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SEC Shoves Executive Pay into the Spotlight

As stock-option scandals multiply, the watchdog agency is demanding more, clearer, and broader information on officers' compensation

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As new revelations about executive stock-option grants continue to mount, with more than 80 companies identified for potentially manipulating the timing, and therefore the value, of the grants, calls for accountability and reform of executive compensation have increased as well. And stock-option grants are only a part of the story. Deferred compensation, pension plans, and perks are receiving increased scrutiny too.

To address these concerns, the Securities and Exchange Commission has adopted changes to disclosure requirements, with most taking effect on December 15, 2006. These include additional and more detailed information about executive and director compensation, director independence, and officers' and directors' securities holdings. The goal is to make total executive pay more transparent and easier to understand.

Will these changes make a real difference? Critics contend that they will be little more than a salve for a deep-rooted problem. SEC Commissioner Christopher Cox disagrees, saying that better information will enable shareholders and boards of directors to determine appropriate levels of executive pay, and let them effectively align compensation with corporate performance.

CONFIDENCE MAY ERODE. "Changes in disclosure do modify behavior," observes Dan Konigsburg, director for U.S. corporate governance at Standard & Poor's Rating Services. "CEOs themselves are starting to realize that outsized executive compensation, if it continues over the long term, can impact people's confidence in the current system."

Moreover, the specter of increased government regulation always looms if companies fail to get their own house in order. Many of the firms cited for questionable timing of stock-option grants have acknowledged the issue and launched their own internal investigations.

"Executive compensation can be a window into how effectively the board oversees management," says Konigsburg, explaining why Standard & Poor's is concerned about rising pay levels. "If executive compensation is closely connected to the company's performance, it could indicate the board is emphasizing management accountability," says Laurence Hazell, also a director for U.S. corporate governance at Standard & Poor's.

WRONG INCENTIVES? But if executive pay rises while other performance measures languish, the board may be providing the wrong incentives. "Moreover, which incentives a company chooses matter a lot," adds Hazell. "The point is to reward performance as a whole and not just the performance of the stock, because changes in a stock's price aren't necessarily linked to executive performance."

Equity investors obviously have significant concerns about excessive executive compensation because it could decrease their dividends or lower their stocks' worth. While creditors have a different focus, given that their investments don't have unlimited upside potential, they still tend to favor measured pay.

Both groups, though, are raising questions about boards of directors whose functions include setting executive pay. If boards can't say no to their chief executive officers when it comes to compensation, they may also be lax in overseeing other, more critical, issues, such as strategy and financial policy, which are of fundamental importance to credit analysis.

TEMPTATION FACTOR. Why has executive compensation spiraled so high? "There are a lot of apologists for high pay, including some directors who are quick to claim that their CEOs are brilliant and deserve every penny they get," notes Konigsburg. He has coined the term "executive exceptionalism" to describe those who justify fat pay packages and perks by insisting on a particular leader's unique qualifications for his or her position.

But it may miss the mark to attribute most of a firm's financial success to the CEO or a few senior executives, as the concentration of pay at the top of some companies implies. Market forces, such as interest rates or an imbalance in supply and demand, may also explain a company's outstanding performance.

Hazell suggests that in setting executive compensation, boards of directors often fail to distinguish between negotiating to retain an existing CEO vs. hiring a new one. "Firms may believe they need to pay a certain amount to tempt someone to come over," he points out.

"In this context, few board members will negotiate for better terms. Doing so may be tantamount to announcing that the firm has recruited a discount CEO. But when they're renewing the contract of an existing CEO, directors are often in a stronger negotiating position than they realize. Boards that recognize this can push for more moderate pay packages."

EMPHASIS ON SHORT TERM. Providing effective incentives for executives represents a challenge, and missteps have occurred. Linking payouts to hitting specific share-price targets, a provision in some stock-option plans, can raise red flags. Such an approach may lead to an emphasis on short-term results at the expense of a company's long-term financial and operational health, and it can also introduce or increase volatility in the share price.

Most companies use outside compensation consultants to advise compensation committees. But many compensation committees, whose members come from the ranks of the board, do not actively question their consultants' recommendations, says Hazell.

Benchmarking, introduced by consultants, has played a large role in driving up executive compensation because companies often use above-average pay within their industry as their measure for how much they wish to pay their own executives. Over time, as more and more companies pay at above-average levels, the numbers climb relentlessly. "It's a rare exception when executives look down rather than up for comparisons," Hazell says.

FAULTY COMPARISON. Some advocates of executive exceptionalism have proposed using pay at private equity firms and hedge funds as benchmarks. Executives in these industries make a great deal of money. But they also put their own funds at risk, with the potential for a very large payoff if things go right, or a total loss if things go wrong. Corporate executives at publicly traded companies, on the other hand, rarely take an entrepreneurial position with the risk of losing everything, so the comparison really isn't apt, according to Konigsburg.

Benchmarks can compound spiraling compensation when they're based on faulty performance data. Former WorldCom CEO Bernard Ebbers, for instance, presided over a company caught misreporting its expenses and inflating its revenues and assets, which created a false picture of financial success.

If Ebbers' compensation contributed to the benchmarks established at other telecommunications companies, did these firms reduce their executives' pay after the WorldCom accounting scandal came to light? There are no indications they have done so.

CHARGES FILED. The U.S. Attorney's Office in Northern California and the SEC recently filed the first criminal and civil securities fraud charges related to backdating of stock options. The complaints accuse former executives at Brocade Communications Systems (BRCD), a data-storage manufacturer, of granting in-the-money options but backdating documents to make the grants appear as at-the-money options, thus qualifying them for favorable accounting treatment.

Brocade granted these options as incentives for new hires. When the backdating was uncovered, Brocade had to restate its financial results for fiscal years 1994 through 2004.

On Aug. 9, the Justice Dept. and the SEC filed criminal and civil charges against the former CEO, chief financial officer, and general counsel of Comverse Technology (CMVT), a software company. The criminal complaint charges that the three executives conspired to commit securities fraud, mail fraud, and wire fraud.

It specifically cites backdating options to periodic low points in the stock's value, as well as maintaining a slush fund of backdated options. The SEC's civil case focuses on the executives' roles in filing false financial statements and false proxy statements.

SIMPLIFYING THE DATA. Neither regulators nor shareholder watchdogs can turn back the clock on what companies have already done. But the SEC has just approved numerous changes to disclosure requirements, aiming to make executive compensation easier for investors to find and understand.

Among the SEC's changes, a reorganized summary compensation table will consolidate information currently scattered among several tables and add new data. It will break out salary, bonus, stock, options, deferred compensation, pension plans, and retirement payments—and use them to calculate total pay for the past three years. An "other" column will include cumulative perks of $10,000 or more, which lowers the threshold from the previous $50,000.

"If you search diligently, you can probably find these amounts now, but it's not easy, and total pay is tough to figure out," according to Hazell. "The revised SEC requirements should change that, and make all the elements of pay easier to understand."

CLARIFYING DETAILS. The summary compensation table will list these data for the three highest-paid executive officers in addition to the CEO and CFO. A new section, "Compensation Discussion and Analysis," will precede the summary compensation table and explain a company's objectives in compensating executives and how it implements its programs. This new section will provide greater detail about the timing and grant dates of executive stock options, and the roles of executives and the compensation committee in these decisions.

In addition to the narrative and the summary compensation table, other tables will spell out specifics about stock grants and stock options (including amounts, value, exercise prices, and expiration dates) and pension benefits. The disclosure requirements about stock options address the need to uncover potential backdating and other methods of manipulating the timing of option grants.

Provisions for potential change-in-control payouts, commonly known as golden parachutes, will also be described and calculated using current values. These calculations will, for the first time, provide investors with an estimate of severance costs if the CEO or other executives were to leave immediately.

PLAIN ENGLISH REQUIRED. Of critical importance, the revised rules mandate the use of plain English, and the SEC has made clear that it will enforce this requirement. "Convoluted or legalistic language often represents the biggest barrier to understanding executive pay," explains Konigsburg.

The changes will take effect on Dec. 15, 2006, for most filings, such as proxy and registration statements, and apply to annual reports with fiscal years ending on the same date or later. Filers using Form 8-K to report material changes will have to comply with the new regulations when the triggering event occurs 60 days or later after publication of the rules in the Federal Register.

Beefed-up disclosure requirements are only a start. Boards of directors, shareholders, and employees must reinforce regulatory actions, urges Hazell.

SHAREHOLDERS GET FEISTY. Shareholders have stepped up their involvement, often refusing to rubber-stamp the official slate of directors presented for a vote at annual meetings, and trying to get other measures on the ballot as well. However, management has frequently tried to block such moves. And shareholder proposals are, in any case, only advisory, even when they win a majority of votes.

Votes on executive pay plans are likewise advisory (although proposed Congressional legislation on executive compensation would make shareholder approval mandatory). This is important, because once pay packages become effective, they have long life spans.

"There might be a good argument for shareholders to examine pay more frequently than once every 10 years," suggests Konigsburg, referring to the typical life span of a stock-option plan. "In the U.K., shareholders have an advisory vote on compensation policy every year. But in the U.S., companies are fighting such a change, arguing it's not needed and, in addition, it might affect competitiveness."

NO SILVER BULLET. But even if management and the board of directors don't have to abide by stockholder votes, can they afford to ignore repeated calls for change? If shareholder activism grows in terms of numbers and actions, the decision makers may rethink their strategy. Ownership is vested in stockholders, however widely dispersed, and their ultimate action can be to sell their shares.

Lawsuits also have the potential to change the balance of power a bit. "Courts may be taking a more critical view when invited to by disgruntled shareholders," Hazell notes.

The problems with setting executive pay are clear, but what about the solutions? "There's no silver bullet," says Hazell, but easy-to-understand disclosure is a first step in the right direction. "Companies should be able to showcase compensation and be proud of it, not want to hide it," he adds. An independent board, engaged shareholders, alert regulators, and responsible employees will take them further along the road to achieving this goal.

Standard & Poor's senior features editor Libby Bruch contributed to this report

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report.
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