One of the most important determinants of a successful corporate strategy is the quality of the compensation committee. The committee is charged with designing and implementing a compensation system that effectively rewards key players and encourages direct participation in the achievement of the organization's core business objectives.
Outstanding, well-integrated compensation strategy does not just happen. Rather, it is the product of the hard work of independent, experienced compensation committee members. The most effective pay strategies are simple in design, straightforward in application, and easy to communicate to management and investors. The pay program for the chief executive officer (CEO) should be in line with pay programs for the company's other executives and with its broad-based incentive programs. In other words, there should be no conflict in the achievement of objectives, and the potential rewards should be as meaningful to all participants as to the CEO.
The United States is unique in its vast number of high-earning entrepreneurs, entertainers, athletes, lawyers, consultants, Wall Street traders, bankers, analysts, investment managers, and other professionals. Yet, it is the pay levels of corporate executives, in particular CEOs, that stir the most heated debate and controversy. It is estimated that the bull market of the 1990s created over 10 million new millionaires whose wealth was derived almost solely from stock options. During this period, many CEOs made hundreds of millions in option gains and other compensationâoften making as much as 400 times the earnings of the average workers in their companies. Beginning in late 2001, the business world changed dramatically. Now, with the public's and investorsâ direct focus on corporate governance and compensation philosophy, and recent changes in accounting rules affecting equity-based compensation, CEOs and other executives should not expect to sustain historic rates of wealth accumulation, absent substantial performance that is no longer linked solely to the price of the company's stock.
While the proxy statement compensation tables provide historical information and raw data about the company's compensation of its top executive officers, the new Compensation Discussion and Analysis (CD&A) provides a window into the company's compensation philosophy and a means for investors to assess whether and how closely pay is related to performance. A thoughtfully prepared CD&A is good evidence of a well-functioning compensation committee that takes its work seriously.
Among the topics covered in this chapter are:
- Board and board committee structure
- Independence measures
- Compensation committee size
- Compensation committee charter
- Role of the compensation committee and its chair
- Duties and responsibilities
- Precepts for responsible performance
- Compensation benchmarking
- The importance of meeting minutes
Board Structure: The Focus on Independence
Much of the recent public scrutiny of corporate governance issues has focused on structural issues as they relate to corporate boardsâquestions related to independence from management; separation of the chair and CEO positions; issues related to the composition and function of board committees; and renewed efforts to create a framework in which outside directors can obtain impartial advice and analysis, free of undue influence from corporate management.
While it has always been desirable to have a healthy complement of outside directors on the board, corporate governance rules adopted by the New York Stock Exchange (NYSE) and the NASDAQ Stock Market (NASDAQ) in 2003 require that a majority of a listed company's board consist of independent directors and, with limited exceptions, that such board appoint fully independent compensation, audit, and nominating/corporate governance committees. The NYSE and NASDAQ rules also prescribe standards for determining the independence of individual directors, which, when layered over the director independence standards under Section 162(m) of the Internal Revenue IRC (IRC) and Rule 16b-3 of the Securities Exchange Act of 1934 (Exchange Act), make the nomination and selection of compensation committee members a challenging exercise.
Compensation Committee Composition and Multiple Independence Requirements
When selecting directors to serve on the compensation committee of a public company, the nominating committee should choose only those persons who meet all the relevant independence requirements that will permit the committee to fulfill its intended function. For example, a compensation committee member must be an âindependent director,â as defined under NYSE or NASDAQ rules, where applicable. In addition, a public company is well served to have a compensation committee consisting solely of two or more directors who meet (1) the definitional requirements of âoutside directorâ under IRC Section 162(m), and (2) the definitional requirements of ânon-employee directorâ under Rule 16b-3 of the Exchange Act. This often leads to a lowest-common-denominator approach of identifying director candidates who satisfy the requirements of all three definitions. Unfortunately, the three tests are not identical, and it is indeed possible to have a director who meets one or more independence tests but not another.
NYSE/NASDAQ Independence Tests
Under the 2003 NYSE listing rules, an independent director is defined as a director who has no material relationship with the company. NASDAQ defines independence as the absence of any relationship that would interfere with the exercise of independent judgment in carrying out the director's responsibilities. In both cases, the board has a responsibility to make an affirmative determination that no such relationships exist. The rules list specific conditions or relationships that will render a director nonindependent. These are summarized in Exhibit 5.1 in Chapter 5.
As of January 2013, NYSE and NASDAQ listing standards require two new factors for determining eligibility to serve on the co...
