This is the sixth edition (2020) of our standard reference on executive compensation in ESOP companies, now covering director compensation as well. The topic raises complex issues, from S corporation anti-abuse rules to ESOP trustee and company board duties. There is no simple solution to executive compensation in ESOP companies, of course. This book, however, provides a guide to the legal, financial, fiduciary, and tax issues involved with various compensation strategies. It also provides best-practice guidelines for how to set executive and director pay. Chapters cover legal, fiduciary, valuation, and S corporation issues, plus sharing equity and using compensation studies. In addition to updates to existing chapters, a new chapter in the sixth edition is devoted to compensation for outside board members. The final chapter then provides a detailed report on the NCEO's 2019 survey of executive and board director compensation in ESOP companies, while also pulling in complementary information from the 2016 NCEO executive compensation survey. The combined data provide a detailed picture of the forms and size of compensation being used in ESOP companies.
Table of Contents
1. Overview of Executive Compensation for ESOP Companies
2. Legal and Regulatory Issues
3. Fiduciary Issues for Trustees Regarding Corporate Governance and Executive Compensation
4. Sharing Equity with Key Employees in ESOP Companies
5. Valuation Issues
6. Special Issues for S Corporations
7. Using Compensation Studies Wisely
8. Compensation for Outside Board Members
9. Findings from the NCEO’s ESOP Executive Compensation Surveys
About the Authors
About the NCEO
From chapter 1, "Overview of Executive Compensation for ESOP Companies"
Advisors universally agree that the gold standard for a board is to have a compensation committee made up entirely or primarily of independent board members. It is very difficult for insiders to set the pay of another insider; one is likely to report to the other.
However, most ESOP companies see a fully independent compensation committee as too burdensome. In many cases, they do not see CEO pay or the pay of other key people as a difficult issue, believing that what they have been doing all along is working well enough.
The NCEO’s 2016 survey of corporate governance practices in ESOP companies found that 55% of the respondents had board compensation committees, up from 45% in 2012, and of those with committees, 83% had at least one independent director on that committee and 26% were comprised solely of independent directors. Just having a structure in place, of course, does not mean that the board is actively involved in setting executive pay, but the trend seems to be in this direction.
Boards must make another fundamental choice. Do they want to actually set executive compensation levels each year, or do they want to create a fixed process to determine compensation? Boards generally make a decision about base compensation on a yearly basis, but the story for incentive compensation is different. Thirty-eight percent of companies grant equity awards on a discretionary basis, while 68% grant awards based on a performance metric (the numbers are over 100% because some companies do both). The rest rely on a formula, such as an annual fixed grant to a percentage of pay. No matter who makes the decision, a process needs to be in place for what guidelines to use to set pay each year. The most common, if not necessarily the best, model is for the CEO to make a recommendation and the board to approve or suggest modifications. Inertia often is the driving force: the most important factor in both the level and form of pay is whatever was in place the year before with some adjustment for inflation, a built-in escalator, or a performance trigger.
From chapter 3, "Fiduciary Issues for Trustees Regarding Corporate Governance and Executive Compensation"
The ESOP trustee is responsible for making sure that the value of the ESOP shares is not negatively affected by excessive compensation levels, and the trustee has a fiduciary duty to take action if it determines that the executive compensation is unreasonable and too dilutive. There is a wide variety of actions an ESOP trustee could take to deal with excessive compensation, such as consulting with the board of directors to express concerns about compensation levels or seeking to change the composition of the board of directors. In an extreme case, the trustee may contact the U.S. Department of Labor, or commence a shareholder derivative suit if the board is not responsive to the shareholders’ concerns.
The ESOP trustee initially relies on its financial advisor to make an assessment as to the reasonableness of the executive compensation. The benefits offered under the executive compensation arrangements must be analyzed and compared with their dilutive effect on the company stock price to determine whether the compensation arrangements are reasonable and appropriate. In many instances, it is prudent for the ESOP trustee to engage a third-party compensation consultant if the financial advisor believes the executive compensation is unreasonable. The NCEO provides significant survey data that measures the market rate of equity-based compensation for executives in ESOP companies. This applies not only to ongoing ESOPs but also to cases where an ESOP company is being sold.
From chapter 8, "Compensation for Outside Board Members"
Almost all boards pay all outside members the same, even if they have different skills and make different contributions. Doing otherwise would create difficult measurement issues and potential resentment among those board members getting less. Boards might pay small additional amounts for being the chair or chairing committees.
While board pay can and often is set simply by a company picking some number it is comfortable with, using survey data to determine appropriate pay helps assure companies they are paying reasonable amounts and board members believe they are being treated fairly. Ultimately, though, the test is whether the pay level is adequate to get the board members a company wants and keep them over time.
Companies also have to decide how to pay board members. Pay most often is either in the form of an annual retainer or a per-meeting fee. The former helps set a controlled, reliable price; the latter can limit costs if a company decides to have fewer meetings. Pay can also have an equity component, most often phantom stock or stock appreciation rights. Using synthetic equity is especially vital in S corporations because if directors own stock directly, they get K-1 statements and will want distributions to pay their taxes. The ESOP then has to get a pro-rata share of distributions that would be many times more. In non-S corporation ESOPs, stock options or grants can be made. As the data below show, however, few companies use equity-based pay to compensate board members.
From chapter 9, "Findings from the NCEO’s ESOP Executive Compensation Surveys" (tables omitted)
Of the respondent companies, 43% offer some form of stock-based compensation, in the form of either direct equity or cash tied to the company’s share value. Companies weigh a number of factors in deciding which form of stock-based incentives to offer their executives, including the percentage of ESOP ownership and the projected growth of share value. The 2016 survey found that stock appreciation rights (SARs) tend to be the most commonly offered form of equity compensation by a wide margin, followed by phantom stock. See figure 9-3.
The most commonly used criteria for granting stock-based compensation is a company performance metric, though annual grants and other criteria are also common. See table 9-11, which uses data from the 2016 survey. Grants based on automatic triggers, such as hiring or length of tenure, are used by relatively few respondents.
Tables 9-12 and 9-13 show results from the 2016 survey indicating that time-based vesting is the most common method for vesting stock-based executive compensation, and that three and five years are common vesting timeframes.