that should be discussed if a reportable risk situation exists. (Both the "illustrative-situations-for-possible-reporting" and the "relevant-issues-for-discussion-if-a-risk-situation-exists" appear at Item 402(s) of Regulation S-K.) 74 Fed. Reg. 68,334, 68,364 (Dec. 23, 2009) (Item 402(s) of Regulation S-K).