In the September 2005 edition of this newsletter we addressed the effectiveness of executive share ownership requirements (See HERE) and the July 2006 edition reviewed the relationship between CEO share ownership and company performance (see HERE).

Given recent criticism of ‘short-termism’ in remuneration practices, particularly within financial services organisations, we considered it timely to re-visit the issue of compulsory share ownership policies as a means of reinforcing the importance of sustainable longer-term performance.

After something of a ‘false start’ in the late 1990s, when we first saw tentative attempts to install compulsory shareholding requirements in Australian companies, the practice has gained some traction in recent years, although it could not really yet be considered widespread amongst ASX-listed companies. But all things have their time, and the current environment might be just the impetus for a fresh look at such an initiative, particularly in the form of the “hold until retirement” and “hold through retirement” approaches.

In the US, some companies require executives to retain, for the duration of their career with the company, a substantial component of the equity awards they are granted under their equity incentive plans. These are distinct from the numerous companies that apply some form of traditional stock ownership guideline, which requires executives to acquire and retain a certain value of company stock (commonly expressed as a multiple of salary).

The “hold until retirement” approach is considered by some to have advantages over the basic shareholding requirement, and can be applied in different ways. It might be expressed as a retention ratio, prescribing a percentage of earned (that is, vested) equity awards that must be retained until the time of leaving the company.

The ratio only applies to “profit” or “gain” shares that remain after allowance for taxes and, in the case of options, payment of the exercise price. As an example, the executives might be required to retain 75% of the net shares received after deducting the taxes and exercise price as described above. This allows the executives to access some value immediately from the vested tranche and at the same time to continue to build the value of the shareholding with each tranche granted during the course of their careers.

Common share ownership guidelines usually require the executive to acquire a certain fixed value of company shares (expressed as a multiple of salary) within a specified period of time. However, once attained, there is no further need to retain a portion of any future grants. An alternative concept is the notion of long-term vesting, under which a defined percentage of the executive’s equity award does not vest until, or even after, normal retirement. In this situation, the equity will be forfeited if the executive departs prior to an agreed “retirement” date.

The benefits of “hold until retirement” policies are perceived as:

• Supporting executive share ownership by providing an effective, manageable and visible way for the continuous accumulation of shares without requiring executives to acquire and finance them via the external market
• Aligning the long-term interests of executives with those of shareholders by increasing exposure to long-term company performance through annual equity grants. This aspect can have a particularly positive impact within organisations that emphasise annual remuneration, by providing balance to the remuneration design
• Addressing the perception that there has not been a corresponding increase in executive share ownership levels as the size of equity awards and wealth of executives has grown over the past 10–15 years
• Reducing the risk of executives inappropriately timing market sales, a practice that was frequently present in the corporate frauds of the past five years
• Improving on the benefits of traditional share ownership guidelines, which usually specify a fixed value of shares that must be held. These policies may have little effect after that level is attained, despite continuing annual equity grants. The number of shares held may even decline as share price increases. Conversely, the executive might be required to purchase more shares as share price declines. The traditional guideline may also impose greater burden on new employees, who feel compelled to build their shareholding quite rapidly, than on longer-serving executives who satisfied the requirement during the earlier part of their careers.

But even a “hold until retirement” approach has its problems.

One problem is that over time an executive will tend to have “too much” of their wealth accumulation tied up in company stock. Compared to the diversified investors also holding their company’s shares, the concentration of wealth in this one asset may make the executive more risk averse. The executive’s growing risk aversion (while the current fashion as we experience a credit crunch) may not best meet the needs of their company’s shareholder base, who expect more risk taking, given that they have diversified away their risk through multiple company shareholdings.

The other major issue with a ‘hold until retirement” approach is the temptation to make decisions and take actions to maximise company results in the executive’s final year to cash out of the holding requirement on retirement. The executive’s successor is left with the legacy of these decisions and actions that may have had a negative impact on the sustainability of shareholder value.

For this reason, we are also urging boards to consider “hold through retirement” policies. In effect these policies require that the performance vesting periods for any outstanding equity grants on retirement run their course. They vest 1, 2, 3 and possibly even 4 years after the executive retires in accord with the performance conditions set by the board. Because it is based on grants made during employment, the value of grants remaining at the end of each year after retirement gradually wind down, in line with the executive’s waning influence on results post their tenure. The main value is the first one or two years after their termination, when the company and its shareholders are still subject to outcomes largely influenced by major decisions made during the executives “watch”.

Guerdon Associates believes that for highly capital intensive companies with long time horizons this approach has merit.

Unfortunately, the Australian tax system is not very cooperative. Under Division 13A of the Income Tax Assessment Act any unvested equity on termination is taxed as ordinary income. Despite this, some boards still require these performance vesting conditions to still apply post termination (sometimes allowing enough to vest to meet tax obligations). But it would be better if the tax regulations were amended to better accommodate these plans. Guerdon Associates will provide a submission to the Henry tax review on this matter.

In the meantime, we suggest that “hold through retirement” policies are worth considering, if we can overcome the unintended consequences rendered upon us by the Australian tax system. Guerdon Associates will write more on this next month.

Companies that find appeal in the “hold until retirement” and “hold through retirement” concepts need to give consideration to the following issues checklist in order to develop and implement the most suitable approach for their business:

1. Decide between the retention ratio or long-term vesting design
2. Identify which executives will be subject to the requirements
3. Select the level of the retention ratio
4. Decide which shares will be covered (for example, include previously vested shares and shares arising from exercise of previously vested options, or only currently outstanding but unvested grants and future grants, or only future grants?)
5. Establish record keeping procedures to monitor the holdings
6. Prepare communication material for the executives
7. Prepare commentary for inclusion in the company’s remuneration report, to gain the full benefit of likely positive investor reaction to the initiative.

Share-trading restrictions mean that the most senior executives are likely to already hold a substantial portfolio of company shares. The “hold until retirement” and “hold through retirement” initiatives therefore offer the opportunity to send a positive message to investors and governance groups with little risk of adverse impact on the participating executives.

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