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August 14, 2014

The world of executive compensation continues to be a work in progress, morphing as new regulations are issued and new strategies devised. Over the last five years, however, the pace of change has increased dramatically, as have the risks to public company directors for the decisions they make regarding such compensation. So it seems like a good opportunity to look at the trends that have developed during those five years, as well as to forecast the future of each trend.

1st Trend: Change in Control Protections
The executive compensation practices that have drawn the most intense criticism in recent years have been the ones where companies (i) failed to cap the amounts payable to an executive on a change in control of his / her company to the maximum amount deductible under Section 280G of the Internal Revenue Code, and (ii) made executives “whole” as a result of paying excess of the Section 280G limit imposed tax. In response to the criticism, many companies amended existing arrangements to eliminate these protections and did not include them in new arrangements.

Outlook: Given the intense disapproval of these benefits and the difficulty companies have had in defending them, few companies are likely to be willing to resist this trend. Consequently, new employment contracts are unlikely to provide either of these protections. The rare exception may be contracts where an executive is being employed expressly to ready a company for sale and may be wary of accepting the position without these protections (or, at least, without uncapped benefits).

2nd Trend: Peer Group Creation and Utilization
Many companies have objected to the peer groups created by the proxy advisory firms, which generally are limited to companies in the same industry and of the same general size. The argument has been that determining peers in this manner does not sufficiently take into account those characteristics that drive a company’s success, and thereby creates an unrealistic model for compensation comparison. Companies and compensation committees have consequently begun to (i) argue for a more in-depth peer group analysis, using more business characteristics, and (ii) reach out to key shareholders to explain why the peer group that the company favors provides a more accurate method for comparing relative compensation.

Outlook: It is difficult to argue with the concept that the increased use of the characteristics that drive a target company’s business and account for its success is likely to produce a more relevant peer group. As more compensation committees recognize this, the battle over the proper method to determine a company’s peer group could easily become more heated. However, it is possible that the move towards a more rigorous analytic approach to peer group selection will ultimately prevail.

3rd Trend: The Compensation Discussion and Analysis (CD&A) Section of the Proxy
In the CD&A, companies are required to value the compensation of their Named Executive Officers (NEO) by valuing future rights to compensation (particularly stock options) as of the grant-date. Many companies argue that this methodology too often results in a distorted compensation picture that can mislead shareholders. Some companies have reacted by expanding their CD&A disclosure to tell their own “story.” This has often included a discussion of why focusing on a NEO’s “realized” pay (actual amounts received, rather than projected amounts) is a better measure of the value of a compensation arrangement.

Outlook: This trend is likely to continue. While the proxy advisory firms and some shareholder advocacy groups continue to argue that grant-date valuation is appropriate, the evidence indicates that the generally accepted valuation methods (e.g., Black-Scholes) in fact dotend to overstate compensation.

4th Trend: Use of Stock Options as the Primary Means of Equity Compensation
The use of stock options as the preferred means of granting equity compensation has markedly declined in the last several years due primarily to (a) the loss of the favorable accounting treatment that applied to options for many years, and (b) the conviction of the proxy advisory firms that options do not reflect pay for performance. Interestingly, while the use of restricted stock unit awards has increased markedly, this increase does not mirror the reduction in option awards.

Outlook: While a strong argument can be made that options do reflect pay for performance as much as other forms of equity compensation, it appears “this ship has sailed,” and the use of options should continue to decline (or may even stabilize) for the foreseeable future.

5th Trend: Inclusion of Clawback Provisions
The Sarbanes-Oxley Act of 2002 contained the first legislative requirement for clawbacks. Public companies were required to recover from their CEO and CFO any compensation considered earned as the result of following their restatement of the company’s financial misconduct. The Dodd-Frank Act went a step further, requiring companies to include a provision in an executive employment contract requiring the repayment of any incentive-based compensation paid in the three years preceding a financial restatement because of “material noncompliance” with any financial reporting requirement, regardless of an executive’s fault or misconduct. The Securities Exchange Commission was charged with promulgating a final rule to implement this requirement, but has not done so to date. Nevertheless, even in the absence of such guidance or any regulatory requirement, numerous companies have voluntarily implemented some type of clawback program.

Outlook: When clawbacks become legally mandated, companies will not have a choice about implementing one. Thus, getting ahead of this issue by implementing a form of clawback may have some value, particularly from a shareholder relations perspective. However, it is questionable whether voluntarily adopted “no fault” clawbacks (i.e. those in which the executive who received the compensation had no involvement in the conduct that gave rise to the over-payment) are appropriate. The concern is that executives may refuse to return the amount at issue or dispute the amount to be recovered, leaving the company no choice but litigation, an unpleasant alternative.

6th Trend: Stock Ownership Requirements
Shareholder advocates have long argued that the interests of management and directors would be better aligned with those of shareholders if the executives and directors were required to have a substantial equity share in the company. Many companies have adopted such a necessity, typically requiring the affected individuals to own (i) a specific number of shares, (ii) shares of a specific minimum value, or (iii) shares equal to a specified percentage of compensation.

Outlook: This trend seems likely to continue, or even escalate, with ownership by management and directors ultimately becoming the norm; and the only issue being the extent of the required ownership and the manner in which it must be satisfied.

7th Trend: Directors’ Fees
Aggregate directors’ fees have increased in recent years, but the mix has changed. The clear trend has been towards substantially raising annual fees, while decreasing or eliminating meeting fees.

Outlook: It is almost certain that this trend will continue, although an argument can be made that meeting fees actually promote the involvement of board members.

8th Trend: Perquisites
Perquisites such as allowances for financial planning or payment of club dues have been a constant target of shareholder advocacy groups. In response, many companies have sharply curtailed such perks and / or entirely eliminated others.

Outlook: Company-offered perks (to date) were easy targets for critics of executive compensation who questioned why an executive earning millions of dollars should have such relatively inexpensive costs paid by the corporation. Sensitivity to this criticism is virtually certain to make it rare for companies to provide new perks and to continue the trend towards eliminating or reducing existing ones, although, in many cases, there are not many perks left.

9th Trend: Supplemental Executive Retirement Plans (SERPs)
The proxy advisory firms have taken the position that SERPs do not properly align pay with performance and thus are not a positive compensation practice. This has resulted in a reduction in new SERPs being established.

Outlook: While the criticism of SERPs seems misguided, it is impossible to say whether or not this criticism will continue to have a negative impact on the use of such arrangements. This is troubling because these plans have played an important role in executive compensation planning for many years and a strong argument can be made that they accomplish what critics of excess compensation claim to seek – a relatively inexpensive means to help retain executive talent. Some pushback by compensation committees on this issue should be expected, although the outcome is unpredictable.

10th Trend: Shareholder Activism
Shareholder activism has increased significantly in recent years, with estimates that as much as 20 percent of all Fortune 500 companies currently have one or more shareholder activists. These activists have often included claims of excessive compensation in their attacks on a company. Affected companies generally have successfully fought back on this issue.

Outlook: Activism appears to be here to stay, but companies can reduce, or even eliminate, an activist’s incentive to challenge executive compensation by ensuring that the company’s compensation program reflects a real desire to reward pay only for demonstrated performance and by carefully communicating the program to shareholders, particularly institutional shareholders.

11th Trend: Metrics Used in Determining Performance
Most companies are using two or more metrics to evaluate executive performance under long-term incentive plans, although a substantial number continue to use a single metric for annual plans. The most commonly used operating metrics are EBIT / EBITDA, net income, earnings per share and return on invested capital. A trend has developed to use total shareholder return (TSR) as the sole or key metric in an increasing number of plans, in response to critics’ assertions that TSR properly aligns incentive pay with shareholder returns.

Outlook: The use of multiple metrics is likely to continue unabated and may even increase, particularly since most commentators seem to agree that it is the most appropriate approach. The use of TSR seems to be waning, as more committees realize that it is (at best) an imperfect metric that does not consider the impact of a bull or bear market.

Executive compensation evolves due to strategy and regulatory requirements. This evolution must be watched carefully as industry demand and focus shifts. The last five years have shown increased scrutiny in this area because public company directors are held to a higher accountability. Watching the trends will determine the forecast and industry attention.

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Executive Compensation