Committees under new pressure: experts discuss current practices and changes proposed for corporate compensation committees in the wake of recent scandals. (Compensation).

It's not true, as some governance critics would have you believe, that compensation committees at major companies are stuffed with CEO cronies all too willing to kowtow to the chief when it comes to keeping his or her pay ahead of competitors'.

Nor is it true that all corporations are exceptionally diligent about explaining in voluminous detail how they arrive at compensation for top executives, though many do a good job of describing the metrics they use to make those decisions.

What is true in these days of heightened scrutiny is that some of the latitude that corporations have had in determining top officers' pay will be disappearing. The New York Stock Exchange, for instance, is pushing ahead with a series of proposed listing standards on executive compensation. The exchange's Board of Governors voted to approve them on Aug. 1, and forwarded them to the Securities and Exchange Commission for final ratifiction.

By promoting an aggressive set of standards for its listed companies, "The NYSE captured the high ground," says Frederic W. Cook, a top compensation consultant whose firm bears his name.

For many, if not most, major corporations, the new standards will simply be codification of existing practices. But for a few, they will present significant challenges.

One of the NYSE's principal recommendations is that all listed companies have a compensation committee. That may seem obvious, but Ira Kay, an executive compensation consultant at Watson Wyatt Worldwide in New York, estimates that about 1 percent of listed companies don't have one. In such cases, he says, the entire board may discuss and vote on executive pay.

"Most major companies have a charter of some kind, and rules and procedures already in existence" for the compensation committee, he says. "If not, they have a lot of implied types of things, such as: Who approves the CEO pay package? And who approves new stock option authorization requests?"

Many compensation committees have strong chairmen, often CEOs or former CEOs, says Cook. "I've been doing this for a lot of years, and in my experience, compensation committees were never patsies for the CEO," he says.

In a written best practices advisory for clients, Cook says that compensation committees should "adopt a written statement of compensation philosophy and strategy, select an appropriate peer group, and periodically review company size, performance and top executive compensation in relation to this peer group."

He adds that the compensation committee should be:

* Appointed by the board on the recommendations of the nominating/governance committee.

* Be composed entirely of outside directors meeting the NYSE's definition of independence.

* Be led by its strongest or most experienced director in executive compensation matters.

* Have a strong charter or mandate. (For the full set of Cook's best practices guidelines, click on the FEI Web site at www.fei.org/down load/best pract.pdf).

Cook adds that the compensation committee should establish policies for stock transactions by senior officers and directors, bar loans to executives for purchasing stock (except for third-party guarantees) and ban use of company stock for collateral for margin accounts. Use of hedging vehicles to protect executives' stock values from declining should also be prohibited, he says.

He goes so far as to argue that while "the committee and management should work in cooperation and harmony," if that is not the case, "[the committee's] relations [with management] will necessarily be adversarial to protect shareholders' interests and the company's reputation."

The compensation committee's report on executive compensation should be a normal part of the annual proxy, and the experts say most large companies have developed a format for displaying how they arrive at that pay. This brings up "explicit discussions on performance, presentations and, therefore, a determination," Kay says, though the discussion varies widely from one company to another.

"If they do show a benchmark or metrics, they compare the performance to plan and also against their competitors," he says. A common benchmark at many corporations is the 75th percentile of pay against a relevant universe of peers. Cook argues that the compensation committee "should oversight all executive compensation tables and text in the proxy statement, including the stock performance graph."

Total shareholder return (TSR) has become a more common performance metric, with perhaps 40 to 50 percent of companies using it, Kay says, although "boards are reluctant to put relative TSR in explicitly" in their proxies. "The question comes up frequently in academic studies: Why don't more companies have relative performance indicators? Part of the answer is that boards are very reluctant to lower an [option] exercise price. There's a self-serving aspect to executives not wanting to be measured against an index."

Kay adds: "There are two examples I can think of in which the companies had relative performance measures, where the board reneged on payments [to top executives] because the companies did outperform their peers, but their actual performance was the worst they had had."

In Cook's view, senior executives' total compensation "should be based heavily on the company's annual and longer-term performance, measured by financial, non-financial and market performance." Non-financial measures, he says, might include market share or meeting goals in areas like product development.

A key goal for some time in executive compensation has been "ownership" of company stock, both for management and directors. Cook says a debate has been ongoing whether this represents compensation or a shareholder incentive. To him, ownership doesn't imply any particular length of holding time, apart from very short-term: "You can't flip it," he says, referring to an immediate sale after being granted shares.

Stock option grants, which are clearly under the compensation committee's purview, "should be administered within known and defensible 'run rate' and 'overhang' targets," Cook says. (Overhang refers to the total number of options granted, plus those remaining to be granted, as a percentage of the company's total shares outstanding.)

Kay says Watson Wyatt has done research on overhang levels and found that those companies with the highest levels in their industries tend to under-perform competitors. There is a "sweet spot," he says -- with too low an overhang, there may be too little motivation for option holders; with too high overhang, shareholders experience too much dilution.

RELATED ARTICLE: Resources a Compensation Committee Should Have

* A staff executive in whom it can rely.

* An independent compensation consultant for ongoing assistance, if requested.

* Certification by the CFO or review by an audit firm of corporate financial performance used to determine annual or longer-term incentive payouts.

* Independent legal advice, when requested, to review employment, change-in-control and severance agreements proposed for executives.

Source: Frederic W Cook & Co.