Vol. XXIX, No. 6                     SPECIAL SUPPLEMENT                     November-December 2004

Highlights of the CompensationStandards.com
 Executive Compensation Conference

The first ever Executive Compensation Conference, co-sponsored by the NASPP, The Corporate Counsel and The Corporate Executive, was an unqualified success, with over 2,500 attending live or via the video simulcast on CompensationStandards.com. The conference focused on the importance of reeling in executive pay, emphasizing the compensation committee’s responsibility in this area.

One theme that emerged over the course of the day was how critical it is for the compensation committee to acquire a clear picture of the total compensation paid to the CEO and other executives. To this end, many panelists stressed the importance of using tally sheets that provide a full analysis of executive pay packages. Other themes stressed throughout the conference included assessing “internal pay equity” (a la DuPont and Intel) in addition to (or, better yet, instead of) relying on inflated survey data, requiring top executives to hold options and restricted stock until retirement, and rolling back the excessive pay packages of past years.

Your input is needed! We are particularly interested in the practices companies are now implementing to address these concerns. Please send us your tally sheets, guidelines for internal pay equity, stock option and restricted stock retention until retirement, and any of the other actions you’ve taken to implement responsible compensation practices along the lines of the 12 steps set forth in the May-June and September-October issues of The Corporate Counsel. [Readers are encouraged to take advantage of the electronic versions of those issues—with links to helpful practice pointers and implementing guidance—on the home page of  CompensationStandards.com. We will be keeping everyone abreast of the new practices companies are implementing on CompensationStandards.com.]

SEC Targets Compensation Disclosures

Unquestionably, the highlight of the conference was the memorable speech by Alan Beller, Corporation Finance Director at the SEC. Beller’s remarks signify a major shift in the priority of executive compensation disclosures for the SEC and underscore the seriousness of the staff’s renewed focus in this area. Beller read—and repeated for emphasis—Item 402(a)(2) which requires disclosure of “all plan and non-plan compensation… to the named executive officers…”

Key points in his 45-minute presentation included:

• “Simply complying with the rules on a literal basis” does not constitute compliance if all compensation is not fully disclosed. Literal item 402 compliance is not compliance.
• “Too many issuers and their advisors have followed a pattern of opaque or unhelpful disclosure…that says as little as possible…”
• The requirement to disclose all compensation takes precedence over the detailed requirements of the tables.
• Those preparing proxy statements must strive to ensure full disclosure of all compensation earned or paid (including perks), keeping in mind that the client is the shareholders who rely on the statement, not management.

Beller also honed in on the compensation committee report, emphasizing the need to eliminate all the boilerplate and provide meaningful disclosure. (In that connection, see the model section we have posted on CompensationStandards.com that will need to be added to this year’s compensation committee reports to address the SEC’s and institutions’ concerns over directors’ failure to tally up and review all the components of CEO compensation.)

Director Liability and Responsibilities: The Changing Face of Delaware Law

The tone for the day was set with a special presentation featuring the current and former Delaware Supreme Court Chief Justices, Myron Steele and Norman Veasey, and Professor Charles Elson, the Director of the University of Delaware Center for Corporate Governance discussing the changing application of Delaware law to director responsibilities and liability. The panelists pointed out that the standards for responsibility may not have changed under Delaware law—as always directors need to perform their duties with care, objectivity, and independence—but public scrutiny has increased and the way in which courts are responding to failures to perform these duties (and holding directors personally liable) is changing.

The panelists stressed that the process of awarding executive compensation must be a legitimate negotiation in which the compensation committee reviews the proposal and seeks counsel from its own advisors regarding what level of pay is reasonable. It is no longer acceptable for compensation committees to merely rubber stamp management’s proposal; the compensation committee must be able to demonstrate oversight.

The panelists also emphasized the importance of careful consideration, explaining that the primary complaint in the Disney case is that the directors showed little regard for the decisions they were making with respect to executive compensation. The compensation committee must insist on receiving sufficient information to make a decision and that enough time is given to evaluating that information, so that they are making informed and considered decisions in executive pay.

What Compensation Committees Should Now be Doing

The next panel built on the foundation established by the special presentation, discussing specific actions compensation committees can take to ensure that they are making informed and considered decisions. Diane Doubleday of Mercer Consulting provided a useful list of twelve practices compensation committees should implement, including:

• Develop a written compensation philosophy. Not the typical boilerplate that all companies already have, but a detailed philosophy that is reviewed annually. All compensation decisions (including decisions about perks) should then be measured against this philosophy.
• Make sure that the annual agenda adheres to the committee’s charter. Review the charter line-by-line to ensure that all responsibilities are included in the agenda. Be sure to allow enough time for each responsibility, with added time for discussion. If necessary, add a meeting to the agenda.
• Don’t rush to judgment; present information at one meeting and make a decision on that information at a subsequent meeting. This ensures that directors have had enough time to consider the information presented.
• Review all elements of pay packages at the same meeting so that directors have a clear picture of the total compensation paid to each executive. Measure current compensation against compensation paid in past years.
• Avoid surprises—evaluate compensation programs under best, worst, and outrageous scenarios. Consider the amount paid out to executives and the financial cost to the company.

Other panelists, including John Olson of Gibson, Dunn & Crutcher and Fred Cook of Frederic W. Cook & Co., offered practical suggestions for ensuring the committee is chaired by the right person, helping directors understand the company’s compensation programs, timing meetings appropriately, and using benchmark data. Olson explained that it isn’t necessary to discard all benchmarking data, but this data must be used with discretion (or it simply becomes another excuse to increase executive pay). Benchmark data should be based on a peer group of companies selected by the compensation committee. In addition, each individual executive’s compensation (especially the CEO’s) must be benchmarked internally—against compensation paid to other executives and to all of the company’s employees.

All of the panelists stressed that the compensation committee must have a complete picture of all compensation paid to executives. This highlights the importance of using tally sheets.( If you haven’t already, check out the examples of tally sheets we have posted—and will continue to post—on CompensationStandards.com.)

The Inside Scoop—Red Flags—Revealing Questions to Ask

This session expanded the morning’s discussion by pointing out potential problem areas or “red flags” for specific types of compensation arrangements. The panel started with supplemental executive retirement plans (SERPs), using an example to illustrate a number of hidden costs that can cause the actual cost of the plan to exceed expectations, in some cases, by more than six times. Mike Kesner of Deloitte & Touche offered tips for controlling the costs associated with SERPs, including carefully defining how salary and bonus are determined under the plan (not just defaulting to highest salary and bonus paid), avoiding lump sum payments, and capping payments. Kesner also advised regularly monitoring the present value of the amount owed executives under the plan, the increase this represents over last year’s amount owed, the current annuity owed, and the aggregate cost of the plan.

Tim Sparks of Compensia offered some insightful tips on employment, severance, and change-in-control agreements, pointing out that in many cases these agreements may not be necessary. Sparks strongly discouraged the use of automatic renewal provisions and also recommended strengthening the definition of termination for cause. The agreements also need to pass the “disclosure test.” Is the compensation committee comfortable disclosing the terms of the agreement to the public? If not, that indicates that the agreement may too strongly favor the executive. In the case of severance agreements, consider whether the company is getting something in return, such as a non-solicitation or non-compete agreement. For change-in-control agreements, watch out for illusory double-triggers, where the second trigger is too easily controlled by the executive, such as voluntary termination or termination with “good reason.”

George Paulin of Frederic W. Cook & Co. discussed the use of restricted stock. In response to the perceived high cost of stock options and the down market, many companies have replaced their stock option program with restricted stock. Paulin pointed out that too often companies issue oversized restricted stock grants by basing the number of shares on option valuations that are unrealistic. He suggested specific ratios that companies should be using to evaluate the size appropriateness of restricted grants. The panel also highlighted the need for all restricted stock awarded to executives to be subject to hold-to-retirement provisions.

Dick Wagner of Strategic Compensation Research Associates walked through an example illustrating how to utilize tally sheets and how important it is for the compensation committee (and investors) to truly have a clear picture of how much total  compensation is paid to the CEO.

How to Implement Internal Controls for Executive Compensation—Avoiding Exposure

Not only are compensation committees responsible for approving executive pay packages, they also need to take an active role in monitoring that the approved packages are adhered to. Mike Kesner of Deloitte & Touche and John Huber of Latham & Watkins suggested practices compensation committees can implement to establish appropriate controls over executive compensation—and avoid potential liability. A few of their tips for the compensation committee are listed below:

• Don’t assume that the inputs are accurate or that the methodology to compute compensation was followed correctly. Review the entire calculation, from the assessment of performance targets to the amounts paid out under the plan.
• Ask questions about the company’s internal controls and meet with both the outside and internal auditors. If time constraints are a concern, consider scheduling joint meetings with the audit committee.
• Read the MD&A and proxy disclosures to verify that the public disclosures agree with the information the committee has received.

How to Determine How Much Total Compensation to Pay the CEO

A very constructive session on “how much” was a highlight—and an eye opener. Paul Hodgson presented real world examples of cutting edge best practices that companies are adopting. Don Delves put forth new criteria and shared his personal tools that companies are now using to analyze and evaluate CEO pay (see his conference materials, including sample analysis for compensation committees, posted on the website). He also provided a sobering chart illustrating how what was viewed as an egregious one-time “megagrant” in the late 1980s has now (as a result of survey distortions) become a routine, median annual grant—echoing Fred Cook’s concern that stock options (and restricted stock grants) for CEOS have reached a level where they are no longer serving their intended purpose.

Mark Van Clieaf, using real company examples, had everyone in the audience taking copious notes on how to use his approach for assessing and tying a CEO’s compensation to long-term performance—and for taking into account the complexity of a company’s operations (instead of size)—when benchmarking against peer companies. Again, his conference materials, posted on the website, are a “must” for all compensation committees.

What to Do About Reviewing Outstanding CEO Pay Packages and Agreements

Ron Mueller of Gibson, Dunn & Crutcher and Michael Melbinger of Winston & Strawn outlined an approach for reviewing existing CEO pay packages and addressing concerns about excessive compensation. The starting point for this process is the tally sheet; using a tally sheet enables all parties to effectively evaluate the CEO’s compensation and will clarify whether or not there is a problem that needs to be addressed. If there is, the compensation committee could be held personally liable; this should motivate the committee to act. Mueller stressed that it’s never too late to address excessive compensation; even if mistakes were made in the past—acting now—before a shareholder lawsuit is initiated, could later reflect favorably on the committee.

Both Mueller and Melbinger found opportunities for negotiating existing packages, including withholding future awards in exchange for modifications to existing arrangements. Even if existing arrangements are not adjusted, it is still possible to modify future awards. One suggestion we like— that addresses the huge option sums that many executives have amassed— is implementing holding periods for CEOs' and top executives' outstanding and future equity grants.  Melbinger suggested requiring CEOs and top executives to hold stock acquired under these arrangements until retirement. (See the chart of leading companies that are now applying hold-til-retirement provisions to their top executives' stock options and restricted stock— with links to their provisions— posted on CompensationStandards.com.)

And Much More…

It is impossible to truly convey the wealth of information delivered at the conference; this is only intended to be a very brief snapshot. The panels described above included far more guidance than we’ve been able to describe here—and the panels that we haven’t mentioned were also extremely valuable. Other highlights included panels on enhancing the executive compensation disclosures in the proxy statement; tips from Jesse Brill and Alan Dye for avoiding insider liability under Section 16 and Rule 144; and Bob Misner on the IRS's audits targeting executives' compensation; and Tim Sparks' red flags for compensation committees and counsel to avoid costly, inadvertent 162(m) violations.

Those that missed this groundbreaking conference can access the video archive of each session—and the invaluable supporting materials—at CompensationStandards.com. [If you have not yet discovered the great resources and practice pointers on CompensationStandards.com, we encourage you to check it out—and take advantage of the no-risk trial for the critical months ahead.]