Under NYSE Rule 303A.01, all listed companies must have a majority of independent directors sitting on their boards.  Directors are not independent if they received over $120,000 in direct compensation, other than director’s fees, in any one year period over the last three years pursuant to Rule 303A.02(b)(ii).  This is a looser restriction than the equivalent NASDAQ Rule, 5605(a)(2), which includes all compensation.  Rule 303A.06 requires that, in addition to the general independence standards, audit committee members must comport with the requirements of Exchange Act Rule 10A-3 (C.F.R. §240.10A-3), also known as SOX 301.  One can see some of the effects of these rules when looking at the director compensation table from General Electric Company (NYSE: GE) 2010 proxy statement.  The proxy statement shows the directors were compensated accordingly:

*This represents a $1,000,000 payment by the company to the director according to the Charitable Award Program (see below).

Director Compensation.  During fiscal year 2009, General Electric held 15 Board of Directors meetings. Each director attended at least 75% of the aggregate number of meetings of the Board of Directors and meetings of the Board Committees on which he or she served.  All of the current directors attended the 2009 Annual Meeting of Shareowners, other than Mr. Beattie who was elected to the Board after the 2009 Meeting.  The current director compensation program has been in effect since 2003.  Additionally, General Electric maintains a Charitable Award Program, where upon termination of a director’s service the company makes a $1 million contribution to charitable organizations designated by the director.

Director Tenure.  In 2009, Mr. Warner held the longest tenure having been a director since 1992.  Mr. Gonzalez served as a director until April 2009 and was replaced at the Annual Meeting of Shareowners by Mr. Beattie.  Several directors also sit on other boards and hold executive positions in other companies.  Mr. Penske serves as Chairman of the Board and Chief Executive Officer of Penske Automotive Group.  Mr. Nunn is also a director of Chevron Corporation, The Coca-Cola Company, and Dell Inc.  Additionally, he is a distinguished professor at the Sam Nunn School of International Affairs at Georgia Tech.

CEO Compensation.  Jeffrey R. Immelt served as General Electric’s Chief Executive Officer during the 2009 fiscal year and earned $9,885,240 in total compensation.  Mr. Immelt’s base salary of $3,300,000 has remained the same since fiscal year 2005.  Mr. Immelt declined to be paid an annual cash bonus for 2009.  The remaining majority of Mr. Immelt’s compensation package is derived from the $4,398,085 increase in his pension value. Keith S. Sherin, Vice Chairman and Chief Financial Officer of General Electric, received $13,955,956 in total compensation in 2009.  This represents a $2,675,000 bonus and $6,876,000 in option awards.  Additionally, the remaining Vice Chairmen, Messrs. John Krenicki, Michael A. Neal, and John G. Rice were compensated $13,102,851, $15,195,888, and $15,385,754 respectively.  A majority of this compensation was derived from large Option Awards. 

Some of the companies this project reviewed are:

Goldman Sachs Group.

J. P. Morgan Chase & Co.

Morgan Stanley

Chesapeake Energy Corporation

Ford Motor Company

Citigroup 

While this is true as far as it goes, it does not tell the complete story.  A comment on the post notecd that it did not take into account the change in tax gross ups.  The agreement limiting personal use of the aircraft to $200,000 per year also eliminated tax gross ups in connection with this benefit.  (See 2009 Proxy Statement at 43).  The gross ups in 2009 were $170,046, $176,775 in 2008, $111,311 in 2007, and $184,790 in 2006 (for a total of $642,922).  When these are taken into account, the company paid out a total of $3,831,113, an amount closer to the value of the benefit (the $4 million paid by the board and the $800,000 of personal use still allowed).    

Michael S. Jeffries is the CEO.  It is clear that he took over a moribund product back in the 1990s and made Abercrombie into a popular and successful brand.  As Business Week described back in 2005:

• Since Jeffries became CEO in 1992, he has transformed a floundering men's haberdashery once owned by Limited Brands Inc. into a brand so popular that the company has posted profit gains for the past 48 quarters (excluding a one-time charge last year). That's a record unmatched by its peers. Jeffries revived A&F by selling preppy but edgy casual clothing at high prices unheard of in that market.

It is also clear from the proxy statement that the Board views Jeffries with considerable deference.  As the Statement notes: 

• The Board believes that combining the Chairman and Chief Executive Officer positions takes advantage of the talent and knowledge of Mr. Jeffries, the person whom the Board recognizes as the 'founder' of the modern day Abercrombie & Fitch, and effectively combines the responsibilities for strategy development and execution with management of day-to-day operations.

For 2009, the proxy statement revealed total compensation of slightly over $36 million.  The Compensation Committee believed that certain "considerations" were "relevant to an understanding of the compensation awarded to Mr. Jeffries in Fiscal 2009."  Most of the compensation related to stock appreciate rights were given as part of a retention agreement.  Moreover, the rights came with significant limitations.  As the proxy statement noted: 

• The Compensation Committee views those stock awards, particularly the Retention Grant provided to Mr. Jeffries through the Jeffries Agreement, as compensation to be earned by Mr. Jeffries over the full five-year term of the Jeffries Agreement. The Retention Grant will not become vested (meaning that Mr. Jeffries will not be able to exercise the award and receive any shares earned under the award), unless and until Mr. Jeffries remains continuously employed by the Company through January 31, 2014 (subject only to limited vesting acceleration under the severance provisions of the employment agreement) and is subject to certain transfer restrictions. Similarly, no portion of the semi-annual grant made in September 2009 under the terms of the Jeffries Agreement vested in Fiscal 2009, as the stock appreciation rights which are the subject of the semi-annual grant will become vested in equal annual installments over the four-year period following the grant date.

What we find particularly interesting is not the total compensation but the board's decision with respect to the CEO's personal use of the aircraft.  We will explore that in the next post. 

• Thus, if the disinterested directors considered the relevant factors, their decision to approve a particular fee agreement is entitled to considerable weight, even if a court might weigh the factors differently. . .  .

Perhaps.  But this assumes a process with integrity. 

Certainly, in Delaware, there is no guarantee that the process of approving executive compensation has sufficient integrity to protect shareholders.  As we have noted, Delaware does not have in place a system that ensures independent directors are independent.  Delaware has done little or nothing to screen for conflicts of interest with respect to compensation consultants (an issue only relevant if shareholders can get past the presumption of independence for directors). Nor does Delaware restrict the interested directors from participating in the decision making process. 

Similarly, with respect to mutual funds, there is likewise no guarantee that the process will protect shareholders.  It is true that mutual fund boards must consist of at least 40% of disinterested directors, see  15 USCS § 80a-10(a) (a percentage that increases to 75% if the fund relies on certain exemptive rules), and that these directors get to approve the agreement with the investment advisor, see 15 USCS § 80a-15(c), this is not enough. 

First, like Delaware, the concept of disinterested is not broad enough.  The definition of interested person doesn't screen for friendship (including structural bias) or fees paid to directors.  Second, while disinterested directors must approve the agreement, there is nothing in the statute that excludes the interested directors from participating in the process.  Third, mutual funds usually have no employees.  Administrative staff is typically provided by the advisor.  Any information or support needed by the directors in reviewing advisory fees would need to be arranged through the advisor.  Finally, the process takes place in an environment where the advisor likely founded the mutual fund and would be logistically difficult to fire.

As with the approach used by Delaware, there is no reason to believe that process will protect shareholders. 

The Court did note that compensation approved through proper process could still be challenged, relying on language from Gartenberg.  Yet the standard, while not the clearest, seems something akin to the waste standard used in Delaware.  As Justice Alito states:

• This is not to deny that a fee may be excessive even if it was negotiated by a board in possession of all relevant information, but such a determination must be based on evidence that the fee "is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining."

The language suggests a tough standard.  In Delaware, waste applies to compensation "so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration."  Brehm v. Eisner, 746 A.2d 244, 263 (Del. 2000).  The standard in Delaware is so high that it imposes no meaningful limits on compensation. 

Nonetheless, the decision contains hints that the standard for challenging fees may be less deferential than he sometimes suggests.  

First, despite the admonishment that courts should not engage in "judicial second-guessing of informed board decisions," he did emphasize that deficiencies in process justified a harder look by the courts.  

• In contrast, where the board's process was deficient or the adviser withheld important information, the court must take a more rigorous look at the outcome. When an investment adviser fails to disclose material information to the board, greater scrutiny is justified because the withheld information might have hampered the board's ability to function as "an independent check upon the management." . . . . "Section 36(b) is sharply focused on the question of whether the fees themselves were excessive."

He left to lower courts to determine what would be a deficient process.  Lower courts, therefore, have room to make the process used by boards of mutual funds meaningful, a hopeful trend. 

Second, the disproportionate standard apparently can be determined through reference to comparable payments by comparable funds.  The disproportionate standard doesn't guarantee that fees approved by boards are fair, but it does reduce the likelihood of fees that are substantially different than the industry norm.  Waste under Delaware law has no comparable reference.  As a result, amounts of compensation disproportionate to what is normal within the industry are common enough and not subject to reasonable challenge.

Jones v. Harris provides a path, not present in Delaware, for approving compensation in a way that may actually protect shareholders.  The only question is whether the lower courts will take it.

On this one, Judge Posner won, with the Court in a unanimous decision reversing the lower court.  With respect to Judge Easterbrooks' argument that the matter of compensation was merely a matter of disclosure and better left to the market than litigation, the Court disagreed, noting that "[b]y focusing almost entirely on the element of disclosure, the Seventh Circuit panel erred.

Towards the end of 2009, it looked like Goldman would continue to pay amounts that, in a time of 10% unemployment, looked excessive.  The investment banking firm was on a path to set a record.  Push back from shareholders and a generally pillorying in the press apparently had some impact.  The firm announced that it would not pay a record amount of compensation, setting it at a percentage in the 30's, well below the typical percentage (between 45% and 50%) over the last ten years. 

The other shoe was the bonus paid to top management.  The CEO (and chairman), as well as four additional officers, received a bonus of $9 million on top of the $600,000 in salary.  The bonus was also in stock and couldn't be sold for 5 years.  The pay was even less than the amounts authorized by the Pay Czar with the companies subject to his oversight.  He allowed a couple of compensation packages to weigh in at $10 million plus. 

The approach used by Goldman was responsible and, as a result, the public criticism was muted.  There is no room to complain.  It was highly responsible and, on this one, the board and CEO did the right thing.  It was an impressive display of proper corporate governance.

The problem is that it is likely to have been a one time event.  Already the firm's Chief Financial Officer, David Viniar, is warning investors and the public not to read too much into the action.  As the WSJ reports, Viniar had this to say about compensation:

• "People ask me if this is the new normal," Mr. Viniar said at a Credit Suisse conference in Miami. "There is no formula. We tried to strike the balance right, and we'll try to strike the balance right this year."

In other words, the days of $65 million plus bonuses may not be over.  Moreover, its even possible that Goldman will pay interim bonuses and increase compensation during 2010 to attempt to compensate for some of the shortfall. 

In the end, the process of determining executive compensation lacks integrity.  For more on this, take a look at Returning Fairness to Executive Compensation.  It remains broken and, despite this act of professionalism by Goldman, it is still not fixed.  Directors need to be truly independent so that they can say no to proposed compensation packages that are unreasonable.  While the debate has calmed a bit because of Goldman's actions, the problem remains unaddressed. 

• the members of Goldman’s Board of Directors (the “Board”) abdicated their responsibility to administer the Company’s compensation plans in the best interests of the Company and its shareholders, and instead have blindly “rewarded” executives for corporate performance that has absolutely nothing to do with the skill of the Company’s employees. Over the last decade, Goldman’s directors have reserved and issued as compensation to employees an amount approaching 50% of the Company’s annual net revenues. Because the majority of the Company’s revenues depend on the reported values of the firm’s investments, however, these revenues are impacted by market forces and not necessarily the productivity of Goldman Sachs employees. Nevertheless, year after year, Defendants have caused the Company to pay billions of dollars in incentive based compensation, regardless of whether the Company’s performance could be attributed to the skill of the employees Defendants determined to so generously compensate.

The complaint does note that Goldman has been remarkably consistent in the amount paid in compensation over the years.  Id. at 19 ("From 1999-2008 that percentage [of monies used to pay employee compensation] has not varied from the range of 44-49% of the revenues."). 

As for 2009, the complaint contains an additional charge.  The Company's success "has not been the product of the skill and business acumen of the Company’s employees, but is attributable directly to the multi-trillion dollar infusion of capital by the American taxpayers to bail out the entire financial services industry."  

Whatever the merits of the case, they are, in the first instance, irrelevant.  The case will turn not on whether a fiduciary violation may have occurred but whether the plaintiffs have met the standard for demand excusal.  That in turn depends upon whether a majority of the board of directors are independent.  Plaintiffs allege that the board lacked a majority of independent directors because most of them sat on the compensation committee (the committee that approved "compensation decisions that were wholly divorced from the performance of the Company") and the audit committee (which "allowed or permitted the above failure to occur in the Company's internal controls"). 

Ordinarily, this case would be slated for dismissal.  Goldman is incorporated under Delaware law.  The Delaware courts do not generally permit a loss of independence solely because of membership on a committee.  See Wood v. Baum, 953 A.2d 136 (Del. 2008)("Plaintiff also asserts that membership on the Audit Committee is a sufficient basis to infer the requisite scienter.  That assertion is contrary to well-settled Delaware law.").  

The suit, however, was filed in New York.  Under the internal affairs doctrine, the courts must still apply Delaware law.  New York courts have sometimes evidenced a more liberal approach towards the definition of independent and, as a result, a New York court may be slower to dismiss the case at the demand excusal stage. 

The Complaint is posted on the DU Corporate Governance web site.

The review (and book) criticized the board for oversight lite and high pay.  Specifically, the piece noted that directors "attend 8 to 12 meetings annually" and "receive as much as $640,000 a year."  Of course, as we have pointed out, directors actually meet less often than that (although maybe during the financial crisis the number of meetings have been aberrationally higher) and can make well over $700,000. 

Surely, the number of meetings is not the sole measure of effectiveness.  Nonetheless, there is plenty of evidence that suggests boards exercise little meaningful oversight of the CEO's behavior.  As the piece noted:  

• The authors note that Rick Wagoner, the former General Motors chairman [and CEO], declared in 2008 that: “I get good support from the board. We say, ‘Here’s what we’re going to do and here’s the time frame,’ and they say, ‘Let us know how it comes out.’ ” (Memo to the board: your shareholders lost $52 billion in equity during Mr. Wagoner’s watch.)

The book called for "public directors" appointed by a nonprofit organization and the separation of chairman and CEO.  We have called for the latter and while the former raises any number of issues and questions, certainly providing shareholders with access to the company's proxy statement would facilitate the election of non-management directors. 

Even this, according to the authors of Money for Nothing, would not be enough.

• But no amount or manner of structural change can ensure that directors will step up and take responsibility for their fiduciary duties to shareholders, the authors assert. Boards overwhelmed by the power and glory of corporate chieftains tend to commit sins of omission, like not asking probing questions and not challenging management presentations of “fact,” rather than sins of commission like active participation in securities fraud.

This suggests extraordinary deference to the CEO.  Yet the deference comes from the legal standards.  Under Delaware law, directors are governed by the ostrich approach to information.  What they don't know in general can't result in liability.  As a result, they have an incentive not to ask, not to probe.  The way to change this ostrich approach?  Create legal standards that require questioning and probing, with liability on those who do not.  But as long as Delaware controls these standards, the ostrich approach will be the controlling standard.    

Much of the commentary is palaver, with a great deal of umbrage but no real solution.  One of the more interesting comments came from the Pay Czar, Ken Feinberg.  Feinberg has done a good job given the limitations of his authority.  Its possible, as we have noted on this Blog, that the role of the Pay Czar may ultimately prove harmful to the financial system.  The harm, though, is structural.  The Pay Czar could only control the compensation practices at a small number of companies and financial institutions, leaving the others to pay excessive compensation.

Over the weekend, Feinberg took note of this.  In the interview with Judy Woodruff, he decried his lack of authority.

• “The biggest disappointment, I think, is that under the statute my jurisdiction is so narrow, and so circumscribed, that I have no real direct mandatory power over other Wall Street or other national companies,” Feinberg said today in an interview with Bloomberg special contributor Judy Woodruff. 

In other words, the problem is systematic and requires a broader cure.  Yet Feinberg said exactly the opposite to Congress back in October.  In testifying before the House Committee on Oversight and Government Reform on October 28, 2009, he had this to day:

• Finally, I do not recommend that my responsibilities related to compensation determinations for senior executives, as currently defined by Treasury regulations, be expanded beyond the current seven companies receiving exceptional TARP financial assistance.

I criticized the comment when he made it, pointing out that this was not the time to view the compensation problem in narrow terms.

Only when the problem is viewed as industry wide willl a cure be possible.  While fixing the board of directors is one approach, the best is to federalize the regulation of executive compensation.  As noted in Returning Fairness to Executive Compensation, the excesses associated with executive compensation are best explained through the lack of meaningful standards imposed under state law.

The solution?  In Senator Dodd's bill on financial reform, he would allow bank regulators to adopt rules that prohibit excessive compensation.  As I have said elsewhere, there is nothing wrong with that. 

“In 2008, Federal Appeals Court Judge Richard Posner stated that, “executive pay is out of control and the marketplace cannot be trusted to rein it in. ” Legislative attempts to address executive compensation include the Excessive Pay Shareholder Approval Act, which mandates that no employee’s compensation may exceed 100 times the average compensation paid to all employees of a given company unless at least 60% of shareholders vote to approve such compensation.”

 The Nathan Cummings foundation does not believe the language is inaccurate.  Laura Shaffer, Director of Shareholder Activities confirmed via email on January 13 that:

“[the Foundation does] not consider the proposal to contain ‘factual errors,’only a quotation that was improperly attributed to Posner himself rather than a NY Times columnist who was summarizing one of Posner’s dissents.  We did not mischaracterize Posner’s views.  We view the challenge as an attempt by Goldman to divert attention from the substantive issues about compensation raised in the proposal.”

One has to wonder why Goldman needs to seek help from the SEC. Instead of asking permission to block the proposal, management might instead just agree to make the corrections – it would be a simple editing change or, Goldman management could just submit the proposal on its own behalf.

Goldman’s rejection of the Shareholder resolution and decision to seek SEC protection seems at odds with a recent, decidedly pro-shareholder move. Back in December, Goldman management made a surprising announcement. The firm voluntarily agreed to permit at the May 2010 annual meeting “an advisory vote on the firm’s compensation principles and the compensation of its named executive officers.”   Goldman was required to include a “say on pay” vote for the 2009 meeting because it was a TARP recipient. However, because Goldman paid back the TARP funds, this vote was not required. Somehow comfortable with giving the shareholders a “say on pay,” it is curious why Goldman management is not so keen on explaining executive pay in a broader social context.

With Goldman expected to announce record bonuses the financial institution has attempted to blunt the anticipated criticism by shifting bonuses from cash to stock and by considering requiring certain employees to make mandatory charitable contributions.  But whatever the steps, providing a straightforward explanation of the compensation practices will not be one of them.

"RESOLVED: shareholders request the Board’s Compensation Committee initiate a review of our company’s executive compensation policies and make available, upon request, a summary report of that review by October 1, 2010 (omitting confidential information and processed at a reasonable cost). We request that the report include –

1. A comparison of the total compensation package of senior executives and our employees’ median wage in the United States in July 2000, July 2004 & July 2009.

2. An analysis of changes in the relative size of the gap and an analysis and rationale justifying this trend.

3. An evaluation of whether our senior executive compensation packages (including, but not limited to, options, benefits, perks, loans and retirement agreements) are “excessive” and should be modified to be kept within reasonable boundaries.

4. An explanation of whether sizable layoffs or the level of pay of our lowest paid workers should result in an adjustment of senior executive pay to 'more reasonable and justifiable levels' and whether Goldman Sachs should monitor this comparison going forward."

The Shareholders asked that the resolution be mailed to shareholders in advance of the May 2010 annual meeting.  This would allow all Goldman shareholders to vote “by proxy” without the need to attend the annual meeting in person.  As a matter of law, publicly-held corporations, like Goldman, are required to include shareholder resolutions in these mailings and to allow shareholders to vote on them subject to a small list of exceptions.  According to a January 11th Reuters story, last Friday, January 8^th, Goldman informed the Nathan Cummings Foundation that it was seeking SEC permission to exclude the proposal from the proxy mailing. In requesting a “no action” letter from the SEC, Goldman is asking the government to promise not to take legal action against the firm for violating the federal securities laws in its refusal to put the resolution to vote. 

The article posited that Goldman was in a tough spot.  As the NYT noted:

• Goldman, like its peers, is caught between conflicting constituencies. The bank cut worker pay somewhat last year, and some employees may leave for hedge funds or private equity firms if they are not paid handsomely for their contributions to the firm’s profits. Some shareholders, however, want the bank to divert more of its money to them as dividends, though others think it should pay to keep workers happy.

It is likely that there are some financial institutions that would suffer a competitive disadvantage if unable to pay competitive salaries.  Some of the limits imposed by the Pay Czar on companies such as AIG and Citigroup may have caused some talent to go elsewhere. 

But having said that, its absurd to suggest that Goldman is in that position. 

First, the argument presupposes that the "underpaid" employees will be paid more at hedge funds and private equity firms.  In fact, hedge funds are likely to see a reduction in compensation.  Congress seems focused on taxing hedge fund compensation at ordinary income rather than capital gains rates.  So, working for a hedge fund is likely to become less lucrative soon.

Second, the argument defies practical logic.  Hedge funds are shutting their doors.  Are there really enough positions to absorb all of the "underpaid" officials at Goldman?  Moreover, with hedge funds capable of going under at a downturn in the economy, one has to wonder whether the "underpaid" employees at Goldman would give up the relative security of the most profitable financial institution for the relative insecurity of a hedge fund.

Third, and more to the point, even with some reduction in compensation, Goldman will still pay lavish amounts in comparison to others in the same industry.  In 2008, a tough year, Goldman paid 953 employees over $1 million.  Compensation in 2009 will be higher, with Goldman creating even more millionaires.  While this is only guesswork, it seems unlikely that had Goldman opted to pay amounts in 2009 comparable to those paid in 2008, there would have been a serious outpouring of talent.   

Finally, by taking the position that employees should donate some percentage of their compensation to charities, Goldman is all but admitting that it is paying more in compensation than it needs to retain key employees.  

Any argument that Goldman needs to pay the lavish amounts of compensation to keep its employees seems to an outsider looking in to be a very weak justification.