February 23, 2005

When Comp is King: New Headaches for Public Companies and Their Directors

When shareholders sued Disney directors to recover the $100 million-plus severance package paid to former president Michael Ovitz, most of the headlines focused on the gossipy testimony that exposed personality clashes between company insiders. Despite these headlines, the real story for directors is the threat of personal liability over a compensation decision that involved no self-dealing or other fraudulent behavior. In letting the case go forward, the Delaware judge ruled that the directors' actions in approving the package and allowing its exercise only 14 months after Ovitz joined the company, would (if proved in court) constitute a lack of "good faith" for which they enjoyed no shield from liability.

The judge's theory has yet to be tested in higher courts. However, the idea of a "good faith" duty that goes beyond the traditional duties of care and loyalty has provoked a wave of unease among directors. Under current law, directors generally cannot be held personally liable for negligent or even grossly negligent behavior, as long as their actions do not feather their own nests. The alleged facts in the Disney case, however, prompted the judge to opine that the typical "business judgment rule" protection doesn't apply when directors fail to use any judgment whatsoever.

Regardless of how the new implied duty of "good faith" ultimately fares in the courts, the Disney case is symptomatic of a new willingness by shareholders to challenge board-level decisions and to go after the directors' own pocketbooks if necessary – particularly in connection with compensation decisions. After several years of focus on the audit committee, scrutiny by shareholders and regulators appears to have shifted to the compensation committee in an attempt to rein in outsized executive pay packages and hidden compensation. As a result, directors must now confront new rules regarding deferred compensation and stock options, increased SEC reporting responsibilities, and the constant threat of court actions or governance challenges. Every compensation decision is being put under the microscope.

More Scrutiny

Popular discontent over executive pay has been bubbling for years, but the nine-figure payday for Ovitz seemed to crystallize shareholder sentiments against compensation packages that appeared to have no reasonable connection to performance. This groundswell is triggering a series of new governance risks for companies and their Board members.

If the ultimate judgment of the Delaware courts goes against Disney, its directors may be protected by insurance, which will foot the bill for any damages awarded in the litigation. In that event, however, public companies are likely to face an even more restrictive and expensive environment for D&O insurance in the future, as insurance companies conclude that plaintiffs' attorneys have found a way around the legal protections for directors. Although we all thought the market for D&O insurance could not get any worse after Enron, we may not have seen the bottom.

There is also often a "regulatory snowball" effect in high-profile litigation. As the Disney lawsuit garnered media attention, the SEC took a closer look at the company and discovered that some children of directors were working for Disney – a fact that looked to regulators like a special perk that had never been publicly disclosed as required by current rules. The company was hit with a cease-and-desist order. The lesson for public companies: bad news has a way of breeding more bad news.

Pay package scrutiny is not limited to the courtroom or the offices of the SEC. Institutional Shareholder Services, an organization representing the interests of many powerful institutional shareholders, is also keeping a close eye on executive compensation. ISS can wield a big stick if it feels that a package is out-of-line. It can recommend that shareholders not approve the plan, or (more dramatically) it can advise shareholders to withhold re-election votes for members of the compensation committee. The consequences of withhold votes will be greatly increased if the SEC follows through and adopts its currently proposed rules that would provide shareholders with a mechanism for directly nominating directors in the event more than thirty percent of shareholders follow ISS's advice.

Taking Stock

Accounting and tax rules for executive compensation are also becoming more complicated.

After years of debate, the Financial Accounting Standards Board, with the blessing of the SEC, took the expected step in December 2004 of requiring public companies to expense the "fair value" of stock options on the income statement. The change begins to take effect in July and moves this change from a footnote disclosure buried in the back of the financial statements to an item that directly hits net income.

Investors had sought the revised rule for years as a way to increase the transparency of financial statements, but many companies (particularly in the tech sector) had resisted fiercely, arguing that expensing options would suppress job growth and make it harder for cash-strapped growing companies to lure talent by using options as a carrot. Congress even weighed in recently on the side of these companies but the FASB would not back down. The fact that investors emerged as the winner in this argument is another example of the growing shift in the balance of power between companies and their shareholders.

The new rule for options comes on the heels of significant changes in the tax treatment of nonqualified deferred compensation arrangements that took effect in January. The changes in tax law create substantial new complications for a wide range of compensation arrangements and may discourage the use of some popular compensation structures altogether, because of negative tax implications for the company and the employee. Not only are traditional deferred compensation arrangements covered, but other arrangements, such as below market stock options, are also swept in. The penalties for being wrong under this new law are severe: any deferred income that does not meet the new standards becomes immediately taxable, plus interest and a 20 percent penalty.

8-K Krazy

The pace of regulatory filings has also accelerated, thanks to new SEC rules that require immediate disclosure for a broad range of corporate actions. Leading the way: decisions related to compensation.

Previously, the SEC required public companies to file an immediate Form 8-K (in addition to its usual quarterly and annual reports) only in the event of certain major corporate actions, such as buying or selling a significant business. Now, the SEC has dramatically broadened the range of events that trigger a required 8-K filing, including any contracts related to compensation of executive officers or directors. The deadline for making the filing is just four business days.

If you adopt a bonus plan without finalizing specific criteria for when the bonus applies, that triggers an 8-K. If you then adopt criteria, that triggers another 8-K. If you make a discretionary payment on a previously adopted plan, that triggers an 8-K again. The SEC has made clear in recent guidance that this trigger applies whether the contract is a twenty page written agreement or merely a handshake. The result is that companies that previously would file only a few 8-Ks a year now find themselves going 8-K Krazy.

Duty Calls

Put it all together, and there is a clear message for directors: comp is king. More and more public company disputes, whether at annual meetings or in courtrooms, are likely to center on compensation. Compensation plans have grown more complicated and expensive, and Board decisions with regard to compensation are under intense scrutiny by investors and regulators. All of it is being conducted in the public eye. There is also a higher risk that directors could find themselves on the hook personally if a pay dispute blows up.

The lessons for directors in the wake of the Disney litigation and other compensation trends are clear. First, get informed and stay informed. The alleged facts that allowed the Disney litigation to go forward arose not from making an informed but flawed choice, but from the perception that the company's directors allowed an inflated compensation package to proceed without proper diligence and oversight.

For compensation committee members in particular, this means getting information on proposed bonuses and compensation packages well in advance of calendar deadlines – not waiting until there is no time to do anything but a cursory review. In many cases, it may also be desirable to hire outside experts to help in crafting compensation packages, providing competitive data on the compensation market, and establishing viable links between pay and performance.

Finally, directors need to know when to say, "Stop!" The expectation today is that directors will ask the hard questions of the executive staff and put the brakes on an ill-advised compensation plan.

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