I have avoided the subject of executive compensation since writing two articles in this space in 2006, primarily because so much has been written about it elsewhere.
But it is hard to avoid a six-ton gorilla, while looking for another, merely 900-pound gorilla about which to write. Indeed, just as I sat down to select a topic for this issue of In-House, I came across an entire section dedicated to CEO compensation in the April 14 edition of the Wall Street Journal.
The subject of compensation, further, is not wholly congruent with a column entitled “SEC Watch.” While the SEC seems deeply involved in executive compensation, in many ways the Commission is much like a sports reporter: It reports the game, or more accurately causes other parties to report the game, but the SEC is really not a substantive player on the field.
Coupled with the fear that increased disclosure does not have any palpable effect on the substantive issues (reducing compensation, assisting the board to control compensation, reducing disparity between executive and non-executive pay), the subject of compensation appears, from the standpoint of this column’s mandate, almost tangential.
However, the flood of information about the regulatory, political and substantive issues affecting executive compensation creates for in-house counsel a host of quandaries. How should in-house counsel view his or her role in the compensation game?
The playing field
It is necessary to understand the playing field. This is not as simple as it may seem. As a starting point, I suggest familiarity with the following:
Understand the SEC reporting scheme, particularly the CD&A (compensation discussion and analysis) section and the mandatory charts in the proxy statements.
Review compliance with “independence” requirements. Is your compensation committee independent under SEC Regulation SK (which in turn relies on the definitions by the Exchanges)? Do you understand who falls within disclosure requirements for related party transactions? Are your directors independent under Internal Revenue Code §162(m) concerning compensation deductions? Are your directors “non-employees” under SEC Rule 16(b)-3?
Familiarize yourself with the SEC’s Internet executive pay tool (see http://www.sec.gov/xbrl).
Brief your compensation committee on the Fifth Edition of the ABA’s Corporate Director’s Guidebook. Section 7 of the Guidebook exhaustively discusses compensation committee structure and operation, and touches on SOX restrictions on executive compensation such as prohibited personal loans and mandatory reimbursement by executives of certain compensation in case of financial restatements.
Brief your compensation committee on the 2008 ISS updates, which contain new policy positions on “say on pay,” stock option overhang and (many pages of) “poor pay practices.”
As the CD&A is “filed” with the SEC and not merely “furnished,” address disclosure controls, and controls over internal financial reporting, as they relate to salary, bonus and equity compensation grants.
Download proxy statements from the SEC website, both for leading companies and for members of your peer group, and share that data with your compensation committee. Take a look at General Electric, a leading company not reliant on consultants, and at several other large companies, in order to get a feel for the way in which both disclosure and substantive matters are handled.
What proxies tell us
From filings so far this year, you will find that many companies are faced with shareholder motions to give shareholders “say on pay” – an advisory vote on executive compensation (to battle “mushrooming executive compensation which sometimes appears to be insufficiently aligned with the creation of shareholder value,” according to a Home Depot, Inc. shareholder motion).
You will find proposals for aligning executive compensation with long-term as opposed to short-term performance. You will find claw-backs in various configurations.
You will find stock ownership guidelines, to make sure that directors hold equity, and various methods to induce directors to obtain equity through purchase.
You will find intense pressure on “termination benefits” and particular focus on eliminating “single-trigger” benefits on change of control (an executive should receive termination payments only if there is both a change of control and adverse employment action taken against that executive).
You can sample the disclosure difficulties the SEC admonishes us should be in plain English.
Can companies overcome hesitancy in disclosing actual performance targets against which compensation is measured, or will they continue to assert that such disclosure will give unfair information to competitors notwithstanding the SEC’s resistance to that argument?
What sort of progress is being made with respect to non-binding “say on pay” shareholder resolutions? The Wall Street Journal in April reported that Goldman Sachs had beaten back such a proposal, although the resolution was supported by almost 43 percent of the voting shares. Interestingly, the top three Goldman Sachs executives each earned more than $67.5 million in 2007.
How much a CEO is paid compared to other senior managers, or the company’s work force at large, is becoming a hot topic. Some commentators believe the significant compensation realized by Bear Stearns executives, notwithstanding the beating they took on the firm’s sale, may result in litigation or legislation. The top five Bear executives earned $165 million in cash and $380 million in total compensation between 203gement compensation arguably drove the willingness to undertake excessive risk.
The IRS issued a private letter ruling in January disqualifying from the exemption under Internal Revenue Code §162(m) any payments upon termination without cause, or termination for good reason, or due to retirement. The result is to deny a deduction for such payments.
Further, the mere possibility of such future payments will disqualify any payments made under an agreement, which will require revision to many policies and agreements. Section 162(m) exemptions will still apply to severance upon death, disability or change of control. There are grandfathering provisions which must be reviewed carefully.
The April 14 edition of the Wall Street Journal contained detailed company and industry data on the substantial increase in 2007 CEO compensation notwithstanding the new SEC disclosure scheme; the painfully slow roll-back of termination payments (the average CEO severance benefit for the 200 largest public United States companies is over $38,000,000); and, the startling number of CEOs being significantly compensated either in fields where their leadership is likely not the driver of profits (such as oil) or in the financial sector (a story unto itself).
Executive compensation is a minefield for in-house counsel because they work with management, are responsible to the board, and are viewed by the SEC as “gatekeepers.” In-house counsel can be protected and provide good governance to the company by supporting the compensation committee. Make sure it is educated and that it considers using compensation advisors. You should also consider whether the compensation committee in your particular circumstances should have separate counsel.
Most important, but often overlooked: Apply your “smell test” for what is percolating out of your compensation committee.
As a reality check, look at your peer group. Is it the correct peer group? Is your executive cadre roughly compensated based upon percentile of performance within that peer group and, if compensated more highly, why?
The SEC is not calling the whole tune here. A public sense of morality also is at work. Recent government statistics indicate a sharp growth in the disparity in compensation for executives and non-executive workers. Does this mean a political solution is in the offing?
The U.S. House of Representatives approved last year a bill requiring non-binding shareholder votes on compensation. In April, both John McCain and Barack Obama criticized excessive executive compensation. Although McCain “opposes new government steps to curb pay and instead favors private-sector intervention,” he noted a backlash “against corporate greed.”
Although Obama’s rhetoric may have to do with positioning himself with voters, according to prominent news services, his rhetoric suggests receptivity to formal government action.
Maybe all this will be taken out of the hands of the SEC, in-house counsel, and even the boards of directors. We already control certain upper limits of executive compensation through the tax code (Section 162(m), penalty taxes on golden parachutes). Might we be moving toward even more express statutory limitations?
Stephen M. Honig is a member of Duane Morris’ corporate department in the firm’s Boston office. You can reach him at email@example.com.