Recent Developments in Executive Compensation

The Response

In June, 2002, The Conference Board (a respected not-for-profit, nonpartisan organization that examines major policy issues having an impact on business and society) convened the Commission on Public Trust and Private Enterprise (“Commission”) to address the breakdown in public trust which grew out of the explosion of corporate scandals and the apparent “disconnect” between executive compensation and performance. The Commission included Peter G. Peterson and John W. Snow, its co-chairmen, as well as Arthur Levitt, Jr., Paul Volker, and Warren Rudman.

The Commission issued its findings and recommendations in three parts, beginning in September, 2002, when it released its report on executive compensation. That report identifies a confluence of events which, according to the Commission, created an environment “ripe for abuse.”

These events included:

• An excessive use of stock options;
• The speculative nature of those options which led to their being undervalued by the executives to whom they were given which in turn required higher levels of grants;
• The lax attitude of boards of directors towards their duty of monitoring executive compensation; and
• The fact that stock options and other equity-based incentives created enormous incentives to manage companies for short-term stock price gain.

The Commission concluded that, as a starting point, “a diligent and independent compensation committee is critical to avoid abuses”, and identified general principles of corporate governance relating to executive compensation, including:

• The necessity for a strong, independent compensation committee;
• The importance of performance-based compensation;
• The proper role of equity-based incentives;
• Compensation policies which create long-term focus;
• Accounting neutrality;
• Respect for shareholder rights and protection from equity dilution; and
• Transparency and disclosure.

More recently, other organizations have also addressed this issue. On Nov. 17, 2003, the Business Roundtable released a set of six governing principles for executive compensation, which mirrored many of the findings of the Commission. On Dec. 18, 2003, the National Association of Corporate Directors' (NACD) Blue Ribbon Commission on Executive Compensation and the Role of the Compensation Committee released its own report, which contains similar conclusions and recommendations. One proposal related to the Blue Ribbon Commission's suggested linkage between executive pay and job performance recommended the use of certain performance metrics to judge job performance, including revenue, net income, profit margin, cash flow, earnings per share, debt reduction, return on equity, capital or assets, market share, and stock market performance.

The Stock Markets React

Shortly after the release of the Commission's report on executive compensation, the Nasdaq and NYSE submitted proposals to the SEC related to corporate governance. The proposed rules were approved by the SEC on Nov. 4, 2003. One notable aspect of the new rules is the focus on independence requirements for compensation committee members and directors involved in the compensation process.

Although the Nasdaq's new rules do not require a compensation committee, they do require that:

• Compensation for CEOs and other executives must be determined, or recommended to the board for determination, by either a majority of independent directors, or a compensation committee comprised solely of independent directors. The CEO may not be present during voting or deliberations on the CEO's compensation; and
• If a compensation committee is appointed, the members must be independent. An exception to this rule applies to a compensation committee having at least three members. In such cases, one non-independent director (who is not a current officer or employee nor a family member of such person) may serve on a compensation committee, under disclosed exceptional and limited circumstances, for a maximum term of 2 years.

Under the NYSE's new rules, listed companies must have a compensation committee composed entirely of independent directors. The compensation committee must also have a charter. In addition to defining membership qualifications, appointment, removal, etc., the charter must address the committee's purpose and responsibilities, which at a minimum must have direct responsibility to:

• Identify and approve CEO compensation goals, evaluate CEO performance in light of those goals (either as a committee or together with other independent directors, according to board direction), and then determine and approve the CEO's compensation, based on this evaluation;
• Provide recommendations to the board concerning non-CEO compensation, incentive compensation plans and equity-based plans; and
• Produce a report on executive compensation, as required by the SEC, for inclusion in the company's annual proxy statement and 10-K.

Under the NYSE rules, an annual performance evaluation of the compensation committee itself is also required. In addition, the new rules require companies to publish the charter on the company's Web site, and be made available to any shareholder who requests a hard copy.

The Amex submitted its own proposals to the SEC, approved by its board of governors in late 2003, which include the following provisions:

• As in the case of Nasdaq and the NYSE, Amex-listed companies must obtain shareholder approval of all stock option plans (subject to limited exceptions), and brokers will not be permitted to vote their customers' shares on stock option plan proposals without instructions from the customer; and
• CEO compensation must be approved by a compensation committee composed entirely of independent directors or by a majority of the independent directors on an Amex-listed company board. Other executive compensation must be subject to review by the compensation committee (or a majority of the independent directors) in consultation with the CEO. The committee will be responsible for making a recommendation to the board.

Whither Stock Options?

The spate of new legislation and rules indicate that the government and stock exchanges are sending a clear message that “business as usual” is no longer acceptable. One telling indicator of the momentum for change will be the way regulators and Congress address the issue of stock options.

The debate over proper treatment of stock options is more than a decade old. FAS 123, “Accounting for Stock-Based Compensation” was issued by the Financial Accounting Standards Board (FASB) in October 1995. FAS 123 established standards for financial accounting and reporting for stock-based employee compensation plans. These standards did not require companies to expense the cost on their income statements. At the same time, applicable tax rules permitted companies to deduct the cost of the options paid to executives. This could result in an overstatement of earnings per share (EPS), enabling certain companies to report net profits rather than net losses. There are a number of severe examples of EPS overstatement; the most public example is Enron's reported overstatement of its 2000 EPS by approximately 10.5%.

Although a number of companies have voluntarily implemented accounting changes to expense employee stock options, FASB voted earlier this year to draft new rules mandating that companies treat employee stock options as an expense. These new rules are expected to be implemented some time in 2004. Congress has begun to act as well. Various bills are currently pending in Congress. The “Ending the Double Standard for Stock Options Act” would prohibit companies from deducting the cost of stock options unless they also expense those options. A competing bill, the “Stock Option Accounting Reform Act,” would only require companies to expense options granted to top executive officers. Meanwhile, a third bill, the “Broad-Based Stock Option Plan Transparency Act of 2003,” would direct the SEC to impose enhanced disclosure requirements for employee stock options.

The Future

It is impossible to predict the full impact recent changes and proposed changes will have in connection with executive compensation. Whether the new regulations will achieve their purpose and re-establish shareholder and public confidence in Corporate America by linking executive compensation and corporate performance remains to be seen. Questions also remain as to whether the “Rule of Unintended Consequences” will create a wave of new crises. Whatever the results, it appears that compensation committees will no longer be allowed to act as rubber stamps in an exercise of “form over substance.” Companies will be required to adopt higher standards of accountability and transparency for executive compensation determinations.

Executive compensation has risen from approximately 56 times the average employee's salary in 1989 to approximately 200 times the average employee's salary in 2002. During the stock market's halcyon days, concerns over this steep increase seemed to be limited to certain activist shareholders, public interest organizations, and Warren Buffet.

Although executive compensation has been the subject of evolving reform for several years, the bright spotlight of public attention is now focused on this issue, due in part to the bursting of the stock market bubble, the collapse of Enron, and a number of other highly publicized corporate scandals. The image of executives enjoying excessive compensation packages as revenues and earnings decline, and stock values of the companies they manage plummet, is a dangerously common stereotype.

In reality, the compensation packages received by most executives is related to their performance. Executives who earn shareholder confidence by their dedication to optimizing shareholder value are in tremendous demand, and deserve generous compensation. Excellent performance mitigates and deflects serious shareholder criticism. Even the most stringent reformers understand that generous compensation packages that are tied to increased shareholder value (ranking at the upper tier of their respective peer groups) are an important incentive in attracting and keeping top executives. Unfortunately, the impression that a few at the top escape with millions as the majority see their investment portfolios and 401(k) retirement plans wiped out has produced a wave of popular outrage. This reaction has been exacerbated by recent headline-grabbing events such as the indictment of former HealthSouth CEO Richard Scrushy (the first CEO to run afoul of Sarbanes-Oxley) and former Tyco, International CEO Dennis Kozlowski's $6000 shower curtain and $2 million “toga party.”

The Response

In June, 2002, The Conference Board (a respected not-for-profit, nonpartisan organization that examines major policy issues having an impact on business and society) convened the Commission on Public Trust and Private Enterprise (“Commission”) to address the breakdown in public trust which grew out of the explosion of corporate scandals and the apparent “disconnect” between executive compensation and performance. The Commission included Peter G. Peterson and John W. Snow, its co-chairmen, as well as Arthur Levitt, Jr., Paul Volker, and Warren Rudman.

The Commission issued its findings and recommendations in three parts, beginning in September, 2002, when it released its report on executive compensation. That report identifies a confluence of events which, according to the Commission, created an environment “ripe for abuse.”

These events included:

• An excessive use of stock options;
• The speculative nature of those options which led to their being undervalued by the executives to whom they were given which in turn required higher levels of grants;
• The lax attitude of boards of directors towards their duty of monitoring executive compensation; and
• The fact that stock options and other equity-based incentives created enormous incentives to manage companies for short-term stock price gain.

The Commission concluded that, as a starting point, “a diligent and independent compensation committee is critical to avoid abuses”, and identified general principles of corporate governance relating to executive compensation, including:

• The necessity for a strong, independent compensation committee;
• The importance of performance-based compensation;
• The proper role of equity-based incentives;
• Compensation policies which create long-term focus;
• Accounting neutrality;
• Respect for shareholder rights and protection from equity dilution; and
• Transparency and disclosure.

More recently, other organizations have also addressed this issue. On Nov. 17, 2003, the Business Roundtable released a set of six governing principles for executive compensation, which mirrored many of the findings of the Commission. On Dec. 18, 2003, the National Association of Corporate Directors' (NACD) Blue Ribbon Commission on Executive Compensation and the Role of the Compensation Committee released its own report, which contains similar conclusions and recommendations. One proposal related to the Blue Ribbon Commission's suggested linkage between executive pay and job performance recommended the use of certain performance metrics to judge job performance, including revenue, net income, profit margin, cash flow, earnings per share, debt reduction, return on equity, capital or assets, market share, and stock market performance.

The Stock Markets React

Shortly after the release of the Commission's report on executive compensation, the Nasdaq and NYSE submitted proposals to the SEC related to corporate governance. The proposed rules were approved by the SEC on Nov. 4, 2003. One notable aspect of the new rules is the focus on independence requirements for compensation committee members and directors involved in the compensation process.

Although the Nasdaq's new rules do not require a compensation committee, they do require that:

• Compensation for CEOs and other executives must be determined, or recommended to the board for determination, by either a majority of independent directors, or a compensation committee comprised solely of independent directors. The CEO may not be present during voting or deliberations on the CEO's compensation; and
• If a compensation committee is appointed, the members must be independent. An exception to this rule applies to a compensation committee having at least three members. In such cases, one non-independent director (who is not a current officer or employee nor a family member of such person) may serve on a compensation committee, under disclosed exceptional and limited circumstances, for a maximum term of 2 years.

Under the NYSE's new rules, listed companies must have a compensation committee composed entirely of independent directors. The compensation committee must also have a charter. In addition to defining membership qualifications, appointment, removal, etc., the charter must address the committee's purpose and responsibilities, which at a minimum must have direct responsibility to:

• Identify and approve CEO compensation goals, evaluate CEO performance in light of those goals (either as a committee or together with other independent directors, according to board direction), and then determine and approve the CEO's compensation, based on this evaluation;
• Provide recommendations to the board concerning non-CEO compensation, incentive compensation plans and equity-based plans; and
• Produce a report on executive compensation, as required by the SEC, for inclusion in the company's annual proxy statement and 10-K.

Under the NYSE rules, an annual performance evaluation of the compensation committee itself is also required. In addition, the new rules require companies to publish the charter on the company's Web site, and be made available to any shareholder who requests a hard copy.

The Amex submitted its own proposals to the SEC, approved by its board of governors in late 2003, which include the following provisions:

• As in the case of Nasdaq and the NYSE, Amex-listed companies must obtain shareholder approval of all stock option plans (subject to limited exceptions), and brokers will not be permitted to vote their customers' shares on stock option plan proposals without instructions from the customer; and
• CEO compensation must be approved by a compensation committee composed entirely of independent directors or by a majority of the independent directors on an Amex-listed company board. Other executive compensation must be subject to review by the compensation committee (or a majority of the independent directors) in consultation with the CEO. The committee will be responsible for making a recommendation to the board.

Whither Stock Options?

The spate of new legislation and rules indicate that the government and stock exchanges are sending a clear message that “business as usual” is no longer acceptable. One telling indicator of the momentum for change will be the way regulators and Congress address the issue of stock options.

The debate over proper treatment of stock options is more than a decade old. FAS 123, “Accounting for Stock-Based Compensation” was issued by the Financial Accounting Standards Board (FASB) in October 1995. FAS 123 established standards for financial accounting and reporting for stock-based employee compensation plans. These standards did not require companies to expense the cost on their income statements. At the same time, applicable tax rules permitted companies to deduct the cost of the options paid to executives. This could result in an overstatement of earnings per share (EPS), enabling certain companies to report net profits rather than net losses. There are a number of severe examples of EPS overstatement; the most public example is Enron's reported overstatement of its 2000 EPS by approximately 10.5%.

Although a number of companies have voluntarily implemented accounting changes to expense employee stock options, FASB voted earlier this year to draft new rules mandating that companies treat employee stock options as an expense. These new rules are expected to be implemented some time in 2004. Congress has begun to act as well. Various bills are currently pending in Congress. The “Ending the Double Standard for Stock Options Act” would prohibit companies from deducting the cost of stock options unless they also expense those options. A competing bill, the “Stock Option Accounting Reform Act,” would only require companies to expense options granted to top executive officers. Meanwhile, a third bill, the “Broad-Based Stock Option Plan Transparency Act of 2003,” would direct the SEC to impose enhanced disclosure requirements for employee stock options.

The Future

It is impossible to predict the full impact recent changes and proposed changes will have in connection with executive compensation. Whether the new regulations will achieve their purpose and re-establish shareholder and public confidence in Corporate America by linking executive compensation and corporate performance remains to be seen. Questions also remain as to whether the “Rule of Unintended Consequences” will create a wave of new crises. Whatever the results, it appears that compensation committees will no longer be allowed to act as rubber stamps in an exercise of “form over substance.” Companies will be required to adopt higher standards of accountability and transparency for executive compensation determinations.