Few Best Practices on Equity Ownership Plans

Sure, every corporate director, internal auditor, and compliance officer wants to tie senior executives’ pay more closely to performance—and requiring executives to hold stakes in their companies through stock ownership rules is one way to achieve that. But new data shows that Corporate America has few standards for what a stock ownership program should look like.

The idea of requiring executives to amass a specified ownership stake is nothing new per se; it gained wide popularity in the early 2000s as a way to align executives’ financial interests with that of shareholders. (Typically, executives must own some multiple of their base salary.) What’s new are requirements that executives must also hold that equity stake in for longer periods, even beyond their actual tenure at the business.

Boyd

“With the spotlight shining brighter on governance practices and more attention being paid to how much skin executives have in the game, holding requirements are become more prevalent,” says Aaron Boyd, research manager at executive compensation research firm Equilar.

Claudio Schneider, a consultant at Frederic W. Cook & Co., says ownership guidelines first came into vogue in 2002 following the corporate fraud scandals of Enron and WorldCom. Another surge came in 2006 thanks to new rules from the Securities and Exchange Commission, which obligated companies to disclose whether or not they had such guidelines.

Governance scoring by proxy advisory firm Institutional Shareholder Services also encouraged companies to adopt formal executive stock ownership guidelines, Schneider says, under a ratings system first known as CGQ and now known as GRId.

All those pressures have led ownership programs to become nearly universal at large companies. Among the 100 largest companies in the Standard & Poor’s 500, 95 percent have some sort of ownership guidelines in place for executives, according to Cimi Silverberg, a principal at FWC. Among 237 Fortune 250 companies analyzed by Equilar, 84 percent disclosed stock ownership policies in 2009.

Hodgson

Similarly, 397 companies in the S&P 500 companies disclosed ownership guidelines for their CEOs in 2009, notes Paul Hodgson, senior research associate at the Corporate Library. That’s up from about half that did so in 2007 and up from 210 in 2005.

Smaller companies are following the same path, although adoption rates are lower. Corporate Library data from 2007 found that about one-quarter of Russell 3000 companies had CEO ownership requirements; the majority of them were in the S&P 500, Hodgson says.

Retention requirements are also rising. About 40 percent of the 237 companies Equilar studied in its recent report disclosed some form of holding requirement in 2009. In 2006, Boyd says, that figure was only 29 percent. He partly attributes the increase to the stock market crash of 2008-09, when falling stock prices resulted in some companies seeing their executives’ holdings fall below their target ownership level.

Schneider says the data he’s collected “shows a clear trend of companies adopting retention approaches in addition to some multiple of compensation.” In the 250 companies he studied, he found that 35 percent of those with formal ownership guidelines also had a retention requirement.

Holding Off Risk

McGurn

Stock holding requirements can help address the risk of poor compensation policies, says Patrick McGurn, special counsel at ISS. While holding periods are not standard practice yet, ownership guidelines and holding periods together are viewed as a governance gold standard by both Risk Metrics and the Corporate Library alike.

“With the spotlight shining brighter on governance practices and more attention being paid to how much skin executives have in the game, holding requirements are become more prevalent.”

—Aaron Boyd,

Research Manager,

Equilar

“Holding requirements are synonymous with a longer-term view and are viewed as risk mitigating,” McGurn says. “Ownership requirements were the number-one thing we saw companies disclose this year as mitigating pay riskiness.”

ISS rates compensation practices in its GRId ratings, although it scores ownership policies and holding requirements separately. The lack of ownership guidelines gets a negative score since they are now standard practice. Holding requirements, however, are “still emerging as a best practice”—so lack of them only results in a neutral score, but having them gives a positive score.

Hodgson says ownership guidelines are an easy governance measure for companies to adopt. “It looks like you’ve adopted best practice, it’s relatively non-confrontational with executives, and shareholders tend to like it,” he says. That being said, stock ownership “may not do a great deal of good either, because many ownership requirements are fairly low.”

Most compensation consultants or analysts say CEOs should be required to hold stock that’s worth at least five times his or her annual salary; that would be considered the norm. Hodgson, however, says that’s not a high enough hurdle. CEOs routinely get four times’ their annual salary in equity every year, he says, so many CEOs exceed the ownership requirement immediately—and at many companies, holding requirements cease as soon as the ownership target is met.

Hodgson says best practices should be a requirement to own a multiple of at least 10 times salary, combined with a requirement to hold that equity into retirement rather than just until retirement.

Still, he notes that holding requirements aren’t a “silver bullet.” Prior to the financial crisis, he notes, all but one of the top seven investment banks had stock holding requirements for their executives. “You’d expect them to be extremely careful about the risk they took that might impact their stock holding, yet that doesn’t appear to have been the case,” he says.

Structure

Stock ownership guidelines that set ownership targets as a dollar value that equals a multiple of base salary are still the most common model; it was used by 82 percent of companies in the Equilar report. Other companies use a fixed number of shares (13 percent of the Fortune 250 companies), and some use a combination of both.

OWNERSHIP GUIDELINES

The following graphs from research firm Equilar demonstrate the prevalence of ownership guidelines and holding requirements at Fortune 250 companies:

Source: Equilar.

Cook

Five times base salary for the CEO “was and is still the norm,” says Silverberg, the Frederic W. Cook principal. Some companies are considering whether to increase that multiple to six, she adds, since that will give them maximum credit under Risk Metrics’ GRId rating.

And some companies go well beyond that. McKesson and General Dynamics, for example, require their CEOs to hold multiples of 10 and 15 times base salary, respectively.

Stand-alone multiples of salary with a certain time period to achieve it (that is, no retention period) used to be standard structure. Now, Silverberg says, an increasingly common approach—and one she views as best practice—is a combination of multiple of salary, along with a requirement to hold a certain percentage of net-after-tax shares until the guideline level is met.

Among the 250 largest S&P 500 companies, the prevalence of ownership requirements only has been on the decline, but still stood at 47 percent as of 2009, Silverberg says. In contrast, the “own-and-hold” approach is on the rise, and hit 35 percent last year.

Silverberg acknowledges that some experts view having both ownership requirements and holding periods as useful, especially in cases where an executive has hit the ownership goal. But when the executive has more riding on unexercised stock options, Silverberg says the combination approach may be overkill.

“I think that if a company has a rigorous stock ownership requirement for executives—for example, six times salary for the CEO along with a requirement to retain a significant percentage of net after-tax profit shares until the guideline is achieved—then also requiring executives to hold stock for a period of time regardless of whether they’ve met the guideline doesn’t get you much,” she says.