Since the adoption of the Sarbanes-Oxley Act in 2002 ("Sarbanes"), much of the focus on changes in corporate governance has been on the Audit Committee of the Board of Directors. However, now that the first wave of internal control reports have been filed under Section 404 of Sarbanes, perhaps it is time to take note of other trends which may make the balance of 2005 the Year of the Compensation Committee.
Sarbanes itself did not do much explicitly to change the rules of the game with respect to executive compensation, as it did with the audit function. There are only two significant new laws in the compensation area. Section 402 of Sarbanes prohibits loans to directors and executive officers. The intent of this section was to curb abuses such as the reported $160 million in loans to Bernard Ebbers of WorldCom to purchase company stock, and a number of instances of loan forgiveness (where questions exist as to whether repayment was ever realistically contemplated in the first place). Of course, as Sarbanes was hastily adopted in 2002, this section also prohibits some rather benign practices, including providing mortgage loans to executive officers who are relocating.
Also, Section 304 of Sarbanes provides that if a company is required to restate its financial statements, its CEO and CFO will be liable to reimburse the company for certain bonuses received, and profits realized from the sale of company securities effected within 12 months after the non-compliant financial statements were first publicly released, if such restatement is due to the material non-compliance of the company, as a result of misconduct, with financial reporting requirements.
However, as a result of the generalized focus on corporate governance in the aftermath of Enron and WorldCom, there have been other developments which have focused attention on executive compensation and the role of the board of directors and the compensation committee in monitoring that compensation. Litigation with respect to compensation issues seems to have increased, or at least become more visible. Also, shareholders are increasingly raising compensation-related issues for consideration in proxy statements.
First have been the scandals and the litigation, such as:
- The Disney derivative litigation involving compensation and severance payments (allegedly exceeding $130 million) to Michael Ovitz following his 14 month failed tenure as COO at Disney;
- The furor over Richard Grasso's $180 million severance package from the New York Stock Exchange, and the resulting lawsuit by the New York Attorney General against Mr. Grasso and the head of the NYSE's compensation committee;
- The recent settlements by Abercrombie & Fitch and Fairchild Corp. of claims of excess compensation received by their CEOs; and
- Recent litigation commenced against Cisco Systems regarding claims both that grants of stock options were exorbitant and that option prices were fixed just prior to the release of favorable news that would increase the price of the stock. A similar claim with respect to unfair timing of option grants has been made against Tyson Foods, in connection with grants to three executives, including CEO John Tyson. Tyson Foods is also reported to be subject to an SEC inquiry with respect to the disclosure of executive perks.
The Disney case1 has focused the most attention on executive compensation, and generated the most fear among directors, as the plaintiffs in that case are seeking to hold the directors of The Walt Disney Company personally responsible for excess payments to Michael Ovitz. The allegations in that case are that the Disney directors totally failed to make any effort to fulfill their fiduciary duties in approving the initial employment agreement for Ovitz and in failing to supervise negotiations between Michael Eisner, Disney's CEO and Ovitz' long-time friend, and Ovitz leading to his no-fault termination. The plaintiffs claim that the directors did not review documents, nor understand the magnitude of the payments, nor receive any advice from a compensation expert. Normally the business judgment rule protects directors operating in good faith from personal liability for their actions as directors. However, the claim in the Disney litigation is that the directors were so delinquent that they could not be found to have acted in good faith, and therefore should not be entitled to the business judgment rule's shield from personal liability. At least at the initial procedural stage, the Delaware Chancery Court has allowed the case to proceed to fact finding.
In other litigation, Abercrombie ended two shareholder lawsuits by (a) reducing CEO Jeffries' final bonus from $12 million to $6 million, and tying the bonus to specific earnings forecasts, (b) eliminating stock options for him in 2005 and 2006, (c) requiring the expensing of stock options, and (d) adding independent directors to the compensation committee. Jeffrey Steiner, Fairchild's chairman and CEO, reportedly agreed to pay $1.5 million and cut his salary by 20 percent to settle claims that he received excessive compensation and improper payments. His son also agreed to a pay cut. Neither of these claims may have been asserted in the pre- Disney world.
A second trend worth noting is increased shareholder activism. There has been a dramatic increase in the number of shareholders seeking to, and succeeding in, having shareholder initiatives placed on corporate ballots that deal with such executive compensation issues as expensing of stock options, pay caps, and related matters. Not surprisingly, most of these shareholder-initiated proposals fail to be adopted, as corporate control of the proxy machinery remains strong. However, some studies have indicated that companies that experience a shareholder proposal on executive compensation, even if defeated, nevertheless see executive compensation increase by a significantly lesser percentage than companies that have not experienced such a shareholder proposal. These results may encourage shareholder activists to continue to press for executive compensation reform at other companies.2
So what is a poor compensation committee member to do? The bottom line for individuals serving as members of the compensation committee is to take the duty of due care seriously. Fixing compensation is an art. Compensation must be sufficient to attract top candidates, yet it is not easy to know where appropriate competitive compensation stops and excess compensation begins, so experts can help. Directors may want the comfort of an expert compensation consultant, and should certainly be permitted to do so where appropriate. In addition, directors should be sure to read all compensation agreements and plans and all disclosures about those agreements and plans in SEC filings. They should understand the benefits that could be provided to executives under various scenarios under the plans, and discuss the plans fully. Members of the compensation committee must also understand how executive officers of their company are performing both in absolute terms and as compared to their peers. They must ask whether compensation is reasonably related to the personal achievements of the executives and the performance of the company. They must ask whether severance benefits are reasonable and in furtherance of corporate goals. Once that understanding is achieved, directors on the compensation committee must be prepared to have tough conversations and tough negotiations with the executive officers of the company concerning the limits of their compensation and their value to the shareholders.
A couple of cautions to consider. One result of the Disney case may be to create full employment for compensation consultants, much like the Smith v. Van Gorkom3 case of 1985 in Delaware is said to have provided full employment for investment bankers. In Van Gorkom, directors were found to have breached their duty of care in hastily approving a sale of their company. One of the reasons that the board was criticized was that no investment banker was hired to opine on the fairness of the transaction. As a result, boards today are usually reluctant to approve a sale without the seal of approval from an investment banker.
Getting an expert report on compensation may now become more commonplace, but it is not necessarily the be-all and end-all for executive compensation decisions. Expert reports may be flawed. For instance, a ratcheting effect has been widely observed.4 As CEO compensation has been skyrocketing, each compensation consultant goes out and surveys the range of compensation for like executives in comparable companies, and the range has been getting higher. Exacerbating that effect is that most boards believe that their CEO (and other executives) is "above average," like the children at Lake Woebegon. Accordingly, executive compensation continually creeps up as inflated personnel assessments are measured against the inflated range reported by the consultants. The real question for the board is, are they getting sufficient value for the compensation dollars they are spending.
To get value, a second focus has been on performance pay as a way to align shareholder and management interests. A recent Wall Street Journal headline proclaimed "Goodbye to Pay for No Performance."5 However, the key is to make the performance requirement real. In its April 11, 2005, issue, which focused on the subject of pay for performance, the Journal itself noted that pay for performance was the hot topic 15 years ago.6
Clearly, it has not yet worked. For the past 15 years, performance-based pay has principally meant fixed price stock options in large quantities, which compensation committees have handed out freely in part because there is no accounting charge to earnings. In many instances performance based goals have been such that it has been an easy stretch for executives to make their target. Further, as the recent corporate scandals have indicated, when targets are missed in the field, there has been pressure to "make the numbers" through the accounting department. The question now is whether we will see any significant changes in the mechanics of performance-based pay in the current round of reform, such as:
- requiring executives to hold their stock and options for longer periods so as not to make a profit on short-term stock price increases; and
- defining performance to reflect long-term economic performance of the company or, even better, economic performance as compared to the company's peer group competitors, as opposed to mere fluctuations in the stock market, which often occur regardless of company performance.
As much as Sarbanes has produced real changes in the way audit committees function, it is expected that the recent flurry of litigation and shareholder activism will have a real effect on the process of approving executive compensation. Less certain of course is whether such activism will truly curb compensation levels or result in new compensation structures that are more successful in aligning management and shareholder interests.
1 In re The Walt Disney Company Derivative Litigation, 825 A. 2d 275 (Del. Chan. 2003).
2Shabina S. Khatri, "Who's Winning", The Wall Street Journal, April 11, 2005, at R3.
3 Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985 ).
4Janice Kay McCleadom, "Bringing the Bulls to Bear: Regulating Executive Compensation to Realign Management and Shareholders' Interests and Promote Corporate Long Term Productivity." 39 Wake Forest Law Review 971 (Winter 2004) .
5Joann S. Lublin, "Goodbye to Executive Pay for No Performance", The Wall Street Journal, April 11, 2005, at R1.
6 "Editor's Note", The Wall Street Journal, April 11. 2005. at R2.
Published May 1, 2005.