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Practising Law Institute. Developments and Trends in Compensation Practices – Aftermath of Enron. Jeffrey M. Kanter Max J. Schwartz Scott P. Spector. Things We’ll Discuss. The Environment Worst Practices Best Practices Possible Change Areas. The Environment. Enron/Andersen collapse
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Practising Law Institute Developments and Trends in Compensation Practices – Aftermath of Enron Jeffrey M. Kanter Max J. Schwartz Scott P. Spector
Things We’ll Discuss • The Environment • Worst Practices • Best Practices • Possible Change Areas
The Environment • Enron/Andersen collapse • Depressed market despite stronger earnings • Continued investor dilution concerns • New disclosure for stock plans • Continued concern about stock plan approval • Finalization of EITF 00-23, but IASB is here • Options continue to be underwater • Missed incentive goals
Enron/Andersen Collapse • Heavy scrutiny of stock options • Distrust of financial disclosure • Earnings comparisons less meaningful • What’s in the numbers? • Re-thinking director compensation • Are options right?
Continued Investor Concerns • Higher average potential dilution from stock plans 19972001% change • S&P 500 10.0% 13.7% 37.0% • S&P Mid Cap 10.5% 15.6% 48.5% • S&P Small Cap 13.8% 17.0% 23.2% • Total Super 1500 11.6% 14.1% 21.6% • Continued scrutiny from institutional investors Source: Stock Plan Dilution, 2002: Overhang from Stock Plans at S&P Super 1,500 Companies—Investor Responsibility Research Corp
Continued Investor Concern Source: Stock Plan Dilution, 2002: Overhang from Stock Plans at S&P Super 1,500 Companies—Investor Responsibility Research Corp
Public Perceptions • Executive greed and duplicity contributed to Enron debacle • Mega-options drove management to falsify accounting to keep stock prices high and rising • Executives used inside information to exercise and sell options while price high • Stock option accounting contributed to the speculative bubble in stocks by inflating the growth rate in EPS • Stock options cause short-term behavior and are misaligned with long-term interests of shareholders
New Financials EBIT: Earnings Before Irregularities and Tampering ROIC: Restated on Instructions of Counsel CFO: Chief Fraud Officers
Worst Practices Enron • Philosophy to reward shareholder value creation • Stock options and restricted stock (50/50) • RS vesting accelerated based on TSR performance • 4 year reduced to 1 year • Large grants (Lay: 1.3 million in 2000) • Limited partnership interests • Executive loans and repayments
Worst Practices Tyco • Loans • Stock sales • Actions without compensation committee knowledge • $20 million to director • Chair of Corporate Governance and Nominating Committee • Reloads with 10-year terms
Worst Practices E-Trade • CEO loan settlement • Forgiveness $15,000,000 Tax Gross-Up 15,211,481 $30,211,481 • “For elimination of certain contractual relocation benefits”
Worst Practices K-Mart • Full recourse retention loans • $2.5 - $5.0 million • Made in 2000 – 2002 • “Vest” in 2004, i.e., • Forgiveness • Tax gross-up
Worst Practices WorldCom • Stock options only • Large grants (Ebbers – 1.2-1.9 million per year) • Loan arrangements • Company guaranteed $195.6 million (B of A) • Company paid at $198.7 million plus $35 million for LC • Company direct loan of $165 million • Why: “to avoid the need for Mr. Ebbers to sell large quantities of WorldCom stock
Worst Practices - Other GE • 3,000,000 stock options and 850,000 RSUs ($48 million) to Welch • 1 year vesting • “Recognize 20 years of service and developing and implementing plans” Conseco • $45 million cash signing bonus to Gary Wendt
Worst Practices - Other Dell and Oracle • 38 million options from 1996 to 1998 to Michael Dell • Already owned 353 million shares • 20 million options to Larry Ellison • Already owned 700 million shares Dynergy • CEO severance 2.99x base and incentive compensation • But incentive compensation includes stock options
Worst Practices • Layoffs with big pay PayLayoffs Disney $72.8 4,000 Cisco Systems $28.7 8,500 WorldCom $10 million 6,000 stay bonus
Best Practices (?) Coca-Cola • Interesting approach • Valuation better than FAS 123
Amazon.com AMB Property Corp. Bank One Boeing Coca-Cola Dole Foods Fannie Mae Freddie Mac iStar Financial Level 3 Communications Sovereign Bancorp Washington Post Winn-Dixie Delta Air Lines Heinz Target Stores Best Practices (?) • Others: Companies Expensing Options Companies Considering Expensing Options
Best Practices Pepsi • Enrico reduced salary to $1 • Money went for scholarships for children of front-line employees
Best Practices Krispy Kreme • Since 1937; public since early 2000 • Development rights agreements while private • Also had franchise equity pool for management • All pools and rights agreements terminated • Return of original investment • All sales through 10b5-1 plans
Best Practices Ownership Guidelines • 13% of Top 250 • Not a lot, but more considering • Most use multiple of retainer • 5x most common • Comcast & Ford – multiple of retainer/fees
Best Practices Ownership Guidelines • Other examples • Citigroup – 75% of shares granted • Pitney-Bowes – $350k owned in order to sell stock • PNC Bank – must use ¼ of retainer to purchase stock • Tribune – 5x most recent stock grant
Best Practices Director Performance Options • Computer Associates – # based on ROE • ADC Telecom – grant only if 10% ROE • SYSCO – options granted only if 10% growth in EPS • UP & CapOne – options vest on stock price
Regulatory Requirement Enhanced Disclosure Best Practices • 1. Compensation Committee Governance • Committee Charter x x • 100% Disinterested (Audit Standard) x x • Compensation Literacy and Experience x • Strong Chair, Periodic Rotation x • Code of Conduct (conflicts of interest; sales) x x • Total Compensation Oversight x • Access to Outside Advisors and Staff Support x x • Legal Representation x x • Executive Sessions x • CEO Pay Determination x Possible Change Areas
Regulatory Requirement Enhanced Disclosure Best Practices Possible Change Areas • 2. Annual and LTIP Design • Relevant Metrics x • Audit Confirmation of Formula Results x • Negative Discretion x • Strategic and Qualitative Factors x • Recapture for Restatements x x • Operational vs. Market Goals x
Regulatory Requirement Enhanced Disclosure Best Practices • 3. Stock Options • SFAS 123 Accounting x x • Managed Run Rate and Overhang x • Nonshareholder Approved Plans x x • Mega Grants x • Performance Vesting x • Ownership Intent x • Inside Information x • Repricings x x Possible Change Areas
Regulatory Requirement Enhanced Disclosure Best Practices • 4. Ownership Standards • Code of Conduct x • Timely Sale Disclosure x • Retention Ratio x • Cashless Exercises x • Proxy Disclosure of Option Sales x • Recapture of Gains in Bankruptcy x • Hedging x x • Rule 10b5-1(c) Sell Programs x x • Loans, Margin, Collateral x x Possible Change Areas
Regulatory Requirement Enhanced Disclosure Best Practices • 5. Deferred Compensation • SERP Accrual Disclosure x • Lump Sum Settlements x x • Recapture for Bankruptcy x • Stock Account Switching x x 10 Possible Change Areas
Regulatory Requirement Enhanced Disclosure Best Practices • 6. Directors’ Compensation • Stock Options x • Restricted Stock x • Committee Chair Fees x • Ownership Standards x Possible Change Areas
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