Corporate Governance

Executive Compensation, the Delaware Model and a Proposed Solution (Part 4)

By J. Robert Brown

We have proposed a solution to the executive compensation problem. It entails an amendment to Section 13 of the Exchange Act to prohibit the payment of excessive compensation. The provision defines excessive and contains a safe harbor that requires the board to implement meaningful procedures for ensuring the integrity of the executive compensation approval process.

The safe harbor would attempt to create a system for approving integrity that eliminated the flaws in the process authorized by the Delaware courts.  Moreover, the safe harbor would, to a large extent, track the provisions of SOX with respect to audit committees.  The safe harbor would not, however, be implemented through the listing standards of the stock exchanges but imposed directly on all reporting companies. 

The safe harbor would require a compensation committee consisting entirely of independent directors.  The definition of independence would be stricter than anything used by the stock exchanges or the Delaware courts.  It would repeat the criteria for independence contained in SOX for audit committee directors (the ban on affiliate status and the receipt of consulting fees) but would go beyond that definition. 

First the definition would provide that any director serving on the compensation committee would agree in writing to not serve for a period of greater than six years.  The purpose of a term of years is two fold.  First, directors often develop personal relationships with the CEO over time (the problem of capture).  This would limit that affect by limiting their time period on the board.  There are a number of corporate governance codes employed by other countries that provide a director is no longer independent after serving a specified number of years.  Great Britain's Code, for example, sets the period at nine years. 

The time period also mitigates the concern over fees.  If directors can serve indefinitely, they have an incentive to give the CEO what he or she wants in order to maintain the position on the board.  One way to handle the problem is to disqualify as independent anyone receiving fees deemed material.  This would effectively limit the category of directors eligible to serve on the compensation committee to those with substantial means.  By limiting overall tenure, directors will know they will lose their sinecure anyway and perhaps induce behavior that is less concerned with the interests of the CEO.

The definition provides a safe harbor from the safe harbor.  Directors nominated by 2% shareholders (assuming they are unaffiliated with the issuer) would be deemed independent for purposes of this provision.  This provides an incentive on the board to encourage nominations by shareholders and to ensure they are elected by including them in the management slate.

The definition of independence also provides that directors on the compensation committee must not have a preexisting and significant personal relationship with any executive officer of the issuer or controlling shareholder at the time they join the compensation committee.  This is an attempt to get at the issue of friendship.  The NYSE listing standards do not screen for friendship and the Delaware courts use a test that is impossible to show. 

We will discuss this proposed safe harbor in one more post.

Full post as published by The Race to the Bottom on April 03, 2009 (boomark / email).