ABA Section of Business Law
ABA Section of Business Law
Business Law Today
July/August 1998
Straight are the gates
How to structure an independent compensation committee
By DENNIS B. DRAPKIN and LOUIS RORIMER
Drapkin and Rorimer are partners at Jones, Day, Reavis & Pogue in Dallas and Cleveland, respectively. Richard H. Koppes, who is of counsel in the firm's Los Angeles office and formerly the general counsel of CalPERS, provided the perspectives on shareholder guidelines.
How should a company go about compensating deserving executives? Very carefully, starting with the right board committee.
Shareholders have made it a priority for public companies to have independent compensation committees. Maintaining a disinterested decision-making body within the board of directors is also a predicate for favorable regulatory treatment of many awards under executive compensation plans. Specifically, approval by a committee of "nonemployee directors" can exempt awards of stock options and other equity-based incentives from the short-swing profit liability provisions of Section 16 of the Securities Exchange Act of 1934. Similarly, approval by "outside directors" is a necessary requirement for exclusion of performance-based compensation from the $1 million cap under Section 162(m) of the Internal Revenue Code.
This combination of shareholder and regulatory forces has made an independent compensation committee practically a minimum requirement for corporate governance today. Structuring an independent committee, however, can be difficult. Securities laws, tax laws and stock exchange requirements all contain their own independence standards. These standards operate completely separately; compliance with one gives no assurance of compliance with any of the others. A number of common circumstances signal potential problems in meeting these standards:
- A committee member is associated with another business entity that supplies products or services to the company, or buys products or services from the company.
- An investment banker, lawyer or consultant to the company serves on the committee.
- A representative of a controlling shareholder serves on the committee.
- A committee member leases real estate to the company.
The development of independence standards parallels the growth of common stock as a medium for compensating executives and directors and provides the backdrop for the current requirements.
During the 1970s and ‘80s, rising equity markets and the dawning insistence of shareholders on "pay for performance" raised the profile of stock-based executive compensation. During this period, the SEC relied on Rule 16b-3 to regulate corporate behavior in this area. The rule provides an exemption for many common transactions under employee stock plans from short-swing profit liability under Section 16. The rule included requirements for "disinterested administration" of awards. If an award was not made by a disinterested body, it could count as a "purchase" under Section 16 and could result in loss of the entire profit as a result of matching of the award with any sale of company stock within six months.
The rule defined a disinterested administrator as a director who could not individually receive stock-based awards under any plan of the issuer. This approach worked reasonably well as long as companies did not routinely compensate directors with stock. During the 1980s, the SEC gradually relaxed these restrictions through no-action letters to permit automatic annual grants of stock under "formula plans." Increasingly complex and diverse formulas obliged the SEC staff to respond to myriad inquiries from companies that needed to keep their plan administrators "disinterested" for purposes of Rule 16b-3, but wanted more flexibility in compensating their directors with stock.
By 1994, the disinterested administration requirement was ripe for reform. The final version of Rule 16b-3 swept away the concept of disinterested administration. Effective for most companies on Nov. 1, 1996, directors were at liberty for the first time to authorize stock-based awards of any kind for themselves without jeopardizing their ability to make exempt awards to management under other company stock plans.
Unfortunately, the final version of Rule 16b-3 included one unpleasant surprise. The only kind of committee that could approve awards on an exempt basis was one composed solely of two or more "nonemployee directors," and this term was defined in a very restrictive manner.
The current Rule 16b-3 defines a nonemployee director as a director who can satisfy four tests for independence. First, the director cannot currently be an officer or otherwise employed by the issuer, or a parent or subsidiary of the issuer. This requirement is straightforward. Former officers and employees qualify under the rule (although they do not necessarily qualify as outside directors for purposes of Section 162(m)). The principal problem arising in practice is that the "parent" provision disqualifies any employee of a controlling shareholder who may serve on the board and who may in fact provide the best voice of independence (and may well be qualified for Section 162(m) purposes). The second test limits the services of qualifying directors to services that would not require disclosure in the company's proxy statement, thereby limiting consulting services to less than $60,000 since the beginning of the last fiscal year. Various issues can arise in applying this $60,000 exception. It is not entirely clear, for instance, that multiple, separate consulting assignments must be aggregated. Since failure of a director to qualify can result in loss of the intended exemption, it is usually necessary to take a cautious approach.
The third and fourth tests are the ones that most frequently raise concerns. Through cross-references to the disclosure requirements of Item 404 of Regulation S-K, they disqualify individuals who have engaged in certain transactions or relationships with the company. Item 404(a) deals with "transactions" that a director may have entered into with the company. Item 404(b) covers "relationships" and includes supplier, customer, investment banking and legal relationships. In view of the variety of these relationships, the disclosure requirements can be difficult to apply. One set of circumstances can fail under either (a) or (b) or both. Item 404 includes instructions designed to integrate these requirements, as well as the requirements of Item 402 (governing disclosure of compensation), but the overlapping rules make interpretation difficult.
In view of these uncertainties, many companies have historically elected to make full disclosure in any borderline situation, since disclosure did not result in any direct cost. Now, since the cost will be disqualification from service on the compensation committee, more decisiveness will be required. Several recurring interpretive issues are worth noting specifically.
Disqualification of service providers
It has long been common for investment bankers and lawyers who have close ties to a company to serve on its board of directors. Item 404(b) requires disclosure of the existence of these relationships and, further, calls for disclosure of dollar amounts and other particulars if certain thresholds are exceeded. Surprisingly, these individuals are disqualified under Rule 16b-3 even if the thresholds are not met. (The same individuals may well be disqualified as outside directors for purposes of Section 162(m).)
Attribution through family relationships
Item 404(a), if read literally, would disqualify a director in certain circumstances even if the disqualifying circumstances were merely deemed to be attributable to the director through a family relationship. The SEC staff has indicated, however, that the director will not be disqualified under Rule 16b-3, even though disclosure may be required, if the director does not have an actual direct or indirect material interest in the transaction. (Interestingly, such family relationships are largely irrelevant for purposes of Section 162(m).)
Double jeopardy for less-than-5-percent relationships
Owing to the overlaps between Items 404(a) and (b) noted above, it is possible for an individual director to have a minor relationship with the company that escapes (b) but would appear to be caught under (a). For example, if the director is CEO of a business that sells raw material to the company, but the sales amount to less than 5 percent of the sales of his business, it is clear that the transactions are excluded under Item 404(b). Nevertheless, since the sales may exceed the $60,000 de minimis threshold in Item 404(a), they might appear to trigger that section. The SEC staff has again provided some relief through a no-action letter. The staff qualified its view, however, by precluding relief if the individual director "derives special benefits" from the relationship.
Beginning and ending of disqualification
Another set of interpretive issues arises from the unfolding of relationships and transactions over time. When does disqualification begin and when does it end? These questions are important because they determine whether a particular committee action, such as an annual award of stock options, will be entitled to an exemption under Rule 16b-3. The SEC staff has given direction on this set of issues as well through an interpretive letter addressed to the American Bar Association. In general, the issuer is entitled to rely on the disclosures contained in its most recent filing with the SEC that responds to Item 404. Typically, this will be the proxy statement for the most recent fiscal year. The latest filing, however, is not dispositive. Further analysis may be required to determine when disqualification begins and ends.
A relationship or transaction that has not yet crossed the disclosure thresholds will not result in retroactive disqualification if it does so at a later date. However, the company must believe in good faith at the time in question that disqualification is unlikely.
The IRS' involvement in compensation committee issues can be traced to 1984. In 1984, adverse publicity concerning large golden parachute payments led to congressional hearings. The tax code was amended to discourage golden parachute payments above a certain level.
With the golden parachute experience as a precedent and responding to what is perceived as excesses in executive pay at public companies, in 1993 Congress decided again to use the tax code to regulate executive pay, this time by limiting the deductibility of executive compensation above certain levels. Section 162(m) of the Internal Revenue Code of 1986 (Section 162(m)) establishes a $1 million cap on the deduction of public company executive compensation as an ordinary business expense. However, qualifying performance-based compensation was exempted from the limitation. As part of the procedural safeguards, performance-based compensation must be administered by a committee of outside directors.
Among the substantive requirements for compensation to qualify as performance-based for purposes of Section 162(m) is that the performance goal under which compensation is paid must be established by a compensation committee comprised solely of two or more outside directors. Likewise, compensation attributable to a stock option or a stock appreciation right will qualify as performance-based compensation only if the grant or award is made by such a compensation committee. The compensation committee must have the authority to establish and administer performance goals and certify that these goals are attained.
To qualify as an outside director under Section 162(m), a director must meet four tests. Most often, the question of whether or not a particular director qualifies as an outside director centers around the issue of receipt of remuneration. Under Section 162(m), disqualifying remuneration is considered received:
- if paid, directly or indirectly, to the director personally or to an entity in which the director has a beneficial ownership interest of greater than 50 percent;
- if paid in the company's prior tax year to an entity in which the director has an interest of at least 5 percent but not more than 50 percent (excluding remuneration of up to $60,000 per year); or
- if paid in the company's prior tax year to an entity by which the director is employed or self-employed other than as a director (excluding remuneration not exceeding 5 percent of the entity's gross revenues; however, if the remuneration is for personal services, the limit is again $60,000). The breadth and idiosyncrasies of these requirements have drawn extensive comment.
The most prominent stock exchange requirement is the New York Stock Exchange Rule requiring every listed company to maintain an audit committee consisting entirely of directors who are "independent of management and free from any relationship that in the opinion of its board of directors, would interfere with the exercise of independent judgment as a committee member." This broadly stated standard presents a stark contrast to the inflexible SEC and tax requirements. It gives a fair amount of latitude, which may often best be applied in doubtful cases after consultation with a representative of the exchange.
In addition to regulatory and exchange requirements, there has recently been a steady development in shareholder expectations for director independence. Although meeting shareholder expectations in this area may not be as urgent as the need to comply with governmental regulations, circumstances can readily arise where shareholders will have the opportunity to hold a company accountable for the independence of its board. Different shareholders, of course, approach independence differently.
The California Public Employees' Retirement System (CalPERS), which has achieved widespread attention for its efforts to improve corporate governance, recently adopted a new definition of independence. The definition (see box on next page) illustrates the type of concerns that shareholders may have. The CalPERS list of factors is noticeably longer and more restrictive than either the securities or tax regulations discussed above. It is especially noteworthy for its wholesale incorporation of the securities law disclosure requirements, apparently including the "interlock" disclosures under Item 402(f) of Regulation S-K.
Given all these regulatory standards and shareholder expectations, how is a company to find appropriate directors? The goal is to have individuals serve on the board who qualify as nonemployee directors, outside directors and independent directors under the respective securities, tax and exchange requirements. This challenge is a difficult one. When the ideal cannot be achieved, various strategies are possible to ameliorate the situation.
Use of a subcommittee
If one member of the compensation committee is disqualified, but there are sufficient qualified members remaining, it is possible for the board or (depending on state law) perhaps the committee itself to appoint a subcommittee consisting of the remaining qualified individuals. This subcommittee can act separately on compensation awards where qualification is important, such as granting of stock options or performance awards intended to be excluded under Section 162(m). Although this approach has some practical drawbacks and requires careful attention to technical detail, it has been approved by both Treasury Regulations and an SEC no-action letter.
Recusal or abstention
A somewhat less burdensome solution permits the full compensation committee, including the disqualified individual, to act until the point at which a decision is to be made on an item requiring a qualified committee. At that point, the disqualified individual either recuses himself or herself by leaving the meeting room prior to the vote (and perhaps prior to the relevant discussion), or remains in the room but simply abstains from voting.
Full board approval
Rule 16b-3 exempts awards if they are approved by a majority of the entire board of directors. The fact that one or more of the directors are not qualified nonemployee directors makes no difference. Sometimes a director does not qualify as a nonemployee director under Rule 16b-3, but does qualify as an outside director for purposes of Section 162(m), as in the case of a nonemployee director with a 404(b) relationship who is not a current or former officer and receives no remuneration from the company. One possible strategy enabling such a director still to serve on the board ‘s compensation committee is to make compensation committee grants subject to approval by the entire board.
Under most interpretations, awards under this procedure would also satisfy the requirements of Section 162(m). The regulations state that a committee of directors is not treated as failing to have the authority to establish performance goals merely because the goals are ratified by the board of directors. Though the language used is "ratification," "subject to board approval" seems to carry out the intent of the tax regulations. The compensation committee still retains authority. Rule 16b-3, on the other hand, does distinguish between approval and ratification. In order to be exempt under Rule 16b-3, awards can be ratified only by the shareholders.
Partial compliance
If it is not possible to structure a fully qualified committee, either by reassigning directors or by using one of the strategies outlined above, partial compliance is available as a last resort by following the dictates of Rule 16b-3 or Section 162(m) only.
In conclusion, companies should attempt to obtain information as early in the director selection process as possible. If a problem is identified, there will then be time to find another suitable candidate, establish a subcommittee, or make use of the abstention/recusal procedure. Committee membership should also be reviewed before adoption of any new executive compensation plan. Solving a director independence problem may require creativity and some administrative flexibility, but it can usually be done if the company identifies the issue in advance and is prepared to deal with it.
