Aligning the Interests of Company Executives and Directors with Shareholders
Commissioner Luis A. Aguilar
Today, the Commission issued proposed rules on Disclosure of Hedging by Employees, Officers and Directors. These congressionally-mandated rules are designed to reveal whether company executive compensation policies are intended to align the executives’ or directors’ interests with shareholders. As required by Section 955 of the Dodd-Frank Act, these proposed rules attempt to accomplish this by adding new paragraph (i) to Item 407 of Regulation S-K, to require companies to disclose whether they permit employees and directors to hedge their companies’ securities.[1]
Over the last three decades, we have witnessed an unprecedented growth in the compensation of corporate executives.[2] Much of that growth reflects the trend towards equity-based and other incentive compensation, which intends to meet the worthy goal of aligning the interests of the corporate overseers of public companies with their shareholders. However, some have suggested that company policies that permit hedging of the company’s equity securities could have the opposite effect.[3] By allowing corporate insiders to protect themselves from stock declines while retaining the opportunity to benefit from stock price appreciation, hedging transactions could permit individuals to receive incentive compensation, even where the company fails to perform and the stock value drops.[4]
Just as problematic, hedging transactions can be structured so that executives or directors monetize their shareholdings while they still technically own the stock, which makes the fact that the hedging took place less transparent to investors.[5] Indeed, in the absence of this proposed disclosure, shareholders may not be aware of the executive officers’ and directors’ true economic exposure to the company’s equity.[6] Accordingly, the proposed hedging rules are intended specifically to address this lack of transparency, and attempt to provide greater clarity to investors regarding employees’ and directors’ actual incentives to create shareholder wealth.[7] In addition, better information about equity incentives could be useful for investors’ evaluation of companies, enabling investors to make more informed investment and voting decisions.
It is important to note what the proposed rules do not do: they do not prohibit hedging transactions by employees or directors of public companies.[8] This is a disclosure rule that is intended to shed some sunlight on this practice. Accordingly, if a company specifically prohibits certain hedging transactions but allows others, it would need to disclose those hedging transactions that are permitted.[9] However, the proposed amendments could result in companies implementing changes in hedging policies that improve the alignment of interest between shareholders and executive officers or directors.
The proposed rules on hedging disclosures are only one in a series of Congressionally-mandated rules that are intended to promote accountability by making executive compensation decisions more transparent to company shareholders. The Commission has already adopted some of these rules.[10] Unfortunately, other significant executive compensation-related disclosure rules have yet to be adopted, including disclosures related to:
- The relationship between executive compensation actually paid and the financial performance of the issuer (known as “pay-for-performance”);[11]
- The ratio between the compensation of the chief executive officer and the total annual compensation of its average worker (known as “pay ratio”);[12] and
- Reports by large investment managers of their advisory shareholder votes about executive compensation and golden parachutes (known as “say-on-pay” votes).[13]
It is my hope that the Commission moves promptly to adopt these additional disclosure rules to provide maximum transparency to investors about companies’ executive compensation decisions. Without such transparency, the true owners of public companies – the shareholders – most assuredly will have a difficult time holding company directors and officers accountable for their executive compensation decisions.
This proposing release is a positive step in the direction of providing more information to shareholders as to whether the interests of corporate insiders are truly aligned with their own. As with all proposing releases, this proposing release includes many requests for comment regarding the approach that the Commission has decided to take to implement the statutory mandate. Public comments are always an important part of the rulemaking process, and I especially encourage investors to review and submit their thoughts on the proposed release.
[1] See Disclosure of Hedging by Employees, Officers and Directors, SEC Release No. 33-9723 (Feb. 9, 2015), available at http://www.sec.gov/rules/proposed/2015/33-9723.pdf (hereinafter “Hedging Proposing Release”).
[2] See Lucian Bebchuk and Yaniv Grinstein, The Growth of Executive Pay, Harvard John M. Olin Center for Law, Economics, and Business (Apr. 2005), available at http://www.law.harvard.edu/programs/olin_center/papers/pdf/Bebchuk_et%20al_510.pdf; Lawrence Mishel and Natalie Sabadish, CEO Pay in 2012 Was Extraordinarily High Relative to Typical Workers and Other High Earners, Economic Policy Institute (June 26, 2013), available at http://s4.epi.org/files/2013/ceo-pay-2012-extraordinarily-high.pdf.
[3] See, e.g., ISS, U.S. Corporate Governance Policy: 2013 Updates (Nov. 16, 2012), at 4, available at http://www.issgovernance.com/file/files/2013USPolicyUpdates.pdf.
[4] Indeed, many executives have been enjoying the benefits of the pay-for-performance boom, without necessarily delivering on that promised performance. One survey found that of the 25 highest-paid CEOs for each year in a twenty year period ending in 2012 (500 total slots), 38% of these slots were held by CEOs who led firms that were bailed out or crashed during the 2008 financial crisis, were fired by their firms, or had to pay settlements or fines related to fraud charges. Sarah Anderson, Scott Klinger, and Sam Pizzigati, Executive Excess 2013: Bailed Out, Booted, and Busted, Institute for Policy Studies (Aug. 28, 2013), available at http://www.ips-dc.org/reports/executive-excess-2013. In fact, the development of the golden parachute has often meant that, in practice, executives like these have been rewarded handsomely for outright failure. Eric Dash, Outsize Severance Continues for Executives, Even After Failed Tenures, The New York Times (Sep. 30, 2011) at B1, available at http://www.nytimes.com/2011/09/30/business/outsize-severance-continues-for-executives-even-after-failed-tenures.html?pagewanted=all&_r=0. To give just a few examples, in 2006, Viacom gave roughly $85 million in severance pay to its then CEO after just nine months in the top job. See Jeff Green, Jumbo Severance Packages for Top CEOs Are Growing, BloombergBusiness (June 6,2013), available at http://www.businessweek.com/articles/2013-06-06/jumbo-severance-packages-for-top-ceos-are-growing; Andy Fixmer, Viacom to Pay Ousted Chief Tom Freston $84.8 Million, Bloomberg (Oct. 18, 2006), available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=awT94a.FifM8. In addition, the former CEO of CVS received a severance package worth $185 million when he left in early 2011, even though his company’s net earnings had declined the prior year. See Nathaniel Parish Flannery, Executive Compensation: The True Cost of the 10 Largest CEO Severance Packages of the Past Decade, Forbes (Jan. 19, 2012), available at, http://www.forbes.com/sites/nathanielparishflannery/2012/01/19/billion-dollar-blowout-top-10-largest-ceo-severance-packages-of-the-past-decade/. As many commenters have observed, safety nets of these sizes can undermine management incentives from the moment they are granted. See, Paul Hodgson and Greg Ruel, Twenty-One U.S. CEOs with Golden Parachutes of More Than $100 Million, GMI (Jan. 2012), available at http://go.gmiratings.com/rs/gmiratings/images/GMIRatings_GoldenParachutes_012012.pdf; Lucian A. Bebchuk, Alma Cohen, and Charles C.Y. Wang, Golden Parachutes and the Wealth of Shareholders, 25 J. Corp. Fin. 140-154 (2014), available at http://ac.els-cdn.com/S0929119913001156/1-s2.0-S0929119913001156-main.pdf?_tid=bb09af3e-ad69-11e4-bf11-00000aab0f02&acdnat=1423163214_c71dc13f0ed9d8db690af33acb078d06 (“Our findings raise the possibility that, despite their positive effect on facilitating some value-increasing acquisitions, golden parachutes have, on average, an overall negative effect on shareholder wealth. This average negative effect could be due to GPs increasing managerial slack and/or by GPs providing executives with incentives to go along also with some acquisitions that do not serve shareholder interest.”). See, also, Sanjay Sanghoee, Golden Parachutes: Why it’s bad business, Fortune (Apr. 11, 2014), available at http://management.fortune.cnn.com/2014/04/11/golden-parachutes-why-its-a-sour-deal-for-business/.
[5] See Jane Sasseen, Some CEOs Are Selling Their Companies Short, BloombergBusiness (Feb. 25, 2010), available at http://www.businessweek.com/magazine/content/10_10/b4169044647894.htm.
[6] Hedging Proposing Release at 60 (“For example, in operating companies, because executive officers’ and directors’ reported equity holdings in proxy statements may not reflect their actual economic exposure in light of potential hedging activity, there may in certain cases exist an information asymmetry between insiders and other investors regarding the executive officers’ and directors’ actual equity incentives.”).
[7] A Senate Committee report discussing the Dodd Frank Act stated that the Congressionally-mandated Commission hedging disclosure rules are intended to allow shareholders to know if executives are allowed “to purchase financial instruments to effectively avoid compensation restrictions that they hold stock long-term, so that they will receive their compensation even in the case that their firm does not perform.” See Report of the Senate Committee on Banking, Housing, and Urban Affairs, S. 3217, Report No. 111-176 (Apr. 30, 2010), available at http://www.banking.senate.gov/public/_files/Comittee_Report_S_Rept_111_176.pdf.
[8] Corporate insiders’ use of derivative transactions to hedge their economic exposure to company equity may not be uncommon. One study found that, between 1996 and 2006, more than 900 corporate insiders entered into more than 2,000 unique derivative transactions to hedge equity exposure at close to 600 companies. This study included in its definition of insiders 10% beneficial owners. See Carr Bettis, John Bizjak, and Swaminathan Kalpathy, Why Do Insiders Hedge Their Ownership? An Empirical Examination (June 2013), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1364810.
[9] See Hedging Proposing Release at 14.
[10] On January 25, 2011, the Commission adopted rules concerning shareholder approval of executive compensation and "golden parachute" compensation arrangements to implement Section 951 of the Dodd-Frank Act (known as “say-on-pay” rules). See Shareholder Approval of Executive Compensation and Golden Parachute Compensation, SEC Release No. 33-9178 (Jan. 25, 2011), available at http://www.sec.gov/rules/final/2011/33-9178.pdf. On June 20, 2012, the Commission adopted rules directing the national securities exchanges to adopt certain listing standards related to the compensation committee of a company's board of directors as well as its compensation advisers, as required by Section 952 of the Dodd-Frank Act. See Listing Standards for Compensation Committees, SEC Release No. 33-9330 (June 20, 2012), available at http://www.sec.gov/rules/final/2012/33-9330.pdf.
[11] Dodd-Frank Act Section 953(a), 124 Stat. at 1903-04.
[12] Dodd-Frank Act Section 953(b), 124 Stat. at 1904.
[13] Dodd-Frank Act Section 951, 124 Stat. at 1900.
Last Reviewed or Updated: Feb. 9, 2015