Chapter 11 Compensating Executives

Key players in setting executive compensation

- Compensation Consultants: usually propose several recommendations for alternate pay packages. Often employed by large consulting firms. Make recommendations. Financial conditions is the most pertinent internal factor regarding executive compensation. Compensation consultants find themselves in conflict of interest situations if they recommend a more lucrative pay than warranted in hopes of gaining management favor and consulting opportunists. - Board of directors: represents shareholder's interest by weighing the pros and cons of top executive decisions. They make final approval of pay recommendations. Changes in the securities and exchange commissions and the passage of the Dodd-Frank Act have increased transparency of how executives are paid. - Compensation Committees: board of director members inside and outside the company make up the committee. outside members make up the majority and serve to eliminate conflict of interest. Perform three duties: - review the consultant's recommendations for pay - Discuss assets and liabilities of recommendations. - recommends the best proposal to the board of directors for decision.

Main components of executive compensation

-CEO jobs do not fall within formal pay structures because highly complex and unpredictable and compensation differs dramatically -Base pay/ Current annual compensation is a small part of CEO compensation because: Takes years to see the fruits of CEOs initiatives realized and the IRS limits the amount of annual salary a company may exclude as a business expense. - Bonuses: Four common types of bonuses in CEO compensation: Discretionary Bonus: "elective basis: uses factors to determine amounts like company profits and financial conditions, business conditions and prospects for future. Performance contingent bonuses: uses a rewards system similar to performance appraisals " Merit increases for performance" Target Plan bonuses: increases with performance (No bonuses when performance is below standards) These bonuses are not fixed Short-term incentives: are distributed to awards based on rank and compensation levels. Usually, a reward for meeting intermediate performance criteria. Can be used to reward other levels of management.

Theoretical explanations for setting executive compensation:

Agency Theory - shareholders delegate control to top executives to represent their own interests. Top executives usually do not own majority of shares of stock. This causes executives do not share the same interests as shareholders. - Agency Problem: actions of executives that on behalf of their own interests . ( short-term goals at the expense of long term goals) Shareholders negotiate executive employment contracts to minimize loss of control. They use compensation to align interests. together. Tournament Theory - casts lucrative executive pay as the prize in a series of tournaments or contests among middle/top level managers who aspire to be CEOs. Winning means promotion to higher rank. Ultimate prize is CEO. There are fewer positions at higher levels in corporate hierarchical structures. Social Comparison Theory - compare yourself to individuals in order to evaluate accomplishments.

Executive compensation packages - Employee benefits: enhanced protection program benefits and perquisites.

CEOS receive discretionary benefits like employees but they differ in two ways: - Include supplemental coverage that enhance benefit levels - Exclusive benefits such as perquisites and perks. Enhanced: supplemental life insurance: provide additional monetary benefit ( increased benefit , favorable tax treatments) Supplemental retirement plans: designed to restore benefits restricted under qualified plans. "Makes the difference that once would of been lost in taxes" Perquisites: Company cars, travel perks, recreational facilities, security detail, legal services. Commonly used to recognize status, for personal and business comfort, security measures, limit distractions.

Executive compensation packages - clawback provisions

Clawbacks: in ceo employment contact allow board directors to take back performance-based compensation if they were to subsequently learn that performance goals were not achieved, regardless of whether the ceo was responsible for falling short of target levels. Clawbacks are becoming more popular because of increased scrutiny

Main components of executive compensation:

Deferred core compensation: an agreement between an employee and a company to render payments to executives at a future date. Hallmark of executive compensation. Creates a sense of ownership by aligning the interests of CEOs with owners or shareholders of the company over a long time. (agency theory) There are two types of deferred core compensation: - Equity Plans: provide ownership through various stock options. - separation agreements: provide payment to an executive upon employment termination.

Executive compensation packages:

Has both core and employee benefit elements Emphasizes long-term or deferred rewards over short-term rewards. Main components: -Current/annual core compensation -Deferred core comp: separation and equity agreements -Clawback provisions -Employee benefits: protection programs and perquisites.

Who are executives?

Key Employees: hold positions of substantial responsibility Highly Compensated Employees:

Laws responsible for disclosure of executive pay and engagement of shareholders.

Securities and Exchange Act of 1934: applies to the disclosure of important company information as well as executive pay practices. Companies that sell and exchange securities ( stocks and bonds) on public stock are required to file information to SEC. This will increase the accountability of the board of directors. - 10-K form a detailed picture of companies business, risk, and the operating and financial results of the fiscal year. - DEF 14A ( definitive proxy statement) reveals information about CEO pay and NEOs ( four most highly compensated officers) and also includes a summary compensation table "Catchall column" ( all other compensation) - CD&A presents an explanation of all executive pay Dodd-Frank Act: requires companies that trade stock on public exchanges to comply with FOUR major provisions 1. Say on pay - gives company shareholders the right to vote yes or no on executive pay proposals. Votes are nonbinding. Advises board of concerns. Limited to USA companies. 2. details independence requirements for compensation committee members and their advisors. Compensation committee members can not receive pay like an employee. 3. requires companies to disclose the circumstances under which executives can benefit from golden parachute agreements 4. requires all companies to provide a ratio of CEO pay to the median pay of employees in SEC filings that require pay disclosure.

Executive compensation packages, deferred core compensation

Separation agreements: Golden parachutes contain pay and benefits to executives after termination that results from change in ownership or corporate takeover. Often included for three reasons: - Limit risks in even of unforeseen circumstances - Promote recruitment and retention - Can keep ceos in align with company interest. Companies benefit from payments because they are a business expense - reduced tax liability - tax deductions. Platinum Parachutes: are lucrative awards that compensate departing executives with severance pay, continuation of company benefits, and stock options. Helps with legal battles or critical report in the press , essentially paying of CEOs to give up position. Golden and platinum parachutes are often used interchangeably.

Equity Plans - Stock options:

Stock compensation plans promote a sense of ownership and motivate executives to strive for excellent performance. Five forms of deferred stock compensation plans 1. Stock Options: - Incentive stock: purchase stock in the future at a predetermined price. A predetermined price can create a capital gain or loss. Tax breaks occur under this option.No tax until they sell their shares. - Nonstatutory stock option: No favorable tax breaks. Advantages include providing lower tax liability over the long term. Executives are required to pay income taxes on discounted stock price and fair market value at the time of stock grant. 2. Restricted stock /units: - restricted stock plans: The company may grant executives stock options at market value or discounted value or provide stock. executives do not have ownership over the disposition of the stock for a predetermined period (vesting period). - Restricted stock units: are shares of company stock that are awarded to executives at the end of the restriction period. "performance plan reward" 3. Stock appreciation rights: "provide executives income at the end of a designated period, executives may never have to exercise their stock right to receive income. Companies reward bonus payments based on differences in stock price between the time the company granted stock rights and the end of the designated period. 4. Phantom stock plan: promise to pay a bonus in the form of the equivalent of either the value of company shares or an increase in the value over a period. Generally two conditions: Remained employed for a certain time and must retire from the company. 5. Stock purchase plans: set aside money through payroll deductions. "offering period"