The Renewed Focus On Compensation Committees: A Push For True Independence

Monday, February 1, 2010 - 01:00

In the wake of the recent market turmoil, there has been much finger pointing as politicians, the media, business leaders, and the general public have tried to determine a root cause for the greatest financial crisis in recent memory. As part of the collective public discussion on the economic events that have transpired over the past two years, there has been much ado about executive compensation practices, which have been perceived by many as a primary contributor to the predicament in which many financial institutions and other troubled companies have found themselves.

While many Americans are coping with reduced wealth as a result of decreased housing prices, spent savings, and losses in retirement portfolios, public company boards of directors and compensation committees are facing increased pressure from investors to ensure that their compensation practices are reasonable and prudent, tie compensation closely to the performance of the company, and encourage disciplined risk taking and sound business decisions. Shareholders have recently become more attuned to compensation issues generally, and the 2006 overhaul by the Securities and Exchange Commission (the "SEC") of the executive compensation disclosure rules under Regulation S-K has helped to bring these issues to the forefront of discussion by making them a substantial component of annual proxy statements and other public disclosure.

Many people have concluded that executive compensation practices have focused too strongly on short-term performance and have rewarded executives for making business decisions that may have imposed excessive undue risks on the company. This conclusion has resulted in even greater shareholder scrutiny of compensation committees and their compensation-setting practices. As has been recognized by members of Congress, government officials, and industry leaders alike, independence from management is an essential characteristic for a compensation committee if it is to be well positioned to deal with this increased pressure and fulfill its duties to its constituents - the shareholders.

As discussed below and as reflected in recent draft legislation in response to the financial crisis - and notwithstanding a director's purported independence for purposes of federal securities laws, listing exchange requirements, and other reasons - a compensation committee must have ready access to the independent advice of competent legal counsel and other compensation advisors in order to equip itself with the tools necessary for considering effectively and making prudent determinations regarding complex compensation issues.

The Regulatory And Legislative Push

In July 2009, the Treasury Department delivered to Congress proposed legislation - the Investor Protection Act of 2009 (the "Treasury Legislation") - which is aimed at making the financial system more fair to consumers and investors. Among the many provisions contained in this proposed legislation are requirements to ensure compensation committee independence. In the Treasury Legislation and in the press releases surrounding its delivery, the Treasury Department suggests that many compensation committees may be independent in name only, while not fully independent of management.

Although the Treasury Legislation has since languished without significant activity on Capitol Hill, the focus on compensation committee independence has not waned. In November 2009, Senator Chris Dodd (D-Conn.) introduced a Senate bill - the Restoring American Financial Stability Act of 2009 (the "Dodd Bill") - that largely incorporates the committee-independence provisions of the Treasury Legislation. If enacted, the Dodd Bill would amend the Securities Exchange Act of 1934 (the "Exchange Act") to require the SEC to direct all national securities exchanges and associations to impose mandates on issuers to satisfy the following standards pertaining to compensation committee independence:

• Members of compensation committees would have to meet exacting new standards of independence, similar to the standards for audit committee members that were established in the wake of corporate scandals such as Enron and WorldCom.

• Compensation consultants and legal counsel engaged by compensation committees would have to be truly independent from management, so as to provide compensation committees with truly objective advice.

• Issuers would be required to give compensation committees the authority and funding to hire independent compensation consultants, independent legal counsel, and other advisors to ensure that the compensation committee has access to the most appropriate resources to assist it in fulfilling its duties in the best interests of shareholders. (Although not contained in the Dodd Bill, the Treasury Legislation would also require a compensation committee to explain to shareholders, if applicable, its decision not to hire its own compensation consultant.)

More recently, in December 2009, Congressman Barney Frank (D-Mass.) introduced a House bill - the Wall Street Reform and Consumer Protection Act of 2009 (the "Frank Bill") - that adopts an approach towards promoting committee independence that is substantially similar to the approach taken by the Treasury Legislation and the Dodd Bill. As part of the Frank Bill, the Corporate and Financial Institution Compensation Fairness Act of 2009 would amend the Exchange Act to require the SEC to issue the same directives as those that would be required by the Dodd Bill.

The Role Of Independent Advisors

The provisions contained in the Treasury Legislation, the Dodd Bill, and the Frank Bill that promote the use of independent compensation consultants and legal counsel are well reasoned. Whether in connection with the negotiation of employment terms or the implementation of new compensation plans, management often comes to the bargaining table replete with an arsenal of expertise, including their own counsel and consultants. Although a company may also retain counsel and consultants to assist with the process, there is a perception that such advisors - who are generally selected by management - may lack the independence necessary to provide the most helpful advice to the compensation committee, in particular where such advice might be adverse to the very members of management who have engaged the advisors.

The few benefits of engaging in the compensation-setting process without the assistance of independent advisors are outweighed by the potential pitfalls that may result. Without objective and independent guidance from advisors who are retained by and report only to the compensation committee, the compensation committee may not be presented with the most comprehensive perspective on important compensation-related issues and may be disadvantaged in its efforts to promote shareholders' interests when bargaining with management. The experience of independent advisors is essential to knowledgeable decision making, including with respect to issues such as legal concerns relating to a given compensation decision, disclosure obligations, alternative compensation structures, industry practices and market trends, and tax consequences of alternative compensation schemes. Failure to be advised on and fully consider these issues may result in a view by shareholders that committee members are not fulfilling their fiduciary duties to the company.

Embracing Independence

The Treasury Legislation, the Dodd Bill, and the Frank Bill all support the notion that independence does not come without responsibility, which compensation committees should endeavor to embrace fully. Regardless of whether any such proposed legislation ultimately becomes law, the reality for compensation committees is that the recent financial crisis has exposed a fundamental flaw in many compensation-setting processes, whether real or perceived, and certain measures must be taken to restore compensation committees' accountability in the eyes of shareholders.

Although regulation of, and shareholder interest in, executive compensation has long been a hot-button issue, the significant increase in transparency called for by the 2006 SEC overhaul of the executive compensation disclosure rules under Regulation S-K has only whetted the market's appetite for even greater disclosure, and the Treasury Legislation, the Dodd Bill, and the Frank Bill signify an intensification of this trend. Compensation committees that begin taking steps now to bolster their independence and equip themselves with access to knowledgeable independent advisors will be better prepared to deal with the above and other complex compensation issues in the future. Engaging the services of independent compensation consultants and legal counsel is a meaningful first step in developing more robust compensation-setting processes.

Conclusion

The concepts described above are not new and have long been considered by corporate governance experts as industry best practices; however, in times of heightened shareholder and public scrutiny, such as compensation committees are currently facing, these ideas are experiencing a revival. Compensation committees should take advantage of the current economic situation to obtain the advice and counsel of independent compensation consultants and legal experts and thus enhance committee independence. Doing so will promote the goodwill of their shareholder constituents and advance the best interests of their companies.

David E. Rubinsky is a Partner in the Executive Compensation and Employee Benefits Practice Group at Willkie Farr & Gallagher LLP in New York. He represents public company compensation committees, negotiates employment and severance arrangements on behalf of public and private companies and senior executives, and advises public companies in regard to employment matters. Jason R. Ertel is an Associate with the Firm in the same practice group.

Please email the authors at drubinsky@willkie.com or jertel@willkie.com with questions about this article.