Journal
Reports: Law and Policy
Transparency and Accountability: The
Changing Role of the Compensation Committee
By Yale D. Tauber ,
Independent Compensation Committee Adviser, LLC
New Canaan, Connecticut
By Carol S. Silverman ,
Mercer Human Resource Consulting
New York, New York
APRIL
2003
Recent corporate and accounting scandals—where the fortunes of
executives have survived intact while shareholders and rank and file employees
have been left holding the bag—have highlighted abuses in executive
compensation. Sensing an opportunity to raise the bar for executive
compensation governance, Congress, the stock exchanges, and the
Securities and Exchange Commission have enacted or proposed the most
far-reaching legislative and regulatory changes to the law affecting publicly
traded companies since the 1930s. In
addition, the Financial Accounting Standards Board (FASB) and various investor
and public interest institutions have all been quick to respond with
recommendations and ratings that are also aimed at curbing these perceived
abuses. These developments are intended
to reconstitute the composition of boards of directors and compensation
committees, reform the way they conduct themselves, and provide for greater
transparency and accountability for their actions (or inactions). Recent developments include:
• enactment by Congress of the Sarbanes-Oxley Act,1 adding to federal law numerous
provisions expanding the responsibilities and liabilities of directors;
• proposed stock listing requirements that would, among other
things, profoundly alter board of director membership and responsibilities, the
composition and role of the compensation committee, and relevant corporate
governance guidelines;
• SEC disclosure rules requiring increased disclosure of
equity compensation plans that were not approved by shareholders and SEC staff
actions narrowing the kinds of shareholder proposals that can be excluded from
proxy statements;
• increased likelihood that U.S. accounting standards will
require companies to expense the fair value of stock options in their financial
statements; and
• various institutions' position papers and ratings that
continue to focus attention on corporate boards and governance practices
generally, and the compensation committee in particular.
Thus, compensation committee members will be required to change
the way they conduct themselves in order to discharge their responsibilities to
determine executive compensation policy, set executive pay levels, and approve
performance based pay plans and the use of equity-based compensation against a
backdrop of heightened scrutiny and demand for corporate responsibility. While recent developments have led
compensation committees of publicly held companies to feel both independent and
empowered, they must understand that they are also more accountable than
ever.
Historical Legal Perspective
While it is nearly universal practice for publicly traded
companies to establish a compensation committee, the specific parameters of the
committee's authority may vary from company to company. These parameters may be proscribed in
several places; the law of the state of incorporation, the corporate charter
and bylaws, board manuals, standing board resolutions, committee charters, and
the corporation's compensation plan documents. However, some areas of
responsibility are almost universally assigned to compensation committees:
• overseeing the company's compensation policy, programs, and
practices for executive officers and directors,
• reviewing the performance of and setting compensation
levels for executive officers,
• overseeing and evaluating the company's management
development and succession planning,
• establishing annual incentive programs for executive
officers,
• administering the company's equity-based and other
long-term incentive compensation programs, and
• advising the full board of significant issues and actions.
At one time, it was relatively common for compensation committees
to make recommendations to the full board, which retained authority to make
final determinations regarding the compensation of the CEO. That practice raises issues under more
recent legal developments (explained below).2
Accordingly, it is common today for the compensation committee to be given
final authority for determining the compensation of all executive officers of
the company, including the CEO.
Regardless of the specific source and parameters of its
authority, the compensation committee is a committee of the board of directors;
committee members are accountable as directors for their decisions and other
actions. Directors are required to act
carefully in monitoring and directing the activities of corporate management.
[T]he principal responsibility of a corporate director is to
. . . [bring] experience and judgment into the boardroom . . . which means to
become informed, to participate, to ask questions and to apply considered
business judgment to matters considered by the board.3
Directors can be protected from liability by the “business
judgment rule.” To obtain this protection, however, they must act in good
faith, without any self-interest in their decision and with a reasonable basis
for believing that their actions are in the lawful and legitimate furtherance
of the corporation's and shareholders' best interests, and must exercise an
honest business judgment after due consideration of what they reasonably
believe to be the relevant facts.
Simply put, this means that directors must make an independent and
informed decision in order to receive the protection of the business judgment
rule.
Compensation Committee Independence
Compensation committees are not strangers to the concept of
independence. Regulatory and
legislative requirements, such as SEC Rule 16b-34
and, later, Internal Revenue Code § 162(m),5
have long compelled publicly traded companies to let independent directors make
most decisions regarding the payment of compensation to executive officers. In
1996, the SEC amended Rule 16b-3 to impose additional independence requirements
on directors who may qualify to administer equity plans for officers and
directors.6
In addition, SEC proxy disclosure requirements required publicly
traded companies to list the name of each individual who served as a member of
the compensation committee during the prior year and to report, under the
separate heading, “Compensation Committee Interlocks and Insider
Participation,” whether any of the committee members are or were officers of
the company and whether any company officers sit on the board of any company of
which any committee member is an executive officer and to describe any
transaction or business relationship between the committee member and the
company that would require separate disclosure.7
As a result of this proxy disclosure requirement, and the intended inference
that compensation committee interlocks taint the judgment of any committee
member in such a position, most publicly traded companies avoid such
interlocks.
Transparency of Compensation Committee Decisions
Compensation committees are also not total strangers to the
concept of transparency to shareholders for the committee's decisions and
actions, regardless of the degree of independence of the committee's
membership. The SEC has long required
substantial disclosures regarding the compensation of the most highly paid
executive officers of publicly traded companies.8
Since 1992, this disclosure has been made primarily in a series
of tables that are uniform for all publicly traded companies and thus
facilitate comparisons between them, regarding the compensation paid or made
available to the company's CEO and four other most highly paid executive
officers.9 In addition, the SEC imposes two proxy
disclosure requirements intended to promote a direct connection between a
company's performance and the compensation paid to its executive officers, in
both cases as compared to other publicly traded companies.
The first is a performance graph. It requires all publicly traded companies to compare their total
shareholder return (stock price performance plus reinvestment of dividends)
with those of both a broad-based market index and a smaller peer group of
competitors, companies in the same industry or companies of comparable size and
market capitalization over a five year period.10
The second additional proxy disclosure requirement is a report
issued over the individual names of the members of the compensation
committee. The compensation committee
report must describe in some detail the company's compensation philosophy
generally and the rationale for specific decisions regarding the CEO's
compensation, in both cases specifically identifying whether such compensation
was contingent on company performance or a result of the exercise of subjective
discretion and, if the former, the applicable performance criteria.11 The need to issue this report marked
the first time that compensation committees were required to explain their
rationale for providing specific amounts of compensation to specific executive
officers.
Newly Legislated Federal
Corporate Accountability
Until the enactment of the Sarbanes-Oxley Act of 2002, the
accountability of directors for their decisions and other actions in the
absence of a securities fraud or other federal securities law violation was
strictly a matter of the law of the state of a company's incorporation. That
act changed that by adding to federal law numerous provisions expanding the
responsibilities and liabilities of directors.
While most of these provisions affect the audit committees of
publicly traded companies and their financial reports and disclosures, like the
one requiring the audit committee to include at least one “financial expert,”12 such provisions foreshadow the type of regulation
that can be expected to apply to compensation committees if perceived abuses in
executive compensation are not curbed.
In addition, the act contains a number of provisions that target executive
compensation abuses directly.13
New Stock Listing Requirements
The New York Stock Exchange (NYSE), the Nasdaq Stock Market
(Nasdaq) and the American Stock Exchange (AMEX) have each proposed new listing requirements
that will become effective upon SEC approval.14 If
approved, these new requirements would profoundly alter board of director
membership and responsibilities, the composition and role of the compensation
committee and relevant corporate governance guidelines.15
Director Independence
All of the proposed new stock listing requirements respond to
concerns about compensation committee and other board level conflicts of interest
by tightening the definition of an “independent director” (thus adding to the
proliferation of independence definitions already in effect)16 and requiring listed companies to have a majority
of independent directors on their boards.
The NYSE proposal goes the furthest by requiring listed companies to
have a compensation committee (as well as audit and nominating/corporate
governance committees) comprised entirely of independent directors. Both Nasdaq and AMEX would permit executive
officers' compensation to be approved by either an
independent compensation committee or a majority of independent directors.17
Role of the Compensation Committee
On the topic of the role of the compensation committee, the NYSE
proposal is the most explicit. It
discusses this role in terms of what must be included in the committee's
charter.18 Compensation committees of listed
companies must have a written charter covering:
• The committee's purpose—at a
minimum to discharge the board of directors' responsibilities relating to the
compensation of executive officers and to produce an annual report on executive
compensation to be included in the proxy statement.
• The committee's duties and
responsibilities—at a minimum to review and approve performance goals
and objectives relevant to the CEO's pay, evaluate CEO performance against
goals, set CEO pay (including, in regard to the determination of the long-term
incentive or equity-based component of the CEO's pay, giving consideration to
the company's performance and relative shareholder return, the value of similar
incentive awards to CEOs at comparable companies and the awards given to the
company's CEO in past years), and recommend incentive compensation plans and
equity-based plans to the full Board.
• Annual self-evaluation of the
committee's performance against the charter.
The NYSE proposal also recommends as “best practice,” but does
not require, that the compensation committee charter address member
qualifications, appointment and removal, committee operations, including
authority to delegate, and committee reporting to the full board. It also suggests that the charter should
give the compensation committee sole authority to hire and fire any consultants
who assist in the evaluation of director, CEO or senior executive compensation,
including sole authority to approve the consultants' fees and other retention
terms.
The charter will need to be posted on the company's Web site, and
the company's annual report will be required to state that the charter is
available there.
Neither the Nasdaq or AMEX proposals explicitly address the
compensation committee charter.
However, the AMEX proposal reportedly provides that the CEO, who is
responsible for making recommendations to the full board (for its approval)
with respect to the compensation of other executives, must consult with the
compensation committee (or a majority of independent directors) in formulating
such recommendations.
Corporate Governance Guidelines
The NYSE proposal would require listed companies to adopt, adhere
to, and disclose corporate governance guidelines specifying the following:
• director qualification standards,
• director responsibilities,
• director access to management and independent advisers,
• director compensation,19
• director orientation and continuing education,
• management succession, and
• annual self-evaluation of the Board.
In addition, nonmanagement directors would be required to:
• meet in regularly scheduled executive sessions without
management to promote open discussion, and
• designate and disclose in the annual proxy statement a
“lead” director who will preside over such meetings.
NYSE-listed companies would also have to adopt, adhere to and
disclose a code of business conduct and ethics and promptly disclose to
shareholders any waivers of the code for directors or executives, which waivers
may only be made by the board or a board committee. The CEO would have to certify annually to the NYSE that he or she
is not aware of any violation of the corporate governance listing standards. In addition, listed companies would be required
to post their corporate governance guidelines and codes of business conduct and
ethics on their Web sites and state in their annual reports that this
information is available on their Web sites.
Although the proposed Nasdaq rules are not as detailed as the
NYSE proposal, Nasdaq would require that the independent directors meet
regularly in executive session and that the company have a code of conduct that
complies with §406 of the Sarbanes-Oxley Act and the SEC's related rules.
The proposed AMEX rules reportedly would require that boards of
listed companies meet at least quarterly and that independent directors meet as
often as necessary to fulfill their responsibilities, including at least one
meeting per year in executive session without the presence of nonindependent
directors and management.
SEC Transparency Requirements
The SEC has also been doing its part to expand the concept of
transparency to shareholders for the compensation committee's decisions and
actions.
Disclosure Rules
The SEC has already implemented new disclosure rules affecting
equity compensation plans. These rules
apply to all plans, regardless of whether they have been previously submitted
for shareholder approval and regardless of whether the plan participants
include officers and directors.
The new disclosure is required to be made in publicly traded
companies' proxy statements whenever the company is seeking shareholder action
on a compensation plan. In any year in
which a publicly traded company is not seeking
shareholder action on a compensation plan, the information has to be included
in the company's annual report on Form 10-K, although the SEC will permit
companies to include the table in the proxy statement instead.
The new disclosure is primarily tabular. The table must set forth the following
information separately for shareholder-approved and nonapproved stock and other
equity compensation plans:
• the number of securities to be issued upon exercise of
outstanding options, warrants, and rights;
• the weighted-average exercise price of outstanding options,
warrants, and rights; and
• the number of securities remaining available for future
issuance under equity compensation plans.
Cash incentive plans would need to be included in the table if
they could be settled in stock.
In addition, publicly traded companies must provide a brief
narrative description of the material features of nonapproved plans—or
cross-reference to the description of these plans in financial statements. Any
plan or arrangement adopted without shareholder approval must be filed with the
SEC if it is material in amount or significance.
Recent SEC Staff Actions Regarding Shareholder Proposals
Three SEC staff actions regarding shareholder proposals that
publicly traded companies can omit from their proxies under the “ordinary
business operations” exclusion—a legal bulletin on equity compensation plan
proposals that must be included and two separate refusals to grant no-action
relief for omission of a proposal requesting stock option expensing—are paving
the way for increased shareholder activism regarding shareholder proposals.
Equity Compensation
Plans
In July 2002, the SEC staff issued a legal bulletin narrowing the
kinds of shareholder proposals regarding equity compensation plans that
publicly traded companies may exclude from their proxies, thus increasing the
likelihood that shareholders will be able to vote on such plans.20 According to the SEC staff's new position,
proposals must be included in the proxy if they focus on equity compensation
plans that
• compensate only senior executive officers and directors, or
• are potentially “materially dilutive,”21 regardless whether the plans compensate senior
executive officers, directors and the general workforce, or only the general
workforce.
This new SEC staff position will become largely irrelevant for
most companies when the NYSE and Nasdaq proposals requiring shareholder
approval of almost all equity compensation plans become effective.22
Expensing Stock Options
The SEC staff also refused on two separate occasions to provide
an opinion to a company seeking to omit from its proxy a shareholder proposal
requesting that the company expense executives' stock option grants.23 In the first no-action letter, the SEC staff
indicated that it was reconsidering its long-held policy of allowing companies
to omit stock option expensing proposals under the “ordinary business
operations” exclusion. In the second,
the SEC staff made it clear that it had reversed its policy. Hundreds of
companies have received shareholder proposals on stock option expensing and
included them in their proxy, since omitting them—absent the comfort of a
no-action letter—runs the risk of SEC enforcement action. Also, shareholder activists
are likely to use the debate over executive compensation and corporate
governance to push the SEC Staff to make additional “social policy” inroads
into the ordinary business operations exclusion.24
Greater Transparency for Stock
Option Compensation Costs
Another significant force affecting the transparency of
equity-based compensation is on the accounting front. Since July 2002, in a
marked divergence from past practice,25 approximately
200 companies have announced that they will voluntarily adopt Statement of
Financial Accounting Standards No. 123 (FAS 123) “fair value” expense
recognition rules for stock options.26 In
addition, Standard and Poor's has begun calculating “core earnings” for the
thousands of public companies it evaluates. Core earnings represents income
from a company's “core operations” and includes such adjustments to reported
earnings as the FAS 123 fair value cost of stock options, as disclosed in the
financial statement footnotes.
In November 2002, the International Accounting Standards Board
(IASB) released an Exposure Draft proposing that companies be required to
expense the fair value of stock-based compensation. IASB is scheduled to complete all substantive decisions by March
2004 and to make its new international accounting standard effective Jan. 1,
2005. Companies that file financial statements in the United States will not
have to comply with the IASB standards. However, in the spirit of international
convergence of accounting standards, FASB, the U.S. accounting standard-setter,
agreed on March 12, 2003, to begin a formal reconsideration of the issue of
mandatory fair value expensing of stock-based compensation and to cooperate
with IASB to achieve maximum convergence. It is very likely that FASB will
require recognition of fair value expense for stock-based compensation in some
fashion in companies' financial statements.27
According to its Web site, FASB will attempt to reach final decisions later in
2003, with an effective date possibly as early as 2004, although it could be
later.
These recent and expected future accounting developments broaden
(and complicate) the practical choices available to compensation committees and
make it incumbent upon them to reevaluate their policies regarding stock-based
compensation programs and determine what long-term actions are appropriate.
Among those companies that have announced voluntary adoption of FAS 123 fair
value recognition practices, few are planning to make major changes immediately
in their compensation programs. However, many are making discrete changes. Some
of the changes these companies have announced for the coming year include:
• reducing the number of options awarded,28
• shifting the pay mix more toward restricted stock29 or existing performance plans,30
• shifting the pay mix from equity to annual cash compensation,
and
• making design changes to stock compensation plans to reduce
the FAS 123 costs or dilutive impact of such plans.31
Institutions' Heightened
Awareness
With shareholder activism on the rise, more institutional
shareholders are using the power of activism to influence policies at companies
where they have significant holdings. Institutional shareholders are turning to
their most powerful form of activism and voting “no” on key items. Shareholder proposals, regardless of whether
they receive enough votes to pass or are binding, draw public attention to
companies' practices and force many to reconsider their policies.
Institutional investors, shareholder activist, and public
interest groups are providing closer scrutiny of, among other things, stock
plan dilution and executive compensation practices. Mutual fund firms, which
now represent 18.7 percent of the U.S. equity market32
but have traditionally not been vocal on behalf of shareholder rights, may be
getting more involved. Companies now include meetings with their institutional
shareholders during the planning stages of a proposal rather than in the
implementation stage. And some companies are submitting all equity compensation
plans for shareholder approval.
In addition to asserting tighter control over stock usage through
the right to vote on all equity plans, institutional shareholders, along with
other groups, will be examining whether compensation committees are performing
their fiduciary duties as protectors of shareholder interests and will monitor
the relationships between management and the companies' compensation
consultants. Various institutions' position papers and ratings will continue to
focus attention on director and officer compensation and stock ownership
levels, and will increase scrutiny of the cost impact of stock option plans and
option repricing on shareholder value.
The Conference Board's Commission on Public Trust and Private
Enterprise
The focus on the role of the compensation committee was sharpened
by The Conference Board's Commission on Public Trust and Private Enterprise, a
“blue ribbon” panel formed to address widespread abuses which led to the recent
corporate scandals and declining public trust in corporations and their
leaders. In September 2002, the
Commission issued findings and recommendations on the role of compensation
committees in dealing with executive compensation as the first in a series of
best-practices guidelines to be issued.
The report begins with an analysis of the causes of past abuses
and a statement of the rationale for its subsequent recommendations.
The Commission shares the public's anger at the misconduct
leading to a breakdown of public trust which grew out of the scandals... .
These egregious failures evidence a clear breach of the basic compact that
underlies corporate capitalism which is that investors entrust their assets to
management while boards of directors oversee management so that the potential
for conflict of interest between owners and managers is policed. Furthermore, various professional advisors
of companies, such as public auditors, compensation consultants, and, in some
cases, law firms failed to provide truly independent advice and professional
judgment as they came to view management as the `client' instead of the
corporation.
. . . .
The balance in the relationship between the board,
management and compensation consultants has, in too many cases, been skewed to
produce an overly close relationship between consultants and management[.]
. . . .
At all too many companies, the Compensation Committee of the
Board has not played as central and vigorous a role as necessary to assure the
public that executive compensation policy is determined independently from
management or from compensation consultants hired by management.
. . . .
A strong, independent Compensation Committee should take
primary responsibility for ensuring that the compensation programs, and values
transferred to management through cash pay, stock and stock-based awards, are
fair and appropriate to attract, retain and motivate management, and are
reasonable in view of company economics, and of the relevant practices of
other, similar companies. The Committee
should be held accountable for the decisions they make. The Compensation Committee should also
recognize the potential conflict of interest in management's recommending its
own compensation levels.33
The report also recommends best practice guidelines regarding the
role of the compensation committee, the use of performance-based compensation
and equity-based incentives, the importance of management stock-ownership,
shareholders rights and the transparency and disclosure of executive
compensation arrangements. Recommended
guidelines include:
• The compensation committee should be comprised solely of
independent directors (i.e., free of any relationships with the company and its
management and who can act independently of management in carrying out their
responsibilities).
• The committee should “vigorously exercise continuous
oversight” over all executive compensation policy matters, should be
responsible for all aspects of executive officers' compensation, including
approval of all contracts, and the chairman should “take ownership” of
committee activities, including being present at shareholder meetings so as to
be able to respond to questions about executive compensation.
• The committee should exercise independent judgment in
determining what levels and types of compensation should be paid,
“unconstrained by industry median statistics or by the company's own past
compensation practices and levels” and should consider the differences in
compensation levels throughout the company in setting senior compensation
levels.
• The committee should retain any outside consultants who
advise it, and the consultants should report solely to the committee.
• The committee should hold executive sessions as appropriate
(e.g., to determine CEO pay and stock option grants) and should schedule its
own meetings and set its own agenda.
• The committee should establish, with the concurrence of the
full board, performance-based incentives that support and reinforce the
company's long-term strategic goals (e.g., cost of capital, return on equity,
economic value added, market share, quality, regulatory compliance, environment
preservation, revenue and profit growth, cost containment, cash management) set
by the board by linking awards to the achievement of specific goals and must
make sure that compensation arrangements do not create an incentive for
behavior that is contrary to the company's best interests and are not designed
to circumvent accounting or legal rules or principles.
• The committee, in establishing compensation policy and
arrangements consistent with its duty to preserve long-term value for the
company, should appropriately consider and balance the relationship between the
perceived value of equity compensation and the effective costs of that
compensation passed on to shareholders through dilution or any direct costs of
acquiring shares in the open market, which costs the committee must disclose in
conspicuous ways.
• The committee should require senior management and
directors to “acquire and hold” a significant amount of company stock on a
long-term basis and, specifically, should impose minimum holding periods for
equity received as compensation that are comparable to holding periods for
other employees under 401(k) or similar retirement plans.
• The committee (with the assistance of experts if required)
should develop and publish appropriate methods by which executive officers
would be required to give advance public notice of their intention to dispose,
directly or indirectly (e.g., by hedging or other similar arrangement), of the
company's equity securities.
• Shareholder approval should be obtained for all
equity-based compensation programs or amendments to such programs, including
the repricing of stock options.
• The company's public disclosures should include a
conspicuous statement highlighting both earnings per share after dilution and
the proportion of future shareholder value that equity-based compensation plans
would provide to employees (including a plain language illustration of the
percentage of total equity represented by unexercised stock options) and a
plain English summary of the significant terms of all employment agreements
with executive officers.34
The report also states that the Commission believes that
compensation decisions should be based on the appropriateness and effectiveness
of the compensation structure, rather than simply accounting implications.
In January 2003, the Commission issued findings and
recommendations on corporate governance and auditing and accounting. Its specific best practice recommendations
for corporate governance include:
• Each company should give careful consideration to having
the roles of CEO and chairman of the board performed by separate individuals,
with the latter being an independent director under stock exchange standards
or, failing that (e.g., where the founder or a major stockholder is chairman),
at least not being a member of the management team and not reporting to the CEO
(in which case a lead independent director, with carefully delineated
responsibilities,35 should also be named).
• Boards that do not chose to separate the CEO and chairman
positions, or that are in transition to doing so, should designate a presiding
director with carefully delineated responsibilities.36
• Boards that choose not to take any of these approaches
should explain their reasons as well as the board structure they employ to
achieve the objective of strong, independent board leadership.
• All directors should have the ability to place items on the
board agenda, be assured that adequate time is allotted for discussion of those
items, and request the information they believe necessary to make sound,
informed business decisions on a timely basis.
• A substantial majority of the board should be composed of
independent directors.37
• Independent directors should not only be independent in
accordance with legislative and stock exchange listing requirements, but should
also act independently of management and should develop norms that favor open
discussion and encourage the presentation of different views.
ISS
Institutional Shareholder Services (ISS), a leading provider of
proxy voting and corporate governance services, with 750 institutional clients,
has begun including in its proxy analysis reports38
a new rating, called the “Corporate Governance Quotient” (CGQ), which is
designed to help institutional investors evaluate the quality of corporate
boards and governance practices. According to ISS, several studies show a link
between good corporate governance and company stock performance and many
investors now take corporate governance into account in making investment
decisions and voting proxies.
The CGQ rating was recently revised to cover eight topical areas:
executive and director compensation, board independence, director education,
charter/bylaws, state of incorporation, ownership, audit, and qualitative
factors.39 CGQ ratings are enhanced when certain
combinations of ratings factors are found to be present. For example, the
combined ratings factor for a company with a board composed of a majority of
independent directors and with all-independent key board committees (audit,
nominating/corporate governance, and compensation) will be higher than the sum
of each of the individual ratings factors that the company would have had if it
had either the independent board majority or the all-independent key board
committees, but not the other.
A table in ISS's proxy analysis reports highlights the primary
factors that drive the company's CGQ rating,40
both positive (e.g., an independent board majority, directors who are elected
annually, a board that is neither too large or too small, an all-independent
compensation committee, a mandatory retirement age for directors or term
limits, stock-based pay for officers and directors and stock ownership
guidelines) and negative (e.g., stock option plans that were not
shareholder-approved, a combined chairman and CEO position, no committee that
oversees governance issues and directors who are overcommitted by serving on
too many boards). In light of recent
concerns, ISS is contemplating adding to the list of factors, including stock
option expensing, board diversity, senior officer certification of financial
reports, and compensation issues, such as option reloads.
The Corporate Library
The Corporate Library, a corporate governance research
organization, is developing its own corporate governance rating system using
three criteria: CEO employment contracts and compensation practices, outside
director shareholdings, and board structure and make-up. It will rate over
1,800 U.S. and international firms. As part of this rating, it will provide a
review of the company's short- and long-term compensation practices for its
CEO, performance measures, and termination and change-in-control provisions and
compare them all to industry peers.
The Business Roundtable
The Business Roundtable (BRT), a group of about 150 CEOs from
major U.S. companies, recently issued corporate governance best practice
guidelines and strongly encouraged all U.S publicly traded companies to adopt
these guidelines. Some of these recommendations have already been mandated for
companies by the Sarbanes-Oxley Act, others appear in the NYSE and Nasdaq
proposals and still others echo recommendations of The Conference Board's
Commission on Public Trust and Private Enterprise. The BRT guidelines include
recommendations to:
• require shareholder approval of stock options and
restricted stock plans in which directors and officers participate;
• create and publish the company's corporate governance
principles;
• require board committees that oversee the board's audit,
corporate governance, and compensation functions to be made up exclusively of
independent directors;
• ensure that independent directors are a substantial
majority of the board;
• ensure prompt disclosure to investors, employees, and the
public of significant business and financial developments; and
• establish a management compensation structure that links
the interests of management and shareholders.
Some Early Reactions
To gauge the early reaction that these developments are having,
Mercer Human Resource Consulting reviewed the proxy statements of 50 companies,
whose fiscal years ended between May and September of 2002.
Of the 50 companies in Mercer's sample, six (12 percent)
disclosed their corporate governance principles, standards or guidelines. Of
these, one company said that they had “amended them in August 2002 to conform
them to the proposed new director independence rules of the New York Stock
Exchange.” Another disclosed “categorical standards of director independence.”
Another company (not part of the six) disclosed having conducted evaluations of
board performance. Ten companies (20 percent) published the text of their audit
committee charter, but none published a compensation committee charter. More recently, many companies have published
the text of all committee charters and corporate governance guidelines in their
proxy statements or on their Web sites.
While this is a small sample and several corporations in it took
a wait-and-see approach, a very high percentage of calendar year filers, which
had more time to consider revisions, made changes to corporate governance
principles, standards, or guidelines and committee charters. In any event, the
impact of corporate governance on the time and effort required by independent
directors is evident.
Implications for the
Committee's Role
Clearly, the bar has been raised for executive
compensation governance by the
tidal wave of laws, regulations, and rules pouring forth from Congress, the
SEC, the major stock exchanges, FASB, and various investor and public interest
institutions. Infrequent and largely
ceremonial meetings at which committee members are the audience for massive
doses of well-rehearsed presentations by management and a consultant hired by
management before being asked to rubber stamp management's proposals will not
suffice to fulfill the compensation committee's vigilant oversight role.
Increased awareness of the importance of good executive
compensation governance holds huge potential for major improvements; however,
it is also a potential pitfall. Feeling
the pressure of public scrutiny and fearing heightened legal exposure,
compensation committee members may feel compelled to provide more than just
vigilant oversight; they may try to micromanage and meddle. They may bow too
easily to growing pressure to limit senior executive compensation. To avoid this pitfall, every company should
have a strategy for the constructive engagement of its compensation committee
that is neither too passive nor too intrusive.
The CEO, as the highest-ranking member of the management team, is
accountable for the company's management and performance. It is the province of
the compensation committee to set the CEO's pay after considering the company's
performance against goals and objectives set by the board. However, it is the CEO and the senior
management team, and not the compensation committee, who are supposed to design
the company's compensation programs.
The compensation committee's job is to provide vigilant
oversight. Their chief responsibility
is to ask probing questions of management and the company's consultants and
take action when needed.
There must be an appropriate balance between the powers of the
compensation committee and those of the CEO. The ability of committee members
to discuss, debate and act objectively and on an informed basis on issues they
deem important should not be compromised. But, neither should the “hands-on”
involvement of the CEO and the senior management team with the company's
compensation programs. Teamwork and
collaboration will lead to the development and implementation of collaborative
executive compensation strategy and review processes, policies, and practices
that engage compensation committee members and help them to discharge their
fiduciary duties to shareholders while maintaining management's appropriate
involvement. This will require leadership from the committee chair, who must
promote and facilitate constructive interaction and discussion among committee
members so as to identify red flags, determine and formulate the difficult
questions that should be asked of management and the compensation consultants,
and provide perspective on issues and areas of risk that warrant further review
by the full board.
To perform their role effectively, compensation committee members
must act diligently and independently of management. They must have adequate information to make good decisions, the
ability to put key questions on the agenda, and adequate time to deal with all
agenda items. This means that, at a
minimum, compensation committee members should read all committee materials in
advance of the meetings, attend all meetings, and fully participate by asking
the difficult questions. Before they
approve a proposal, compensation committee members must understand it fully
and, most importantly, the proposal must pass their moral or ethical
review. They must appreciate why the
proposal is in the corporation's and shareholders' best interests.
Just as audit committees, and especially the committee chairs,
are now required to have a degree of expertise and to be more proactive in
their processes, so should compensation committees and their chairs. Compensation committee members are expected
to be knowledgeable about compensation risks and issues and extremely thorough
in reviewing questionable areas.
Even such relatively routine questions as setting compensation
levels involves the resolution of multiple issues. In the first place, analyses will often vary radically based upon
the groups of companies selected for comparison and whether extreme cases are
included or excluded. Beyond that, it
is important to note that competitive market data, while useful information, is
not by itself sufficient for evaluating appropriate compensation. The magnitude of the compensation for any individual
executive should reflect the particular circumstances of the person in the job
and the purposes to be served by the compensation payments. Within any sample of competitive
information, actual compensation levels are typically disbursed above, at or
below percentile points within a range that reflects competitive company
evaluations of relevant factors with respect to their own incumbent executives.
For example, the compensation committee should determine the
value to the company of various levels of performance and set an equitable
formula for sharing that value given the relative degrees of risk assumed by
management and investors. The committee
should take the same balanced, sharing formula approach with equity awards,
like stock options or whole share awards such as restricted stock. The
committee should determine how much of the company's invested capital investors
should be willing to share with management by transferring an equity stake to
them and what performance contingencies investors should want to place on such
transfers. Thus, even after the data
analysis has been completed, the committee must examine all the relevant
factors and exercise its subjective, independent and informed judgment as to
where within the market the individual executive's compensation should be.
Only a strong, diligent, and independent compensation committee
that understands the key issues, asks management tough questions, and provides
wise counsel can ensure that shareholders' interests are being properly served. However, many compensation committee chairs
and members do not have the knowledge and information necessary to fulfill
their vigilant oversight role.
When Should the Committee
Obtain Independent Advice?
Some of the most critical issues for the compensation committee
concern when the committee should have its own independent compensation adviser
and the degree of involvement that adviser should have.
The CEO and the senior management team typically obtain expert
advice from compensation consulting firms of one type or another to assist them
in designing and implementing executive compensation programs that support the
strategic goals set by the board and reward key team members for achieving
those goals. The committee should
always have direct contact with any consultants that the company is using in
order to ask probing questions and address issues and concerns about the
consultants' data and recommendations or obtain their reaction to alternative
approaches. Committee members should at all times feel free to request and
obtain additional information regarding a management proposal.
Where the compensation
committee does not feel comfortable that such contact will provide sufficient
basis for it to render its independent and informed judgment, it should obtain
the additional expertise and assistance (and protection) that its own
independent compensation adviser can provide.
Care must be taken, however, not to incite a duel between two
consultants, either as to data or matters of judgment (which really is the sole
province of the compensation committee).
The committee must control the process, but as indicated above, the CEO
and the senior management team must retain “hands-on” involvement with the
executive compensation strategy and plans in order for them to have the tools
they need to achieve the Board's strategic goals. Thus, the committee should carefully delineate the role of its
independent adviser so as to supplement, rather than supplant, the company's
consultant.
Some Do's and Don'ts
Compensation committees should reevaluate their total rewards and
remuneration program for senior executives periodically, not just in light of
the new corporate climate but in light of changing economic conditions,
business performance and strategy, and organizational design. Compensation committees should also review
their processes, policies, and practices to make sure they are doing all they
should to identify key executive compensation issues and risks, to ensure
adequate controls are in place, and to maintain vigilant oversight on
management.
With that in mind, here is a list of “do's” and “don'ts” for
compensation committees and their members.
DO: Adopt a
Compensation Committee Charter. In order to ensure that the committee
charter is consistent with the company's charter and by-laws and state and
federal law,41 the committee should work closely
with the CEO and the senior management team as well as the company's
attorneys.
DO: Formalize an
executive compensation philosophy and strategy. Once again, this should be an interactive process between
senior management and the committee.
The executive compensation philosophy and strategy should encompass:
• an assessment of the company's short- and long-term
business objectives;
• an assessment of the environment for attraction, retention,
and motivation of key executives;
• guiding principles in areas of—
• organization values and expectations of performance
• focus of performance measurement and alignment with
financial/business performance
• relationship
between compensation programs and strategic business objectives
• balance between
internal pay equity and external practices;
• the basis for
salary and annual incentive, stock option, and long-term incentive award
levels—
• targeted pay
positioning versus the competitive market
• targeted pay mix
(base salary versus incentives, cash vs. equity); and
• the role of
benefits, perquisites, severance, and change-in-control agreements.
Once the executive compensation philosophy and strategy has been
formalized, the committee should use it to test the logic of management's
proposals against a predetermined ”template” for a pay-for-performance
approach. The issue is not just how much, but, more important, how a company
pays its senior executive talent. A company that just tries to match or exceed
what other companies pay can miss some important opportunities to use executive
compensation as a management tool that influences business decisions and
outcomes in accordance with its strategic plan while equitably allocating
between investors and management the value created by successful implementation
of that plan.
DO: Design and
implement pro-active premeeting and meeting procedures. Determine the kinds and frequency of reports
and other information the committee needs, including financial results and
relevant external market compensation and performance trends, and assure the
timely distribution and informed review of all materials in advance of
meetings. Draft compensation reports
should be circulated to committee members in sufficient time for them to study
matters in detail, ask questions, and request additional information or
analyses. This will allow management to craft changes to accommodate committee
concerns before positions get ”frozen” at a formal meeting where proposals have
been made.
DO: Meet at least
four times a year, maybe monthly. Compensation committees have in the
past often scheduled their meetings to coincide with regularly scheduled board
meetings. However, this may not allow adequate time for the discussion and
deliberation necessary to fulfill the legal, regulatory, and stock exchange
requirements imposed upon the compensation committee. Moreover, the timing of certain reporting or administrative
requirements may dictate another schedule.
The committee should develop a schedule of issues to be addressed over
the course of the year and maintain ultimate approval over its meeting agendas
and schedules to ensure that committee members have sufficient time for
discussion of all agenda items.
DO: Develop the
knowledge and expertise to provide effective oversight. The committee should consist of truly
independent directors and should either include or hire people with the
expertise to delve into the details and understand the alternative courses of
action and consequences for the company.
Be sure the consultants know they work for the company, not management,
and seek out independent advisers, if necessary.
DO: Exercise
objectivity and autonomy. Study the relevant documents in advance of the
meetings, including consultant's reports, the company's own financial reports,
and internal and external analyses of the company's performance. Speak up, before the meeting if possible.
It's not enough just to show up at meetings, listen to presentations, and
approve proposals. Each compensation
committee member should feel free to state his or her opinion at an open
discussion at the meeting so that the committee can make independent, informed
decisions after discussion of all points of view. (If this is not the case,
committee members should consider resigning.) Ask the difficult questions. Probe for disagreements between management
and the consultants. Finally, vote as
your judgment and conscience dictates.
Look out for shareholders first, not company management.
DO: Report to the
Board. After each compensation committee meeting, the committee chair
should communicate the committee's actions to the full board and seek further
review where necessary.
DON'T: Be
uncomfortable or reticent. Avoid
serving on a compensation committee if you have personal or financial ties to
management, can't understand the applicable disclosure, regulatory, accounting
and tax rules, even with the assistance of an independent adviser, or are timid
and uncomfortable confronting others.
DON'T: Ignore
outsiders' criticisms. When your
company's compensation programs are reviewed in media or by investor or public
interest institutions, pay attention.
And, never approve anything that you would not want to read about in the
newspapers.
DON'T: Rubber stamp. Never rely solely on company executives or
consultants hired by them for information needed to oversee management. Get second opinions, especially when the
consultants propose programs that they concede are risky.
Conclusion
Today, companies are judged by the independence of their board
and key board committees as much as their bottom line. Compensation committees in particular are
expanding their scope, altering their composition, and amending their
procedures to comply with new governance standards and better serve
shareholders' interests. Committees are
formalizing their relationships with firms who give the committee and
management advice on executive compensation and related matters. To reassure shareholders, compensation
committees are communicating their corporate governance efforts through their
companies' proxy statements and other publicly available resources. Every
compensation committee should make sure it is doing all it should to identify
key executive compensation issues and risks, to ensure adequate controls are in
place, and to maintain vigilant oversight on management.
Reproduced with permission from Benefits Practice Center, "Transparency and
Accountability: The Changing Role of the Compensation Committee"
http://benefits.bna.com/. Copyright 2003 by The Bureau of National Affairs, Inc.
(800-372-1033)
