Material in this article is provided with full permission from J. E. Richard’s new 6th Edition of the Compensation Committee Manual released in October 2003. It is available from www.jrichardco.com.

Background (The Drivers)

Boards and their key standing committees have been and will continue adjusting to elevated governance standards mandated from various serious sources. More strict regulatory requirements combined with ongoing shareholder pressures and court decisions have compelled Boards and committees to adopt radical reform measures.

As a result, Board Compensation Committees have undergone very dramatic and necessary changes. Earlier transitions were motivated by significantly enhanced proxy statement (Schedule 14A) disclosure rules mandated by the Securities and Exchange Commission (“SEC”). Other catalysts promoting more diligent oversight by Compensation Committees were the highly acclaimed National Association of Corporate Directors’ (“NACD”) Commission Report(s) on executive compensation practices and the clamorous complaints from shareholder activists, Congressional leaders. The American public through media, including Dave Letterman and Jay Leno has reacted to perceive executive compensation excesses.

In addition, the Internal Revenue Service raised the governance independence requirements bar by effecting Section 162(m) of the Internal Revenue Code limiting corporate tax deductions (up to $1 million annually) for compensation expenses for corporate officers. New onerous tax rules and final regulations on golden parachutes are now in effect.

More recent reforms have been mandated by Congress (Sarbanes-Oxley Act), as well as by the major stock exchanges (NASDAQ and NYSE). Many experts are now considering the new stock exchange listing standards to be the most serious developments. For instance, Compensation Committees have to be comprised entirely of independent directors and this is a new definition of independence, a critical change in Compensation Committee composition. Loss of investor confidence as well as major corporate scandals provided the major impetus for these events. Recent proxy seasons have included a record number of shareholder resolutions to control runaway executive officer pay. Finally, there is the “red face quotient”: the new Board rating agencies such as the corporate governance quotient (“CGQ”) used by the Institutional Shareholder Services (“ISS”). How embarrassing to some boards not up to par!

What does this all mean to directors? How have Boards responded? Have these power brokers really gotten the messages? And, what are the Compensation Committees, dedicated to “best practices” doing about all this? These are the questions addressed in this article. The information presented here is based on my experience in client situations, through close observations of industry practices, and from the feedback I have received at my presentations to various groups and association meetings.

Best Top Ten Practices

In the exercise of its required duties of care and loyalty, diligent Compensation Committees must do at least the following on a consistent and timely basis:

1. Meet regularly to review and refine its (usually expanded) charter and assure that it clearly delineates its delegated responsibilities from the Board;

2. Include a proactive chairperson (two-to three-year rotation) that commits the necessary time and effort to provide effective leadership that facilitates needed and sufficient discussion time, consideration, understanding, and resolution;

3. Have members that are prudently selected (three-year rotation), qualified, and truly independent to provide thorough and quality review time and objective oversight;

4. Plan and establish, with input from management (and advisors), meeting agendas, dates, priorities, and goals for each fiscal year (well ahead of meetings);

5. Ask pertinent questions and request data, information, industry performance benchmark analyses, sector economic reviews, outside analyst reports, detailed cost analyses, and other pertinent documents from management well in advance of each meeting, and utilize regular executive sessions and multiple meeting formats (some non-decision/information-review only meetings) on highly complex or controversial issues;

6. Prepare for each meeting by carefully reviewing all information requested, available, and received as well as recent regulatory developments;

7. Retain outside advisors/experts to provide information, data, research, and opinions (sometimes also seeks second opinions) that can be relied upon (for Business Judgment Rule protection) in the consideration of any matter; approve peer groups and pay surveys to participate in and/or purchase;

8. Assure full awareness and very strict compliance with all pertinent laws and regulations such as those relating to the SEC-required Compensation Committee report for disclosure in the proxy statement each year;

9. Evaluate the committee’s performance and effectiveness and identify developmental needs as well as skill set requirements; and

10. Review all material matters and shareholder sensitivities with the full Board.

This list is fundamental to best basic Compensation Committee practices; however, there are some relatively novel nuances beyond the basic that are interesting and perhaps trend-setting. For instance, some Compensation Committees also perform CEO evaluation and review director pay and benefits (including Directors & Officers Liability Insurance coverage). However, with the evolution of governance committees (and expert legal opinion), there is a trend toward the latter handling some of these critical chores. At any rate, many advisors are suggesting that one committee should not consider both executive and director pay in the same breath, meeting minutes, or room. A conflict of interest may be perceived (or charged) and protection under the Business Judgment Rule may be impaired.

In recent times, more Compensation Committees have also expanded their charters to include the review of executive succession, employee benefits, company human resource policies, and other broader organizational development issues. As a result, some committees have re-named themselves. Examples of the new nomenclature are: Organization and Compensation (O&C) Committee; Human Resources and Compensation (HRC) Committee; Management Development and Compensation (MDC) Committee; and Compensation and Benefits (C&B) Committee.

About the Author:

J. Richard’s early experience included a fifteen-year corporate human resources executive and compensation consulting firm career. He then established his own firm in 1984, and also served on the faculty of the National Association of Corporate Directors between 1988 and 1994. He also served on NACD’s Blue Ribbon Commission on Executive and Director Compensation. J. Richard & Co. specializes in executive and outside director compensation, evaluation and development. Other long-term experiences and competencies include CEO contracts; board education/retreats; board committee evaluations and development; and litigation support/expert witnessing.

J. Richard has authored and published a vast number of books, monographs, chapter contributions, articles, and newsletters since 1969. His most recent books, Compensation Committee Manual (5th edition) and Board Compensation Guide (2nd edition which includes board evaluation systems) were named two of the top governance publications by NACD in 2002. He also authored an NACD monograph: The Board’s Strategic Review Role.

For further information on this topic, contact J. Richard at (info@jrichardco.com). For additional information on “FY ’04 Planning Imperatives” related to Corporate Compensation Committees, please contact Columbia Consulting Group (attn: Maydina Smith) at 443-276-2525 or e-mail: msmith@ccgsearch.com

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