The facts about CEO compensation

HRM. What trends are we seeing in terms of CEO compensation right now?

HG. What we’re seeing is the continuing integration of best practices that have emerged in the last few years in response to a number of factors – namely, the increased awareness of compensation committee members regarding their fiduciary responsibilities as directors; and increased regulatory issues, particularly in the accounting and SEC area, which call for greater precision and disclosure.

In terms of CEO compensation trends, the main one is that we are no longer seeing a reliance on options as the primary form of long-term incentive (LTI) as we did in the 1990s; in fact, we’re seeing something of a mixed picture in terms of executive LTI, with salaries that are flat or only slightly increased, and bonuses that are increasingly variable. The new accounting rules that came into effect as of January 2005 changed the playing field with respect to the accounting treatment of LTI devices, and as a result stock options are no longer favored from an accounting point of view.

The advantages of stock options have lessened compared to the advantage on other LTI devices. So for that reason, and because of investor and some employee sentiment that stock options shouldn’t be the preferred device, we’ve seen an increased reliance on ‘plain vanilla’ restricted stock (stock that does not have a performance contingency attached) and performance contingent options. In the US, performance contingencies were not a major part of the array of LTI devices as they were in, for example, the UK, but it is increasing.

In addition, the disclosure rules recently finalized by the SCC will require an extensive amount of work to disclose all components and a total value with respect to pay for the named executive officers, including the CEO. This puts the spotlight again on compensation committees to make sure that there is a linkage between pay and performance. Pay and performance was always something that was a principle adhered to by many, if not all committees, but people are more aware of what they have to do in terms of performance, which is to have a metric that is measured. Compensation, particularly in the LTI, is measured against that metric.

HRM. Do you think performance related compensation is the only satisfactory means of compensation in the public and shareholders’ eyes?

HG. It is a large part. In the eyes of employees, investors and shareholders, they do not want to see a disconnect between the CEO and named executive officers’ pay and the performance of the company. Compensation committees are very aware of this now and have been in the last 2-3 years. Sarbanes Oxley was obviously a spur to that awareness. For the most part, well-run public companies with good governance, which are generally the types we work with, are very aware of the link and are trying to work towards it. I think we are also in a phase that started with the collapse of Enron and Sarbanes Oxley that has not yet quite concluded. We’ve had the increase in judiciary issues, we’ve had the accounting changes, we’ve had disclosure from the SCC side – so there has been a fair amount of regulatory activity and judiciary concern, and also increased scrutiny from investor-related organizations like ISS and corporate library and others, and that is going to result in best practices that are probably going to emerge in the next two years. Now we finally have the SCC disclosure rules, and we will see the first results from them and the proxy rules early next year through May. And by 2007-08, we’ll be able to see new best practices in the period that has been in tumult somewhat since 2002.

HRM. What will these best practices entail?

HG. I should think they will relate to scrupulous corporate governance, truly independent directors, compensation committee awareness of all material elements with respect to pay, the use of tally sheets so that the compensation committee and the shareholders can understand every component of pay (death, disability, change in control, retirement, etc.) – and while the SCC rules do not call for tally sheets, they will in fact require their use. Also, an understanding of the appropriate relationship between pay and performance so that you don’t pay without good performance. I’ve been in the industry over 30 years and I know it takes a good couple of years to get it right, but the efforts are being made.

HRM. Following recent corporate governance scandals, do you think there is a lot more public interest in the way CEOs are compensated? Is this justified?

HG. No one thinks that scaremongering is justified and I think the great majority of companies have attempted, as they learn the changing playing field, to make sure they comply with the new high governance rules. The important thing for public companies is that compensation committees are becoming aware of their duties and want to get it right.

HRM. What can the business community do to improve transparency and better communicate the facts of CEO compensation?

HG. Transparency is the answer. The chair of the SEC says that they are not out to set levels of pay, it’s out to have transparency with respect to pay so that people know what CEOs or named executive officers make. And one could always quibble with the details of any disclosure rule as to whether something is aptly organized or phrased, whether it will lead to a good result or is superfluous. We’ve not yet seen what is expected to be a 300-page doc that will contain the final rules, but it will be out soon and we will be analyzing them and the proof will be in next year’s proxy disclosures, which will be subject to the new rules. But it will be up to investors and shareholders to take the position on CEO pay and also for compensation committees to properly use market data to look at it from the proxy and survey perspective, and how it relates to the particular executive they’re looking at. But I do think disclosure is the answer and if corporate American takes a stand against bad practices, which I think many of the big organizations do, that’s a good start.

HRM. What will be the major developments driving CEO compensations over the next two years?

HG. I think it will be the relationship of the CEO’s particular performance and results with respect to projected goals. Under the US internal revenue code, performance-based compensation is subject to certain requirements with respect to setting goals early in the year and having the compensation committee certify the goals are correct and have been met at the end of the year in order for the compensation to be deductible (162 end rule). That type of analysis is going to go through and be thoroughly explored. Even under the current SEC rules, a compensation committee is supposed to write in its report how pay-related CEO performance and how specific performance actions and items justified the paying of certain amounts and also the types of vehicles used.

The three-legged stool of the regulatory environment, the compensation committee’s awareness of its judiciary role and the shareholder and institutional shareholder input and comment has created this matrix that is driving where we are going now and I don’t see that stopping in the foreseeable future. Every year there may be another regulatory issue or another view of best practices from the institutional shareholder organizations, which management and compensations committees will have to consider, which is why it is such an exciting time. I like to think that this period of constant change that began in 2002 will stabilize in a year or two. Once we have a couple of years under our belt (and assuming there are no other regulatory issues or pressure from shareholder organizations) we may have a period of clarity as to best practices.