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2012 Executive and Director Compensation Update: Considerations for Compensation Committees Of Public Companies

September 13, 2012

I. Background

The compensation committee of a public company must consider numerous issues with respect to executive and director compensation. Such issues include, most notably, tax-efficiency, the requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”), the views and recommendations of institutional shareholders’ groups such as Institutional Shareholder Services (“ISS”), the views and recommendations of retained compensation consultants, the financial accounting treatment of equity-based awards under ASC 718 (formerly FAS 123R), and, of course, the economics of the deal.

II. Tax Efficiency

As noted in our recent Client Alert entitled “Looming 2013 Capital Gains, Dividend and Medicare Tax Increases: Key Considerations for Executives, Directors and Companies,” the favorable federal income tax treatment of equity-based awards, particularly the 15% long-term capital gains and maximum dividend tax rates, will erode considerably as of January 1, 2013. In addition, a Medicare tax to fund Health Care Reform will make equity-based grants even less tax-efficient.

Given these looming tax changes, the compensation committee of a public company should consider doing the following, perhaps as early as this fall:

Engaging Compensation Consultant – To advise the committee as to the proper mix of cash-settled and equity-settled equity compensation awards;
Granting More Incentive Stock Options (“ISOs”) – ISOs are not subject to Medicare (or Social Security) taxes;
Reexamining Executive and Director Equity Ownership Guidelines – The same level of share ownership may not make sense in the context of greater “tax equalization” between equity-settled awards (e.g., shares of restricted stock) and cash-settled awards (e.g., restricted stock units); and
Implementing Share Repurchase Program (Cash Flow Permitting) – Because executives and directors could be “insiders” under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), the company should consider integrating any such share repurchase program with its insider trading policy and the requirements of Exchange Act Rule 10b-18 (which could provide the company with a non-exclusive safe harbor from certain market manipulation rules).

III. Dodd-Frank

In June 2012, the Securities and Exchange Commission (the “SEC”) issued a final rule entitled “Listing Standards for Compensation Committees.” (Prior SEC rulemaking addresses other Dodd-Frank requirements, including shareholder “say on pay” and approval of golden parachutes.) This rule implements the Dodd-Frank “independence” requirements for compensation committees and compensation advisors (e.g., compensation consultants and legal counsel). The national exchanges must issue, by September 25, 2012, proposed rules prohibiting the listing of any stock of a company whose compensation committee and compensation advisors do not comply with the independence requirements of such exchanges. These requirements must be established by integrating a non-exclusive list of SEC requirements specified in the final rule.

Potentially “red flag” practices that should be evaluated (arguably, avoided) by the compensation committee include the following:

Approving or Permitting Additional Fees for Committee Member – The company paying a member of the committee a consulting, advisory or other compensatory fee, in addition to committee or board retainer fees, raises material independence concerns;
Permitting Affiliation of Committee Member with Management – A member of the committee affiliating himself or herself in any way with the company or any subsidiary apart from his or her role as a committee member also raises material independence concerns;
Retaining Compensation Advisor That Has Business or Personal Relationship with Committee Member – The committee retaining a compensation advisor with respect to which chairperson of the committee has a business or personal relationship appears to be particularly problematic;
Retaining Compensation Advisor That Owns Stock of Company – The key question that must be answered by the exchanges is the level of stock ownership that compromises the independence of the advisor; and
Retaining Compensation Advisor That Does Not Have Conflict of Interest Policies – The absence of established policies and procedures for preventing conflicts of interest with the company or the committee may indicate that an advisor is more likely to engage in a prohibited conflict of interest.

The SEC still must issue rules relating to Dodd-Frank’s “clawback” policy and “CEO pay ratio” disclosure requirements. Dodd-Frank’s clawback policy requirement mandates recoupment of incentive compensation paid to executive officers in the three years preceding any accounting restatement of the company’s financial statements that exceeds the amount of incentive compensation that would have been paid had the restated financial statements applied. There is no requirement that an executive engage in misconduct: the clawback policy requirement reflects a “no fault” approach to the recoupment of incentive compensation. Dodd-Frank’s “CEO pay ratio” disclosure requirement mandates the disclosure of the ratio of CEO pay to the median pay of all other employees.

On July 13, 2012, in a speech to the Society of Corporate Secretaries & Governance Professionals, 66th National Conference on “The Shape of Things to Come,” SEC Commissioner Troy A. Paredes voiced three material concerns regarding upcoming SEC rulemaking with respect to Dodd-Frank’s clawback policy and CEO pay ratio disclosure requirements:

Workability in Practice – “This seems to be a particular concern when it comes to the CEO pay ratio disclosure. Having to compile extensive data for their employees in the U.S., let alone around the globe, and then ensure that the data is standardized so that the ratio can be calculated would seem to present significant practical difficulties that could be quite costly for companies.”
Effects on Incentives of Boards, Senior Executives and Shareholders – Such effects could include, for example, “compensation arrangements [being] restructured so that executives receive less incentive pay that could be clawed back but larger discretionary bonuses that are not linked to specific financial targets,” executive demands for higher base, and less incentive, pay and executive performance issues if the CEO pay ratio is too “low”; and
Disconnect between Rules and Company’s Culture and Business Strategy – “Executive compensation does not lend itself to one-size-fits-all approaches, but instead demands a textured, company-by-company analysis.”

It will be interesting to see the extent to which the SEC incorporates Commissioner Paredes’ concerns into the clawback policy and CEO pay disclosure rules that it issues.

IV. Views and Recommendations of Institutional Shareholders Groups

ISS updates its proxy voting guidelines annually, usually in January. As applied to CEO compensation, it would not be surprising to see ISS build upon its enhanced focus on total shareholder return (“TSR”) in determining whether to recommend an approval, withhold or no vote on such compensation. Last year’s update focused on the methodology used to determine the degree of the alignment between CEO compensation and TSR.

V. Views and Recommendations of Retained Compensation Consultants

The views and recommendations of any compensation consultant retained by the compensation committee can materially affect the types and amounts of compensation provided to executives and directors. For instance, whereas one compensation consultant might weight TSR most heavily in making its recommendations, another compensation consultant might view peer company practices as most critical. A compensation committee would be well-advised, therefore, to consult with its compensation consultant early and often as to the approach to be undertaken with respect to the compensation review.

Further, in light of the Dodd-Frank independence requirements, a compensation committee would be well-advised to have its compensation consultant do the following:

Make Independence-Related Representations in Retainer Letter – Perhaps the most obvious representation relates to business or personal relationships with members of the compensation committee; and
Provide Copy of Conflict of Interest Policies and Procedures – The committee should consider enlisting the assistance of counsel in reviewing such policies and procedures (sometimes these procedures can require members of the committee to indemnify and hold harmless the compensation consultant for losses attributable to “inadvertent” conflicts of interest).

VI. Accounting Rules

The compensation committee should consult management’s accounting firm regarding the proper treatment of equity awards. In general, under ASC 718, equity awards settled in stock are treated as equity and equity awards settled in cash are treated as liabilities for financial accounting purposes.

VII. Economics of Deal

Executive and director compensation for a public company still must reflect, in the end, the business dynamics of the company. A compensation committee would be well-advised to take steps to prevent the “regulatory tail” from wagging the “economic dog.”

For more information, please contact Adam B. Cantor, (973) 530-2020 or