Salary Clampdown

When the SEC voted to overhaul its executive compensation disclosure regulations last year, commission officials assured businesses the new rules were not meant to serve as a corporate salary cap.

"The SEC is not in the business of setting compensation, and we will not interfere in the free market for salaries," Commissioner Roel C. Campos told attendees at a January summit on executive compensation in New York. "Rather, our goal is to make executive compensation as transparent as possible, so that shareholders fully understand what executives are being paid."

But it's questionable whether institutional shareholders got that message.

Over the past year, shareholder activism on executive pay was a contributing factor to CEO ousters at Pfizer, Sovereign Bank and--most famously--Home Depot. And investors have recently demanded a vote on executive pay packages at Citigroup, Wells Fargo and WellPoint.

As public companies file their first proxy statements under the new disclosure rules this spring--giving shareholders an unprecedented volume of information about pay packages to mull over--many experts are predicting that investor activism on executive compensation will come into full bloom.

"There is an increased risk of shareholder litigation under the new rules," says Mark Poerio, partner at Paul Hastings. "In many cases companies are now disclosing four times more information than they have in the past, and shareholders are not shy about questioning items that seem out of line."

Lawsuit Triggers

The first thing that shareholders will be looking at on 2007 proxy statements is the "total compensation" figure that companies now must disclose for each of their five highest-paid executives. Along with that, shareholders will be paying close attention to previously undisclosed forms of compensation such as pensions, severance agreements, deferred compensation and perks. Some experts are predicting that shareholders will get an unpleasant surprise when they see these numbers for the first time and will try to curb compensation they deem excessive through proxy votes or derivative actions.

"These forms of 'stealth compensation' were never fully disclosed in the past," says Patrick McGurn, executive vice president and special counsel for Institutional Shareholder Services (ISS). "We're likely to see actions driven by some of the eye-popping numbers in these categories."

Particularly annoying to shareholders are perks such as reimbursement for tax planning services and severance arrangements that entitle executives to collect millions of dollars on their way out the door.

To avoid having to disclose unpopular perks, some companies are eliminating them in favor of a boost to executives' base salary or bonus. But bonuses too are drawing increased scrutiny under the new rules. Investors are fighting back against bonuses that are not clearly tied to explicit performance goals.

"You should disclose a specific target," says James DiBernardo, a partner at Morgan Lewis. "Saying a bonus is 'tied to earnings-per-share' is not enough."

Reasoned Decisions

Just as important as the "how much" of executive compensation will be the "how" of boards' decision-making process for determining compensation.

Under the new rules, companies' 10-K filings now must include a narrative "compensation discussion and analysis" section that describes the underlying philosophy and goals of the board's compensation plans. Unsatisfactory explanations for generous pay packages are coming under fire.

"Berkshire Hathaway discloses that its compensation practices are purely discretionary," Poerio points out. "But the only reason they can do that is because they're very conservative with their pay. By and large, shareholders are looking for data and company-to-company comparisons that make sense."

Another wrinkle in the discussion and analysis requirement is that the new rules make this a "filed," rather than "furnished" document--meaning the CEO and CFO must certify its accuracy.

"A material omission or misstatement in that document would be grounds for liability," DiBernardo says. "There's always a risk that a company didn't put in every detail that the shareholders want to know about."

Furthermore, shareholders are using this document to challenge methods of determining executive pay that they don't like. For instance, a group of institutional investors, including state governments and union pension funds, sent letters to the boards of 25 large companies in February, asking them to disclose their overlapping entanglements with the consultants they use to help them set executive pay. They raised concerns that consultants will recommend excessive compensation in exchange for assurances that the executives will later steer lucrative consulting work their way.

"Where you have a generous pay out to an executive being recommended by a consultant who's also doing all kinds of other business with the company, that gives rise to questions," McGurn says. "And it will be rich fodder for litigation."

Almost immediately upon the receipt of the letter, Morgan Stanley announced it had dropped Hewitt Associates as the company's pay consultant. ExxonMobil and GE agreed to disclose what other services they buy from their pay consultants. Other companies have implemented written policies requiring directors to use independent pay consultants.

Having A Say

As if the SEC rule changes and ever-intensifying shareholder scrutiny of executive pay weren't putting enough pressure on corporate boards' compensation committees, Massachusetts Rep. Barney Frank proposed legislation in March that would add one more layer to shareholders' ability to influence pay packages. His so-called "Say-on-Pay" law would give shareholders a non-binding advisory vote on public companies' executive pay plans.

The House Financial Services Committee, of which Frank is the chair, approved the measure March 29. While on paper the bill would not give shareholders the right to override the board's judgments, many believe that the likely effect of the legislation would be just that.

"If the Frank bill goes through, there's going to be a lot more communication from boards to shareholders," DiBernardo says. "I think it would make it very hard for compensation committee members to retain their seats."

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