©2010

CURRENT TRENDS IN EXECUTIVE COMPENSATION

Robert L. Musick, Jr.J.D. , University of Virginia

M.L.T, William and Mary

Your Strategic HR Partner

©2010

• To 'run amok' is to behave in a wild or unruly manner. 'Run amok' is now synonymous with the term 'go crazy', but originally meant 'a murderous frenzy or rage'. (the Phrase Finder)

• In the beginning, Enron…2001

• Other dishonorable mentions—Tyco, Adelphia, WorldCom

• Reaction to perceived abuseso “Cooking the books” begets “Sox”o “Free” stock options result in accounting changeo Nonqualified deferred compensation and the “haircut”

cash-out lead to Section 409A

• At the core, deceptive business practices were the problem, but egregious compensation abuses attracted special attention.

Background—Executive compensation run amok!

©2010

• Sarbanes-Oxley Act of 2002 addressed many issues, including:

o Boardroom inattention: Corporate failures pointed to Board members who either did not exercise their responsibilities or did not have the expertise to understand the complexities of the businesses. In many cases, Audit Committee members were not truly independent of management.

o Executive compensation: Stock option and bonus practices, combined with volatility in stock prices for even small earnings "misses," resulted in pressures to manage earnings. In addition, stock options were not treated as an expense by companies, encouraging this form of compensation.

Good Governance—Who is responsible?

©2010

• Securities Exchange Commissiono Enhanced disclosure—detailed tables of various types of

compensationo Requirement of the Compensation Discussion and Analysis—

the company’s executive compensation “story”o Responsibility of the Compensation Committee—certification

required

• Nonqualified deferred compensation reform – Section 409Ao Effective for 2005o Strict rules as to time of election/time of paymento No more “haircuts” and early distributions

• Accounting for stock options – FAS 123(R)o Effective for 2006o Options must be reported as compensation expense over

service period

Good Governance—Who is responsible?

©2010

• Financial meltdown 2008-09 results in Troubled Asset Relief Program (TARP)o Executive compensation caps as a condition to receiving aid

o $500,000 limit on compensationo No bonuseso Restricted stock only (no options), vesting when TARP

money repaido “Clawbacks” for incentives awarded on erroneous financial

datao Certification of risk analysis by Compensation Committeeo Non-binding shareholder vote (“Say on Pay”)

• Dodd-Frank Act of 2010—massive new regulatory impact on financial and other public companieso Comparing company performance with executive

compensationo Comparing chief executive compensation with median

employee compensation (“internal pay equity”)o “Clawbacks” for incentives awarded on erroneous financial

datao “Say on Pay” and “Say on Golden Parachutes” advisory

shareholder votes

Good Governance—Who is responsible?

©2010

o Board accountability/Committee responsibilityo Review and retrenchment generallyo Re-thinking “Pay for Performance”o Trickle-down Effect

Major Trends Emerge

©2010

• Independence—those who oversee executive compensation must be independent of the executives themselves

• Tally sheet—committee must see and understand the value of “total compensation” (fixed and variable, short- and long-term, cash and stock, current and deferred) for executives

• Market data/analysis—what are similarly situated companies doing? How are they performing?

• Executive compensation philosophy—how does the executive compensation structure connect with the company’s business strategy? How much compensation is fixed, variable, performance-driven, etc.

• Aligning with shareholder interests—does pay link to shareholder value?

Prudent Process—An Overview of Compensation Committee Procedures

©2010

• Variable incentives drive behavior—is it clear that “good” behavior benefits the company in the long run?

• Risks are associated with most types of incentives—what are they?

• Risk mitigation is necessary to protect the company—how do we do that?o Focus on “team goals” that assure individual income

depends upon the company’s successo “Clawbacks”—recovering incentives paid on the basis of

bad datao “Holdbacks”—delaying payment of earned incentives to

be sure risk to the company has passed

Balancing Reward Against Risk—A Lesson Learned but Forgotten from Enron!

©2010

The Way Ahead—“Reform” run amok?

• The cost of compliance is still undetermined, as are the benefits.

• Do stronger rules produce better conduct?

• Expect continued close scrutiny of executive compensation process.

©2010

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