Editor: Paul, please describe your practice at Kramer Levin.
Ritter: Basically my group advises and counsels companies and compensation committees on a wide variety of compensation matters. In particular we represent companies and compensation committees in negotiating employment and severance arrangements with senior executives. We conceptualize and implement equity and non-equity incentive arrangements. We also advise with respect to golden parachute issues, the limitation on deductions in excess of $1 million for executive compensation by public companies, deferred compensation arrangements and clawbacks. We also have a significant practice in representing senior executives of major companies, both public and private, and fund managers and other financial professionals in connection with their employment and severance arrangements.
Editor: Many of the measures contained in the Senate's Restoring American Financial Stability Act of 2010 and the House's Wall Street Reform and Consumer Protection Act of 2009, currently in conference, have to do with executive compensation. One of the early measures, the Schumer bill, includes a provision that directors must receive a majority vote of those voting or step down. What difficulties does this pose for boards if it should pass?
Ritter: The Senate bill does have a provision that imposes a majority vote standard on the uncontested election of directors of a company that is listed on a national stock exchange. If a director does not receive a majority of the shares voted in the election, the director would be required to tender his or her resignation to the board. The board would have the ability to either accept or reject the resignation, but if it decides to reject the resignation, there must be a unanimous vote of the board to reject the resignation and the board would have to then disclose to its shareholders this decision and its rationale for doing so within 30 days. The House does not have a similar provision.
This majority vote provision has to be considered together with the recent SEC's change regarding voting by brokers of shares in a street name. Until this year brokers were permitted to vote such shares in a street name in director elections if the beneficial owners of such shares failed to provide voting instructions, which was the norm. Historically brokers would vote for the management slate.
Under the new SEC rule that is basically in effect, brokers are not permitted to vote such "retail" shares in director elections, thereby reducing the overall number of votes for a director. The requirement that directors receive a majority of the shares voted, together with the loss of the shares voted by brokers, will likely result in many directors having to submit resignations. Boards will have to make an often difficult decision of whether or not to accept or reject these resignations.
Then there is a third aspect to all of this. As you know, the big proxy advisory firms, such as ISS, Proxy Governance, Inc., and Glass-Lewis, sometimes advise against voting for a particular director for one reason or another. The implementation of the majority voting requirement will enhance the powers of these proxy advisory firms.
Editor: I would assume the institutional investors will have greater weight?
Ritter: Institutional investors often listen to either their proxy advisory firms or to their internal advisory staff. To the extent you have big shareholders voting against a proposed director, their votes are going to be very meaningful. Also, keep in mind that historically election of directors was a matter of state corporate law. This is a new federal intrusion into an area that previously had been determined by the states. The bottom line for all of this is that this is going to lead to instability in corporate governance. Some director candidates may decide that being a director is just not worth the candle. It may even have an adverse effect on the way that directors think about their responsibilities when faced with a particular issue - they may start thinking more about issues from the point of view of shareholder perception rather than from their fiduciary duties of doing what is best for the company and its shareholders.
Editor: One of the measures included in both bills is "say on pay," which provides a non-binding vote by shareholders on executive pay. Do you consider that this measure will make any fundamental change in the way in which directors are selected?
Ritter: My view is that "say-on-pay" sounds good from the standpoint of shareholder democracy, but I have always been concerned about how it works and whether or not it is helpful. Determining an appropriate compensation package for senior executives is very difficult and nuanced. So much effort goes into designing the compensation package - there are compensation consultants along with multiple meetings of experienced directors who are considering various inputs. A balance has to be struck where you don't pay too much but you want to give executives an incentive sufficient to retain them as well as to motivate them to work hard. Those structuring compensation packages need to understand the business, its strategies and goals. They need to understand current best compensation practices and to know what a company's competitors are doing. They need to understand how desirable it is to keep your current management team. And they need to know a great deal about the future outlook for the economy and what the prospects of the business are. Beyond that, they need to consider the accounting and the securities law aspects of designing a given package - what the disclosure aspects are and what the tax aspects are, both for the company and for the executive. The ordinary retail shareholder cannot review the disclosures in a proxy statement and make an informed decision unless he or she spends an inordinate amount of time. And I just don't think that most retail shareholders will do that.
Then you have the proxy firms, like ISS, that do spend time going through these proxy statements and make judgments, but what they tend to do is use the measure of "one size fits all" in making judgments. They have various criteria - that one practice is good while another is bad. If a company has too many bad practices or policies, they will tell their clients to vote no. Under the "say-on-pay" principle, if the compensation packages receive a no vote, while not binding, in the following year if the board has ignored the no vote, the proxy firm will urge voting against incumbent directors, especially against the incumbent members of the compensation committee. While some of the proxy firms are more sophisticated and do spend some time looking deeper at total governance, they all tend to follow a formulaic principle.
My feeling is that many times shareholders may just vote against a pay proposal out of the current spirit of outrage. In 2010 three of the companies that volunteered "say on pay" proposals have received no votes. They were not companies in the banking or securities industries, and there was no outside force agitating for a no vote. It was just a pure grassroots reaction to incumbency, and that can be very concerning. Again, what does that do for directors? It is going to force them to adopt the "best" pay practices, whether or not they are best for the company.
Editor: The Dodd (Senate) bill requires a pay-versus-performance disclosure, but the House bill does not. This measure has had many advocates over time. What performance measures should be used and should there be a uniform standard?
Ritter: Such a measure should be decided by the compensation committee on a basis of what is best for the company, given its industry and the economy and its strategies and goals. Again, the proxy advisory services tend to recommend voting based on shareholder return or some similar measure. And that just may or may not be best for the company.
Editor: The Dodd bill includes a provision to the effect that companies must disclose whether an employee or director is permitted to purchase financial instruments which would hedge against a decrease in the market value of securities that he/she owns. Would not an absolute prohibition on such a purchase be more in keeping with assuring a duty of "loyalty"?
Ritter: You're correct that the Dodd bill only talks about company policies, some of which permit hedging. Permitting it presents a bad image. Unless there is a very good solid reason otherwise, companies should have a policy that does not allow an executive to hedge, especially if the stock was part of his or her equity compensation. I am hesitant about making an absolute rule saying hedging should be prohibited, but I am leaning in that direction.
Editor: The proposals call for independence of members of the compensation committee - not unlike the rule under Sarbanes for audit committee members.
Ritter: The language is not so clear, but it sounds like it is going to be more of the definition of independence for members of the audit committee. There is a subtlety there as to what the differences are. One matter discussed is the consideration that large shareholders would not be deemed to be independent under the new rules whereas large shareholders are not currently prohibited from being members of a compensation committee.
Editor: The financial regulatory reform bill gives the compensation committee authority to hire, in their discretion, independent compensation consultants, legal counsel and other advisors. While the draft language suggests the compensation committee is not required to adhere to the advice of consultants, will their failing to do so be at their own peril?
Ritter: If a company is being sued, the failure to follow a consultant's advice will come up in litigation. On the one hand, if you are suing the compensation committee and you know that it had independent consultants, you will surely ask for information as to what that advice was. If the committee hires independent advisors but doesn't follow their advice, then it needs to have a good reason as to why it did not follow their advice.
Editor: While certain institutions still under regulation as a result of not having refunded TARP funds have limits on executive pay, do you see any likelihood that Congress will seek to limit executive pay across the board?
Ritter: The current limitation on the deductions that a public company can take on the pay of its five most highly paid executives was an attempt by Congress to limit the amount of executive pay. The law allows corporations to pay over $1 million, but it is not deductible unless the compensation fits within specified exceptions. In the case of golden parachute payments, a company doesn't get a deduction and the executive is subject to a 20 percent excise tax for the portion constituting excess parachute payments. This provision was meant to reduce the use and amount of parachute payments. Although many senior executives are protected against being subject to tax by way of tax gross-ups, such gross-ups, which are costly to the company and shareholders, certainly were not intended by Congress. The point is that every time that Congress imposes limitations on compensation, there are unintended results, usually increased compensation. My guess is that Congress will continue to have an impact on executive compensation, probably in a more indirect way by taking away benefits or imposing additional taxes or excise taxes. Just putting caps on the amount that can be paid is anathema to the notion of free enterprise.
Editor: What do you see as the most deleterious measures relating to compensation in the present regulatory climate (whether SEC or Congressionally inspired)? What likelihood do you see for their adoption?
Ritter: I think that the whole thing about majority voting together with the "say-on-pay" is going to have a very negative impact on a director's willingness to do what he or she thinks is right as opposed to what will be approved by shareholders, who may not be happy with anything directors do. While shareholder democracy sounds great, it may turn out to be a nightmare with those unintended consequences.