The MC Academy The Employee Benefits and Executive Compensation Series EXECUTIVE COMPENSATION July 30, 2013
Overview of Executive Compensation Practices And Trends
Highlights Heightened focus on executive pay Basic components of the executive compensation program Compensation philosophy/design Key legal (and other) issues Miscellaneous hot-button issues 3
Heightened Focus on Executive Pay Scrutiny/controversy surrounding executive pay practices Attention from multiple directions Shareholder activists/proxy advisors Institutional Shareholder Services (ISS) Glass-Lewis Media E.g., Gretchen Morgenson, NY Times Unions 4
Heightened Focus on Executive Pay Politicians/legislators Internal Revenue Code Section 162(m) Sarbanes-Oxley Act of 2002 ( SOX ) Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ( Dodd-Frank ) Troubled Asset Relief Program ( TARP ) Internal Revenue Code Section 409A Regulators E.g., SEC proxy disclosure rules High profile cases (e.g., Grasso, Kozlowski, Mullin) 5
Basic Components of the Executive Compensation Program Base pay Health and welfare benefits Retirement and asset accumulation plans Tax-qualified retirement plans (DC and DB) Nonqualified benefit plans (DC and DB) 6
Basic Components of the Executive Compensation Program Annual incentive (bonus plans) Long-term incentive (e.g., equity plans) Also: Change in control plans and agreements Signing bonuses Retention pay Perks Severance pay 7
Compensation Philosophy/Design At a high level, what the compensation program is designed to accomplish and how Evolving disclosure requirements for public companies Compensation Discussion and Analysis (CD&A) Impact of those requirements on perceived compensation best practices 8
Compensation Philosophy/Design With respect to each component of the compensation program: What is the plan primarily intended to do, e.g.: Retain executive(s) Incent behavior to achieve specific company goals Are the plan s terms (e.g., conditions on receipt of the compensation/payout metrics) consistent with those objectives Are performance-based criteria/objectives/metrics aligned with the plan s goals Do the combined elements of the compensation program achieve the overall objective/philosophy Are the plan s terms and potential payouts consistent with concepts of good corporate governance 9
Key Legal (and other) Issues Income tax consequences FICA tax consequences Application of ERISA Funding considerations Securities laws Disclosure considerations Accounting impacts 10
Miscellaneous Hot-Button Issues Severance pay/change in control arrangements Golden coffin (excess death) benefits Tax gross-ups Perks 11
Incentive Compensation
Forms of Incentive Compensation Cash Equity Stock Phantom Stock 13
Purposes of Incentive Compensation Reward Short-Term performance E.g., annual bonuses Reward Long-Term performance Typical period of 3-10 years Retention May target specific employee(s) or broad groups Allow employees to share in stock valuation growth 14
Types of Incentive Targets Company Performance Stock price Earnings per share Sales Return on assets Achievement of specific business goal (such as IPO) Individual Performance Quantitative Qualitative Time-Lapse (continued employment) Plan or Award may include multiple types of targets 15
Section 162(m) $1 Million Deduction Limit Applies only to corporations with stock traded on a U.S. stock exchange $1 million limit on corporation s tax deduction for compensation in any year paid to a covered employee Corporation loses deduction but employee is not subject to penalties 16
Section 162(m) Covered Employees CEO Three highest-paid officers other than the CEO or CFO whose compensation is required to be disclosed in proxy CFO is never a covered employee even if in top three Must be employed on last day of the corporation s tax year 17
Section 162(m) Covered Compensation Limit generally applies to all compensation that the employee includes in taxable income (and company would otherwise deduct) in the company s tax year Compensation may be deferred until limit does not apply Exception for performance-based compensation 18
Section 162(m) Performance-Based Compensation Payable solely upon achieving objective performance goals Shareholders must approve the performance criteria that may be used and maximum amount of compensation any employee may receive Compensation Committee must establish the specific goals for a performance period within 90 days of the beginning of the period (and within the first one-fourth of the period) 19
Section 162(m) Performance-Based Compensation Performance Goal Requirements Third-party must be able to determine if performance goal is achieved Examples: o Earnings per share o Income o Sales o Options and SARs granted at Fair Market Value Payment must be contingent on achievement of goals o No discretion to increase (even for unforeseeable events) o Negative discretion okay o Exception for death, disability, change in control is permissible, but not involuntary termination or retirement 20
Section 162(m) Performance-Based Compensation Common Issues Plan or Award gives Committee discretion to adjust the targets or increase the payment Payment will not be performance-based even if discretion is not used Committee makes adjustments/exceptions in practice Practice of making exceptions may affect awards even in years when exceptions are not made Award is payable on involuntary termination or retirement even if target not met Payment will not be performance-based even if employee does not terminate 21
Equity Compensation Plans
Types of Equity Compensation Awards Incentive Stock Options Nonqualified Stock Options Stock Appreciation Rights Restricted Stock Phantom Stock or Units Employee Stock Purchase Plans 23
Why Use Equity in General? Aligns employee interests with shareholder interests May have tax benefits over cash Can be subject to vesting conditions that encourage longevity and/or performance 24
What is a Stock Option? Employee is granted the right to buy shares of employer stock at a fixed exercise price Often subject to conditions that must be met before the employee is permitted to exercise the right to purchase shares 25
Types of Stock Options Incentive Stock Options ( ISOs ) Have to meet statutory requirements When the option is exercised, the employee is not taxed on the value of the spread (the difference between the stock value at time of exercise and the exercise price) Nonqualified Options More flexibility in terms and provisions (though limited by 409A) When the option is exercised, the employee has ordinary income for the value of the spread If an ISO fails any of the requirements, it gets nonqualified tax treatment 26
Incentive Stock Options Highlights of Requirements Plan must state who is eligible and how many total shares may be granted Plan must be approved by shareholders and expires after 10 years Option price must be at least equal to fair market value of stock at grant Option expires no later than 10 years after grant Option may not actually be exercised more than 3 months after termination of employment (except death or disability) Employee has to hold shares for at least 1 year after exercise and 2 years from date of grant Dollar limit on amount that may become vested each year 27
Why Use Stock Options? Ties employee compensation directly to increase in share price, which directly benefits shareholders Employee has flexibility when to exercise and receive income May take advantage of beneficial tax treatment for ISOs Can have a long-term compensation program exempt from 409A (if exercise price is FMV at grant) 28
Stock Appreciation Rights Employee is granted the right to receive the difference in current value and the stated exercise price of shares of company stock Generally, the value is paid to the employee in cash, but can be paid in shares of stock as well Employee has ordinary income when exercised 29
Why Use Stock Appreciation Rights? Does not require actual issuance of stock, so can be simple administratively Can have a long-term program that is exempt from 409A Ties employee compensation directly to increase in share price, which directly benefits shareholders Employee has flexibility when to exercise and receive income Employee does not have to pay an exercise price 30
Restricted Stock Immediate transfer of shares of employer stock to employee The shares are subject to a substantial risk of forfeiture for a period of time During the forfeiture period, the shares are nontransferable Once vesting conditions are met, the shares are freely transferrable and the employee is taxed on their value 31
Why Use Restricted Stock? Allows the employee to have some benefits of ownership of the stock immediately (for example, voting rights) Taxation deferred until vesting unless employee elects otherwise Employee does not have to pay exercise price, so can be easy to administer Increase employee share ownership to align interests with shareholders Exempt from 409A 32
Phantom Stock or Units Employee has the right to receive payment in the future Payment amount is calculated based on the value of employer stock Payment may be made in cash or stock shares Often subject to 409A if not paid immediately upon vesting 33
Why Use Phantom Stock or Units? Flexibility to pay in cash or shares of stock, but still have the amount determined by stock price Since payment is based on share value, aligns employee s interests directly with shareholder interests Company avoids having to issue shares or payment until award becomes payable Deferred taxation 34
Employee Stock Purchase Plans Broad-based plan used to encourage company stock ownership for rank-and-file employees Generally an ongoing program where shares are purchased periodically through payroll deduction Shareholder approval of the plan required Shares must be priced at least 85% of fair market value Each employee may only purchase up to $25,000 of stock per year Greater-than-5% shareholders ineligible 35
Accounting Issues Employer must account for equity awards as a compensation cost Stock options are accounted for using an option valuation model such as Black-Scholes Additional accounting charges may be triggered if an award is modified Shares offered under an employee stock purchase plan may not require a compensation cost, depending on plan design For stock appreciation rights and phantom stock awards, the charge is taken ratably over the vesting period based on the increase in value and vesting 36
The Compensation Committee
Compensation Committee The Compensation Committee of the Board of Directors of publicly-traded companies is at the center of the activities regarding executive compensation The Committee is charged with designing and implementing the executive compensation program As focus on executive compensation has risen, so has the focus on this group of directors 38
Duties The Compensation Committee s responsibilities generally include: Overall compensation philosophy and strategy Compensation of the CEO (and other executives) Equity compensation arrangements Contractual arrangements, including employment and severance agreements, with executives Management development and succession (sometimes with full Board or another committee) 39
Some Important Current Considerations/ Issues Facing Compensation Committees Independence requirements Impact of shareholder input Say on Pay Influence of shareholder activists and proxy advisory firms Role of risk in compensation programs Stock ownership/holding period requirements Clawback policies Advisor independence Internal pay equity Litigation risks/exposures 40
Clawbacks Concept: provide a process for requiring executives to pay back some compensation in the event of subsequently discovered wrongdoing Performance-based compensation to the extent it is later determined that performance goals were not actually achieved Other cases involving serious misconduct or malfeasance SOX requires clawback of certain CEO and CFO compensation if misconduct results in restated financials Does not define misconduct 41
Clawbacks TARP clawback provisions apply to senior executives of financial institutions that participate in TARP Incentive compensation subject to clawback if payment was based on materially inaccurate financial statements or performance metrics Dodd-Frank directs the SEC to issue rules requiring stock exchanges to impose clawbacks Applies to excess incentive compensation attributable to material non-compliance with financial reporting requirements Applies to current or former executive officers (unclear which ones) 42
Clawbacks Many companies have adopted clawback policies broader than legal requirements Design considerations for clawback policies Who should be covered What types of compensation should be at risk What conduct/events should trigger clawbacks Why time limits should apply State laws that disfavor contractual forfeiture provisions may limit enforcement of clawback provisions 43
Independence of Committee Consultants and Advisors Stock exchange listing standards require that Compensation Committees consider certain independence requirements before engaging compensation consultants and other advisors (including legal counsel) Use of independent consultants/advisors is not mandatory But, the Committee must take into account certain (6) independence factors before selecting (i.e., receiving advice from) such advisor(s) These requirements became effective July 1, 2013 44
Impact of Disclosures Regarding Internal Pay Equity Dodd-Frank requires disclosure of CEO-to-worker pay CEO s compensation as a multiple of median worker pay Controversial requirement; much resistance from the business community Unions have been major proponents of this disclosure SEC has recently indicated that its proposed rules may be released in August (to be effective after a comment period) The average multiple of CEO pay to that of rank and file workers is 204, up 20% since 2009 (according to a recent analysis by Bloomberg of S&P 500 Index companies) 45
Litigation After enactment of Say-on-Pay requirements, plaintiffs firms filed several actions Alleging breaches of fiduciary duties by directors of companies who received unfavorable say-on-pay votes The majority of these cases were dismissed (a few were settled) In a subsequent wave of lawsuits, plaintiffs sought to enjoin the annual meeting unless the company made additional compensation related disclosures Claiming the directors had breached their fiduciary duties by making materially deficient disclosures 46
Litigation While these lawsuits have not generally been successful, they have been very costly Legal and other expenses incurred in defending the suit Time and effort devoted to the suit by the Board of Directors and executive team Such claims may be largely preventable through careful planning and compliance efforts 47
Shareholder Approval and Securities Laws
Why is Shareholder Approval Required? Favorable Tax Treatment Stock Plans Incentive Stock Options ( ISOs ) Employee Stock Purchase Plans ( ESPPs ) Section 162(m) Cash Plans Section 162(m) 49
Why is Shareholder Approval Required? Stock Exchange Rules NYSE and NASDAQ both require shareholder approval of most equity compensation plans Limited exceptions e.g., broad-based plans, inducement grants Material amendments must be approved Increase in number of shares Expansion of group of eligible employees 50
How Often Must Shareholder Approval Be Obtained? Every 10 years for ISOs and ESPPs Every 5 years for 162(m) if compensation committee establishes terms of awards As needed to replenish authorized shares 51
What Securities Laws Affect Employee Benefit Plans? Registration Requirements SEC Reporting Requirements Short-Swing Trading Rules SEC Blackout Rules 52
Securities Laws Registration Requirements Registration with SEC may be required if there is a sale of a security A sale occurs if the employee s own money is invested A security includes both employer stock and the employer s obligation to pay deferred compensation 53
Examples of Sales of Securities Sales Stock options payment of exercise price Investment of employee contributions in company stock fund Contributory nonqualified deferred compensation plan employee deferrals even if plan does not offer company stock fund No Sale Pure bonus plans Restricted stock grants Stock appreciation rights Noncontributory deferred compensation (e.g., SERP) 54
Exemptions from Registration Rule 701 for non-public companies Also available for deferred compensation plans of subsidiaries of public companies Dollar limits on sales Disclosure to employees may be required Non-public offerings Generally Facts and Circumstances Example: Plan covering only senior officers or directors Regulation D Safe Harbors 55
Registration of Compensation Plans Public companies may use Form S-8 Minimal information required Participants must receive a prospectus Prospectus is not filed with SEC For ERISA plans, generally can use SPD with a few additions Updating for material changes Funded plans (including 401(k) plans with company stock funds) must file a Form 11-K each year Cover sheet plus Form 5500 audit Due 180 days after end of plan year 56
SEC Reporting Requirements Public Companies Form 8-K Filed within 4 business days of a material new compensation arrangement or material amendment to an existing compensation arrangement covering an executive officer Covers employment agreements, plans and other compensation arrangements Exception for broad-based plans 57
Proxy Disclosure of Executive Compensation Disclosure for named executive officers CEO, CFO and three highest-paid executive officers Includes all types of compensation and benefits Summary compensation table Table of outstanding equity awards Table of option exercises and stock vested Table of pension benefits Table of nonqualified plan benefits 58
Proxy Disclosure of Executive Compensation Equity Compensation Plan Table Number of options outstanding Average exercise price Shares remaining available Employment Contracts and Change in Control Arrangements for Executive Officers Description and quantification of estimated payments upon termination or change in control 59
Proxy Disclosure of Executive Compensation Plans submitted for shareholder approval Description of material plan terms New Plan Benefits table Compensation Discussion and Analysis (CD&A) Narrative description of compensation committee s executive compensation policies Say on Pay Non-binding vote on executive compensation 60
Section 16 Short-Swing Trading Rules Officers of public companies may be liable for a purchase or sale of company stock and an oppositeway transaction within a 6-month period Applies to both stock and derivative securities such as options Holdings and transactions must be reported on Forms 3, 4 and 5 Most benefit plan transactions are exempt under Rule 16b-3 Possible liability for intra-plan transfers in and out of company stock fund in a 401(k) or nonqualified plan 61
Insider Trading Policy Intended to protect employees from claims that officers bought or sold securities when in possession of material non-public information ( inside information ) No specific SEC requirements, so policies are not uniform Covered employees generally may trade only during window periods following company s release of financial information Regardless of window period, policy should prohibit all trades when employee is in possession of inside information Consider impact of trading policy on plan terms and administration 62
Regulation BTR Trading During 401(k) Blackout Periods Triggered when 401(k) plan with company stock undergoes a blackout period of more than 3 business days Blackout must affect 50% of all participants in all individual account plans Executive officers and directors generally may not purchase or sell company stock during the blackout period Company must provide notice to officers and directors and file a Form 8-K 63