Trends in Director Compensation

(Corrects spelling of Frederic W. Cook & Co., Inc. in first paragraph)

Directors of large technology companies, those in the Nasdaq 100, historically have been better paid than their counterparts at large general-industry companies in the NYSE 100. This is largely because technology companies base director compensation more on stock options, while general-industry companies rely more on cash and stock awards. In the wake of governance lapses and increased stock market volatility, data from Frederic W. Cook & Co., Inc. show that Nasdaq companies' director compensation practices are maturing and becoming similar to those of NYSE companies. Differences in directors' pay levels and program design are narrowing, although the gap is far from being closed. (For more information on these trends, see our eighth annual research report on directors' compensation.)

In 2010, director compensation in technology companies was up 18 percent compared with 2009. This tracks the stock market recovery in the first quarter of this year. The increase, however, returned total compensation for technology directors only to the level it had reached in 2004. In the top 100 NYSE companies, director compensation continued its trend of low- to mid-single-digit annual increases and has lagged technology companies, except in 2009, when general-industry directors received higher total compensation.

A principal reason for the shrinking compensation gap between technology and general-industry companies is that stock options are becoming less prevalent in the compensation packages of technology directors. Also, for both Nasdaq and NYSE companies the equity portion of director compensation is increasingly based on a dollar amount rather than as a number of shares. Providing a dollar amount in shares dampens the volatility of compensation from year to year because the impact of stock price fluctuations is reduced. Nasdaq companies will likely continue to have more volatile total director compensation as long as they have a higher incidence of share-based option awards. Although reduced from historic levels, options remain a significantly larger portion of compensation in Nasdaq companies than in NYSE companies.

Long Vesting Periods

Although it remains a minority practice in both groups, technology companies are more likely than general-industry companies to vest equity over periods longer than one year. Technology companies may have longer vesting periods because equity is a larger portion of total compensation than at NYSE companies. Long vesting periods can make directors beholden to a continued service relationship with the company in order to receive their compensation, which raises governance concerns. We expect, however, that pressure to end staggered terms for directors and hold annual elections for all directors will cause more companies to shorten vesting of director-equity compensation to one year or less to align with an annual service period.

The use of meeting fees for board and committee service continues to decline in both Nasdaq and NYSE companies and is now a minority practice. In today's environment of slow business recovery and greater regulation, neither Nasdaq nor NYSE companies have room for no-show directors, and from a practical point of view, getting rid of meeting fees simplifies director compensation. During periods when companies have more frequent—and often shorter—meetings by phone, a question is whether meeting fees should be paid. Not paying meeting fees makes the issue moot, but doing so also caps compensation at a time when many directors, particularly those in distressed industries, are working harder to fulfill increased responsibilities. Directors are reluctant to approve increases for themselves when employee pay increases are low or nonexistent and public scrutiny and criticism of executive and director compensation is heightened. Perceptions of inadequate pay in relation to the expected workload, however, could further limit the supply of qualified independent directors.

Paying lead (or presiding) directors additional compensation is increasing as the leadership and governance roles of the lead director have become better defined and formalized. While our research found that more lead directors are receiving additional compensation, median fees for this position have not increased in either large technology or general-industry companies. One possible explanation is that companies rotate the lead director position.

The Case of Nonexecutive Chairmen

It is not possible to determine a similar trend in the compensation of nonexecutive chairmen because there are too few of them and, for many companies, this position is a transition stage for retiring chief executives. NYSE companies, however, continue to pay significantly higher compensation to nonexecutive chairmen than do Nasdaq companies. The reasons for this are not evident but may be related to paying lower compensation for board membership and higher compensation for leadership roles on the board.

The trend for modest, single-digit increases for director compensation is expected to continue in 2011. Following the Sarbanes-Oxley Act in 2002, there were several years of 20 percent to 30 percent annual increases as director compensation realigned to the new realities of expanded responsibilities for directors and increased demand for directors who meet independence rules. The pay increases came at a time when the supply of new directors was declining due to the additional risks—real or perceived—of serving as a director. We do not expect the 2010 Dodd-Frank Act to have the same impact, however, even though it also increases directors' requirements and responsibilities. Increased time commitment, expanded roles, and a strengthening economy support continued increases in director compensation, but the new governance environment makes small annual compensation increases more acceptable than large compensation readjustments.

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