The compensation committee recharged
By Martin Nussbaum

COMPENSATION COMMITTEE The compensation committee recharged Whafs being asked of the committee in the coming year challenges the traditional distinction between oversight and management. How should the members fulfill their expanded role? BY MARTIN NUSSBAUM C OMPENSATION COMMITTEE members, like their colleagues on the audit committee, are facing higher levels of responsibihty and increased scrutiny. The focus on the audit committee in- tensified with the scandals leading to the passage of the Sarbanes-Oxley Act in 2OO2.While that law did not impose the same sorts of requirements on com- pensation committees, it did address certain of the compensation practices associated with those scan- dals, such as loans, trading blackouts, and bonuses paid on the basis of incorrectly reported earnings. More generally, tonahty and approach of SOX has been extended to other areas of governance. An obvious parallel is the relationship between the compensation committee and the consultants who assist it in making its decisions. Auditors were required to be independent before the adoption of SOX, but the precise delineation was principally a matter determined by occasional SEC pronouncements and self-regulatory mandates. SOX specifically prohibited firms functioning as independent audi- tors from performing services that had traditionally been deemed acceptable. While there is no list of prohibited re- lationships that would debar a compen- sation consultant from performing any particular services, disclosures concern- Martin Nussbaum is a partner in the corporate and secu- rities and mergers and acquisitions groups of Dechert LLP ( He was named a leading corporate/ M&A lawyer in the 2006 and 2007 editions of Chambers USA, and is named a leading lawyer by Legal 500 (USA) for key legal areas including corporate governance and SEC, M&A, and private equity. Dechert partner Stephen W. Skonieczny and associate Evan D. Michalovsky assisted in the preparation of this article. 42 DIRECTORS a BOARDS ing the compensation committee and the compen- sation process call for disclosure of the roles played by management and consultants in compensation decisions. To the extent that a consultant is engaged by management to perform services for the com- pany, that too must be disclosed. Such retention of the consultant by management can become a basis for challenging the consultant's independence. The traditional role of the compensation con- sultant in working with management to design programs and administer benefit plans may well be bifurcated, with one consultant working with management to create and administer plans and another, working solely for the compensation committee, charged with reviewing compensation and providing advice with respect to market stan- dards. To the extent that such a division becomes the norm, and the number of consultants involved in the compensation process increases, there will be a greater burden placed on small and midcap companies and their boards. Disclosure... and more disclosure Disclosure is also the route that is driving increased involvement by the compensation committee in the determination of compensation. The extent of compensation disclosure has been increas- ing over the past several years. Initially, expanded disclosure was directed at factual and historical information. There was an increase in the number of tables and footnotes de- scribing the amounts being paid, broken into categories and surrounded by nar- rative descriptions of perquisites and benefits that did not neatly fit into the tables. With the adoption of a required Compensation Discussion and Analysis (CD&A), companies became required to COMPENSATION COMMrTTEE disclose policies, practices, and objectives. This nar- rative requires a discussion of six mandated top- ics: compensation objectives, what is intended to be rewarded, each element of compensation, why each element was selected, how the elements are balanced, and how each element fits into the over- all compensation structure. In furtherance of this requirement, the SEC lists 15 additional suggested issues for disclosure. The compensation committee is required to con- firm that it has reviewed the CD&A and agrees with its inclusion in disclosure materials. In order for the compensation committee to fulfill this require- ment, it must become familiar with the decisions that underlie the compensation process. This level of participation challenges the traditional distinc- tion between oversight and management. While many of the topics required to be disclosed in the CD&A can be addressed, in large part, on a policy level, the 15 topics "suggested" by the SEC reach a level of detail that could well involve participation in the execution of those policies. The required disclosures undoubtedly provide additional information for shareholders and pro- spective investors to consider. However, they also provide substantial fodder for critics and the curi- ous. Criticism by activist investors and the notori- ety that comes from publicity tend to put greater pressure on the boards and committees that have approved the compensation. Prospect of litigation A separate level of pressure on the committee comes from the prospect of litigation. As a general proposi- tion, courts are loath to become involved with and to second-guess compensation decisions. Even when the deliberative process is felt to be far from perfect — absent fraud, self-dealing, or bad faith — com- pensation committees can take comfort from the continued vitality of the business judgment rule. Cases brought to challenge excessive compensation have thus far created a greater danger of uncomfort- able publicity than actual liability. When, however, the acts of the committee are the central issue of a malfunction in the compensa- tion system, the litigation and other risks are great- er. Most notably, the epidemic of option backdat- ing reflects a breakdown in the functioning of the compensation process. While the most egregious cases may have involved actual fraud by members of management who assisted in the administration of the plans and who may have benefited in some way from the backdating, many instances appear to have involved a lack of awareness by commit- tee members of the requirements of equity-based plans and of the accounting implications of option granting practices. The resulting costs to compa- nies of restatements, resulting loss of market value, fines, and legal expenditures have given rise to a plethora of litigation. Even non-activist governance firms have sought to hold compensation commit- tee members accountable through the withholding of votes to impose accountability. No more ad hoc The most common and appropriate response of compensation committees is to bring to bear the time and resources necessary to fill their expanded role. There should be an increased reluctance of compensation committees to act on an ad hocoT informal basis. Acting by unanimous written con- sent, while technically permitted by the corporate laws, is becoming a suspect practice. Indeed, settlements with plaintiffs' counsel regu- larly call for an agreement by the compensation com- mittee to abandon this prac- tice. Similarly, compensation committees are and should be more skeptical about granting awards or making decisions at special meetings, especially those called on short notice. The opportunity for spring loading — granting perfor- mance awards on the eve of an event ensuring the attainment of the objectives — has led to a trend to require that compensation committee members generally act at regularly sched- uled meetings. There may be clearly understood ex- ogenous events requiring action between meetings, but this should be the relatively rare exception. Human resource and compensation experi- ence should be added to the skill sets desired when recruiting directors. While there is not yet a re- quirement that compensation committees have "compensation experts" like the audit committee's "fmancial experts," literacy on the part of com- pensation committee members in compensation practices and consequences should be a focus so the committee can appropriately perform its duties, including the duty to review and understand the elements and background of the CD&A. And, as noted above, the compensation commit- tee should have ready access to resources to assist it in formulating and obtaining the answers to the ques- tions that diligent directors must be asking in the in- terests of the company and the shareholders. • The author can be contacted at martin.nussbaum® Compensation committees can take comfort from the continued vitality of the business judgment rule. FIRST QUARTER 2008 43

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