Executive Compensation Best Practices

Transcription

1 Executive Compensation Best Practices Frederick D. Lipman Steven E. Hall John Wiley & Sons, Inc.

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3 Executive Compensation Best Practices

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5 Executive Compensation Best Practices Frederick D. Lipman Steven E. Hall John Wiley & Sons, Inc.

6 This book is printed on acid-free paper. Copyright 2008 by Frederick D. Lipman and Steven E. Hall. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, , fax , or on the web at Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, , fax , or online at Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at , outside the United States at or fax Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our Web site at Library of Congress Cataloging-in-Publication Data: Lipman, Frederick D. Executive compensation best practices / Frederick D. Lipman, Steven E. Hall. p. cm. Includes index. ISBN (cloth) 1. Executives Salaries, etc. 2. Compensation management. I. Hall, Steven E. II. Title. HD L '072 dc Printed in the United States of America

7 To Jordan Sienna Lipman

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9 Contents Preface Acknowledgments xi xvii chapter 1 Introduction 1 Should the CEO be Rewarded or Punished for Events Beyond the CEO s Control? 1 Warren E. Buffett on Executive Compensation 3 CEO Compensation Theories 4 CEO Forced Exit Packages 6 Private Equity Compensation 8 Entertainment and Sports Celebrities 8 Benefits of Good Corporate Governance 9 chapter 2 Motivating Executive Performance 13 Tying Performance to the Strategic Plan 15 Unintended Consequences 16 Firm Expansion and CEO Pay 19 Equity-Based Compensation 20 A New Role for CEOs 21 Satisfying Investor Expectations 22 Minimum Equity Ownership Requirements 23 chapter 3 Peer Groups and Benchmarking 25 Adjusting the Peer Group 28 Peer Groups for Different Levels of Executives 30 Benchmarking 31 Lake Wobegon Effect 33 Benchmarking with Medians 34 chapter 4 Competing With Private Equity Funds 35 vii

10 viii contents chapter 5 Explaining Executive Compensation to Shareholders 43 Introduction 43 Reconstructing Executive Compensation Disclosure for Shareholders 50 chapter 6 Compensation Committee Ordinary Operations 57 SEC Action Against Tyson Foods 62 Earnings on Deferred Compensation 64 Practical Steps for Compensation Committees 65 Compensation Committees of Non-Profit Organizations 67 chapter 7 Negotiating Executive Employment and Severance Agreements 71 Negotiating with New CEO Candidates 71 Negotiating with Existing CEOs 76 Best Practices Applicable to New and Existing CEOs 77 Council of Institutional Investors 78 Gross-Up Clauses 89 Retirement Arrangements 94 The Grasso Case 95 Section 409A of the Internal Revenue Code 96 Other Best Practices in Negotiating Employment or Severance Agreements 96 chapter 8 Compensation Committee Structure and Process 99 Creating Incentives for Good Corporate Governance 108 Disney Litigation 110 chapter 9 Equity Incentive Choices 113 Overview of Equity Incentives for Key Employees 113 Dilution 114 Stock Option versus Stock Appreciation Rights 114 Restricted Stock versus SARs or Phantom Appreciation Plans 120 Phantom Plans 121 ISOs versus Non-ISOs 122 The Advantage of ISOs 124 Non-ISOs with Tax Reimbursement 125 The Tax Benefit to the Company 127 chapter 10 Option Granting Practices 129 Option Granting Practices 135 The Council of Institutional Investors 142 Equity Retention Practices 143

11 contents ix chapter 11 Director Compensation 145 Retainer and Differential Pay 147 Minimum Equity Requirements 148 Director Compensation Procedure and Process 149 Shareholder Approval 151 Perquisites, Repricing and Exchange Programs, Change in Control, and Severance Payments 151 Disgorgement 152 chapter 12 Negotiating for the Executive 153 CEO Turnover 154 New Candidates for CEO or Other Executive Positions 154 Employment Agreements with Private Equity Buyers of CEO s Business 161 chapter 13 Executive Compensation and Section 409A of the Internal Revenue Code 163 Background 166 Plans That Do Not Provide for the Deferral of Compensation 168 Nonqualified Deferred Compensation Plan Plans that Provide for Deferred Compensation 172 Special Rule Applicable to Specified Employees 173 Change-in-Control Events 174 Change in the Ownership of a Corporation 175 Change in the Effective Control of a Corporation 176 Change in Ownership of a Substantial Portion of a Corporation s Assets 177 Structuring the Payments upon an Event Payment Trigger 178 Specified Time or Fixed Schedule 179 Equity-Based Compensation 179 Section 409A Compliance 181 appendix A Compensation Committee Charter 183 appendix B Corporate and Securities Update: SEC Adopts Sweeping Overhaul of its Executive Compensation Disclosure Requirements (September 2006 and revised December 2006) 189 appendix C Employment Agreement 213 appendix D Public Company Equity Incentive Plan 233

12 x contents appendix E Search Terms Typically Required to be Researched by Public Company in Option Backdating Investigations by the Securities and Exchange Commission 285 appendix F What an Employee Should Know About His or Her Stock Options 289 Index 309

13 Preface T here are many conscientious members of the compensation committee of the board of directors of public companies. This book is written for them as well as for executives who want to use best practices in negotiating their own compensation packages. The best practices suggested in this book are, in many cases, also applicable to not - for - profit organizations and private companies. Best practices do not necessarily lead to lowering executive compensation. In fact, as discussed in Chapter 4 of this book, they may require an increase in executive compensation in order to compete with private equity funds. Indeed, the recent wave of private equity fund acquisitions of public companies is partly due to the failure or unwillingness of compensation committees to provide equity compensation to senior management that is competitive with private equity funds. A stingy compensation committee can be as harmful to the organization as an overly generous one. Executive compensation practices are under enormous scrutiny from activist shareholders, corporate governance rating groups, the media, and lawmakers. Outrage has been repeatedly expressed by both the media and the public over allegedly excessive executive compensation. Corporate governance groups have accused boards of directors and their compensation committees of mass give a ways of shareholder wealth to greedy CEOs. As of April 1, 2007, investors had made 266 proposals related to executive pay for insertion in public company proxy statements, about twice as many as in 2006 according to Institutional Shareholders Services. A bill has been introduced in the U.S. Congress to require an advisory vote by shareholders on CEO compensation and one state (North Dakota) adopted such a law. xi

14 xii preface Equally important is the view of corporate governance rating agencies who are judging the quality of the board decision - making process by the disclosures required to be made concerning executive compensation. For example, Moody s Investors Services, Inc. has stated that they will analyze executive compensation arrangements with a view to assess how favorable the terms are compared to peers and consider what this suggests regarding the quality of the board decision - making process. 1 Institutional investors may well refuse to support the reelection of directors whose decision - making on executive compensation has been criticized. The public controversy over executive pay has resulted from the failure of compensation committees to use best practices in establishing CEO compensation and in the failure to adequately explain to shareholders both the methodology used and the growing competition for executive talent with private equity funds. The Securities and Exchange Commission (SEC) attempted to remedy the full disclosure problem by requiring a very comprehensive discussion in public filings of the executive compensation methodology practiced by public companies in a section of these documents called Compensation Committee Discussion and Analysis. However, it is not enough to make full disclosure of the methodology unless the compensation committee also uses best practices. Best practices will vary with each public company or other organization. However, this book attempts to explain what should be considered universal best practices for all public companies. In addition, many of the best practices recommended for public companies are equally applicable to not - for - profit organizations and private companies. What are Best Practices? Best executive compensation practices are those that align the rewards to the executive with what is critical for the company to succeed in both the short - term and long - term and to accomplish its strategic plan. Best practices should create conditions in which executives feel a strong commitment to the results. However, best practices can vary between industries and between companies in the same industry. Therefore, the best 1 A User s Guide to the SEC s New Rules for Reporting Executive Pay, April 2007, p. 4.

15 preface xiii executive compensation practices discussed in this book must be tempered by the particular facts and circumstances of each company and of each executive within the company. This book provides a list of best practices for the compensation committee of the board of directors. It is understood, however, that the compensation committee may delegate some of its duties to management, so long as it provides effective oversight over management and retains full responsibility for these best practices. Organization of Book Chapter 1, entitled Introduction, is devoted primarily to a discussion of whether a CEO should be rewarded or punished for events beyond the CEO s control (as to which there is no best practice) and two conflicting theories for the rise in CEO compensation. We also quote Warren Buffett s theories on executive compensation, compare CEO exit packages with the compensation of sports and entertainment celebrities, and review the benefits of following good corporate governance. Chapter 2, entitled Motivating Executive Performance, explains the necessity of establishing goals and objectives for executives before performance, and of tying executive officer goals into the strategic plan of the company as well as the year - to - year budget. This chapter also deals with motivating executive performance through use of both long - term and short - term incentives and minimum equity requirements and discusses some of the unintended adverse consequences of misdirected executive compensation programs. One method of establishing competitive compensation is through using peer groups and benchmarking. Chapter 3, entitled Peer Groups and Benchmarking, reviews the best practices in establishing peer groups and benchmarking, the use of which will help avoid headline risk for the company. Chapter 4, entitled Competing With Private Equity Funds, discusses the competition with private equity groups for executive talent. We advance the theory that the significant number of private equity transactions to acquire public companies is partly the result of the unwillingness or inability of the compensation committee to provide sufficient equity incentives to management to remain part of a public company.