Confronting the Biggest Elephant in the Boardroom -- Executive Compensation

MEMORANDUM
To: John Doe, Chairman and Chief Executive Officer
From: Mary Roe, General Counsel
Subject: Confronting the Biggest Elephant in the Boardroom--Executive Compensation

I have given a lot of thought to recent developments relating to executive compensation and what, if anything, we should do about them in the current environment.

I recognize, of course, the natural reluctance to deal with a sensitive topic in what continues to be a challenging economic environment, especially after we just went through the Sarbanes-Oxley process. Nonetheless, I don't think that a stay-the-course approach is wise. Nor is an incremental one. Instead, I think we should directly confront and get ahead of this.

Before outlining my specific suggestions, it might be helpful to put the issue in context.

There is popular/political pressure on executive compensation in any recession--you'll recall the "pay for performance" mantra that dominated this topic and in fact fueled the now-reviled shift to equity-based compensation in the mid-1990s. In part, this is because compensation goes up in the good times, and senior management compensation tends to stay up because it has stock-based and other longer-term elements that carry over period to period. An always-present populist strain in Europe and America that finds broader acceptance when management is left intact but rank-and-file cutbacks abound also plays an important role.

However, the pressures this time are different, both in degree and in kind. One gets a sense of them from a sampling of compensation-related events over the past year or so.

• Options Waning: Options are now widely perceived in many quarters, including the institutional investment community, Congress and the SEC, as motivating factors for pushing the GAAP envelope, and even outright financial fraud. Given this, the FASB reversed course and clearly signaled that it will require that options be expensed by U.S. companies. In anticipation, while there still are many holdouts (especially in our sector), a few U.S. companies, including very big ones like Citicorp, Coca-Cola, GE, Microsoft and Wal-Mart, have voluntarily begun to expense them. Of course, many non-U.S. companies have been doing this for some time and the U.S. FASB and its international counterpart are in the midst of trying to harmonize GAAP here.
• Option Alternatives: The institutional investment community has made it clear that an important part of its mission next proxy session will be to require the substitution of performance-based for service-based equity concepts. Anticipating this, as I'm sure you saw, GE announced that it was abandoning options for senior management and substituting performance share units, which will be paid out only if specific cash flow and ROE targets are attained. This followed Microsoft's announcement a few months ago that it would eliminate options and instead award restricted stock units.
• Management Give-Ups: Individual managers whose arrangements have come under attack have voluntarily relinquished them and managements of other companies, including big ones like Schwab whose arrangements were not under public scrutiny, declined to take incentive bonuses for 2002 even though they had been earned. Experts in the area anticipate there may be more pressure to renegotiate existing compensation arrangements.
• Post-Retirement Perks: Jack Welch was pilloried by his once-adoring press for, among other things, his post-retirement perks and voluntarily gave many of them up.
• Likely SEC Actions: Chairman Donaldson and other SEC Commissioners have gone out of their way to express their view that companies are just not "getting it" in the executive compensation area. This has already shown up in the SEC's approach to shareholder proposals, and underlies its proposed rules on shareholder rights to propose director nominees as well as various changes the stock exchanges are implementing in this area. In addition, new, more draconian disclosure requirements on executive compensation and compensation committee operation have been promised before the next proxy session.
• Severance Limits: HP's stockholders rejected their Board's recommendation that limits not be imposed on severance benefits for senior management, after which a number of companies, including giants like Alcoa, voluntarily adopted similar measures. Shareholder activism on this subject can be expected to continue.
• Director Exposure: The Chief Justice of the Delaware Supreme Court, one of the Country's most respected and thoughtful voices on corporate governance, wrote in a Harvard Business Review article that it's likely that a case will come out soon holding directors personally liable for having failed to carry out the mission implicit in their now essentially boilerplate proxy statement compensation committee reports.
  The Delaware courts held this summer that Disney's outside directors could be personally liable for insufficient oversight during the approval of the COO's employment arrangements; the same court invoked the business judgment rule and summarily dismissed an identical case five years earlier. While I personally feel that this reversal was wrong, it vividly illustrates the extent to which process is critical in a post-SOX world.
• Management Exposure: The CEO of American Airlines stepped down because of the untimely adoption (and failure to disclose) of a conventional SERP security arrangement, and last month the Chairman of Ahold resigned following a shareholder and public relations flap over the compensation package promised to Ahold's new CEO (who voluntarily cut it back). Dick Grasso's voluntary relinquishment of $50 million in earned benefits and subsequent resignation wasn't enough to avoid the NYSE's directors being put through the wringer for, in essence, not paying sufficiently close attention to the details of the compensation arrangements they had approved over the years. The Grasso affair will further coalesce pressure for "reform" in respect of executive compensation generally.

Exactly what this means is, of course, impossible to perfectly predict. But as you well know, these events occurred in a context of the major legal, political and, most important, attitudinal changes about corporate governance that followed the bursting of the Millennium Bubble. Whatever else, it's clear to me that management will have far less freedom in this area, the Board will be more directly and actively involved and, unless the shareholder-Board-management paradigm is openly confronted, I think the directors of most companies, even including ours, will feel compelled to push, and cut, back. If they do this, or even initiate it, on their own, or if it is done in response to shareholder agitation, I believe that in the current environment management will lose the ability properly to influence where things go.

I therefore think that a passive approach here is unwise. Instead, I'd suggest something along the following lines:

• Catalogue Everything in an Understandable Way: We need to catalogue and summarize in a simple (graphic, not textual) way current and historical compensation for at least the five proxy statement executives and estimate the cost/value of future obligations. Yes, all this can be gleaned from our SEC filings, but it's not presented in a usable way anywhere. Disclosure was a huge part of the Grasso and American Airlines stories, and even GE's public disclosures were widely criticized. As indicated below, I'm suggesting a substantial rewrite of our compensation committee report this year, and plan to revamp our now nine-page general compensation disclosure to make it much shorter and more effective.

• Adjust Concepts Where Appropriate: The prior system of targeting the 75th percentile of our peer group based on a spiral-bound summary prepared by our benefit advisory/actuarial firm was discredited even before the Grasso affair, but surely won't work any more. Instead, it seems to me that we need to think through all of the elements of senior management compensation and adjust them to take the new paradigm into account:

- Although some people, particularly in tech, don't think so, a case can be made that options are essentially dead, at least for top management, and that share-retention is a reality regardless of formal policies--as a practical matter, none of our Form 4 filers can sell company stock before retirement nears. However, restricted stock is back and the Jones Day lawyers have been thinking about some interesting concepts to bridge these issues.

- Performance triggers for incentive comp need to be reformulated consistent with the 162(m) limits to be based on targets other than GAAP earnings growth per se, the tie between them and our forecast has to be better articulated and in all events they need to be clear and readily understood.

- SERPs are under pressure and severance concepts are rapidly changing; in all events, substantial non-cash post-employment benefits are dead.

- We should get rid of all the ancillary stuff that makes our proxy statement compensation description read like we've latched onto everything that's come down the pike.

My suggestion is that we work through all this with our lawyers from Jones Day, who are ahead of the curve on this, and our compensation consultants, and come up with an overall package that is readily understandable and supportable, with the objective of working with the Compensation Committee Chair so that it ends up a collaborative effort.

• Assist Compensation Committee in Setting its Agenda: Even before Grasso, the compensation committee's role became more important and sharply focused since Sarbanes-Oxley, and as indicated above it would be unrealistic for us to expect that the committee will not be more actively involved in all of this going forward. We ought to suggest a Compensation Committee meeting to lay all this out well in advance of the February meeting at which incentive amounts are fixed and equity awards are typically approved, after which my group will come up with a draft Compensation Committee Report and refocused compensation discussion generally for the proxy which puts us at the head of the pack in terms of thinking through all this. As indicated, in today's environment, it's very important that our directors receive meaningful outside advice on these subjects.

The easy thing to do is, of course, hope that this all just blows over. To me, that's naïve, but this is of course your call at the end of the day.

I would, of course, be pleased to review all of this with you at your convenience.