We’ve lost track. We don’t know how many executive compensation reform plans we’ve witnessed over the decades. Each time, proponents claim that this particular reform is the magic bullet. Each time, unintended consequences follow. Each time, someone says, “This time is different.”

In 2006, they may finally be right.

No, we’re not predicting an end to the executive compensation battles. They’ll continue to rage. But 2006’s proposed reforms have the potential to define the rules of engagement for those battles. What has changed? Finally, the prescriptions being discussed—by the Securities and Exchange Commission, among others—suggest ways to strengthen the accountability links between shareowners, executives and directors. That’s a fundamental shift away from the normative fixes of yesteryear, such as compensation above $1 million not being tax deductible unless performance related, or CEO pay not exceeding some arbitrary multiple of average worker salary.

In theory, accountability is simple: executives are accountable to the board, which is then accountable to shareowners. In practice, accountability requires not just transparent information, so that the responsible party can monitor those to whom it has delegated responsibility; it requires the ability to act if the information suggests a problem. In this case, there are four accountability links: information flow between the executives and the board, and between the board and the shareowners; and the ability of the shareowners to act to affect the board’s decisions and the ability of the board to act to affect executives.

The problem is that three of the four links are weak.

Let’s start with the information flows. While most of the focus is on compensation disclosure to shareowners, the problem actually starts with disclosure to the board. In theory, an information gap there shouldn’t exist; the board itself sets executive compensation. But, time and again, we’ve seen smart executives find a way to obtain more compensation than the board believed it was granting. Often this occurs because executive compensation consultants load up on the extras: retirement accounts, change-in-control provisions, and other forms of pay that Harvard professor Lucian Bebchuck has come to call “stealth compensation.” Boards have had trouble getting their collective arms around what it all totals. Witness the chair of the compensation committee of the New York Stock Exchange saying he had no idea that former CEO Richard Grasso was entitled to more than $140 million in deferred compensation.

Of course, if boards are sometimes less cognizant of executive compensation details than they’d like to be, then shareholders live one shade deeper in darkness. Compensation committee reports are mandated disclosures, but they often read like a legally required process document, rather than a substantive review of how much was paid to whom and why.

This year, both those links are being strengthened. The disclosure statement to shareholders has received most of the attention, with the SEC’s January announcement that it was proposing regulations to require plain-English disclosures of myriad executive pay details, including compensation in the past three years, holdings of equity-linked interests complete with valuations of not-yet-exercised options valued at the FAS 123 valuation, disclosure of post-employment payments and benefits, and all perquisites valued at more than $10,000. While we’re sure that someone will figure out a loophole or two, clearly these requirements, including the required tabular material, can only help better inform owners.

Perhaps more importantly, though, and somewhat under the radar, boards are already taking action to strengthen the information flow to them. Equilar, the executive compensation consultancy, noted last month that “within a short period of time, tally sheets moved from an enigma to an important and well-publicized analytical tool.” In other words, boards now routinely demand to see the whole picture for all the elements of executive compensation, to make sure that Grasso-like situations don’t happen to them. A few brave companies even make their tally sheets public. With the upcoming SEC rule mandating almost that much disclosure anyway, expect more firms to join them.

Evidence also suggests, at least anecdotally, that the improved information flow is having an effect. Equilar notes that severance benefits–a large part of Bebchuck’s “stealth compensation”—seem to be shrinking at a number of large (Fortune 75) companies. Hewlett Packard reduced the multiple used to calculate its severance payouts, as did Chevron. Wells Fargo & Co. terminated its CEO’s severance agreement altogether.

Of course, information alone is not enough to establish a fair market for executive talent. Improving information flow without a concurrent improvement in the ability to act upon it may have the perverse effect of ratcheting executive pay higher, not lower, as compensation consultants include higher total numbers (now disclosed) in their calculation of peer groups. Boards and shareowners must be able to act upon that information. Boards always could do so; after all, they sign the CEO’s contract. And, as is manifest from HP’s, Chevron’s and Wells Fargo’s actions regarding severance benefits, they continue to seize more control over the executive compensation process as they gain better information about it.

The biggest broken link in the accountability chain, however, has been in the shareowners’ ability to influence boards. As noted in our very first column for Compliance Week, shareowners in the United States can’t vote against directors short of a proxy contest. Harvard’s Bebchuck, for one, believes that the adoption of a majority rule standard and shareowner nominating procedure, together with other measures designed to strengthen the dependence of directors upon shareowners, is necessary to bring the accountability equation back into equilibrium. We agree. But we also note that, in this particular area, one shareowner has proposed a logical interim step.

AFSCME, the public employees union, through its pension plan, has called for an annual shareholder advisory vote on the compensation report. The pension plan has submitted resolutions to be added to the agendas at the annual general meeting of five U.S. companies. While that would be a new development here, such votes have been mandatory in the United Kingdom for years and went into effect in Australia last year. Although non-binding, the referenda provide a useful feedback mechanism and can even help stiffen directors’ spines, enabling the compensation committee to delineate what the company’s owners will, or will not, accept. We expect knee-jerk opposition to an advisory vote on the new Compensation Disclosure & Analysis (CD&A) report—but don’t be surprised if, in the next few years, it becomes a common shareowner demand.

To be sure, unintended consequences will flow from this year’s class of compensation reforms, just as has happened to every class of reforms before this. But 2006’s reforms have the potential to change the dynamic, rather than to apply specific band-aids. So if you want to get ahead of the new executive compensation accountability paradigm, what should you do? Here are five practical steps:

Make sure your board has all the compensation information it needs. Don’t put it in the position of being surprised when a severance or other event triggers a large payout. Prepare a tally sheet for all appropriate executives, including various scenarios such as retirements, resignations, changes in control, and so forth.

Consider making the tally sheet public. At a minimum, confirm publicly that the board has reviewed the tally sheet and the scenarios.

Read the SEC proposal for a new CD&A. Prepare a mock-up and see what it shows.

Expect more resolutions like AFSCME’s, calling for advisory votes on the compensation report in the 2007 proxy season. New ideas generally need a year to gain traction.

If you receive such a proposal, don’t immediately assume the worst. You might want to ask some corporate directors in Britain about their experience in having such resolutions on the AGM agenda. It’s usually a non-event, and can be a positive.

This column solely reflects the views of its authors, and should not be regarded as legal advice. It is for general information and discussion only, and is not a full analysis of the matters presented.

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