Executive compensation is the most critical and visible aspect of a company’s governance. Directors’ decisions about CEO pay speak volumes about the board’s accountability to shareowners. Too often, the story they tell is a dismaying one: Overly generous pay packages for under-performing CEOs are the top governance concern of Council members. Inadequate disclosure about executive compensation compounds the problem. Even with the Securities and Exchange Commission’s (SEC) 2006 overhaul of pay-disclosure rules, many companies do not give shareowners a clear picture of CEO pay, particularly the board’s rationale for the structure and levels of compensation granted.
As a result, a growing number of shareowner-sponsored resolutions seeking to rein in pay or lift the veil of secrecy that surrounds some pay practices are appearing on company proxy statements. Shareowners are increasingly willing to challenge egregious pay policies at the ballot box and in court. They also are more inclined to withhold votes for, or vote against, directors who lavish compensation on CEOs at companies where performance has been mediocre—or worse. Council believes that executive compensation should reward a CEO for sustainable, superior long-term performance. Compensation should be structured to enhance the company’s short- and long-term strategic goals and to retain and motivate top executives to achieve those strategic goals.
Many companies use stock options to reward, retain and attract employees. Stock options give employees the right to buy a specific number of the company’s shares at a fixed price within a certain period of time. A key goal of employee stock options is to motivate employees to act in ways that enhance the company’s performance and, as a result, its stock price. When the stock price rises, the employee’s options are worth more than when they were granted. Stock option awards can be a powerful tool for aligning executives’ interests with those of shareowners if the awards are linked to company performance and creation of value for long-term investors. But stock options can be manipulated in ways that undermine the link between performance and pay.
The Council was alarmed by reports in 2006 that some companies may have backdated stock option grants to allow executives to benefit from stock price lows. This practice, while not always illegal, calls into question a host of issues ranging from the integrity of corporate managers and directors to the reliability of the reported financial statements. The Council subsequently bolstered its policy on the timing of stock awards to read: “Except in extraordinary circumstances, such as a permanent change in performance cycles, long-term incentive awards should be granted at the same time each year. Companies should not coordinate stock award grants with the release of material non-public information. The grants should occur whether recently publicized information is positive or negative, and stock options should never be backdated.”
More recently, another route for misleading reporting of stock options has emerged that involves questionable methodologies for valuing options. In February 2007, the SEC approved a financial product that offers a novel method for valuing employee stock options for financial reporting purposes. These Employee Stock Option Appreciation Rights Securities, or ESOARS, were created by Zions Bancorp. Unfortunately, Zion’s ESOARS are designed to generate low-ball valuations for stock options. Using ESOARS allows companies to report artificially higher profits by reducing the reported expenses from employee stock option awards, found a March 30, 2007, study by Compensation Valuation Inc.
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