Nowhere To Hide

When Exxon filed its definitive proxy statement with the SEC in April, the business press zoomed in on one juicy bit of data in the 129-page document: former CEO Lee Raymond's retirement package.

Various analysts added up the numbers and declared Raymond's golden parachute to be worth a colossal amount--as much as $400 million, depending on how it was counted. ABC News reported Raymond's 2005 salary alone as "equivalent to $141,000 a day, nearly $6,000 an hour," and "five times what the CEO of Chevron made."

Such reports sparked outcries of executive-pay abuse among shareholder groups, politicians and customers. Newspapers and TV news programs all over the country interviewed angry motorists at Exxon stations who accused Raymond of taking bread from their kids' mouths.

What most reporters didn't explain, however, was that Raymond had already reported much of that $400 million income in previous years. It came in the form of stock and other deferred compensation Raymond earned--justifiably or not--over the course of his 12-year tenure. And almost $183 million of that package was comprised of restricted share grants he won't be able to touch for up to 10 years.

Such subtleties, however, are lost in the cacophony of indignant outrage, which is one reason many companies are taking a close look at their executive-compensation programs lately.

"Compensation committees are much more concerned today about how they discharge their fiduciary duties," says Glenn J. Borromeo, senior counsel with Pillsbury Winthrop Shaw Pittman in San Francisco. "As a result, lawyers are now much more involved in the strategic design of compensation plans, as well as severance agreements."

Their involvement, moreover, seems certain to expand in the near future. With new SEC disclosure rules anticipated for 2007, in-house counsel are helping executives and directors understand how their compensation data will look when exposed to shareholders' and the media's magnifying glass on a regular basis.

SEC Sunshine

Exxon is hardly the first company to have its executive pay practices become a public controversy and proxy-season battleground. Other cases have drawn similarly unwelcome attention in recent years: Disney's Michael Ovitz, Coca-Cola's Doug Ivester; and the NYSE's Dick Grasso, to name a few.

The essential complaint is that compensation committees--and directors in general, for that matter--have been asleep at the switch while making decisions on executive pay, or they've been unduly influenced by executives. Either allegation is damning in the public eye, and virtually impossible to disprove.

"In this environment, the perception is almost every CEO is overpaid, and there's a lot of rubber-stamping taking place," says Jim Clary, president of MullinTBG Inc., an executive compensation and benefits consulting firm in Chicago. "Directors have been put on notice that people are paying attention."

In particular, proxy seasons can get confrontational when executives collect on long-term incentives while stock prices are suffering. For example Merck Inc. shareholders were angered last year when CEO Roy Gilmartin collected a $1.4 million bonus as the company's stock tumbled following adverse verdicts in Vioxx-liability cases.

Shareholders want to know how much executives are being paid, but more to the point they want proof that executive pay is based on reasonable performance metrics and benchmarks. Because salaries, stock options, free shares and perquisites aren't always reported in uniform or understandable ways, shareholders are frustrated in their efforts to understand compensation policies.

"A good deal of sunlight needs to be focused on the entire process by which executive compensation is determined," said SEC Chairman Christopher Cox, speaking in March to an institutional investors' group. "It's already hard enough for shareholders to exert themselves without inadequate information compounding the problem."

Specifically, starting next year, the SEC plans to implement a raft of rule changes intended to bring greater transparency to executive- and director-compensation disclosure. The changes include 14 rule amendments and three additions, appearing under five separate titles, including Regulation S-K and the Securities Exchange Act of 1934.

In general, the changes would formalize disclosure rules and standardize tabular formats for reporting various types of executive compensation; require a compensation discussion and analysis (CD&A) in certain filings (though it resisted prescribing what must be included in that CD&A); treat the CD&A narrative as a "filed" document rather than a "furnished" document; and formalize disclosure rules regarding the independence of compensation committee members and compensation counsel. Additionally, the new rules would consolidate disclosure requirements involving director independence for compensation and other corporate governance areas into a single, expanded disclosure requirement--in effect, unifying the new rule changes with existing requirements under SOX, Regulation FD and other laws.

"It was logical for the SEC to require full transparency on compensation issues," says Patrick McGurn, executive vice president and special counsel with Institutional Shareholder Services Inc. "Chairman Cox has struck a theme in telling investors the SEC will give them the information, warts and all, and it's up to them to do something about it. Executive compensation information was cloudy before, and this SEC package brings it into sharp focus."

Filed, Not Furnished

As companies have evaluated how the SEC's proposed rule change will affect them, virtually none have opposed the changes in principle. "There's a sense it's a foregone conclusion," Clary says.

However, dozens of comments were submitted to suggest refinements and alternative approaches to executive-compensation disclosures. The biggest lightning rod for criticism has been the proposal to define the CD&A narrative as a filed rather than furnished document. This raises concerns for several reasons, most obviously because it greatly increases the diligence burden for compensation committees, as well as CEOs and CFOs, in explaining compensation policies.

"It's a liability concern," says Troy Calkins, a partner at Gardner Carton & Douglas in Chicago. "Having the CD&A filed rather than furnished dramatically raises its risk profile."

Part of the issue involves SOX's management-certification requirements. The new rules would require companies to reference the CD&A in their 10k annual statement, the accuracy of which CEOs and CFOs must certify under SOX. This creates a diligence burden that executives might find difficult to carry.

"A lot of the CD&A involves the compensation committee's thinking in setting the CEO's pay," Calkins says. "Asking the CEO to certify that seems a little circular to some people."

Similarly, for companies floating new stock in public markets, a filed CD&A might trigger the requirement for outside auditors to analyze the numbers and validate them as they do for all figures included in a prospectus. "How do auditors give comfort on compensation numbers, performance metrics and peer-group benchmarks?" Calkins asks.

Companies are also critical of the SEC's prescribed tabular formats for reporting annual compensation figures. Namely, companies may have to include some types of compensation in more than one table, leading to inaccurate analysis. "There's concern the type of tables they are using will cause confusion," Clary says. "A lot of information could get double counted."

Additionally, tabular reporting might encourage analysts to compare annual compensation figures to stock-price performance over the same period. "Most compensation is not tied to a one-year change in stock price," says Michael Kesner, principal in charge of the executive compensation practice at Deloitte Consulting in Chicago. "Focusing on one year's worth of results is very dangerous. You run the risk of incentivizing bad behavior."

Additionally, the revised reporting requirements may impose inconsistent burdens on certain industries. Banking institutions, for example, are worried that greater disclosures of related-party transactions will discourage some prospective board members from serving for fear of broadcasting their family members' bank-account totals. And the rule that requires disclosure of compensation totals for the highest paid employees elicited fears of poaching.

"While non-executive employees will not be identified by name, it will be easy to discern who they are based on the position descriptions," commented Henry H. Hopkins, chief legal counsel for investment firm T. Rowe Price. "This will make it easier for competitors to target and hire away our top-performing investment professionals."

In general the changes have been met with enthusiasm among investors and resignation among corporate filers.

"A lot of people say it's a damn nuisance, and I'm sure it is if you are set in your ways," says Pearl Meyer, senior managing director with executive-compensation consultancy Steven Hall & Partners. "But many of our companies are looking at it as an opportunity. It really is a healthy, challenging environment."

Avoiding 'Holy Cows'

The prospect of rule changes has spurred many companies to take a close look at their executive compensation policies. Compensation committees that don't already retain outside counsel on compensation programs likely will do so now--both to ensure they are in full compliance with the new rules, and to help them anticipate how their policies and numbers will appear under the new regime.

"Companies are thinking about it today to get an idea of how they will look," Clary says. "This will lead toward rethinking of plans in light of that scrutiny."

Most companies will not make any major changes this year, but will wait until the new rules take effect. But in some cases, compensation committees might want to make adjustments to avert embarrassing disclosures.

"Boards will be surprised how these 'wealth-accumulation' tables are going to look," Kesner says. "When you add salary together with outstanding equity and the net-present value of benefits, that's quite a number. But people will discover there's nothing you can do for the rest of this year to minimize the effect of that disclosure. All the details will become public."

However, some companies may adjust their practices now in anticipation of closer scrutiny in the future. "Personal use of the corporate aircraft is getting a lot of attention," Kesner says. "Proposed IRS rule changes will eliminate favorable tax treatment, which will increase company costs."

Perks in general are drawing increased attention, and the SEC rule changes will only intensify that attention.

"In past years, compensation was treated separately from benefits and perquisites, and you never added the two," Meyer says. "That's why we are seeing 'holy cow' reactions now, when the costs of benefits and perks are added to compensation, particularly in post-retirement benefits. Now we are telling the compensation committee that we need to add it all up."

The GCs' Responsibilities

In practical terms, this means in-house counsel need to engage with compensation committees and consultants to identify all the perks and benefits that will be tallied up with compensation figures. But it also means compensation committees should begin evaluating how those perks will appear in disclosures, and whether they are justified as part of the overall compensation package. Compensation committees might decide to eliminate some benefits or handle them differently to avoid a laundry list of apparent largesse appearing in the newspapers.

"When all the details are known, boards will be embarrassed to disclose a lot of practices, and will make those things go away," Kesner says. "Why are companies paying for financial-planning services? It's easy enough to load those costs into the salary if that's what they want to do."

In the longer term, the new disclosure rules will focus greater attention on some esoteric aspects of executive compensation that have yielded embarrassing lottery-size payouts. Under the new rules investors will have an easier way to scrutinize the appropriateness of generous severance policies and change-of-control payouts, in particular.

"Giving a CEO $4 million to $8 million a year for life is how you get to $180 million on a net-present value basis," Kesner says. "Crediting deferred compensation with above-market rates is another area that compensation committees will be reining in. Companies know they can't defend some of this stuff, so they will strip it away."

Additionally, companies are facing greater pressure to ensure compensation is based on performance, rather than cronyism or caprice, and that compensation policies create appropriate incentives.

"You need balanced incentives that consider where the company is at a given time, and where executives are in their careers," McGurn says. "There should be a balanced diet, with some near-term and some long-term incentives."

How to craft that diet will depend on a variety of factors, including the company's market position and the talents an executive brings to the organization. Compensation committees must apply their judgment to make these decisions. And given the SEC's pending rules, they should do so with the knowledge that their judgments will be scrutinized by shareholders.

"Each organization has to find its own way in determining what is right for the company and stockholders," Meyer says. "You may be paying a little or a lot, but what are the performance metrics and objectives? Are they focused on revenue, profit margins, market share? We pay directors to exercise that kind of judgment, and they have to stand up in the glare of the spotlight and feel comfortable with what they have done."

What the IRS Wants

The SEC is not the only federal agency focusing on executive compensation lately.

"We're seeing a significant increase in employment-tax audits and executive compensation audits by the IRS," says Marianna Dyson, a member with Miller & Chevalier in Washington, D.C. "There's a real convergence between congressional directives, new statutes and regulatory activity."

Increased attention from the IRS has, in part, resulted from its implementation of the American Jobs Creation Act (AJCA) of 2004, which includes tax-policy changes affecting executives' and directors' deferred compensation plans and their personal use of company assets, most notably aircraft.

Specifically, the IRS created Section 409A, of the Internal Revenue Code, which created new rules, restrictions and enforcement penalties affecting how companies report deferred compensation.

The same law also changed the rules regarding deductions the company may take for expenses incurred for the personal benefit of a company officer or director. Under the new rule, the company can only deduct the portion of expenses it treats as compensation. In other words, if an executive uses the corporate jet for a vacation getaway, and the fair-market value of that flight was $1,000, the company can claim only a $1,000 expense deduction.

Coke Gets Transparent

The Coca-Cola Co. has been at the center of the executive pay battle for years. In 2000 when Douglas Ivester, former chairman and CEO, left Coke after just three years at the helm, shareholders were dismayed to learn his severance benefits totaled nearly $120 millon, including a laundry list of perks.

As a result, shareholder dissent has been growing at Coca-Cola, culminating in 2004 in a proxy fight against members of the company's compensation committee.

Since then, Coke has taken major steps to revamp its compensation programs. It adopted a shareholder resolution that gives shareholders the power to approve or reject future severance agreements, and created a new compensation program that firmly ties directors' pay to Coke's earnings-per-share performance-similar to the way the company coompensates executives.

In these respects, Coca-Cola is among a small group of companies responding to shareholder pressure by making fundamental changes to compensation policies. In General Electric's recent proxy statement, CEO Jeff Immelt asked that the company change its compensation program so his bonus will be paid in restricted shares accessible only under certain conditions. For Immelt to collect half of his bonus, GE's cash flow from operations must increase by 10 percent each year for the next two years, and he won't get the other half unless GE's stock outperforms the S&P 500 Index during that time.

Other companies, such as Pfizer, Applied Materials and Hewlett-Packard, have applied some of the SEC's proposed disclosure requirements in their 2006 proxy statements. How their shareholders respond this proxy season might serve as an early indicator of whether the pending changes will soothe irate shareholders, or whether the disclosures will just spark more outrage over executive pay.

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Editor-at-Large

Michael T. Burr

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