Executive Compensation: It's Hot and About to Get Hotter

With the Enron (Lay/Skilling) trial having concluded and the business community eagerly anticipating more reports recommending SOX ' 404 relief for smaller companies, executive compensation issues seem far removed, except for the occasional (or not so occasional) headline. Don't be lulled, however, into a false sense of security. Executive compensation is about to take center stage as THE latest 'corporate governance' topic.

SEC Overhaul

With some, but not overwhelming, fanfare, the SEC, on January 27, 2006, proposed the most sweeping overhaul to the requirements for executive compensation disclosure since 1992. If you've been paying attention, the reasons for the overhaul should be clear:

• The Disney directors' handling of the Michael Ovitz hiring and termination ' they ultimately weren't held liable, but they also weren't held up as a model of how to run a compensation committee.
• Orders to cease and desist from future violations of the disclosure requirements of the federal securities laws in the cases of:
• General Electric for undisclosed compensation arrangements and perquisites to former CEO Jack Welch;
• The Walt Disney Company for un-disclosed compensation and business arrangements with certain directors and their children;
• Tyson Foods, Inc. for hundreds of thousands of dollars in undisclosed perquisites and other personal benefits lavished on Don Tyson and his family members and friends, including oriental rugs, antiques, a horse, use of company-owned vacation homes and use of company-owned aircraft; and
• The directors of the New York Stock Exchange, taken to task by New York Attorney General Elliot Spitzer over the severance and pay package for Dick Grasso.

The Stage Is Set

The stage has been set ' much like Sarbanes-Oxley addressed many of the failures of independent directors who were believed to be at the heart of the some of the market failures of the turn of the millennium, the perceived inattention or outright mismanagement by directors of the executive compensation process is at the heart of the SEC's proposed executive compensation disclosure rules. Alan Beller, the former head of the SEC's division of corporate finance said as much when he discussed the practice of 'benchmarking':

Too many boards have apparently operated on the principle that compensation must be in the top half or even the top quartile of some benchmark group (the basis of selection of which is often not disclosed) for the company to be competitive in attracting talent. (This principle apparently operates without regard to whether performance is commensurate with compensation.) This approach produces what I have called the Lake Wobegon effect, where everyone is above average. Boards of directors ought to do better than this.

But Beller didn't stop there. Think about the compensation committee reports that appear in proxy statement and that have become largely 'boilerplate':

In addition to the questionable disclosure practices regarding items of compensation, I have concerns regarding compensation committee reports. Much disclosure we see in the compensation committee report is just boilerplate and is not very informative. This is the case even though the instructions to the relevant item specifically state that boilerplate should be avoided. I think that a significant number of companies and compensation committees would benefit from taking a fresh look at their compensation committee reports.

And he continued with comments about the practice of companies trying to 'pigeonhole' compensation into some exclusion to avoid disclosure:

And in my view that basic requirement to disclose all compensation takes precedence over the detailed requirements of the various tables in which disclosure is to be presented under our rules. All compensation must be disclosed. It may be time to revisit some areas of our executive compensation disclosure rules.

And so they have and over 500 comment letters have been received (many supportive). Now, companies must watch and wait. Reform is coming and here are some of the highlights:

Reform Highlights

• In place of the compensation committee report that currently is 'furnished' rather than 'filed' and, therefore, not subject to certain liabilities or other requirements, there will be a section entitled Compensation Discu-ssion and Analysis (CD&A) requiring discussion of many aspects of a company's compensation policies and practices including the role of compensation consultants and the role of executive management in the process. The CD&A will be 'filed' and, therefore, subject to certain additional liabilities and certification requirements.
• Who appears in the summary compensation table will now be based upon 'total' compensation (rather than salary and bonus as it is today) that is proposed to include the value of stock options and other stock awards using FAS 123R criteria.
• Never-before disclosed values of deferred compensation plans (previously all that was required to be disclosed was the 'above market' earnings on these plans) is virtually guaranteed to 'raise some eyebrows' and cause some compensation committee members to experience the 'Dick Grasso effect.'
• Disclosure will be required for up to three other employees whose total compensation exceeds that of the 'top five' ' those who appear in the summary compensation table.

Perk disclosure threshold will be lowered to $10,000 along with a requirement to disclose the perks with greater specificity.

New tabular disclosure (including perks) for boards of directors as well as executives.

Will the proposed rules be adopted 'as is'? No ' but, without question, they will be adopted in some form that provides greater disclosure requirements than those of today and the focus will be where there have been perceived abuses, such as undisclosed retirement compensation and perks. Accordingly, compensation committees would be well advised to begin to structure their practices to address the issues that undoubtedly will be addressed by the new rules.

What Compensation Committees Should Do

Among some of the things that compensation committees should do (if they haven't already):

• Adopt a 'tally sheet' approach to compensation if for no other reason than to avoid the 'Dick Grasso effect' and the criticisms leveled at the Disney directors that they were out of touch with the Company's compensation policies and practices. Plus, the new rules will essentially adopt a 'tally sheet' approach to disclosure.
• Consider stock ownership guidelines. These are expected to be a required discussion point in the new CD&A and there is nothing that aligns the interests of management with those of shareholders better than requiring ownership ' not just options to acquire ownership.
• Act independently from management and, to the extent necessary, engage independent advisors, such as compensation consultants. Just as SOX requires the auditors to work for and report to the audit committee, however, the compensation consultant and other advisors for the compensation committee should work for and report to the compensation committee.
• Establish a meaningful compensation policy. What are you trying to reward?
• Beware the practice of 'benchmarking.' See Alan Beller's statement above.

Compliance

And what about matters of immediate compliance concern? Even if the rules are not adopted, there are several such items.

The first relates to the current compensation committee reports. In view of Alan Beller's statements above, companies and their compensation committees would be well advised to revisit their current (as well as review the past few) compensation committee report. Important guidance for the preparation of such reports and what they should contain was set forth in Securities Act Release No. 7009 (Aug. 6, 1993). Because this is in the nature of 'guidance' from the SEC, it is a matter for immediate concern and compliance. Given some of the elements of compensation (eg, deferred compensation values) that are expected to now be disclosed under the new rules, when adopted, are the actions of your compensation committee defendable? Do their reports contain the required disclosures? When they are called to testify, will they say, 'We had no idea!'? You see, many compensation committees (and perhaps their advisors as well) have taken comfort in the fact that these reports are not 'filed' and, therefore, not subject to certain liabilities. While true, they nevertheless can form the basis for a 'Disney-like' fiduciary duty suit essentially claiming that directors were 'asleep at the switch.' Some of the numbers, when disclosed, will be eye-popping. The complaints probably are already drafted simply waiting for next year's proxy season to drop in the names of the companies and the defendant directors. I can assure you that the plaintiffs' class action lawyers are getting ready. Shouldn't you as well?

In a similar light is the SEC's position on perquisites in the proposed new rules. In addition to lowering the disclosure threshold, the SEC gave interpretive advice on what is and what is not a 'perquisite.' Because this is interpretive and perquisite disclosure currently is required, this again is a matter for immediate concern and compliance. Are items that your company currently is not classifying as a perquisite really 'integrally and directly related to the performance of the executive's duties'? The SEC emphasized that this was a 'narrow' concept. The SEC also advised companies to discard a popular method of valuing perks. Accordingly, companies and compensation committees should immediately review their policies and practices on perks. Some pundits already have suggested that the administrative burden alone of maintaining records to substantiate perk disclosure will make many companies rethink and possibly do away with perks ' in their place would be simply a higher salary or other cash compensation.

Conclusion

Although the SEC's new rules may seem like they are far, far away, they are just around the corner. In fact, because of the interpretive nature of certain aspects of the rules, they already are here and companies and their compensation committees should act accordingly. In today's environment, 'how' you get to a particular level or form of compensation is as important as 'how much.' The proposed new rules, much like SOX, are simply the latest reaction to the perceived failings of corporate directors. In other words ' message to compensation committees ' 'Do your jobs.'

Gary M. Brown, a member of this newsletter's Board of Editors, is the Chairman of the Corporate Department of Baker, Donelson, Bearman, Caldwell and Berkowitz, P.C., a national law firm with offices in 12 cities, including Washington, DC. Brown was former Special Counsel to the U.S. Senate Governmental Affairs Committee in its investigation of Enron. He also serves as General Counsel to the Ethics and Compliance Officer Association. He can be reached at [email protected]

With the Enron (Lay/Skilling) trial having concluded and the business community eagerly anticipating more reports recommending SOX ' 404 relief for smaller companies, executive compensation issues seem far removed, except for the occasional (or not so occasional) headline. Don't be lulled, however, into a false sense of security. Executive compensation is about to take center stage as THE latest 'corporate governance' topic.

SEC Overhaul

With some, but not overwhelming, fanfare, the SEC, on January 27, 2006, proposed the most sweeping overhaul to the requirements for executive compensation disclosure since 1992. If you've been paying attention, the reasons for the overhaul should be clear:

• The Disney directors' handling of the Michael Ovitz hiring and termination ' they ultimately weren't held liable, but they also weren't held up as a model of how to run a compensation committee.
• Orders to cease and desist from future violations of the disclosure requirements of the federal securities laws in the cases of:
• General Electric for undisclosed compensation arrangements and perquisites to former CEO Jack Welch;
• The Walt Disney Company for un-disclosed compensation and business arrangements with certain directors and their children;
• Tyson Foods, Inc. for hundreds of thousands of dollars in undisclosed perquisites and other personal benefits lavished on Don Tyson and his family members and friends, including oriental rugs, antiques, a horse, use of company-owned vacation homes and use of company-owned aircraft; and
• The directors of the New York Stock Exchange, taken to task by New York Attorney General Elliot Spitzer over the severance and pay package for Dick Grasso.

The Stage Is Set

The stage has been set ' much like Sarbanes-Oxley addressed many of the failures of independent directors who were believed to be at the heart of the some of the market failures of the turn of the millennium, the perceived inattention or outright mismanagement by directors of the executive compensation process is at the heart of the SEC's proposed executive compensation disclosure rules. Alan Beller, the former head of the SEC's division of corporate finance said as much when he discussed the practice of 'benchmarking':

Too many boards have apparently operated on the principle that compensation must be in the top half or even the top quartile of some benchmark group (the basis of selection of which is often not disclosed) for the company to be competitive in attracting talent. (This principle apparently operates without regard to whether performance is commensurate with compensation.) This approach produces what I have called the Lake Wobegon effect, where everyone is above average. Boards of directors ought to do better than this.

But Beller didn't stop there. Think about the compensation committee reports that appear in proxy statement and that have become largely 'boilerplate':

In addition to the questionable disclosure practices regarding items of compensation, I have concerns regarding compensation committee reports. Much disclosure we see in the compensation committee report is just boilerplate and is not very informative. This is the case even though the instructions to the relevant item specifically state that boilerplate should be avoided. I think that a significant number of companies and compensation committees would benefit from taking a fresh look at their compensation committee reports.

And he continued with comments about the practice of companies trying to 'pigeonhole' compensation into some exclusion to avoid disclosure:

And in my view that basic requirement to disclose all compensation takes precedence over the detailed requirements of the various tables in which disclosure is to be presented under our rules. All compensation must be disclosed. It may be time to revisit some areas of our executive compensation disclosure rules.

And so they have and over 500 comment letters have been received (many supportive). Now, companies must watch and wait. Reform is coming and here are some of the highlights:

Reform Highlights

• In place of the compensation committee report that currently is 'furnished' rather than 'filed' and, therefore, not subject to certain liabilities or other requirements, there will be a section entitled Compensation Discu-ssion and Analysis (CD&A) requiring discussion of many aspects of a company's compensation policies and practices including the role of compensation consultants and the role of executive management in the process. The CD&A will be 'filed' and, therefore, subject to certain additional liabilities and certification requirements.
• Who appears in the summary compensation table will now be based upon 'total' compensation (rather than salary and bonus as it is today) that is proposed to include the value of stock options and other stock awards using FAS 123R criteria.
• Never-before disclosed values of deferred compensation plans (previously all that was required to be disclosed was the 'above market' earnings on these plans) is virtually guaranteed to 'raise some eyebrows' and cause some compensation committee members to experience the 'Dick Grasso effect.'
• Disclosure will be required for up to three other employees whose total compensation exceeds that of the 'top five' ' those who appear in the summary compensation table.

Perk disclosure threshold will be lowered to $10,000 along with a requirement to disclose the perks with greater specificity.

New tabular disclosure (including perks) for boards of directors as well as executives.

Will the proposed rules be adopted 'as is'? No ' but, without question, they will be adopted in some form that provides greater disclosure requirements than those of today and the focus will be where there have been perceived abuses, such as undisclosed retirement compensation and perks. Accordingly, compensation committees would be well advised to begin to structure their practices to address the issues that undoubtedly will be addressed by the new rules.

What Compensation Committees Should Do

Among some of the things that compensation committees should do (if they haven't already):

• Adopt a 'tally sheet' approach to compensation if for no other reason than to avoid the 'Dick Grasso effect' and the criticisms leveled at the Disney directors that they were out of touch with the Company's compensation policies and practices. Plus, the new rules will essentially adopt a 'tally sheet' approach to disclosure.
• Consider stock ownership guidelines. These are expected to be a required discussion point in the new CD&A and there is nothing that aligns the interests of management with those of shareholders better than requiring ownership ' not just options to acquire ownership.
• Act independently from management and, to the extent necessary, engage independent advisors, such as compensation consultants. Just as SOX requires the auditors to work for and report to the audit committee, however, the compensation consultant and other advisors for the compensation committee should work for and report to the compensation committee.
• Establish a meaningful compensation policy. What are you trying to reward?
• Beware the practice of 'benchmarking.' See Alan Beller's statement above.

Compliance

And what about matters of immediate compliance concern? Even if the rules are not adopted, there are several such items.

The first relates to the current compensation committee reports. In view of Alan Beller's statements above, companies and their compensation committees would be well advised to revisit their current (as well as review the past few) compensation committee report. Important guidance for the preparation of such reports and what they should contain was set forth in Securities Act Release No. 7009 (Aug. 6, 1993). Because this is in the nature of 'guidance' from the SEC, it is a matter for immediate concern and compliance. Given some of the elements of compensation (eg, deferred compensation values) that are expected to now be disclosed under the new rules, when adopted, are the actions of your compensation committee defendable? Do their reports contain the required disclosures? When they are called to testify, will they say, 'We had no idea!'? You see, many compensation committees (and perhaps their advisors as well) have taken comfort in the fact that these reports are not 'filed' and, therefore, not subject to certain liabilities. While true, they nevertheless can form the basis for a 'Disney-like' fiduciary duty suit essentially claiming that directors were 'asleep at the switch.' Some of the numbers, when disclosed, will be eye-popping. The complaints probably are already drafted simply waiting for next year's proxy season to drop in the names of the companies and the defendant directors. I can assure you that the plaintiffs' class action lawyers are getting ready. Shouldn't you as well?

In a similar light is the SEC's position on perquisites in the proposed new rules. In addition to lowering the disclosure threshold, the SEC gave interpretive advice on what is and what is not a 'perquisite.' Because this is interpretive and perquisite disclosure currently is required, this again is a matter for immediate concern and compliance. Are items that your company currently is not classifying as a perquisite really 'integrally and directly related to the performance of the executive's duties'? The SEC emphasized that this was a 'narrow' concept. The SEC also advised companies to discard a popular method of valuing perks. Accordingly, companies and compensation committees should immediately review their policies and practices on perks. Some pundits already have suggested that the administrative burden alone of maintaining records to substantiate perk disclosure will make many companies rethink and possibly do away with perks ' in their place would be simply a higher salary or other cash compensation.

Conclusion

Although the SEC's new rules may seem like they are far, far away, they are just around the corner. In fact, because of the interpretive nature of certain aspects of the rules, they already are here and companies and their compensation committees should act accordingly. In today's environment, 'how' you get to a particular level or form of compensation is as important as 'how much.' The proposed new rules, much like SOX, are simply the latest reaction to the perceived failings of corporate directors. In other words ' message to compensation committees ' 'Do your jobs.'

Gary M. Brown, a member of this newsletter's Board of Editors, is the Chairman of the Corporate Department of Baker, Donelson, Bearman, Caldwell and Berkowitz, P.C., a national law firm with offices in 12 cities, including Washington, DC. Brown was former Special Counsel to the U.S. Senate Governmental Affairs Committee in its investigation of Enron. He also serves as General Counsel to the Ethics and Compliance Officer Association. He can be reached at [email protected]