article is reprinted with permission from the
July 29, 1991
New York Law Journal.
© 1991 NLP IP Company.
Corporate Pay Responsibility Act
By Joseph E. Bachelder.
AMID THE CRITICISM of CEO pay in recent months, legislation has been introduced in Congress that, among other things, would afford shareholders a greater voice in the setting of CEO pay, provide them with greater information regarding executive compensation generally and permit them to nominate their own slates of directors. The provisions of the bill, entitled the "Corporate Pay Responsibility Act," would
(1) require public corporations to include in proxy statements shareholder "recommendations, proposals, or statements on the policies, criteria, or methods to be used in determining or providing the compensation" of CEOs and directors. (A shareholder seeking inclusion of any such recommendation, proposal or statement would have to meet the requirement of SEC Rule 14a-8 that the shareholder is, and for at least one year has been, a record or beneficial owner of at least 1 percent or $1,000 in market value of securities entitled to vote.)
(2) require additional disclosure of information as to compensation of each director and "senior executive," including
(a) "a single dollar figure representing the total compensation paid to such person" (emphasis added) for the year being reported;
(b) "the estimated present value . . . of deferred, future, or contingent compensation provided during such year" (emphasis added) to each such person;
(c) a "graphic representation" of
* the "total compensation" paid to each such person in the current year ((a) above)
* the "total compensation" paid to each such person in each of the two prior years
* "estimated total compensation" for each such person for each of the succeeding five years.
(3) require public corporations to reduce their earnings, as reflected in their earnings statements to their security holders, by the estimated present value of deferred, future, or contingent compensation of each director and "senior executive."
(4) permit shareholders meeting a beneficial ownership test to nominate persons for election to the board of directors and require corporations to include such nominees in their proxy statements. The ownership test would be beneficial ownership of either (A) 3 percent or more of the voting power or (B) $1 million or more of the market value of voting equity securities. The shareholders must be permitted to give descriptions or other statements regarding the nominations on the same basis as management.
(5) require shareholder access to the corporation's shareholder list (provided it is otherwise permitted by law), subject to a monetary penalty for failure to do so.
(6) require confidentiality of proxy votes and tabulation of the votes by an independent third party.
Senator Carl Levin (D. Mich.) introduced the legislation in the Senate (S. 1198) and Representative John W. Bryant (D. Texas) introduced a companion bill in the House (H.R. 2522). Senator Levin held a hearing in May on the subject of "The SEC and the Issue of Runaway Executive Pay."1
Under current law, shareholders do not set executive pay (at least not ordinarily). The SEC does not set executive pay. Generally, the board of directors of a corporation (or its compensation committee) sets executive pay. Under New York and Delaware state corporation laws, for example, the Board of Directors has the authority to set executive pay unless the certificate of incorporation or the by-laws provide otherwise.2 In the case of stock or stock-related plans, some states, such as New York, provide that certain compensation matters are subject to shareholder vote.3 Also, in the case of stock or stock-related plans, shareholder approval may be required under rules of the stock exchanges,4 rules of the SEC requirements of Rule 16b-3 applicable only to certain insider transactions) and rules under income tax laws (e.g., rules regarding incentive stock options under Section 422 of the Internal Revenue Code of 1986 (the Code)).
The proposed legislation would not change current law in this regard. If a shareholder wishes to question the reasonableness of a particular compensation action, the shareholder's direct recourse is -- and would continue to be -- to the courts for a determination under state corporation law. (The bill, of course, would afford shareholders opportunity to make recommendations, proposals and statements regarding board action on CEO or directors' pay and to nominate slates of directors who might subsequently revoke or modify decisions by a prior board as to such pay.)
The author of this column has assumed that in using the word "proposal" the legislation does not intend to give shareholders the authority to act directly on such compensation matters or to veto board action in respect to such compensation. It is assumed the legislation, as proposed, intends that the shareholders, under the circumstances noted, are entitled to a precatory voice only.
Actions by a board of directors on compensation matters are generally immunized from court scrutiny by the business judgment rule. Courts do not consider it appropriate, under normal circumstances, to review decisions by boards of directors. Exceptions to this immunity from judicial scrutiny are made in circumstances in which there is a question whether a board decision was made in good faith (e.g., if a board member taking part in the action was self-interested) or circumstances in which there is evidence that the board did not exercise an appropriate degree of care (e.g., if a board adopts golden parachutes in the face of a pending takeover without careful deliberation of the issue whether the parachutes are appropriate for the corporation).
Disclosure of shareholder proposals. For many years, the SEC did not consider shareholder proposals regarding executive compensation as something requiring disclosure in the proxy statement. The reason given by the SEC has been that if the subject matter of the proposal was not the proper subject for action by shareholders, it was not appropriate to compel a corporation to include such a proposal in the proxy statement. (Another way in which this rule has been expressed is that if the subject matter of the proposal relates to the conduct of the ordinary business of the corporation, its management should be entitled to exclude it from the proxy.)
In the past two years, the SEC has made exceptions to its "ordinary business" exclusion in several categories of shareholder proposals:
(i) those relating to golden parachute payments
(ii) those relating to disclosure of more information about executive compensation
(iii) those relating to creation of a shareholders' committee to advise boards of directors on various matters including executive compensation.
Disclosure of information on executive compensation. Under existing SEC rules, disclosure requirements relating to executive compensation fall into several categories:
(i) Cash Compensation. This is reported in the Cash Compensation Table for each of the five highest paid executive officers (whose individual cash compensation exceeds $60,000) and for all executive officers as a group. Cash compensation means salary, bonus or similar benefits that are paid for services rendered during the year being reported, or that would have been paid but for deferral.
(ii) Plan compensation. This includes compensation relating to stock option and stock appreciation rights plans, stock award plans, and other forms of long-term incentive plans, as well as pension and retirement plans. Certain plans, such as group life, health and medical plans, may be excluded provided they are not discriminatory.
(iii) Other compensation. This includes personal benefits if they exceed certain minimum amounts.
(iv) Miscellaneous. In addition, there are disclosure rules regarding compensation of directors, certain types of termination arrangements for executive officers and certain transactions between officers and directors and the corporation.
Disclosure of alternate slates of directors as proposed by shareholders. Under Rule 14a-8, corporations are not required to include in the proxy statements slates of directors nominated by shareholders.
Disclosure of shareholder lists. Corporations are not required under any SEC rule to disclose shareholder lists to their shareholders. (State laws, on the other hand, may require such disclosure.5)
Tabulation and confidentiality of shareholder votes. There is no current SEC rule requiring tabulation of votes by an independent party nor a requirement of confidentiality as to shareholder votes.
Offset against current earnings of estimated future compensation payments. There is no current accounting rule of the SEC or the FASB that would require a corporation to treat future or contingent compensation as a current expense to the full extent of the award (even on a present value basis). For further discussion of this subject, see discussion below under comparable caption in connection with the following critique of S. 1198.
S. 1198: A Critique - Disclosure of shareholder proposals.
It should be emphasized again that the author assumes the proposed legislation would not authorize shareholder action in the sense of determining the pay of either directors or the CEO. Nonetheless, S. 1198 likely would have significant impact on the setting of CEO and director compensation.
(i) Undoubtedly there would be numerous recommendations, proposals or statements by shareholders that would require study and response by management in connection with the proxy disclosures.6 It may not be an impossible burden, but it would not be something management would be very happy about, considering the time and the cost likely to be involved in the process.
(ii) The vulnerability of director compensation to attack on the ground that it inherently involves self-interested directors is bound to be aggravated by shareholder proposals and comments displayed in the proxy statement. This will be the case, it would seem, whether or not a shareholder vote against director compensation decisions amounts to a majority vote. In an era in which it is becoming increasingly difficult to attract well-qualified directors, S. 1198 undoubtedly would make it even more difficult to attract directors.
(iii) S. 1198 could significantly impact the application by courts of the business judgment rule. Whether in regard to CEO or director compensation, it is very likely that courts would take into account shareholder recommendations, proposals or statements in determining whether boards of directors used the proper duty of care in setting such compensation. Whether or not a shareholder recommendation was approved by a majority of the shareholders, it would not be wise for a board of directors to reject the recommendation without some explanation on the record including evidence of careful consideration of the recommendation.
Disclosure of information on executive compensation. The objective of improving current disclosure of executive compensation is a worthwhile one. Critics of the current rules do have a point: it is frequently very difficult to ascertain current executive pay, long-term awards and other remuneration for a particular year from a proxy statement even though the proxy statement properly follows the SEC disclosure rules. On the other hand, the disclosure proposed by S. 1198 is rather draconian. Among other things, the bill would require:
(i) a present value estimate of such varied forms of long-term compensation as stock options, restricted stock and performance shares. Such valuations are required under the proposed regulations pursuant to Code §280G dealing with special tax rules for golden parachute payments. Anyone who has dealt with problems of valuation, under §280G, of awards to be earned out in the future will appreciate the difficulty S. 1198 poses in this respect. (It is noteworthy that the regulations under Code §83, dealing with the transfer of property in consideration for services, provide that in virtually no case does a stock option have a readily ascertainable market value.)
(ii) projections of estimated total compensation payments for each "senior executive" for each of the succeeding five years (in addition to a backward look at compensation paid for the two years prior to the current year, which is not so burdensome). It strains the imagination to contemplate accurately forecasting for the next five years the total payments for each of those years for "senior executives" of a corporation. (In this connection it would be helpful if the authors of the legislation would suggest what they mean by "senior executives." Is it the five highest paid "executive officers" who are currently included in the Cash Compensation Table? It would place a serious burden on management to provide such forecasts for the five highest paid "executive officers," let alone providing it for an even larger group.)
It also should be noted that the requirement of a single dollar figure for all compensation paid to a director or senior executive during the year being reported will enhance the view, expressed frequently in press reports on CEO pay, that salary and annual bonus should be lumped together with long-term incentives in describing executive pay for a given year. In the author's thinking this is unfortunate because it ignores the period in respect of which long-term incentives are earned out and distorts the real compensation attributable to the year in which the award is paid out.
Disclosure of alternate slates of directors proposed by shareholders. This provision in a bill entitled Corporate Pay Responsibility Act may prove to be a Trojan horse. It is possible, of course, that shareholders disenchanted with amounts paid the officers and directors of their corporation might advance a slate of alternate directors. Yet the implications of this provision go far beyond executive compensation matters. Corporate raiders and other parties proposing to take over a corporation will find this procedure a most inviting way around the costs associated with putting up their own slates of directors.
Disclosures as to lists of shareholders. Comments in respect of this provision are much the same as made in respect of the preceding provision. The implications as to executive compensation pale in significance to those for corporate takeovers generally.
Tabulation and confidentiality of shareholder votes. Provision for tabulation by an independent party does not carry with it significant implications as to executive compensation. Preservation of confidentiality from management does have significant implications. Many investors do not want to impair their relations with management by revealing to management a vote against it. These include institutional investors who generally seek to keep communications open with management. These also include employees of the corporation and entities holding stock in the corporation for the benefit of employees (e.g., ESOPs).
Although reluctant to do so if their votes were disclosed to management, some of these shareholders might very well vote against a management position, including an executive or director compensation matter, if their votes were confidential.
Reduction of earnings by estimated present value of deferred, future or contingent compensation (presumably compensation awarded during current year). This includes such diverse arrangements as stock options, restricted stock awards and performance shares. Does it cover deferred compensation, including supplemental pension plans? Despite technical uncertainties created by the drafting of the bill, it seems clear that the bill's sponsors intend this to apply to the reporting of earnings in the financial statements of the annual report of the corporation. This is an extraordinary suggestion. Current accounting for stock compensation is governed by Accounting Principles Board Opinion No. 25 published by the Accounting Principles Board of the American Institute of Certified Public Accountants in 1972.
Accounting for other forms of compensation that span more than one accounting period, including deferred compensation in the form of supplemental pensions, are subject to rules, often quite complex, administered by the Financial Accounting Standards Board. Do Senator Levin and Representative Bryant intend to scrap existing accounting rules for reporting by public corporations of "senior executive" and director pay? What about all the other executives of a public corporation -- is their comparable pay to be accounted for on a different basis from "senior executives"?
In all events, hearings and commentary on S. 1198 should prove interesting.
1The SEC and the Issue of Runaway Executive Pay. Hearing Before the Subcomm. on Oversight of Government Management of the Senate Comm. on Governmental Affairs, 102d Cong., 1st Sess. (May 15, 1991) [hereinafter cited as Hearing].
2 N.Y. Bus. Corp. Law §701 (McKinney 1986); Del. Code Ann. tit. 8, §141 (1990).
3 See. e.g., N.Y. Bus. Corp. Law §505(d) (McKinney 1986) (Shareholder approval is required for the insurance of stock rights or options as compensation for directors, officers or employees of the corporation.). But see Del. Code Ann. tit. 8, §157 (1990) (Subject to any provisions in the certificate of incorporation, Delaware does not require shareholder approval for the issuance of stock rights or options as compensation for directors, officers or employees of the corporation.).
4 See, e.g., New York Stock Exchange Listed Company Manual Para. 312.03(a); American Stock Exchange Company Guide §711.
5 See. e.g., Del. Code Ann. tit. 8, §220 (Any stockholder has the right to inspect for any proper purpose a list of the corporation's stockholders and to make copies or extracts therefrom.)
6 Presumably as a result of the recent changes in the SEC position on such proposals, more than 30 shareholder proposals regarding golden parachutes were submitted to a shareholder vote over the past two proxy seasons, During the 1989-90 season, such proposals won from 6.1 percent to 41.5 percent of the votes cast. The results for 1990-91 are not yet known. Seven compensation disclosure proposals were submitted to a shareholder vote during the 1989-90 proxy winning from 3.4 percent to 17 percent of the votes cast. Twenty-two such proposals were submitted during the 1990-91 proxy season, but the results are not yet known, Hearing, supra note 1, Testimony of Linda C. Quinn, Director, Division of Corporation Finance, SEC 13 & n. 35, 14 & n. 37.