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What's Happening in Executive Compensation By Dick Dauphinais Corporate governance issues created by Enron, Tyco, WorldCom and others have driven two very important developments. The Sarbanes-Oxley Law and the pending decision by the Federal Accounting Standards Board (FASB) will alter the way board members and company executives are rewarded financially. Let’s take a quick look at each of these new requirements: Sarbanes-Oxley Law This legislation was signed into law by President George Bush this past summer. This new law places more accountability on CEOs, directors and officers in an effort to avoid further corporate scandal. This legislation is focused primarily on how boards should be structured, more clearly defining their fiduciary responsibilities. The law strips away some long-time privileges previously afforded to the executive set. Three major impacts of Sarbanes-Oxley on financial rewards include: Executive Loans Previously, high ranking officials and directors of large corporations were eligible to receive personal loans. Many times these loans were later “forgiven” by the company. The new law prohibits loans and "lines of credit" to executives and officers. Incentive Based Pay In the past, many executives and officers were rewarded handsomely for financial performances that exceeded pre-established revenue, net margins, and/or ROI targets. Under the new law, if a company restates its financials in ways that are not in compliance with reporting requirements, the CEO and CFO must reimburse the company for any incentive pay or equity-based pay they received in the previous twelve months. The CEO and CFO also must reimburse any profits realized from the sale of company stock during that period. Blackout Periods for Stock Action Previous laws were not clear and/or were silent on what officers, directors, and other board members could do relative to stock transference during defined “black-out” periods. The new law clarifies this issue dramatically. It is now illegal for a director or executive to directly or indirectly purchase, sell, acquire, or transfer company stock during a “black-out” period. This rule applies to any securities the executive received as rewards for service or employment. Further, all directors, officers and others who own 10% or more of company stock must report securities trades within two business days. Additional legislation pending in Congress may have a significant impact on deferred executive compensation such as Rabbi Trusts, deferred amounts received for disabilities, hardships, and change of control. This legislation deserves careful monitoring in the near future. The Sarbanes-Oxley Law is beginning to influence board composition and director pay. A number of directors who serve on multiple boards are resigning their positions on one or more boards and focusing on their primary interest companies. Steve Job’s recent departure from the Microsoft board is indicative of this trend. A principal driver of this shift is the fact that boards now must perform even more due diligence on company strategy and direction . . .which creates more work for directors. Replacement board members are not coming cheaply. Since board members will be more difficult to find and hold, the cost to maintain board stability will increase. Another interesting development is the closer look at the board’s compensation committee. As a result of the new law, boards will now want to consider the role Human Resources should have in board structure. Some organizations are deciding that the company’s top compensation professional should be an active member of the compensation committee. Concurrently, there are discussions underway about creating a dual reporting relationship for this compensation professional. On the board side, this person would report to either the chairman of the compensation committee or to the board chair. On the company side, the compensation professional would report to the Vice President Human Resources, who would report to the president or CEO. Federal Accounting Standards Board (FASB) Currently the FASB allows companies to elect one of two standards to account for equity grants to employees. Under APB 25, stock options granted at fair market value do not result in a compensation expense charged to earnings. Therefore issuing stock options does not have any impact on the profit and loss statements (especially those in the Silicon Valley and other technology based entities). It is not uncommon for technology companies selecting APB 25 to grant options to employees at all levels in the company because "they are free" and may have important motivational value. Only when stock options are "exercised" do they become an expense. FAS 123, however, defines compensation expense for stock option grants based upon a fair value method using option pricing models. The most popular is the Black-Scholes model. Under FAS 123, all types of stock option plans have a charge to earnings. Within a year, FASB will decide whether companies in the United States will have to treat stock option grants to employees as expenses. Since this decision will have major impacts on corporate bottom lines, the majority of companies have developed a "wait and see" attitude regarding their treatment of options. Currently 8-10% of publicly traded companies either continue to expense stock options or have "switched" to expensing stock options (the most notable being Coca-Cola). The general consensus among the consulting firms is that FASB will indeed rule that stock options must be expensed. An early indicator of this preference is also seen when one looks at the continuing budding relationship between FASB and the International Accounting Standards Board (IASB). IASB has remained constant in insisting that all stock options must show as an expense to earnings. In light of the potential accounting changes, an increasing number of companies are considering other long-term incentive vehicles to either replace current plans in place and/or use in conjunction with existing stock option plans. There are four major categories of long-term incentives being explored: Restricted Stock (Both "time" and "performance" vesting) Generally under restricted stock programs, employees are granted company shares with "restrictions" which are stipulated with respect to sale and/or transfers under a time-vested program. These "restrictions" usually last 3-5 years, with 4 years being the most common. Under a performance based program these "restrictions" can accelerate on improved achievements of pre-established company performances. Time vested stock plans are desirable for companies that want to encourage employee ownership (as restricted stock confers immediate ownership rights) while helping to retain top performances through the vesting periods. Although there are no cash outlays for executives, there is a charge to earnings and dilution as soon as the "restricted" stock is issued. Stock Appreciation Rights (SARs) SAR provides the holder a dollar value of stock "appreciation" as a cash payout. Therefore if a stock grant is issued with a fair market value of $10.00 per share and an employee is issued 1,000 SARs, there is an established "value" of $10,000. Let’s assume that a year later the fair market value has risen to $15.00 per share. The new "increased value" or "appreciation" can be either paid out in cash or delivered as additional shares of company stock. In this example, an executive could either receive a cash payment of $5,000 or receive 333 shares of company stock. Once again there is no cash outlay by the executive. In this plan there is less dilution (since the executive only actually received 333 shares). Stock Indexing Under this type of plan, the ultimate exercise price of stock options is linked to a pre-determined index such as Dow Jones or Standard & Poors. Therefore, with an established stock price of $10.00 per share when issued, and a year later the selected stock index rose 20%, the new exercise price for the indexed option is $12.00 per share. If the actual fair market value of the company stock is $14.00 per share, the executives get an excellent return as a reward since they will only have to pay $12.00 per share to receive $14.00 per share as a return. While shareholders like indexed option plans, these plans are not widely used. The two major issues why indexed options haven’t been attractive to date are: the issued stock options were always expensed as a performance based plan type and because of the increased numbers of shares (and dilution effects) required to make competitive grants. Performance Shares Many companies have had performance shares in place for several years (Xerox comes to mind). These grants of "shares" have attached absolute dollar values contingent on the achievements of specified performance goals over a specific time period. Although the "shares" are supposed to mirror stock grants, they are actually hypothetical. The benefits, however, are paid in cash if the established goals are met. Phantom Stock, etc. Phantom stock has also been around for a while, sometimes enjoying popularity similar to long-term cash plans. Phantom stock plans are designed to provide executives with compensation directly related to the value of the company, without the actual issuance of company stock. Phantom stock shares are "designed" to "mirror" the actual shares of stock. There are a couple of major disadvantages to these plans. One issue is that these plans are subject to "market-to-market" accounting which is applied until the phantom options are exercised. This means that companies utilizing Phantom stocks need to provide for an objective "valuation" method which is perceived as "fair" by the participants. Also it is important that these "market valuations" are done in a timely enough manner to handle mid-reporting valuation necessities. The second major issue is one of legality. There have been several legal issues surrounding executives leaving organizations with "phantom" stock that have been challenged in the courts with mixed results. Of course, there are also "unique" and/or "customized" programs that are designed to support the long-term incentives of many companies. Most of these customized programs have cash options and many have acceleration features to cover topside performances, however, no trends are prevalent to cover. It is apparent that compensation professionals will be very active in the up-coming months trying to solve the question of what will continue to keep our executives motivated when it comes to compensation rewards. In Summary There is a significant creativity in the compensation of "C" level employees today. Senior leaders such as Chief Executive Officers, Chief Operating Officers, Chief Financial Officers, Chief Marketing Officers, Chief Human Resource Officers, and others expect to be well-compensated for their intellectual capital and performance. The Sarbanes-Oxley Legislation and the FASB decision rulings will definitely re-shape the thoughts as to what will be the important links of "rewards to performance" for the future. Whatever compensation strategy decisions are made for these senior level company officials will be reflected in the reward strategies for "the rest of the organization". 2003 provec to be an extremely interesting year for compensation professionals. The prevailing predictions are as follows: Stock options will be required to be expensed in the company financials. Stock Option distribution will become more limited to higher levels in the organization. Cash distributing variable pay incentives will be needed as a "replacement" for the previous liberal stock option distribution to those below "C" level positions in most organizations. Solidly driven companies will not be swayed in their long-term rewards selection by tax and accounting efficiencies, but will take the opportunity to "re-state" their compensation philosophies and continue to insure the linkage of financial rewards to true business drivers that are supported by the shareholders. This article was written by Dick Dauphinais, President of Strategic Compensation Partners a compensation consulting company. Phone number: 207-439-5135.