Executive compensation and the actions of compensation committees clearly will be the next focus for corporate governance's bright light.
Consider the furor over Richard Grasso's compensation and the New York Stock Exchange's reaction. Combine that with no less a shining light than Warren Buffet, who believes corporate governance will not be truly effective until it reaches into executive compensation issues. Finally, look at the most recent proxy season. The 2004 proxy season was just under way and the Investor Responsibility Research Center reported that more than one-third of the shareholder proposals addressed executive compensation issues.
Lawyers can help companies prepare for this scrutiny by developing a process that ensures independent analysis of executive, and particularly CEO, compensation. Independence is the most critical factor in developing a compensation committee that can withstand the heightened scrutiny now being focused on such committees. The regulatory framework that was adopted following the enactment of Sarbanes-Oxley makes this clear: both the NYSE and NASDAQ have implemented rules which require companies to determine officer compensation through an independent committee or a majority of independent directors.
Directors should adopt best practices for compensation. A clearly articulated best practices policy can help demonstrate the objective and independent nature of the process, should it come under review. Best practices in the area include:
- Objective Third-Party Criteria for Performance Assessment and Relative Compensation Levels
Committees should use information from a variety of sources. Committee members need the flexibility to set compensation levels that support the company's business goals and attract talented executives whose performance will be measured against those goals. Third-party criteria will enable members to maintain impartial, and perhaps critical, judgment regarding performance and pay. - Use of Independent Consultants Selected and Retained by Compensation Committees or Independent Members of the Board
Committee or board members should have the right to select and retain compensation consultants and any independent compensation expert to provide them advice and enable them to make informed decisions based on market data. - Employ Independent Counsel for Special Circumstances
Some circumstances, such as negotiation of CEO employment agreements and similar unusual situations, may warrant the compensation committee or independent members of the board to employ the services of an independent counsel with expertise in areas such as corporate governance and securities law.
With all the new attention being paid to executive compensation issues, companies have the opportunity to establish new standards for corporate governance in these areas. The key to success is an independent process.
The Executive Compensation Controversy Before and Beyond Grasso and Buffett
Executive compensation has risen exorbitantly since the late 1980s. From approximately 56 times the average employee's salary in 1989, executive paychecks had climbed to approximately 200 times the average employee's salary in 2002. In theory, executive compensation is related to performance. CEOs are expected to optimize shareholder value. In the past several years, as long as CEOs accomplished this, their salaries passed board approval and were granted with little oversight or outside control. Even the toughest critics of CEO pay know that generous compensation packages are an important incentive in attracting and keeping top executives.
Not much concern was expressed while the economy was booming; but, following the recession in the early 1990s, shareholders began to scrutinize CEO pay as never before. Little wonder. During the recession, shareholders watched their stock values plunge, along with their investment portfolios and 401(k) retirement plans, while CEO compensation grew, remained the same, or, worse, some CEOs left their positions with millions. Reaction to the latter situation exploded into the furor that helped lead to the passage of the Sarbanes-Oxley Act in 2002.
HealthSouth CEO Richard Scrushy was the first CEO to feel the sting of the new legislation. In a press release dated Mar. 19, 2003, the Securities & Exchange Commission reported that the SEC had filed a complaint in federal district court in Birmingham, Ala., alleging that, since 1999, at the insistence of Scrushy, HealthSouth systematically overstated its earnings by at least US$1.4 billion in order to meet or exceed Wall Street earnings expectations. The false increases in earnings were matched by false increases in HealthSouth's assets. By the third quarter of 2002, HealthSouth's assets were overstated by at least US$800 million, or approximately 10 percent. The complaint alleged that HealthSouth and Scrushy's actions violated and/or aided and abetted violations of the antifraud, reporting, books-and-records, and internal control provisions of the federal securities laws.
In the summer of 2003, the CEO of American Airlines resigned because of the untimely adoption (and failure to disclose) of a conventional supplemental executive retirement plan security arrangement. In the fall of 2003, the chairman of Ahold (an international food provider based in The Netherlands) resigned amid a shareholder and public relations backlash over the compensation package promised to Ahold's new CEO. The new CEO voluntarily cut back his compensation.
Richard Grasso's exploits were perhaps the most widely publicized. Although he turned down US$48 million in pay he had coming and subsequently resigned, that was not enough to avoid the NYSE's directors being put in the line of fire for not paying close attention to the details of the compensation arrangement they had approved over the years. According to lawyers who have been briefed on the Grasso investigation, regulators may question the validity of the US$188 million payout granted by NYSE's board in 2003. On Jan 8, 2004, the NYSE requested that New York Attorney General Elliot Spitzer and the SEC take legal action against Grasso.
A week after the NYSE's request for action against Grasso, shareholders of Vivendi Universal S.A. requested that the company's chairman and chief executive, Jean-Rene Fourtou, take steps to recover 35 million euros from Edgar Bronfman Jr., Vivendi's former vice chairman. Vivendi paid Bronfman this salary under a consulting contract and a part-time employment contract with Vivendi's U.S. subsidiary. The shareholders threatened to take their own legal action if Fourtou declined to take action.
Finally, The Coca-Cola Co. recently reported that it paid US$8.4 million in bonuses to its top six executives last year, the equivalent of about US$2,300 for each of the 3,700 employees that the world's largest beverage maker laid off during the same period. The company also reported that present value of the retiring chief executive's (Doug Daft) restricted stock awards is US$86 million.
Clearly, the scrutiny of, and outrage over, exorbitant CEO pay is not going to go away anytime soon. SEC Chairman William Donaldson said that executive compensation "is not a popular thing to talk about. But, if you look out there across the country, it's on everybody's minds." He added, "We have a long way to go in this area."
In the wake of Enron and other corporate scandals, several independent commissions turned their attention to the topic of executive compensation and the committees that oversee it. In June 2002, The Conference Board convened the Commission on Public Trust and Private Enterprise (CPTPE) to address the breakdown in public trust that grew out of the explosion of corporate scandals and the apparent disconnect between executive compensation and performance. CPTPE concluded that, as a starting point, "a diligent and independent compensation committee is critical to avoid abuses." It identified general principles of corporate governance relating to executive compensation, including:
- The necessity for a strong, independent compensation committee
- The importance of performance-based compensation
- The proper role of equity-based incentives
- Compensation policies that create long-term focus
- Accounting neutrality
- Respect for shareholder rights and protection from equity dilution
- Transparency and disclosure
Other organizations have completed studies and come to conclusions similar to those of CPTPE. For example, the National Association of Corporate Directors' Blue Ribbon Commission on Executive Compensation and the Role of the Compensation Committee released its own report that included similar recommendations plus one new proposal. The proposal suggested linkage between executive pay and job performance, and recommended using certain performance metrics to judge job performance, including revenue, net income, profit margin, cash flow, earnings per share, debt reduction, return on equity, capital or assets, market share, and stock performance.
New NYSE and NASDAQ Rules
Both the NYSE and the NASDAQ proposed new standards to ensure the independence of compensation committees. These new standards have an overriding purpose, which is to insulate the compensation committee from CEO pressure, influence and interference. Although many companies willingly started initiatives to follow the new standards, most companies now have little choice.
On Nov. 4, 2003, the SEC approved revised NYSE and NASDAQ listing standards that implement many important corporate governance reforms. Many experts believe these reforms will have a greater impact on both employee benefits and executive compensation than the Sarbanes-Oxley Act itself.
For NYSE companies, the compensation committee must:
- Consist entirely of independent directors
- Have a written charter addressing the committee's purpose, goal and responsibilities
- Conduct an annual self-evaluation of the committee
- Have authority to review and approve corporate goals and objectives relevant to CEO compensation
- Evaluate CEO's performance in light of goals and objectives
- Determine and approve CEO compensation based on the evaluation, either
- as a committee or with other independent directors
Under these rules, independent directors should have no material relationship, either directly or indirectly, with the company. And a former employee can be a director only if five years have passed since his or her employment.
In addition to the makeup of compensation committees, the NYSE proposes that companies adopt a written charter for their compensation committees. The charter must address the committee's purpose, duties, responsibilities, and an annual process for evaluating the performance of the compensation committee.
The NYSE also has instituted a rule change that (with limited exceptions) will require that any equity compensation arrangement and any material revision to the terms of such an arrangement be subject to shareholder approval. The exceptions include employment-inducement options, option plans acquired through mergers, and tax-qualified plans such as employee stock ownership and 401(k). For exceptions to apply, the grants under the plans must be subject to the approval of the company's compensation committee. In addition, treasury shares can no longer be used to avoid shareholder approval.
The NASDAQ rules are similar to those of NYSE, yet do not require a compensation committee. Instead, they require that:
- Compensation for CEOs and other executives be determined, or recommended to the board for determination, by either a majority of independent directors or a compensation committee composed solely of independent directors. The CEO may not be present during voting or deliberations on the CEO's compensation.
- If a compensation committee is appointed, the members must be independent. An exception to this rule applies to a committee having at least three members. In such cases, one nonindependent director (who is not a current officer or employee nor a family member of such person) may serve on a committee, under disclosed exceptional and limited circumstances, for a maximum term of two years.
Others Weigh In
Other agencies are announcing efforts to examine more closely executive compensation. A senior Internal Revenue Service official stated at the American Bar Association's Tax Section midyear meeting in January 2004 that the IRS is continuing, expanding and strengthening its new executive compensation audit initiative. Focused on large- and mid-sized businesses, the IRS says the initiative ends the "period of benign neglect" of executive compensation issues in order to confront the IRS' finding of what it views as significant noncompliance involving executive compensation. The IRS publicly announced its expanding efforts in November 2003, indicating that it had initially targeted only 24 large companies as test cases, but that the initiative is likely to expand beyond the initial target list.
SEC Chairman William Donaldson recently weighed in by saying that corporate boards should be more vigilant when awarding huge pay packages to senior executives. Donaldson told an SEC conference in April 2004 that such compensation should be linked to long-term performance. He said he would like to see companies expand the definition of performance to one that goes far beyond pay packages based on earnings per share. While adding that he thinks corporate boards are taking the pay issue more seriously, Donaldson said the SEC has no plans to propose new disclosure rules for executive compensation.
Finally, the issue of executive compensation has been at the forefront of two recent court decisions on corporate law. These cases, decided under Delaware law, may signal a trend toward state judicial scrutiny of director behavior and board and compensation committee processes in granting oversized employment and severance packages to senior executives.
In the case of In re Walt Disney Co. Derivative Litigation (Del. Ch. C.A. No. 15452-NC, May 28, 2003), the plaintiffs claimed that defendant directors approved the employment agreement for Michael Ovitz and his no-fault termination package without any meaningful review, analysis, consultation or deliberation. The complaint alleged that Disney's CEO, Michael Eisner, unilaterally offered the position of president to his friend of 25 years. Meeting a month after Eisner's offer to Ovitz, the compensation committee relegated the compensation agreement to a minor slot on their agenda, received only a rough summary of a draft agreement, did not receive or ask for any industry comparisons, did not ask about the possible cost of the severance arrangement, and did not seek the advice of a consultant. As a result, according to the complaint, Eisner unilaterally dealt with Ovitz and provided him with a no-fault termination package alleged to exceed US$140 million.
Although the case involves a motion to dismiss, where the plaintiff's allegations are assumed to be true, the decision may be a harbinger of significant change. It marks the first time a Delaware court has scrutinized the details of a compensation process and decision, rather than giving directors the benefit of the business judgment rule. The court's finding that the directors may have violated their obligation of "good faith" rather than just the "duty of care" may expose the directors to personal liability where neither corporate indemnity nor exculpation is available.
In the other case, Trace International Holdings, Inc. v. Cogan (2003 U.S. Dist. LEXIS 7818, S.D.N.Y. 2003), the trustee in bankruptcy alleged that defendant directors breached their fiduciary duties of loyalty and care in allowing the controlling shareholder and CEO, Marshall Cogan, to pay himself compensation in excess of US$23 million, and to borrow (and default on) more than US$13 million in company loans. The court set down a standard of governance for private companies at least as high as the current expectations for public companies.
"Given the lack of public accountability present in a closely held private corporation, it is arguable that such officers and directors owe a greater duty to the corporation and its shareholders to keep a sharp eye on the controlling shareholder. At the very least, they must uphold the same standard of care as required of officers and directors of public companies or private companies that are not so dominated by a founder/controlling shareholder. "
Moreover, the court found numerous procedural flaws in the behavior of the board and its compensation committee.
"Further, the evidence at trial demonstrated that neither the Compensation Committee nor the Board followed procedures that would lead to an informed decision as to whether Cogan's compensation for the seven-year period was reasonable. The evidence demonstrates that the Committee did not in fact conduct any real investigation into the reasonableness of Cogan's compensation. It is undisputed that the Committee retained no compensation consultant or other professional to assist it. Nor does it appear that the Committee consulted any salary surveys or other analyses. While the Committee's findings purport to find that Cogan's compensation was comparable to that of 'similarly situated executives,' none of the witnesses at trial knew who the similarly situated executives were, where they worked, or how much they made."
The New Whipping Boy: Stock Options
The use of stock options to make a CEO's pay more attractive has been an easy target for those trying to regulate compensation committees. Many of the corporate governance failures of the past decade have been blamed on undue reliance on stock options as a key form of executive compensation plans. According to this line of thinking, the overuse of options not only gave rise to excessive compensation but also induced executives to focus on stock market prices at the expense of long-term business growth.
In the Commission on Public Trust and Private Enterprise study, CPTPE identified a confluence of events which, according to them, created a business environment "ripe for abuse." Several factors identified by CPTPE pointed directly at stock options as a main culprit, including:
- An excessive use of stock options
- The speculative nature of those options that led to their being undervalued by the executives to whom they were given, which in turn required higher levels of grants
- The lax attitude of boards of directors toward their duty of monitoring executive compensation
- The fact that stock options and other equity-based incentives created enormous incentives to manage companies for short-term stock price gain
The debate over proper treatment has actually been simmering for years. As far back as 1995, the Financial Accounting Standards Board (FASB) established standards for financial accounting and reporting for stock-based employee compensation plans. These standards did not require companies to expense the cost on their income statements. At the same time, applicable tax rules permitted companies to deduct the cost of the options paid to executives, which often resulted in an overstatement of earnings per share.
After several CEOs of underperforming companies walked away with millions of dollars in the form of stock options, such benefits are now widely perceived as ways to get around the spirit, if not the letter, of U.S. generally accepted accounting principles (GAAP). Recognizing this, the FASB reversed course and signaled late last year that it will require U.S. companies to recognize the cost of employee stock compensation in their financial statements. On March 31 of this year, it released its long-awaited proposal to do just that. Approximately 500 public companies have already begun expensing them voluntarily, and the FASB and its international counterpart, the International Accounting Standards Board, are in the midst of trying to bring GAAP into line with this approach.
Congress has decided to act as well with various bills now pending that would increase the requirement for stock options to be expensed at some level. The "Ending the Double Standard for Stock Options Act" would prohibit companies from deducting the cost of stock options unless they also expense those options. A competing bill, the "Stock Option Accounting Reform Act," would only require companies to expense options granted to top executive officers. A third bill would direct the SEC to impose enhanced disclosure requirements for employee stock options.
Advice for Corporate Counsel
Many examples of excessive compensation, and cases involving egregious conduct, are concerning executives as outliers and involve extreme facts. Nevertheless, they do provide important lessons to boards and compensation committees about good governance and protective processes. Although these suggestions may be more relevant to publicly traded companies, they may also be useful for private companies.
- Take the Role Seriously. The compensation committee's charter, and more importantly the committee's actual practice, should make the committee responsible for approving the actual employment agreements of identified senior executives. The committee should be able to delegate the negotiating authority to one or more of its members, and in many situations, to the CEO. However, delegation to the CEO alone to negotiate and approve final terms may have some inherent conflicts, particularly if the two are friends, and invites second-guessing if problems arise.
- Be Informed (i.e., Meet the Duty of Care). It is not enough to review a summary term sheet and "ask a few questions." Find out what industry comparables are; require calculation of total benefits under various scenarios (including severance if termination occurs without "cause"); use a compensation consultant if needed to understand current industry and other peer group approaches; and obtain independent legal advice, if appropriate, for negotiating and drafting assistance.
- Trace Your Steps. Document the process. Although keeping detailed minutes generally has not been "fashionable," in situations involving process, more is better and is the best proof that good process actually occurred.
- Adopt Strict Independence Guidelines. The new NYSE and NASDAQ standards show that independence is the key to having a compensation committee that can withstand the new scrutiny. Compensation complaints are often made in the context of shareholder derivative suits and are first heard in a motion to dismiss, upon the recommendation of a committee of independent directors. Here, courts have a higher standard of independence than do the proposed listing standards of the stock markets. Long-term personal and business relationships tend to taint the perception of independence. And when the court (whether of law or public opinion) reviews the actions of a compensation committee, inclusion of a friend of the executive can become a liability, or at least an embarrassment.
- Become and Stay Educated. Members of compensation committees should learn the basics of the company's compensation philosophy and the components of incentive compensation. For example, do not wait for a shareholder proposal to arrive in the mail to find out whether the company includes pension fund gains in income for bonus purposes, or has a deferred compensation plan that accrues interest at above-market rates. The need to stay educated plays out in the duty to monitor whether compensation plans continue to incite desired management behaviors and continue to align management and shareholder interests.
- Monitor Value Added by Compensation Programs. Simply linking compensation to shareholder returns is neither a broad nor deep enough analysis by itself. Execution of strategy should have its own place in the program, and the length of vesting and holding periods for equity components can be important tools to focus executive attention on the medium-term, rather than just the short-term, performance of the company.
These approaches, if implemented and followed, should protect board and committee processes from bad faith characterizations and directors from exposure to personal liability. And by ensuring an equitable process, they may even enhance a company's image, which is something most companies can't pay enough for.
Sidebar One
Both the NYSE and NASDAQ have implemented rules which require companies to determine officer compensation through an independent committee or a majority of independent directors
Sidebar Two
Many examples of excessive compensation, and cases involving egregious conduct, are concerning executives as outliers and involve extreme facts. Nevertheless, they do provide important lessons to boards and compensation.