MGST 451 - Chp 8,9,12,13,11,& 2

Compensation Governance

a collection of mechanisms to align the interests of managers **(agents)** and owners **(principals)** through salaries, bonuses, and long-term incentive compensation, such as stock options

3 Primary Purposes of Compensation Plan

* must attract right people (w/ skill, experience to succeed)
* must be sufficient to retain those individuals
* must provide right incentives to motivate them to perform appropriately

Compensation Package Includes

* annual salary
* annual bonus
* stock options
* premium options
* performance-vested options (based on acct. performance)
* performance-vested options (based on stock performance)
* performance-vested options (based on nonfinancial performance metrics)
* restricted stock
* performance units (shares)
* perquisties
* contructual agreements
* benefits

Determining the Level of Compensation

1. determine how much value company exects to make during a time horizion
2. determine how much of this value should be attributable to efforts of CEO
3. determine what % of that value should be fairly offered to the CEO as compensation

Ratcheting Effect

When multiple companies within a group try to meet or exceed the median, the median itself tends to increase

Tournament Theory

large pay differentials might also reflect competitive dynamics within the organization

* senior executives not only serve a current operating function, but also compete for promotion

Challenges of Exec. Pay

* excess pay, costs shareholders
* poorly structured pay arrangements:
* dilute incentives to serve SH
* dilute incentives - ex: ability to unwind stock early causes execs. to focus on short-term earnings, at XP of long-term value

Purpose of Exec. Compensation

* attract talent
* retain talent
* motivate exec. to create value for SH

Who sets Exec. Comp.

\- in Large Corp.:

* compensation consultants
* compensation committees
* board of directors
* SH

\- Say on Pay

\- Compensation Committee, includes independent directors

* HR & 3rd party comp. consultants help

Say on Pay

* non-binding, most corps. in Canada have adopted it
* SH get to vote on the executive pay plan once every three years @ annual meeting

Determining Comp. (Benchmarking)

* Boards usually compare CEO pay to other similar companies in terms of size, industry, and location.
* A common practice is to target a salary and bonus package at the middle point of what other similar companies are paying (the 50th percentile), and to target long-term pay (like stock options) at a higher level, like the 75th percentile.

Drawbacks to Benchmarking:

1\. Ratcheting effect – the median compensation tend to increase

* If all orgs seek to pay median or above, median will inevitably \n rise.

2\. Benchmarking can lead to very different pay packages, depending on the companies included in the peer group.

3\. Sometimes, unrelated companies are included in the comparison group, which can make pay go up even more

Exec. Compensation Main 2 Parts

1. **Annual base pay**: This is a fixed amount of money paid annually to the executive as their salary.

* Companies can only deduct up to $1 million of an executive's salary from their tax liability.


2. **Bonuses**: These are extra payments given to executives on top of their base salary, and can be awarded in different ways:

* Discretionary bonuses
* Performance-contingent bonuses
* Predetermined allocation bonuses
* Target plan bonuses

Discretionary Bonuses

* awarded on an objective basis:
* given at the discretion of the company or board, and may or may not be tied to specific performance targets

Performance-contingent Bonuses

* based on whether or not the executive achieves specific goals or performance criteria

Predetermined Allocation Bonuses

* bonuses are calculated based on a specific formula

Target Plan Bonuses

* ties bonuses to executives’ performance

Long Term Comp.

* added to the compensation mix to encourage executives to select long-term investments that increase SH value
* reduces risk averse execs.
* often a substantial part of executive compensation

Stock Options

* stocks **purchased** at a designated price for a specific time (usually 10 yrs)
* awards given that **lets them buy** company shares for a cheap price and sell them later for more money
* increase in value as stock price increases - long term inv.
* increase in value w/ stock-price volatility - taking risk
* vesting requirements - not immediately available to be exercised or cashed in by an employee. Instead, they become available over time

Stock Grants

* a company offers stock to employees
* **don't have to pay** for the shares but usually have to wait for a certain amount of time before they can sell them

Exercise of Stock Grants

* purchase of stock

Disposition

* sale of stock

Fair Market Value

* avg. stock price on the TSX (Toronto stock exchange)

How Stock Options Work

* Right to purchase stock at a later date
* Strike price set @ the date when opt. was granted
* Vesting – how long till the option is yours
* Maturity – how long do I have till I exercise my right to \n purchase

Vesting

* how long till option is yours
* requirements: deferred payoffs that encourage a focus on long-term results

Maturity

* how long do I have till I exercise my right to buy

Types of Stock Options

* premium options
* performance-vested (acct-based)
* performance-vested (stock-price based)
* performance-vested (nonfinancial-based)
* **only 5% of top 250 us firms have performance-based vesting**

Premium Options

Exercise price higher than current price

Performance-Vested (Acct-based)

Accelerated vesting based on achieving accounting-based targets

Performance-Vested (stock price-based)

Accelerated vesting based on total stock price returns

Performance-Vested (nonfinancial-based)

Accelerated vesting based on strategic milestone (e.g., FDA approval)

Non-Statutory Stock Options

• Company awards stock at discounted price

• when an employee exercises their option to purchase stock at a discounted price, they are required to pay taxes on the difference between the discounted price and the fair market value of the stock at the time it was granted

Restricted Stock

* The company grants its employees shares of stock that are restricted from being sold or transferred & are subject to vesting
* Awarded 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

Stock Appreciation Rights (SAR)

* Similar to restricted stock, but the executive **never has to** **exercise stock rights to receive income**
* Instead, the company awards a bonus payment:
* difference in the value of the stock between the time the company gave you the stock rights (based on the current stock price) and the end of the time period specified in the agreement
* company grants 1,000 SAR when stock price is $10. Employee exercises it when stock price is $20 and gains $10,000 ($20-$10)\*1000. Divide $10,000/current stock price of $20=500 shares (minus tax)
* This arrangement permits the executive to keep the stock

Phantom Stock

* Bonus in the form 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, or
* Executives must retire from the company

Employee Stock Purchase Plans

* allow execs. to buy company stock after a set amt of time (offering period)
* during offering period, execs. set aside $ thru payroll deduction
* companies may establish stock purchase plans on a tax qualified or nonqualified basis

Restrictions on Compensation

* stock ownership guidelines - exec. is required to own a min. amt of company stock, generally expressed as a multiple of base salary (5 times)

Severance

* Most CEO employment contracts include a clause specifying the situations under which the CEO is considered to be in breach of contract
* These terms usually relate to behavior that is harmful to the company's reputation or involves dishonesty
* If the CEO violates these terms, they can be removed from their position.
* If the CEO is removed for reasons other than a breach of contract, the company is typically required to fulfill the terms of the agreement.
* This often includes paying the CEO a severance package, which is a sum of money paid to the CEO as they leave their position.

What is Severance

compensation or benefits that are provided to an executive or employee upon termination of their employment, usually due to circumstances beyond their control such as downsizing, restructuring, or a change in management.

* packages typically include financial compensation, such as a lump sum payment or continued salary for a period of time, as well as benefits such as healthcare coverage or stock options.

CEO Termination

* entitled to severance agreements (AKA golden parachutes)

Golden Parachutes

Provides executives with pay and benefits following termination due to ownership change or corporate takeover.

\
Advantages to executives and the company:

* Eases hiring new CEO in climate of corporate takeovers
* Virtually eliminates execs from making decisions to save their job at expense of company welfare
* Gives chief execs incentive to work towards shareholders' interests in takeover threat
* Increases cost to predator company

Golden Parachutes Criticism

* An inappropriate use of a company's money.
* Doubt that CEO positions would go unfilled without golden parachutes.
* Believe the cost of golden parachutes is unlikely to prevent a takeover.
* Not tied to performance or takeover premium.
* Argue that CEOs are already well-compensated and paid to manage the company in the best interests of shareholders, even if it may not be in their own personal interests.

Platinum Parachutes

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

Clawback Provisions

* Allows BoD to take back performance-based compensation when performance goals were not achieved.
* These provisions are more common because of \n increasing public scrutiny of exec compensation \n practices.
* Policies are now required under the Dodd-Frank Act.

Common Perquisites

* company car
* security services
* loans at low or no interest
* legal services; counselling, estate planning, tax prep, etc…
* recreational facilities; country club membership, exec. dining room
* travel perks; first-class air travel, spouse travel

Compensation Mix - Consideration

* not enough risk = low manager effort
* too much risk = manager avoids risky projects
* goal is to control compensation risk, **not eliminate it**
* managers are risk averse & trade off risk & return

Company Size

Largest Determinant of CEO Pay Levels

Optimal Contracting

efficient market, process ensure fair compensation

Rent Extraction

inefficient market, executives are overpaid

Management Entrenchment

ability of mgmt to shield itself from market forces and pressures to perform from the board, SH, and stakeholders

* large differentials might indicate that the CEO is able to engage in rent extraction, which the corporate governance system has not adequately controlled against

Target Award

size of bonus

STIPS

short-term incentive plans

LTIPS

long-term investment plans

RSUS

restricted share units

Rent Extraction

refers to situations where individuals or groups within a company use their power and influence to extract excessive compensation or other benefits from the company at the expense of shareholders and other stakeholders.

Realized Compensation

potentially problematic measure bc it reflects the combined value of stock and options granted during multiple yrs but exercised in a single yr

Firms with Weaker Governance

have greater compensation & firms w/ greater agency problems perform worse

Criticism of Exec. Comp. Levels

1. large differential between the pay granted to the CEO & pay granted to other senior executives
2. large differential between CEO pay and the average employee pay

ex; Large gaps in pay btwn CEO and other NEOs may signal that the CEO is earning an excessively large share of the compensation paid to top execs. or that the pay is **not tied to performance**

Short-Term Incentives

annual payment (usually cash) for achieving predetermined performance objectives

Warranted Equity Value (WEV)

* 40% weighting
* discounted cash-flow measurement that derives the intrinsic value of the company resulting from operating performance

Pension-Adjusted Operating Margin

* 20% weighting
* based on the implementation of a phased improvement program to drive operating margin performance beyond a weighted average of peer company performance levels.
* Goals were based on achieving specific operating margin dollar amounts

Cash From Operations

* 20% weighting
* designed to reward the improved efficiency of converting earnings into cash, a key indicator of earnings quality and management’s ability to generate operating cash.
* Goals were based on analysis of cash conversion rates

Supplemental Goals for Sector Operating Units

* 20% weighting
* designed to maximize operational performance, which includes metrics such as customer satisfaction, new product development, new business initiatives, productivity, quality improvement, workplace diversity, employee management, leadership development & environmental management
* NEOs received the weighted average score of all sectors

Long-Term Incentives

encourage executives to select long-term investments that increase shareholder value

* extend the time horizon of the executive and mitigate the natural tendency of a risk-averse executive to reject risky investments

Why Stock Options

when stock prices increase = opts. increase

* motivates executives to add corporate value by identifying and implementing investments with positive net present value (NPV).

when stock-price volatility increases = opts. increase

* motivates executives to accept risky, positive NPV investments

opts have deferred payoffs that encourage long-term results

Benefits & Perquisites

* value of these awards is not negligible
* only 3% of total comp.
* argue: form of “stealth compensation” that enriches executives at the cost of shareholders

Efforts to Reform Compensation

* increase proxy disclosure
* say-on-pay
* set strict limits on comp.
* take into account cumulative pay before setting future comp.
* decrease flexibility of execs. to cash in on earned/accrued long-term incentives

See-Saw Shaped Relationship

* between ownership and firm performance
* @ low levels of managerial ownership, equity ownership & firm value are **positively correlated**
* Large ownership positions allow for management entrenchment and weakened oversight

Target Ownership Plans

* requires that an exec. own a min. amt of company stock
* can be expressed as:
* multiple of annual comp.
* fixed # of shares
* “retention approach” (exec. retains a % of vested awards)

Retention Approaches

* execs. are required to take a % of proceeds that they realize thru option exercises & keep $ invested in company stock
* Some plans make executives keep a percentage of the money they make from selling stock options and invest it in the company's stock. Other plans require executives to own a certain number of shares of company stock.

Equity Ownership

ownership of shares or stock in a company

* intended to provide incentives that motivate managers to improve corp. performance
* has the potential to encourage undesirable behaviours
* ultimately should discourage selfishness

Undesirable Behaviours from Equity Ownerships

* Manipulating accounting results to inflate stock price or achieve bonus targets
* Manipulating the timing of option grants to increase their intrinsic value
* Manipulating the release of information to the public to correspond with more favorable grant dates
* Using inside information to gain an advantage in selling or otherwise hedging equity holdings

Manipulation of Equity Grants

* manipulating the timing of the grant
* grant date is delayed so that it occurs after stock price decline has already taken place
* manipulating the timing that info. is released to the public
* release of favourable info abt product is delayed so it occurs after scheduled grant date

exec. seeks to maximize value received from an equity grant by taking actions that are not in interests of SH

Scheduled Option Grants

equity-based compensation plan that involves granting executives stock options at pre-determined intervals, typically on an annual basis

Stock Option Backdating

changing the grant date of stock options to a time in the past when the stock price was lower, thereby increasing the potential profits for the option holder

Spring-Loading

awarding opts. immediately before the release of unexpected positive news that’s likely to increase price of stock

Bullet-dodging

waiting to award opts. until after the release of unexpected negative news that’s likely to decrease price of stock

Exercise Backdating

changing exercise dare of stock opts. to a date when mkt price was lower to reduce taxable gain that the opt. holder would have to pay at an ordinary income tax level

How Execs. get Diversification

* selling company shares outright
* hedging a portion of the ownership position thru financial instruments
* pledging a portion of shares as collateral for a loan that’s used to buy more assets

risk arises that executives will engage in self-interested behavior to maximize the value of their holdings at the expense of shareholders

Insider

* individuals- corp. officers, directors, employees, & certain professional advisors who have access to material financial & operational info abt a company that has not yet been made public
* restricted in ability to engage in transactions involving company securities & only can trade when they do **not** have material non-public info

Insider Trading

when insiders trade when they are in possession of material non-public info

* illegal

Blackout Period

restrict execs. from violating insider trading laws, this time is designated

* typically occur btwn time when material info is known (ex: quarterly earnings, new prod. launch, acquisition) & the time when it is released to public
* 50 calendar days usually

Trading Window

time outside out of the blackout period

SEC Rule 10b-5

* Employment of Manipulative and Deceptive Devices
* Insider trading lawsuits are prosecuted under this

SEC Rule 10b5-1

* Trading ‘on the Basis of’ Material Nonpublic Information in Insider Trading Cases
* outlines a set of procedures that, if followed, provide an “affirmative defense” against alleged violations of insider trading laws
* 10b5-1 plans

10b5-1 Plans

insiders are allowed to enter into a binding contract that instructs a third-party broker to execute purchase or sales transactions on behalf of the insider

* can be agreed to only during a period in which the insider does NOT have knowledge of material nonpublic info
* insider is required to specify a program or algorithm that dictates the conditions under which sales are to be made
* insider may not interfere with the execution of trades. However, he or she is allowed to make amendments to (or terminate) the plan at any time

Hedging

* taking a position in an asset/investment to prevent potential losses in another investment

tend to follow periods in which the stock price has run up, and precede periods of underperformance

Hedging Problems

1. unwinds equity incentives that board had to align interests of mgmt w/ those of SHs
2. costly, mgmy will demand larger comp. for receiving risky equity incentives instead of risk-free cash comp.
3. hard to convince SHs

Zero-Cost Collar

hedging strategy that involves buying a put option on a stock to limit downside risk while simultaneously selling a call option to finance the put option

Prepaid-Variable Forward (PVF)

financial instrument that allows investors to monetize their stock holdings while retaining some exposure to potential stock price appreciation

* investor sells their shares to a counterparty at a discounted price and agrees to repurchase the same number of shares at a future date

Short-term trading

investor buys and sells securities with the intention of profiting from short-term price movements

Short sales

trading strategy in which an investor borrows shares of a security from a broker & sells them with the expectation that the price of the shares will decline in the future. If the price does indeed fall, the investor can buy the shares back at the lower price, return them to the broker, and pocket the difference as profit

Publicly traded options

contracts that give the holder the right, but not the obligation, to buy or sell a specific underlying asset, such as a stock or commodity, at a predetermined price and time

Standing orders

pre-authorized instructions given by a bank account holder to their bank, authorizing the bank to make regular, recurring payments to a specific recipient on a specified date

Pledging

a borrower uses their assets as collateral to secure a loan or line of credit. The borrower pledges an asset, such as real estate, stocks, bonds, or other valuable property, as security for the loan. If the borrower defaults on the loan, the lender can take the pledged asset

* exec. may decide to pledge shares for a loan

Repricing or Exchange Offer

transaction in which employees holding stock opts. are allowed to trade those opts. for either a new opt, restricted stock, or cash

* often happens when stock opts. are trading out-of-the-money to such an extent that they’ll likely not become profitable/offer value to employees in the foreseeable future

True

True or False: Employees are not required to accept an exchange offer made by the company

False

True or False: Employees do not have the right to retain unexercised options (both vested and unvested) if they choose to do so