Reprinted with permission from the 2007/2008 Lexpert/CCCA Corporate Counsel Directory and Yearbook, 6th Edition.
Canadian companies are in the midst of significant changes to their executive compensation regimes. These changes are the result of increased shareholder focus and activism, particularly in the light of recent U.S. option and compensation scandals.
Companies are establishing multifaceted compensation plans that combine share and leveraged awards that vest on the basis of time and performance criteria.
Significant changes to the disclosure of executive compensation have been proposed by the Ontario Securities Commission – to take effect for fiscal years ending December 31, 2007 or later. The attention paid to backdating and springloading options in the United States has increased Canadian sensitivity to these issues.
Forms of Share-Based Incentive Compensation
An executive compensation package is usually composed of short-, mid- and long-term components. The short-term component is focused on annual performance and usually consists of salary and annual cash bonuses that are paid out on the basis of the achievement of measurable annual targets. The mid-term component is focused on performance over the one- to three-year period and is commonly in the form of cash, shares or restricted share units. The long-term component is focused on performance over more than three years and is often in the form of options, deferred share units or shares.
A proper compensation plan provides awards that create balanced incentives to achieve annual, mid-term and long-term corporate goals.
In response to shareholder pressure, companies have reduced the role of leveraged compensation such as options and share appreciation rights, and have increased focus on whole share compensation such as restricted share units and performance share units. Leveraged compensation rewards executives for an increase in value of the company’s shares and is perceived as being "upside only" – that is, the executive does not exercise options if the share value decreases. Whole share compensation increases and decreases in value in direct relationship with changes in share value. Whole share compensation, unlike options, continues to provide an incentive even when share value decreases since the grant date.
Understanding the changes in share-based incentive compensation requires an understanding of the essential elements of these awards.
An option is the right to purchase a share for a price (the exercise price) fixed at the time of the grant of the option. When the share value exceeds the exercise price, the option is "in-the-money". When the share value is less than the exercise price, the option is "out-of-the- money" or "underwater". The real value of an option is that the holder can benefit from the increase in value of a share without investing until exercising the option; that is why options are perceived as having upside only. Shareholders have criticized the use of options because they may motivate volatile increases in the share prices rather than consistent growth in value, and because they lose any incentive value when significantly underwater. Moreover, executives may not place as high a value on options as the company’s financial statements reflect.
Options are taxed in Canada in a way that is generally more advantageous to the holder than whole share compensation. It is primarily for this reason that options will likely remain a component of many Canadian incentive plans unless the Income Tax Act (Canada) (ITA) is amended.
An option may be granted with a tandem share appreciation right (SAR), which entitles the holder to a payment of the in-the-money amount, as if the holder had exercised the option, paid the exercise price and immediately sold the underlying shares. SARs are generally tax advantageous to both the holder and the company. However, their accounting treatment may make them unattractive.
Restricted share unit (RSU) plans were introduced in Canada a number of years ago, apparently in response to the shift in the United States to restricted stock as compensation. Canadian tax rules are not the same as those in the United States, which permit deferred taxation of restricted stock; so in Canada, RSUs have generally been squeezed into a three-year bonus exception to salary-deferred rules under ITA. A classic RSU converts bonus compensation into a number of RSUs, determined by dividing the amount of the bonus by the value of a share at the date of grant.
RSUs can be redeemed in the form of shares issued from treasury, shares purchased on the market or cash. On redeeming an RSU, the executive will receive one share for each RSU or a cash payment determined by multiplying the number of RSUs by the fair market value of the shares on the redemption date. The value of the grant increases or decreases directly with changes in the value of shares.
Since most RSU plans are designed to fit within the three-year bonus exception, they are designed to be redeemed and taxed within three years of the year in which they were granted. This makes them suitable as a mid-term incentive. However, as the pressure to provide whole share compensation increases, companies will look for share-based compensation that permits a longer tax deferral.
On redeeming RSUs, the participant is taxed on the entire value of the benefit received, on a regular employment-income basis.
A performance share unit (PSU) plan is a form of restricted share unit that requires the achievement of performance targets for the award to be redeemed. Common performance targets include earnings per share or EBITDA. Business-specific targets, such as operating without any worker injuries or properly planning for executive succession, can also be set, to allow PSUs to motivate specific behaviour in addition to increasing share value.
A deferred share unit (DSU) functions economically in the same way as an RSU, but is designed to come within a regulation under the ITA that allows taxation to be deferred until the DSU is redeemed. The regulation requires, among other things, that the participant not be permitted to redeem the DSU until retirement or death or the person ceases to hold office or employment. This requirement makes a DSU suitable only for long-term compensation. Furthermore, DSUs are generally unsuited to executives or to cyclical industries because they may motivate the executive team to resign in order to realize on the award. Accordingly, DSUs are more commonly awarded to directors.
On redeeming DSUs, the participant is taxed on the entire value of the benefit received, whether in cash or shares, on a regular employment-income basis.
Share grants are becoming more common and may be granted subject to restrictions, similar to U.S. restricted stock. However, in Canada share grants are fully taxed on a regular employment-income basis at the time of grant. Future increases in value are generally eligible for taxation at capital gains rates, which can make this an attractive form of compensation for high-growth companies.
Increasingly, companies require executives to achieve specified levels of share ownership. Generally all whole share awards, such as RSUs, are included in determining whether share ownership requirements are met. Some companies tie awards of leveraged share-based compensation to shares purchased by the executive – for example, 10 options will be granted for each 2 shares purchased by the executive.
Income funds are a good example of the development of an incentive plan with a particular business focus. An income fund is designed to maximize distributions to unitholders, rather than increase the value of the units. A long-term incentive plan rewards executives who achieve this by creating a fund that is generally a percentage of the fund distributions in excess of the target distributions. That pool is divided among executives and usually vests over time to encourage executive retention. In many cases, the award is actually or notionally invested in units during the period of deferred vesting as an additional incentive to maximize distributions and to maintain the value of the units.
New Approaches to Compensation
Many companies have introduced specific performance features to their share-based incentive plans. Common performance features include these:
- The achievement of performance targets such as EBITDA, earnings per share or revenue is required for the award to vest.
- The exercise price of the option increases over time, at a specific rate, at the rate of inflation or in accordance with peer group share prices to ensure that the option has value only if the shares outperform the appropriate metric. |
- An award will only be made if target performance is achieved.
The single biggest change to compensation plans is the multifaceted approach. Companies are combining awards with performance features and time-based vesting, and are combining whole share and leveraged share awards. These multifaceted compensation arrangements are specifically designed to reward short-, mid- and long-term performance goals. Although this increases the complexity of compensation arrangements, it tends to generate more predictable performance-based awards. For example, a new form of CEO compensation plan might provide for
- salary equal to 20% of total compensation.
- annual cash bonus equal to 20% of total compensation at target, awarded on the achievement of annual corporate objectives, with the bonus increasing by up to 50% for performance significantly in excess of target objectives.
- restricted share units that vest one-third per year for three years, equal to 15% of total compensation.
- performance share units that vest on the achievement of EBITDA targets for three years.
- time-vesting options that vest 25% on the fifth through eighth anniversaries of the grant, equal to 15% of total compensation.
- performance options that vest over time with an exercise price that increases annually in accordance with the TSX index, equal to 15% of total compensation.
A sensible compensation plan takes into account the financial position of the company – in particular, whether it is in the best interests of the company to pay for performance by outlaying cash or by diluting shareholders’ interests. The executive’s tax liability is also relevant because the executive will focus on the after-tax value of the award.
Proposed Changes to Executive Compensation Disclosure
Canadian securities regulators have proposed an overhaul of the disclosure rules for executive compensation to improve the quality and transparency of executive compensation disclosure. The proposed rules would require significant changes in disclosure and compensation-setting practices in Canada.
The proposed rules would replace the current requirements, introduced in 1994, which the regulators say have not kept pace with evolving disclosure practices and result in fragmented compensation information, making it difficult for investors to assess the total compensation paid to executive officers and to evaluate a key aspect of a company’s corporate governance.
Although the proposals are similar in substance to the rules recently adopted by the U.S. Securities and Exchange Commission, the proposed Canadian rules depart from the SEC rules in several important respects in an attempt to clarify and simplify those elements of the SEC rules that have been criticized as being confusing or overly complicated as well as to maintain the more principles-based approach favoured by the Canadian regulators.
The Canadian securities regulators intend the proposed rules to apply to the 2008 annual proxy season for companies with a financial year ending on or after December 31, 2007.
Summary Compensation Table
The summary compensation table would remain the main vehicle for executive compensation disclosure. It would be accompanied by a narrative description of any material factors that are necessary to understand the information in the table. A new column at the end of the table would present the sum of the other columns and would therefore show the total compensation of each named executive officer (NEO). The elements of the summary compensation table would be as follows:
- annual salary and bonus (the proposed rules define bonuses to mean purely discretionary payments not based on any predetermined performance criteria);
- the dollar value of stock, option and similar equity-based incentive awards, based on the amount recognized for financial statement reporting purposes;
- the dollar value of all other amounts earned through non-equity incentive plan awards and earnings on any outstanding awards (including performance-based bonuses);
- increases in the actuarial present value of the accumulated benefits under all defined retirement benefit plans (including supplemental plans); and
- all other compensation, such as amounts paid to an NEO at or after termination, tax gross-ups and similar payments, contributions to defined contribution plans, and perquisites and other personal benefits.
The Canadian securities regulators have designed the new summary compensation table to eliminate the perceived shortcomings in disclosure under the current requirements. For example, whether someone is an NEO would depend on total compensation (other than increases in the value of benefits under retirement plans), rather than just salary and bonus. Further, companies would no longer have the discretion to ignore an unusually large one-time cash payment in determining which executives qualify as NEOs.
The proposed rules maintain the current requirement that perquisites and other personal benefits must be disclosed unless they represent less than $50,000 and 10% of the NEO’s annual salary and bonus. However, because fewer payments would qualify as bonuses, companies may have to disclose a greater number of perquisites.
In addition to the summary compensation table, the proposed rules call for two other tables: one showing grants of equity awards made during the year and the other showing any amounts realized during the year from exercising option awards and from the vesting of stock and similar equity-based awards. The purpose of these tables is to give investors information about the position of outstanding options (both in- and out-of-the-money), as well as the value accrued to and realized by NEOs during the year.
The proposed rules would require companies to explain, in narrative form, the material terms of all awards, both equity and non-equity. In addition, for non-equity incentive awards, companies would be required to include information on estimated future payouts (threshold, target and maximum amounts).
Compensation Discussion and Analysis
The current Report on Executive Compensation would be replaced by a "compensation discussion and analysis" (CD&A) that puts into perspective for investors the detailed compensation numbers and accompanying narrative. Much like the overview that companies are encouraged to provide with their management’s discussion and analysis (MD&A) of financial condition and results of operations, the CD&A would provide discussion and analysis of the material factors underlying compensation policies and decisions reflected in the data presented in the tables. The CD&A would also have to indicate (i) how the compensation levels for the period might have been different under various performance scenarios; and (ii) what compensation levels for future periods might be expected under various performance scenarios.
- What are the objectives of the company’s compensation program?
- What is the program designed to reward?
- What are the elements of compensation?
- Why does the company choose to pay each element?
- How does the company determine the amount (and, where applicable, the formula) for each element? and
- How do each element and the company’s decisions regarding that element fit into the company’s overall compensation objectives and affect decisions regarding other elements?
The CD&A should be prepared with the same rigour as MD&A, reflecting the company’s specific facts and circumstances, and avoiding boilerplate disclosure.
The proposed rules would require companies to identify target levels for specific quantitative or qualitative performance-related factors and disclose targets that are based on objective, identifiable measures (e.g., stock price or earnings per share) unless that disclosure would result in competitive harm to the company. For targets that are subjective or based on internal processes, companies could describe the target without providing specific measures. If companies do not disclose targets, they would have to state what percentage of an executive’s total compensation relates to the undisclosed targets. Companies should consider this disclosure requirement in formulating targets and adopting new plans.
The proposed rules identify other items for discussion in the CD&A. For example, if companies use any benchmark in determining compensation, they would have to identify the benchmark, who was included in the benchmark and what criteria were used. If the benchmark uses a peer group, companies would also have to explain how the peer group sample was formed and why certain companies were included and excluded from the group. In addition, in response to concerns regarding the backdating of options, companies would be required to disclose their practices related to granting stock options and management’s role in determining who is awarded options.
The proposed rules maintain the requirement that companies provide a performance graph comparing their cumulative total return over the past five years with that of at least one broad equity market index. However, these rules would also require companies to discuss how the trend shown by this graph compares with the trend in the compensation paid to executives over the same period.
Retirement Plan Benefits
The proposed rules call for a new table disclosing the details of all defined retirement benefit plans, including the present value of the accumulated benefits. The requirement for this table responds to the criticism that the current form provides general information on benefit entitlements for specified compensation levels and years of service but does not disclose the particular circumstances and entitlements of each executive.
Post-employment Compensation and Benefits
The proposed rules call for detailed disclosure of post-employment compensation and benefits, including amounts payable upon retirement, termination or a change of control of the company. Companies would have to disclose the material terms of any written or unwritten agreements that provide for payments to an NEO at termination and quantify the payments and benefits that NEOs would receive under each termination scenario, with assumptions disclosed where necessary. The amount of detail would substantially exceed current requirements and is intended to prevent investors from being surprised by the size of an executive’s severance package, after the fact.
Backdating and Springloading of Options
The U.S. press and securities regulators have, over the last year, become concerned about backdating and springloading of option grants. Backdating refers to dating the grant of an option to a time prior to the actual grant date, when the market price of the underlying share was lower than the current market price. Springloading is the granting of an option when the board has material undisclosed information that it believes will increase the market price of the underlying shares. Both backdating and springloading options are designed to achieve the same result – namely, granting an option that is already in-the-money (the exercise price exceeds the grant price) on the grant date.
This practice is under fire in the United States because companies have not been properly disclosing the grants. Neither backdating nor springloading options are illegal per se in the United States, although both may reflect poor governance. The SEC is proposing to require specific disclosure of backdated options and may also issue guidance regarding when it is appropriate for companies to springload option grants. In addition, a number of large pension funds have commenced class action lawsuits against companies that have backdated options. These lawsuits are targeting directors on the basis that they have breached their fiduciary duty to shareholders.
The situation in Canada is quite different. Both backdating options (to take advantage of a lower market value of shares) and granting options when the board has material undisclosed information are prohibited. The TSX Company Manual expressly requires that the exercise price of an option not be lower than the fair market value on the grant date of the option. This rule applies notwithstanding shareholder approval. The TSX Company Manual also prohibits setting option exercise prices on the basis of market prices that do not reflect material undisclosed information. Further, to attract the equivalent of capital gains rate tax on the exercise of an option, the option must have an exercise price of not less than fair market value on the date of grant.
Given the existing prohibitions, we would not expect backdating or springloading of options to become significant issues for Canadian companies.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.