Corporate Governance

Designing Defensible Director and Executive Compensation Packages

Director and executive compensation has increasingly come under fire as being excessive when companies fail to perform well financially or top leaders are believed to have violated their responsibilities. Shareholders are taking companies to court to make their point.
— By Royston Arch

There has been a steady increase in litigation by stakeholders challenging executive compensation. There are the expected lawsuits by stockholders claiming directors and CEOs are overpaid based on corporate financial performance. There have also been a variety of lawsuits claiming directors and/or the CEO set misleading performance targets, acted with disregard for their fiduciary responsibilities, and approved unusually large bonuses or other awards that were not justified, to name a few reasons. In the U.S., the courts are increasingly applying the entire fairness review standard rather than the business judgment, which means more cases concerning board and executive compensation and awards are going forward.

The implication is that companies need to pay more attention to developing strong processes and procedures for setting high-level position compensation. Compensation needs to be independently set, connected to performance targets, and defensible which takes into account incentive plan language and the company's culture.

In All Fairness: Novel Claims Make it to the Courts
The legal cases involving compensation for board of directors and executives are complicated. They also reflect a number of novel claims not made in the past

People are empowered today and more willing to challenge what they consider to be inequities. It is social activism in many respects because empowered stockholders are not willing to sit back and let people at the top be paid exorbitant amounts when they believe the payments hurt the company, employees, and stockholders. To size the issue, the Economic Policy Institute said its research found the average CEO pay is 271 times the annual average pay of the typical American worker.

How CEOs and directors talk and act does matter today. Paying large salaries to people who act like "royalty" will not sit well with the public or stockholders who have a much louder voice thanks to the internet.
Recent litigation offers a glimpse of the perspective of stockholders.

In Stein v. Blankfein, the claim is that the compensation paid to Goldman Sachs directors was excessive compared to what directors in other companies earned. The court has allowed the case to continue based on the entire fairness standard, which means it will address issues like director self-dealing and bad faith.

In the Investors Bancorp case, settled in June 2019, stockholders challenged equity awards of $51 million given to company directors shortly after a new equity incentive plan was approved by stockholders. The entire fairness standard was applied, and the court partially rescinded the director awards.

In The Hertz Corp. v. Frissora case, Hertz is trying to recover $70 million in incentive payments and $200 million for related damages from former executives (CEO, CFO and GC). The claim is that the executives fostered an aggressive company culture that led to financial statements being restatement. Hertz claims the inappropriate "tone at the top" led to the executives breaching their duties and thus triggered the company's clawback policy.

In Tornetta v. Musk, stockholders are claiming the controlling stockholder and CEO’s award of stock options of $55.8 billion was a breach of the CEO and board of directors fiduciary duty, unjust enrichment, and corporate waste. The case moved forward with the corporate waste claim dismissed, but the court applied the entire fairness standard of review and said the company had not met the requirement that an independent board committee be utilized for setting compensation.

Empowered Global Public Increases Scrutiny of Compensation
These are just samples of the types of ongoing litigation involving board of directors and top executives. There is pressure on companies to align director and executive pay with performance. The complication is that companies do not always clearly explain how they reach compensation decisions at the highest corporate levels.

Combine this fact with investors and the public are paying more attention to director and executive performance, and the scene is set for litigation that may or may not be justified. Investors today are more engaged – even small investors – and this places a responsibility on the company to be transparent about things like a costly compensation package for a CEO who may or may not succeed, comparison to peers, the compensation model, and how compensation is linked to performance.

This is not an issue limited to the United States. There is discussion among Europe's politicians, finance ministers, and legislators to curb executive pay and awards for CEOs who leave the company with large severance packages. Luxembourg Prime Minister Jean-Claude Juncker called soaring corporate compensation a "social scourge." French President Nicolas Sarkozy wants a debate on implementing European-wide pay limits for CEOs. Prompting these statements is Europe's economic slowdown, a struggling financial industry, and shareholder and public demands for accountability for company underperformance.

Develop a Defensible Compensation Plan
To reduce the possibility of litigation, companies need to put several safeguards in place. One is ensuring there is a defensible policy and procedure for setting executive and director compensation. Defensible means a compensation committee takes certain factors into consideration, like peer company compensations, proposal of an independent compensation consultant, performance targets, future plans, and so on.

How CEOs and directors talk and act does matter today. Paying large salaries to people who act like "royalty" will not sit well with the public or stockholders who have a much louder voice thanks to the internet.

Ideally, large awards to executives who also are controlling stockholders should be approved by an independent committee and put to a vote by disinterested stockholders. Full and enhanced proxy disclosure of compensation setting is advised

Prove it
Companies prefer courts to judge litigation based on a business judgment review instead of the entire fairness standard of review. The entire fairness standard gives the judge much more leeway in determining the case.

Maintaining high-quality documentation of the company's decision-making process for director and executive compensation and awards setting is imperative. Every aspect of compensation is subject to explanation – compensation, bonuses, stock options, golden parachutes.

The public and shareholders want to know the figures are independently derived and defensible. Companies say they must pay these huge amounts of money to attract and retain the most qualified directors and executives. Stakeholders say, "Prove it."