Chapter 11 Compensating Executives

Compensation Consultants

*propose recommendations *develop packages based on strategic analysis -external market context -internal factors *possible conflicts of interest

SEC Disclosure Requirements: Definitive Proxy Statement (DEF 14A)

-Compensation information for the CEO and Named Executive Officers (NEOs) -NEOs are the four most highly compensated officers after the CEO -Disclosure must be presented in tabular and narrative form -The narrative is referred to as the Compensation Discussion and Analysis (CD&A)

Liquidity

-Current Ratio -Quick Ratio -Working Capital from operations -Cash flow from operations

Leverage

-Debt-to-equity-ratio -Short-term vs. long-term debt -Cash flow vs. interest payments

Who are Executives continued

-Key employees are used by the IRS to determine the necessity of top-heavy provisions in employer-sponsored qualified retirement plans that cover most nonexecutive employees •Highly compensated employees are used by the IRSfor nondiscrimination rules in employer-sponsored health insurance benefits

Advantages of Golden Parachutes

-Limit an executive's risk on occasion of these unforeseen events-Promote recruitment of talented executives -Virtually eliminate an executive from making decisions to save his/her job at the expense of company welfare -Reduces company's tax liability—treated as business expense—public outcry

Board of Directors

-Represents shareholders' interest -Usually 15 members -CEOs and executives -Community leaders Professionals -Give final approval to reccommendations -Are compensated well for services, often, more than $50,000 annually

Dodd-Frank Act Four major Provisions

-Say on Pay vote—Shareholder vote -Independence requirements for compensation committee members and advisors -Disclosure of circumstances under which an executive would benefit from a golden parachute arrangement -Disclosure of the ratio of CEO pay to the median compensation of nonexecutive employees

Disclosure Rules

-Securities Exchange Act of 1934 -Amended in 1992 and 1993 -Clarify disclosure of compensation to CEO and top executives -Increase board of directors accountability

Corporate Performance Measures

-Size -Growth -Profitability -Capital markets -Liquidity -Leverage

Compensation Committees

-Usually other board of directors' members -Major duties include: -Review consultants' recommendations - Discuss assets and liabilities -Make final recommendations

Key Employees

-an officer having annual compensation greater than $170,000 in 2015, OR -And individual who for 2015 was either of the following: -A 5% owner of the company -A 1% owner having an annual compensation of more than $150,000

Executive Compensation Theories

1. Agency Theory -Share holders give control to executives 2. Tournament Theory -Managers compete for promotions 3. Social Comparison Theory -Compensation compared to others

Components of Current Core Compensation

Annual base pay and bonuses

Common Perquisites

Company car security services legal services Recreational facilities Travel perks

Key Players

Compensation consultants Board of directors Compensation committees

Bonus Types

Discretionary Performance-contingent Predetermined allocation Target plan

Employee Benefits

Employee benefits represents an additional key component of executive compensation packages: -Enhanced benefits -Common perquisites (perks)

Deferred Compensation: Separation Agreements

Golden parachutes Platinum parachutes

Stock Plans

Stock options -incentive stock options -Nonstatutory stock options Restricted stock plans and restricted stock units Stock appreciation rights Phantom stock Employee stock purchase plans

Enhanced benefits

Supplemental life insurance Supplemental retirement Perquisites

Discretionary

awarded on an objective basis (e.g., financial condition of company is strong)

Predetermined allocation

based on a fixed formula ( e.g., company profit regardless of how well executives perform)

Performance-contingent

based on the attainment of specific performance criteria

perquisites (perks)

cover a broad range of benefits, from free lunches to the free use of corporate jets

Supplemental life insurance

increases the value of executives' estates bequeathed to designated beneficiaries (usually family members) upon their deaths, as well as provides executive with preferred tax treatments

Supplemental retirement

restores benefits restricted under qualified plans

Capital gains

the difference between the higherpurchase price and the lower stock option price (taxed at the time of disposition)

Capital loss

the difference between the lower purchase price and the higher stock option price Tax Rate substantially lower than exec's normal tax rate

Target Plan

ties bonuses to executives' performance

Highly Compensated Employee

•A 5% owner at any time during the year, Or •For the preceding year: -Had compensation from the employer in excess of $120,000 in 2015, And -If the employer so chooses, the employee was in the top-paid group of employees where top-paid employees are the top 20 percent most highly compensated employees

Contrasting Executive Pay with Pay for Non executive Employees cont.

•A conflict of interest may arise because the consultant may feel obligated to promote the financial interests of the CEO, who hired the consultant •Applying this practice contradicts the main assumption of performance-based pay such as merit pay, which most often applies to nonexecutive employees

Clawback Provisions

•Allow board of directors to take back performance-based compensation when performance goals were not achieved •These provisions becoming more common because of increasing public scrutiny of executive compensation practices

Common Perquisites continued

•Among Fortune 500 companies, about 85% offer perks to their CEOs •Typically, these companies offer fewer perks than before •The percentage of companies offering three or more perks has dropped from 60% to 30% since 2008

Incentive Stock Options

•An executive's right to a future purchase of their company's stock at a predetermined price, often at the stock price when the options were granted

Phantom Stock

•Bonus in the form of the equivalent of either the value of company shares or the increase in value over a period of time based on meeting two conditions: -Executives must be employed for many years -Executives must retire from the company

Ethical Considerations: Is Executive Compensation Fair ?

•Company's ability to attract and retain top executives -Compensation packages for external candidates were 42% higher than for CEOs who were promoted from within -About 50% of total compensation was awarded in equity agreements

Are U.S Executives Paid Too Much

•Comparison between executive compensation and other work groups •Strategic questions: Is pay for performance •Ethical considerations: Is executive compensation fair •International competitiveness

Summary of Compensation Table

•Compensation for CEO and four top-paid executives over three-year period •Disclosure of annual compensation •Disclosure of long-term compensation •"All other compensation ($)"

Executive Compensation Components

•Current or annual core compensation •Deferred core compensation: equity agreements •Deferred core compensation: separation agreements •Clawback provisions •Employee benefits: enhanced protection program benefits and perquisites

Stock terminology continued

•Disposition: sale of stock •Fair market value: average stock price on the NYSE

Capital Markets

•Dividend yield •Total return to shareholders •Price-earnings ratio •Payout

Deferred Compensation: Equity Agreements

•Equity refers to ownership stake in a company, particularly focused on financial interests •Company stock represents equity shares of equal value •A variety of important terminology to fully understand these concepts

Examples of Clawback Provisions

•Example: Wilmington Trust Corp. rescinded more than $1.8 million in compensation from CEO Donald Foley .•Example: Corporate scandals—execs withdrawing deferred compensation payouts before company goes bankrupt—Enron—Sarbanes-Oxley Act of 2002

Broad Comparison of Executive and Nonexecutive Compensation

•Executive compensation has both core and employee benefits elements, much like compensation packages for other employees •Executive compensation packages emphasize long-term or deferred rewards over short-term rewards

Restricted Stock

•Executive is awarded its company stock options or stock units at the market or a discounted price •Ownership of stock is granted at a specified future date, often multiple years (vesting period) •Executive must sell stock back to the company at the same price if they leave before vested

Employee Stock Purchase Plans

•Executive may purchase stock after a specified time period •The executive sets aside money through payroll deduction throughout this time, which is the offering period •Companies may establish stock purchase plans on a tax qualified or nonqualified basis

Annual Base Pay

•Fixed element of annual cash compensation •Only up to $1 million in fixed annual salary is exempt from a company's tax liability •CEO jobs do not fall within formal pay structures -CEOs' work is highly complex and unpredictable -Setting CEO compensation differs from the rational processes to build market-competitive structures (reviewed later)

Stock Appreciation Rights Continued

•Instead, the company awards a bonus payment: -The difference in stock price between the time the company granted the stock rights at fair market value to the end of the designated period

Ethical Considerations: Is Executive Compensation Fair ? cont.

•Layoffs of thousands of nonexecutive employees for a variety of reasons -Global competition -Reduction in demand -Technological advances -Mergers and acquisitions -Relocating production plants overseas -Economic recessions (2008)

Platinum Parachutes

•Lucrative awards that compensate departing executives with:-Severance pay-Continuation of company benefits-Stock options •Awarded in order to avoid legal battles or critical press reports

Comparison Between Executive Compensation and Other Work Groups

•Median annual earnings for all civilian U.S. workers was $47,230 in 2014 •Least paid nonexecutive—fast food cooks at $19,480 •Highest paid nonexecutive—anesthesiologists at $246,320 •Typical annual salary and bonus for chief executives was about $3.5 million

Nonstatutory Stock options continued

•No favorable tax treatment •No tax due in the future when they choose to exercise their nonstatutory stock options—provides tax advantage assuming the stock prices increase over time.

Profitability

•Profit margin •Return on assets (ROA) •Return on equity (ROE)

Golden Parachutes

•Provide executives pay and benefit following termination due to ownership change or corporate takeover (merger or combining of two separate companies)

Growth

•Sales •Assets •Profits •Market value •Number of employees

Size

•Sales •Assets •Profits •Market value •Number of employees

Stock Appreciation Rights

•Similar to restricted stock options, but the executive never has to exercise stock rights to receive income •This arrangement permits the executive to keep the stock

Executive Compensation to Be Disclosed

•Stock option and appreciation rights •Long-term incentive plans •Pension plan •Stock performance comparison •Compensation committee report •Directors' compensation •Employment contracts and golden parachutes

Stock terminology

•Stock options: stocks purchased at a designated price for a specific time •Stock grants: a company offers stock to employees •Exercise of stock grants: purchase of stock

Nonstatutory Stock Options

•Taxes paid on difference between the discounted price and the fair market value at the time stock was granted •Company awards stock at discounted price

Contrasting Executive Pay with Pay for Non executive Employees

•The chief executive officer (CEO) is the seller of his or her services and the compensation committee is the buyer •An awkward situation arises when the CEO hires a compensation director or consultant

Contrasting Executive Pay with Pay for Non executive Employees continued

•The consultant recommends to the compensation committee what the CEO compensation package should be •CEO Compensation—London School of Economics and Political Science •It is possible that CEOs could be compensated for nonperformance

Common Perquisites cont.

•The percentage of companies dropping perks altogether increased to 15% from 6% in 2008 •Requirement that companies report perks valued at $10,000, or more, apiece

Who are Executives?

•To understand the main difference, it is essential to define what we mean by executives •The Internal Revenue Service (IRS) recognizes two groups of employees who play a major role in a company's policy decisions: key employees and highly compensated employees