Rules of executive compensation Featured

8:00pm EDT September 25, 2007

It’s been just a little over one year since the Securities and Exchange Commission (SEC) amended its disclosure rules around executive and board pay packages. The new rules require specific and more extensive reporting of prequi-sites, pension benefits, equity, non-qualified deferred compensation and compensation-related performance measures than have been reported in the past. While these new rules go further than ever before in revealing just how and how much executives are paid, making more transparent previously hard-to-find information, it’s only now that the first year of proxy statements have been filed that the SEC can make their reviews of the rules’ effectiveness. Recently, the SEC began by issuing more than 300 letters to companies requesting further information.

CEOs and boards can now begin to anticipate some of the likely changes that the SEC will require going into year two, says Ann Costelloe, San Francisco office practice leader of Executive Compensation for Watson Wyatt Worldwide.

“Certainly the results from implementation of round one of the new disclosure rules is that we’re getting a much clearer understanding of the process around executive compensation, including who’s involved and how the plans operate,” says Costelloe. “But the proxy filings fell short of actually establishing the relationship between pay and performance for the executives, and when we look to measure the pay of executives against peer companies with a similar performance, the link just isn’t clear.”

Smart Business spoke with Costelloe about what CEOs can learn from the results following the first year under the new reporting regulations and what changes to expect going into year two.

Which disclosure areas scored the worst following round one?

You can look at the proxies and see that less than 50 percent of the companies reported what the executives’ compensation-related performance goals actually were. For example, when you review the section of the proxy that describes the amount of bonus that the executive was granted in relation to the firm’s performance objectives and results, it becomes clear that, in many cases, the companies simply didn’t want to state the specific performance measurements and goal benchmarks.

Many of the proxy statements weren’t written in plain English and I think, because the process was new, many authors erred on the side of caution and included more information to the detriment of clear, concise explanation. Also, many of the proxies failed to consolidate all of the key information in one single place where the reader could easily access it. After this first round, the SEC is going back to ask for more information about the performance thresholds that are tied to executive compensation pay-outs and a more reader-friendly format.

What were some of the best elements from the proxies?

The best proxies included an executive summary that clearly listed what the executive was paid and how the pay-out tied back to performance in a condensed easy-to-read format. Also, I think after reviewing the first year’s proxies, the best proxies resulted from the cumulative work effort of HR, the legal department and finance. When the document is created solely by the legal department, it starts to take on the characteristics of a legal document and can become overly wordy and hard to understand from a layman’s perspective. Investors want to see a straightforward and transparent approach to providing the required information that is easy to understand.

What other trends have emerged in the areas of plan changes, change in control provisions, retirement or other executive benefits as a result of the new disclosure rules?

What’s really interesting is that we are definitely starting to see companies take a harder look at the business rationale for these programs. Many companies took a proactive approach in anticipation of the new disclosure rules and eliminated some of the traditional perks, like country club memberships, post-retirement perquisites and extra travel benefits. In relation to change of control provisions, we saw some organizations begin to make or consider changes (reductions) to existing arrangements, although generally companies are holding fast to the contracts that have already been executed. I think on a go-forward basis, as new contracts are negotiated or new plans are implemented, you’re going to see a more conservative approach to severance payments and elimination of some of the kickers in supplemental executive retirement plans.

What other changes should CEOs expect around reporting and what else should CEOs do to prepare for next year?

I think to prepare, companies should expect to fully explain the link between executive pay and performance. Many people think that the SEC will have higher expectations and will demand more rigor around the metrics that are used to measure executive goals and detail about how the compensation was actually earned and how the executive’s performance ties back to the compensation payment.

It will be important for the proxy author to understand the differences between the pay opportunity and the pay that was actually realized by the executive and be able to articulate it. Most importantly, start early, involve numerous members of the team in completing the metrics for the document and exercise the utmost transparency in providing the necessary information to comply with the regulations.

ANN COSTELLOE is the San Francisco office practice leader of Executive Compensation for Watson Wyatt Worldwide. Reach her at (415)733-4244 or ann.costelloe@watsonwyatt.com.