Tips From Campos; SEC OKs Option Scheme

S

ecurities and Exchange Commissioner Roel Campos had a few suggestions for companies recently on how boards can control runaway executive compensation, before the issue explodes into shareholder ire.

Foremost, he said: Boards should do their homework before hiring an executive. “The board must investigate and do diligence on the front end,” Campos said in his Jan. 23 remarks before the 2007 Summit on Executive Compensation. “It seems that many boards truly do not understand the ramifications of their executive compensation decisions, particularly as they relate to severance pay, pensions, and golden parachutes upon termination without cause or a change in control.”

Campos’ message, says Stewart Landefeld, a partner at the law firm Perkins Coie, is the same one the SEC has repeated many times: “the most important responsibility of a board is knowledge.” Landefeld says most boards have gotten the message and are educating themselves through tally sheets, which itemize the cost of many elements of benefits and compensation.

Campos

Campos also suggested boards set up a “negotiation team,” working for the board and the compensation committee and led by a neutral professional, such as a lawyer, law professor, compensation consultant or compensation-committee member. Such a team should decide whether it wants to engage in competitive bidding to hire a celebrity CEO; commit itself to not paying an outrageous amount in total compensation; focus on long-term, sustainable performance; and concentrate on job jeopardy, with attention at the time of hiring on how much (if anything) the CEO should get if he or she is fired for poor performance.

The team also should get investor support for any tentatively negotiated package by soliciting input and suggestions from significant investor groups prior to finishing the deal. Finally, the compensation committee and the negotiation team “must be ready, as a viable alternative, to hire someone within the company who has not been a CEO previously,” Campos said.

Landefeld

Landefeld is skeptical that boards will create a separate negotiation team, but says they may adopt some of the issues Campos recommended. “The suggestion appears to be most applicable in negotiations with a so-called ‘rock star’ CEO, or maybe for a CEO who’s already in place,” he says. “Since compensation is only one of [a] number of critical factors that must be considered, it would be hard for the board to make a decision on a CEO and then have someone else set compensation.”

One measure Landefeld says he has discussed with some boards is capping CEO pay. “They may not do it, but they should at least ask themselves as they review the tally sheets, ‘Is there a maximum that we don’t want an executive to be paid more than?’” he says. He also suggests boards get input from their investor-relations executives about potential shareholder reaction to executive pay deals.

Finally, he advised boards to “consider carefully” giving shareholders a non-binding advisory vote on executive compensation—already a shareholder right in the United Kingdom and Australia, and one investors are clamoring for in dozens of shareholder resolutions filed this season.

Calling shareholder-advisory votes “the future of executive compensation,” Campos said, “I’m not advocating that we adopt this in the U.S., but I am saying that the idea deserves study … Companies should strongly consider whether to be proactive and to adopt such policies before they are forced to put them in their proxy materials.”

SEC Approves Market Means To Value Options

The Securities and Exchange Commission has given its first blessing to a market-based approach to establish an expense value for stock options granted to employees.

SEC Chief Accountant Conrad Hewitt sent a letter Jan. 25 to Zions Bancorp suggesting some modifications, but generally approving of an auction-based method that Zions developed for selling a security related to an option grant and basing the option expense on that auctioned security. Zions and a handful of other firms, including Cisco Systems and Bear Stearns, have been working to develop a market-based approach to valuing stock options since the Financial Accounting Standards Board adopted Financial Accounting Statement No. 123R, Share-Based Payment, requiring companies to deduct stock option expense from earnings.

Last June, Zions sold 93,610 such securities—called Employee Stock Option Appreciation Rights, or ESOARs—for $7.50 each to 21 buyers from among 57 bidders. The ESOARs derivatives track the cost Zions incurred in granting 936,000 stock options to employees and will pay investors a pro rata share of the value employees realize when they exercise their options.

“The SEC staff believes that Zions Bancorporation has made significant progress in identifying a suitable market-based approach to valuing employee share-based payment awards,” Hewitt wrote. “We encourage you to share with us your results and analysis of future auctions of ESOARs.”

Hewitt cautioned Zions to assure that any future auctions produce a true market value by timing the auction more closely with the option grant and assuring an adequate number of independent bidders.

In addition, Zions needs to follow one of two methods it proposed to assure that investors are not taking any risk of forfeiture into consideration when making their bids, Hewitt wrote. Statement 123R says stock option valuation cannot take into account any consideration of possible forfeiture, Hewitt said, so the ESOARs sale must insulate investors from that effect as well.

And while acknowledging the market-based method will establish a value that meets FAS 123R requirements for booking an option expense, Hewitt also cautioned against hasty abandonment of existing option-pricing models.

“The prices determined by the auction process for ESOARs need not replicate those produced by one or more models in order to be deemed suitable for use as estimates under Statement 123R,” he wrote. “Nonetheless, in analyzing the auction results, management may find it useful to compare the auction results to the estimated fair value of the instrument derived through broadly accepted modeling techniques.”

Zions is delighted with the SEC’s position on its method. “This is great news for all option granting companies,” says Evan Hill, a vice president at Zions. “Companies can now have the market tell them what their employee stock options are worth.” He said he’s confident there will be “a steady supply of companies turning to the market to value their stock option grants.”

Hill says Zions has filed a patent on the instrument design, auction process, and market-pricing mechanism and plans to sell the auction process to other companies. “We want the first batch of issuers to be well-known seasoned issuers,” he says, because they have a strong track record of clean, uncomplicated filings with the SEC, which will minimize the likelihood of snags in the startup process.

Since the SEC is looking for auctions to occur almost simultaneously with option grants, companies that choose to try the auction will make their intentions known two weeks in advance to correspond with filing requirements surrounding the planned option grant, Hill says.

Zions will run “probably above 10” auctions before the end of 2007, Hill predicts; the earliest auction could occur perhaps in March. Zions already has an auction of its own on its calendar for early May.