An interesting aspect of the proposed new Security & Exchange Commission (SEC) regulations on Executive Compensation relate to the need to supply justification for their decisions (see February 2006 issue for details of the proposed regulation). Currently, most Boards provide a written section, which discusses their general philosophy, such as “providing a total compensation package for executives that is competitive with a group of comparable companies”. In recent public filings, the narrative has even spelled out relative to the measures that will be used in evaluating the level of performance achieved, in order to show that the Compensation Committee has imposed realistic performance metrics as the justification for granting incentives and equity based awards.
In the past, the specific numerical targets have not been provided, even though the performance measures have been identified, the rationale being that this would offer confidential, strategic business information to competitors. Some have argued, however, that by not stating the exact performance requirements up front, the Committee has left some “wiggle room” that will allow them to modify the requirements later to levels below the original expectations, and thereby granting awards when they are not truly deserved. Until the SEC issues its final regulations, it will be interesting to see how the Compensation Committees handle this issue, which in effect requires them to provide sufficient information to shareholders without disclosing confidential business information.
It is interesting to note, though, that the SEC regulations only cover a small percentage of employers that exist in the United States. While SEC and other Federal regulations cover publicly-traded firms, and IRS regulations (Section 4958) cover not-for-profit organizations, the overwhelming majority of firms — privately-held companies — are not subject to such intense scrutiny. Currently, the only instances where executive compensation in a privately-held firm is subject to examination are when excessive compensation triggers tax liabilities or minority shareholder actions. Otherwise, privately-held firms fly under the radar screen with regard to executive compensation. Lately, however, many privately-held companies recognize that they cannot stay hidden for much longer, and are embracing the concepts that the regulators have imposed relative to proper governance, reasonable pay, and arms-length dealings.
What, then, will be the new role of the Compensation Committee in the dawn of the proposed SEC rules? As the emphasis on the Compensation Committee has intensified as a result of Sarbanes-Oxley, the proposed SEC rules, and similar regulations, Committees are being reconstituted, and are reevaluating their role within the public companies they serve. Generally speaking, the overall role of the Compensation Committee is to serve in an advisory role to the Board of Directors, both in strategic and administrative capacities.
· Strategically, the Committee will consider how the achievement of the overall goals and objectives of the Company can be supported by adopting specific compensation plans that will drive the intended performance.
· Administratively, the Committee will authorize the undertaking of the required competitive studies to ensure that the Company’s executive compensation programs (covering base salary programs, short- and longer-term incentives, as well as supplemental benefits and perquisites) are competitive within the market.
In its role, the Compensation Committee recommends executive compensation programs for Board approval, and makes recommendations to the Board relative to the executive compensation programs for the company’s top executives. The intent of the executive compensation programs is driven by the company’s compensation philosophy, established in conjunction with top management, which represents the organization’s position on executive pay relative to an appropriate peer group. It is the Committee’s responsibility to ensure that the compensation philosophy properly addresses the company’s business goals and objectives, and that the compensation programs are consistent with this philosophy, so that the appropriate financial motivation is present to focus each executive’s attention on goal achievement.
With the advent of Sarbanes-Oxley, Boards and Compensation Committees are being more diligent in their search for qualified members to serve. These new members bring a level of credibility and comfort to the process, as many possess special knowledge and expertise to assist in making appropriate decisions for the benefit of the organization. The abilities of Board and Committee members are complemented by the use of independent advisors and consultants (attorneys, accountants, compensation professionals), engaging them directly to provide objective counsel on matters dealing with compensation.
Most notably, the new roles of the Compensation Committee will be to:
1. Provide the necessary transparency required by the regulations through proper disclosures within the Company’s SEC filings.
2. Recommend for Board approval the specific performance criteria and annual and longer-term performance targets for awards under the executive compensation program that will drive desired business objectives and shareholder value.
3. Review the performance of the Top 5 officers, relative to the achievement of performance objectives for use in calculating award levels under the executive compensation program. The Committee is not involved in the evaluation of performance of any other individuals within the company.
4. Provide periodic oversight on all short- and long-term incentive plans, perquisites, and other benefits covering the company’s executives, to ensure that the programs are meeting the intended performance goals of the organization.
5. Insure that all Committee business is conducted in a moral and ethical fashion, maintaining the highest levels of personal conduct and professional standards, and taking action to notify the Board of any issues, as well as the necessary corrective action, that may impact the Committee’s ability to objectively fulfill its duties and responsibilities.
The role of the Compensation Committee becomes more challenging each year; however, the functions of the Committee will only serve to benefit, in the long-term, both executives and shareholders, where executives benefit with awards correlated to their level of performance, and where shareholders see adequate returns on their investments through increases in the value of the company stock.
Source by Paul R. Dorf, APD