This article is reprinted with permission from the
May 31 , 2006
edition of
New York Law Journal.
2006 NLP IP Company.


Compensation Committees and the Setting of CEO Pay

By Joseph E. Bachelder

There has been much criticism, by academics, the media and shareholder advocates, among others, of the process by which boards of directors — in most cases compensation committees — of U.S. public companies set the pay of CEOs and other senior management.

Following is a discussion of some of the criticisms.

Director Independence

A major target of the critics is lack of director independence in the compensation setting process. One such criticism is expressed by Professors Bebchuk and Fried in their book "Pay Without Performance":

Flawed compensation arrangements have been widespread, persistent, and systemic, and they have stemmed from defects in the underlying governance structure that enable executives to exert considerable influence over their boards . . . The absence of effective arm's-length dealing under today's system of corporate governance — not temporary mistakes or lapses of judgment — has been the primary source of problematic compensation arrangements.[1]

On May 24, 2006 a front-page article in The New York Times, by Julie Creswell, examined the compensation process in the setting of the pay of Robert Nardelli, the CEO of The Home Depot Inc. It discusses in detail relationships of directors to Mr. Nardelli and among themselves on the compensation committee of Home Depot. It notes that:

The Home Depot board has awarded him [Mr. Nardelli] $245 million in his five years there. Yet during that time, the company's stock has slid 12 percent while shares of its archrival, Lowe's, have climbed 173 percent.

* * * * *

To its critics, the panel [meaning the Home Depot Compensation Committee] exemplifies the close personal and professional ties among board members and executives at many companies — ties that can make it harder for a board to restrain executive pay. They say this can occur even though all of a board's compensation committee members technically meet the legal definition of independent, as is the case at Home Depot. [Bracketed material added.]

The article then quotes Professor Fried: "When you have a situation like this where it is so incestuous, it creates uncertainty whether [Mr.] Nardelli's pay is a reflection of these relationships or from his performance."

Corporate scandals such as those at Enron and Worldcom have led to federal legislation (Sarbanes-Oxley in particular) and new regulations addressing director independence.[2] In addition, regulatory agencies like the New York Stock Exchange (NYSE) and Nasdaq have adopted rules relating to director independence.[3]

In the commentary to §303A.02 of the Corporate Governance Standards as contained in the NYSE Listed Company Manual, the New York Stock Exchange comments that material relationships that may affect director independence "can include commercial, industrial, banking, consulting, legal, accounting, charitable and familial relationships, among others."

The NYSE requires boards to take into account such relationships in determining whether individual directors are "independent" (a prerequisite under the NYSE rules, for example, for a director to become a member of a compensation committee). In addition, the rules treat as lacking independence any director who fails to meet certain specific tests embodied in §303A.02(b).

There are some, like Professors Bebchuk and Fried, who argue that, given the leverage of CEOs, it is unrealistic to expect directors to be appropriately independent of the CEOs unless shareholders have significantly greater say in the director selection process. The alternative of shareholder selection of directors, considered in a modified form by the Securities and Exchange Commission (SEC) several years ago, seems unlikely in the near future.

There is a significant gap between the aspirations of critics, such as those cited above, in their expectations of director independence and what our legal system may define as "independence" in particular circumstances. (This gap is recognized in The New York Times article quoted above.) In a recent decision involving the issue of good faith in the decade-old litigation involving the Walt Disney Co., Chancellor William B. Chandler III observed:

This Court strongly encourages directors and officers to employ best practices, as those practices are understood at the time a corporate decision is taken. But Delaware law does not — indeed, the common law cannot— hold fiduciaries liable for a failure to comply with the aspirational ideal of best practices, any more than a common-law court deciding a medical malpractice dispute can impose a standard of liability based on ideal — rather than competent or standard-medical treatment practices, lest the average medical practitioner be found inevitably derelict . . .

[t]he development of aspirational ideals, however worthy as goals for human behavior, should not work to distort the legal requirements by which human behavior is actually measured.[4]

What Chancellor Chandler says regarding director "good faith" in our legal system could be applied to director independence and the setting of CEO pay as well. Adopting a legal test for independence that eliminates all interrelationships among directors and between them and managements for whom they set compensation would be impossible. Interdependence among members of a community, including our business communities, is inevitable. This includes boards of directors.[5]

To critics of director independence it should be noted that many directors today are "running scared." The current widespread attention to director independence, in legislation and regulation, together with the ever-present media, has created a much greater vigilance by directors. To those of us dealing with board members on a regular basis this is quite apparent. This will not quiet the critics but it should be of some comfort to them.

Independence of Advisers

Independence of Advisers to Compensation Committees. Another recent article in The New York Times (May 10, 2005), by Gretchen Morgenson, describes how a consultant serving Verizon in numerous roles also served as adviser to the Verizon Compensation Committee.

The article notes that over a period of years the consultant received many millions of dollars providing services to management, only a very small portion of which was attributable to serving the compensation committee. Without commenting on the Verizon case specifically, there would seem to be little question that, as a general rule, a compensation committee adviser who also serves management (usually in a much more remunerative role) is in an awkward position in providing independent advice to the compensation committee.

Compare an accounting firm providing consulting and audit advice to a single client. A combination of consulting and auditing services by an accounting firm to a single client contributed to the downfall of both Enron and Arthur Andersen and led to passage of a new law intended to prevent such blending of services by an accounting firm to a single client.

There is no corporate governance requirement that the compensation committee consultant be independent of management. The self-regulatory agencies do not currently require that the consultant to the compensation committee be independent of management. The proposed SEC disclosure regulations require that the consultant to the compensation committee be identified but do not require that the consultant be independent of management. Nonetheless, it would seem important, as good corporate governance practice, that the compensation consultant be independent of management.

Lack of Continuity

• Lack of Continuity in Membership of Compensation Committees. Frequently major compensation decisions are made at a time of significant turnover in compensation committees. Examples in which committee turnover occurred just before a major compensation decision include Hewlett Packard[6] and the New York Stock Exchange[7], both of which have been widely criticized for their compensation decisions. In some cases, such as corporate restructurings, significant turnover in compensation committee membership is inevitable. If possible, continuity from one year to the next of at least a majority of members of the committee is desirable. Careful attention should be given in the event of turnover to familiarizing new members of the committee with the employer's compensation objectives, policies and programs and the background of current compensation issues.

Committee as Manager

• The Compensation Committee as a Manager. Most of the time, boards of directors are involved in the oversight of the management of the enterprise for which they are fiduciaries. By its nature, the role of a director is not a full-time job. (Exceptions, of course, include full-time chairpersons and, from time to time, situations involving corporate emergencies or major restructurings which can be very time-consuming for all directors.)

Estimates of "average" time spent by directors of major U.S. corporations vary. Most estimates that the author is familiar with range from 100 to 200 hours per year.[8] More time than this is spent by most chairpersons of audit and compensation committees (and, in many cases, the hours spent by chairpersons of these two committees significantly exceed the hours spent by most other members of the board).

In its management of CEO pay, the compensation committee is not only an overseer. It is involved directly in the management process. The compensation committee's work includes:

• selecting its advisers including a consultant, a legal adviser and, in some cases, an accountant;

• planning and review of the reports it receives from its advisers (hopefully with time to absorb the conclusions and supporting data of its compensation consultant and to actively engage in review of the conclusions with the consultant);

• supervising reports required on compensation matters such as the compensation section of the proxy statement (to be called the Compensation Discussion and Analysis under the SEC's proposed new rules);[9]

• meeting with management to obtain management's perspective on the compensation program;

• meeting with its legal advisers (very important in 2006, for example, if the SEC proceeds to adopt its proposed new disclosure rules);

• meeting in executive sessions to review among themselves the numerous components of senior management pay.

The above process is greatly compressed and complicated when a negotiation for a new CEO is being conducted (usually through the search committee, which often is a clone or near-copy of the compensation committee). Management of compensation, in such a case, is further complicated by the need for advice from a search consultant, meetings with CEO candidates, selecting the new CEO, negotiating the CEO's arrangements (which can be quite time-consuming if the new CEO is selected from outside the company), working with the lawyers involved in the negotiation and dealing with the public relations aspects of the appointment of a new CEO.

Especially important in the context of part-time management is the careful budgeting of the available time of compensation committee members to avoid, to the extent possible, last-minute "crunches" on the committee as it makes its key decisions on CEO pay.

In addition to criticisms discussed above, note should be made regarding compensating the compensation committee itself.

Assuming the importance attached to compensation matters supervised by the compensation committee, an additional $5,000-$15,000 of fees (as seems to be the practice) for those directors serving on the compensation committee, especially the chairperson, may not be sufficient to compensate them for the additional effort they are called upon to make. Careful consideration should be given to this issue. With a separate director's compensation table under the proposed new SEC disclosure rules, concern has been expressed as to the possible "ratcheting effect" on directors' pay of the presentation in tabular form of the compensation and benefits paid to directors (in a fashion similar to the Summary Compensation Table for Named Executive Officers).[10] If some directors discover themselves under-compensated relative to directors in other companies, their own compensation arrangements will likely become an issue. (In most U.S. corporations, directors set their own compensation.)

In order to encourage compensation committees to devote sufficient time to the management of CEO pay, they should be compensated so as to reflect the additional time required of them in their work on the compensation committee. Consideration should be given to budgeting for and logging in the additional time Committee members spend on compensation committee work. They could be compensated on a per diem or per hour basis for this time. If we do not compensate members of compensation committees to reflect the time needed to do the job adequately, we may be jeopardizing appropriate supervision of one of the most important elements of effective corporate governance, CEO pay.


FOOTNOTES:

[1] Lucian Bebchuk and Jesse Fried, "Pay Without Performance: The Unfulfilled Promise of Executive Compensation" (Harvard University Press, 2004), at p. ix.

[2] On Feb. 8, 2006 in respect of executive pay disclosure, the SEC proposed new rules. These are entitled Executive Compensation and Related Party Disclosure; Proposed Rule, Securities and Exchange Commission, 71 Fed. Reg. 6542 (Feb. 8, 2006). The provisions relating to director independence appear in Item 407 Corporate Governance, 71 Fed. Reg. 6542 at 6621.

[3] In §303A of the NYSE Listed Company Manual, Corporate Governance Listing Standards, the NYSE adopted rules relating to independence of directors. Section 303A.02 provides definitions of "independent director" and §303A.05 provides rules relating to the compensation committee. For Nasdaq's rules relating to independence of directors see NASD Manual 4200(A) and 4350(c).

[4] In Re the Walt Disney Company Derivative Litigation, 2005 Del. Ch. LEXIS 113, *10.

Five published decisions in the Disney litigation to date are as follows:

Disney I: In Re The Walt Disney Company Derivative Litigation, 731 A.2d 342 (Del. Ch. 1998)

Disney II: Brehm, et al., v. Eisner, et al., 746 A.2d 244 (Del. 2000)

Disney III: In Re The Walt Disney Company Derivative Litigation, 825 A.2d 275 (Del. Ch. 2003)

Disney IV: In Re The Walt Disney Company Derivative Litigation, 2004 Del. Ch. LEXIS 132

Disney V: In Re The Walt Disney Company Derivative Litigation, 2005 Del. Ch. LEXIS 113

[5] Most Delaware cases that the author is familiar with have addressed director independence in the context of derivative litigation to determine, under Delaware procedural rules, whether shareholders must first make a demand that the board bring litigation or take other action. (There are cases which use the term "independence" in the context of fiduciary responsibilities involving due care, loyalty and good faith. But, in such cases, the concept of independence is merged into the relevant fiduciary standard rather than standing on its own.) For a careful discussion of the meaning of director independence in the context of derivative litigation (and in that case, one in which the independence of a special litigation committee (SLC) was an issue, putting the burden on the SLC to establish its independence), see In Re Oracle Corp. Derivative Litig., 824 A2d 917 (Del. Ch. 2003); see also, the findings as to director independence by Chancellor Chandler in Disney I (see footnote 4 above).

[6] See this column, NYLJ, March 24, 2005.

[7] See this column, NYLJ, March 25, 2004, footnote 3.

[8] In "Symposium on Norms & Corporate Law: Should Corporation Law Inform Aspirations for Good Corporate Governance Practices - or Vice Versa," former Chief Justice Norman Veasey of the Delaware Supreme Court observed as follows on time spent by directors in carrying out their duties:

[D]irectors should meet face-to-face frequently throughout the year and spend substantial time on their homework. A minimum of at least one hundred hours per year on routine matters on each board has been suggested and seems reasonable, in my view. Of course more may be required in time of crisis, and directors should not become so overcommitted that they cannot deal adequately with crises.

[9] Although the proposed new SEC rules do not require the names of the committee members to appear at the end of the report as they do in the current compensation committee report (under the proposals the compensation discussion and analysis will be included in materials required to be certified by the CEO and the CFO) the compensation committee obviously will be the committee with responsibility for the preparation of the discussion of compensation. Under the proposed new rules, this would involve much greater detail and complexity than under current rules.

[10] See this column, NYLJ, March 31, 2006.