Nasdaq and the NYSE have similar rules with respect to director independence.  NYSE Rule 303A.01 requires that each listed company’s board of directors be comprised of a majority of independent directors.  A director does not qualify as “independent” if he or she has a “material relationship with the company.”  NYSE Rule 303A.02(a).  In addition, the director is not considered independent under NYSE Rule 303A.02(b)(ii) if the director received more than $120,000 in direct compensation, other than director’s fees, during any of the previous three years.  NYSE Rule 303A.06 imposes a higher independence standard for directors serving on the company’s audit committee by requiring them to comport with Rule 10A-3 (C.F.R. §240.10A-3).

 Independent directors are compensated for their service on the board.  The amount of compensation can be seen from examining the director compensation table from the Verizon Communications Inc. (NYSE: VZ) 2011 proxy statement.  According to the proxy statement, the company paid the directors the following amounts:

* Mr. O’Brien and Mr. Stafford retired from the board in May 2011.

** This amount reflects the 2011 installment of a charitable contribution made on Mr. Stafford’s behalf through the NYNEX Charitable Giving Program that is discussed below.

Director Compensation.  During the 2011 fiscal year, Verizon Communications held thirteen board of directors meetings, including seven scheduled meetings and six special meetings. Each director attended at least 75% of the aggregate number of meetings of the board of directors, with an average attendance of 97%. The cash retainer awarded to the directors began at a flat fee of $85,000. In addition, Committee Chairpersons were awarded fees from $15,000 to $25,000, based on position held. Meeting fees of $2,000 were awarded for attendance of each board meeting or committee meeting not occurring the day before or the day of a regularly scheduled board meeting. Directors elected before 1992 were invited to participate in one of several charitable giving programs. The programs were contingent on either retirement or death, and resulted in contributions by either Verizon, NYNEX, or GTE of installment-based amounts ranging from maximums of $500,000 to $1,000,000. The GTE and NYNEX programs were funded by life insurance policies taken out for each participant.

Director Tenure. In 2011, Mr. Neubauer, a member of the board of directors since 1995, held the longest tenure. Mr. O’Brien and Mr. Stafford retired from the board in May of 2011. Mr. Carrión has served as a director at Verizon since 1997 and was a director at NYNEX from 1995-1997. The Corporate Governance and Policy Committee recommended each of the incumbent directors for re-election. Several directors also sit on other boards. For example, Mr. Lane is a director of the General Electric Company and Northern Trust Corporation, and a supervisory board member at BMW AG. Dr. Moose has served as a director at Verizon since 2000 and at GTE from 1978-2000. She is Chairperson of the Board of Trustees of Natixis Advisor Funds and Loomis Sayles Funds, and a director of the AES Corporation.

CEO Compensation.  Ivan G. Seidenberg, Verizon’s former Chairman and Chief Executive Officer, earned $26,455,107 in total compensation prior to stepping down August 1, 2011. He did not formally resign and retire until December 31, 2011. Lowell C. McAdam, Verizon’s current Chairman and Chief Executive Officer, earned $23,120,499 in total compensation in 2011. Mr. McAdam and Mr. Seidenberg were compensated an aggregate total of $339,695 in personal use of company vehicles and aircraft. The board approved a special one-time equity award to Mr. McAdam of a $7,000,000 Performance Share Unit and a $3,000,000 Restricted Stock Unit, in connection with his succession of Mr. Seidenberg as CEO. Daniel S. Mead, Executive Vice President, received $5,660,641 in total compensation in 2011. Mr. Mead was awarded $17,295 in financial planning services and personal travel expenses related to his spouse’s attendance at a business event.

Nasdaq and the NYSE have similar rules with respect to director independence.  NYSE Rule 303A.01 requires that each listed company’s board of directors be comprised of a majority of independent directors.  A director does not qualify as “independent” if he or she has a “material relationship with the company.”  NYSE Rule 303A.02(a).  In addition, the director is not considered independent under NYSE Rule 303A.02(b)(ii) if the director received more than $120,000 in direct compensation, other than director’s fees, during any of the previous three years.  NYSE Rule 303A.06 imposes a higher independence standard for directors serving on the company’s audit committee by requiring them to comport with Rule 10A-3 (C.F.R. §240.10A-3).

 Independent directors are compensated for their service on the board.  The amount of compensation can be seen from examining the director compensation table from the Citigroup Inc. (NYSE: C) 2011 proxy statement.  According to the proxy statement, the company paid the directors the following amounts:

*Compensation amount reflects fees earned through resignation date.

Director Compensation.  During the 2011 fiscal year, Citigroup held 22 board of directors meetings. The Audit Committee held 12 meetings; the Personnel and Compensation Committees held 13 meetings; and the Nomination, Governance and Public Affairs Committees held 8 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. Mr. Joss was awarded $350,000 in other compensation for consulting services he provided to Citigroup. In 2011, the Compensation Committee’s usual review of benchmarking assessments determined that no change in director compensation was appropriate. Director compensation was last adjusted in 2005.

Director Tenure.  Dr. Rodin is the longest tenured director, having held her position as a member of the board of directors since 2004.  Mr. Parsons, the current Chairman of the Board, will not stand for re-election to the Board. Nor will Mr. Collins or Mr. Belda. Mr. Liveris and Mr. Grundhofer resigned from the Board on April 21 and June 23 of 2011, respectively. Several directors also sit on other boards. For example, Ms. Taylor is Managing Director for Wolfensohn Fund Management, L.P. and has served as a director for Allianz Global Investors and FNMA within the last five years. Dr. Rodin is President of the Rockefeller Foundation and President Emerita for the University of Pennsylvania. 

CEO Compensation.  Vikram Pandit, Citigroup’s Chief Executive Officer, earned $14,857,103 in 2011, after accepting $1 as total compensation in 2010. The Compensation Committee also awarded Mr. Pandit a three-part CEO Performance Retention Award, which included deferred stock, a profit-sharing plan, and a triple installment option grant. Mr. Pandit was given an Aircraft Time Sharing Agreement with Citiflight, Inc. for personal aircraft use. The agreement was premised on Mr. Pandit reimbursing Citigroup at an hourly rate for his use. John Havens, President and Chief Operating Officer of Citigroup, received $7,160,916 in total compensation in 2011, which reflected an increase from his compensation of $4,728,462 in 2010. Mr. Havens was also awarded an Executive Long-Term Performance Retention Award, including a profit-sharing plan and a triple installment option grant. On April 17, 2012, Citigroup’s shareholders voted to reject Citigroup’s executive compensation package for Mr. Pandit in accordance with the company’s say on pay provisions. More information on the implications of the vote can be found here.

Nasdaq and the NYSE have similar rules with respect to director independence.  NYSE Rule 303A.01 requires that each listed company’s board of directors be comprised of a majority of independent directors.  A director does not qualify as “independent” if he or she has a “material relationship with the company.”  NYSE Rule 303A.02(a).  In addition, the director is not considered independent under NYSE Rule 303A.02(b)(ii) if the director received more than $120,000 in direct compensation, other than director’s fees, during any of the previous three years.  NYSE Rule 303A.06 imposes a higher independence standard for directors serving on the company’s audit committee by requiring them to comport with Rule 10A-3 (C.F.R. §240.10A-3).

 Independent directors are compensated for their service on the board.  The amount of compensation can be seen from examining the director compensation table from the McKesson Corporation (NYSE: MCK) 2011 proxy statement.  According to the proxy statement, the company paid the directors the following amounts:

*These amounts represent credited dividend equivalents and matching gift payments made by the McKesson Foundation.

Director Compensation.  During the 2011 fiscal year, McKesson held eight board of directors meetings. Each director attended at least 75% of the aggregate number of board of directors and committee meetings. The cash retainers awarded to the directors began at a flat fee of $75,000. In addition, directors were awarded various fees based on positions held within the board and meetings attended. Directors were also invited to participate in the McKesson Foundation Matching Gifts Program, in which directors’ gifts to charitable organizations were eligible for a match of up to $5,000 by the foundation.

Director Tenure. In 2011, Mr. Irby III and Ms. Jacobs, who have been members of the board of directors since January of 1999, held the longest tenure. The Governance Committee for re-election recommended each of the existing directors with no new additions. Mr. Hammergren is President, Chairman, and Chief Executive Officer for McKesson, has been with the company since 1996, and has served as an inside director since 1999. Several directors also sit on other boards. For instance, Mr. Budd is Senior Counsel at Goodwin Procter L.L.P. and is Vice President, General Counsel, and a director of John Hancock Financial Services, Inc. He is a former Commissioner of the U.S. Sentencing Commission, former U.S. Attorney, and former Associate United States Attorney General. Mr. Bryant has been a director and Chief Administrative Officer at Intel since 2007. Ms. Jacobs is the Chairman, President, and Chief Executive Officer of Theragenics Corporation.

CEO Compensation.  Mr. Hammergren, McKesson’s Chief Executive Officer, President, and Chairman, earned $46,149,360 in 2011. This represented a 15.5% reduction from his 2010 compensation, primarily due to lowered annual and long-term cash incentives as well as reductions in the executive pension program resulting from stabilizing interest rates. Ninety-three percent of Mr. Hammergren’s compensation was variable, based on performance. The board of directors authorized Mr. Hammergren to use the corporate aircraft for both personal and business travel. He was also provided with security services, including reimbursement for installation and maintenance of undisclosed security equipment, as well as a car and driver.  Paul C. Julien, Executive Vice President and Group President, received $20,093,640 in total compensation in 2011. Mr. Hammergren authorized Mr. Julien’s personal use of the corporate aircraft. Mr. Julien was also provided with a car and driver. Total compensation of McKesson’s executive officers decreased by 10.6% from 2010 to 2011. The executive officers were also invited to participate in the McKesson Foundation Matching Gifts Program, as discussed above.

Plaintiff had sufficiently alleged that the severance agreement was not required.  The complaint, according to the court, also alleged that the board “could have avoided paying Hurd severance under the Company's general executive officer severance policy by terminating him for Cause.”  Nonetheless, this was not enough to allege waste.

Although the Board could have elected to pay Hurd nothing, determining whether it should have done so, or whether making the deal it did constitutes waste, involves a broader legal analysis. While "the discretion of directors in setting executive compensation is not unlimited," "[i]t is the essence of business judgment for a board to determine if 'a particular individual warrant[s] large amounts of money, whether in the form of current salary or severance provisions.'" The "outer limit" necessary to sustain a claim of waste is "executive compensation . . . so disproportionately large as to be unconscionable," but a finding of waste is inappropriate "[s]o long as there is some rational basis for directors to conclude that the amount and form of compensation is appropriate and likely to be beneficial to the corporation."

But, of course, Plaintiff alleged more than just the payment of compensation that was not required.  Plaintiff also challenged the justification for the severance.  Plaintiff argued that the heart of the consideration for the severance, the agreement by Hurd to give up any claims against the company, had no value. 

The court, however, bent over backwards to conclude that the release had some value.  It took resort to "creative counsel."  As the court reasoned: had Hurd been dismissed by the board, “[c]reative counsel advocating on Hurd's behalf could have claimed that he, in fact, was entitled to severance under HP's general executive officer severance plan notwithstanding the expense report violations.”  Thus, “even if the release was worth relatively little, Plaintiff overstates his case to say it was worthless.”  Moreover, the court added a justification for the compensation that was not apparently one actually used by the board.  Id.  (“even if the Board terminated Hurd for Cause, it arguably still could have compensated him for his past stewardship of HP.”).

Most extraordinary, however, was the court's willingness to accept consideration, not by Hurd, but by other directors.  Since two directors initially opposed the dismissal of Hurd, it was a "reasonable inference" from the facts to conclude that "the directors who initially dissented also would have opposed terminating Hurd for Cause and ultimately agreed to vote with the rest of the Board only because Hurd received the severance benefits he did." 

In other words, the court found (based upon its own fact finding) that the severance was reasonable because it was necessary to ensure a unanimous board decision.  Moreover, the court engaged in further fact finding and found that the failure to pay severance could have harmed the company because it "could have undermined its efforts to attract outside executive talent." 

The court's reasoning supports a conclusion that consideration by the person receiving the severance is entirely unnecessary.  The company can pay severance merely to avoid spooking future candidates for the CEO position or to ensure a harmonious board.  In any event the severance can be justified on the basis of past service. 

As for the amount paid to Hurd, the court more or less created a big company exception to the waste doctrine.  Without making any attempt to ascertain whether the amount paid (estimated at $40 million) was even remotely connected to the benefits received by the company (by, for example, determining the value of a harmonious board), the court simply concluded that big payments were acceptable for big companies. 

Having found that the Severance Agreement reflects at least some element of bilateral exchange and that there were rational bases for the Board to agree to it, Plaintiff's waste claim reduces to his belief that $40 million was just too much. Be that as it may, "the size of executive compensation for a large public company in the current environment often involves large numbers," and "amount alone is not the most salient aspect of director compensation" for purposes of a waste analysis.

The case shows the weakness in the doctrine of waste as a safety valve designed to provide an outer limit for compensation.  The court is willing to accept almost any argument concerning benefit to the company, including arguments not made by the board or benefits not provided by the person receiving the compensation.  At the same time, courts will not consider the relationship between the benefits, however modest or weak, and the amount paid.  

With waste not sufficient to restrain compensation, Delaware effectively has no limits on the amount of compensation that the board can pay (assuming proper process).  It is this problem of compensation without limits that has greatly encouraged federal intrusion into an area historically left to the states. 

We have been looking at the problem of executive compensation.  In that regard, we are discussing the most recent Delaware decision on the subject, Zucker v. Andreessen, 2012 Del. Ch. LEXIS 135 (Del. Ch. June 2012).  The case addresses the standard for waste under Delaware law.

According to the complaint, Hurd was dismissed by the board.  The same day the board approved a severance package.  The package provided Hurd with: 

over $12 million in cash; (2) an extension of the expiration date for any outstanding options to purchase 775,000 shares of HP common stock; (3) pro rata vesting and settlement of 330,177 performance-based restricted stock units; and (4) settlement on December 11, 2010 of 15,853 nonperformance-based restricted stock units at a price equal to the lesser of (a) the closing price of HP's common stock on August 6, 2010 or (b) the per share closing trading price of HP common stock on December 11, 2010.     

The benefits were not the product of any existing contractual obligation.  The Agreement provided that the benefits "exceed[ed] any payment and benefits to which you are otherwise entitled."  Indeed, the existing employment agreement with Hurd had expired.  More general benefits paid to departing officers were explicitly unavailable to those "involuntarily terminated without Cause." 

The severance was apparently provided in return for additional commitments by Hurd.  He agreed to extend certain already existing confidentiality provisions, not to disparage the Company, to cooperate with the Company in certain circumstances, and to release any claims he had against the Company. 

The Complaint asserted that the Company had not identified any claims held by Hurd and, that as a result, he “provided nothing of value to the Company in exchange for the compensation in excess of that which the Company was obligated to provide to him pursuant to his employment agreement, or otherwise.”  The compensation was, according to Plaintiff, a gift. 

In considering whether to dismiss the case for failure to make demand, the court applied the traditional standard from Aronson.   Because Plaintiff did not challenge the independence of the board, the only issue under Aronson was whether the severance agreement was a valid exercise of the board’s business judgment.  To show that it was not, Plaintiff asserted that the agreement amounted to waste.    

It was destined to be a high standard to meet.  Waste, according to the court, required a showing that the board’s action “was so egregious or irrational that it could not have been based on a valid assessment of the corporation's best interests."  A claim for waste would be defeated by a showing that the board received “any substantial consideration” and made in good faith.  This was true even if the transaction was “ill-advised."  In presaging the ultimate result, the court acknowledged that “[t]his is obviously an extreme test, very rarely satisfied by a shareholder plaintiff." 

This case arose out of the separation between Hewlett-Packard and Mark Hurd, the former CEO.  Hurd left HP under a cloud.  According to the Complaint, an internal investigation found "that Hurd filed inaccurate expense reports" and that this constituted "a breach of the Company's standards of business conduct."  The board, however, approved a severance package for Hurd estimated to be worth $40 million.  Plaintiff asserted that the severance arrangement violated the board's fiduciary obligations.

Hurd was dismissed by the board on August 6.  His compensation package was determined the same day.  Thus, he was either still a director at the time the compensation was determined or a non-director by a matter of minutes or hours.  Ordinarily when directors determine compensation for someone inside the board room, the operating standard is the duty of loyalty. 

In Delaware, however, the applicable standard has been changed to the duty of care.  Because this is a process standard, the duty of care does not consider substance only process.  Thus, in reviewing challenges to compensation, Delaware courts for the most part do not care about the amount or form of compensation only whether the process was adequate.  As long as the board was independent and informed, any amount of severance will be deemed to be consistent with the board's fiduciary obligations. 

Yet a purely process driven standard can lead to absurd results.  Delaware deals with this possibility through the doctrine of waste.  Even if the process is proper, compensation can still be so extreme that in amount that it constitutes waste.  In Zucker, Plaintiff had little choice but to argue that the $40 million in severance constituted waste.  

Waste in Delaware, however, is a theoretical limit.  As a practical matter, it is almost never used to reign in the amount of compensation, no matter how extreme.  This case illustrates that basic point as we shall show in the next few posts. 

There are many similarities between the rule governing audit committees (Rule 10a-3) and the rule governing compensation committees. See Rule 10C-1, 17 CFR 240.10C-1. Both require independent directors. Both allow the committee to hire consultants. The audit committee hires the auditor; the compensation committee the compensation consultant. Both give funding and oversight authority to the committee.

There are some differences. With respect to independent directors on the respective committees, Congress defined standards for the audit committee directors but specified only factors that had to be considered for directors on the compensation committee.

Nonetheless, as the dust settles, there are at least two additional differences in the structure of the two committees. First, with respect to funding, Rule 10A-3 specifies that the committee shall determine the compensation for the auditor, any advisers employed by the committee, and "[o]rdinary administrative expenses of the audit committee that are necessary or appropriate in carrying out its duties." In other words, the audit committee has the authority to determine its full budget.

This is not true with respect to the compensation committee. The compensation committee has the authority to determine only the appropriate funding "for payment of reasonable compensation to a compensation consultant, independent legal counsel or any other adviser retained by the compensation committee." There is nothing in the rule that allows the compensation committee to determine "ordinary administrative expenses." Thus, unlike the audit committee, the compensation commmittee lacks the the authority to determine its entire budge. The full board could, therefore, hobble the activities of the compensation committee by depriving it of administrative and other support, something not possible with respect to the audit committee.

There is at least one other significant difference. Under the rules of the exchanges, listed companies must have an audit committee. Thus, the auditor will always be selected by a committee of independent directors.

In contrast, not all of the exchanges require a compensation committee. Nor does Rule 10C-1. As a result, there is no guarantee that a group of independent directors will consider and hire an independent compensation consultant.

Rule 10C-1 applies to companies traded on an exchange.  Rule 10C-1 does not, by its terms, apply to other public companies (those registered under Section 12(g) of the Exchange Act and traded on the OTC Bulletin Board or in the Pink Sheets).  Thus, the factors that must be considered when retaining a compensation consultant are only explicitly applicable to exchange traded companies. 

Yet this is not quite the case.  In adopting the rule, the Commission imposed additional disclosure obligations on non-exchange traded companies with respect to the independence of the compensation consultant.  As the Commission noted: 

issuers subject to our proxy rules will be required to disclose, with respect to any compensation consultant that is identified pursuant to Item 407(e)(3)(iii) as having played a role in determining or recommending the amount or form of executive and director compensation, whether the work of the compensation consultant has raised any conflict of interest and, if so, the nature of the conflict and how the conflict is being addressed.

The disclosure is limited.  Only actual conflicts must be revealed.  The rule does not "require disclosure of potential conflicts of interest or an appearance of a conflict of interest, nor will it require disclosure with respect to compensation advisers other than compensation consultants."  Exchange Act Release No. 67220 (June 20, 2012).

The information is considered important to investors.  As the Commission reasoned, "investors are better served by requiring all issuers subject to our proxy rules to provide timely disclosure of compensation consultants’ conflicts of interests".  Id.  Specifically the information would allow investors to "adequately monitor compensation committee performance" and "to help investors make better informed voting decisions with respect to the election of directors, including members of the compensation committee."  Id. 

Whatever the benefit to shareholders, the effect was more substantive.  The SEC has sometimes used disclosure requirements to alter the substantive behavior of the board of directors.  This requirement has that affect.  See Essay: Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure.  To meet this disclosure requirement, boards of non-listed traded companies will need to consider the same factors imposed on listed companies in Rule 10C-1.  See Exchange Act Release No. 67220 (June 2012) (instruction to Item 407 requires that the "factors listed in §240.10C-1(b)(4)(i) through (vi) . . . are among the factors that should be considered in determining whether a conflict of interest exists.").

Thus, compensation committees of companies listed on the exchanges and traded on the OTC Bulletin Board or in the Pink Sheets must consider the factors set out in Rule 10C-1.  Rule 10C-1 affects all public companies, not just those traded on an exchange.    

The release contains one very unfortunate sentence that goes beyond the statutory mandate of the Commission and may not reflect accurate analysis.   

Rule 10C-1 (under the framework provided by Congress in Dodd-Frank) provided that compensation committees hiring a consultant (particularly a compensation consultant) needed to "consider" certain specified factors in determining the independence of the consultant.  Once considered, however, the committee was left with the discretion to select a compensation consultant even if it did not meet the definition of independent.  In other words, the SEC defined the factors and the board decided their weight and their consequences. 

Yet the adopting release did not leave the analysis entirely to the board.  The release specified that the factors contained in Rule 10C-1 "should be considered in their totality and that no one factor should be viewed as a determinative factor of independence."  This "guidance" has a number of problems. 

First, the "guidance" intrudes into the role of the board of directors.  Rule 10C-1 requires that the compensation committee consider six factors.  It does not, however, specify the relative weight to be given each factor.  The SEC, however, had done so by specifying that no single factor was determinative. 

Second, the "guidance" is not necessarily correct.  The quote in the adopting release suggests that no single factor will control the analysis of independence.  Yet in fact a single factor can easily be determinative.  For example, the factors require consideration of any business and personal relationships between the compensation consultant and executive officers.  To the extent that the compensation consultant has a material personal or business relationship with the CEO, the consultant will almost certainly not be independent, irrespective of the other factors.  In other words, the application of a single factor can result in the loss of independence by a consultant.

This quote will come back and haunt the Commission.  Those under investigation for inadequate disclosure of the independence of compensation consultants will cite the sentence as evidence that a single factor does not demonstrate a lack of independence. 

The new requirement is tentative and not likely to have much impact on the determination of executive compensation.  Most of the tentativeness comes from the statute itself.  While Congress required consideration of certain factors in selecting a compensation consultant, it stopped short of imposing a requirement that the compensation consultant actually be independent. 

Nonetheless, the statute does push the compensation committee toward the retention of an independent compensation consultant.  Even if one is hired, however, the statute specifically provides that the committee can disregard any advice or recommendations by the consultant.  Said another way, the presence of the compensation consultant does not "affect the ability or obligation of a compensation committee to exercise its own judgment in fulfillment of the duties of the compensation committee." 

In at least one case, the SEC strengthened the requirements of the statute.  In adopting Rule 10C-1, the Commission went beyond the express language of Section 952 of Dodd Frank and added to the factors that must be considered when hiring a compensation consultant.  Specifically, the rule requires consideration of any personal or business relationship between the compensation consultant and the executive officers and members on the compensation committee.  This will ensure greater independence between the consultant and the company.  

The rule, however, did not go far enough in at least one instance.  The rule did not mandate the use of a compensation committee. See Exchange Act Release No. 67220 (June 20, 2012) ("The final rule will not require a listed issuer to have a compensation committee or a committee that performs functions typically assigned to a compensation committee.").  Nor do all of the exchanges mandate the use of a compensation committee.  Id.  ("Some exchange listing standards currently require issuers to form compensation or equivalent committees, and others permit independent directors to oversee specified compensation matters in lieu of the formation of a compensation or equivalent committee."). 

Where the company does not use a compensation committee but instead relies on the independent directors of the board to determine compensation, portions of the rule are nonetheless applicable.  These directors must, for example, consider the factors set out in Rule 10C-1 when hiring a consultant.  See Exchange Act Release No. 67220 (June 20, 2012) (independent directors are subject to "requirements relating to director independence, consideration of the independence of compensation advisers and responsibility for the appointment, compensation and oversight of compensation advisers to these directors").  As a result, the release concluded that "there will be little difference between the requirements applicable to listed issuers that do not have compensation committees as compared to those applicable to issuers that do have compensation committees."

In fact, however, the provision does not give the independent directors as a group the right to, "in its sole discretion, retain or obtain the advice of a compensation consultant, independent legal counsel or other adviser."  The authority was apparently viewed as unnecessary since the boards of exchange traded companies must have a majority of independent directors.  As a result, independent directors already have the "legal" ability to appoint an independent compensation consultant.  As the Commission reasoned:   

we understand that action by independent directors acting outside of a formal committee structure would generally be considered action by the full board of directors. As a result, we believe it is unnecessary to apply these requirements to directors acting outside of a formal committee structure, as they retain all the powers of the board of directors in making executive compensation determinations.

Yet the practical effect of the provision is to deny independent directors the ability to appoint an independent compensation consultant, at least where the CEO objects.   By permitting the decision to be made at a meeting of the full board, one where the CEO and other non-independent directors will be in attendance, independent directors will be less likely to take actions that are opposed by the CEO.  For a discussion of this dynamic, see Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty. 

Rule 10C-1, therefore, provides an incentive on the part of companies to avoid the creation of a compensation committee.  In the absence of such a committee, the CEO may have a greater say in the decision to hire an independent compensation consultant. 

Of course, those boards that do not use a compensation committee will have to apply the requirements for director independence contained in Rule 10C-1 to all of independent directors, not just those who would otherwise sit on the compensation committee.  Yet applying these standards to all independent directors has advantages.  With three separate definitions for director independence (audit committee, compensation committee, other independent directors), the application of a single strict standard will minimize the number of categories, facilitate the director selection process and allow all independent directors to serve on all board committees. 

As noted in prior posts, state law is the appropriate place to fix the problem of executive compensation.  Yet the existing dynamics, particularly the race to the bottom, make this highly unlikely.  As a result, reform has shifted to the federal level.

Congress has increasingly intervened into the executive compensation process.  In doing so, it has needed to find a place in the federal regulatory scheme for oversight of compensation issues.  That authority has been given to the Securities and Exchange Commission.  The SEC administers say on pay.  The SEC writes the disclosure requirements for executive compensation.  See Item 402 of Regulation S-K.  Most recently, the SEC adopted rules designed to implement Section 952 of Dodd-Frank regarding compensation committees.

These requirements are contained in Rule 10C-1.  17 CFR 240.10C-1.  See also Exchange Act Release No. 67220 (June 20, 2012) (adopting release).  Much like the counterpart in SOX with respect to audit committees, Rule 10C-1 regulates compensation committees through the use of listing standards.  The provision continues the trend toward the imposition of stricter governance requirements not on all public companies but on those traded on an exchange. 

Much of the rule relates to the appointment by the committee of consultants, particularly compensation consultants.  Rule 10C-1 gives to the compensation committee the authority to retain these consultants, determine their compensation, and oversee their work.  The committee also gets to set a portion of its own funding. 

In hiring the compensation consultant, the rule commands that the committee consider certain factors.  Consideration is mandatory although there is no requirement that the consultant actually be independent.  See Exchange Act Release No. 67220 ("The statute does not require a compensation adviser to be independent, only that the compensation committee of a listed issuer consider the enumerated independence factors before selecting a compensation adviser.").

The factors that must be considered include: 

• The provision of other services to the issuer by the firm that employs the consultant; 
• The amount of fees received from the issuer by the firm that employs the consultant as a percentage of the total revenue of the firm that employs the consultant;
• The policies and procedures of the firm that employs the consultant that are designed to prevent conflicts of interest;
• Any business or personal relationship of the consultant with a member of the compensation committee;
• Any stock of the issuer owned by the consultant; and
• Any business or personal relationship of the compensation consultant, legal counsel, other adviser or the firm employing the adviser with an executive officer of the issuer.

The determination of the relationship between the consultant and the members of the compensation committee must be done by the compensation committee.

With respect to the personal and business relationship, this requires consideration of "situations where the chief executive officer of an issuer and the compensation adviser have a familial relationship or where the chief executive officer and the compensation adviser (or the adviser’s employer) are business partners." 

As for the stock ownership factor, the compensation committee must take into account the shares owned by the consultant including the "shares owned by the individuals providing services to the compensation committee and their immediate family members."  It does not require "consideration of stock owned by" the firm employing the compensation adviser. 

The new rule raises some interesting issues, all of which will be discussed in the next posts. 

No issue has been more discussed or has better captured the public imagination than the issue of executive compensation.  Among large public companies, top officers, particularly the CEO, are well paid.  In some cases, the amount of pay croses an invisible line that separates the well paid from the excessively paid.  In other cases, the pay is structured in a manner that makes the company seem like a piggy bank for the CEO. 

Compensation issues raise questions about the role of the board of directors. For public companies traded on a stock exchange, there must be at least a majority of independent directors.  In fact, the largest public companies typically have a super majority of independent directors.  Yet this structure has been unable to stop a steady increase in the amount of compensation, the payment of unnecessary perqs, and, until say on pay, a not uncommon disconnect between pay and performance.  Nor has the structure stopped an escalation in director compensation.

This is one of those areas where the problem is clear, the source obvious, and the solution straightforward.  State law determines the obligations of the board, including those connected to the approval of executive compensation.  State courts, particularly those in Delaware, have adopted standards that impose no meaningful limits on executive compensation.  This phenomena is discussed at length in Returning Fairness to Executive Compensation. 

The solution?  Toughen fiduciary standards a bit.  This straightforward approach would cut off abuses on the margin, particularly the ones that inflame the public.  The reform would leave compensation entirely a matter of state law.  Moreover, compensation would be determined by each specific board based on the company's unique facts and circumstances.  Toughening fiduciary obligations could be done through legislation or could be done by the courts deciding to give compensation decisions, in the words of VC Laster, some form of "enhanced scrutiny." 

But this won't happen.  The dynamics at state law -- the race to the bottom -- are such that any state toughening fiduciary responsibilities, particularly those that regulate executive compensation, will suffer the consequences.  Other states will leave in place the looser standards in the hopes of attracting corporations to the state (and the revenue flow that comes with it).  No state, particularly Delaware, will take that risk.

So, we know the problem, we know the source of the problem, and we know the appropriate solution.  Yet in the complicated system of corporate governance, one that divides responsibilities among multiple regulators (states, stock exchanges, the SEC), each with differing philosophical approaches to governance, the optimal solution is out of reach.  The division of regulation for corporate governance is discussed in Corporate Governance, a textbook published by Lexis-Nexis. 

As a result, the area is left only with suboptimal solutions.  Moreover, they are more complicated and less effective than toughen fiduciary obligations.  As a result, the problem of executive compensation continues and, as Britain shows, the solutions get more extreme.

The next seven or so posts will look at developments in the area of executive compensation and the progress of the current spate of "solutions."  Specifically, we will look at the problem under Delaware law, some of the reforms implemented by Congress, the role of the SEC, including a review of Rule 10C-1, the recent enactment imposing obligations on compensation committees used by boards of listed companies, and some international responses, particularly developments in Britain. 

Nasdaq and the NYSE have similar rules with respect to director independence.  NYSE Rule 303A.01 requires that each listed company’s board of directors be comprised of a majority of independent directors.  A director does not qualify as “independent” if he or she has a “material relationship with the company.”  NYSE Rule 303A.02(a).  In addition, the director is not considered independent under NYSE Rule 303A.02(b)(ii) if the director received more than $120,000 in direct compensation, other than director’s fees, during any of the previous three years.  NYSE Rule 303A.06 imposes a higher independence standard for directors serving on the company’s audit committee by requiring them to comport with Rule 10A-3 (C.F.R. §240.10A-3).

Independent directors are compensated for their service on the board. The amount of compensation can be seen from examining the director compensation table from the Hewlett-Packard (NYSE: HPQ) 2011 proxy statement. According to the proxy statement, the company paid the directors the following amount:

*Compensation amount reflects fees earned though retirement date.

Director Compensation:  As of the date of the proxy statement, HP had fourteen directors, five standing committees, and held eighteen meetings, including eight executive sessions. All directors attended at least 75% of the meetings except for Ms. Senequier. Mr. Lane received a particularly large amount of compensation compared to the other board members. He was designated Chairman of the Board on September 20, 2011 and received an option for 1,000,000 shares of HP common stock in connection with the designation. All other compensation represents, what HP calls, product donations to the directors. HP's stock ownership guidelines required non-employee directors to accumulate shares of HP common stock equal in value to at least five times the amount of their annual cash retainer, within five years of election to the board. Currently, all directors who have served five years or more have met the requirement.

Director Tenure: Mr. Banerji, Mr. Reiner, Ms. Russo, Ms. Senequier, and Ms. Whitman  are the newest directors and were  elected to the board effective January 21, 2011. Mr. Babbio, Jr., Ms. Baldauf, and Ms. Senequier are not nominees for re-election for the 2012 year. Ms. Senequier served only one year, while Mr. Babbio Jr. held the longest tenure of ten years. Several directors also hold board positions in other companies. For instance, Mr. Andreessen sits on the board of eBay, while Mr. Gupta is a director of Delphi Automotive PLC; Tyco International Ltd.; The Vanguard Group; and several private companies.

Executive Compensation: On September 22, 2011, the board elected Ms. Whitman to serve as the President and Chief Executive Officer of HP, effective immediately. At that time, she continued to serve as a member of the board but ceased to receive separate compensation for her services as a director. Ms. Whitman received only $1 as her salary but earned a total compensation of $16,518,930 in 2011, $16,146,331 of option awards and $372,598 of all other compensation. From 1998 to March 2008, she served as the President and Chief Executive Officer of eBay, and prior to that, she held executive level positions at companies such as Hasbro Inc., The Walt Disney Company, and others. The next highest paid executive is Ms. Lesjak, the Executive Vice President and Chief Financial Officer, who received a total compensation of $11,005,978 in 2011. This reflected a $2,909,010 increase from 2010; however, Ms. Lesjak’s total compensation was lower in 2010 than in 2009. Leo Apotheker, former President and Chief Executive Officer of HP, was terminated and then resigned as a member of the board in September of 2011. He received the highest total compensation of all executives in 2011 of $30,412,776.

Nasdaq and the NYSE have similar rules with respect to director independence.  NYSE Rule 303A.01 requires that each listed company’s board of directors be comprised of a majority of independent directors.  A director does not qualify as “independent” if he or she has a “material relationship with the company.”  NYSE Rule 303A.02(a).  In addition, the director is not considered independent under NYSE Rule 303A.02(b)(ii) if the director received more than $120,000 in direct compensation, other than director’s fees, during any of the previous three years.  NYSE Rule 303A.06 imposes a higher independence standard for directors serving on the company’s audit committee by requiring them to comport with Rule 10A-3 (C.F.R. §240.10A-3).

Independent directors are compensated for their service on the board.  The amount of compensation can be seen from examining the director compensation table from the JPMorgan Chase & Co. (NYSE: JPM) 2011 proxy statement. According to the proxy statement, the company paid the directors the following amounts: 

*Mr. Bell joined the board in November 2011.

Director Compensation: In the 2011 fiscal year, the board met eleven times and each director attended at least 75% of the meetings. The total compensation for each director was allocated into about one-third cash and two-thirds stock. Each non-management director received an annual retainer of $75,000 a year and an annual grant of deferred stock units valued at $170,000. On an annual basis, each director has the right to defer his or her cash compensation into a number of investment equivalents, such as, deferred stock units. The company will distribute the deferred compensation to the directors in January of the year following their retirement in either a lump sum or annual payments.

Director Tenure: Having joined the board in November 2011, Mr. Bell is the newest director. Mr. Gray has the longest tenure of any director; he has served on the board of JP Morgan Chase or its predecessor institution (JPMorgan Chase merged with Bank One in 2004) since 1992. Several directors also sit on other boards. Mr. Crown is a director of General Dynamics Corporation and of Sara Lee Corporation, and Mr. Gray is a director of Dell Computer Corporation; Pfizer Inc.; and Prudential Financial, Inc.

Executive Compensation: James Dimon has served as President and Chief Executive Officer since 2005, received a salary of $1,416,667 in 2011, and received total compensation in the amount of $23,105,415. In 2011, his salary was $416,667 more than in the previous two years. Before becoming CEO, Mr. Dimon served as the President and Chief Operating Officer at JPMorgan Chase since the company’s merger with Bank One Corporation in July 2004. He was appointed to the board in 2005.  Prior to the merger, he held the position of President and Chief Executive Officer at Bank One since 2000.  The other executives received a total compensation ranging from $13,037,825 to $17,625,312. 

Nasdaq and the NYSE have similar rules with respect to director independence.  NYSE Rule 303A.01 requires that each listed company’s board of directors be comprised of a majority of independent directors.  A director does not qualify as “independent” if he or she has a “material relationship with the company.”  NYSE Rule 303A.02(a).  In addition, the director is not considered independent under NYSE Rule 303A.02(b)(ii) if the director received more than $120,000 in direct compensation, other than director’s fees, during any of the previous three years.  NYSE Rule 303A.06 imposes a higher independence standard for directors serving on the company’s audit committee by requiring them to comport with Rule 10A-3 (C.F.R. §240.10A-3). 

Independent directors are compensated for their service on the board.  The amount of compensation can be seen from examining the director compensation table from the Ford Motor Company (NYSE: F) 2011 proxy statement.  According to the proxy statement, the company paid the directors the following amounts:

*This table excludes Jon M. Huntsman, Jr. because he joined the board in February 2012.

Director Compensation.  The board of directors met nine times during the 2011 fiscal year and held thirty-four board committee 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.  The board approved a $50,000 increase in the annual retainer fee for each member, bringing the total to $250,000.  This increase in compensation reflects the finding that Ford was below average for director pay.  Ford required directors to defer 60% of their retainers into common stock units each year.  In addition, each director received $200,000 in life insurance and had access to two company vehicles, reflected above in the “All Other Compensation” column.

Director Tenure.  Mr. Hockaday, Jr. holds the longest tenure, having served on the board since 1987.  Mr. Huntsman, the board’s newest member, joined in February 2012.  Most directors serve on at least one other public company’s board.  For instance, Mr. Thornton sits on the boards of News Corporation; China Unicom Limited; HSBC Holdings, plc; and Barrick Gold Corporation.  Mr. Hance, Jr. is on the boards of Sprint Nextel Corp.; Cousins Properties Inc.; Morgan Stanley Corp.; and Duke Energy Corp.  Mr. Gephardt also sits on the boards of Centene Corporation; CenturyLink; Spirit Aerosystems Holding, Inc.; and United States Steel Corporation.  In addition to their public company directorships, most members of the board are also involved in private organizations.   

CEO Compensation.  Alan Mulally has served as the Chief Executive Officer of Ford since September 1, 2006.  Mr. Mulally received total compensation of $29,497,572 in 2011, including a base salary of $2,000,000 and stock awards of $13,924,993.  Prior to working at Ford, Mr. Mulally was the Executive Vice President of the Boeing Company and Chief Executive Officer of Boeing Commercial Airplanes.  William Clay Ford, Jr. is the Executive Chairman and earned $14,458,146 in 2011.  Both Mr. Mulally and Mr. Ford were required to fly private aircraft for business and personal travel, and they each were given access to company phones, car and driver services, and tickets to athletic events.  Their families could join them on the private flights, or Ford would pay for their commercial travel.  In addition, Mr. Mulally received $89,277 for housing and living expenses in 2011.  The housing compensation is to continue indefinitely.