This article is from the Ayco Compensation & Benefits Digest May 15, 2020 edition.
Share ownership guidelines for executives continue to be a common feature at an overwhelming majority of U.S. public companies. The basic premise of mandating ownership of company stock is that the interests of senior management will more closely align with those of shareholders.
We have been tracking the design of share ownership guidelines at Ayco corporate partners for the past 27 years. In the early 1990s, only about a quarter of companies had guidelines in place, while nearly 97% (see following chart) of the public companies we reviewed now have ownership requirements for senior executives. This percentage has remained fairly constant over the past 12 years while the number of companies with share retention requirements related to their ownership guidelines has continued to increase. Retention provisions often take the form of long- term equity award holding requirements in place until an applicable ownership guideline is met; however, other structures may apply which we discuss later.
The following chart reflects what we now see in regard to ownership guidelines and retention requirements among the 194 companies we recently reviewed.
Design and Structure of Ownership Guidelines
Of the 194 public companies at which Ayco provides financial counseling or education services, 61% are part of the S&P 500. 2019 and 2020 proxies, corporate governance guidelines and corporate stock ownership documents (where available) were reviewed during our analysis. The Securities and Exchange Commission (SEC) requires public companies to disclose details of their executive stock ownership and retention guidelines in the Compensation Discussion and Analysis (CD&A) section of proxy statements. Holdings required of non-employee directors are also provided in the proxy. Companies typically also describe the status of executives and directors as they pertain to compliance with the guidelines.
Most companies with executive stock ownership targets continue to use a “multiple of salary” approach. That is, an executive must own company stock (or stock equivalent) equal in value to a stated multiple of theirsalary. Other approaches we encountered included:
- Multiple of salary—but once the required value is achieved, the number of required shares is then fixed
- A fixed number of shares
- Lesser of a salary multiple and fixed share approach
- Dollar value
One of the inherent problems with a strict multiple of salary approach is that it may not work as intended when a company stock price is volatile, and especially when there has been a significant drop in share price. We are seeing this scenario play out currently. Approaches to addressing this concern vary and could incorporate the alternatives noted above or guidelines that consider an average stock price over some extended period of time, when reviewing compliance. In times of crisis, existing requirements significantly impacted by a sharp stock price decline may require reviewby the Board of Directors to determine whether a short-term waiver is prudent, at least for those already meeting the guideline requirements.
The number and position level of executives subject to guidelines vary by company. In all the cases where we saw guidelines, the amounts were tiered by position level. The CEO, and sometimes the executive chairman, have the highest ownership requirement(s). Most companies have several additional tiers with lower ownership levels.
As noted in the previous chart, we saw only 2% of companies with no specified targets and 1% without ownership due to the retentive design of their stock award programs.
What Counts Toward Ownership?
In designing ownership guidelines, a company must establish what type of ownership will count. The level of detail provided in proxies on this issue varies. The indicated categories encountered included the following:
- Shares owned outright or beneficially, including via Employee Stock Purchase Plans (ESPPs)
- Shares held in trust for the benefit of the executive or an immediate family member
- Shares held by family (typically a spouse or minor in the same household)
- Company stock held in a 401(k) plan
- Company stock units under a nonqualified deferred compensation top hat or excess 401(k) plan
- Time-based restricted stock or restricted stock units (RSUs)
- Long-term performance shares (sometimes only those considered “earned” or vested prior to the end of the performance/distribution period)
- Vested/unexercised stock options or Stock Appreciation Rights (SARs) (in very limited cases, inclusion of unvested portions)
The chart below provides perspective on the frequency in which stock awards, options and nonqualified plans were counted as shares for purposes of ownership guidelines.
The prominence of RSUs today comes both from the frequency in which those types of awards are now being granted, as well as incorporation by many guidelines.
How Are Stock Awards Valued in the Mix?
As can be seen in the prior chart, stock options infrequently count toward meeting targets (and we saw vested SARs counted only once). However, when they are included, it is typically the “in-the-money” value of vested stock options which is counted toward meeting ownership targets. About 40% of those companies that count stock options will consider less than the full intrinsic value, most commonly at 50%. There was also an instance of a company indicating that option and RSU value could not count for more than 50% of the total ownership requirement. In 90% of cases where RSUs or restricted stock were included in targets, the full value of shares or units were used.
Performance-based, long-term incentive awards are very common compensation components for executives and are occasionally considered in the ownership target calculation. However, they rank last by way of inclusion compared to the other two prominent incentive award categories.
Further, the nature of their inclusion varied. For example, in some cases unearned, unvested shares or share units would be included at target, while in others only earned shares were included (i.e., those associated with an overall vesting period which had not yet concluded). When included, however, it was very common to see use of their full value. On a final note, one company in our survey group settled long-term performance awards 50% in stock and 50% in cash until 200% of the ownership guideline was met, then 100% cash could be received.
Share Ownership Guidelines by Position Level
In the chart to follow, we have illustrated how the 194 companies reviewed have established their targets by position level or tier. What we have called the “2nd Tier” typically are direct reports to the CEO, often other Named Executive Officers (NEOs) or executive vice presidents. The “3rd Tier” are executive officers, such as senior vice presidents. The “4th Tier” are commonly vice presidents or “other” senior executives. While 72% of the companies we tracked have at least three tiers in their guideline structure, nearly 30% have four (or sometimes more) tiers.
When compared to the survey we performed in 2018, CEO multiples have trended upward, primarily from the 5–5.5X salary-multiple range to 6X.
Exactly when and how ownership levels are measured varies considerably. Companies typically attempt to measure stock ownership levels at least annually. However, we have also seen companies provide for a recalculation anywhere from quarterly to every three years. Some even simply indicated they recalculate “periodically” or “regularly.” Because ownership will almost always include shares owned directly and indirectly by the executive (and often immediate family members and certain trusts), a company may need to solicit information from the executive confirming total ownership.
The means by which stock price is measured is important. Here again, we see a wide variety of techniques, which sometimes take into account stock price volatility as well as administrative convenience. Here are a few stock price measures we noted:
- Company closing stock price as of a designated day
- Average closing stock price over a specified number of prior days or months (our survey group included use of 1, 3, 20, 30 or 60 days, as well as 12, 24 or 36 months)
- Greater of the stock price when guideline is measured and closing price at share acquisition
- Greater of stock price when the guideline is measured and the average high and low of the stock price on three interim valuation dates
- Highest stock price over prior 12 months
For companies with certain executives who are not paid in U.S. dollars, we have seen them convert the executive’s salary to dollars (as of a defined date or using a 30-day average exchange rate) and then measure compliance with the target.
Share Retention Requirements
Totally distinct from share ownership guidelines are share retention requirements. These are now very prominent, but vary. We count 63% of our survey group that now have share retention requirements in place—slightly higher than the 60% we noted in our 2018 survey, but a significant increase from the 45% noted in our survey conducted in 2012. The different types of retention programs in place included the following:
- All or some percentage of shares received as long-term incentive compensation must be maintained as stock holdings until targets are attained (most common approach at 54%)
- If ownership guidelines are not timely met, similar retention rules as noted above apply
- Ongoing retention period applies, regardless of whether ownership guideline has been met
The below chart focuses on the most common retention program in place, which is directly connected to the achievement of share ownership requirements. It should be noted that in almost all cases, the percentages noted are used uniformly across all stock award and option grants (as opposed, for example, to 100% for RSUs and 50% for stock options). Further, in some cases the CEO had a higher retention percentage than other executives. In those cases, that was included in the “Mix” category.
In regard to other retention requirement structures, we counted 21% of the survey group with requirements in place for those not timely meeting guidelines and 12% that required executives to retain all or a portion of the net after-tax gain upon the exercise of stock options, vesting of restricted stock/RSUs, or payment of other compensation in shares—even if ownership goals had been achieved. Those retention periods were anywhere from six months up to possibly, retirement. Finally, about 14% had more than one type of retention requirement approach in place.
Note that a stock retention requirement does not delay the timing of taxation for shares acquired by stock option exercise or upon the vesting of restricted stock or the payout of RSUs. This is because the subsequent retention period is not equal to an additional “substantial risk or forfeiture” period associated with the shares received. It is more simply a restriction on the ability to transfer those shares.
Almost all companies have also adopted policies that prohibit the hedging (98%) and even pledging (85%) of company stock positions, especially by Section 16 insiders and NEOs. Even where pledging was allowed, there were often limitations, such as an inability to use shares in a margin account or having to obtain prior authorization in order to pledge them.
In most cases, executives are required to meet their employer’s ownership targets within a five-year period, but often no period is stated due to the retention requirements. In our review, timeframes to meet the targets ranged from three to seven years. In many cases, executives are expected to show progress toward meeting the guidelines on an annual basis, through review (which may require some degree of substantiation from the executive), graded requirements (e.g., 20% achieved in each year over five years) and/or the retention program discussed previously.
While it is expected that executives will meet their targets voluntarily, several companies established retention ramifications if guideline targets are not met or even if annual progress is not made toward meeting the guidelines. In addition to the retention of shares related to various stock awards and options, other consequences may result, such as:
- Annual cash awards may instead be paid in stock (implemented at 6% of the companies with ownership requirements)
- Future, long-term incentive plan grants may be reduced or eliminated (implemented at 5% of that group)
Ownership requirements typically last as long as the key executive remains employed. We found evidence of a few companies (approximately 2% of the those with requirements) tempering or reducing the guideline when the key executive is a specified age (e.g., age 55, 60 or 62). A few other companies allow the executive to request an exception for certain transactions. This may mean that stock may be disposed of, with permission, in the event of:
- A financial hardship
- Estate planning needs
- A divorce
- Gifts to charity
- Educational requirements for children
Guidelines for Directors
Of the companies in our survey group, we count 96% that have requirements for outside directors. Typically, a director’s ownership target will be a multiple of the annual cash retainer (5X being most prominent, at 60%). Multiples, however, ranged from 1.5X to 10X. In more limited cases, a multiple of the annual stock award was used.
Achievement is typically expected within five years (67% of the time), but ranged from two years to seven years. In addition, we saw one company that allowed guidelines for directors to be waived, at the Board’s discretion, for new directors joining the Board from academia or government service.
Corporate Governance Outlook
The major corporate governance monitors—ISS and Glass Lewis—do not target or recommend a specific ownership requirement. ISS has indicated that a best practice is for key executives to attain “substantive” share ownership by a certain time after appointment. Their 2020 “Quality Score” further considers the percentage/multiple of salary for the CEO. For U.S. companies, a multiple of less than 3X salary for the CEO could “raise the level of governance risk concern.”
As it pertains to retention, ISS will give full points in this area if an executive is expected to hold shares received, net of taxes, for at least 12 months or until retirement or other end of employment. A “meaningful portion” to retain is considered 50% of net shares (after-tax) or 25% of gross. A retention requirement only until share ownership guidelines are met receives no points.
The ISS Quality Score further looks for “robust” anti-hedging policies, which is essentially no hedging allowed; and further looks negatively upon the pledging of shares. Their U.S. Proxy Voting Research Procedures and Polices’ FAQs indicate that “any amount of pledged stock is not a responsible use of company equity.”
Glass Lewis encourages executive ownership of a “significant number of shares” and recommends strict company policies prohibiting the hedging of company stock. For them, restrictions on pledging stock can depend on the exact circumstances.
Help in Meeting Guidelines
The increased utilization by many companies of RSUs is helping executives meet their ownership requirements. In addition, allowing the deferral of salary or bonus into plans with a stock-based, notional investment option or the deferral of equity-based awards—such as restricted stock units (RSUs) or performance shares or units—can also help executives meet ownership targets. In fact, using such units can make sense for an executive attempting to meet a guideline because they are a means of pre-tax savings (like shares held in a 401(k) plan), so can “cost” less than acquiring shares by other means. Finally, the use of time or performance-based, full-value stock incentives settled in stock continues to help executives achieve required targets.
Final Viewpoints on Ownership Requirements
Public companies have concluded that share ownership guidelines have positive “optics” and are consistent with good corporate governance. Thus, ownership targets are an expected part of the corporate governance and stock incentive program space. When stock prices are rising, ownership targets are often easier to attain for most senior executives. It is when company stock price plummets—or the market as a whole significantly declines, as we have recently seen—that ownership targets and retention requirements can seem unduly restrictive. This is especially true since most executives are prohibited from hedging their company stock position. Implementing certain ownership guidelines and/or share valuation structures can help to relieve that negative impact.