The New Compensation Committee Responsibilities–
Personal Liability/D&O Insurance
SERPs, Severance and Change in Control —
And Tallying It All Up
Step Eight: Surveys, Benchmarking and
Peer Groups —
In executive compensation surveys, it is easy to inflate numbers by including extraordinary or one-time payments and grants, or by relying on surveys conducted for other companies that included such items. This reliance might even be unintentional. On top of all this, as more companies adopted the practice of "benchmarking" — taking the position that their above-average CEO should be paid in the top 25th percentile of all CEOs — a slippery slope resulted. Compounded each year, benchmarking quickly became an out-of-control ratcheting-up phenomenon that resulted in exponential growth in compensation, as this year’s top 25th percentile becomes next year’s 50th, requiring another increase to get back into the top 25th, and so on.
Another problem is that these surveys often do not take into account that some companies may put greater emphasis on cash compensation than stock options, while other companies may place greater emphasis on long-term incentives. By cherry picking from each category, a CEO can have his cake and eat it too.
All of this can help largely explain how at some companies CEO salary and bonus and stock grants and other components of CEO compensation have gotten so far out of line — not just from the median workforce salaries generally, but also from other senior and mid-level executive compensation at the CEO’s own company.
It still is troubling that many compensation consultants, who acknowledge how surveys have brought CEO compensation into the stratosphere, still use those inflated survey numbers — that have years of compounded inflated numbers built into them — to help clients determine what is the appropriate level of salary, bonus and other compensation. This continues to perpetuate all the mistakes of the past. Going to a 50th percentile now — which may have been last year’s 25th percentile and which would have been off the charts just a few years earlier — is not reform.
[Compensation committees cannot afford to ignore the admonitions about surveys in recent governance reports: "The committee should resist an over-reliance on surveys and other statistical analyses in determining compensation levels." (Business Roundtable) "So-called market-based compensation. . .is a root cause of the current problem." (NACD Blue Ribbon Commission) "Percentile benchmarking should not ever be practiced except to provide broad market reference points." (Breeden Report)]
Step Nine: Directors Must Take Charge and
But the buck must stop somewhere. And it is becoming increasingly clear that all eyes are now fixed on the directors who comprise the compensation committee. As a result, it will no longer be sufficient for directors to blindly accept survey numbers. Instead, each board has an obligation to analyze its CEO compensation going all the way back to when divergences with the rest of the workforce began — which for many companies will mean having to analyze the CEO’s total compensation going back to the early 1980s. Several surveys have demonstrated the divergences. An excellent article that explains how we got to where we are now — which should be basic reading for every director and every advisor — is the Fortune magazine piece by Geoffrey Colvin entitled "The Great CEO Pay Heist". For more thought provoking suggestions for compensation committees assessing CEO pay, see the articles just posted on CompensationStandards.com entitled "Excessive Executive Compensation: A New Test For Director Liability" and "How Much Pay For How Much Performance?"
As one major consulting firm points out, one reason why boards may not have realized just how far CEO compensation has skyrocketed is that decisions on various compensation components are made at different meetings, thus making it more challenging to tie all the components together and comprehend them. The result has been loading up on all the available components of compensation, instead of being selective.
As directors start to conduct the hard analysis, it will come out at a number of companies that not only has the cash compensation and the stock compensation gotten way out of line internally from the company’s starting point back in the 1980s, but that the heretofore inadequately understood and undisclosed components — when now added to the cash and stock compensation — take the true numbers farther out of line, leading to the inescapable conclusion that rollbacks may be the only corrective solution.
[One corrective approach that we like is what we call the "internal pay equity check" — following the Dupont and Intel models of checking for "internal pay equity" at various levels within a company to ensure that the CEO’s compensation has not gotten out of line within the company. As stated above, compensation committees should direct their H.R. people to provide a comparison chart that goes back to the 1980s (when the gaps began to get out of line) comparing the gaps in compensation levels within the company between the CEO and NEOs and senior and mid-level executives, down to the rank and file (and including all components of compensation, e.g., SERPs and perks and accumulated option and restricted stock gains, etc.) as a framework to bring the CEO’s (and, in some cases, NEOs’) total compensation back in line.]
Step 10: And So Many Other Things To
How Can We Take Back and Modify Existing
After tallying up the compensation components, if a compensation committee finds it has been paying a lot more than it realized, hopefully that fact alone will be enough to motivate a CEO to agree to changes — rather than face the embarrassment of public disclosure of the excesses in the compensation committee report in the next proxy statement and a disclosure that the CEO refused to agree to meaningful adjustments.
One challenge with roll-backs is that many CEO contracts provide for a severance payment for termination without cause or if the CEO walks for "good reason." Good reason typically is defined to include any diminution of salary or other benefits. As a result, a CEO could easily say, "I won’t agree to a rollback and you can’t make me or I walk and receive a big payout."
Here is one respected colleague’s response: "But the court in Disney made it pointedly clear [at pgs 29-32 of the opinion] that the executive has a fiduciary duty here as well. Query whether a committee could bootstrap that into some leverage: ‘We think you, Mr. Executive, have a fiduciary duty to the company and its shareholders to be sure that the package was fair and appropriately authorized and if you don’t cooperate with our re-examination under a review that applies the proper process and asks the right questions, we think you are breaching your fiduciary duty, and therefore providing a basis for us to terminate you, Mr. Executive.’ In other words, the executive may have a self-interest in having the committee re-evaluate the existing compensation arrangements and defending the pay by being able to show that the committee had thoroughly considered it."
[See the excellent Task Force piece posted on CompensationStandards.com that provides practical guidance regarding how to deal with excessive CEO compensation, "Taking From The King: The Mutual Need and Practical Tips for Rolling Back or Modifying Excessive CEO Compensation."]
Converting Options to Restricted Stock or
Another troubling aspect of the rush to restricted stock at some companies is the failure to attach any meaningful performance conditions. Query: Would directors be so quick to grant restricted stock if they viewed it as essentially handing cash to an executive to buy company stock (which can be kept — no matter how the executive performs — simply by hanging on with the company for a few years). And worse, the vesting period often is accelerated under various scenarios, as several of our Task Force submissions point out. In addition, restricted stock generally does not qualify under the 162(m) one million dollar cap.
[It would be interesting to see whether compensation committee minutes covering the approval of simple time-vested restricted stock grants address the absence of performance risk, or reflect any discussion of the cost to the company of the lost tax deductions for amounts granted to top executives exceeding the $1 million cap — and whether the proxy statements of those companies that recently have made large restricted stock grants to replace outstanding options have included any discussion or rationalization in their 162(m) proxy statement disclosure (or compensation committee report) or have just included the same old boilerplate — leaving directors vulnerable.]
Stock Grants to CEOs and NEOs: The Need
to Calculate Total Accumulated Gains —
This means that, at a minimum, the compensation committee should seriously consider whether top executives should be required to hold the after-tax portion of these shares until retirement so that the executive truly has a long-term incentive. To avoid unintended effects (e.g., encourage early retirement), retention provisions can provide for something like "the shares must be held after exercise or vesting for the longer of __ years (the difference between the person’s then age and age 65) or retirement." Compensation committees can take a major positive step by implementing a hold-til-retirement policy for CEOs and NEOs, particularly with respect to large outstanding awards. [Remember our colleague’s suggestion, above, on the CEO’s fiduciary self interest in agreeing to modifying existing grants. CEOs (and boards) may find that, in some instances, adding a retirement retention requirement could be a sufficient and more palatable fix than a rollback. Note also the possible application of such an approach to addressing the problems with recent conversions from options to restricted stock, raised above.]
The List Goes On:
Three Times Salary and Bonus,
It is clear that a company that does have a long-term employment contract with its CEO has an affirmative obligation to consider its automatic renewal. The recent case of Pereira v. Cogan, 294 B.R. 449 (S.D.N.Y. 2003), decided by a district judge applying Delaware law, found directors of a privately-held company to have abdicated their fiduciary responsibility when they failed even to consider the automatic renewal of a CEO’s long-term employment agreement, without a review of the CEO’s performance and the continuing appropriateness of the terms of agreement. The bottom line here is to avoid evergreens where possible, but if you have one, you still must fulfill your fiduciary obligations.
Note also that companies should carefully review the definition of "cause" in employment contracts, possibly adding such elements as cooperation with governmental investigations (this has never been more important than in today’s environment, given the recent $25 million Lucent penalty for its lack of cooperation and the just updated Federal Sentencing Guidelines, which take into consideration corporate cooperation; not to mention a growing SEC Enforcement Staff and the birth of the PCAOB) or fraudulent CEO/CFO certifications under Section 302 or 906 of Sarbanes-Oxley. It would be inequitable if the company is required to pay the executive severance or a lucrative lifetime pension when the executive is fired because of fraud or other securities violations.
Hand in hand with refining the definition of "cause" is the need to add to all outstanding agreements (including options and restricted stock agreements) for CEOs and NEOs a clawback in the event of restatements or other harmful actions by the CEO/NEO to the employer — even where there has been no fraud or certification claim. (See our Task Force pointers regarding "cause" provisions and clawbacks.)
Note that in those instances where contracts cannot be avoided, the negotiation process is paramount. Consultants and independent counsel can help ensure that the compensation committee engages in real negotiation with the executive over the pay package contained in an employment contract. Without a real analysis and negotiation (and without fresh reviews of outstanding contracts — including running projections annually of payouts under various scenarios), the plaintiffs’ bar will have a field day.
Double—Triggers, Severance Formulas. In addition, severance and golden parachute provisions that only have a single trigger (i.e., awards become vested upon a change in control) need to be re-examined to assess whether there should be a double trigger (e.g., awards become vested only after a change in control and termination in connection with the change in control). The practice of providing single-trigger acceleration was driven by accounting considerations that are now largely obsolete. In light of today’s market, there is no compelling reason to provide the "windfall" of accelerated vesting. Where a double-trigger acceleration is used, severance is paid out only in the event of termination of employment. The plan will need to provide detail about what constitutes a qualifying termination for accelerated vesting, such as being fired without "cause" or resigning for "good reason."
Further, as many responsible critics have pointed out, the practice of using 3x salary as a severance formula needs to be re-examined and cut back to reasonable levels. In a recent letter to CalPERS from the California State Treasurer, it was noted that "[f]ederal law places a steep excise tax on ‘excessive’ golden parachutes, those that provide more than three years of compensation. But what federal law set as a ceiling has become a floor for golden parachutes." The Treasurer went on to request that CalPERS put in place a "model severance policy that more closely ties payouts to shareholders’ interests." Providing more than one year’s base salary to a departed executive (and adding bonuses — which are supposed to be incentives that are earned — to the formula) is out of step in today’s world, especially when taking into account the CEO’s other payments, including SERPs, vesting accelerators and the size of accumulated equity gains. (See the helpful Task Force submissions addressing potential severance pitfalls and the need to run all the numbers resulting from payments from different overlapping components that can be triggered by termination of employment.)
162(m) Violations. The IRS is wrapping up an executive compensation audit pilot program in which it found Section 162(m) violations surprisingly common among the two dozen large-cap companies that it audited. As a result, we understand that the IRS has targeted 162(m) non-compliance as a focus area for future audits. As our readers know, Section 162(m) disallows a public company’s deductions for compensation in excess of $1 million per year for its CEO and its next four highest-paid officers unless the compensation meets the requirements for "performance-based compensation" paid under shareholder-approved plans.
Common 162(m) compliance problems include: options granted under a non-shareholder approved plan; restricted stock (or restricted stock units), where neither the award nor the vesting is tied to objective, pre-established performance criteria; failure by the compensation committee to certify in writing prior to payment that the performance goals have been satisfied; or failure to timely set the performance goals — e.g., not set within the first 90 days of a one-year performance period.
To avoid these 162(m) violations, it is imperative that the members of the compensation committee understand 162(m) and its technical requirements. Further, a company’s human resources staff should consult and coordinate with both the chairman of the compensation committee and the company’s compensation consultant, if any, so that the staff acts as a backstop for compliance — and compensation decisions are not made in a vacuum.
Moreover, as is true for much of the compensation committee report, it appears that quite a few companies simply regurgitate boilerplate language about 162(m) compliance in their proxy statements each year, putting directors as well as those responsible for internal controls at risk for regulatory actions — and providing additional fodder for plaintiffs’ lawyers. The boilerplate disclosure can be particularly problematic if a company is sitting on a Section 162(m) violation. Compensation committees should make sure that, in addition to setting forth the company’s policy on Section 162(m), companies are, in fact, disclosing what they are actually doing in practice, including the actual costs the company is incurring where there is non-compliance. [See the excellent Task Force submissions providing 162(m) pointers and red flags for compensation committees, including a 162(m) checklist for compensation committees.]
The Art of Minute-Taking — The
Plaintiffs’ Bar is Watching
Although many companies have traditionally followed the school of thought that board minutes should be "bare-boned," the tide appears to have changed in the past few years and now many practitioners believe that boards should take care to provide sufficient detail in their minutes to reflect more clearly what transpired. It is not that the minutes need to be so detailed as to reflect what each particular director said — but they should state that discussions took place (as opposed to merely noting that a specific action was approved). This might be important if a government investigation or lawsuit ensues — but also will assist independent auditors, underwriters and any others that need to conduct due diligence.
In fact, for compensation decisions that are considered major corporate actions, it might even make sense to have a litigation-savvy lawyer draft the minutes. Remember that boards and board committees have the authority to hire their own counsel — and this may be an appropriate role for such counsel.
Recent cases that have challenged board or committee actions have faulted the corporate record left behind, preventing directors from establishing that they have met a duty of care or good faith (e.g., the specific reference in the Disney opinion that only one and one-half pages of the minutes covered the approval of Mr. Ovitz’s contract).
In short, minutes should include a description of each major item acted on, including a summary of the item, the major issues presented, the major factors taken into account — or relied upon — by the board, the board’s decision and, in appropriate cases, the alternatives considered.
Based on the complaint filed against Cendant, those drafting compensation committee minutes may also want to address:
The Importance of Your Proxy Disclosures — and the Need to Go Beyond S-K
[One respected colleague (and former SEC Staff member) who reviewed this issue responded to the above as follows: "You can cite Rule 12b-20 for the requirement to disclose other material information necessary to make the disclosures not misleading. If the committee follows all of your recommendations above, they should have a lot to talk about regarding how they set compensation and what they looked at."]
As part of each compensation committee’s fresh review of compensation disclosure, many companies will need to take a hard look at their compensation committee reports. In 1993, the SEC issued interpretive guidance after an exhaustive analysis of the first batch of these reports (which were first filed in the 1993 proxy season — see Securities Act Release No. 7009, Aug. 6, 1993). This interpretive release identified a variety of deficiencies in the compensation committee reports, including "[t]he lack of specificity…with respect to CEO compensation for which more individualized disclosure is required by the rule." After an initial improvement in quality in response to this release, compensation committee reports appear to have deteriorated further.
[An excellent article analyzing the inadequate state of compensation committee report disclosure today, which parses a number of recent committee reports — that should be must reading for anyone responsible for drafting or reviewing the committee’s report in this year’s upcoming proxy statements — has been written by Martin Mobley and is posted on CompensationStandards.com.]
An obvious immediate fix is to list each component of the CEO’s compensation — complete with dollar amounts — and then tally it all up and conclude with a statement that each member of the committee found that the total amount was not excessive or unreasonable. Since every compensation committee should routinely be conducting such analysis in connection with its annual CEO (and NEO) compensation review, this should be the standard in every compensation committee report. [We have just posted a model disclosure for this section of the compensation committee report on CompensationStandards.com.]
Note that specifically naming a compensation consulting firm and disclosing that the firm is now retained by the board (rather than management) does not in any way reduce the obligation of compensation committee members to ensure that the compensation committee report is providing a true and complete picture. (We also refer readers to suggestions about the compensation committee report made in the May-June 2004 issue of The Corporate Executive.)
Because each member of the compensation committee literally goes on the line by having his or her name printed beneath the report, committee members should not blindly accept the verbiage of the past drafted by their well-intentioned advisors. Compensation committee reports that follow the old mode and remain boilerplate could well become fodder for the plaintiffs’ bar — and the SEC.
[Readers should be aware that the Director of the SEC’s Division of Corporation Finance, Alan Beller, recently admonished those responsible for compensation disclosures, stating forcefully, that the Staff of the SEC is fed up with inadequate executive compensation disclosure that, in fact, fails to comply with the requirements, as well as disclosure that obfuscates. It is clear that the SEC expects to see much more specificity and transparency in this year’s upcoming disclosures, not the least of which includes straight talk in compensation committee reports. — While on the subject, those of our colleagues who may have missed its significance should be aware that the SEC Staff is considering recommending that the Commission bring administrative actions against those responsible for drafting misleading, incomplete proxy statement disclosures of perks at Tyson Foods. Readers should not dismiss this as simply applying to an isolated, egregious fact pattern. Our take is that the Staff has reached its boiling point with those of us responsible for compensation disclosures.]
The Plaintiffs’ Lawyers, Institutional
Investors and Regulators
We believe that compensation committees that take the bull by the horns and actually fix their past mistakes (which, in some instances may require rolling back excessive grants and pay packages) will have a powerful good faith defense, pointing out that clear guidance that pulled it all together in one place was lacking until now.
Those compensation committees, on the other hand, that try to rationalize past actions, and simply pay cosmetic homage to the new standards, including those that make changes only going forward (thus ratifying their past actions), run the risk of greater exposure.
A Heads Up — "Internal Controls" and
What our readers should not miss here is the allegation that the company "failed to maintain an adequate system of internal controls…" Whether the Staff is speaking of internal controls in the Sarbanes-Oxley Section 404 sense or in a broader sense, it is clear that the Staff expects companies to have compensation related controls in place.
As covered above, the IRS recently found many companies with 162(m) violations involving potentially significant dollar amounts. Apparently none of those companies had any proper 162(m) compliance controls in place. Our concern is that the SEC (or PCAOB) could well look at these and many other companies to ascertain whether there are any controls in place with respect to not only 162(m), but also other compensation related areas, including the company’s potential payout obligations under SERPs, deferred compensation plans, severance and change in control arrangements, not to mention the real costs of perks.
It should not be overlooked that CEOs and CFOs may face potential personal exposure here for their certifications about internal controls if, and when, all the potential payout obligations are tallied up, the amounts in the aggregate are material and the lack of controls is deemed a material weakness.
In short, companies (and auditors) would be well advised to implement procedures to ferret out and add up all the compensation related payment obligations, including projected payouts under SERPs, severance and change in control scenarios. Note that this is one more reason why compensation committees should insist on being provided with tally sheets.
[Because of this very real concern, we have put together an important panel with John Huber of Latham & Watkins and Michael Kesner of Deloitte & Touche at the October 20 Conference that will address compensation related internal controls exposure and steps companies should be implementing now.]
SEC Speaks on Compensation
The "One Stop" Reference Tool — A Thank
We are gratified that so many companies and law firms are now relying upon the website — and that so many directors have found that they now have a resource. (Anyone who has not yet taken advantage of it should go to CompensationStandards.com and enter a no-risk trial.)
[Website vs. Conference — Confusion. As our readers may recall, CompensationStandards.com was launched initially as the repository for the course materials and practice pointers to accompany the October 20 Conference. Because we were receiving so many excellent, timely submissions, we decided to launch the site in advance of the Conference. But, the website has now taken on a life of its own. So, essentially people now are getting two for one. Those signing up for the Conference (in San Francisco, or by live simultaneous webcast) get all the resources on CompensationStandards.com at no additional charge. And those wanting just the website, get the Conference "thrown in."]
The Upcoming October 20 Major
And, we are gratified with the overwhelming response, especially from all the companies and law firms that are having people "attend" the conference via the simultaneous, live video and audio webcast. [Don’t forget, immediately after the conference we will post the audio and video of the entire conference on CompensationStandards.com so those with schedule conflicts will still be able to hear it all. And, we will maintain it on the site until the end of the year so that each session can be accessed to facilitate subsequent reference and usage (which can be useful for boards that want to focus on specific topics at a convenient time, including board or compensation committee meetings).]
Some Confusion over the "Sold Out" Hotel
Unfortunately, the Marriott
Reservations center sometimes incorrectly advises people that the Marriott is
fully booked for the other days of that week during which the NASPP Annual
Conference is taking place. In fact, there still are rooms available at the
Marriott from October 20 and thereafter. (Those who have not yet registered for
the NASPP Conference are encouraged to register now as it is expected to sell
out — particularly with all the changes upon us impacting every company’s equity
compensation plans.) Don’t forget to mention to the hotel the NASPP Annual
Conference to get our special rate for the remaining blocked rooms. If you have
trouble securing reservations, please contact the Marriott directly in San
Francisco at 415-896-1600 or contact us at
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