New executive compensation disclosure rules from the Securities and Exchange Commission that go into effect for 2007 proxy statements aren't designed to regulate executive compensation, but to give shareholders more information about pay practices.
But in reality, the increased visibility that will surround executive compensation in the aftermath of the most sweeping revision of the rules since 1992 is certain to create greater scrutiny. The change is likely to have a long-lasting effect on the elements that make up executive pay - but not necessarily the sum totals.
``The biggest change in the short-term is that there will be far more disclosure and transparency, which will lead to more accountability,'' said Andrew Goldstein, an executive compensation analyst in the Chicago office of Watson Wyatt Worldwide Inc.
``The more that shareholders know - and the more information that they have - the more they will hold boards of directors and compensation committees accountable,'' particularly when pay packages are out of sync with performance, he said.
``The picture around what a company's total executive compensation package is, including benefits and perks, will now be out in the open for all to see,'' Goldstein continued. ``You can't just disclose what you did. You have to disclose why you did what you did, and provide a narrative that explains the philosophy behind the approach.''
Critically, a firm's disclosure statement on executive compensation must be certified under Sarbanes-Oxley requirements, making the chief executive officer, the chief financial officer and the full board all legally responsible for what's in the analysis. The rules, published in July, take effect for fiscal years ending on or after Dec. 15.
For the first time, companies must disclose total pay, perks and lifetime retirement benefits for their five highest-paid executives. Those executive pay proxies must assign a dollar value for all equity-based awards, nonequity incentive plan compensation, changes in pension values and nonqualified deferred compensation. They also must disclose the value of CEO severance packages in the event of a merger or acquisition.
But it is the requirement that companies provide, in plain English, a detailed narrative that explains the objectives of the compensation program, each element of the plan and the rationale that went into creating the plan that will stir up the hornet's nest of scrutiny.
The analysis must explain the plan's design, including why each element was chosen, what it rewards and how it is intended to improve corporate performance; how the dollar amounts for the elements in each executive's pay package are determined and how they fit into overall compensation objectives.
``These are not easy rules,'' said James Reda, managing partner of James F. Reda & Associates LLC in New York. ``Companies will have to be more specific about the use of the company car, the use of the corporate jet, pension entitlements, extra life insurance, and enhanced severance and retirement packages.''
The rules, for example, require that companies disclose the actuarial present value of pensions of each of the top five executives as well as how much each executive has accumulated under the pension plan.
In addition, the value of each individual perquisite must be itemized unless they are valued collectively at less than $10,000, compared with the current $50,000 minimum.
They also must provide information on stock-option grant dates, the fair value of the stock on the grant date, how they value options, the date when the board took action to grant the award and the methodology used to determine the exercise price of options.
The rules also require disclosure of backdating of stock options, the practice that led to the new reporting requirements surrounding options.
The Department of Justice has filed a criminal lawsuit against two former Brocade Communications Systems Inc. executives over stock options backdating and is investigating similar practices at more than 80 companies.
Earlier this month, electrical connectors molder Molex Inc. of Lisle, Ill., announced that an independent audit found the firm had not backdated options, but had misdated them back to 1995, leading to overpayments of $685,000 to 14 executives. CEO Martin Stark said the firm is paying the money back and no one will profit from the fact that the options were issued on the wrong date.
``The bottom line is that boards and compensation committees have to really step up their efforts to improve corporate governance around executive compensation because they are being held to a higher standard of accountability, responsibility and liability,'' said Watson Wyatt's Goldstein.
Most compensation experts believe the rules will cause boards and compensation committees to trim a number of perks, kill supplemental executive retirement plans and consider modifying hefty severance and change-in-control packages since firms must disclose their actual value.
``Some will take things away and replace them with more cash compensation,'' Goldstein said. ``Others will take things away and not give executives anything in return. Boards can't take away things in current long-term contracts, but with newly promoted executives, they can eliminate participation in such legacy problems.''
In determining what to keep and what to alter, retirement, severance and change-in-control plans will be brought front-and-center in the compensation debate, said Joseph Rich, president of Pearl Meyers & Partners. The New York-based firm is the executive compensation arm of Clark Consulting.
Unless it is altered, ``post-separation compensation will become much more visible as a major component of the total compensation package - the fourth leg of the pay table,'' Rich said. ``Boards can be sure that when media pundits and investors weigh in on 2007 proxy statements, they will zero in on disclosure of potential future compensation. All of these now will be the `holy cow' numbers.''
Likewise, perks - with their values disclosed - will move to center stage. ``Companies may decide some things aren't worth keeping,'' said Reda.
Joe Mallin, managing director of the Atlanta office of Pearl Meyers, said compensation committees will begin to question whether the relatively small dollar amounts for perks are worth the public discussion that is ``sure to take place.''
``There are a couple of perks that act as lightning rods. The corporate jet is first on the list and some of the things at the frothy end of the market - extra retirement packages, severance packages and change-in-control packages - might begin to go away.''
And while some downplay the impact of the new SEC rules in changing CEO compensation practices and bringing them more in line with performance, Goldstein of Watson Wyatt thinks important changes lie ahead.
``I don't think the mix between salary, bonus and long-term incentives is going to change a lot,'' he said. ``But the underlying details will change a lot and there will be some fairly dramatic changes. At the end of the day, the bar is being raised. Management is going to have to perform better to earn the same amount of compensation.''
But Mallin has a different perspective.
``The SEC rules can drag from the shadows highly lucrative arrangements that currently fly under the radar screen,'' he said. ``But rather than rein-in pay levels ... many companies will simply rearrange how executives get paid, but not necessarily how much.''
That is, controversial benefits - such as use of corporate aircraft and country club memberships - will decline in use, but their value simply will shift ``to more politically acceptable areas, such as performance-based equity awards,'' Mallin said.
But even as boards begin to implement changes, don't expect the actual impact to be reflected in compensation numbers for several years, he warned. The changes will happen over time.
``In many cases, contractual changes may need to be made over a period of years to allow for contracts to expire and be renegotiated on new terms,'' Mallin said.
``It will take five to 10 years to achieve this, as we will have to go through a generation of agreements before it starts to be reflected in the pay packages.''
