It has become a rite of summer: Add up the previous proxy season compensation disclosures, slice them, dice them, and spit out numbers. This year’s proxy records, for instance, show that median CEO compensation at S&P 500 companies was up 10.2 percent in 2003, to just over $8 million, according to a study by executive compensation firm Equilar, Inc. Interesting stuff. But, ultimately, interesting stuff viewed in the rear-view mirror.

The bigger—and perhaps more useful—challenge is to understand where the trend is going, rather than where it’s been.

Herewith, then, are our executive compensation predictions for 2006.

Our criterion for inclusion in the list below is based on whether or not we believe a particular prediction has a 50 percent chance of realization.

That means many, perhaps most, will not come true.

But it also means that some are likely to materialize. So we suggest that you read them not as guarantees, but as challenges to conventional thinking designed to provide an early warning to Compliance Week readers:

Restricted Stock

Restricted stock will become the single biggest part of the executive compensation puzzle.

Institutional investors want it because they believe, rightly or wrongly, that using restricted stock instead of stock options reduces share dilution and adds downside risk to compensation. And executives want it because they see restricted stock as less risky than options after several years of falling and sideways markets.

This is one trend that is taking hold now: Restricted stock accounts for nearly as much compensation as options in the Equilar survey. According to the Equilar analysis, restricted stock accounted for $2.6 million of total compensation this proxy season, an increase of 29.8 percent over 2002, while the value of option grants was down 8.5 percent to $3 million.

Still, there’s a long way for the restricted stock phenomenon to run; less than half of large companies use restricted stock, and only 27.4 percent of smaller ones us it.

Higher Pay, Less Risk

For every action there’s a reaction, and the explosion in restricted stock is no different.

The unintended consequences haven’t yet come home to roost, but they will. And institutional investors will be the ones screaming they’ve been plucked.

What restricted stock will do is increase the levels of realized compensation, predicts Joseph Rich, vice chair of compensation consultant Pearl Meyer and Partners. “What you’ve really done is told executives you can get the same total comp and get it with less risky instruments [compared to options] because they serve some other purposes. So risk-adjusted compensation is up.”

Hmm, higher compensation with less risk … doesn’t exactly sound like the “alignment of interest” that institutional investors thought they were getting.

(Non) Performance Targets

Investors will try to drive the restricted stock phenomenon toward performance-based restricted stock, but there will be problems. “No one is advocating time-vested [restricted stock],” says Council of Institutional Investors Executive Director Ann Yerger. “We want meaningful performance hurdles.”

The key there, of course, is the word meaningful.

Many companies appear to be adopting the same type of stock price trigger that has been used with mixed results for options. For the stock of Office Depot's CEO to vest, for example, the company's stock price must achieve a market price $24 for 10 days, anytime within seven years. That’s less than a 5 percent per year price appreciation—without compounding.

Moreover, most performance-based restricted stock cliff vests upon achievement.

Our prediction: The combination of easy performance targets, combined with cliff vesting, will trigger not just the vesting, but also all the issues and institutional investor ire associated with mega stock option grants.

Lead Director Pay Raises

Lead directors will start seeing serious increases in special compensation.

Rich at Pearl Meyer notes that his firm's research shows lead directors get an average of an 18 percent premium in director compensation compared to ordinary non-executive directors. By contrast, non-executive board chairs receive a 117 percent premium.

Some of that differential is related to historic accident—non-executive chairs in the U.S. are often former CEOs of the company on whose board they sit. It's also related to function, in that non-executive chairs tend to have industry-specific knowledge and be more involved in substantive corporate decisions, while lead directors focus more on the process of the board.

Nonetheless, the differential appears too great to be maintained. And, since, as we all know, compensation rarely goes down, the only way the gap will close is for lead directors to start receiving more.

Compensation Litigation

Get ready for an increase in compensation-related lawsuits. This is another unintended consequence of good intentions; namely, the combination of FAS 123’s focus on calculating option cost, and Sarbanes-Oxley’s focus on reporting and transparency.

Companies are trying to minimize the cost of options being granted by either shortening the term of the options or decreasing the volatility implicit in the option, or both. In fact, the Equilar survey found that nearly two-thirds of all companies decreased their volatility assumptions.

Some of these decreased assumptions will be wrong, and somewhere, someplace, a company will be sued for a compensation giveaway, with plaintiff’s counsel arguing that the company deliberately manipulated the assumptions so as to reduce the stated, but not the real, costs of the compensation. The allegations, if not the lawsuits, are already being made in Australia, where a recent study by Proxy Australia showed that options were worth more than three times as much as companies asserted at the time of the grant.

Back here in the litigious United States, the increased compensation disclosure requirements may add ammunition to plaintiffs’ counsel’s arsenals, as they may start claiming that sensitive documents—including compensation consultant reports—are back-up for the newly required SEC filings, and so should be discoverable.

Condensed, In Real-Time

Increased disclosure requirements—including those in place today, like the accelerated 8-K requirements, and those that may be coming, like the "updating" to Item 402 of Regulation S-K hinted by the SEC's Alan Beller—will have a major impact on executive compensation.

Rather than continually file 8-Ks, companies will start grouping compensation events so that fewer, but far more extensive, 8-Ks will be required. This, in turn, will put pressure on companies to demonstrate greater consistency in executive officer compensation.

At the same time, the level of required disclosure will force a curtailment of some of the more extravagant perquisites. According to a speech Beller delivered in November 2004, the SEC staff is reviewing numerous compensation issues, including the inappropriate categorization of perks, as well as the "valuation of perks and whether there are better methods, in particular, the incremental cost."

The recent enforcement action against Tyson Foods and its former chairman, which involved underreporting and misreporting $3 million in perks, may already be having an impact on perk disclosure. And the case, coming on the heels of another enforcement proceeding against General Electric for failing to fully describe benefits paid to former CEO Jack Welch, shows that the SEC is getting serious about compensation disclosure.

So consider using performance-linked restricted stock (with real performance hurdles), proactively look at the compensation and work load of your lead director, get counsel’s opinion—as well as a compensation consultant's advice—when working on your executive compensation plans, and carefully consider how you want to fulfill the Sarbanes-Oxley filing requirements.

Of course, you can feel free to agree or disagree with these predictions, but don’t ignore them; after all, looking only in the rear-view mirror may be interesting, but it’s a great way to crash head first into what will seem to be an obvious roadblock.

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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