What’s Next in Corporate Pay Practices?

EXECUTIVE SUMMARY

RECENT SCANDALS HAVE CREATED A PUBLIC perception that corporate executives are putting their own interests ahead of shareholders’ concerns. While the Sarbanes-Oxley Act of 2002 does not directly mandate changes in compensation methods beyond placing restrictions on personal loans to executives, its emphasis on corporate governance has been a catalyst for public companies to reexamine how they pay their top executives. IT’S NOW UP TO COMPANIES TO REVISE THEIR pay methods with CPAs’ assistance. On a practical level, greater duties for board compensation committees and a reconsideration of companies’ use of stock options will have the greatest impact on how companies compensate their executives. FOR COMPENSATION COMMITTEES SEEKING GUIDANCE on how to begin, CPAs can recommend a list of best practices developed late in 2003 by the National Association of Corporate Directors’ blue ribbon commission on executive compensation. Executive Compensation and the Role of the Compensation Committee suggests compensation committees maintain their independence, create fair pay packages, focus on long-term shareholder value, link pay to performance and encourage transparency. CPAs CAN HELP COMPENSATION COMMITTEES CAREFULLY examine how stock options should fit into the mix. Option grants became less appealing after the market boom ended. They also were perceived as encouraging executives to focus on short-term results that would cause a temporary stock surge and raise the option value just in time for exercise. FASB has introduced mandatory expensing of stock options, which may diminish their appeal for some companies.

ANITA DENNIS is a JofA contributing editor and a freelance business writer.

n a speech last fall, PCAOB Chairman William McDonough said many members of Congress had asked him whether he could “figure out a way they could pass a law controlling compensation.” In expressing his doubts to the National Association of Corporate Directors annual corporate governance conference, McDonough said he didn’t believe any one law could fit each company’s unique situation, though “that doesn’t mean that one won’t get passed if the American people stay angry enough.”

Regulators and Congress have begun to scrutinize how public companies pay their executives; the subject remains a sore spot for investors as well. “Something has gone wrong with executive compensation in the United States,” Sean Harrigan, president of the California Public Employees’ Retirement System—the country’s largest public pension system and a powerful institutional investor—told Congress last year. Harrigan said it was “shocking” to see top corporate executives insulating themselves from any risk while shareholders are losing value.

This article identifies some of the key concerns on which CPAs—in their capacity as CFOs, human resources professionals, financial managers or consultants—can advise companies as they seek to revise their pay practices. CPAs also can offer important advice on tax, financial reporting and compensation issues. In addition, the information in this article will be helpful to the CPAs who, because of their financial expertise, are increasingly being asked to serve on corporate boards (see “ CPAs as Audit Committee Members, ” JofA , Sep.03, page 32).

THE CPA’s ROLE
“CPAs employed by companies can take a proactive role in advising their boards on compensation practices,” says Roselyn Morris, CPA, associate dean of the McCoy School of Business Administration, Texas State University at San Marcos. Depending on the CPA’s position, “this may even be part of his or her job.” A CFO, for example, could offer advice and opinions when dealing with the board and other executives. CPAs in other areas of the organization not directly involved in compensation can direct governance issues, shareholder advocacy concerns and other questions to the company’s ethics hot line.

For CPAs seeking to guide employers or clients through the compensation minefield, Morris says openness will be a key concern. “Today, a company wants to be more transparent rather than less,” she says. That may mean going beyond minimum disclosure rules to consider what information an investor might want. For example, from a financial reporting standpoint, “in an audit, if something is not material, you don’t have to be transparent.” But, Morris notes, “what may not be material to a company may be material to creditors and investors. If you’re doubling someone’s salary and paying them $1 million in cash and $1 million in stock options, I don’t care if it’s immaterial to General Motors. If you don’t tell investors or creditors about it, they feel you’re playing games with them.” CPAs can help companies understand the value of exceeding basic requirements to satisfy creditor and investor concerns. “Even if it’s possible to avoid disclosure, you may want to do so anyway,” she says.

In working with or serving on compensation committees, CPAs are in an excellent position to help the committee understand various pay options. On some committees not all members will be familiar with different pay strategies, so CPAs can help fill the gaps in their knowledge. CPAs also can offer valuable perspective—for example, ERISA laws prohibit companies from offering executives benefits packages that are unavailable to other employees. “Compensation committees need to start asking whether they would be willing to pay all their employees the way they are paying top executives,” Morris says. A CPA can provide the answers.

CPAs also can play a role based on their more traditional areas of expertise. They are in the best position to advise human resources executives and the board of directors on the financial reporting and tax implications of new compensation strategies. Before a board adopts a new incentive plan it will need to know what impact the plan will have on the company’s balance sheet. A new strategy is worthless if it will require changes to the financial statements that are even more detrimental than the old one. Board members, particularly compensation committee members, also will want to know the tax effect—to the company and to individual recipients—of switching, for example, from stock options to restricted stock. CPAs can provide the necessary reassurance that the tax consequences will not be harmful to the company or act as a disincentive to executives.

A FOCUS ON CORPORATE GOVERNANCE
The changes companies make in their pay strategies will be effected in large measure by new approaches in two key areas: greater duties for board compensation committees and a reconsideration of the use of stock options. According to Tom Wamberg, chairman and CEO of Clark Consulting in Barrington, Illinois, 2003 “was the culmination of watershed events for executive compensation.” Wamberg says boards of directors’ compensation committees are under tremendous pressure to meet and even exceed shareholder expectations by putting a proper compensation structure in place.

Recent scandals have left the impression that corporate executives are putting their own interests ahead of shareholders’ concerns. To address this issue, the major U.S. stock exchanges established new rules in 2003 requiring shareholder approval of all equity compensation plans. As a result, during the 2003 proxy season, Home Depot asked shareholders to approve the terms of performance-based compensation payable under the company’s management incentive plan. In 2004 Hewlett-Packard asked its stockholders to approve its stock incentive plan. Other companies are putting forth similar resolutions.

Meanwhile, although the Sarbanes-Oxley Act of 2002 did not mandate changes in compensation methods beyond placing restrictions on personal loans to executives, its strong focus on corporate governance issues has been a catalyst for companies to reexamine standard operating procedures—including how they pay top executives.

A STRONGER ROLE FOR COMPENSATION COMMITTEES
In any public company responsibility for changing pay practices generally rests with the board of directors’ compensation committee—a body CPA directors may be asked to serve on or advise in their capacity as the executive charged with overseeing compensation. “We’re seeing these committees doing a lot more work,” says Joseph Sorrentino, managing director of compensation consultants Pearl Meyer & Partners in New York City. In its 2004 proxy statement, Massachusetts-based EMC Corp. said its compensation committee met 12 times during 2003.

CPAs advising compensation committees on how to begin changing pay structures can take advantage of a list of best practices put together in 2003 by the National Association of Corporate Directors’ blue ribbon commission on executive compensation. In Executive Compensation and the Role of the Compensation Committee ( www.nacdonline.org ), the commission recommends these principles and practices CPAs can use to advise employers and clients on executive compensation.

Independence. Compensation committee members not only should be independent (as they must be under new stock exchange listing requirements) but also should consider engaging an outside consultant—as necessary—to help develop an overall compensation philosophy and specific pay packages for company executives. (NYSE’s corporate governance rules also mandate an independent compensation committee have a written charter and make an annual report to the SEC. CPAs can find these rules at www.nyse.com/pdfs/finalcorpgovrules.pdf . The American Stock Exchange rules are at www.amex.com/?href=/atamex/news/press/sn_CorpGovRules_091302.htm and the Nasdaq’s rules can be found at www.nasdaqnews.com/news/pr2002/ne_section02_141.html .

In the past top managers often were involved in hiring compensation consultants to craft their own pay packages. A 2003 survey by Corporate Board Member magazine and Towers Perrin found management hired 25.1% of executive compensation consultants while the board, with management’s input, hired 55%. Nearly 70% of those surveyed expected retention of consultants in the future would involve greater director participation—with continued management involvement. Many compensation consultants say that from an ethical standpoint, they prefer the compensation committee hire them.

Fairness. The blue ribbon commission recommends against wide gaps between the CEO’s pay and the pay of other senior managers—or between executives and other employees—without reasonable justification.

Long-term shareholder value. The commission believes executives should be rewarded for meeting short-term targets, “but companies also should award additional variable compensation based on achieving key metrics over an extended period of time, using company performance measures, rather than stock price, as criteria.”

Link pay to performance. Managers should have a long-term stake in the company through stock ownership requirements and stringent holding periods. In light of this recommendation CPAs should advise the full board to participate in setting performance objectives rather than delegating this responsibility to the compensation committee. “Pay should be linked to performance as reported, and performance metrics should not be changed after the fact to compensate for failure to meet stated objectives,” the report says.

Transparency. Every element of compensation should be clearly disclosed to investors—even when the company is not required to do so.

“Coupled with a spirit of courage and rigor, these practices can help ensure that we motivate and retain the best talent while minding the long-term interest of the organization and its shareholders,” said Barbara Hackman Franklin, cochair of the blue ribbon commission, who also is a corporate director and former U.S. Secretary of Commerce.

Given such principles as a basis for compensation decisions, CPAs should remind compensation committees they face the practical task of figuring out specifically what to pay their executives. The committee’s job will be a juggling act in which it will rely on some established benchmarks in crafting a program that is unique to the company and includes a mix of external and internal points of reference.

“A lot of compensation committees are starting with a blank slate”—building a tailor-made plan that is not based on past practices, says Donald Sagolla, a principal of Mercer Human Resource Consulting in Los Angeles. “They’re looking not only at the cost of their compensation program but also at the return on their compensation expense.” Committees are scrutinizing the dilution and “overhang” effect of various strategies on share value, as well as how compensation decisions mesh with the corporate culture and the business plans of the company and its parent. (As used here dilution is the reduction in stock value and earnings per share when an employee exercises stock options; overhang is stock options granted, plus any remaining promised options still to be granted, that can depress the company’s stock price if an employee sells them.)

In some cases apparently successful companies with seemingly competitive pay strategies continue to see turnover at the top. These businesses, Sagolla says, need to gain a perspective on succession and leadership issues—as well as define overall performance measures both qualitatively and quantitatively—with compensation as only one factor in their analysis.

Sagolla says as a result of recent trends, CPAs involved in crafting compensation programs will see a new externalized element in the approach companies take to compensation. In the past an executive who met his or her business-plan targets might have been well-rewarded automatically. Today, companies also want to know how their own performance stacked up against the competition before they hand out rewards. If the company did well but not nearly as well as its competition, it may factor that in to reduce the executives’ final payout.

But while companies should examine the competition’s performance, they will likely place less emphasis on duplicating its pay packages. In the past corporations often sought to set executive pay based on compensation surveys. But that approach will no longer work. “Everybody can’t be paid at the 75th percentile,” Sagolla says, referring to a former goal for executive pay. CPAs should recommend that companies that once scrambled to keep up with their peers’ pay packages now set aside the benchmarking surveys and take a closer look at their own performance and how their executive has influenced it, then use those results as a basis for compensation.

At the same time, companies still will want to know how their pay packages compare with those of their competitors. According to Pearl Meyer’s Sorrentino, that will mean a greater effort to define the business’s proper peer group. Issues CPAs should consider when companies ask them to help make this determination include not only the company’s size and industry but also what businesses it competes with for revenues and for talent, which ones usually serve as the recruiting grounds for top talent and which lure away departing leaders.

Beyond paying and retaining executives, companies also should consider how to let them go. Given the number of cases where an executive was terminated for poor performance but still got a whopping severance package, “this issue is definitely on institutional shareholders’ radar screen,” says Sorrentino. The board of directors may ask CPAs in finance and payroll functions to help it determine how much it will cost the company if an executive leaves under a variety of scenarios. CPAs typically can consult the executive’s contract and make “what-if” calculations under different likely termination scenarios so the board can consider potential severance costs in making personnel decisions.

PRACTICAL TIPS TO REMEMBER

CPAs should advise public companies that their compensation committee members should be independent. It’s also a good idea for them to consider engaging an independent consultant to help develop an overall compensation philosophy and specific executive pay packages. When recommending corporate pay strategies, CPAs should suggest companies set aside benchmarking surveys. Instead, they should look closely at their own performance and how the executive influenced it and use those results as a basis for compensation. The specific business performance metrics CPAs should advise public companies to use when developing compensation strategies depend on the company itself. For example, a retailer might use return on sales as a basis for ongoing compensation, while an investment bank might rely on return on equity or capital employed. Given the bright light investors and regulators are shining on corporate compensation practices, the best advice CPAs can offer a company is that it be more transparent rather than less in what it discloses. That may mean going beyond minimum disclosure rules.

STOCK OPTION ALTERNATIVES
One critical step for any board committee charged with setting executive compensation is to examine how stock options fit into the mix. During the boom of the late 1990s, many companies handed out options as a cheap form of compensation. Executives welcomed the chance to own options on stock that—it seemed during the market’s headiest days—would only increase in value. The practice became less attractive, however, when the market tanked, leaving many options essentially worthless. Worse yet, option ownership seemed to encourage executives to focus on short-term results that would cause a temporary stock price surge and raise the value of their options just in time for exercise.

In 1995 FASB issued Statement no. 123, Accounting for Stock-Based Compensation, which introduced the concept of voluntarily expensing stock options and required new disclosures. More recently, as part of its ongoing equity-based compensation project, FASB released an exposure draft, Share-Based Payment, an Amendment of FASB Statements No. 123 and 95, in March 2004. Under the ED companies would have to treat all forms of share-based payments to employees, including stock options, the same as other forms of compensation by recognizing the related cost in the income statement.

Companies clearly have begun to make changes. A study released in April 2004 by Pearl Meyer & Partners found that the average value of options granted to CEOs fell to $3.2 million in 2003, a 38% decline from the prior year. Approximately two-thirds of the companies paid their CEOs more cash in 2003 than a year earlier, while less than 20% provided options with a higher grant value. Company boards and their compensation committees are seeking alternatives—or at least complements—to stock options.

Investors want other changes as well. At its 2004 annual meeting, Hewlett-Packard faced a shareholder resolution that would have required the company to expense all future stock options in its income statement. The inevitable result would have been the granting of fewer options to avoid too large a drain on earnings. Stockholders in other companies proposed similar measures during this year’s proxy season in advance of a final FASB statement that is likely to require essentially the same treatment.

Mercer’s Sagolla predicts CPAs will see companies making greater use of restricted stock. Under this scenario a company might make an outright grant of stock rather than an option, but with some strings attached. For example, the stock may have a vesting schedule to compel the executive to stay with the company for a certain period or it may vest based on the achievement of certain goals. In the Mercer survey, among companies that recently had introduced a new equity plan, two-thirds used service-based restricted stock and one-third used performance-based restrictions.

Whether combined with restricted stock or in another strategy, tying pay to performance definitely has gained in popularity. “One way to link compensation to performance that shareholders care about is to pay executives based on key business performance metrics,” says Sorrentino. “We’re going to see fewer discretionary annual incentive awards. There will be a stated formula, based on key performance drivers, using criteria tied not just to profits but also to key business requirements.” His firm recommends long-term incentive packages have a mix of some stock options as well as a plan that focuses on business performance rather than stock price.

The specific business metrics CPAs should recommend depend on the company. For example, a retailer might use return on sales as a basis for ongoing compensation, while an investment bank might rely on return on equity or capital employed, according to Sorrentino. “Then we would design a three-year plan based on the company’s financial projections, determining the targets and payout based on performance over that period. The goal is to improve long-term shareholder value.” The three-year horizon helps build a better foundation for business decisions and planning. If the company doesn’t meet the set thresholds at the target dates—or if it exceeds them—the executive’s compensation varies accordingly.

According to Sagolla, companies will “no longer use a bunch of performance measures the competition uses or that they read about in a book. CPAs should encourage them to consider their own business model and how the metrics relate to their own goals or to those of their parent. And the most important question will be, what performance creates value for shareholders?”

Stock appreciation rights (SARs), which give executives the chance to benefit from stock price increases without having to actually pay the exercise price of a stock option, also will gain in popularity as a way to reward and retain employees, says Sorrentino. (If an employee has 100 SARs, for example, and the stock’s price rises by $5 a share during a specified period, he or she receives an award of $500 in either cash or stock.) Although businesses must treat an SAR’s value as a compensation expense, this drawback will be less of an issue when companies are required or choose to expense stock options. In addition, they don’t require the employee to lay out cash and, if paid in the form of company stock, don’t dilute share values the way stock options can. They also don’t require a loan to purchase the shares, as is the case with stock options; companies thus can avoid the Sarbanes-Oxley restriction on loans to executives.

Other “options.” There are other alternatives CPAs can encourage employers to consider. In February IBM became the first large U.S. company to adopt a program that grants senior managers stock options at a price higher than what the shares are selling for at the time of the grant. Under the program IBM shares must rise 10% or more before the options have any value. At present the new terms apply to IBM’s chairman and CEO and to 300 of the company’s most senior executives. IBM expects to expand it to 5,000 executive-level employees in the next year.

This and other new programs signal a shift in how companies compensate their top executives. “In recent years the stock market and the competition for talent drove compensation,” Sorrentino says. “Companies were afraid to lose skilled executives to Internet start-ups, hedge funds or investment banks, so they provided ‘upside’ opportunities in the form of stock options or equity to try to retain them. However, the economy and the labor market have changed.” While the stock market has come off its lows, Sorrentino does not believe companies will relapse into their former practices. “I think we’ll see more customized compensation programs,” he says. “Options won’t go away but will be used selectively to provide upside leverage. When they have to expense options, companies will look at them more critically.”

WHAT’S BEST FOR SHAREHOLDERS?
As governance issues become more of a priority, corporations are reexamining executive pay and the role it plays in achieving shareholder goals. CPAs need to encourage their employers and clients to put on their shareholder hats and ask, “What would bother me about this approach? Does this method send the right message?” Shareholders understand that strong performance is rewarded with salary or other incentives, Sagolla notes, “but companies are now saying, ‘Let’s define the purpose of each element of pay.’ That helps refine a cost-effective way of deploying compensation.” The bottom line will be fairly paid executives who align their long-term goals with shareholder needs. In the end both parties will come away happy.

However, new IRS rules changed the taxation of these plans to prevent them from offering tax-free compensation. The premium payments—once tax-free to the employee—are included in the employee’s income and treated as loans. And employees have to pay taxes on the policy’s equity at termination and on the cash value. At the same time, Sarbanes-Oxley classifies corporate split-dollar life insurance premium payments as loans because they generally have been interest-free loans to executives for the life of the arrangement. Under the act top executives no longer can receive loans from their employers, making these arrangements unworkable for public companies.

The insurance industry apparently hasn’t given up, however. Split-dollar policies remain potentially viable for private companies, which might use them to fund buy-sell agreements, for example. Even on the corporate side, “while the death of insider loans is a slow one, that of split-dollar insurance may have been greatly exaggerated,” says The Low-Carb Corporate Loan, a report by the Corporate Library. “It remains to be seen whether lobbying to remove split-dollar life insurance from the act’s prohibitions will be successful or not.”