Sense and Recompense: Executive Compensation in the Crossfire

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Even in the best of times, people maintain a certain smoldering indignation over how, and how much, senior corporate executives are paid. But as long as markets rise, most folks are content merely to grumble about it, the way they do about baseball salaries or the price of gas.

Factor in a full-blown economic collapse, however, replete with tales of multimillion-dollar bonuses paid to executives even as their companies bummed billions off taxpayers, and that simmering rage blossoms into the kind of apoplexy that moves legislators and regulators to action.

"People stood up and said, 'Dammit, I've had enough,'" says Mike Conover, senior director of the compensation consulting practice at BDO Seidman. "That has precipitated a reaction in Washington, D.C. The Treasury Department, Congress, everybody jumped on board to say, 'We're going to stop these greedy SOBs from this kind of raping and pillaging.'"

That focus has made compensation issues more complex and inherently legalistic than ever, drawing in-house counsel deeper and deeper into an area that used to be the province of HR directors.

Whether tracking the pending Say-on-Pay legislation, complying with new SEC reporting requirements, revising governance and risk assessment practices, or even bracing for shareholder litigation, general counsel are getting involved in compensation issues like never before. And let's not forget, as corporate officers, they have a horse in this race themselves.

The exasperation with executive pay is not merely a question of excess--although the exponential growth of CEO pay relative to average employee paychecks in recent decades is frequently cited. For shareholders and regulators alike the more pressing concern is the relationship of compensation to risk and performance. That places the issue squarely in the general counsel's jurisdiction, especially for those who are also the corporate secretary.

"The issue of how risk is managed and explained in the company is an area where the corporate counsel can really help," says Charles Tharp, executive vice president of policy at the Center on Executive Compensation, an arm of the HR Policy Association. "They have a role in managing the board meetings where risk is discussed, in the interaction of the different committees, especially the audit committee and the comp committee, and in making sure from a process point of view that there's a good understanding of the risk associated with business plans, and then relating that to the incentive plans."

In-house counsel also must make sure their companies are in compliance with fast-evolving and often murky laws and regulations governing compensation. Disclosure requirements are expanding, but exactly what to disclose and how to render it remains a matter of some interpretation.

"General counsel certainly have become acutely aware of all the new reporting that's required," Conover says. "For that reason alone, anything that goes on now in terms of the compensation committee is immediately in their purview. It's become a big deal."

Whac-a-mole

Amid the sprawling legislative response to the economic crisis, lawmakers have introduced several bills that would give shareholders greater input on the size and structure of compensation packages. Most notably, bills launched by Rep. Barney Frank, D-Mass., and Sen. Chuck Schumer, D-N.Y., and draft legislation from Sen. Chris Dodd, D-Conn., seek sweeping if nebulous reform to compensation practices.

The proposed laws address a host of compensation-related issues, from the way board members are appointed, to the way compensation committees are structured and vetted, to, most controversially, the ability of shareholders to vote on pay schemes--so-called Say-on-Pay provisions. The Frank bill is furthest along, having passed the House in July, but the final form of any legislation remains to be seen.

"The story on the legislative front is that nothing final has happened yet," says David Lynn, co-chair of the public companies practice at Morrison Foerster. "Back in April, I would've thought it was pretty highly likely that Say-on-Pay legislation would be in place this coming proxy season, but it isn't. Nonetheless, people are getting ready for it."

The trouble with compensation legislation is achieving the intended result. When Congress attempted to rein in CEO pay in the mid-1990s by capping at $1 million the salary companies could deduct as a business expense, the effect was widespread raises to $1 million and the rapid proliferation of stock options as compensation. Legislators may be taking their time in an attempt to avoid a similar outcome, but there are no guarantees.

"Legislating executive compensation is like playing Whac-A-Mole--you think you're fixing a problem here, but it pops up over there," says David Chun, CEO of Equilar, a firm that aggregates publicly available compensation data. "There are a lot of smart people out there whose job is to design plans that can work within certain constructs."

Some feel that Say-on-Pay as proposed wouldn't have much impact at all, intended or otherwise. The provisions are most likely to pass in a nonbinding form--shareholders would have the right to have their say, but boards would not be obliged to act on their input. Moreover, there's no consensus on the type of information companies would have to submit for consideration--whether actual details of pay packages or merely the company's general compensation philosophy.

Proponents hope the process itself would engender some form of moral persuasion, but to critics that seems unlikely.

"Say-on-Pay might get through, but it's a big joke," says Bud Crystal, the longtime compensation guru and founder of the Crystal Report blog. "It's what's called precatory--from the Latin meaning to beg, to pray. And it's a prayer that the board will do something about it. The board can just ignore it. It's not binding. Why the corporate governance priests and priestesses thought this was a burning issue, I don't know."

Risky behavior

More certain is the impact of regulatory revisions by the SEC. Since 2006, companies have been required to include a detailed Compensation Disclosure & Analysis (CD&A) in their annual proxy statements. Experts say the SEC intends to finalize new, more exacting requirements before proxy season.

"The rule changes talk about companies having to disclose more about the relationship between compensation and risk, and not just for the most senior executives, but also for the company as a whole," says Lynn, who previously was general counsel of the corporate finance division at the SEC. "This will be a big change."

The rule changes are intended to root out compensation packages that reward executives and even lower-level employees for high-risk decisions at the expense of the long-term stability of the company. Packages that rely too heavily on stock options, post-employment compensation and some types of bonuses, for example, may lead to actions that have more upside for the employee than the shareholder.

During the comment phase, many companies questioned just how refined the disclosure need be, and even how it should be formatted.

"Ever since CD&A came out, the SEC has opted for what they call this principles-based disclosure; i.e., 'I'm going to tell you what I want to know, and then it's up to you to figure out how to tell me," Conover says. "If you don't answer the question, they write you right back and say, 'You didn't answer it, so answer it.' They're insistent that you have to be forthcoming."

Companies that received TARP funds are already bound by legislation requiring such a compensation/risk assessment, so there are some benchmarks in the financial sector. But risk assessment in, say, manufacturing, retail or tech firms is a far cry from that in investment banks. Mainline companies may struggle, at least initially, with how to comply with any new reporting requirements.

"By and large for nonfinancial companies, it's going to be a bigger challenge," Lynn says, "because for them it's less clear exactly what sort of risks the SEC is talking about and how the compensation that people get affects the risk profile."

Tell your story

Governance issues are also in flux as companies await new legislation and regulations. The Schumer and Frank bills, as well as Dodd's proposed legislation, all recommend changes to the way boards are structured and the role and independence of the compensation committee.

"There are even proposals around the appropriate structure of the combination of the CEO and the chairman of the board roles," Tharp says. "There are proposals to establish risk committees, and to make sure there are more rigorous standards for qualifications of board members and committee members. These are all right in the sweet spot for in-house counsel, in terms of helping the board craft the appropriate guidelines around qualifications."

Under particular scrutiny is the role of outside compensation advisers. Although consulting with one is already a best practice, new rules may mandate that compensation consultants be hired and paid by the board and strictly prohibited from doing other work for the company.

"[At] issue is the question: Is there transparency through disclosure, and does the board get unbiased information to help them set pay?" Tharp says.

That of course feeds back to proxy statements and the ultimate connection of pay to performance for shareholders.

"What's been absent from CD&As, which will now be at a premium, is a way to tell the company's story around pay, rather than just filling out the tables and putting in what sometimes reads like boilerplate," Tharp says. "That's an area where in-house counsel really need to stand up and work with the PR department, work with the head of HR and do a much better job of being really clear on telling the compensation story."

Companies have historically fought the disclosure of their performance target metrics and incentive plans, but given the new regulatory climate, such revelations may be in their best interest. In fact, since the inception of CD&A reporting, Equilar has tracked a significant increase in the disclosure of performance metrics.

"When we looked at this in 2006, just more than half of the Fortune 100 included actual targets in their CD&As," Chun says. "Now that number is up to about three-quarters. But the bottom line is that there's a pretty wide gamut on the quality of the information. Some companies do a much better job than others when it comes to making the data coherent and easy to digest."

Experts suggest including clear charts that explain the metrics used and plot performance against growth and goals. Institutional investors appreciate charts and tables, and a clear graphical representation of data shows regulators the company is proud to demonstrate the connection between compensation and risk, not trying to obscure it. Such an approach will keep a company in the clear--assuming there are no pay-related skeletons in the closet--regardless of how laws and regulations ultimately shake out.

"It really is all about communication, so why not get out in front of it now?" says Steve Barth, a partner at Foley & Lardner. "You need to be talking to your key institutional holders, talking to the proxy advisory firms, getting their perspectives. You need to know what's going on with your peer group. You need to be doing all of that work up front. You need a very knowledgeable comp committee that's supported by a very knowledgeable HR and general counsel so that all of those pros and cons can be taken into account when you're making your executive compensation decisions."

Contributing Author

Steven Andersen

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