Based on the dialogue we have seen among compensation committees, we believe the 2010 proxy season will demonstrate that a new level of responsibility has taken hold. Management and committees are struggling to ensure they are doing the right thing when it comes to compensation and that pay is closely aligned with performance. Additionally, some of the incentive program designs and governance practices imposed on financial services companies operating under TARP have had an impact on other industries.

Some of the early trends we are seeing in 2010 are detailed below.

Base Salaries

In 2009, roughly one-third of companies did not give salary increases. Many companies even cut salaries for executives, typically by 5-10%. With the economy showing early signs of a recovery, close to 90% of companies are planning for salary increases in 2010. Merit pools are expected to be lower than pre-recession levels, typically ranging from 2-3%. While many companies are providing salary increases, they will use these smaller pools more strategically, by targeting top performers and highest potential executives, and withholding increases to others.

In the financial services industry, given the impact of TARP and other regulatory initiatives, compensation is being re-mixed. Many financial service firms had increases to rebalance the mix between fixed and variable compensation. This helps avoid any perception that leveraged compensation packages encourage excessive risk-taking. In addition an annual risk assessment is becoming integral to the committee’s process across industries (this topic will be covered in the upcoming CAPflash on Risk Assessment).

Annual Incentives

Many companies’ experiences during two recessions within the last decade have highlighted the challenges with setting targets for incentive plan purposes. Beginning in 2009, many companies have started to incorporate a greater level of discretion in their annual incentive plans.

Companies found that strictly formulaic incentive plans sometimes failed to capture the true quality of the financial performance delivered. Additionally, Committees increasingly want the ability to improve the alignment between pay and performance. Providing for a level of discretion over incentive payouts allows Committees to recognize non-financial factors, individual performance and the challenges management faced in delivering the financial results on a retrospective basis.

For 2009 payouts, we expect to see an increased use of discretion by compensation committees, with more in-depth analysis of the factors influencing payout decisions. This may include a review of multiple financial metrics, analysis of performance relative to peers, strategic and operational results.

While results will vary by industry, we expect 2009 annual incentives payouts to exceed 2008 levels, when many companies paid zero or below target awards.

Long-term Incentives

In 2009, companies struggled to reconcile collapsing share prices with the need to recognize and reward their top performers and rising stars. Many companies did not grant equity as deeply or as broadly as they had in the past. In many cases, we saw a reduction in long-term incentive awards ranging from 10% – 30%. This decrease was partly due to efforts to manage annual share usage in a year with significantly lower stock prices In 2010, we are expecting grant values to level off or increase slightly as stock prices recover. We also expect to see a continued focus on performance-based long-term incentive plans and a decline in the use of or emphasis on stock options.

In 2010, individual differentiation will continue to be a key theme in long-term incentives as companies continue to manage their share usage and overall expense. The most dramatic examples occur deeper in the organization. At middle management levels, 100% may be eligible for awards, but typically 50%, and in some companies as few as 25%, actually receive awards.

Time-vested restricted stock and “salary stock” has become commonplace for companies operating under TARP. Outside of financial services, however, compensation committees have sharpened their focus on performance, employing a variety of performance-based awards. Shareholders and the various shareholder advocacy groups support these approaches, encouraging the trend.

Pay Mix

In 2009, many companies reviewed the mix of pay they offered. Companies want to ensure there is an appropriate balance between short and long-term compensation as well as fixed vs. variable pay. Within financial services, many companies re-balanced the amounts executives received in salary, annual cash incentives and equity. This rebalancing is intended to align the time horizon of compensation with the risk profile of the company and will vary by industry.

Clawbacks

Clawback provisions for annual and long-term incentives are becoming more common across industries. This is another example of a practice required by TARP spilling over into general industry. Clawbacks come in a variety of flavors. Some require employees to forfeit or reimburse compensation for a period of time if an executive engages in conduct that results in a restatement of financial results. Other clawbacks are fashioned more broadly, allowing companies to recoup compensation if results deteriorate over time for any reason. Providing for clawbacks helps further align pay and performance and mitigates the potential risks of executives making short-term decisions that have a detrimental impact on the company over time. Some companies, especially in financial services, are increasing the use of deferred compensation to make it easier to recoup compensation later, if the need arises.

Stock Holding Requirements

The requirement to hold stock for a period of time following vesting or exercise of options has become increasingly prevalent over the last few years, although still not a majority practice. Companies with such requirements generally ask executives to hold 50% to 100% of net shares for a period of one to three years, or even to retirement or beyond for a minority of companies. Stock holding requirements continue to be a focus for companies as they are viewed as another practice to mitigate risk in compensation programs. Stock ownership guidelines, most often expressed as a multiple of base salary, are common for most companies.  Some companies are re-evaluating their stock ownership guidelines and denominating the guideline in shares as opposed to a multiple of salary as a response to the volatility in the market.

Change in Control Protections

Pressure from shareholder advisory groups and activist investors are leading to reductions in change in control protections. As companies review their programs, many are committing to eliminate gross-ups on 280(g) excise taxes going forward. Some of these companies are grandfathering this provision for existing participants, while select companies are eliminating them completely for all participants. A few companies are asking executives with contractual rights to gross-ups to waive them. These companies recognize that gross-ups are a red flag in the current environment and acknowledge that the potential cost to the company, or acquiring company, far exceeds the benefit to the executive. As companies eliminate the gross-up feature, some provide the executive with the choice to receive the full amount of their change in control benefits and pay the excise tax themselves or reduce the benefits to a level just below the level which would trigger the excise tax payment.

In addition to eliminating gross-ups, more companies are moving to double-trigger vesting on equity following a change in control (i.e., executive must be terminated without cause or terminate for good reason following the change in control).

Summary

The magnitude of the economic crisis increased the level of scrutiny of executive compensation practices over the past two years to unprecedented levels. The actions we have seen companies take in 2009 have been greatly impacted by the environment. As companies release their proxy statements in the next few months, we will get a better sense of the final decisions, but we believe that both senior leaders within companies and compensation committees are supporting a new level of responsibility and accountability.

Please contact us at (212) 921-9350 if you have any questions about the issues discussed above or would like to discuss your own executive compensation issues. You can access our website at www.capartners.com for more information on executive compensation.

We view the report as required reading for outside directors, senior management and HR professionals. The report amounts to a call for action for boards of directors and compensation Committees to re-examine their compensation programs to ensure that the link between pay and performance is strong and the programs reflect best practices and high governance standards.

The report recommends that executive compensation programs reflect the five guiding principles:

1. Principle One – Paying for the right things and paying for performance
   “Compensation programs should be designed to drive a company’s business strategy and objectives and create shareholder value, consistent with an acceptable risk profile and through legal and ethical means. To that end, a significant portion of pay should be incentive compensation, with payouts demonstrably tied to performance and paid only when performance can be reasonably assessed.”
2. Principle Two – The “right” total compensation
   “Total compensation should be attractive to executives, affordable for the company, proportional to the executive’s contribution, and fair to shareholders and employees, while providing payouts that are clearly aligned with actual performance.”
3. Principle Three – Avoid controversial pay practices
   “Companies should avoid controversial pay practices, unless special justification is present.”
4. Principle Four – Credible board oversight of executive compensation
   “Compensation committees have a critical role is restoring trust in the executive compensation setting process and should demonstate credi ble oversight of executive compensation. To effectively fulfill this role, compensation committees should be independent, experienced, and knowledgeable about the company’s business.”
5. Principle Five – Transparent communications and increased dialogue with shareholders
   “Compensation programs should be transparent, understandable and effectively communicated to shareholders. When questions arise, boards and shareholders should have meaningful dialogue about executive compensation.”

In addition to the guiding principles, the report contains concrete recommendations on how to implement effective executive compensation programs. Click on the link http://www.conference-board.org/pdf_free/ExecCompensation2009.pdf to access the full report of Conference Board?s Task Force on Executive Compensation.

Please contact us at (212) 921-9350 if you have any questions about the issues discussed above or would like to discuss your own executive compensation issues. You can access our website at www.capartners.com for more information on executive compensation.

We found that 20 out of 25 companies (80%) retained the services of an executive compensation advisory firm in 2008. The large multi-service human resource consulting firms dominated, with either Towers Perrin, Mercer or Watson Wyatt providing services to 12 of the 20 companies (60%). The remaining eight companies (40%) retained smaller boutique firms that are unlikely to provide other services, including Pearl Meyer & Partners, Frederick W. Cook, Total Reward Strategies LLC, Compensation Strategies LL, ExeQuity and icca .

Two of the 20 companies (10%) reported changing advisors, but a trend toward the boutique firms was not apparent. Chevron replaced Hewitt, a multi-service firm, with ExeQuity, but Unitedhealth Group moved in the other direction, replacing Semler-Brossy, a boutique, with Towers Perrin, a multi-service firm.

Seventeen of the 20 companies (85%) indicated that their executive compensation advisory firm was independent. Three companies (15%) did not address this issue in their disclosures.

Nine of the 20 companies (45%) defined an independent compensation consultant as a firm that did not do any other work for the company. One company (5%) applied this standard to the individual adviser, rather than the firm, noting that the individual consultant did no other work for the company. Seven of the 20 companies (35%) maintained that their compensation consultant was independent, while allowing the consulting firm to provide other services. Several noted that the extent of these services were modest or immaterial. In some cases, the Compensation Committee required advance approval of other services. In other cases, Committee approval was not required specifically.

Several companies added their own unique provisions to their definition of independence. Some examples include:

• Requiring that the consulting firm annually attest to compliance with the stipulation to do no other work;
• Rotating the consultant after five years, and prohibiting the Company from hiring any consulting firm staff involved with the account for one year;
• Requiring that the individual consultant not be involved in other work, prohibiting sharing of information on compensation with other staff of the consulting firm, and requiring that the consultant’s compensation not depend on cross-selling other services;
• Limiting payments to affiliates of the consulting firm to two percent of aggregate gross revenues of the consulting firm and its affiliates;
• Prohibiting the consulting firm from providing services directly to senior officers of the Company.

Two companies embraced the concept of enhanced disclosure. Home Depot disclosed fees paid to both its consulting firm and to an affiliate of its consulting firm that provides other services related to the retirement plan. Another company committed to disclose aggregate fees by category of service if it determined that its consultant was not independent. In this case, the consulting firm would not be deemed independent if it or its affiliates provide other services that exceed two percent of gross revenues; or if individuals serving the Compensation Committee provide other services not at direction and under supervision of the Committee. A third approach we have seen used outside of the Fortune 25 population is to publish the ratio of executive compensation consulting fees to fees for other services, with the consulting firm deemed independent provided fees for other services are less than compensation consulting fees.

In summary, the majority of companies are now defining independence strictly to prohibit the firm and the individual consultant from doing other work for the company. A minority of Compensation Committees allow their consultants to perform other work, but require Committee approval and/or a materiality threshold.

Assuming the SEC is ultimately called to develop standards for consultant independence, what approach will they take? If the SEC requires consulting firms to do no other work, the SEC will limit the ability of the large multi-service consulting firms to compete in the marketplace. On the other hand, if the SEC imposes less rigorous standards, it may be in the awkward position of espousing a set of standards that are less comprehensive than in place currently at the majority of large companies.

Please contact us at ((212) 921-9350 or [email protected]) if you have any questions about the independence issues discussed above or would like to discuss your own executive compensation issues.

Below we review the recent legislative and regulatory activity, culminating in passage of the Corporate and Financial Institution Compensation Fairness Act of 2009 by the House on July 30, 2009.

Shareholder Empowerment Act

Representative Gary Peters proposed an amendment to the Securities and Exchange Act of 1934 that would require a number of reforms, including enhanced proxy access, independent chairman for corporate boards and say on pay.  The Act would require boards retaining advisors in connection with negotiating employment contracts or compensation agreements with executives to retain only independent advisors that report solely to the board of directors or the committee responsible for executive compensation. The Act also requires that companies not agree to indemnify or limit the liability of compensation advisers or advisory firms.

Examples of criteria Boards should consider in determining whether an adviser is independent suggested by Peters include:

The extent (as measured by annual fees and other relevant metrics) to which the individual adviser or advisory firm provides other services to the Company or its executives;

Whether individual advisers are permitted to hold equity and do hold equity in the  Company; and

Whether an advisory firm’s incentive compensation plan links the compensation of individual advisers to the advisory firm’s provision of other services to the issuer.

Corporate and Financial Institution Compensation Fairness Act of 2009

Representative Barney Frank, Chairman of the House Financial Services Committee, submitted H.R. 3269 a few weeks later.  The primary purpose of this Act is to amend the Securities Exchange Act of 1934 to provide shareholders with an advisory vote on executive compensation and to prevent perverse incentives in the compensation practices of financial institutions.  But independence standards for both Compensation.

Committee members and outside compensation consultants are also addressed.  H. R. 3269 was passed by the House on July 30, 2009.

H.R. 3269 requires that Compensation Committee advisers for all public companies – including compensation consultants, legal counsel, or other advisers — meet new standards for independence to be established by the SEC within nine months of the Act’s enactment.  While the bill will not become law unless the Senate acts, many feel that independence will almost certainly become an absolute requirement for Compensation Committees.

The bill was amended to provide that the SEC’s regulations for independence and disclosure are competitively neutral among categories of consultants.   The intent here is to preserve the ability of Compensation Committees to retain either boutique consulting firms that only provide compensation consulting advice or multi-service consulting firms that provide other services, such as actuarial services or outsourcing.  Nevertheless, we predict that it will be difficult for multi-service firms to compete effectively if they provide substantial other services to corporate clients.

The Compensation Committee would have the authority, in its sole discretion, to retain an independent compensation consultant and would be directly responsible for the appointment, compensation, and oversight of the work of the consultant. Committees would not be required to follow the adviser’s recommendations and would continue to be expected to exercise its own judgment, but they would own the process.

Frank’s Act also requires disclosure in the proxy whether or not the adviser met the standards for independence that the SEC will establish.  Finally, appropriate funding of payments to independent advisers, as determined by the Compensation Committee, will be required, assuring Committees’ access to appropriate advisers.

Treasury’s Proposed Investor Protection Act of 2009

On July 16, 2009, Treasury submitted draft legislation to congress that would ensure the independence of Compensation Committees.  Treasury noted that Compensation Committees without access to independent compensation consultants may be at a significant disadvantage when negotiating pay plans with management. Treasury sought to level the playing field by providing Committees with access to compensation consultants, legal counsel, and other advisers.

Treasury noted that conflicts of compensation consultants are pervasive since advisory firms often provide other, non-compensation related services to companies.  In addition the fees earned for other services often dwarf the fees earned from compensation consulting.

Treasury outlined several new requirements applicable to all public companies within nine months of the bill’s enactment.  First, the SEC would be empowered to set standards for consultant independence. Each Compensation Committee would be authorized to retain an independent compensation consultant and would be directly responsible for the appointment, compensation, and oversight of the work of the independent consultant.

The Committee’s choices would be subject to proxy disclosure.  The company would be required to disclose whether or not the Compensation Committee retained an independent compensation consultant.  If the Committee did not retain an independent consultant, the rationale not to do so would need to be explained.

SEC Proposed Rules on Proxy Disclosure and Solicitation Enhancements

The SEC also weighed in on the compensation consultant independence issues.  Currently companies are required to disclose the role of compensation consultants in determining executive and director compensation, including whether they are engaged directly by the Compensation Committee. The SEC noted that many compensation consultants provide a broad range of additional services to companies, and fees for other services may be larger than fees earned by consultants for executive compensation. The SEC noted that “ provision of such additional service by compensation consultants or their affiliates may create the appearance, or risk, or a conflict of interest that may call into question the objectivity of the consultants’ executive pay recommendations.”

Under the SEC’s proposed rules, if a consultant played a role in determining or recommending the amount or form of executive or director compensation and also provided additional services, the Company would be required to disclose:

A description of all additional services provided during the prior fiscal year;

Aggregate fees for all additional services, as well as aggregate fees related to executive and director compensation consulting;

Management’s role in the decision to engage the consultant for additional services;

Whether the Board or Compensation Committee approved all of these additional services.

We expect the SEC to modify these disclosure rules to respond to the requirement for “competitively neutral” regulations embedded in H.R. 3269. The SEC’s proposed rules are not competitively neutral since fee disclosure would apply only if additional services were provided.  This confers a major advantage on boutique firms that do not provide additional services, since they would be exempt from the disclosure requirements.  The  attention of regulatory and legislative bodies on this issue will certainly continue. As we point out below (“How Companies Handle Independence Issues”) some companies are already initiating their own independence standards for compensation consultants.

Please contact us at ((212) 921-9350 or [email protected]) if you have any questions about the independence issues discussed above or would like to discuss your own executive compensation issues. Compensation Advisory Partners LLC