Executive Compensation: Getting Ready for the CD&A

The board members who gathered for Directorship’s Executive Compensation roundtable on Dec. 6 all agreed: If there’s a nucleus around which anti-corporate outrage spins, it’s chief executive pay. Many participants, immersed in year-end performance appraisals, are looking warily ahead to the new Compensation Discussion and Analysis (CD&A)—the Securities and Exchange Commission’s latest disclosure requirement concerning decisions on executive pay. “No one’s done it before,” mused former Interpublic Group chairman David Bell, who’s now a director at Primedia, Warnaco and the Partnership for New York.

The roundtable was sponsored by AIG National Union, a member company of American International Group that provides management and professional liability insurance.

Boards know that when proxies get sent around this spring, the CD&A will be the first thing shareholders look at, and directors will be judged principally by how they do their duty on compensation. In fact, Michael Smith, president of AIG Financial Lines Claims, kicked off the proceedings by quoting Warren Buffett: “Executive compensation is the acid test of governance.” Smith warned the group that the recent slowdown in securities class actions—which he ascribed largely to problems at plaintiff law firm Milberg Weiss—shouldn’t lull directors into a false sense of safety. The Supreme Court’s decision barring plaintiff firms from filing lawsuits without showing causality between a stock dip and a board or management decision doesn’t let directors off the hook, either.

The options backdating scandal, Smith said, could bring hundreds of derivative suits in its wake. In fact, the CD&A offers disgruntled shareholders a potent new cache of weapons to use against directors. “There’s going to be one number there, and that number’s going to be big,” he said. “And if you’ve got other issues—backdating of options or anything else that might not smell right—the bigger that number is, [the more] fodder for the plaintiff’s bar.” Indeed, the new section will bring into the open information that boards have never had to disclose before. The table summing up all the various forms of pay—even after the SEC’s late December easing of the rules—is only the most dramatic innovation. Boards must also supply the names of compensation consultants and other professionals who advise on pay decisions. And they must list the other companies that, by virtue of their size, industry or other characteristics, are considered peers and thus whose executive pay levels are used as benchmarks.

Peer group disclosure may prove especially tricky. “Comparable” companies will have to truly be peers. And for companies that straddle more than one industry or geography, defining that group can be a nightmare. Said Steven Hall, managing director of the eponymous compensation consultancy Steven Hall & Partners: “We are beating ourselves into the ground trying to find the perfect comparator group. One company I’m dealing with right now wants to have 30 companies in their peer group.”

Ross Zimmerman, founding principal of compensation consulting firm EXEQUITY, is in the same boat. “I have some clients with four or five different peer groups—all of which will have to be articulated in the CD&A,” he sighed. According to Hall, all this detail means many readers won’t make it through the 20-page CD&A. Lawyers are already creating templates, pretty much ensuring that the disclosures will be boilerplate. “I guarantee you nobody’s going to read this darn thing,” Hall declared. “It’s plain English, but it’s just brutal to go through.” What shareholders will do, he said, is eyeball the summary compensation table, then turn the page and see what payouts will occur in the event of a change in control.

Many directors think those numbers will cause an outcry, thanks to years of pay inflation. “Right now, executive compensation, particularly [for the] chief executive, is out of control,” declared Gary Wendt, the former chairman and CEO of GE Capital Services, who serves on the boards of FTI and Covansys. He predicted that only federal legislation can bring CEO pay levels back to earth. But other directors suggested ways to head that off. Rita Foley, former president of MeadWestvaco’s global consumer business, who sits on the compensation committee of PetSmart, says a keen, good-faith effort to link pay to performance is critical.

She recommends a process in which the CEO writes a self-appraisal, the board hires an outside law firm to compile directors’ evaluations (with each one commenting on the same 10 performance areas), and the results are discussed during a conference call. “I think it’s a very healthy process to have the verbal discussion,” Foley observed. She also thinks that CEOs should write a brief list of their goals—“almost an executive summary of the annual plan.” That way, the board has a clear benchmark for evaluating performance, and the CEO is in effect saying, “This is how I expect to be measured.”