The following is our July-August Supplement with the latest new Compensation Trends and Developments. We are also sending this to nonmembers in the hope that it will demonstrate why you should be taking advantage of CompensationStandards.com.
 

CompensationStandards.com Special Supplement

July - August 2005

An Analysis of Compensation Trends and Disclosure Developments

As many of you know, Fred Cook’s June 21st seminal speech from Stanford Directors’ College – "Fred Cook Speaks to Directors" – (which also was video webcast on CompensationStandards.com; text, reference papers and video archive are still available there) is a “must read” for all directors, staff and advisors.  Two important segments are repeated below.  Also below, we have excerpted just a few of the entries from Mark Borges’s "The Compensation Disclosure Blog" and Mike Melbinger’s Compensation Blog on CompensationStandards.com that you may have missed:


The Latest Guidance

Highlights from Recent Blogs

Vulnerable Severance Arrangement

As we go to press we have just posted on CompensationStandards.com the complaint in the lawsuit brought against Morgan Stanley’s directors over the severance packages received by outgoing CEO Phil Purcell and Co-President Stephen Crawford. 

Many of our readers will want to take this opportunity to review your own severance provisions and contracts.  Because many companies may be sitting on potentially vulnerable arrangements, we urge you to refer to the excellent guidance (and red flags) provided in the Severance Arrangements Practice Area on CompensationStandards.com.

Also, you will not want to miss the very latest on severance arrangements that will be imparted at the 2nd Annual Executive Compensation Conference.

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What's Another Approach to Equity Grant Guidelines?

Here is a key excerpt from Fred Cook’s seminal June 21st speech: "It is my belief that currently high stock option grant values for executives have gone beyond any rational motivational value and are sustained only by compensation surveys.  To illustrate, what can be the possible purpose served in granting a CEO who already has an equity carried interest of 150-200 times salary, another option whose "face value" is 20 times salary?  The CEO is likely to be already so motivated by stock price performance that new grants add no incremental motivational value.  They only add cost.  It is only done because the surveys say that, without the new grant, the CEO's total compensation will not be competitive.  No survey, to my knowledge, considers what executives have already received in options.

Jesse Brill challenged me to suggest an alternative way for a compensation committee to deal with options if it wants to step off the survey treadmill.  I have tried to do so in Reference Paper B entitled "A Different Approach to Stock Option Grants - Stock Option/Pay Multiple Formula" accompanying this presentation.  In summary, my idea is to consider the total equity carried interest, which the executive has received from the company over the past 10 years, when granting new options.  If the total is more than some logical multiple of salary, say 30 times for the CEO, then throttle back on new grants and let the multiple fall to a more reasonable level as older options run out.

Why 30 times?  Because for good stock price performance over a sustained period, 30 times salary in equity carried interest will produce a net future gain after tax of 6-15 times salary.  The prospect of earning this amount of net equity through sustained good performance should be sufficient to optimize a leader's alignment with shareholders and motivation for share price appreciation.

Will this alternative approach work?  Frankly, I'm not optimistic.  A board faced with an aggressive management that demands to be treated "competitively" according to the surveys needs new tools to counter the pernicious effect of surveys.  One idea is to ask for a new survey of executives' equity carried interest or shareholder value transfer that compares the cumulative effect of stock option and other equity grants over the past 10 years.

What would it take to put surveys back into their proper place? It would take a management and a board who are more internally focused than survey driven and who come together to devise new ways to think about and administer equity grants that is motivational to executives and fair to shareholders.  The solution lies in recognizing that an option is not part of current compensation.  It is an incentive for future performance whose motivational effect continues for a long number of years."

 

The Problem with Surveys

Here is a key excerpt from Fred Cook’s seminal June 21st speech: "So now let me come to my main point.  From my vantage of almost 40 years of executive compensation consulting, and attending countless compensation committee meetings, I believe the major problem in executive compensation is that we, all of us, have become too dependent on executive compensation surveys to set target executive compensation pay levels and equity grants.

It is at the start point of the executive compensation cycle that surveys create the problem, not the end point where performance and the market take over to determine the outcomes.

In the paper accompanying this presentation, which has been posted on Compensation Standards.com for easy access, I identify many of the problems contributing to the misuse and abuse of surveys in setting the start point of executive compensation.  That this problem exists, I'm sure, is not a surprise to you.  All of you have a healthy suspicion of surveys.  But some of the points I make in the paper may add to your awareness and deepen your suspicions.

A good friend, Ken West, known to many of you as a former CEO of Harris Bank, chair of Motorola's compensation committee, and a respected consultant on governance to TIAA-CREF, goes so far as to name the survey consulting firms as "Ratchet, Ratchet & Ratchet."

No one doubts that the misuse and abuse of surveys has contributed to the escalation of executive pay levels and the widening pay gap between CEOs and other executives and salaried employees in large U.S. corporations, and to the widespread public perception that something is fundamentally wrong in executive compensation.

Why are we so dependent on surveys to set the start point of executive compensation?  The answer is that we do not know how to value the job of management.  In the absence of that knowledge, we rely on surveys to give us the answer.  But do the other companies in the survey know how to value the job of management?  I don't believe they know any more than you do.  A survey of other companies who do not know how to value something does not produce an answer to the value of management.  A collective lack of knowledge does not create knowledge.

To recap, the sum of all these points is that surveys are a major contributing cause to what's happened in executive compensation over the last 30 to 40 years. And as compensation committee members, and as outside advisors, we are too dependent on the use of surveys to make and take action that otherwise might not be justifiable or rationale on their merits. This problem particularly comes into play with long-term incentives and stock options, which make up the dominate portion of total executive compensation today." (For more about Fred's guidance about surveys and what to do now, go here.)

Here is the link to the full text of Fred Cook's seminal talk to directors—and the accompanying materials.

We are gratified to hear that so many of our readers have already circulated Fred Cook’s talk to all their directors–and that some companies are beginning to implement his suggestions. Along those lines the upcoming 2nd Annual Compensation Conference will pick up where Fred left off, providing important practical guidance for directors and their advisors. The full agenda for the Conference has just been posted. As you will see, this conference truly is a "must" for directors and those of us that advise boards. Those that have not yet made arrangements to attend (at least via the video webcast) are encouraged to do so now.

Highlights from Recent Blogs

Many of us have now bookmarked Mark Borges' and Mike Melbinger's excellent blogs and read them on a daily basis to help keep us abreast of the latest developments. Those that are not yet reading these excellent blogs on a daily basis are encouraged to enter a no-risk trial so that you do not miss this essential guidance. Here are a few of the latest gems.

Progressive's Proxy Statement (Borges – 7/19)

The annual proxy statement of The Progressive Corporation, the Mid-Western insurance holding company, which was filed in March, contains some interesting disclosures.

Security Ownership

The Beneficial Ownership Table is presented in two parts - the security ownership of the more than 5% shareholders and a separate table showing the security ownership of directors, director nominees, and management. This latter disclosure includes a breakdown for each individual of the (i) shares beneficially owned, (ii) shares subject to restricted stock awards, (iii) shares subject to currently exercisable options, (iv) units equivalent to shares, and (v) total interest in shares and unit equivalents.

Annual Compensation Table

The required Summary Compensation Table is supplemented with a 2005 Annual Compensation Table, showing the salary and maximum potential bonus for each of the named executive officers. Thus, a reader can see both the actual annual compensation paid for the last completed fiscal year and the projected annual compensation for the current year.

Restricted Stock Awards Table

The Summary Compensation Table is further supplemented with a Restricted Stock Awards Table that includes the number of shares of restricted stock granted during 2003 and 2004 (broken down on the basis of whether the award is service- or performance-based), the dollar amount of dividends received on restricted stock holdings during 2004, and the number of shares and aggregate value of restricted stock holdings at the end of the last completed fiscal year.

This table essentially replaces the Stock Option Grants table since the company did not grant stock options in either of the past two fiscal years.

Board Compensation Committee Report

The Board Compensation Committee Report is one of most thorough I've seen this year. It starts with a lengthy discussion of the company's executive compensation program, including an explanation of the annual cash bonus and long-term incentive components. The Report also includes an extensive discussion of the company's executive perquisite policies.

In discussing the CEO's compensation, the compensation committee includes the following statement about its review of his total compensation:

"As a part of its annual review of the executive compensation program and strategies, the Committee has reviewed [the CEO's] aggregate compensation and equity-based awards for 2004 and those that are planned for 2005, including the perquisites described above. The Committee believes that [the CEO's] overall compensation is reasonable when compared with the compensation of chief executives of comparable companies, especially in view of the outstanding performance achieved by the Company under his leadership, and that his compensation program strikes an appropriate balance between salary and variable compensation arrangements, consistent with the Company’s compensation policies for employees in general."

The committee goes on to indicate that it has looked at the potential amounts that could be received by the CEO under the company’s various compensation and benefits plans upon his retirement, an involuntary termination of employment, or in connection with a change of control of the company. It next summarizes theses benefits under each scenario. The committee then states that it has reviewed this information and has concluded that the amounts to which the CEO would be entitled and the potential payouts are "reasonable under the applicable circumstances." It also explains its rationale for reaching this conclusion, addressing such issues as severance amounts, payouts under the company's deferral program. accelerated vesting, and tax "gross-up" commitments. It's a fascinating discussion, to say the least.

The proxy statement is definitely worth checking out, as the compensation disclosures, particularly the BCCR, live up to the company's name.

Nordstrom's Proxy Statement (Borges – 7/18)

Nordstrom, the Settle-based retail clothing store, filed its most recent proxy statement in April. I've had a few people compliment its Board Compensation Committee Report, so I thought I'd take a look.

Generally, the Report is pretty clear. It contains several interesting features, including the committee's guiding principles for total executive compensation and its total compensation components - a list of the various plans and programs that comprise the total compensation package for the company's president and executive management group.

The Report identifies the members of the company's peer group for executive compensation purposes and describes in some detail the framework that the committee uses for establishing its pay components - base salary, annual cash bonus, and long-term incentives. The Report also makes liberal use of graphics to explain how the annual cash bonus program works and how long-term incentive awards are calculated.

While the company's tabular disclosures are well-laid out, they're fairly standard and don't appear to go much beyond what is required. The related-party transaction disclosure is pretty interesting, however. It describes Nordstrom's aircraft leasing arrangements with a company wholly-owned by three of its directors (including two members of the Nordstrom family). During the last year, the company leased its aircraft to Nordstrom at an hourly rate of $2,700 per hour. The disclosure also reveals several other financial aspects of this and other aircraft-related arrangements. Nordstrom makes a point to explain how it benefits from these arrangements (primarily because it avoids the capital investment of owning an airplane outright).

From my standpoint, the hourly rate disclosure provides a helpful frame of reference when looking at the aircraft costs incurred by other companies. Nordstrom is one of the few companies I have seen that really gets into the details of the direct costs of this perquisite.

162(m) Disclosure - The Shaev Case (Melbinger – 7/15)

Apparently some plaintiffs class action lawyers are suing companies for their 162(m) disclosures based on the Shaev v. Datascope Corp. (3d Cir. 2003), case. In Shaev, the court found a potential violation of federal securities laws where the corporation allegedly did not fully disclose the material terms of an executive's incentive compensation program. The court held that the material terms of the company's incentive plan and the performance goals on which the chief executive's compensation was based were “material” within the meaning of Code Sec. 162(m)(4)(C)(ii), even though the specific business criteria, discussed in Reg. §1.162-27(e)(4), were not. Thus, the company's failure to disclose those terms could be a material omission under SEC Rule 14a-9.

In other cases, lawyers are alleging that the Compensation Committee report promised pay-for-performance but then adopted a plan that paid significant amounts no matter what. Although these claims seem legally unsupportable, companies should pay more attention to both the Compensation Committee report discussion of Internal Revenue Code Section 162(m), and the description of the plan in the shareholder approval section of the proxy statement.

So let's be careful out there.

Legg Mason's Equity Plan Disclosure (Borges – 6/20)

I haven't spent much time this proxy season commenting on companies' Item 201(d) equity compensation plan disclosure; primarily because I hadn't seen anything significantly noteworthy. Today, however, in reading Legg Mason's proxy statement, I saw some interesting disclosure triggered by the company's extensive phantom stock program.

Legg Mason does a good job of integrating information about its phantom stock program into the equity plan disclosure table. The company also provides narrative descriptions of six different phantom and NQDC plans, none of which has been approved by shareholders.

One of the concerns that was raised when Item 201(d) was first adopted had to do with the feasibility of requiring narrative disclosure of each non-shareholder approved plan. Here, the disclosure is neither overwhelming or dense. The descriptions are sufficiently detailed so that a reader can understand the operation of each plan, but also are fairly concise and focused. While this is one of the longer equity plan disclosures I've seen this year, it reads fairly smoothly. If you're looking for an example of disclosure for a non-conventional (that is, a non-option) plan, Legg Mason's proxy statement is worth checking out.

Lessons from the "Other" Disney Case (Melbinger – 6/15)

Broc Romanek blogged about the Delaware court's denial of the Walt Disney Company's motion to dismiss in a lawsuit - Shamrock v. Iger - challenging the company's CEO succession process. However, I wanted to repeat some of the important points for those of you who do not get Broc's Daily Blog on TheCorporateCounsel.net. The novel opinion in this case, as well as the complaint and the motion to expedite the trial, is posted in the "Disney's CEO Succession Lawsuit" section of TheCorporateCounsel.net.

To recap, Stanley Gold and Roy Disney sued the Company and the board, seeking to invalidate this year's board election, alleging that they would have run a competing slate but for the fact that the Company had previously disclosed that it would conduct a CEO search and consider external candidates. The board ultimately selected COO Robert Iger to succeed CEO Michael Eisner when he steps down later this year.

Here are some things to consider about this lawsuit and the court opinion:

  1. What is the Duty of Disclosure? The opinion notes that the "duty of disclosure" under Delaware law is not an independent fiduciary duty but rather "stems from, and is an application of, the general fiduciary duties of care and loyalty." See note 30 on page 11 of the court opinion.
  2. CEO Succession Practices. This case implicates what constitutes good CEO succession practices. Among other things, the court pointed out that having the outgoing CEO involved in the interviews of the successor candidates is a bad idea (see the "troubling seven facts" alleged by the plaintiffs, noted on page 8 of the court opinion).
  3. Careful with Disclosures. This lawsuit should remind us to take care with everything we say in our proxies and other disclosures. It might encourage the plaintiffs' bar to flyspeck proxies for statements that later turned out differently than what the proxy disclosed. For example, a compensation committee report could be fodder if the committee says it is "committed to pay-for-performance," but the CEO nonetheless gets a raise after a down year.
  4. Duty to Update. The court suggest a "duty to update" statements that were truthful when made. This could be chilling in terms of voluntary disclosures - why say anything not required if that gives you a duty to update? And who can even remember or track all statements made - and constantly evaluate whether need to be updated? This may be an overstatement of concern about the opinion, but still something to keep an eye on.

Keep in mind that this decision was only on whether to permit the lawsuit to proceed to trial. It is not a determination on the merits of the case. However, it means much more time and money for the Company and it board. The court is giving the plaintiffs the chance to prove that the Company's succession process was a sham intended to keep Roy Disney and Stanley Gold from running a competing slate. A trial is slated for August in the Delaware Chancery Court.

Freddie Mac's Deferred Compensation Disclosure (Borges – 6/15)

The Federal Home Loan Mortgage Corporation (Freddie Mac) filed its annual report and proxy statement yesterday. Most of the media stories about the filings have focused on the amount of compensation paid to recruit and retain the company's top executives.

What has interested me the most has been the company's disclosure about the nonqualified deferred compensation arrangements of its named executive officers. Following the Summary Compensation Table, the company provides two tables concerning its 2002 Executive Deferred Compensation Plan.

The first table indicates the dollar amount of salary, bonus, and restricted stock units that have been deferred during the past three years by each NEO that elected to defer some of his or her compensation. It is then followed by a second table that sets out the total accumulated deferrals, plus interest (again broken out by salary, bonus, and RSUs), for these NEOs.

The disclosure is helpful, but the way it is presented leaves some unanswered questions. For example, in the case of two of the NEOs, the numbers in the second table don't quite mesh with the amounts that have been deferred over the past three years (in one case, salary deferrals of $352,500 have now grown to $2.2 million). Obviously, something is missing. (Perhaps it's the effect of daily compounding of interest as provided under the company's plan) It would have been nice if the company had anticipated this question and addressed it as part of the disclosure. As it stands, readers are left to speculate as to how the NEOs' accounts got so large so quickly.

Over all, though, I like this disclosure. Other than MBNA, it's the only company I've seen this proxy season that has offered supplemental information about its executive NQDC arrangements.

More Directors' Compensation Disclosure (Borges – 6/7)

QAD Inc.'s proxy statement discloses its directors' compensation in a format that I've now seen a couple of times this year. The company employs a table to list the different amounts and types of compensation paid - as a retainer, as meeting fees, for committee service, and for chairing a committee.

Unfortunately, it does not then aggregate these amounts to present a total compensation figure for each non-employee director. A reader has to look elsewhere to figure out the committees on which, and in what capacities, a director serves. Even then, it's difficult to calculate how much a director earned because you don't know how many board and committee meetings each director attended (unless one assumes perfect attendance). While I like the tabular approach, this disclosure would have worked better had it been more like AMD's or The Gap's.

Lessons in Top Hat Plan Drafting and Administration (Melbinger – 6/6)

Another recent case in the ERISA plan area illustrates some important points about plan drafting and administration. In the case of Kergosien v. Ocean Energy Inc. (5th Circuit 2004), the ERISA plan was a severance plan. The plan document had the appropriate language giving the plan administrator the discretionary authority and duty to interpret the plan's terms. So, when the plan administrator denied severance payments to employees who continued in the same positions with buyer on the day after a sale, the deferential standard of review required by the Firestone case probably would have carried the day in court. (See our Blog from May 24.) However, imperfect plan drafting and a critical procedural misstep led to a victory for the plaintiffs.

The first problem for the company was that at had already lost the case in arbitration. In the arbitration, rather than apply the Firestone arbitrary and capricious standard, as a court would have, the arbitrator found wiggle room in the plan's arbitration provision and reviewed the plan committee's decision de novo, giving it no deference.

The second problem for the company was the plan administrator's rush through the claim process. As noted in the court's opinion: "The Committee met for one hour and considered twelve items. Plaintiff's claims were the last item on the agenda and the Committee spent less than five minutes on that item." The claim denial letter was prepared by the company's general counsel, who was also the committee's recording secretary, before the meeting.

ERISA gives significant advantages for companies with SERPs, severance plans and other non-qualified retirement plans. Let's be careful not to throw them away.

Rule 10b5-1 Trading Plan Disclosure (Borges – 6/6)

I saw something new this morning when reviewing the day's proxy filings - a specific disclosure concerning Rule 10b5-1 trading plans. It's in the Plantronics' proxy statement (just scroll down a bit), under the heading "Additional Information" (which is a bit of a misnomer since the section includes all of the company's executive compensation disclosure). The section reads as follows:

"Plantronics permits our Officers and Directors to adopt trading plans under Rule 10b5-1 promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), which allows stockholders to establish prearranged written plans to buy or sell shares or exercise stock options in accordance with predetermined formulas. Rule 10b5-1 plans allow stockholders to buy or sell shares of Plantronics common stock according to their plan on a regular basis (for example, weekly or monthly or in accordance with another predetermined formula), regardless of any subsequent nonpublic information they receive. As of April 30, 2005, any officers who previously entered into 10b5-1 Trading Plans had terminated all such plans."

While it's unusual disclosure, it has some appeal - providing shareholders with the status of any currently outstanding trading plans. The disclosure also raises the question of what should be disclosed when there is one or more plans in place. Last year, Plantronics simply identified the executives with outstanding plans, without providing any specific details. I'm curious as to how other companies handle this type of disclosure as part of their proxy statements.

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Those that are not yet reading these excellent blogs on a daily basis are encouraged to enter a no-risk trial so that you do not miss this essential guidance.

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