This article is reprinted with permission from the
August 29 , 2005
edition of
New York Law Journal.
2005 NLP IP Company.


Compensation Committees: Tally Sheets and Other Issues

By Joseph E. Bachelder

This column discusses the use of “tally sheets” by compensation committees and also considers other ways for improving the process by which such committees review executive compensation.

In August 2005, Christopher Cox, the new chairman of the Securities and Exchange Commission (SEC) made the following statement:

I think you can look in the near future to the SEC for some improved rules on disclosure to make sure that, for example, shareholders can have one number, that the different kinds of executive compensation add up to a number that's comparable, executive to executive and company to company.[1]

The “one aggregate number” approach suggested by Chairman Cox is involved in the “tally sheet” approach adopted in recent years by many compensation committees.  The tally sheet involves a presentation of each compensation and benefit item.  These items are then added together to represent, presumably, the total value of the “whole package.”  In theory, this allows a “tallying up” in one place of the total pay of CEOs and other executives.  Thus, the tally sheet, according to some, becomes an effective tool to determine the reasonableness of executive pay, including making comparisons of executives' pay on a company-by-company basis. 

Tally Sheets

Following is an examination of how some compensation and benefit items are treated in tally sheets (with comments on some of the pluses as well as some of the limitations of the tally sheet approach).[2]

1. Perquisites.  Individual items making up perquisite packages of senior-level executives may include such fringe benefits as tax and financial advisers, country clubs, cars and drivers, personal automobiles, annual physicals and use of company aircraft.  A noteworthy example of perquisites, which created a media furor, was the list of retirement perquisites for Jack Welch when he left General Electric.

Comment:  For the sake of full disclosure it is a proper objective to itemize and total up the values of corporate perquisites.  In the case of most executives, the total value of all their perquisites probably represents a small percentage of their total pay package.  The tally sheet approach, however, will reduce the risk of perquisite abuse.

2. Pensions.  Tally sheets generally provide more detailed breakdown of defined benefit pensions than the information supplied in the pension table” required in proxy statements.  (It also puts the pension values “on the same page” as the other items of compensation like salaries, bonuses and long-term incentives.)  In addition to an estimate of future annual pension benefits for each covered executive, a tally sheet may provide the following information:

(a) The present value of the defined benefit pension for each covered executive (for this purpose, “covered executive” means a named executive officer of a company, generally the CEO and the four other highest-paid executives).  (Some tally sheets call for additional explanation as to key assumptions, e.g., interest rates and mortality--used in calculating present values.)

(b) The increase in the present value of the pension as accrued for the current year over the prior year for each covered executive.

Comment:  There is no question that the current pension table required by the proxy statement is an inadequate source if one is trying to determine the value of the pension accrued for an executive as of a particular date.  That table simply indicates that for a certain number of years of service at different compensation levels annual pensions of a certain amount will be earned.  In some cases, accompanying narrative descriptions identify the annual pension benefit accrued by each of the named executive officers.  However, unless one is an actuary, or at least acquainted with the method of valuation of pensions, it is difficult if not impossible to identify accumulated values.[3]

3. Deferred Compensation (other than pensions).  This includes elective as well as nonelective deferred compensation.  The tally-sheet approach requires current presentation of the build-up of the deferred compensation amounts including annual credits to accumulated amounts based on interest or other earnings.

Comment:  While “ferreting out” credits to deferred compensation that might otherwise be overlooked, any tally-sheet presentation must take into account (a) the extent to which the deferred compensation is attributed to amounts such as salary or annual bonus that are being deferred but already have been taken into account as current compensation and (b) at least to some extent, earnings credited to deferred compensation accounts are not compensation but represent interest, or an interest equivalent, to be paid by the employer for being able to defer the payment of the amounts involved.[4]

Stock Options

4. Stock Options.  Some tally sheets call for projections of stock option values (spread) under different assumptions.  This, of course, reflects what has been an alternative presentation permitted in the stock option table of the proxy statement (that is, a “potential realizable value” displayed under different assumptions of future growth of stock price (generally, 5 percent and 10 percent) as an alternative to presentation based on present value at date of grant using an acceptable option pricing model (e.g., Black-Scholes).

Comment.  It is quite understandable that some tally sheets call for projected values based on a range of possible future prices of the stock.  On the other hand, in a “one aggregate number” approach, it is hardly appropriate to aggregate a possible future value (not only subject to the uncertainties of the market place but also often subject to vesting conditions) with the value of a current item of compensation like salary.  The uncertainty is compounded when an equity award--whether a stock option, performance share or other form of award--is subject to the attainment of performance targets.[5]

5. Severance Arrangements.  Under the tally-sheet approach, the multiples of salary and bonus to be paid in the case of certain terminations would be included, along with other severance entitlements.

Comment:  Presumably, it is not intended by the parties to most severance arrangements that the severance payments will be triggered.  Contingent severance values should not be presented as numbers comparable to elements of compensation like salary and bonus.

6. Change in Control Protections.  These entitlements are generally similar to the protections afforded on severance except they only occur in connection with a change in control and generally the severance component is larger than in a severance absent a change in control.  In addition, if there is a gross-up for the excise tax incurred by an executive on “excess parachute payments” (a 20 percent tax on top of income tax) the cost may be significantly greater and nondeductible by the employer for tax purposes.

Comment:  While the amounts involved may be significant and clearly warrant careful attention by compensation committees, such protections, as noted in connection with severance, are, with few exceptions, not comparable to the values associated with current pay.  Perhaps the answer is to provide a separate presentation that displays the amounts that would be involved if the applicable contingency occurs.

7. Comparative Data for Executives at Other Companies.  Some, but not all, tally sheets for compensation committees include space for comparing compensation for executives at the employer with compensation for executives holding comparable positions at other companies.  (This is also suggested by the statement by SEC Chairman Cox noted above.)

Comment:  Whether it is accumulated as part of a tally sheet or separately, care must be taken that comparative data involving specific executives at other companies is actually comparable and that special circumstances that may explain significant differences are included in the discussion.

It may be very difficult to “gear into the equation” the unique factors of other company situations.  These factors conclude, for example, (a) the consequences of age, experience and accomplishments in setting the pay of different executives at different companies and (b) compensation that may reflect special circumstances such as sign-on, including make-whole, awards for new executives.[6]

Summary

Summary of the Tally Sheet Approach.  The tally-sheet approach assists in surfacing information that may not have been fully explored by compensation committees.  For example, the Disney compensation committee might not have approved the Michael Ovitz package if it had realized what a substantial severance package was involved.  Would the compensation committees at the New York Stock Exchange (NYSE) have approved, over a period of years, the huge build-up of deferred compensation for Richard Grasso if they had better understood the amounts involved?  In avoiding these problems, the tally-sheet approach is a worthwhile addition to compensation reviews by compensation committees.  On the other hand, compensation committees should avoid equating different items of compensation that carry with them very different values (i.e., a dollar of salary is not the same as a dollar of potential stock option gain).  And comparisons with specific executives at other companies can be very misleading without careful attention to why differences exist.

Observations

Other Observations on Compensation Committee Review of Executive Pay.

(a) An Inherent Difficulty for Compensation Committees.  Adequacy of attention to complex matters directly involving the management process.  Boards of directors generally oversee the management of the business and do not engage in managing the business itself.  In executive compensation matters and especially in respect of the CEO, the work of the compensation committee is a very “hands on” part of the management process.  Year after year, and generally with substantial turnover in committee membership over the years, compensation committees make managerial decisions in compensation matters that are frequently very complex.  In that involvement, a compensation committee is operating on a part-time” basis.  It is not sufficient that a compensation committee receive a report from its outside adviser if it does not fully understand the report or give enough time to its review, including time in meeting with the adviser.

Disney/Ovitz, NYSE/Grasso

The Disney/Ovitz and the NYSE/Grasso cases are illustrative.  Disney's compensation committee, according to the findings of the Delaware Court of Chancery in its August 2005 decision, spent less than 30 minutes reviewing a summary of the arrangements with Mr. Ovitz before giving its approval.[7] This does not take into account time spent by the chairman and another member of the committee with an outside consultant.  However, the outside consultant did not attend the compensation committee meeting at which the arrangements were approved.  In the NYSE/Grasso matter, the accelerated payout of Mr. Grasso’s deferred compensation apparently was added to the meeting agenda shortly before the board of directors met to approve it.  Not only was time for review lacking but, according to the attorney general's complaint, no outside consultant attended the board meeting.[8] (Due to the last-minute scheduling of the matter, apparently the compensation committee's compensation consultant was unable to travel in time to meet with the board when it discussed the matter.)

It is generally recognized that compensation committees, like audit committees, must give greater time and attention to the matters in their portfolio than have been given such matters in the past.  The tally sheets noted earlier in the column will help, but the time spent studying and discussing the advice of independent advisers is equally important.

(b) Use of Outside Advisers.  According to the new rules adopted by the NYSE in 2003, the compensation committee must be given discretion to choose its own compensation consultant.  The independence of that consultant from management is important.  If the consultant picked is also the consultant for management, its independence is compromised.

In addition, the compensation committee needs a single adviser to coordinate the different components of compensation and benefit packages that it reviews.  These components include executive pay (including salary, annual bonus and long-term incentives), pensions, employee welfare benefits, perquisites and, in some cases, pay equalization for foreign-based executives.  One consultant should have the responsibility for coordinating all the components (providing availability of other specialists as needed, but with the primary consultant present whenever other advisers are reporting to the compensation committee).

Education and Continuity

(c) Education and Continuity of Compensation Committees.  Often problematical is the inheritance of information by one compensation committee from its predecessor.  It is not unusual for the majority of the compensation committee to be made up of different persons from those serving on the committee one or two years before.  The outside consultant generally can provide continuity.  A meaningful part of the initial meetings of a newly constituted compensation committee should be a careful review of how the current executive pay package has been developed.  Each member of the committee should understand not only the total value, and each item making up that value, for each package under its purview, but also should understand the background of how the package, and each of its parts, got there.


FOOTNOTES:

[1] Chairman Cox's statement regarding improved disclosure for executive compensation was made as part of an interview with Stephanie Dhue on PBS' “Nightly Business Report” on Aug. 10, 2005.  A transcript of his statement was available at the time of the writing of this column at http://www.nbr.com/transcript/2005/transcript081005.html.

[2] The typical tally sheet resembles, in certain aspects, the Summary Compensation Table required to be set forth in the proxy statement.  However, it covers items, some of which are discussed in the text of the column, that are not included in the Summary Compensation Table.  An example of a Total Compensation tally sheet is provided as Attachment D to Frederic W. Cook's compensation committee Advisory Letter 05-02 “Top Executives' Total Compensation.”  Examples of other tally sheets are available to members of www.CompensationStandards.com at http://www.compensationstandards.com/Member/Pointers/Doc/079-tally.htm.

[3] As reported by Professor Lucian A. Bebchuk and Robert J. Jackson Jr. in their report entitled “Putting Executive Pensions on the Radar Screen” (March 2005), available at http://papers.ssrn.com/abstract_id=694766, the accumulated values of defined benefit pensions for some senior-level executives are huge.  The tally sheet provides the opportunity to display such aggregate present value as well as the increase in such aggregate value from year to year, as if, like salary, it were part of the annual remuneration package.  A note of caution in this regard: in cases where there is a significant vesting condition to the pension entitlement, this risk element needs to be taken into account in connection with the presentation of the value of the pension or else the current value will appear larger than is appropriate.

[4] It would be helpful to compensation committees to see the difference between the amounts credited to the deferred compensation accounts and the amount that would be credited based on the current borrowing rate for the employer.  If the earnings credit for a particular year is 7 percent and the current borrowing rate for the employer is 5 percent, the compensatory element in the deferred compensation is arguably limited to 2 percent.  This is true, of course, if the assets that would be used to pay out the compensation are available to be used by the employer in its business.  If the assets are transferred to a trust and are unavailable, in fact, to the employer, then it may be argued that the entire 7 percent (in the example) is deferred compensation to the employee.

[5] The nature of this problem is illustrated in the proxy statement treatment of certain types of long-term awards that are performance based.  In a separate table called the Long Term Incentive Plan Table awards made in the current year are displayed with information as to performance criteria and in the case of non-stock-related plans estimated future payout depending upon whether threshold, target or maximum levels of performance are achieved.  In the year of payout the amounts paid out pursuant to such a plan are then displayed in the Summary Compensation Table.

[6] Complaints already have been made regarding the “ratcheting” effect of comparative data: as compensation increases at other companies are noted, each company tends to ratchet up its own compensation so that its own executives will not “fall behind the pack.”  For commentary, see “Fred Cook Speaks to Directors About Executive Compensation,” a summary of his remarks at Stanford Directors' College on June 20, 2005 (pp. 3-4) at www.fwcook.com and Lucian Bebchuk and Jesse Fried, “Pay Without Performance” (pp. 71-72) (Harvard University Press, 2004).  This effect may be enhanced if focus is put on the aggregate pay of individual executives at individual companies without satisfactory explanation of why differences exist.

[7] In Re The Walt Disney Company Derivative Litigation, 2005 Del. Ch. LEXIS 113 at *39.

[8] Spitzer v. Grasso et al. (Exhibit A. Frank Ashen's Statement of Facts, para. 41) (N.Y. Sup. Ct. Index No. 401620/2004).