David Wise

Clearly, not every compensation committee has the same exposure to organizations like ISS—this will vary based on factors relating to the make-up of the company’s institutional shareholder base, current shareholder relations and, yes, recent company performance.  However, in today’s governance environment, it’s become a must-have for committees to understand who their top shareholders are, their voting history, and the degree to which those institutions rely on groups like ISS when they cast their votes.

In our experience, we find that directors tend to fall into one of three categories when considering the input of organizations like ISS:

1. The Agnostics.  These directors aren’t preoccupied with ISS’ views, and their decisions aren’t impacted by them.  They manage compensation without any visibility to—or concern about—ISS outcomes.  Today, outside of closely-held companies, this population is dwindling.
2. The Centrists.  Directors in this category want to understand and be prepared for ISS’ views.  They will consider modifying their pay programs on noncritical elements or on issues that cannot be defended by market practice, but will hold their ground on issues core to the program, even if they may run afoul of ISS’ guidelines.  That said, these directors never want to be surprised by a potential ISS outcome.  In our experience, this category makes up the largest proportion of directors today.
3. The Believers.  Directors here care very much about ISS’ views, and will push for program changes to align with ISS outcomes.  They will look to ensure that no box on the ISS scorecard remains unchecked, and may even take steps to modify payouts in order to align with the most influential ISS standard, the “pay for performance” test.  We find this population, while still a minority, to be growing.

Irv Becker

We have clients in each of the three categories, who often ask us how to interpret how ISS will view—and recommend—on their compensation program.  In fact, ISS now offers this service, providing consulting to companies who wish to understand what “the answer” will be.  This yields a fascinating question—what could compensation governance look like in a world where ISS calls the shots?  If all compensation committee members become Believers, how might programs change?

For 2012, ISS has overhauled its most influential screen, its “pay for performance” test.  This analysis has been broadened to include multiple tests that view pay on both an absolute and relative basis, with relativity being both to peers as well as to company performance, represented by total shareholder return (TSR).

If companies began using this new suite of tests exclusively to manage pay, we can foresee several changes to the way companies will need to reconsider their executive pay processes and outcomes.  Here are four:

• Limit the breadth of the peer group.  Today, most effective compensation programs establish benchmarking peer groups using a variety of factors that are intended to reflect the company’s potential market for executive talent, organizational complexity, and business challenges.  For 2012, ISS actually improved their peer group selection process by adding in a revenue screen and reducing the reliance on market capitalization.  However, ISS’ continued use of General Industry Classification System (GICS) codes as a broad proxy for the company’s “business” presents an issue for companies that may not compete exclusively for executive talent in their industry alone.  Many of our clients—small and large—now use peer groups that also reflect factors like business model, client profiles, and other business similarities that go beyond pure industry classifications.  Outcome: for these companies to better align their pay outcomes with ISS’ assessment, they would eliminate any company that did not fit within the industry-specific screen.

• Delay the timing and sizing of equity grants. ISS’ tests view the alignment over time between TSR and CEO pay.  In its definition of CEO pay, they focus on the accounting values of equity grants, rather than what those grants are ultimately worth over time.  Today, most companies (a) make their equity grants early in their fiscal year, before they know what their year-end TSR will be, and (b) do not vary the size of the equity grants based on annual performance.  Companies do this because they are attempting to align the equity grants with the performance review from the prior year.  They also do not usually vary equity grants as these are go forward awards usually based on title or grade.  Outcome: in order to optimize alignment with ISS’ tests, companies would both delay sizing and making those grants until they had a better sense of their annual TSR performance (and would use that TSR to govern the size of grants).

• Increase the use of TSR in annual incentive plan performance measurement.  ISS’ tests use TSR as the baseline for both annual and long-term company performance.  While TSR (according to our research) is the prevalent metric in long-term performance-vested share plans, very few companies use TSR as an annual metric—under the belief that management decisions in a given year need to be made for the long-term benefit of shareholders, rather than for short-term stock gains.  Outcome: Here, to optimize alignment, companies would need to consider TSR as a primary driver of annual incentive plan payouts.

• Adopt a more conservative target pay positioning and mix of pay. One of ISS’ new tests will look at 1 year pay as a multiple of their peer group median, where—presumably—anything materially above the median will yield a negative outlook.  For companies that have a business reason for targeting above median, this will put more pressure to reduce their target market positioning.  In order to achieve that new positioning, however, companies are unlikely to look to reduce base salaries, which will put pressure on the other forms of compensation—or the performance-driven—pay elements.  Outcome: This will—perhaps paradoxically—shift the overall mix of pay away from performance.
  (Be careful, however—in its contextual review of pay programs, which are completed once the hard “tests” are calculated, ISS will look at the proportion of performance-based pay in the entire package, with the more performance weighting, the better.)

Clearly, some of these changes may be more realistic—and appropriate—than others.  However, the great paradox of the ISS influence on pay programs—which presumably is to make them more appealing to shareholders—is that it makes it more difficult for compensation committees to have the freedom to align their pay programs with how the company makes money.  It prevents the creation of programs that meet the company where it’s at, that reflect the company’s culture and strategy.  ISS’ focus is on the output—the TSR—and does not leave much room for any focus on inputs—the drivers of the business.

Many committees are now being forced to choose between optimizing the strategic value of their program and complying with ISS-driven metrics.  In our experience, the companies with programs that “work”—irrespective of whether or not they are ISS Agnostics or Believers—can rationalize why they work.  The most effective programs we see are focused around inputs as well as outputs, are tailored to the needs of the company’s business, and—importantly—can tell a good story that will make sense to shareholders who are willing to listen.

David Wise is a senior principal and director of Practice Development at Hay Group. Irv Becker is the national practice leader for Executive Compensation at Hay Group.

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The Dodd-Frank Wall Street Reform and Consumer Protection Act created Section 14A of the Securities Exchange Act of 1934, which requires most public companies to conduct a shareholder advisory vote on executive compensation not less frequently than every three years; and to allow stockholders to vote once every six years on whether the “say-on-pay” vote should occur every one, two or three years. The compensation arrangements subject to vote include those paid to the chief executive officer, the chief financial officer and the three other highest-paid executive officers.

Section 14A specifically provides that these resolutions will not overrule the board’s compensation decisions or create or imply any change to or any additional fiduciary duties for the issuer or board.

Despite disclaimers by Congress, at least 10 companies are now facing one or more derivative lawsuits following negative stockholder votes. These complaints set forth similar allegations, including claims for breach of the fiduciary duty of loyalty against the company’s current directors, claims against the recipients of the pay raises for unjust enrichment, and claims against the company’s compensation consultant for aiding and abetting breaches of fiduciary duty.

Most interesting, the complaints also allege that the “no” vote constitutes “direct and probative evidence” that the pay decisions were not in the best interests of the company’s stockholders. This allegedly overcomes the business judgment rule and shifts the burden to the defendants to prove that the challenged compensation decisions were made in good faith and in the stockholders’ best interests.

It may seem difficult to understand how a nonbinding stockholder vote that, by its terms, was not to overrule the board’s compensation decisions or impose any new or enhanced fiduciary duties, could alone be sufficient to defeat the business judgment rule. One federal court, however, has found the argument persuasive, at least at the motion-to-dismiss stage. In NECA-IBEW Pension Fund v. Cox, Cincinnati Bell shareholders brought suit after the directors, inter alia, granted $4 million in bonuses, plus $4.5 million in salary to the CEO, in the same year that the company incurred a “$61.3 million decline in net income, a drop in earnings per share from $.37 to $.09, [and] a reduction in share price from $3.45 to $2.80.” Sixty-six percent of the voting shareholders voted against the plan. The court recognized that the negative vote was not binding nor should it alter the directors’ fiduciary duties, but nonetheless held that, under Ohio law, the business judgment rule did not apply because the factual allegations raised “a plausible claim that the multimillion dollar bonuses approved by the directors in a time of the company’s declining financial performance violated Cincinnati Bell’s pay-for-performance compensation policy and were not in the best interests of … [the] shareholders and therefore constituted an abuse of discretion and/or bad faith.”

As the business judgment rule “imposes a burden of proof, not a burden of pleading,” it may be that the plaintiffs are ultimately unable to prove the directors acted with “a deliberate intent to cause injury” or “reckless disregard for the best interests of the corporation” at trial, but their allegations were sufficient at the pleading stage.

The Georgia Superior Court reached the opposite conclusion in Teamsters Local 237 Additional Security Benefit Fund v. McCarthy et al. There, the directors of Beazer Homes recommended that the shareholders approve the 2010 compensation plan, which included raises for executives in a year in which the company suffered a $34 million net loss and a 17 percent decline in share price. The shareholders rejected the recommendation.

The complaint alleged, inter alia, that by approving the plan, recommending that the shareholders approve the plan and failing to rescind the plan after the negative vote, the directors breached their fiduciary duties to the company.

The court disagreed, holding under Delaware law that neither the negative vote nor the directors’ decision not to rescind the plan rebutted the business judgment rule. The directors could not have considered the results of the February 2011 vote when they approved and recommended the plan in 2010. As such, the vote failed to cast doubt that the directors acted on an informed basis, in good faith and in the company’s best interests a year earlier. “Hindsight second-guessing and Monday morning quarterbacking of the sort [the stockholders] urge are fundamentally inconsistent with the business judgment analysis,” the Georgia court wrote.

Even prior to this uncertainty, other suits had settled, encouraging more suits. In March 2011, KeyCorp, after being sued under a similar provision found in the Troubled Asset Relief Program (TARP), agreed to make changes to its compensation practices and to pay $1.75 million to the plaintiffs’ law firms. Recently, perhaps as a consequence of the unfavorable decision received in the Ohio federal court, Cincinnati Bell announced that it had reached a settlement in another lawsuit, pending in Ohio state court, involving its compensation plan.

In light of these varying outcomes, companies should recognize that they could be targets of similar litigation and take steps that may reduce the risk of such suits.

Know your constituents. Prior to any vote, consider: Have significant institutional investors previously indicated that they are unhappy with the company’s compensation practices or decisions? Have any of these same institutions voted “no” at other companies or filed suit, and if so, why? Are there aspects of the company’s recent performance that could be characterized (rightly or wrongly) as “disappointing”? Can the company take steps by way of additional communication, disclosure or the like, to address these risk factors proactively and render a positive vote more likely?

Be prepared. If there is genuine risk of a “no” vote, have a plan. Will the compensation committee revisit a rejected decision and adjust it, or will only prospective adjustments be considered? What are the ramifications (accounting and otherwise) of a retroactive adjustment? As a matter of good corporate housekeeping, the minutes of compensation committee and board meetings should capture and accurately convey the rationale for any action or nonaction that is taken in light of a negative vote.

Review your disclosures. Consider explaining what is meant by “pay for performance.” The plaintiffs’ bar often seeks to use the company’s Compensation Discussion & Analysis to support their claims, usually relying upon language that the company has a pay-for-performance policy. This argument is based on the latent ambiguity in terms that may not be defined or described in detail in the CD&A. Companies should consider explaining whether “pay for performance” means that pay is based solely upon total shareholder return, or whether it takes into account other considerations. Disclosing what goes into executive compensation decisions can provide defense counsel with more robust disclosures to rely upon, including in seeking to have claims dismissed at the outset.

Potential Impact on Compensation Advisors
The plaintiffs’ bar is also pursuing “aiding and abetting” claims against compensation advisors. As a result, companies should review whether, and to what extent, they have indemnification obligations, whether such obligations are insured, and what impact a lawsuit might have on their relationship with their advisor.

Roger A. Lane is a partner in law firm Foley & Lardner’s Securities Enforcement & Litigation Practice. He can be reached at rlane@foley.com. Courtney Worcester is senior counsel in the Boston office of Foley & Lardner. Her practice focuses on complex commercial litigation involving corporations, venture capital and private equity firms, financial institutions and their directors and officers. She can be reached at cworcester@foley.com.

Only 53 percent of management teams recommended annual votes, and 42 percent recommended the maximum triennial votes citing the need for extra time to evaluate the programs, review shareholder input and implement changes.

At the time of GMI’s study, 40 percent of companies had not yet decided which voting frequency to use, 10 percent adopted a triennial policy, 50 percent adopted a annual schedule and only 0.37 percent chose biennial.

“The fact that the management of 42% of companies recommended that the Say on Pay vote take place every three years stands in stark contrast to how 72% of shareholders voted on the issue,” said Greg Ruel, Research Associate at GMI, in a statement on the report’s findings.  “That gap shows a real disconnect between how management and boards believe companies should be run and the way shareholders want their companies to be run. We’ll be watching closely to see which policies the remaining 40% decide to adopt.”

The Dodd-Frank Act requires companies poll shareholders at least every six years on whether they want to vote on compensation plans every one, two or three years, or abstain. GMI’s study looks at Annaly Capital Management as a case study, where the board opted to institute a triennial voting policy though the annual option received over 70 percent of non-binding shareholder votes. Almost three-quarters of the company’s investors approved the compensation packages.

GMI analyzed the results of say on frequency votes at 2,176 companies in the Russell 3000, of which 907 companies recommended triennial votes. About half of those 907 companies have not yet announced the official voting frequency, while 23 percent confirmed the triennial policy and 29 percent implemented annual votes. Less than one percent of these companies chose a biennial policy.

For more on the GMI say on pay voting frequency study, please click here.

Towers Watson’s report links the compensation bump to the increase in the value of equity awards, which have been growing since 2006. The equity award values increased nine percent in 2010, and made up 54 percent of director pay, with the other 46 percent in cash. The cash compensation values also increased, by 5 percent, to an average of $89,000.

“Similar to executive pay trends, director pay levels increased in 2010, consistent with improved financial and stock performance,” said Doug Friske, global head of executive compensation consulting at the professional services company, in a statement on the findings. “These changes also reflect increased demands placed on outside directors in terms of the time commitment as well as the level of debate, discourse and discord among directors. The question is whether this trend can continue, given growing uncertainty around the sustainability of the recovery.”

In addition, more of the 464 publicly owned companies surveyed are eliminating board and committee meeting fees, opting to compensate directors with fixed service retainers instead. Only 36 percent of companies paid meeting fees in 2010, down from 40 percent in 2009 and 62 percent in 2004.

Of the 39 percent of companies with the chairman and CEO roles separated, nonexecutive board chairs received an average of $150,000 more in compensation than the average director.

Yonat Assayag

With the 2011 proxy season behind us, we examine what influence the pay-and-performance relationship has had on say-on-pay votes and consider what we have learned as we look ahead to 2012 compensation decision-making.

Say-on-Pay Voting Results Among the First 100
Among the First 100, all but two companies – Jacobs Engineering and Hewlett-Packard – garnered a majority of shareholder votes in favor of their executive compensation program. On average, 89 percent of shareholders voted in support of executive compensation programs, and 66 of the 100 companies received support from more than 90 percent of shareholders.

Results for the First 100 are very consistent with voting results in the broader market. As of Aug. 12, 2011, approximately 2,600 companies held say-on-pay votes; 37 companies (including Jacobs Engineering and Hewlett-Packard) failed to win majority shareholder support – less than two percent. A study of Russell 3000® companies indicates that almost 75 percent of companies passed say-on-pay votes with more than 90 percent shareholder approval.

Influence of Performance on Say-on-Pay Votes
Performance, as measured by total shareholder return (TSR), has a significant influence on the shareholder vote. As shown in Table 1, companies with stronger TSR on a one- and three-year basis were more likely to get “for” votes from shareholders on their executive compensation programs.

Russell Miller

Not surprisingly, as shown in Table 2, average TSR among those companies that failed to win majority shareholder support for their say-on-pay votes was significantly below the broad market (based on the S&P 500), further supporting the conclusion that performance matters.

Influence of the Pay-and-Performance Relationship on Say-on-Pay Votes
The results of the first say-on-pay votes send a clear message that performance matters, and that pay that is disproportionate with performance can result in a negative vote, particularly if pay is high and performance is low.

An analysis of CEO total compensation and TSR for the First 100 finds a relationship between CEO pay, company performance and say-on-pay votes. Companies that paid their CEO in the top quartile of all companies in the First 100, but had one-year TSR that was in the bottom quartile (i.e., the companies that paid high and performed low), on average, had the lowest level of shareholder support for their executive compensation program. Also noteworthy, First 100 companies in the top quartile for TSR received, on average, more than 90 percent shareholder approval on say on pay regardless of how the CEO was paid. Conversely, companies in the bottom quartile for TSR performance received, on average, less than 90 percent shareholder approval, regardless of CEO pay.

Alignment between pay and performance appears to have influenced votes for the 37 failed say-on-pay companies as well. For most of these companies, the rationale for failing to receive majority shareholder support for their executive compensation programs was due to:

• A perceived pay-and-performance disconnect (e.g., CEO pay increased in a period where TSR was negative or below the median of a comparator group), or
• Significant concern among shareholders about non-performance based pay (e.g., large severance packages, excise tax gross-ups or tax gross-ups on perquisites).

Influence of Program Design on Say-on-Pay Votes
Institutional investors and shareholder advisory groups are paying considerable attention to ensuring that companies limit non-performance-based pay elements and enhance shareholder alignment (e.g., eliminating executive perquisites and increasing stock ownership guidelines). In a study conducted by ClearBridge Compensation Group earlier this year, we noted many First 100 companies made changes to their compensation program aimed at enhancing the relationship between pay and performance in preparation for their first say-on-pay votes.

Despite this focus, there is little evidence, based on the results of the First 100 say-on-pay votes, that any one compensation practice had any significant influence on the outcome of the shareholder votes. A study of four compensation practices that are often a focal point by shareholders and advisory groups – excise tax gross-ups, perquisites, stock ownership guidelines and clawbacks – indicates that say-on-pay votes for companies with those pay practices did not significantly differ from companies without them. While these practices individually do not seem to influence the say-on-pay vote, when combined with other shareholder concerns (such as a pay and performance disconnect), there is the potential for these practices to swing the vote.

Another effect of say on pay has been an increased level of engagement with shareholders. Early in the proxy season, companies recognized the importance of knowing their shareholder base and understanding fully their perspectives on compensation and governance issues.

Determining when and how often to reach out to investors is a strategic decision companies should make each year. During this proxy season, a significant number of companies determined that engagement with shareholders following an “against” vote recommendation from proxy advisory firms (e.g., ISS and Glass Lewis) was critical to overcoming the negative recommendation. Among the First 100, seven companies, including Disney, Hewlett-Packard and J.C. Penney, filed supplemental materials following ISS’s negative recommendation, in large part to defend their pay-for-performance orientation. This approach proved successful in swaying shareholder votes for many companies, providing further evidence that effective communication of the pay-for-performance story can influence shareholder votes.

Influence of Disclosure on Say-on-Pay Votes
Effective disclosure had a clear impact on the say-on-pay votes. Companies that used a “layered” approach with an executive summary – highlighting key program design features and pay/performance alignment early in their CD&A, with supporting detail provided in later sections – enjoyed higher say-on-pay results as compared with those companies that did not. Seventy-one percent of First 100 companies that used executive summaries received “for” votes from 90 percent+ of shareholders. In contrast, of the companies without executive summaries, only 57 percent received FOR votes from 90 percent+ of shareholders.

A Look Ahead to 2012
Much can be learned from the 2011 proxy season and can be incorporated into compensation decision-making for 2012. A design that fully supports the business, aligns with shareholder interests, and is sensitive to shareholder perspectives is critical to the success of any executive compensation program. Companies should consider the following with respect to their compensation programs:

1. Establish a transparent link between pay and performance. Successfully demonstrating the pay/performance linkage is critical to gaining majority support of the executive compensation program. In particular, companies should:
   1. Identify the key measures of the company’s success;
   2. Determine how to assess actual performance (for example, should performance be compared to budget, relative to peers or some combination of both?); and
   3. Determine how to assess pay (for example, should it reflect grant values or realizable gains?) and understand what influences pay.
2. Aim to minimize non-performance-based pay and enhance shareholder alignment. While doing so may not be the primary driver for say-on-pay vote outcomes, it can signal to institutional shareholders and advisory firms that the company takes pay for performance and shareholder alignment seriously.
3. Engage with Shareholders. Proactive outreach to shareholders heavily influenced SOP voting outcomes this proxy season. Talk with top investors early in the season to gain insights on their compensation governance policies and their views of the company’s pay practices. Pay attention to proxy advisory firms’ influence, but also know that an “against” recommendation often does not translate into a failed say-on-pay vote.
4. Use proxy disclosure to your advantage. Companies that use proxy disclosure to tell their story and incorporate user-friendly formats such as executive summaries and charts can provide clear understanding of their compensation decisions and effectively demonstrate the pay and performance relationship.

Applying what has been learned from the first year of say on pay and making informed decisions on the executive compensation program going forward will result in effective compensation programs and positive say on pay outcomes in 2012 and beyond.

Yonat Assayag and Russell Miller are partners at ClearBridge Compensation Group, an independent executive compensation consulting firm based in New York City. They can be reached at yassayag@clearbridgecomp.com, and rmiller@clearbridgecomp.com.

Compensation Metrics Need a Re-haul
Compensation drives behavior, and it is the compensation committee’s responsibility to take all reasonable steps to ensure that management is not taking imprudent risks by virtue of their pay structure, and to require – if not insist – that any retained compensation consultant recommends a “risk-adjusted compensation” regime that reflects true costs and risks for management compensation, for the specific company within its industry.  The compensation committee however, has an obligation to employ its own judgment, skill and experience in approving and recommending this regime to the board.

The Dodd-Frank Legacy: “Risk-Adjusted Compensation”
It is important to note, however, that risk-adjusted compensation is not attempting to control the amount of executive compensation – only to ensure that the compensation be sufficiently aligned with actual performance and appropriate risk mitigation.

Approaches to Align Executive Compensation with Risk
There are two main time frames and four types of approaches to align compensation with risk: before and after compensation accrues or is awarded; and quantitative, qualitative, explicit and implicit approaches.  The compensation committee should be familiar with timing and approaches, as well as their interactions.

Combining the two time frames and four approaches gives us four adjustments to align executive compensation with risk and achievement:

1. Quantitative Risk Adjustments Before Compensation Accrues or is Awarded
2. Qualitative Risk Adjustments Before Compensation Accrues or is Awarded
3. Explicit Risk Adjustments Based on Actual Results
4. Implicit Compensation Adjustments

Compensation Committees Need to Drive These Reforms
These approaches are emerging practices for addressing risk and compensation in the aftermath of the global financial crisis.

To expect that management, compensation consultants or industry associations, alone or even in combination, will advance or implement the above reforms is ambitious, and perhaps misguided.  Management’s interests may often be contrary to the practices recommended above.  Compensation consultants may prefer simplistic metrics, that are not risk-adjusted, that can be used and explained, and that can be rolled out firm-wide.

The drivers of the above reforms will have to be compensation committee chairs and committee members themselves, who understand the need for such approaches and commit to mastering these emerging standards.

To implement such reforms, compensation committees should employ their experience and judgment; retain independent, qualified compensation consultants; and insist upon tailored, risk-adjusted compensation advice and reporting.

Institutional shareholders and proxy advisors would also be wise to consider this sort of explicit linking of risk and compensation, when voting upon or assessing pay-for-performance linkages and compensation regimes, as risk-adjusted compensation may prove to have a higher alignment with shareholder value creation than more simplistic, non risk-adjusted performance measures.

Dr. Richard W. Leblanc is a corporate governance expert and advisor to leading boards and committees.  He can be reached at http://www.boardexpert.com.

The views and opinions expressed in the article do not necessarily reflect the views of the NACD.

Yonat Assayag

New federal regulations under the Dodd-Frank Act require companies to hold non-binding shareholder votes on their executive pay programs (say on pay), the frequency of future say-on-pay votes (say on frequency) and golden parachute payments in the event of a transaction (say on golden parachutes). The say-on-pay and say-on-frequency votes are required for all publicly-traded companies with annual shareholder meetings held after Jan. 21, 2011.  The say on golden parachutes requirement is effective for proxies filed on or after April 25, 2011.  Smaller reporting companies (less than $75 million in public float) are granted a two-year delay until these votes are effective.

As the proxy season progresses and say-on-pay vote results filter in, new learnings for boards continue to surface. One theme is clear: companies that perform, and successfully demonstrate that their pay programs support and drive performance, are more likely to win shareholders’ votes.

Program Changes

Russell Miller

This year’s filings indicate that in 2010, companies focused on minimizing non-performance-based pay and enhancing shareholder alignment:

• Excise tax gross-ups: Nearly 40 companies, including companies such as AT&T and OfficeMax, eliminated excise tax gross-ups (either from existing or future arrangements).

• Severance multiples: Three companies reduced severance multiples for the CEO from 3x cash compensation to 2x cash compensation.  Six companies have a policy requiring shareholder approval of any payouts greater than 2.99x cash compensation, including one company (Bank of New York Mellon) that adopted the policy in 2010.

• Clawbacks: Of 79 companies disclosing clawback provisions for their named executive officers, 34 adopted or enhanced these provisions recently.

• Ownership guidelines: While CEO stock ownership guidelines of 5x salary is most common among the first 100 companies (45 companies), a growing number of companies are increasing their guidelines beyond 5x.  In 2010, six companies increased their guidelines from 5x to 6x, resulting in 24 total companies with guidelines greater than 5x.

The first 100 companies focused their disclosure on their pay-for-performance story:

• Many companies took a “layered” approach and highlighted key program features and the alignment between pay and performance early in their disclosure.
  • Prevalence of executive summaries more than doubled, from 30 companies last year to 64 companies this year.  Companies focused their executive summaries on their pay-for-performance relationships, often enhancing disclosure from 2009 through graphical representations of pay and performance.
  • A few companies, including General Electric, took this disclosure a step further by including a summary of the compensation program and why shareholders should vote for it at the very beginning of the proxy statement.  This disclosure focused primarily on 2010 compensation decisions and 2010 company performance.

• Several companies, including Kimberly Clark and Lockheed Martin, enhanced their pay-for-performance discussion by adding a comparison of Total Shareholder Return (TSR) vs. CEO pay at the beginning of the CD&A.   This level of disclosure may be a preview to the pending pay/performance disclosure requirement under Dodd-Frank, which won’t likely be effective until 2012.

• Some companies have re-introduced the proxy performance graph, which compares the company’s TSR to TSR of an index and peers over a multi-year period and is now required 10-K disclosure.  Variations of this performance graph were included in proxy statements for BB&T, Goodrich Corp and Honeywell International.

• While companies discussed their performance in terms of various financial, operating, and stock-based measures, graphical analysis of performance tended to focus on TSR.  However, some companies, including Eli Lilly, provided graphical analysis of pay-and-performance based on measures such as revenue and earnings per share growth.

Jane Romweber

As do regular restricted stock awards, LRS awards specify a number of shares and set a vesting period. But they also stipulate that the number of shares ultimately received will vary with the change in the stock price over the vesting period. For example, boards can design awards so that a 10 percent increase or decrease in stock price will result in participants’ earning 10 percent more or fewer shares than the number specified in the award.

LRS does not necessarily assure participants that they will receive any particular number of shares. Rather, the number granted at the outset is a target. This design means that no value is guaranteed – that a dwindling stock price could result in the delivery of no shares whatsoever. To the extent that LRS awards are at risk, they make a compelling performance story for institutional investors and proxy advisory services.

Yet awards can be designed to deliver some shares regardless of the stock price. This is accomplished by setting a floor – for example, 50 percent of the target.

Donald Kalfen

The degree of leverage in LRS awards can be adjusted through the use of design features such as factors. For example, when a factor of 2X is used, if the stock price increases 10 percent, participants receive 20 percent more shares. If the price decreases 20 percent, participants receive 40 percent fewer shares. Factors can be applied asymmetrically – for example, 2X the increase and 1X the decrease.

Another way to adjust leverage is to subtract a fixed number of percentage points from the change in the stock price. When awards are designed to subtract 10 points, a 10 percent stock price decrease would mean a 20 percent reduction in shares. A 20 percent price increase would result in a 10 percent increase in shares. This design feature reduces rewards if the stock price is flat.

Thus, LRS enables compensation committees to manipulate leverage according to corporate circumstances and strategic goals.

Because of its design flexibility, LRS can be used to meet the executive motivation and retention needs of most large public companies. (The concept could also be applied to director compensation, though this would run counter to a general disinclination to use performance-based pay for directors.)  Using LRS in a company’s mix of long-term incentives is most appropriate when:

• There is a desire for both retention and performance aspects in long-term incentive plans.
• Economic factors or market conditions make it especially difficult to set performance goals.
• The unique nature or circumstances of the company make it difficult to select a peer group (companies of similar size, industry and complexity) for performance comparisons.
• The stock market is relatively healthy — free of bubbles and historic lows.
• The influence of stock options in an LTI program has waned, perhaps due to share-price fluctuations or concerns about share consumption from shareholder-approved pools.

Depending on how LRS awards are designed, companies might be able to deliver the same value using fewer shares than they would through a combination of stock options and regular restricted stock. Moreover, companies can set a cap on the number of shares that can be earned – for example, 150 percent of the target. Thus, LRS can help companies conserve shares and limit windfalls – excessive compensation resulting from factors unrelated to executive performance.

LRS has both the leverage characteristic of options and the value characteristic of plain restricted stock. As a result, it can be used in lieu of plain restricted stock, where appropriate, to increase performance motivation while preserving the retention benefit.

Jane Romweber, a partner and senior consultant with Meridian Compensation Partners LLC and an expert on pay-for-performance linkage, has been working with the LRS concept for several years. She previously spent 26 years as an executive compensation consultant with Hewitt Associates, and worked as a CPA with a tax specialty for Arthur Andersen & Co.

Don Kalfen, a partner and senior consultant at Meridian Compensation Partners LLC, advises clients on regulatory and governance matters. He is a former consultant with Hewitt Associates, Ernst & Young and PricewaterhouseCoopers, and was an employee benefits attorney with Keck, Mahin & Cate and Kirkland & Ellis.

The study—which looked at 170 Fortune 1000 companies whose annual meetings were on or after January 21, filed proxies by late March 2011 and whose CEOs were in their role for the last three years—found that 74.7 percent of the companies’ say-on-pay proposals were supported by at least 90 percent of voters. Only 2.7 percent of the companies had did not have majority support on their proposals.

“One of the most common questions we were being asked was: would proxy advisors like Institutional Shareholder Services be influential on these new votes?” said James Kroll, a senior consultant in Towers Watson’s Executive Compensation Practice, in reference to the say-on-pay and say-on-frequency votes that many companies are facing for the first time this proxy season.

While most companies’ investors approved say-on-pay practices, the 14 percent of companies who received negative ISS recommendations received above-average shareholder opposition. At companies where ISS encouraged a “for” vote, 94 percent also voted “for.” But the 20 companies surveyed who ISS recommended a “no” vote on their say-on-pay provisions received on average 71 percent positive votes; four were rejected by shareholders.

Annual say-on-pay votes have been popular among shareholders so far this proxy season, with annual votes receiving majority support at three quarters of the companies surveyed. Of the companies that recommended triennial votes, a majority of shareholders agreed to only a third.

Doug Friske

Of the decisions made so far, 46 companies chose annual, one chose biennial and 14 chose triennial say-on-pay votes.

“In early January and February, most proxies recommended triennial votes, now most are recommending annual,” continued Kroll. “Companies may be seeing the majority support for annual [votes] from shareholders, which may be driving more businesses to make the annual vote recommendation.”

The study also reported that the median annual base salary for executives increased by three percent. “The pay mix has stayed the same,” explained Olivia Wakefield Lee, a senior consultant at Towers Watson’s Executive Compensation practice. “What has changed is the long- term incentive mix,” with companies using stock options for 33 percent of the mix, as opposed to 39 percent in 2008. Restricted stock has stayed relatively constant, while performance plans make up a higher percentage at 41 this year, over 37 and 36 in 2008 and 2009, respectively.

“Options are not on the verge of extinction, but they will decrease in percentage of the mix,” predicted Wakefield.

Compensation committees and consultants were recently handed new regulations stemming from the Dodd-Frank Act regarding their independence and possible conflicts of interest. Steve Seelig, executive compensation counsel for Towers Watson’s Research and Information Center, advised companies to be on the lookout for more regulations. “We don’t anticipate things to be too tumultuous when it comes to regulations from Washington,” he said, but “there are some regulations pending, and it’s not too early for companies to focus on complying with them, since the rules are somewhat cumbersome.”

While there is currently legislation in the House to repeal the mandated disclosure of CEO pay vs. median employee pay, Seelig said: “I don’t see it going through the Senate or being approved by the President.”

Considering the combination of these types of increased disclosures and shareholder say on pay, companies must be especially cognizant of how they present their compensation practices in their proxies.

There is no formulaic method to encourage shareholders to approve say-on-pay plans, Seelig said. Rather, companies must look at their own shareholders and determine what their concerns are, and what the proxy advisors that most shareholders listen to are recommending.

“The results will change every year,” Seelig explained. “Stay committed to your principals and practices; shareholders will support your approach if they see it’s been thought through.”

Directors like to joke that in the “old days” before Dodd-Frank, the audit committee handled most of the board’s heavy work. Not any more. Some compensation committee members, investors and their advisors believe the most profound and lasting impact of Dodd-Frank is to shift the balance of power from management to the shareholder, as new and pending regulations empower compensation committees as never before.

“We have to keep the intent of Dodd-Frank front and center,” says Robin Ferracone, the founder and executive chair of the compensation consulting firm Farient Advisors. “The intent was to encourage shareholder communication more directly, frequently and openly with their directors and Dodd-Frank is the catalyst for that. The law is not trying to become the dominant force. The law is trying to facilitate this communication. And we should not lose sight of that.”

There’s no doubt, however, that the effect of Dodd-Frank on boardrooms—more specifically the pay-for-performance proxy disclosures effective last year and the new rules expected this year for “say on pay,” clawbacks, and compensation committee and advisor independence—“is a seminal change,” says Catherine R. Kinney, a public company director who retired from NYSE Euronext in 2009 as president and co-chief operating officer and now serves on the boards of MetLife, MSCI (the parent company of ISS Governance Services) and NetSuite. “I think it’s a huge power shift in the boardroom… The fact that an investor can look at the CD&A and vote against a director is one of the biggest changes relative to performance around the boardroom table.” She sees it as one more step in the direction of progress, that is, “management and the board working together to find the right performance for the shareholder.”

Click here to view the full Director’s Guide to Compensation

More stories in the Director’s Guide to Compensation:
New Risks and Rewards
An Investor’s Point of View
Executive Pay and the Boardroom After Dodd-Frank

Says one Fortune 100 director, who asked not to be quoted by name, “Management can no longer ask the HR person and the top three directors they like to serve on the compensation committee. Today, the compensation committee is chosen by the independent directors and working on behalf of the shareholder. It’s dramatically different and as a result, most compensation committees today are scrambling for information and education.”

Stephen W. Sanger, retired chairman of General Mills and a prominent public company director whose board service currently includes Target, Pfizer and Wells-Fargo, concurs. He says Dodd-Frank dramatically transforms the compensation committee role from “compliance to advocacy.” David Lynn, a partner at the law firm Morrison Foerster, notes that in addition to new disclosure, “what shows up in the proxy statement is more important because of the environment we’re in.”

Most compensation committee chairs are seeking direction and education on implementing both new and pending rules, and how the language of disclosure in the annual proxy statement should read. Like their audit committee brethren, compensation committee members are being encouraged to set their own budgets and retain independent compensation consultants and advisors.

“There’s a lot of trial and error—and learning— in the compensation process right now,” observed Ferracone during a meeting of the NACD Advisory Council on Compensation (See below for complete participants’ list). “As a compensation committee member, you have to be sensitive and attuned to the issues being faced from an emotional and dynamic standpoint. It takes a lot of skill to not let the mechanics of the discussion overwhelm the process and leave you with a dysfunctional result.”

New rules for all publicly traded companies— including say on pay and say-on-pay frequency in effect for the upcoming proxy season—stipulate greater disclosure, while opening the door for boards to communicate more often with shareholders. By one count, Dodd-Frank requires regulators to create 500 rules, conduct 81 studies and issue 93 periodic reports. The stated objective of the legislation is “to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail,’ to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices and for other purposes.”

One of the “other” purposes is to rein in risktaking promoted by excessive compensation or by compensation that is tied too closely to short-term financial performance—especially in the financial services sector, the main focus of the law.

A Long Way to Go
A recent study commissioned by the Council of Institutional Investors (CII) found that while the pay-forperformance link on Wall Street has strengthened somewhat since the global financial crisis, banks still are not tying compensation to long-term gains in performance. CII comissioned the report, “Wall Street Pay: Size, Structure and Significance for Share-owners,” to gain a better understanding of pay at big Wall Street banks and how it differs from executive compensation at other large U.S. companies. “While many banks have strengthened their pay practices, there’s still a long way to go,” says Ann Yerger, CII executive director. “The report suggests they need to do more to make sure that executive compensation rewards performance over the long term.”

Motivation
Executive compensation policies should motivate high-level managers to make decisions that are compatible with the organization’s strategy. However, many would argue such compensation practices failed to achieve this mission over the past two years, or adequately discourage executives from excessive risk taking. Already a complex issue before the recent economic crisis, executive compensation is now a critical issue for organizations of all sizes.

Authors Harry Cendrowski and Adam Wadecki

In general, while public companies appear to have stolen the executive compensation spotlight, compensation plans for private companies remain an essential motivating factor for employees. These plans can provide smaller companies with the power to attract talented individuals as well as a mechanism to motivate key employees.

There are four fundamental steps directors, executives and others involved in the compensation-setting process can employ in attempting to satisfy stakeholders while also ensuring executives and employees remain properly incentivized.

Executive Compensation Defined
For the purposes of this article, compensation is divided into four elements: base salary, benefits (including perquisites), short-term variable pay and long-term incentives. While the first two categories are self-explanatory, short-term variable pay is compensation not included in base salary that relates to performance achievements over a short period of time (generally a year or less) and most often does not exceed a typical business cycle. Short-term variable pay typically includes bonuses and incentive payments earned when an executive exceeds pre-defined goals. Long-term incentives are compensation components that reward executives for achieving goals over a time period that exceeds one business cycle. The equation below presents a definition of executive compensation using four compensation elements.

Total Executive Compensation = Base Salary + Benefits + Short-term variable pay + Long-term incentives

All other things equal, talented executives will be looking for compensation packages whose expected value is commensurate with their historical experience and expertise, as well as the potential value they can bring to a firm. A compensation package’s expected value is:

Expected Value = ∑ Compensation Element_i x Likelihood of Payout_i

Within this equation, each of the four previously mentioned components of executive compensation is multiplied by its likelihood of payout to arrive at a compensation package’s expected value. Note that the likelihood of payout will generally vary by component. The structure of executive compensation packages, as well as the likelihood of payout, largely depends on the nature of a compensating organization and its strategy.

Step One: Understand the Nature of the Organization and Its Strategy

The first step in devising an appropriate compensation plan requires compensation managers to understand their organization’s current stage of development and strategy for its future. For the purposes of this article, we separate organizations into three categories: start-up, growth and mature organizations. Start-up firms, by definition, are those that are just beginning life. In their nascent stages, these organizations generally do not possess positive cash flows from operations, though they may have some form of revenue stream or established customer base. Growth firms are organizations that are more mature than start-ups, but are continuing down a path of significant year-over-year cash flow growth. These firms generally have positive cash flows, but they may lack historical stability. Some growth companies serve developing markets that may not yet allow the company to experience stable revenues. Mature companies do not see consistent year-over-year increases in cash flows above the rate of GDP growth. They frequently participate in nongrowth industries and generally achieve modest cash flow growth through cost containment rather than revenue expansion. Exhibit 1 depicts these organizational stages with respect to a firm’s operating cash flow.

Exhibit 1: Stages of Development

For several reasons, compensation managers must understand the nature of the organization, its strategy and the metrics it values. A company’s ability to compensate its key employees—and the ways by which it can do so—is greatly dependent on the stage of the company. Executive compensation plans must also reinforce the organization’s strategy in order to ensure long-term value is created for shareholders.

Many start-ups have strategies that are evolving with the milestones that they meet. Their products may not yet be fully developed. However, virtually all start-ups are united in one element of their strategy: they want to become cash flow positive. Positive cash flow allows a start-up to become a viable venture capital candidate. It also signifies the firm has taken a step toward the growth stage. In order to assist a start-up in building cash flow, executives are frequently compensated through long-term incentives. Such a compensation scheme allows the company to preserve cash while ensuring executives are incentivized to build long-term value in the company. Executives cannot realize the full value of their compensation package until a financing or liquidity event takes place. Even with such an event, the full payout of a long-term incentive package might not be realized. Because long-term incentives have less likelihood of payout as compared to annual base salaries, an executive may require greater amounts of such compensation in order to compensate them for the chance that their incentives might not realize their initially estimated future value.

Within the growth stage, base salary and benefits become increasingly standard components of executive compensation. If a company has made it through its start-up phase, its risk has decreased commensurately with its success. Consequently, founders and investors will likely be less willing to provide executives with portions of stock or options befitting a start-up, though these may still be important components of an executive’s pay. Furthermore, the company’s cash flows permit higher base salaries to be paid to these individuals, and short-term incentives, including annual bonuses, become increasingly important in this stage.

By the time a company reaches the growth stage, a foundational strategy is in place. Compensation managers should examine this strategy when tailoring executive compensation packages. For instance, a company might possess a strategy to produce the highest-quality goods on the market. In such a case, an executive compensation package should contain metrics related to customer satisfaction, customer retention, returned items and warranty claims.

Once the organization reaches a mature stage, it will be difficult to motivate employees through long-term incentives, though short-term bonuses are frequently used to compensate key individuals. Unless a mature company is growing revenue in some area of its business, it is unlikely that its value will increase through revenue growth. Rather, its value is likely to appreciate through cash flow and earnings stability. This stability is often a component of mature organizations’ strategy which is sometimes achieved through diversification or divestiture of nonperforming assets.

Exhibit 2: Importance of Plan Components by Organizational Stage

Step Two: Select Appropriate Compensation Metrics
Compensation managers should use a variety of metrics in evaluating the performance of executives, including financial, product quality, operational and internal growth goals.

Financial. In order to more accurately assess an executive’s performance, compensation managers should focus on organizational metrics that most closely resemble the company’s operating characteristics. Two such metrics related to the organization’s finances are operating cash flow and EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). Compensation managers should use these metrics to manage compensation plans for the same reason they are used or examined by valuation professionals: they perhaps best showcase the operating nature of the business.

Although not an accrual-based metric, operating cash flow, rather than net income, can generally give compensation managers a clearer picture of the company’s affairs. Moreover, operating cash flow takes into account a company’s working capital (receivables, payables, and inventory) while eliminating noncash charges associated with depreciation. EBITDA is similar to operating cash flow; however, it does not take into account working capital or the firm’s capital structure. Capital structure may be an important consideration for many companies as they deleverage their balance sheet and control interest expense in the near future.

Financial metrics are generally used in defining parameters for short-term variable pay or long-term incentives for companies of all stages. For instance, an executive might receive a bonus for achieving market share or earnings growth. Nonfinancial metrics, however, should be incorporated into these components of executive compensation.

Nonfinancial. Other metrics should also be used in devising executive compensation plans. In the early 1990s, Balanced Scorecard pioneers Robert S. Kaplan and David P. Norton asserted that financial metrics should, at most, represent one category of metrics that managers should employ in measuring their firm’s performance. However, while the approach advocated by Kaplan and Norton is now used within the strategy department of many organizations, it appears the philosophy it espouses has not yet been embraced in most compensation plans.

According to Charles Elson, director of the John L. Weinberg Center for Corporate Governance at the University of Delaware, executive compensation is typically based on “a blend of earnings targets, sales targets, sometimes the success or failure of dispositions or acquisitions and the company’s stock price.” According to Elson’s description, a Balanced Scorecard-like approach to executive compensation seems conspicuously absent. It is simply a reflection of the environment in which many companies operate: whenever a business is valued, nonfinancial metrics rarely play a part in the valuation. However, these metrics are some of the most important to track, especially in organizations that are focused on achieving high growth levels. As Benjamin Heineman, former general counsel of General Electric and fellow at Harvard’s JFK School of Government, recently stated, “Executive compensation shouldn’t merely compensate individuals for short-term stock price appreciation.”

A balanced approach comprised of numerous metrics should be used in evaluating key executives and managers. The saying, “What gets measured, gets done,” appropriately speaks to the incentives created by executive compensation. Compensation plans will always focus in part on financial metrics. However, the best CPA compensation managers will recognize that financial metrics are outputs of organizational processes; they are not inputs.

The method by which the organization operates will drive top-line growth and bottom-line improvements. Product quality and operations often tie directly to financial results. In general, compensation managers should look to include metrics related to product quality, operations and internal growth—examples of which are shown in Exhibit 3—within their executive compensation plans. Inclusion of these metrics can incentivize executives to achieve organic growth through long-term value creation rather than short-term value inflation that might result through an intense focus on financial metrics alone.

Exhibit 3: Example Nonfinancial Metrics

Inclusion of these metrics in compensation plans can further assist the organization in achieving its financial goals and also help executives cascade compensation metrics down through the organization.

Achieving a Balance of Financial and Nonfinancial Metrics
An appropriate balance between financial and nonfinancial metrics must be achieved for executives to be properly incentivized. The weighting between financial and nonfinancial metrics is dependent on the organization’s stage. Exhibit 4 presents a sample weighting of financial and nonfinancial metrics as well as base salary and benefits. As shown in the exhibit, base salary and benefits grows as the organization matures. This growth in base salary is commensurate with the organization’s cash flow-generating ability. Financial goals are extremely important for start-up companies as they travel down the road to profitability. They are also important for mature organizations looking to gain shareholder value through cash flow and earnings stability. Lastly, nonfinancial goals are perhaps most important in growth companies where profitability has been demonstrated, but sound strategy execution is needed to take the organization to the next level.

Exhibit 4

Step Three: Cascade Compensation Metrics Throughout the Organization
Compensation metrics should reflect the organization’s nature and its overarching goals; therefore, it is imperative that such metrics be appropriately cascaded down through the organization. In smaller companies, this generally means ensuring lower-level managers’ remuneration schemes mimic those of their executives.

In some cases, it will be necessary to translate high-level organizational metrics for employees to afford them ownership of metrics within their compensation packages. For instance, if directors of a company are concerned with growth in net earnings (as is typically the case), what does this mean to plant managers? Should they be measured on the firm’s growth in net earnings? Would they take ownership of such a metric?

In such a situation, it is best to translate this goal for such an individual so that he or she can directly affect it: the plant manager could instead be measured on the facility’s throughput, labor cost, lead time or product quality, each of which impact net earnings and are under his or her direct control. As such, this process can be more easily facilitated if high-level executives are measured on a variety of metrics outside of those directly related to the firm’s finances. Such a practice allows for a more intuitive cascade of compensation metrics throughout the organization.

Large corporations pose numerous challenges to the aforementioned cascading process. A key element of executive compensation plans for mature companies is the compensation plan of divisional managers. Large corporations are often composed of many divisions, with the degree of autonomy exercised by each division varying by company and industry. Compensation of divisional managers is especially difficult because a division’s financial performance may be distorted by inter-company transactions and accounting methods.

In compensating these individuals, compensation managers should bear in mind that the organization’s goal for the division may differ from that related to the company itself: while the company may be in one phase of organizational development, the division may not resemble the corporation as a whole. In this sense, compensation managers should view the division as its own entity in devising appropriate compensation schemes. They must understand the division’s stage of organizational development and how it differs from that of the complete organization. Divisional managers, where possible, should be more heavily compensated on metrics they can influence, rather than those beyond their control.

Step Four: Monitor Performance of Plans
In monitoring the performance of executive compensation plans, compensation managers need to first make an objective assessment of each executive’s performance. This assessment should include an investigation of the company’s past performance against other firms in the industry, as well as potential future benefits that the executive has been responsible for creating. This latter component is especially important for executives operating in turnaround settings where the company might have been performing poorly prior to the executive’s arrival. Much as one cannot expect a first-year football coach to lead last year’s 0-16 team to an undefeated season, compensation managers should evaluate executives based on realistic expectations that may differ from company to company in a given industry.

The selection of an appropriate peer group against which executive pay is benchmarked is an important component of the executive compensation process. However, in the extreme, deference to peers can eventually lead to “herd behavior” within the executive compensation process: directors may act according to the actions of others, rather than in the best interest of the company they represent. Thus, directors should ensure that their compensation monitoring process examines not only peer actions, but also takes into account any idiosyncrasies that separate their company from its peer group.

Compensation managers must also take into account the accuracy of underlying data used in compensating executives. Most large corporations use accrual-based accounting methods which necessarily require calculation and recording of reserves, estimates, and accruals. This process inherently allows executives and financial managers to exercise subjective judgment in preparing financial statements. The larger the company, the more judgments it must make with respect to accruals. In contrast, smaller companies, especially start-ups, will use accounting methods more closely tied to cash flow—some may even use cash flow-based accounting methods. The “noisier” the data employed by compensation managers in their monitoring of executive pay, the more work they will have to perform in order to discern whether an executive’s actions are commensurate with the company’s strategy.

Harry Cendrowski, CPA, ABV, CFF, CFE, CVA, CFD, CFFA is a founding member of Cendrowski Corporate Advisors.
Adam Wadecki is a manager of operations with Cendrowski Corporate Advisors and specializes in operational analyses and quantitative risk management modeling.

Highlights from this year’s survey of non-employee director compensation conducted by the NACD and The Center for Board Leadership, and produced in collaboration with compensation consultancy Pearl Meyer & Partners (PM&P) include:

• Minimal change in board compensation levels following a year of very modest growth.

• A smaller proportion of directors’ Total Direct Compensation delivered in equity, largely due to depressed share prices.

• A shift toward granting annual equity awards based on a fixed value, rather than a fixed number of shares, to ameliorate the impact of share price volatility.

• Continued increase in companies providing equity incentives in the form of full-value shares, rather than stock options.

To put this year’s compensation into perspective, PM&P managing partner Jannice Koors says that with the exception of double-digit pay increases in the two years immediately following the passage of the Sarbanes-Oxley Act of 2002, director pay typically has increased on average five, six or seven percent a year. “Director comp doesn’t tend to change. It goes up once every three or four years rather than on an incremental basis…In 2008, we saw comp levels flatten and go down among smaller companies, but that was largely driven by equity. The numbers for 2009 are negative for all but the Top 200 companies so it’s flat, but none of this represents decreases in compensation,” Koors says. Retainers and meeting fees are not being cut and companies of all sizes are following the NACD’s best practice that recommends that half of a company’s director compensation be paid in equity to align directors with shareholders.

Board Composition
For the first time, a majority of companies in four of the five revenue groups studied now have declassified boards (one-year terms), with the small-revenue group close to that standard. Declassified boards were first adopted by the Top 200 largest companies, where they are the practice at 76 percent of companies, slightly higher than a year ago. There was relatively little change in other aspects of board composition.

As has historically been the case, board practices tend to be differentiated by company size. Among the entire survey group, median board size increases with revenue size and ranges from eight to 11 members. Likewise, the percentage of female directors and the prevalence of a disclosed mandatory director retirement age increase with company size.
Despite increased governance pressure to separate the roles of the chief executive and board chair, a combined CEO/chair leadership structure is still the majority practice among virtually all size groups.

TAKEAWAY: Board composition continues to be under fire on two fronts: the maintenance of a combined CEO/COB role and expanded shareholder access to board seats. Absent adoption of a regulatory requirement to separate the executive and board leadership roles, we expect to see an evolutionary increase in the separation of CEO and COB positions, rather than a revolutionary changeover, given the difficulty of taking away the chair title from a sitting CEO. On the second front, governance watchdogs are making a strong move to open up the director nomination process to significant shareholders. Ironically, the unintended consequence of such a change might be increased resistance from directors to annual elections—after all, few directors will want to wage a contested campaign for re-election annually.

The down economy resulted in decreases in median director compensation across all groups but the Top 200 (see chart, page 57). The last major growth in director pay levels occurred in the 2004 and 2005 proxy seasons in response to SOX, when companies adjusted pay programs to reflect significantly increased oversight demands.

Total board compensation expense—including all fees and equity grants for board and committee service for all non-employee directors—is a function of both board size and the level of pay per individual director. While the total cost of board oversight increases with company size, it represents a progressively smaller percentage of company revenues. The median price tag for board oversight at smaller companies was $489,304, or 0.21 percent of revenues. Among the Top 200, total board costs were four times higher at nearly $2.1 million, but accounted for just 0.01 percent of revenues.

TAKEAWAY: In general, director compensation has leveled off in the past two to three years, following a post-SOX “bump.” This year’s report finds pay down slightly or flat compared to a year earlier, despite an increased workload for directors, largely due to depressed stock prices and concern over the poor optics around increasing pay. As company financial results begin to improve, with a corresponding rebound in equity values, we expect director pay levels may show above-average increases over the next year or two.

Board Pay Mix
Public boards of all sizes generally rely on the same menu of cash and equity components: a combination of a board cash retainer, board meeting fees, committee pay, full-value stock and stock options.

Compared to last year, the median value of traditionally cash elements of board pay—consisting of annual retainers and fees for board and committee service—represented a greater proportion of total board pay. As a proportion of TDC, board cash retainers ranged from 33 percent to 38 percent; board meeting fees between 3 percent and 13 percent; committee pay between 8 percent and 15 percent; and equity awards between 34 percent and 54 percent.

As companies increase in size, full-value equity awards represent an increasing portion of total compensation; ranging from 22 percent among smaller companies to 45 percent at Top 200 com-panies. There is more uniformity in median option value across size groups. Among smaller companies, options represent 12 percent of total compensation, compared to 9 percent at Top 200 companies.

Prevalence of Pay Elements
As implied by the pay mix comparison, the prevalence of pay elements differs very little across company size groups. There are two notable exceptions to the uniformity that highlight continuing trends in compensation structure.

First, there is a steady, although modest, decline in the use of meeting fees across all size groups. While board-meeting fees are still majority practice among most size groups, fewer than 40 percent of Top 200 companies provide board-meeting fees. One reason: as board oversight expands and remote communication becomes more sophisticated, companies have struggled to define what constitutes an official “meeting” for purposes of compensation. To eliminate that issue, more companies are providing an increased board retainer in exchange for eliminating board-meeting fees.

Second, there is a continued trend to favor the use of full-value equity awards over stock options. For the first time, full-value share grants are majority practice among all size categories.  In contrast, the prevalence of stock options continues to decline and now hovers at around one-third.

Cash vs. Equity
Due largely to lower share prices, there was a drastic decline this year in the number of boards in each revenue group that provided at least 50 percent of board compensation in the form of equity, a key NACD governance recommendation. While a year earlier only the smaller and small companies failed to meet that standard, prevalence plunged to fewer than 50 percent of companies in all but one revenue group. Even in the Top 200, where a year earlier 74 percent of companies reported that at least half of board pay was in the form of equity, compliance with the NACD standard fell to 63 percent.

The median cash/stock board pay mix among the companies in the study was much closer to the NACD recommendation, with every revenue group except smaller companies providing close to or more than 50 percent of board compensation in equity. As has historically been the case, cash accounted for the greatest proportion of total compensation at the smallest companies, and was the smallest part of pay at the very largest companies.

Full-Value Share Grants Favored
There has been a significant retreat from the use of stock options in board pay programs since mandatory option expensing removed the perception that such grants offered a “free” means of rewarding employees and directors. At the same time, governance critics increasingly have blamed stock option grants for engendering an excessive focus on short-term performance gains. Among the Top 200 companies, which historically have set the pace in board pay practices, the use of stock options peaked at 75 percent of companies in 2002, falling to 51 percent by 2005 and 27 percent in the 2009 proxy season.

Over that same period, the proportion of companies providing full-value board equity awards has grown steadily. In terms of prevalence, a majority of companies in every revenue group in 2008 made full-value board equity awards, increasing with company size from 57 percent of the smaller companies to fully 92 percent of the Top 200. Full-value grants were also favored over options within each revenue group.

TAKEAWAY: A gradual move by all revenue groups to adopt Top 200 equity practices and move toward increased use of full-value equity awards is expected, given an environment of heightened scrutiny of compensation, combined with a growing focus on the need for more stringent risk management and oversight. However, the NACD does not expect stock option use to cease altogether. On the cash side, more com-panies are also likely to follow the lead set by the Top 200 by simplifying their cash compensation structure and eliminating meeting fees. The continued reluctance by companies to start paying their committee members solely in the form of a retainer could reflect uncertainty about their future work demands, or a desire to compensate directors in direct proportion to their time commitment. Regardless, more companies will move to a more fixed-cash pay structure.

Equity Grant Practice: Fixed Values vs. Fixed Shares
While the decision by boards to calculate equity grants on the basis of a fixed number of shares or as a fixed-dollar value also correlates with company size, in every revenue group there was increased use of the fixed-value equity grant approach when compared to a year earlier. The proportion of companies that provided fixed-share grants ranged from 56 percent of the smaller companies down to 24 percent of the Top 200. Conversely, board equity awards were provided as a fixed dollar value at 35 percent of the smaller companies, increasing to 62 percent of the Top 200.

TAKEAWAY: Over the past two years, many companies have struggled with declining and/or volatile stock prices and the corresponding impact on equity grant values. The result has been that the use of fixed- value versus fixed-share equity grants to directors has been a growing topic of discussion. It is noteworthy that smaller companies are more likely than larger companies to grant equity awards based on a fixed number of shares, rather than a fixed value. A likely correlation is that smaller companies are also more likely to award stock options than larger companies, where full-value equity awards are more prevalent. The NACD recommends that whatever the structure, equity grants should include a floor or ceiling on the range of possible compensation and/or share use. While there are arguments for and against both practices, as a general principle compensation for directors should reflect their contributions to the company and expectations related to stock ownership, rather than linked to short-term fluctuations in share prices.

Committee Service
The work of the board is increasingly being conducted at the committee level, as directors seek to “divide and conquer” the volume of issues they face. Virtually all companies in this survey maintain audit and compensation committees. The prevalence of other board committees generally correlates with company size: between 79 percent and 99 percent of companies reported a governance/nominating committee, while 26 percent to 46 percent maintain an executive committee and 10 percent to 48 percent have a finance committee. Beyond that, prevalence generally drops to single digits for committees devoted to specialized topics such as pensions, nuclear, technology, etc. While there has been much discussion around board responsibilities for risk management, the study found no increase in the prevalence of separate risk committees, as broad risk oversight is best viewed as the responsibility of the full board.

It is important to note this report includes all committees in “total committee compensation” calculations, reflecting both actual committee assignments and the actual number of meetings held. The report focuses on committee fees and retainers only for the audit, compensation and governance/nominating committees, which are the only standing board committees maintained by at least 75 percent of companies in each revenue group.

Generally, meeting frequency for the audit, compensation and governance/ nominating committees was largely unchanged over the past three years. However, in a possible reflection of the troubled economic environment, there was an uptick in some committee activity among certain revenue groups. For example, compensation committees for four of the five revenue groups—smaller, small, medium and Top 200 companies—held more meetings than a year earlier.

Differentiated pay for service on the three leading board committees continues to be a majority practice among all revenue groups. More than 80 percent of companies across all revenue groups tailored some aspect of committee compensation to their level of work and responsibilities. Interestingly, most companies
limit such differentiation to the committee chair retainer.

The chairs of audit committees continue to receive the highest compensation for committee service, ranging from 51 percent to 75 percent more than that of compensation chairs. The pay differential between compensation and governance/ nominating committees is less pronounced: compensation committee chairs receive between 7 percent and 45 percent more than governance/nominating, with the smallest differential by far at Top 200 companies.

Committee member pay follows a similar pattern. Compared to a year earlier, the practice of differentiating pay through the use of a retainer increased in three of the five revenue groups to between 20 percent and 37 percent of companies. Audit committee members received a premium over compensation committee members, ranging from 100 percent among the Top 200 to 42 percent at smaller companies. The premium for compensation committee members, compared to their governance/ nominating counterparts, ranged from 40 percent at smaller companies to two-thirds among the large companies. In a departure from that pattern, the pay gap narrowed to 25 percent for the Top 200, down from 50 percent a year earlier.

TAKEAWAY: A significant majority of companies differentiate pay among committees in some way, reflecting the difference in relative workloads. It may seem surprising that outside of the committee chair role, there is not much differentiation of committee pay levels. One reason is that most companies historically paid committee members through meeting fees. As a result, pay differentials were “self-correcting”—the more meetings held by a committee, the higher its members’ compensation. As companies now consider moving to retainers for committee service, we may well see more structural differentiation of committee member pay. On the other hand, a case can be made that board members should be compen-sated for the value, not just the volume, of their contribution and that all board members are equally responsible and liable for all committee decisions. This argument would suggest that less differentiation may be the trend of the future.

Board Leadership
The practice of having a non-executive leading the board—either as chair or lead/presiding director—continues to correlate with company size, as is traditionally the case with emerging governance and compensation trends. The survey found that 74 percent to 99 percent of companies designated a non-executive board leader, with 41 percent to 53 percent of those firms providing additional compensation for that additional role.

Companies generally pay a higher premium for service as a non-executive chair than as a lead/presiding director. Non-executive chairs, at median, receive 1.45 to 1.77 times the Total Board Compensation (excluding pay for committee service) of an average director. The median premium provided for lead/presiding directors is significantly smaller, ranging from 1.13 to 1.17 times the Total Board Compensation of an average director.

TAKEAWAY: There are two items of particular note in the findings on board leadership compensation. First, it is striking that only about half of non-executive chairs/lead directors received additional compensation for the role. Contrast this prevalence to the virtually universal practice of providing additional compensation to board members who serve as chairs of any of the major standing committees. It suggests that the board chair/lead director position at many com-  panies is still evolving into a position with meaningful leadership responsibilities.

Also of interest is the differential between the premium paid to non-executive chairs versus lead directors. The premium for the lead director title is significantly lower, even though from a governance perspective, it would seem by definition that many of their responsibilities are similar. While this may just reflect a perception by directors that the two roles are meaningfully different, other studies have shown that, in practice, the non-executive chair role often has considerably greater responsibilities.

Lastly, many of the governance-related proposals currently before Congress include a provision to require mandatory separation of the CEO and chair positions. If this requirement is enacted, directors can expect dramatic changes in the structure and prevalence of compensation for board leadership.

Share Ownership Guidelines
After years of steady increase in the prevalence of ownership guidelines, this year’s prevalence dropped in four out of five groups, ranging from 24 percent among the smaller companies to 84 percent at the Top 200. Ownership guidelines generally require a minimum equity value, typically expressed either as a multiple of the annual board retainer or as a fixed number of shares (a formal guideline). Some companies instead require that stock awards be deferred to retirement, and other companies maintain both ownership and deferral standards. Additional methods used by companies to ensure stock ownership by directors include holding requirements and retention ratios.

Typically, directors have a stated period within which to acquire stock equal to the minimum requirement and must maintain that level of ownership during their tenure. That standard has been fairly consistent over time, with new board members typically given five years to comply.

TAKEAWAY: Notwithstanding this year’s decline, the NACD expects a continued long-term increase in the prevalence of stock ownership guidelines among all size groups. Two issues in terms of compliance are noteworthy. First, at companies where minimum ownership is based on value, the volatile market has caused some board members’ stock holdings to fall below compliance levels.

There are a number of design features that can alleviate this issue, such as calculating ownership levels based on an average stock price measured over a specified period (e.g., one year) to reduce the effect of volatility on compliance. Second, companies should be aware that RiskMetrics Group (RMG) does not count retention ratios and/or holding requirements as a stock ownership guideline in its evaluation of companies’ governance practices. In fact, RMG expects a minimum ownership multiple of three times the annual retainer.

As with many board pay practices, disclosure of perquisites and benefits for directors tends to increase with company size, from 3 percent of smaller companies up to 56 percent of the Top 200. Prevalence of disclosed perquisites and benefits declined from a year earlier in every revenue category, reflecting widespread shareholder and media criticism. Corporate matches for directors’ charitable gifts was the most common perquisite, reported by 14 percent of all companies, and was also most prevalent among the medium, large and Top 200 companies. Among smaller and small companies, life and health insurance for directors was most frequently reported, at 3 percent and 6 percent of companies, respectively.

TAKEAWAY: At this point, most companies have significantly curtailed or eliminated “status” perquisites to outside directors. The NACD expects that both the prevalence and value of benefits and perquisites will continue to decline over time. That said, other perquisites such as reimbursement for director-education programs will continue to be perceived as of value to the company and its shareholders.

CHARTS AND TABLES*:
Board Composition and Structure
Historical Year-Over-Year Total Direct Compensation Trends
2009 Prevalence of Premium Pay for Board Leadership and Prevalence of Perquisites/Benefits
2009 Prevalence of Full-Value Stock and Stock Options
2009 Median Total Compensation for Committee Members
2009 Median Total Direct Compensation

*Source: The 2009 2010 NACD Director Compensation Report

Now available: The 2009-2010 NACD Director Compensation Report produced with Pearl Meyer & Partners. Please visit the Governance Resources section of www.nacdonline.org to obtain a complimentary copy (NACD members only) or to purchase a hard copy.

What issues are most challenging in terms of complying with the new executive compensation regulations and climate?

The biggest issue is “say on pay” and how that will affect boards’ decision making. It’s non-binding, so compensation committees technically don’t need to do anything other than perhaps reflect on the results of the voting when shaping their compensation programs. Questions include: How much should say-on-pay votes influence compensation committees who must take a holistic view of the situation? What are the demands of the market and the company? What is being asked of management in terms of performance and what is needed to attract, retain and motivate management in order to maximize shareholder value?

What executive compensation issues do you see most frequently in M&A transactions?

Often, with respect to companies being acquired, executives have employment agreements that may allow them to exit following the transaction with substantial severance payouts, immediate vesting of long-term incentives and other perquisites. One of the first questions for the buyer is: Are we trying to keep these people? If so, what plans need to be put in place to make sure they stay in the organization? Or, if we need to sever people, then the question is, how do we retain them long enough to make sure that the integration is successful? For the seller, the issues center around maximizing shareholder value. This may require downside protection for executives at risk of losing their jobs. It may also require incentives structured around execution of a successful sale.

Have you seen M&A transactions in which the compensation issues caused the transaction to fail?

Most often the deal-breakers are on the front end. Sometimes it’s a failure on the part of the sellers. They might not have put in place programs to ensure that management doesn’t feel threatened or unprotected despite knowing that their jobs may be in jeopardy should the transaction occur. There’s a natural tendency for people to behave more conservatively if they fear losing their jobs. They also may not be as aggressive in helping to sell the company or in getting the greatest value for shareholders. So often that’s a big deal breaker. The second issue is the inability of the buyer to structure programs that will be acceptable on a go-forward basis to retain current management. How, for example, do you create significant opportunity in order to retain the CEO who has accumulated millions through  long-term incentives?

Do companies need separate compensation consultants in M&A transactions or can they rely on their benefits and tax counsel?

That becomes a judgment issue. The compensation consultant brings to the table a perspective that accounting, legal or benefits firms don’t necessarily bring. We tend to have a broader perspective that drives a different approach: let’s get a structure and a strategy that will help the merger succeed. We aren’t focused solely on the legality of issues, but rather on the strategy and implementation process.