The values of equity awards as reported in proxy statements, based on so-called “date of grant” values, do not adequately take into account the risks associated with such awards at the time of grant.1 For example, if a named executive officer receives a dollar of salary and a “dollar’s worth” of restricted stock, these two “dollars” are treated as equivalent for purposes of the Summary Compensation Table. (The Summary Compensation Table is the table in the proxy statement that sets out total compensation, including amounts involved in different categories of pay making up total compensation, for each named executive officer.)
Risk factors noted below that are associated with equity awards are not generally taken into account in reporting equity awards in the Summary Compensation Table. (Footnote 2 provides a summary of how equity award values are reported in the Summary Compensation Table.)2 This means that the two “dollars” are treated as equivalent values in the computation of total compensation, as reported in the Summary Compensation Table, notwithstanding risk factors accompanying an equity award.
The significance of this problem was underscored by the Securities and Exchange Commission’s publication on Sept. 18, 2013, of proposed regulations on the “CEO Pay Ratio” required under Dodd-Frank Section 953(b).3 Dodd-Frank Section 953(b) requires issuers to report a ratio involving total pay of the CEO and median total pay of all other employees.4 The calculation of the CEO Pay Ratio is tied to pay as reported in the Summary Compensation Table and, hence, likewise does not adequately reflect risk associated with a major portion of CEO pay. This is discussed further below.
Market Risk During Period of Non-Transferability. Most equity awards vest gradually over several years. Some “cliff” vest, meaning no vesting until a future date when the entire award vests all at once. During the period of vesting, whatever it is, the executive does not have the right to transfer the award.5 As a result, executives are subject to the risk of a drop in the market price of the stock during the period they must hold the award. While the opportunity for gain also exists, in the absence of discretion as to when and if to sell, the holder (the executive) faces a risk of loss that he or she could avoid if the equity were transferable.
Most executives have a substantial portion of their wealth tied up in the employer. Unlike most investors in the stock market, the typical executive is not very diversified in his or her portfolio (i.e., the executive’s equity portfolio is principally committed to equity of the employer). This magnifies the market risk associated with a period of non-transferability because so much of the executive’s wealth is tied up in the equity of the employer.6
Forfeiture Due to Termination of Employment. The possibility of forfeiture due to termination of employment significantly reduces the value of an equity award from what it would be if granted outright.
Following are different types of terminations that may occur before an equity award vests:7
a. by the employer: for cause; without cause;
b. by the executive: for good reason; without good reason;
c. due to disability;
d. due to death.
Consequences differ depending on the type of termination. Terminations by the employer for “cause” or by the executive without “good reason” generally result in forfeiture. Terminations by the employer without cause or by the executive for good reason or terminations due to disability or death generally result in at least some acceleration of vesting. In some cases, a termination as described in the preceding sentence may result in continued vesting, following termination, rather than accelerated vesting.
Risk Imposed by Performance Targets. In many cases, equity awards are subject to attainment of performance targets. In some of these cases, targets are operating targets such as a specified growth in revenue or in earnings per share. Other performance targets may be tied to the performance of the employer’s stock, such as total shareholder return. In all events, the requirement that performance targets must be achieved before an award is earned out adds to the risk factors already noted. (As discussed in footnote 2 to the column, risk associated with targets based on the employer’s stock performance is taken into account in reporting values in the Summary Compensation Table. This is not so in the case of targets based on operating performance.)
Clawbacks. In recent years, an increasing number of companies have provided for clawbacks of equity awards, even after termination of employment. For this purpose, “clawback” means that if the executive violates certain requirements contained in the clawback provision the employer takes back the value that had been realized by the executive upon vesting or transfer of the stock (or cash) involved. The circumstances most frequently covered in clawbacks are those relating to the filing of a financial statement that contains misstatements.8 In some cases, clawbacks have been extended to circumstances such as a breach of a restrictive covenant (e.g., a no-compete covenant). In many cases, the clawback is of the pre-tax amount. Except to the extent the executive is able to obtain an off-setting tax benefit through deduction of the amount paid back to the employer, the executive is out-of-pocket the tax in addition to the amount paid back.
Other Risk Factors.
• A “change in control” of the Company. It is rare that an equity award in a public company is forfeited in consequence of the company’s merging into another entity. But it does happen. If an option is cashed out in a merger, it usually is at the intrinsic value and not the greater Black-Scholes value. If the equity award converts into stock of the surviving entity and continues to vest, the stock of the surviving entity may not perform satisfactorily after the conversion and the executive continues to have no way out until it vests.
• Dilution. Most long-term incentive plans provide some anti-dilution protection but less than shareholders are ordinarily entitled to. Generally, it is described in terms of adjustments at the discretion of the board of directors.
Estimate of Risk-Adjusted Pay
In his paper, “Executive Compensation: Where We Are, and How We Got There,” Professor Kevin J. Murphy estimates that for 2011 the median risk-adjusted pay for CEOs in S&P 500 firms was approximately $6 million, about one-third less than the median reported pay of $9 million.9 Risk-adjusted pay for purposes of that paper takes into account the market risks associated with delay in transferability during the period in which equity is not yet vested. It also takes into account the lack of diversification in executives’ portfolios.10 Most S&P 500 CEOs receive about half of their compensation in the form of equity. Therefore, unless meaningful adjustment for risk is made in the value of equity pay, total CEO pay (as well as that of other named executive officers) will be significantly overstated.
Failure to Consider Risk
Total compensation, as reported in the Summary Compensation Table, is the figure most prominently displayed for purposes of reporting CEO pay in the media, academic commentary and benchmarking among comparative companies. Equity awards are a significant element in total compensation. To treat a “dollar” of equity award as the equivalent of a dollar of salary clearly exaggerates the value of the equity award and, hence, exaggerates the value of total compensation.
A Specific Consequence: Reporting the “CEO Pay Ratio” Under Dodd-Frank. Dodd-Frank Section 953, as noted above, requires that a ratio composed of CEO total compensation and the median total compensation of all other employees be displayed in the proxy statement.
Dodd-Frank Section 953(b) provides as follows:
(b) ADDITIONAL DISCLOSURE REQUIREMENTS.—
(1) IN GENERAL.—The Commission shall amend section 229.402 of title 17, Code of Federal Regulations, to require each issuer other than an emerging growth company, as that term is defined in section 3(a) of the Securities Exchange Act of 1934, to disclose in any filing of the issues described in section 229.10(a) of title 17, Code of Federal Regulations (or any successor thereto)—
(A) the median of the annual total compensation of all employees of the issuer, except the chief executive officer (or any equivalent position) of the issuer;
(B) the annual total compensation of the chief executive officer (or any equivalent position) of the issuer; and
(C) the ratio of the amount described in subparagraph (A) to the amount described in subparagraph (B).
(2) TOTAL COMPENSATION.—For purposes of this subsection, the total compensation of an employee of an issuer shall be determined in accordance with section 229.402(c)(2)(x) of title 17, Code of Federal Regulations, as in effect on the day before the date of enactment of this Act.
It is noteworthy that the SEC, in its proposed regulations, reverses the ratio set forth in Dodd-Frank Section 953(b)(1)(C). Instead of the statutory ratio of total compensation of all employees (other than the CEO) (in the numerator) to the total compensation of the CEO (in the denominator) the proposed regulations reverse the ratio. Prop. Reg. §229.402(u)(1)(iii). What was done by the SEC, notwithstanding the ratio as stated in the statute, makes a more dramatic presentation of the ratio.
Regulation 229.402(c)(2)(x), as referred to in Dodd-Frank Section 953(b)(2), provides that “[t]he dollar value of total compensation” is to be the sum of all reported dollar values in the Summary Compensation Table including equity awards. The proposed regulation under Dodd-Frank Section 953(b) simply reiterates that the meaning of “total compensation” for purposes of determining the Section 953(b) pay ratio will be total compensation as described in Regulation 229.402(c)(2)(x). Prop. Reg. §229.402(u)(2)(i).
In the determination of CEO total compensation under the proposed regulations, the SEC evidences no willingness, or even awareness, of the significance of risk as a major component of CEO pay. Risk as attached to an equity award to a CEO is not present in the compensation of most other employees in most public companies. Certainly it is not a meaningful element (if present at all) for the employee at the median level of pay.11
In the determination of median total pay for all employees, other than the CEO, the proposed regulations provide specifically for estimates of certain elements of total compensation. If the SEC has the flexibility under Regulation 229.402(c)(2)(x) to provide for estimates of certain elements of compensation for “all other employees” it should be able to provide guidelines for estimating risk associated with equity awards to CEOs.
What Can Be Done?
1. Compensation Committees in making equity awards should have in mind the impact of risk on the value of the awards they are making. This means taking into account risk in valuing the award itself and also in determining values of similar awards at comparator companies for benchmarking purposes.
2. Committees should provide explanation of how they take into account risk factors in determining the appropriate level of equity awards, including in benchmarking against comparator companies. The explanation can be given in narrative form (including footnotes) associated with the applicable tables (the Summary Compensation Table and the Grants of Plan-Based Awards Table) as well as in the Compensation Discussion and Analysis section of the proxy statement.
3. To avoid serious distortion in the CEO Pay Ratio under Dodd-Frank Section 953(b), the SEC must somehow make allowance for the risk factors noted in this column. If its failure to do this is based on the statutory reference in Section 953(b) to Regulation 229.402(c)(2)(x) as in effect on the date of enactment of Dodd-Frank, then legislative action to modify that reference to allow flexibility in this regard may be required.
Joseph E. Bachelder III is special counsel to McCarter & English. Andy Tsang, a senior financial analyst with the firm, assisted in the preparation of this column.
1. This column does not discuss the point of view expressed by some commentators (and incorporated by some issuers in the Compensation Discussion and Analysis section of the proxy statement) that “realized” or “realizable” value should be used for purposes of evaluating equity awards. See prior NYLJ column, Dec. 21, 2012, for a discussion of “realized” and “realizable” values.
2. Item 402(c)(iv) and (v) of Regulation S-K (17 CFR §229.402(c)(iv) and (v)) provides that equity awards are to be reported in the Summary Compensation Table as “the aggregate grant date fair value computed in accordance with FASB ASC Topic 718.” In its guidance as to determining grant-date fair value of an equity award, FASB ASC 718-10-30 gives limited recognition to the risks accompanying the award. The grant-date fair value of a time-vesting stock or stock unit award (that is, with no performance conditions) is the market value of the stock on the date of grant. The grant-date fair value of a stock option is based on the Black-Scholes or other financial model, but this estimation of fair value does not take into account certain risk factors including forfeiture upon termination of employment. In the case of performance-based equity awards, risk of failure to attain performance targets may or may not be taken into account depending upon the type of performance target. As noted in the text, in some cases, targets are based on operating performance of the employer, such as a specified growth in revenues or earnings per share. In such cases, reporting on the value of the award as required in the proxy statement does not take into account the risk associated with the requirement that such target be met as a condition to earning the award. Instead, the value reported in the proxy statement assumes attainment of the target. Other performance targets, as also noted in the text, may be tied to the performance of the employer’s stock, such as total shareholder return. In the latter case, the value reported reflects the likelihood of achieving the target. To this extent, risk is taken into account for performance targets that are based on performance of the stock of the employer.
3. The new rules were announced in SEC Rel. Nos. 33-9452, 34-70443 (Sept. 18, 2013). Assuming final rules are adopted in 2014, the first proxy season in which the Pay Ratio would be required to be disclosed would be in 2016. The SEC proposal requires compliance “with respect to compensation for the registrant’s first fiscal year commencing on or after the effective date of the rule.” See SEC Rel. Nos. 33-9452, 43-70443 at p. 133.
4. Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law No. 111-203, §953(b), 124 Stat. 1376, 1904 (2010), as amended by Public Law No. 112-106, §102(a)(3), 126 Stat. 306, 309 (2012).
5. Sometimes, executives are required to hold some or all of an award without transferring it for a period beyond vesting. (See prior NYLJ column, July 17, 2013.) FASB ASC Topic 718, incorporated into Item 402 of Regulation S-K, takes into account risks associated with non-transferability in the case of equity that has vested. See FASB ASC paragraph 718-10-30-10.
6. Senior-level executives at public companies are under strict limitations as to hedging in the employer’s stock. SEC rules, SRO rules and rules contained in employers’ own corporate and equity plan documents (including, sometimes, the awards themselves) impose limitations on hedging.
7. In almost all cases, once an award vests it is no longer subject to forfeiture. An exception would be a vested award, not yet delivered, that might be forfeited in the event of a termination for cause. See also discussion of clawbacks later in the text.
8. Legislative requirements as to clawbacks include those contained in Section 304 of Sarbanes-Oxley (15 U.S.C. §7243) and Section 954 of Dodd-Frank (15 U.S.C. §78j-4(b)). For a discussion of clawbacks under federal legislation, see prior NYLJ column, May 27, 2011.
9. Murphy, Kevin J., “Executive Compensation: Where We Are, and How We Got There,” in George M. Constantinides, Milton Harris and Rene M. Stulz (eds.), Handbook of the Economics of Finance, 2013, Vol. 2A, Chapter 4, pp. 211-356, at p. 232. See also Hall, Brian J. and Murphy, Kevin J., “Stock Options for Undiversified Executives.” Journal of Accounting and Economics, 2002, Vol. 33, No. 1, pp. 3-42.
10. In his paper, Murphy does not take into account other risks discussed in the text including risk of forfeiture due to termination of employment. As discussed in the text, an unvested award carries with it two risks. First is the delay in transferability (i.e., loss in market value which Murphy takes into account) and second is the loss of the award if forfeited due to termination of employment. It is this latter risk that Murphy does not take into account. Explanation as to why he does not is given in the earlier paper cited in footnote 9 above. Hall and Murphy at p. 14.
11. The CEO pay ratio is determined, under the proposed regulations, on a pre-tax basis. While not a risk-related point, it is noteworthy that the ratio will not take into account the likely fact that the CEO’s pay will be taxed at a higher rate than the employee at the median pay level, leaving the CEO with proportionately less total compensation (for purposes of the ratio) after taxes than before.