Top committee agendas: trust & accountability; Executive compensation ranks high on every list of issues dominating corporate boardrooms, and good compensation committees--concerned about public perceptions of pay programs--want to do the right thing.

The facts surrounding the Michael Ovitz employment fiasco at The Walt Disney Co. continue to garner headlines--for as governance scenarios go, this case is indeed a nightmare. When CEO Michael Eisner hired Hollywood agent Michael Ovitz to be his top lieutenant, and fired him 14 months later, Ovitz walked away with a severance package worth about $140 million, mostly in stock options.

[ILLUSTRATION OMITTED]

Eight years later, Eisner and the Disney board are still embroiled in the aftermath of Ovitz's no-fault termination, trying to determine whether Disney's directors adequately scrutinized his hiring and firing. While such cases rarely go to trial, the Delaware chancery court permitted a shareholder derivative suit alleging a breach of fiduciary responsibility against Disney's board to proceed.

A key point is how much time and thought the compensation committee gave to reviewing Ovitz's employment contract and severance agreement. The case has far-reaching implications for compensation issues and the potential for making directors personally liable for rubber-stamping an irresponsible pay package.

[ILLUSTRATION OMITTED]

Compensation committees face real pressure deciding how to reward and motivate executives while simultaneously ensuring that management meets expected or planned results. The practice for executive compensation throughout the 1990s became, in some instances, not just to recruit the best talent and compensate competitively, but to structure packages that created risky incentives and sometimes were--in the view of investors and the public--alarming and excessive. Directors can no longer ignore shareholders' expectations for implementing a more balanced approach and reining in unrealistic compensation packages. As boards craft solutions to assess all parties' interests and demonstrate their diligence and independence, investors and regulators want compensation committees to place trust and accountability at the top of their agendas.

"Board members, management and shareholders are much more sensitive to governance issues since all the corporate debacles made headlines," says John T. Chain Jr., chairman of the board of Thomas Group Inc., a business-process consulting firm headquartered in Irving, Texas. "People are recalibrating their responsibilities because they want to ensure their companies are running as ethically as possible," he adds.

Chain is a retired Air Force general who served in the Reagan administration and has spent more than 10 years on compensation and governance committees, both as a member and chairman, of Reynolds American Inc., ConAgra Foods Inc., Kemper Insurance Cos. and Northrop-Grumman Inc., as well as participating on many nonprofit boards. He observes that companies are run by very smart, hard-working individuals, who frequently are paid astounding sums. "Under ideal circumstances, a CEO would only receive a bonus for extraordinary performance, not as an annual entitlement, but that's not reality," Chain laments.

Not Just a Formula

Creating compensation strategies is based not only on science but includes political, economic and sociological factors, observes compensation consultant James F. Reda, managing director of James F. Reda Associates, LLC in New York City. "It's not a coincidence that successful companies have successful compensation plans, with a committee chair who devotes significant time and effort to committee responsibilities," says Reda.

Every organization needs to understand the objectives of its compensation plan and how it will measure success. "It's not only possible, but it's standard practice for companies to link consistent and transparent metrics, both financial and nonfinancial, to executive pay," says Frederic W. Cook, founder and chairman of Frederic W. Cook Inc., an executive compensation consulting firm.

Considering the diminished appeal of stock option plans and the desirability of a long-term focus based on performance, how does a compensation committee select the most efficient way, in terms of economics and incentives, to reward executives? A good starting point would be to learn about recent governance and regulatory developments, examine how these issues affect the company's compensation structures, then adopt necessary changes.

Cook sees an emerging trend as compensation committees study best practices, reach consensus and communicate their philosophy to the rest of the board. He notes many sources for help, among them: the Business Roundtable (BRT), the National Association of Corporate Directors (NACD), The Conference Board and the Council of Institutional Investors.

Information-seekers can also review guidelines from huge pension funds like Calpers and TIAA-CREF. Compensation consultants regularly provide relevant materials to their clients, and many organizations offer training and continuing education to keep directors current and informed. "Companies routinely send their directors important materials to read, and committees can always invite experts to come in and speak on current issues," says Chain. "This dialogue also helps the chairman know what items to include on the committee's agenda."

[ILLUSTRATION OMITTED]

Compensation plans, with all their components, can be enormously complex. "One best practice businesses should consider is including a summary of the company's executive compensation policy and program in each board book for every board meeting," suggests Cook. "With a written summary in their board materials, not only the compensation committee, but all other directors, have the pay plan available."

Cook also suggests that at the end of every compensation committee meeting, the chair should set a brief executive session to allow individuals the opportunity to speak freely. "If this is a regular practice, CEOs won't get nervous when these sessions occur," he says. He notes that the executive session is the place for the committee to analyze its recommendation for the CEO's compensation, without the CEO's advance knowledge of what the recommendation will be.

When Reynolds was spun off from RJR Nabisco several years back, the first thing Chain did, as chair of the compensation committee, was hire an independent consultant who helped formulate financial metrics tied to goals, objectives and long-term incentives. Compensation committees always had the ability to retain their own consultants, but now having one who reports only to the committee may become standard procedure. "Independent consultants are an additional resource who can protect confidentiality around compensation discussions and act as a buffer between both sides," argues Reda. Particularly for smaller companies, he says, "a consultant gives more breathing room to the committee to conduct its own analysis."

Both Reda and Cook believe independent compensation consultants are invaluable in performing audits for their clients. "It's really surprising how many boards do not know the total value of the compensation package for the CEO and other top officers," says Cook. "The consultant can perform an audit and add up all the elements, including pension, health benefits and all the perquisites. This also applies to severance--directors should know what it would cost to terminate the CEO," he says.

Benchmarking Blues

Not all CEO roles are equal, nor is the level of urgency for addressing compensation issues the same for all companies. Reda finds that market practices can make it difficult to send the right signals about executive compensation. He questions, for example, whether the new 45-year-old CEO should be in the same category as the CEO who is 60 and has held the job for 10 years.

Everyone wants to believe their company's management is the best, and senior executives expect to be paid accordingly. When compensation levels are consistently set high, it's easy to simply continue the practice year after year. Many companies routinely compensate their top officers at the 75 percentile in consultants' benchmarking surveys.

Chain thinks this is going to be the new big issue in the spotlight. "Every consultant comes in with a built-in annual inflation factor of 5 percent, along with statistics showing all your peer companies doing the same thing. Trying to reject these pay proposals just doesn't sell in the boardroom," he notes.

Cook agrees there is too much reliance on benchmarking and thinks companies should stop using the 75 percentile target. "Surveys should not drive compensation but should act as a check on compensation. Survey data are typically two years out of date when used, so consultants resort to the automatic 5 percent inflation adjustment," says Cook. He recommends that companies look at their internal pay relationships and examine how much of a gap exists between top executives and their subordinates. "Companies simply don't do this. There is no pay proportionality, and the CEO's pay is not connected to what others on the team are earning."

When The Conference Board created its Blue Ribbon Commission in 2002 to address the the corporate scandals that rocked the markets and public confidence, one of the areas it examined was executive compensation. The commission recommended that the best way to serve shareholders was to provide transparent, prompt and understandable disclosure of executive compensation and executive equity ownership and the economic impact of such compensation and ownership, including a description of market overhang represented by unexercised options.

Another task facing compensation committees is establishing procedures to recoup compensation and bonuses in the event of executive malfeasance; maybe severance should be awarded in periodic payments, rather than as a lump sum.

Do boards still unquestionably believe that the best way to align management interests to shareholder value is through stock option programs? Judging corporate performance based on stock price led to a fixation on short-term results. Now the New York Stock Exchange requires shareholder approval of all new stock-based compensation plans and amendments to existing ones.

While the Financial Accounting Standards Board (FASB) moves forward to implement its new stock option expensing standard, a sizeable number of companies in the Standard & Poor's 500 have voluntarily chosen to become early adopters of FAS 123. Indeed, the FASB proposal was an important impetus for companies to change the design of their long-term incentive pay packages. The trend now is to reward executives with a diversity of compensation vehicles, particularly restricted stock and performance-based equity compensation. Experts believe executives, as well as directors, should be required to hold significant amounts of stock for the long term; some argue these individuals should retain all their stock until after retirement.

The link between CEO pay and performance need not be mysterious. By exercising enhanced oversight and adhering to good governance practices, boards and compensation committees can establish effective compensation policies that promote the company's strategic goals.

RELATED ARTICLE: Checklist for Success

* Keep the job description in mind. Directors of a public company owe a duty of care, loyalty and good faith to the corporation and its shareholders. The business judgment rule will only be available when the compensation committee process is based on care, lack of conflict of interest and a good-faith attempt to discharge duties properly.

* Build on independence. Compensation committees of public companies must be composed of only independent directors. Independence isn't just about meeting the letter of the law, but requires individuals to exercise good judgment about their personal relationships.

* Assemble the basics. Members should be competent to handle matters within the scope of compensation duties that should be delineated in a formal charter. Continuing education on emerging compensation and benefits issues should be mandatory.

* Keep an eye on disclosure. Committee members should be aware that disclosure limited to legal requirements may not fully communicate compensation objectives. When members approve compensation and benefit items of substance, they should consider how they fit into the compensation philosophy that will be disclosed in the annual compensation report.

* Manage the meetings. Meetings should be scheduled regularly, at least quarterly. Materials should be circulated to allow enough time for full and fair review, and members should refuse to approve any matter for which there was insufficient advance notice.

Material considerations should be scheduled over two meetings so that members can become informed before they are asked to act on the information. There should be regularly scheduled executive sessions so the members can meet without management--preferably each time the committee meets.

* Draw the map before stepping into the maze. Executive pay must first be discussed in the context of the goals and objectives the company wants to deliver to shareholders. Only after the board of directors sets business goals with management should the compensation committee develop the tools to encourage attaining the goals and the rewards for achieving them.

* Set key policies early and evaluate them annually. The policies included in an annual review cycle include such things as use of employment contracts, severance payments, the availability and types of perquisites, use of derivatives by management and adherence to stock ownership guidelines.

* Quantify before deciding. It is difficult to demonstrate that directors used due care if relevant financial information for a decision was not prepared and examined. Costs associated with all material matters, and with material contingencies, should be presented to the committee as part of its consideration and review.

* Set benchmarking rules. Define the relevant "compensation marketplace" before starting conversations about compensation. Directors should oversee the process, understand the survey methodology and use multiple criteria, not just revenue, when choosing companies to include in the peer group.

* Control advisors and establish a process for access by internal staff. The compensation committee should control the selection of its consultants, and should also consider consulting with independent counsel to maintain a process consistent with the duty of care. Committees need to establish rules to allow internal experts access to the committee, along with safeguards to address any conflicts that may arise from this direct line of reporting.

Adapted from A Practical Guide for the Compensation Committee: Ten Steps to Success, by Kenneth J. Lavarriere, Esq., Partner in the Executive Compensation and Employee Benefits Group of Shearman & Sterling LLP, New York City (www.shearman.com).

RELATED ARTICLE: Compensation Survey Results

As reported in The Wall Street Journal/Mercer Human Resource Consulting CEO Compensation Survey for 2003, of the 350 largest public U.S. companies, 278 companies awarded stock options to CEOs, compared to 295 the previous year. The number of companies awarding option mega-grants, which have a face value of at least eight times the CEO's total annual compensation, fell from 62 to 22. In the long-term incentive component, stock options dropped from 76 percent of the mix in 2002 to 62 percent in 2003, while restricted stock climbed from 12 percent to 20 percent. More than one-third of the companies did not increase the CEO's salary in 2003, but more companies chose to give the CEO an annual bonus than in the previous year.

Cynthia Waller Vallario, J.D., ([e-mail]) is a freelance business writer based in Livingston, N.J., who specializes in corporate governance.