“No topic in the history of the Securities and Exchange Commission (SEC) has generated so much interest” as the new norms approved by that regulatory agency regarding managerial salaries, asserts Christopher Cox, president of the SEC. Cox has had to pore over as many as 20,000 different comments and suggestions about the SEC’s decision that requires publicly traded companies in the U.S. to make public every last detail about their packages for compensating their five most senior executives.
The SEC, an institution quite similar to Spain’s National Stock Market Commission (the CNMV), has just announced that, starting next year, every publicly traded company with a market capitalization of more than $700 million will have to reveal the salaries and other benefits of its top managers, including its chief executive. The goal is to facilitate transparency of information and to make it easier to compare companies and sectors. With this measure, the SEC hopes to put an end to scandals stemming from stock options, which have been the leading system of compensation in the U.S. for the past decade.
The announcement coincides with an investigation of more than 80 companies that are suspected of irregularities in the way they issued stock options. According to sources in the sector, federal authorities [in the U.S.] suspect that those companies manipulated the dates on which their managers profited most from rising stock prices. From now on, everything will have to be more transparent. Companies will be obligated to inform the public about the date when their stock options are awarded and their market value on the day when they are granted.
Some people view these kinds of rules as interference in corporate management, while some disagree, and are demanding deeper sorts of reforms. The SEC has not made it obligatory for employees who are not top executives to reveal their compensation packages, an idea proposed by some more combative voices on Wall Street. The very idea that these sorts of thing could happen has generated criticism from some companies. They argue that if the salaries of specific individuals are made public that could create envy among those employees who feel that they have been mistreated in comparison.
Spain’s Good Governance Code, approved last May, establishes the practice of publicizing the salaries of individual senior managers. However, this new practice is nothing more than a recommendation. In those cases where a company does not follow this recommendation, the company must merely explain why it is not making that information public, so the markets can evaluate its decision. In the United States, however, this practice will be mandatory, and the information will have to be in detail.
If you compare compensation policies on the Spanish stock exchange with those of the European Union or the United States, you arrive at this conclusion: In Spain, the fixed part of overall compensation packages is higher; as high as the portion that comes from pension plans and severance packages. However, variable long-term incentives are less significant in Spain. Although the composition of compensation packages differs, the total value of such packages in Spain is quite similar to the value in the rest of Europe and in the United States. This is one of the conclusions of Tony Gennaoui, who heads the Spanish operations of Towers Perrin, a consulting firm that specializes in human relations and other services, and is a well-known expert in stock options and compensation systems.
According to Gennaoui, compensation packages in Spain reflect the fact that Spanish companies want “managers who are loyal over the long haul.” However, the way things work in Spain is gradually converging with trends in the E.U. The latest trend involves “reducing the discretional nature of the annual bonus and applying the bonus rigorously,” notes Gennaoui. “Until now, Spain had a paternalistic approach” to dealing with people when it came to handing out bonuses. Such payments were made at the discretion of top managers. When it comes to variable compensation packages, they should be more closely tied to the results achieved [by the company] during the fiscal year.”
Stock options lose their allure
Stock options, the leading means of compensation for board members and managers during the 1990s, are losing steam among Spanish companies. When someone owns an option, he or she has the right to buy a block of corporate shares at a price that is fixed beforehand and [is exercised] at a specific date. The goal is to provide managers with an extra incentive to create the greatest possible value for their company. The reasoning is that, if they achieve that goal, the share price on the day when the options expire will be higher than the price was when their option was granted. The managers earn the difference between the two prices. Following in the footsteps of such countries as the U.S. and the United Kingdom, Spain’s top publicly traded companies are abandoning stock options, which are inherently volatile, and are moving toward a more controllable, more predictable system that involves providing variable compensation that is tied to the business’ medium- and long-term strategic plan. Among other companies, this is the case in Santander and Popular banks, as well as in Telefónica [the telecom company,] and Repsol, the oil producer. These companies are designing remuneration programs for their board members and senior managers based on annual results.
Juan Antonio Maroto Acín, a member of the finance and accounting department of the Complutense University in Madrid, believes that “the viability and capacity of incentives are tied as much to the efficiency of markets as to the way the taxation system deals with those companies’ plans and the potential gains made by senior executives. If the market has any doubts about the efficiency of stock valuations – and about the possibility that stock prices can be manipulated – then, shareholders must take a skeptical view not only of these share prices but also of the dates when those options can be exercised.” This is one reason why systems that tie compensation plans to medium-term [financial] performance are starting to be taken more seriously than such more arbitrary models as stock options.
Íñigo Sagardoy, a partner at Sagardoy Abogados, the Spanish law firm, believes that “this system, which provides variable, medium and long-term compensation, is more logical because it is easier to tie the personal performance of a manager to a company’s progress than to its stock price.” This new model is related more closely to the realities of the company. In this approach, a portion of a manager’s salary is contingent on specific initiatives taken by the company. Alfonso Jiménez, a partner at People Matters, a consulting firm, agrees with Sagardoy. Jimenez adds, “These systems are easier to quantify because you can measure more precisely the influence that a manager has had on a company’s sales or its profitability.” These plans typically cover three to five years, which is a shorter time frame than is common for stock options.
Spain’s tax regulations are another reason why large Spanish companies have chosen this approach to compensation. Stock options have been subject to high taxes [in Spain] since 1998. Carmen Povedano, who heads the Watson Wyatt consulting firm, says that stock options are falling out of favor because accounting rules treat them as expenses. In his opinion, a more innovative approach, which guarantees variable compensation when it comes to exercising stock options, would be to link options to the achievement of specific results over a period of two or three years. For his part, Juan Antonio Maroto of the Complutense University of Madrid, believes the Spanish practice of penalizing stock options with taxes can be explained by “the leading role of fixed compensation, and the existence of incentives that are tied more to the goals of real markets (growth in the volume sales; customer volume; reduced operating costs…) than to stock markets.”
Gary Locke, who manages Towers Perrin’s compensation programs worldwide, notes that in the United States, 80% of large companies continue to use stock options as their compensation model. However, they are increasingly turning to other approaches as well. He asserts, “For the first time in the history of the U.S., long-term incentives play a larger role in compensation packages than do stock options.”
John Carney, who manages compensation programs in Europe for Towers Perrin, notes that in such European countries as the U.K. and Holland, there has been a “sharper drop” in stock options than there has been in the U.S. Whereas, five years ago 25 out of every 30 European companies used stock options, only one out of every three companies uses them now, says Carney. Despite this decline, experts agree that stock options will not disappear as a means of compensation. Instead, stock options will play a role in variable compensation packages that involve two or three different systems.
According to Locke, the advantage of stock options is that they are “an objective way” to set goals and obtain results, despite the fact that the stock market can wind up being “capricious.” In the United States, stock options are subject only to the value of specific shares; otherwise, they would have to be treated by the accountants as an expense. However, in Europe, with the exception of some countries such as France, stock options are tied as well to the business results, goals and achievements of the company. As recently as a few years ago, the system of compensation in the United Kingdom closely resembled the system that currently exists in Spain. The fixed component of compensation was quite high; as important as the component provided by pension plans. But that trend has changed and variable incentives now play a greater role [in the U.K.] than they did in the past. The current expectation is that Spain and other countries will increasingly follow that approach.
New compensation formulas
In the U.S., the typical mix of compensation incentives is one-part stock options, and another part, three-year variable incentives, either via multiyear bonuses or shares that vary in value according to a company’s business results, says Locke. For senior managers, the fixed portion of compensation “is small,” he adds. According to Carney, there is a trend in Europe toward increasing the component [of packages] that varies annually, as well toward implementing a long-term, mixed formula for compensation. Some of the new formulas involve restricted options. In such a case, if a manager remains with the company for a longer period, he or she receives a package of options at no cost. In the United States, ‘performance czars’ are becoming the mode. In such a case, an executive not only has to stay in the company, but must also comply with goals fixed in advance. In Spain, this sort of approach is still new, although some companies, such as BBVA bank and Telefónica, are putting it into practice.
Another area where there are differences between the Anglo-American and the European system is severance packages. Whereas in Spain, they involve a long period of compensation (more than one year), in Europe they tend to be no longer than a year in those cases when a manager is fired. In the United States, these sorts of packages are also more likely to be aimed at defending shareholders from a possible merger. Some managers have their own “golden parachute” that favors a hostile takeover bid [for the company’s share] so long as it makes sense for the company; even if that process endangers the actual manager’s job. According to Locke, even when star employees are hired in the U.S., they can be provided with these sorts of clauses in their severance package, despite considerable criticism by American investors.
Compensation packages are divided into one portion that is fixed and another portion that is variable. The variable portion itself can comprise both short- and long-term incentives. The key difference between the Anglo-American and European models is that the Anglo-American version gives much more importance to variable long-term compensation; this part of the package can involve up to 60% of a chief executive’s salary. In the case of Spain, compensation packages comprise a fixed portion (worth 35% of the package); an annual cash bonus (40%); a variable, long-term incentive (20%); and benefits in kind, such as cars, mobile phones and so forth (worth 5% of the total value of the package). In the Anglo-American model, both the fixed portions and the short-term incentives are each about 20%, while compensation in kind is minimal. In some companies, stock options are giving way to long-term cash bonuses (of two or three years), which vary as a function of a company’s results. Restricted options are another long-term compensation system that some big companies are using. In such a case, the executive is issued corporate bonds in his or her name, but he or she cannot sell those bonds until three years have passed. That serves as an incentive to generate value over this period for the company. According to Povedano, although this is something common in the U.S., it is not common in Spain. In Spain, the sorts of shares that cannot be sold until a manager leaves his or her job are only starting to become a substitute for shares of stock.
Good governance
Although some people believe that the stock option system is on the decline, a report by Mercer HR Consulting notes that, in reality, “the stock option system is not obsolete in Spain. Although it has suffered some loss of confidence, it is still a good formula for sharing a company’s success or failure to create value with those professionals who are committed to the company for the medium and long term.” The Spanish Code of Good Governance brings together the recommendations of the European Union and cites the U.S. initiative [for good governance] as one example of a regime that involves publicly revealing the salaries of individual senior managers. The Code recommends that compensation vary according to a company’s results. Experts anticipate that the practice of providing variable compensation that is tied to corporate goals will spread gradually through both the U.S. and the E.U.
“These types of practices preclude the possibility that the stock market can be manipulated when it comes time for a stock option to expire,” explains Alfonso Jiménez of People Matters, [an HR consulting firm]. That sort of manipulation was one of the triggers that set off such financial scandals as WorldCom in the U.S. and Parmalat in Italy. In the United States, the most developed market for stock options, stock option plans have been on the decline in recent years. Coca-Cola is one of the latest companies to take a new approach to compensation. The soft drink giant has just approved a plan that provides senior managers with a cash payment of $175,000 after three years, if the company’s earnings per share grows by an annual rate of 8%.
