In September, a judge rejected a $33 million settlement between the Securities and Exchange Commission and Bank of America that it deemed unfair to stockholders. The settlement related to bonus payments to Merrill Lynch executives at the time of Bank of America’s acquisition of the firm. The rejection was another indication to Scott Landau that change is on the horizon for compensation committees.
And even though legislation changing the rules about executive compensation has yet to be enacted, the ruling signaled to Landau, an executive compensation lawyer and partner at Pillsbury Winthrop Shaw Pittman LLP, that compensation committees should start now to address potentially sweeping changes.
“At the end of July 2009, the U.S. House passed the Corporate and Financial Institutional Compensation Fairness Act of 2009,” Landau says. “It dealt with three main ideas in executive compensation: executive compensation should be subject to more transparency and accountability; decisions on compensation practices are too often tainted by actual or perceived conflicts of interest; executives should not be incentivized for taking unreasonable and imprudent risks.”
While the Act has not yet become law, it does provide some guidance for companies wanting to get a head start on rules that may be coming. Landau recently authored a white paper, “Executive Pay Reform Poses Complex Risks for Compensation Committees,” on the topic in an effort to give compensation committees some perspective on the potential challenges they face. He agreed to discuss elements of the paper with BLR®.
“Compensation committees should be independent and so should their advisors.” Landau says the independence of the compensation committee members and its advisors is of the utmost importance. “In the past, you might have had the company’s consultants or legal counsel also providing advice to the compensation committee,” he says.
“If a company is bringing in a senior executive, the chairperson of the compensation committee may be negotiating the employment agreement. If they are using the company’s counsel to negotiate with the senior executive, the advice offered may not be exclusively in the company’s best interest. Keeping the committee’s and the company’s counselors and advisors separate maintains arm’s-length relationships.”
“Committees should not make decisions in a vacuum.” The term “Compensation Committee” may be misleading because much more is required of committee members than just an understanding of executive salary and bonus issues. Landau says members must also be well trained in the benefits offered the executives, as well as in employment agreements. “All of these things are interrelated,” Landau says. “You can’t look at these areas as separate, because they aren’t. The benefits, the compensation, and the employment component all make up the total compensation package, and committee members need to understand each of them.”
Members of the compensation committee, then, must be willing to roll up their sleeves and get into the details. “Make sure your compensation committee members have the necessary expertise,” Landau says. “Depending on the company, the benefit plans and programs may be quite complex, so make sure members have the necessary training.
“For instance, if there is a defined benefit pension plan or a nonqualified SERP (Supplemental Executive Retirement Plan), do members understand the actuarial assumptions being used? Do they understand what will happen if the assumptions change? What would that mean for the business and for the executive, short term and long term? It could impact not only the underlying financials of the company, but also the potential compensation or benefits of the employee. Committee members should understand the various actuarial terms and the formulae being provided to the executives.”
To illustrate, Landau discusses a company that wants to hire a particular executive away from another employer. “The compensation package needs to be designed with that particular executive in mind. What do you need to do to get that executive to move? Sometimes, executives are leaving dollars on the table and in order to get them to leave you’ll need to make up for that.
“For instance, they might have stock grants that are currently unvested, but that will vest if they stay with their company for another year or two. Or if the other employer has a defined benefit plan and you don’t, you’ll have to offer something else. It’s a negotiation. The key here is about fully informed decisions. The compensation committee members need to have all the information and expertise necessary to understand the decisions being made.” Training may come from the committee’s legal counsel, consultants, internal staff, or a combination. However, use caution when calling on staff to train committee members, says Landau, in order to maintain independence.
Compensation committee members must also be knowledgeable about the employment agreements between the company and the executives. “They need to understand restrictive covenants, for instance, noncompete and nonsolicitation provisions. The value to the company of these provisions depends in large part on how they are drafted.”
“Align executive interests with corporate and shareholder interests.” “Certain companies may have seen their stock prices go down significantly in the last year or year and a half,” Landau says. “If the company is providing equity grants to the executive, they want to make sure those grants are tied to performance.
“So, let’s say the company is currently undervalued. If an equity grant is provided to the executive, and all of a sudden the stock price goes up for a reason that is not tied to the performance of the executive team, then is the company rewarding for performance?
“Or maybe the stock options are under water. What should the company do if outstanding stock options that formed part of an executive’s compensation have lost all their value because the exercise price is higher than the market price? Should there be repricing? Should there be other grants given? These are some of the issues that the compensation committee needs to start grappling with. The key is to make sure the executive’s interests are aligned with shareholder interests.”
“Don’t incentivize for unreasonable or imprudent risk-taking.” “If equity-based compensation is being provided, consider having the payout occur later,” Landau recommends. “By pushing the payout into the future, you can make sure the executive’s results are not a result of undue risk and short term results.
“Let’s say that for 2010 the executive needs to achieve A, B, and C in order to get a certain number of grants of restricted stock. He achieves those objectives. The real question is, are those objectives sustainable, or will they look different 3 years from now?
“Maybe the results look great in year 1, but in year 3 or 4 it becomes apparent that the executive took unnecessary risks to achieve those objectives.
“Taking a longer term view is better, because sometimes you need more time to really see if those objectives have been achieved. Maybe there was an upswing in year 1 or 2, but then there’s a significant drop in years 3 and 4 and you’re back where you started. Extraordinary risk is not easy to assess, so taking a longer view helps.”
Landau believes that these are practical ideas that can address public outrage resulting from huge payouts to executives in failed or failing companies. “The idea here is to try to get the balance of total compensation right,” he says. “How can pay for failure be curtailed? You don’t want to reward people for failing, or for taking excessive risks.”
By following a thoughtful, well-designed executive compensation program, companies can take steps now, in advance of legislation, to ensure good results for the company, the shareholders, and the executives.
Note: The white paper, “Executive Pay Reform Poses Complex Risks for Compensation Committees,” is available online at www.pillsburylaw.com/compensationreforminsights.