Executive Compensation and the Search for a Solution: Its the Board of Directors Stupid

The debate over the right framework for regulating executive compensation has drawn increasing attention from regulators.  There have been proposals designed to cap compensation but those seem to have fallen by the wayside.  Instead, as we have written time and time again on this Blog, the focus seems to be on improving the process at the board level.  Timothy Geithner indicated SOX like reforms for the Compensation Committee.  As he noted:

• Secondly, we will propose legislation giving the SEC the power to ensure that compensation committees are more independent, adhering to standards similar to those in place for audit committees as part of the Sarbanes-Oxley Act. At the same time, compensation committees would be given the responsibility and the resources to hire their own independent compensation consultants and outside counsel.

Note that we have called for compensation committees with truly independent directors.  The definition used in SOX, however, is not strict enough (at least as it has been interpreted by the SEC).  It more or less uses the stock exchange definition with some extra limits on payments to directors.  We have called for a stricter definition of independence.

We have likewise recommended that the committees be given the authority to hire their own advisors and the authority to self fund, much like the provisions in SOX applicable to audit committees. 

At the same time, Mary Schapiro announced proposals for stepped up disclosure requirements in connection with executive compensation.  She has called for increased disclosure of conflicts of interest by compensation consultants and: 

• a company’s overall compensation approach. Incentive structures that rewarded short term risk taking without taking into account the potential long term effects on the company are widely believed to have contributed to the economic crisis.

The compensation consultant proposals are long overdue and one of the items listed in our top ten most important governance reforms that the SEC should undertake.  Nonetheless, the SEC has often tried to use disclosure to affect substantive behavior with very mixed success (see Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure).   Indeed, in the compensation area, there is reason to believe that disclosure accelerated the increase by providing CEOs with easy comparisons within their particular industry. 

These are all worthy issues to kick around and strengthening the Compensation Committee is a good start.  Nonetheless, the reality is that these changes will not work.  Even with independent directors on the Compensation Committee, the CEO can still have untoward influence.  For this to be reduced, at least some of the directors on the Committee need to be nominated by shareholders rather than management.  This is the promise of Proxy Access, something the SEC is again putting forward.

In addition, however, the other change that needs to occur is the federalization of the standard for determining executive compensation.  The Delaware courts have developed an abysmally low standard of behavior for directors engaging in compensation decisions, something we have addressed often.  In fact, the standard needs to be set by the federal government.  Our proposal is here.