This article is reprinted with permission
from the
edition of
New York Law Journal.
© 2003 NLP IP Company.
Compensation Committee Developments
By Joseph
E. Bachelder
Current developments of concern to
Compensation Committees of public companies include: [i]
new requirements of self-regulatory organizations [the New York Stock Exchange
[the NYSE], the Nasdaq Stock Market, Inc. [Nasdaq] and the American Stock Exchange [Amex] [SROs]] regarding processes to be followed by Compensation
Committees; [ii] new SRO requirements regarding director independence; and
[iii] judicial developments regarding independence of directors and the good
faith of directors in reaching a decision.
Procedures
The NYSE has adopted detailed rules on how a compensation
committee should function and its specific responsibilities.1 [The Nasdaq and Amex rules are discussed below.] The NYSE rules
are effective as of the earlier of [i] the Company's
first annual meeting after Jan. 15, 2004 and [ii] Oct. 31, 2004.2 In a filing
with the SEC on Aug. 3, 2004, the NYSE has proposed a number of changes to its
corporate governance rules, which may affect the current compensation committee
rules, discussed below.
The NYSE requires listed companies to have a
compensation committee composed entirely of independent directors or,
alternatively, the duties and responsibilities of the committee can be
allocated by the listed company's board of directors to another board committee
as long as that committee satisfies the requirements of the rules.3
The committee must have a written charter
addressing, among other things, the committee's purpose and responsibilities,
member qualifications, appointment and removal of members, committee structure
and operations, reporting to the board and the requirement for an annual
performance evaluation of the committee. The charter must be published on the
company's website and the company's annual report that is filed with the SEC
must state that the charter is available. The committee is also charged with
producing the report on executive compensation for the company's annual proxy
statement or annual report.
The NYSE rules also list the duties of the
compensation committee in connection to CEO and "non-CEO" pay.
For an NYSE listed company, the compensation
committee is charged with evaluating and setting CEO pay as follows:
[a] The compensation
committee has direct responsibility to review and approve corporate goals and
objectives relevant to CEO compensation and to evaluate the CEO's performance
in light of these goals and objectives.
[b] The compensation committee [either alone
or together with the other independent directors [as directed by the Board]]
must also determine and approve the CEO's compensation level based on this
evaluation.
In contrast to the Nasdaq and Amex rules, as noted below, the NYSE rules
do not prohibit CEO presence during voting or consideration of his or her
compensation.
With non-CEO pay, however, the compensation
committee is charged only with the responsibility to make recommendations to
the board. Non-CEO pay is defined as the pay of those individuals [other than
the CEO] who are officers within the meaning of Section 16 of the Securities
Exchange Act of 1934.4
The Nasdaq and Amex
Rules focus primarily on the procedures for approving the compensation of the
CEO and other Section 16 officers.5 There is no explicit requirement to have a
compensation committee or, if a company has such a committee, to require it to
have a written charter or operate in a certain way [such as requiring it to
evaluate the CEO's performance]. These rules are effective as of the earlier of [i] the company's first
annual meeting after
Under the respective rules of Nasdaq and Amex, the compensation for both the CEO and
other Section16 officers must be determined by [1] the majority of independent
directors, [2] a compensation committee comprised solely of independent
directors [with one limited exception where the rules permit one
non-independent director] or [3] the board upon recommendations provided to it
by either [1] or [2]. CEO presence during voting or consideration of his or her
compensation is explicitly banned.
Sarbanes-Oxley Act of 2002 does not address
the makeup, roles or processes of the compensation committee [in contrast to
the audit committee].
Independent Directors
Under the NYSE rules, the compensation
committee [or, as noted above, a similarly constituted committee] must be
comprised entirely of independent directors. For a director to be deemed
independent, the board must make an affirmative determination that such
director has "no material relationship with the listed company." The
NYSE rules specify that a material relationship includes being a partner,
shareholder or officer of an organization that has a relationship with the
company.6 In addition to the requirement of the board's affirmative determination, there are specific bars in the NYSE rules to
a finding of independence. These include, among others:
[i] Employment of a
director or family member. Employment of the director as an employee, or of an
immediate family member of a director as an executive officer, by the listed
company within the last three years [although the NYSE exempts former service
as an interim Chairman or CEO and, if the Proposed Amendments are approved by
the SEC, former service as an interim executive officer].7
[ii] Receipt of compensation from a listed
company. Receipt by the director or his or her immediate family member of more
than $100,000 per year in direct compensation from the listed company during
any of the last three years [although certain compensation, such as director
and committee fees, a pension and other deferred compensation for prior
service, and compensation paid an immediate family member who is a
non-executive officer, are exempt]. The Proposed Amendments, if approved by the
SEC, would clarify that the test is receipt of more than $100,000 during any
12-month period within the last three years.
[iii] Compensation Committee Interlocks.
Employment within the last three years of a director, or his or her immediate
family member, as an executive officer of a company on whose compensation
committee any of the listed company's present executive officers serve. The
Proposed Amendments would clarify this look-back provision.8
The foregoing list does not include two
additional bars involving auditor relationships and inter-company payments.9
Nasdaq and Amex Rules
Like the NYSE rules,10
the Nasdaq and Amex rules require an affirmative
determination by the board of each director's independence. Nasdaq's test for independence is the absence of a
relationship which, in the board's opinion, would interfere with the exercise
of independent judgment in carrying out the responsibilities of a director.
Amex's test is that a director does not have a material relationship with the
listed company that would interfere with the exercise of independent judgment.
Nasdaq and Amex provide similar, but not exactly identical,
specific bars to a finding of independence, including:
[i] Employment of a
director or family member. The rules are the same as the NYSE's current rule,
except Nasdaq does not
exempt former service as an interim Chairman or CEO.
[ii] Acceptance of payment from a listed
company. Acceptance by the director or his or her family member of any payments
[not just direct compensation as in the case of NYSE] from the company in
excess of $60,000 during any 12-month period within the last three years [for Nasdaq] or during the current or last three fiscal years
[for Amex] [with certain exceptions, including fees paid for being a director
or committee member and compensation paid a family member who is a
non-executive officer].
[iii] Compensation Committee Interlocks.
Employment of a director, or his or her family member, as an executive officer
of another entity if at any time during the past three years any of the listed
company's executive officers served on the compensation committee of such other
entity.
As in the discussion of the NYSE rules, the
column does not cover all of the specific bars under the Nasdaq and Amex rules.11
Established Rules
Regulations under two Federal statutes
require, in certain circumstances, director independence. The degree of independence
required differs under the regulations pursuant to these two laws.
Under the 1934 Act, the SEC, in Rule
16b-3[d], states that a "grant, award or other acquisition" of a
security approved by a committee of two or more "non-employee
directors" is exempt from the short-swing profit rules of Section 16[b] of
the 1934 Act.12
Under Section 162[m] of the Internal Revenue
Code, in order for compensation awards to be exempted as performance-based
awards from the $1 million cap on certain compensation to a "covered
employee" [generally, the CEO and the other four most highly compensated
officers], the performance goals on which the pay-outs are based must be
established by a compensation committee comprised solely of two or more
"outside directors." Treas. Reg. § [1.162-27[e][3][i].13
Judicial Developments
Director independence was the subject of a
2003 decision by the Delaware Court of Chancery in In
re Oracle Corp. Derivative Litigation, 824 A2d 917 [Del. Ch. 2003]. This case
requires a standard of independence that is broader than the specific
independence tests established by the self-regulatory organizations as noted
above. In the Oracle case, in weighing the independence of a special litigation
committee appointed in connection with a shareholder's derivative action, the
Delaware Court of Chancery found independence lacking, citing, among other
things, social and academic ties between the directors making up the special
litigation committee and the defendants in the shareholders' derivative action.
Judicial interpretations of director
"independence" may be of significance for purposes of self-regulatory
organization rules. As discussed above, the board must make an affirmative
determination as to the independence of each director. [In addition to this
board determination, the CEO must certify the company is in compliance with the
NYSE rules.] As part of its general determination of directors' independence,
the board should take into account applicable judicial determinations, such as
in the Oracle case, regarding requirements for a finding of director
independence.
Good Faith
Director "good faith" has been the
subject of decisions by the Delaware Supreme Court and the Delaware Court of
Chancery in the Disney litigation.14 For example, in the latest opinion, the
Court of Chancery made the following statement,
[A]ll of the
alleged facts, if true, imply that the defendant directors knew that they were
making material decisions without adequate information and without adequate
deliberation, and that they simply did not care if the decisions caused the
corporation and its stockholders to suffer injury or loss. Viewed in this
light, plaintiffs' new complaint sufficiently alleges a breach of the
directors' obligation to act honestly and in good faith in the corporation's
best interests for a Court to conclude, if the facts are true, that the
defendant directors' conduct fell outside the protection of the business
judgment rule.15
As noted above, a context in which director
independence is lacking may "set the stage" for a court's examining
whether a CEO pay decision was in good faith. For example, in a case in which
one or more members of a compensation committee are not independent, in the
sense suggested by the Oracle case, it is likely that a court will take a
careful look at whether lack of independence led to a decision not being made
in good faith.
Independent Consultants
The self-regulatory organizations rules do
not prevent the compensation committee from selecting as its own consultant the
compensation consultant to company management. This decision should, however,
be made only after very careful consideration by the compensation committee.
If, for example, a compensation consultant is receiving hundreds of thousands
of dollars [in some cases even more] to advise management [including the CEO],
can the consultant maintain objectivity in serving as consultant to the
compensation committee if conflicts of view exist between management's wants
and what an independent third party would consider to be in the best interests
of the shareholders?
Budgets
What is an adequate budget for the expenses
of a compensation committee in seeking information, consulting advice and its
own counsel on its decisions? Should the compensation committee have its own
staff? To what extent should the Committee draw upon the staff of the employer?
What if it needs to have confidential communications among its members? In some
cases, if a consultant independent of management is retained, that consultant
can provide independent, confidential staff assistance. In all events, the
compensation committee should estimate annually in advance the amount of time
and the budget needed for carrying out its duties, including outside advisors.
FOOTNOTES:
[1] NYSE Listed Company Manual, Section 303A.05.
[2] If a listed company with a staggered
board needs to replace a non-independent director in order to fully comply with
these rules and the director is not up for re-election in 2004, the Company
will have until the earlier of [i]
the second annual meeting after
[3] The compensation committee is not
required to have a minimum number of members. This contrasts to the audit
committee which is required to have at least three members under the NYSE rules.
See NYSE Listed Company Manual, Section 303A.07[a].
[4] In the proposed amendments, the NYSE
changes the reference from "non-CEO compensation" to "non-CEO
executive officer compensation." This codifies the NYSE's prior public
announcements [see "Frequently Asked Questions," updated Feb. 13,
2004] that "non-CEO compensation" refers to the compensation of
Section 16 officers other than the CEO. In the proposed amendments, the NYSE
also clarifies that the board can delegate approval of non-CEO executive officer
pay to the Compensation Committee. See SR-NYSE-2004-41. See also Rule 16a-1[f]
under the 1934 Act for a definition of "officer" under Section 16 of
that Act.
[5] Nasdaq Rule 4350[c]; Amex Company Guide, Section 805.
[6] See NYSE Listed Company Manual, Section
303A.02.
[7] Until
[8] The proposed amendments would clarify
that in applying the look-back period, the board should determine whether there
was an overlap between the director's employment [or that of his or her
immediate family member] and the executive officer's service on the
compensation committee during the last 3 years. See SR-NYSE-2004-41 amending
Section 303A.02[b][iv].
[9] These additional bars include [i] ties with the listed company's internal or external
auditors and [ii] payments between the listed company and a company which
employs the director as an employee, or a member of the director's immediate
family as an executive officer, which exceed the greater of $1 million or 2
percent of such company's consolidated gross revenues. See NYSE Listed Company
Manual, Section 303A.02[b][iii] and [v]. The proposed
amendments would significantly change the test for director independence based
on ties with the Company's auditors. See SR-NYSE-2004-41 amending Section 303A.02[b][iii].
[10] For Nasdaq's
definition of "independent director," see Rule 4200[a][15]; for Amex's definition of "independent
director", see Amex Company Guide, Section 121A.
[11] These additional bars include ties with
the company's outside auditors within the last three years and payments between
an organization of which a director or the director's family member is a
partner, controlling shareholder or executive officer and the listed company if
such payments exceed the greater of 5 percent of such organization's
consolidated gross revenues for that year or $200,000 in any of the most recent
three fiscal years. For more information see Nasdaq
Rule 4200[a][15][D] and [F] and Amex Company Guide,
Section 121A[d] and [f].
[12] The definition of "non-employee
director" under SEC Rule 16b-3[b], in some respects, differs significantly
from the self-regulatory organizations rules. For example, a director does not
qualify as a "non-employee director" under Section 16[b] if he or she
is engaged in a business relationship requiring disclosure under Item 404[b] of
Regulation S-K. Thus, a director who is a member of, or of counsel to, a law
firm that the issuer has retained during the last fiscal year or is a partner
or executive officer of an investment banking firm that has performed certain
services during the last fiscal year could be deemed to be
"independent" under the self-regulatory organizations rules [if the
fees paid by the issuer were below a certain threshold amount] but not a
"non-employee director."
[13] Under Treasury Regulation § [1.162-27[e][3][i], certain of the
requirements to qualify as an "outside director" are more stringent
than the SRO rules for determining "independence." For example, the
Treasury Regulation would deem a director as not being an "outside
director" [i.e., not being independent] if the director is a former
officer of the employer at any point in time [not just within the last 3 years]
or is a former employee of the employer who receives any compensation for prior
services [other than benefits under a tax-qualified retirement plan] during the
taxable year [thus, not exempting compensation of $100,000 or less in the case
of the NYSE and $60,000 or less in the case of Nasdaq
and Amex].
[14] In re The Walt Disney Co. Derivative Litig., 731 A2d 342 [Del. Ch. 1998] [dismissing shareholder
derivative action], rev'd in part, Brehm v. Eisner, 746 A2d 244 [
[15] 825 A2d at 289.