Into the Eye of the Hurricane - Rethinking Executive Pay Going Forward - 1 Oct 2009

COMPENSATION IN
CONTEXT

October 1, 2009

Into the Eye of the Hurricane -
Rethinking Executive Pay Going Forward

Shareholder
outcry, undesired media attention, Congressional
hearings, as well as legislative, regulatory and accounting initiatives
have rendered many executive pay practices impractical or obsolete -
and have
set the stage for significant changes and opportunities in the year
ahead.

Pay-for-performance
has long been the “sine qua non” of
executive compensation programs - yet one of the biggest issues facing
companies today remains how to best structure incentive awards to
foster
truly meaningful results and drive shareholder value over the long-term.

For
the remainder of 2009 and into 2010, the white-hot debate over
executive
pay will continue to be colored by the degree of influence on
compensation decision-making exerted on Boards of Directors and senior
executives by
outside interests, from institutional watchdogs and activist investors,
to governance gurus and the media - very often with wildly conflicting
priorities.

Supporters of better corporate governance generally agree that executive
compensation payouts should be based on sustainable shareholder gains, with payments that are based on the achievement of success, and
proportionate to the availability of company resources.

It’s
no secret - unfortunately, institutional shareholders and the
media seem to favor CEOs who are focused on driving quarterly earnings
results, rather than investing in what's needed to ensure long-term
gains. This
can sometimes have disastrous results.

With
the implosion the diversified financials that have rippled through all
industry sectors, corporate meltdowns have ushered in a long string of
corporate scandals. As always, the established pillars of executive pay
programs are called into question. Subsequent legislative, regulatory
and accounting initiatives have rendered some past executive pay
practices
ineffective, impractical or flat-out obsolete, creating a demoralized
workforce and, as well, a significant drain on company resources as
programs are
redesigned  and often stifling compliance-related protocols are
implemented.

At
the same time, control over executive compensation is shifting to
Compensation Committees, whose directors who are justifiably acting as
independent and more assertive shareholder guardians. Rather than take
their
lead from senior management, board members increasingly are seeking
detailed information from independent counsel like Veritas in order to
better
understand and analyze complex issues themselves, so they are prepared
to defend their decisions in the public arena, if necessary. However,
if candid
and effective executive pay communication between the Board of
Directors and senior management does not take place, it can have
disastrous results as
well.

For
the remainder of 2009 and into the foreseeable future, the main focus
of
attention will continue to be choice and design of performance-based
long-term incentive plans. Stock-option awards surged during the 1990s
market
boom, fueling steep gains in executive pay levels, but also creating
high levels of share dilution and, after implementation of FAS 123R,
significant
real impact on earnings. The recent decline of the stock market,
combined with earnings impact from option expensing, has really
curtailed old
fashioned time-vested stock option and restricted stock grant and
participation levels, and has created keen interest in
performance-based long-term
incentives such as performance accelerated stock options (PASOs),
performance contingent restricted shares (PCRS), as well as cash-based
long-term
incentives like performance shares and performance units.

Both
thoughtful plan design, as well as moderation in grant and
participation
levels will be the key to avoiding stock option plan nightmares.
Options will certainly continue to serve as a vital element in
executive compensation
programs; however, their significant focus on short-term stock price
movement and the vagaries of capital markets in general can be
mitigated and
balanced by performance-based long-term incentive plan designs that
utilize multiple vehicles that incorporate operational and financial
targets other
than stock price.

Let's look in more detail at key 2009 - 2010 executive pay
trends.

TUNING UP PERFORMANCE-BASED LONG-TERM INCENTIVES AND TUNING DOWN STOCK
OPTIONS

Companies
have continued to tune down their use of stock options, driven by
the need to minimize the often significant financial impact of option
expensing and equity dilution. There is also the very real need to
better align
executive compensation with sustained growth in shareholder value.

The
most common approach to the options issue is reduction of option
grants, elimination of broad-based plans, amendment or elimination of
employee stock purchase plans, and/or adjustment of the vesting period
or other
terms of existing plans. While stock options should, and will remain a
key element of executive compensation, the multi-million
dollar “mega-grants” that fueled the biggest executive pay packages in
recent history will continue to
dwindle.

In
place of stock options, companies are tuning up the use of
performance-based
restricted stock and restricted stock units (RSUs), as well as
cash-based performance shares and performance units. With pure
time-vested awards
widely criticized by shareholders and governance watchdogs as “equity
giveaways”, well designed long-term incentive (LTI) plans are
based on meeting tangible, clearly defined, and measurable financial
and/or operational goals that are ultimately linked to boosting overall
corporate
performance - rather than just share price alone. The new accounting
rules support this new trend, permitting companies considerable
creativity and
flexibility and in combining the use of different LTI vehicles,
including cash-based alternatives such as stock appreciation rights
(SARs) that pay
out the difference between the strike price and the fair market value
of the underlying shares. Even better, the optics of these
performance-based
plans look great to the very public eyes of shareholders and the
media. We still have to be thoughtful though, and need to take into
account the
reduced risk of full-value plans such as restricted stock, as compared
to stock options or other LTI vehicles, and need to carefully consider
the
standards and methodologies used by different institutional shareholder
and governance ratings services when assessing new LTI
plans.

Some
companies, particularly start-ups, pre-IPO, and other high-growth
companies, continue to conclude that the usefulness of stock options in
attracting, retaining and motivating essential talent is worth
swallowing the charge to earnings. Other companies use the advent of
option expensing as the rationale for continuing to curtail or
eliminate
stock option participation, particularly among lower level employees.
Either way, companies should ensure that, in analyzing the impact of
accounting
considerations and investor pressures, business and human resource
considerations do not take a back seat.

As
companies focus LTI plans on nuts-and-bolts business fundamentals that
drive
sustained growth rather than just market performance, short-term
(annual) incentive (STI) plans are assuming a much more prominent role.
Revised STI
metrics reward executives for meeting specific tactical
(quarter-by-quarter) targets, such as business unit or departmental
performance goals that
represent milestones that are key to the achievement of multi-year
strategic goals.

For
example, a performance-based long-term incentive plan pegged to
three-year
return on invested capital might be supported by an annual plan with
related goals such as increasing revenue, lowering expenses,
restructuring debt
or developing new business opportunities.

Opportunities
and leverage in both STI and LTI plans are also being customized
to an organization's business strategy and financial situation. For
instance, rather than adopting the traditional "80/120" leverage
design, payout
thresholds might be lowered when budgets are "stretched" and difficult,
or raised when performance is more certain. Likewise, some companies
have
chosen to increase upside opportunities to make rewards for incremental
performance more meaningful.

BOARD USE OF ENHANCED EXECUTIVE PAY DISCLOSURE

For
many corporate boards, a key priority is avoiding “sticker
shock” by addressing the real cost of top talent. As many compensation
committees have discovered, it is easy to lose track of the big picture
when individual elements of complex compensation packages are assessed
on a piecemeal basis. Historically, data provided to boards rarely
captured the
accrued and projected values of all current and future financial
obligations to top executives like they do with today’s SEC required
tally
sheets and the corresponding compensation discussion and analysis
(CD&A).

To
avoid being caught red-faced, as many public company boards have been
in
recent executive pay scandals, compensation committees have been keenly
employing tally sheets as a primary means of tracking total
compensation
costs. Tally sheets are the detailed snapshot of all received, owed and
contingent compensation and benefits under multiple potential
scenarios, such
as change-in-control and termination, as well as the accrued value of
sometimes-overlooked long-term components such as deferred
compensation,
perquisites, post-service benefits and supplemental executive
retirement plans. The CD&A then goes on to explain in-depth and
(hopefully)
“plain english” the “how" and "why” of executive pay.

RETHINKING EXECUTIVE PAY BENCHMARKING

Companies
are really rethinking the concept of what is really "reasonable"
and "competitive" with regard to executive compensation programs.
Boards are actively considering whether historically accepted
benchmarking practices
really suit the often unique needs of their own companies, and whether
other common tools of analysis, such as the non-regressed use of proxy
data and
published compensation surveys, are sufficiently rigorous. Special
focus should be given to industry sector analysis as well. Lastly,
given the
significant decline in the economy over the past year or so, it's
important to focus on what future projected company size and
performance will be,
setting pay levels appropriately, rather than looking back at what pay
levels were in the past.

Companies
are taking a fresh look at the "peer companies" against which their
executive-compensation targets are set, asking whether they provide a
truly suitable match by industry, size, financial performance and other
factors.
These "compensation peers" are often unique, and not always the SEC
registered peer group that the company is compared to in its proxy
statement.
Additionally, boards are paying far more attention to “relative
performance positioning” - ensuring that above-average pay is
provided only for exceptional results.

CLAWBACKS WITH SHARP TALONS

Repayment
of bonuses or other compensation provided to current
or departed executives under questionable financial circumstances is
another area getting white-hot attention. While there are no
“money-back” guarantees with management, investors are making a strong
push for boards to seek disgorgement of awards found to have been
paid on the basis of subsequently questioned financial results, or
provided to former executives who violate restrictive covenants in
their contracts.
This goes far deeper than Sarbanes-Oxley Section 304 that specifically
calls upon companies to seek repayment from CEOs and CFOs for
compensation paid
on the basis of incorrect numbers.

Shareholders
are pushing boards to implement their own clawback policies, which
often cover employees besides the CEO and CFO, and to then enforce them
themselves. The new enhanced executive pay disclosure rules, which
explicitly
ask boards to reveal whether or not such a program is in place, along
with UnitedHealth Group's landmark clawback of roughly $900 million in
pay from
former executives involved in the company's option backdating scandal,
are bound to further accelerate adoption of clawbacks by
companies.

Right now clawbacks are on every compensation committee's radar, and they
understand that these policies give them the discretion to do what they need to do to protect shareholders.

The
most common trigger for clawback policies is financial restatements
and/or
ethical misconduct or negligence. The more prevalent these policies
become, the easier it is for boards to make the case that they need to
adopt their
own.

Precisely
how such clawback policies are implemented varies from company to
company, however all are “putting it into writing”, with some choosing
to work clawback language into the company's incentive-plan
programs, while others are putting them directly into employment
agreements.

For
example, Intel adopted a corporate policy as part of its incentive plan
seeking the return from executive officers of cash incentive payments
and stock sale gains if they had been inflated due to financial results
that
later had to be restated. In comparison, part of American Express’
clawback policy requires that roughly 575 executives, including named
executive officers, sign an agreement requiring them to return
compensation if they “engage in conduct,” such as working for a
competitor, deemed detrimental to the company after leaving the
financial services firm – AmEx did just that, using the “detrimental
cause” of its policy, clawing back “unspecified amounts” when Gary
Crittenden left the company to take his
ill-fated CFO post at Citigroup.

Companies
are taking different approaches as to exactly which employees are
covered under their clawback provisions. Intel's policy applies equally
to all named executive officers in the case of a restatement, whether
or not
such executives engaged in any misconduct. At UnitedHealth Group, the
policy applies to a list of roughly 30 members of senior management,
but it is
only triggered if an executive engages in fraud or misconduct that
leads to a restatement. To be fair, only that individual is
penalized.

With
shareholders, the media, regulators, and the public holding directors
to
greater levels of accountability, more and more boards are now becoming
bulldogs versus watchdogs, and are becoming much tougher in their
attempts to enforce clawbacks.

Companies,
however, may find recapturing previously paid compensation to be an
expensive, uphill, and not necessarily worthwhile battle. More likely,
there will be more attention to making future disgorgements easier.
Provisions
for such "clawbacks" will become increasingly standard in employment
contracts and stock and bonus awards provided to top
executives.

"PUT IT IN WRITING"

"Put
it in writing" is definitely the new rule for corporate boards that
need
to better systemize and document their decision-making in response to
new regulatory requirements and the threat of complicit liability from
disgruntled shareholders.

In
place of the brevity and generalities that previously characterized
most
board minutes, members are keeping detailed records of when and how
issues are considered that, if needed, can serve as evidence of careful
deliberation and the application of reasonable business judgment. Votes
on major compensation issues follow multiple - and generally lengthier
-
meetings, where directors are asking more questions and want more
documentation and information to support management proposals.

SIGNIFICANT INCREASES IN DIRECTORS PAY

Increased responsibilities, time commitment, potential liabilities created
by new regulatory mandates, governance pressure, and activist shareholders are also driving double-digit increases in director
compensation.

Growth
in directors pay is focused on the value of stock-based compensation
and
pay for members and chairs of the audit, compensation and
nominating/governance committees. There is a broad-based move in board
pay away from options
and toward more use of full-value grants, as a way to promote a
long-term performance horizon and to mitigate risk-orientation.

SUCCESSION PLANNING

Succession
planning is moving to the top of board to-do lists, as recent
events make clear the need to better identify and groom future leaders
given reduced public tolerance for executives who become subjects of
personal
or financial controversy.

Key
issues in developing a more formal succession process include whether
to
focus the search within or outside the company; how far in advance of a
chief executive's departure to name a successor; and what formal
relationship,
if any, the departed executive should maintain with the board and the
company.

For
the remainder of 2009, shareholders, the media, and the general public
will continue to take a "show me" attitude with regard to executive
compensation programs. They want to see evidence companies are
incorporating
genuine risk and appropriate opportunities for corporate leaders in new
plans, rather than boilerplate assurances.

Realistically,
it's likely that negative headlines and subsequent public
outrage will continue to be sparked by revelations of controversial
executive pay packages. But they will remain the exception to the
otherwise steady
progress being made toward ensuring that executive rewards are linked
to performance that will drive significant and sustained value growth
for
shareholders.