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Determining How Much Pay is Appropriate

  1. Compensation Landmines for Directors and Their Advisors
  2. Practice Pointers
  3. Video Webcast Panel (2004 Compensation Conference)
  4. CII Policy on Incentive Compensation, Salaries and Dilution
  5. Benchmarking and Survey Use Practice Area
  6. Tallying Up Total Compensation Practice Area
  7. Media Articles
  1. Compensation Landmines for Directors and Their Advisors: Ten Rules of Thumb Inspired by the SEC’s New Rules
    Harvey Pitt, Kalorama Partners (9/11/06)

    Below are the highlights of Harvey Pitt’s speech at our conference "Implementing the SEC's New Executive Compensation Disclosures: What You Need to Do Now!:"

    Mr. Pitt opened his remarks by acknowledging the scrutiny given to executive compensation by the media and investors and the reaction of outrage at the amounts being disclosed by public companies.  However, Mr. Pitt took the position that the issue at the heart of executive compensation is not the size of the amounts paid, but the lack of correlation between those amounts and performance.  In light of this perceived disconnect, Mr. Pitt suggested the following “rules of thumb” to assist directors and those who advise them in devising compensation programs that are understandable and more transparent to investors and regulators.

    • Start with a careful re-evaluation of every aspect of the company’s compensation philosophy.

    Even without the new SEC rules governing executive compensation disclosures and the stock option backdating scandals, boards of directors and compensation committees should be taking a fresh look at their programs.

    • In order to evaluate its compensation philosophy, a company must first have a compensation philosophy.

    Companies need to provide better disclosure regarding the process and rationale for the compensation determinations made by the compensation committee and/or board of directors.  The SEC wants companies to develop a philosophy for compensating executives, create a well-defined process for making compensation decisions, and to disclose both this philosophy and process to investors.

    • Once the company has established its compensation philosophy, identify the components of each senior executive’s job, the measures for determining successful performance of those components, and a method for determining whether compensation has been earned, and the consequences for failing to meet stated job requirements.

    Use performance criteria that are objective, as opposed to subjective criteria that may be easily manipulated (e.g., EPS).  This facilitates the company’s disclosure why and/or how the executive was compensated, not just the amount.

    • Gather all relevant compensation philosophy and procedures information (e.g., employment agreements and plans, performance reviews and consulting studies).

    These documents form the basis for drafting the CD&A, and may prevent the company from failing to address in the CD&A material amendments to the employment agreements.  Also, don’t forget to review internal e-mail, which may offer views regarding what certain compensation provisions really mean.

    • Recognize that the compensation committee’s obligations are not satisfied merely by making compensation decisions.

    The compensation committee must also develop a method to measure how well the executive meets the objectives established for that position and then apply that measurement to determine whether compensation was earned.
     

    • Larger companies should consider appointing an internal compensation officer tasked with ensuring that the compensation decisions are appropriately recorded and carried out.
       
    • Determine the company’s standards for director independence and then survey the independent directors for compliance with these standards.  Obtain a list of all companies and entities affiliated with each independent director and companies with enough interrelationships to the company on whose compensation committee these directors serve to raise concerns.  The company’s independence standards should ensure that directors are independent in fact.
       
    • Review the company’s procedures and control manual for disclosure surrounding compensation and option grants to make sure its processes are up to current standards (e.g., will current controls and procedures permit timely and accurate disclosure regarding option grants?).
       
    • An outside expert should review compensation tables and Form 4 matrices for accuracy and completion so that inadvertent errors are avoided.  In hindsight, it may not be easy to demonstrate that an oversight or inadvertent error was not intentional.
       
    • The compensation committee and the board each should review drafts of the compensation table, the options grant matrix, the timeline, and the CD&A.  This should assist the company in explaining its use of executive management and establishing a meaningful link between company performance and executive compensation.
       
    • If the compensation committee or the board of directors is uncomfortable with the draft executive compensation disclosure or with prior policies or procedures, then appropriate changes in the company’s executive compensation philosophy, program, policies or processes should be made to address the source of discomfort or change of judgment.
     

  2. Practice Pointers
  3. Video Webcast Panel: What is the Appropriate Amount of Compensation for CEOS (2004 Compensation Conference)
    • What responsible ways (and yardsticks) can be used to structure each component of top executives’ compensation, including cash compensation, bonuses, stock compensation, retirement plans, severance and more
    • What types and levels of compensation are now appropriate for CEO pay – and how to identify them
    • What should be the role of surveys regarding CEO pay; including how to overcome the problems of defining peer groups
    • How to critically evaluate survey data and avoid the pitfalls of benchmarking – red flags and nuggets
    • How to implement internal pay equity methodology

    Speakers: Don Delves, The Delves Group; Paul Hodgson, The Corporate Library; Mark Van Clieaf, MVC Associates International
     

  4. CII Policy on Incentive Compensation, Salaries and Dilution

    Here is what the Council of Institutional Investors included in its recently updated policy on executive compensation regarding annual and long-term incentive compensation; salaries; and dilution:

    ANNUAL INCENTIVE COMPENSATION

    Cash incentive compensation plans should be structured to appropriately align executive interests with company goals and objectives and to reasonably reward superior performance that meets or exceeds well-defined and clearly disclosed performance targets that reinforce long-term strategic goals set and approved by the board and written down in advance of the performance cycle. 

    Structure

    • Formula plans:  The compensation committee should approve formulaic bonus plans containing specific qualitative and quantitative performance-based operational measures designed to reward executives for superior performance related to operational/strategic/other goals set by the board.  Such awards should be capped at a reasonable maximum level.  These caps should not be calculated as percentages of accounting or other financial measures (such as revenue, operating income or net profit), since these figures may change dramatically due to mergers, acquisitions and other non-performance-related strategic or accounting decisions
    • Targets:  When setting performance goals for "target" bonuses, the compensation committee should set performance levels below which no bonuses would be paid and above which bonuses would be capped.
    • Changing targets:  Except in unusual and extraordinary situations, the compensation committee should not "lower the bar" by changing performance targets in the middle of bonus cycles.  If performance targets must be lowered, amended or changed in the middle of a performance cycle, reasons for the change and details of the initial targets and adjusted targets should be disclosed.

    Proxy Statement Disclosure

    • Transparency: The compensation committee should commit to provide full descriptions of the qualitative and quantitative performance measures and benchmarks used to determine annual incentive compensation, including the weightings of each measure.  At the beginning of a period, the compensation committee should calculate and disclose the maximum compensation payable if all performance-related targets are met.  At the end of the performance cycle, the compensation committee should disclose actual targets and details on the determination of final payouts.  

    Disgorgement

    Executives should be required to repay incentive compensation to the company in the event of malfeasance involving the executive, or fraudulent or misleading accounting that results in substantial harm to the corporation. 

    Shareowner approval

    Shareowners should approve the establishment of, any material amendments to, annual incentive compensation plans covering the oversight group.

    LONG-TERM INCENTIVE COMPENSATION

    Well-designed compensation programs can lead to superior performance.  Long-term incentive compensation, generally in the form of equity-based awards, can be structured to achieve a variety of long-term objectives, including retaining executives, aligning executives’ financial interests with the interests of shareowners, and rewarding the achievement of long-term specified strategic goals of the company and/or the superior performance of company stock. 

    But long-term incentive compensation comes at a cost, and poorly structured awards permit excessive or abusive pay that is detrimental to the company and to shareowners. 

    To maximize effectiveness and efficiency, compensation committees should carefully evaluate the costs and benefits of long-term incentive compensation, ensure that long-term compensation is appropriately structured and consider whether performance and incentive objectives would be enhanced if awards were distributed throughout the company, not simply to top executives. 

    Companies may rely on a myriad of long-term incentive vehicles—including, but not limited to, performance-based restricted stock/units, phantom shares, stock units and stock options—to achieve a variety of long-term objectives.  While the technical underpinnings of long-term incentive awards may differ, the Council believes that the following principles and practices apply to all long-term incentive compensation awards.  And, as detailed below, certain policies are relevant to specific types of long-term incentive awards. 

    Structure

    • Size of awards: Compensation committees should set appropriate limits on the size of long-term incentive awards granted to executives.  So-called "mega-awards" or outsized awards should be avoided except in extraordinary circumstances, because they may result in rewards that are disproportionate to performance. 
    • Vesting requirements: Meaningful performance periods and/or cliff vesting requirements—consistent with a company’s investment horizon, but no less than three years—should attach to all long-term incentive awards, followed by pro rata vesting over at least two subsequent years for senior executives. 
    • Grant timing: Except in extraordinary circumstances, such as a permanent change in performance cycles, long-term incentive awards should be granted at the same time each year. 
    • Hedging: Compensation committees should prohibit executives and directors from hedging (by buying puts and selling calls or employing other risk-minimizing techniques) equity-based awards granted as long-term incentive compensation or other stock holdings in the company.  And, they should strongly discourage other employees from hedging their holdings in company stock. 

    Proxy Statement Disclosure

    • Philosophy/strategy:  Compensation committees should have a well-articulated philosophy and strategy for long-term incentive compensation, which should be fully and clearly disclosed in the annual proxy statement. 
    • Award specifics: Compensation committees should disclose the size, distribution, vesting requirements, other performance criteria and grant timing of each type of long-term incentive award granted to the executive oversight group and how each component contributes to long-term performance objectives of a company. 
    • Ownership targets:  Compensation committees should disclose whether and how long-term incentive compensation may be used to satisfy meaningful stock ownership requirements.  Disclosure should include whether compensation committees impose post-exercise holding periods or other requirements to ensure that long-term incentive compensation is appropriately used to meet ownership targets. 

    Disgorgement

    Executives should be required to repay long-term incentive compensation to the company in the event of malfeasance involving the executive, or fraudulent or misleading accounting that results in substantial harm to the corporation. 

    Shareowner approval

    Shareowners should approve all long-term incentive plans, including equity-based plans, any material amendments to existing plans or any amendments of outstanding awards to shorten vesting requirements, reduce performance targets or otherwise change outstanding long-term incentive awards to benefit executives.  Plans should have expiration dates and not be structured as "evergreen," rolling plans. 

    DILUTION

    Dilution measures how much the additional issuance of stock may reduce existing shareowners’ stake in a company.  Dilution is particularly relevant for long-term incentive compensation plans since these programs essentially issue stock at below-market prices to the recipients.  The potential dilution represented by long-term incentive compensation plans is a direct cost to shareowners. 

    Dilution from long-term incentive compensation plans may be evaluated using a variety of techniques including, but not limited to, the reduction in earnings per share and voting power resulting from the increase in outstanding shares. 

    Proxy Statement Disclosure

    • Philosophy/strategy: Compensation committees should develop and disclose the philosophy regarding dilution including definition(s) of dilution, peer group comparisons and specific targets for annual awards and total potential dilution represented by equity compensation programs for the current year and expected for the subsequent four years. 
    • Stock repurchase programs: Stock buyback decisions are a capital allocation decision and should not be driven solely for the purpose of minimizing dilution from equity-based compensation plans.  The compensation committee should provide information about stock repurchase programs and the extent to which such programs are used to minimize the dilution of equity-based compensation plans.
    • Tabular disclosure: The annual proxy statement should include a table detailing the overhang represented by unexercised options and shares available for award and a discussion of the impact of the awards on earnings per share.

    SALARY

    Since salary is one of the few components of executive compensation that is not "at risk," it should be set at a level that yields the highest value for the company at least cost.  In general, salary should be set to reflect responsibilities, tenure and past performance, and to be tax efficient—meaning no more than $1 million.  The compensation committee should publicly disclose its rationale for paying salaries above the median of the peer group."
     

  5. Benchmarking and Survey Use Practice Area
     

  6. Tallying Up Total Compensation Practice Area
     

  7. Media Articles

 

For more information, contact info@compensationstandards.com or call 925.685.5111.
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