Executive Compensation

Lavish severance packages, lack of disclosures about perquisites and tax gross-ups, "backdating" stock options - all can raise questions about executive pay.

2005 was an epic year for fallen CEOs, including some ousted by the very boards they headed. Their fates and their severance packages caught the public's eye, and the resulting publicity may trigger questions at annual meetings. At the same time, investors became increasingly concerned about poor compensation practices, "backdating" stock options, clawbacks, and disclosure practices, especially regarding the parts of executive pay that are hidden from proxy statements and public reporting.

Severance Packages

Severance packages for senior management were very much in the spotlight again during 2005. These payouts can seem lavish compared with what others earn, even though boards must make competitive offers to attract talented executives. This is not a new issue, but it has been exacerbated due to the changing legal landscape and growing demands for accountability of boards. This environment has created so much uncertainty that directors may feel pressured into making changes at the top to avoid allegations of corporate malfeasance and boardroom acquiescence.

One important development this past year was the ruling by a Delaware court that the Disney board would not be held liable for approving a severance package for the company's former president. But this ruling sends a mixed message because of the tone set by the judge when he agreed the case could go to trial.

In effect, by allowing the case to go to trial, the judge said that directors could be held personally liable for making a bad compensation decision, even if they do not benefit personally from the decision. As a result, the key measure of directors' culpability today appears to be one of failing to act in good faith and live up to their fiduciary responsibilities.

In response to these developments, shareholders may question whether the board is considering any actions to limit excessive severance packages. Possible steps include the following:

• Directors may incorporate into employment contracts for CEOs reasons why the executives can be terminated without severance pay. Such reasons may include indictments for certain felonies (a lower standard than convictions) and refusal to provide testimony or cooperate with an investigation.
• Companies may voluntarily elect to seek shareholder approval for certain severance agreements. For example, Coca-Cola is one of several companies that have agreed to seek approval if the payout exceeds 2.99 times the sum of the executive's annual base salary and bonus. The 2.99 multiple has been suggested in shareholder resolutions. It falls just short of the maximum tax-deductible severance package in a merger or acquisition. For simplicity, companies may use the same maximum for all severance packages.
• In extreme circumstances, CEOs may take the initiative by accepting a position without a contract, or even voluntarily giving up pay. For example, one CEO reportedly gave up agreed-upon pay after the news of his employment contract and the severance pay for the departing management team were released at the same time, resulting in a public relations challenge.

Poor Compensation Practices

Several institutional investors have developed voting policies based on well-defined lists of "poor compensation practices." In effect, these policies allow investors to discourage compensation practices by withholding votes from compensation committee members who approve those practices.

Near the tops of the emerging lists of poor compensation practices are tax gross-ups. These payments may be considered a form of "disguised compensation" because they don't require separate disclosure in proxy statements.

Typically, payments for tax gross-ups are made to executives to cover personal income taxes on base pay or perquisites that are treated as income by the Internal Revenue Service. The payments may also consist of excise tax gross-ups on "golden parachute" payments for executives who lose their jobs in mergers.

Typically, payments for tax gross-ups are made to executives to cover personal income taxes on base pay or perquisites that are treated as income by the Internal Revenue Service. The payments may also consist of excise tax gross-ups on "golden parachute" payments for executives who lose their jobs in mergers.

The list of poor compensation practices prepared by ISS also includes the following:

• Excessive perks that dominate compensation.
• Significant bonus payouts without justifiable performance linkage.
• Performance metrics that are changed during the performance period.
• Overly generous Supplemental Executive Retirement Plans (SERPs).
• Overly generous new hire package for a new CEO.
• Internal pay disparity.

ISS adds that poor disclosure, the absence or non-transparency of disclosure, and poor design of compensation payouts compound the problems of egregious pay practices.

"Backdating" Stock Options

Stock options have traditionally been an area of concern to shareholders. This year, investors are especially concerned about stock option awards due to SEC investigations into an alleged practice known as "backdating." The allegation is that some companies granted options on one date but used hindsight to choose an earlier date with a lower stock price as the stated grant date.

The SEC's investigations were precipitated by academic research that examined thousands of companies and found a few with odd patterns of stock movement around the dates of grants. Those companies showed recurring patterns of option grants dated just before a rise in the stock price. The likelihood of such recurring patterns occurring by chance or luck is probably negligible.

The implications of these studies are of concern to shareholders because they indicate that boards of directors might have allowed the backdating of grants, either deliberately or inadvertently.

One way to address concerns about the potential for backdating is for the compensation committee to make it a policy that all grants are awarded at the same times each year.

Disclosure Practices

Some companies continue to voluntarily improve disclosures about executive pay in response to shareholder questions and a rule-making initiative underway at the SEC.

The SEC has released proposed rules that, if adopted, would require companies to provide better disclosures about the various elements of executive pay. For example, more disclosures would be required about retirement and post-employment benefits including SERPs, deferred compensation arrangements including all of the interest paid on executives' accounts, and executive perquisites including dividends paid on restricted stock.

The proposed rules would also require a new "compensation discussion and analysis" report to be included with proxy statements. This report would replace the current compensation committee report and would provide more disclosures about how pay for senior executives is determined, especially under pay-for-performance plans. The details might include the identity of any outside consultants hired and the specific performance metric used, for example, earnings per share.

An important difference between the current compensation committee report and the proposed new report is that the former is "furnished" while the latter would be "filed." That increases a company's liability for misleading statements. In addition, CEOs and CFOs would certify that the statements are true.

The proposed rules would also require a total compensation table that would include all forms of compensation for the highest-ranking executives. This table would, for the first time, require companies to report a dollar value for stock options side by side with salary, bonus, restricted stock and other forms of compensation, so investors can quickly and easily grasp the big picture of how much top-ranking executives are paid.

The SEC's rules are proposed, not final, and changes are still possible. But the proposed rules are already prompting companies to enhance disclosures, and institutional investors are using the proposed rules as a basis for drafting minimum disclosure policies for the 2007 proxy season.

"Clawbacks" of Bonuses

A final issue that may be of interest to shareholders following a year of record restatements is the possibility of paybacks (also known as clawbacks) of bonuses paid to CEOs and CFOs based on performance targets met in financial statements that were subsequently restated for noncompliance with financial reporting requirements These paybacks are required under Section 304 of the Sarbanes-Oxley Act.

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