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Many of the corporate governance failures of the past decade can be blamed on inappropriate executive compensation plans. In particular, there was undue reliance on stock options as a form of executive compensation, which not only gave rise to excessive executive compensation, but also concentrated the minds of executives on stock market prices rather than long-term business growth. Recent developments, which will be discussed in this column, may help to make stock options a less-significant component of executive compensation in the future. Further reforms are likely. During the 1990s, executive compensation reached exorbitant levels. In 1980 the ratio of CEO pay to the pay of rank-and-file employees was 42 to 1; in the early 1990s, it surged to 120-to-150 to 1. It then rose to about 475-to-500 to 1 by the end of the decade. [FOOTNOTE 1] It has been argued that this differential was due in part to the shareholder primacy norm, [FOOTNOTE 2] but it can also be argued that shareholders have inadequately constrained executive compensation norms and that executive compensation is set by managers with little outside control. [FOOTNOTE 3] Although the setting of executive compensation is a self-dealing transaction, there has been a curious absence of judicial review of CEO pay in the state courts and, instead, a deference to market forces to determine appropriate compensation levels. A recent Delaware case suggests a possible rethinking of this deference. [FOOTNOTE 4] DISCLOSURE REGULATION The traditional approach of the Securities and Exchange Commission (SEC) to executive compensation was through disclosure regulation, with a strong suggestion that the compensation committee should be composed of independent directors. Although annual compensation paid to the CEO and four other highest-paid officers of public companies, which exceeds $1 million may not be deducted as an ordinary and necessary business expense, [FOOTNOTE 5] this legislative effort to cap executive pay has either been avoided through the structure of contingent compensation schemes, especially stock option plans, or ignored. Rather than tighten up on this tax code provision, it has been suggested that a needed reform for executive compensation is to make corporations fully expense and fully deduct all forms of executive pay. [FOOTNOTE 6] The campaign by institutional investors in the 1990s to align management compensation with shareholder interests only made matters worse because this idea led to putting a portion of CEO compensation at risk according to a performance-based formula devised by compensation consultants beholden to management. Stock option grants were a significant component of CEO compensation in part because such options were not treated as a cost for financial reporting purposes. In a rising market, these options and other stock-based compensation arrangements became very valuable, but the widespread use of stock options was a key cause of the 1990s stock market bubble and its collapse. The equity-based compensation formulas, which became so popular, focused corporate executives on stock market prices, instead of more traditional metrics of business prosperity and growth and provided strong incentives to manipulate accounting principles and financial statements. In 1993, the Financial Accounting Standards Board (FASB) proposed to require companies to deduct the value of executive stock options from earnings starting in 1997. This proposal led to intensive lobbying by business interests against such a standard. Congress then threatened to abolish the FASB’s role as a standard setter if it adopted a standard that would treat stock options as an expense. The SEC did little to protect the FASB from this congressional undermining of its role, and, so, the FASB backed off and passed a footnote disclosure requirement in the form of SFAS 123 on Accounting for Stock Based Compensation. Currently, the International Accounting Standards Board is considering a new standard for the valuation of stock options and a requirement that they be expensed and the FASB is reconsidering the issue for the sake of international harmonization of accounting standards. Some of the opponents of expensing stock options in the past — Microsoft, Citicorp, the Business Roundtable and big accounting firms — have now come out in favor of expensing them. Once again, however, Congress is threatening to pass legislation to forbid stock options to be expensed. Opposing legislation would require stock options to be expensed. ‘DANGEROUS AND IRRESPONSIBLE’ Interference by Congress in the work of the FASB is dangerous and irresponsible, especially at a time when a new regulatory framework has been imposed on the accounting profession in the name of corporate accountability. It was this very interference that led to the overuse of stock options and many of the financial frauds of the 1990s, and the enactment of the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley)[FOOTNOTE 7] which has imposed massive new regulations on public corporations and their accountants. Although Congress did not try to limit executive compensation directly, four provisions of Sarbanes-Oxley were aimed at specific management compensation abuses. SEC rulemaking was not required to implement these provisions, which were made self-executing. Pursuant to � 304 of Sarbanes-Oxley, if an issuer is required to prepare an accounting restatement due to material noncompliance, as a result of misconduct, with any financial reporting requirement under the securities laws, the CEO and CFO must reimburse the issuer for any bonus or other incentive-based or equity-based compensation and any profits from the sale of securities of the issuer during the 12-month period following the publication of the financial statement required to be restated. To give some teeth to this provision, in � 1103 of Sarbanes-Oxley, the SEC was given the authority to obtain asset freezes to prevent an issuer from paying bonuses to executives in cases involving financial fraud. In addition, directors and executive officers of issuers are prohibited by � 306 of Sarbanes-Oxley from trading in any equity securities of the issuer during any blackout period when employees are so prohibited. These relatively noncontroversial provisions were in response to some well-publicized abuses at Enron and other companies, which failed prior to the time Sarbanes-Oxley was enacted. Section 402 of Sarbanes-Oxley, which prohibited companies from extending, maintaining or arranging for the extension of credit to any director or CEO of any public company proved very disruptive of standard arrangements at many corporations. Questions concerning indemnification advances, travel advances, personal use of a company car, split-dollar life insurance and cashless option exercises have been so pervasive that 25 major law firms released a joint outline describing their views on interpretive issues with respect to the prohibition against loans to CEOs.[FOOTNOTE 8] FEDERALIZATION Although the foregoing provisions of Sarbanes-Oxley were addressed to specific outrageous abuses, regulation of any aspect of executive compensation is a major step in the federalization of corporate governance. Further federal regulation of executive compensation has been proposed in the form of new listing requirements by the New York Stock Exchange Inc. (NYSE) and the National Association of Securities Dealers Inc. (NASD). Before Sarbanes-Oxley was even passed, the chairman of the SEC requested the NYSE and Nasdaq to consider whether listing rules should require shareholder approval of all stock-option and other equity-based executive compensation plans. It is of interest that, before 1996, shareholder approval of equity compensation plans was required by an SEC rule, as a practical matter, because in order for the exercise of such options and the sale of the stock underlying the options to be exempt from the short-swing profit prohibitions of � 16(b) of the Securities Exchange Act of 1934 (Exchange Act), a shareholder vote was required. The SEC then adopted Rule 16b-3 under the Exchange Act so that such a shareholder vote was no longer necessary for this exemption. Responsive to the SEC’s suggestions with regard to stock-option plans and some related matters, in June 2002 a committee of the NYSE issued a report on possible changes to the NYSE listing standards.[FOOTNOTE 9] This report had a variety of recommendations that went beyond Sarbanes Oxley, including: requiring listed companies to have a majority of independent directors, with a stringent definition of the term “independent”; provision for regularly scheduled executive sessions of boards chaired by a lead director or independent chairman; requiring listed companies to have a nominating and compensation committees composed entirely of independent directors; and requiring shareholder votes on equity-compensation plans. Several of these recommendations were then filed with the SEC as proposed new listing standards. Among the NYSE proposals were listing requirements to the effect that nonmanagement directors must meet at regularly scheduled executive sessions and that nominating and compensation committees be composed entirely of independent directors.[FOOTNOTE 10] Nasdaq similarly filed new listing rules with the SEC addressed to shareholder voting on stock-option plans and independent directors on compensation committees, which were similar although slightly different from the NYSE proposals.[FOOTNOTE 11] NEW LISTING REQUIREMENT Last month, the SEC approved a new listing requirement proposed by both the NYSE and Nasdaq that shareholders vote on stock compensation plans.[FOOTNOTE 12] On the one hand, this approval merely returns matters to where they were before the SEC passed Rule 16b-3 in 1996. On the other hand, events in the interim should give investors and regulators the incentive to take a much-needed hard look at executive compensation. One result is likely to be a listing requirement that nominating committees be comprised solely of independent directors. Whether further reforms will be forthcoming is difficult to predict. These new listing requirements are far-reaching changes in the federal regulation of corporate governance as to matters that state law has never regulated. Nevertheless, the business groups that commented to the NYSE’s Committee on Corporate Accountability and Listing Standards were in agreement as to the efficacy of the changes the committee recommended. For example, the Business Roundtable, which sued the SEC with regard to its authority to promulgate a voting-rights rule, [FOOTNOTE 13] expressed the view that public corporations should have corporate governance and compensation committees composed of independent directors, that independent directors should have the opportunity to meet without management representatives present and that shareholders should have the opportunity to vote on stock-option and restricted stock compensation plans in which officers and directors participate. [FOOTNOTE 14] The National Association of Corporate Directors similarly endorsed the idea of independent nominating and compensation committees and independent director-only executive sessions.[FOOTNOTE 15] A MATTER OF FEDERAL LAW? Assuming that in today’s world both business and government leaders believe that these are good corporate practice, there is still a serious question as to whether independent nominating and compensation committees should be made a matter of federal law. While stock exchange listing requirements were once a matter of state contract law, they have probably been transmogrified into federal law through the Exchange Act.[FOOTNOTE 16] Yet, whether they have the force of federal regulations, which pre-empt state law, remains unclear. Further, where federal law ends and state law begins also is murky. Sarbanes-Oxley resolved the SEC’s authority to mandate the structure of corporate audit committees, but did not address other board committees or stock-option or restricted stock plans. Although Sarbanes-Oxley changed the equation between state and federal authority over internal corporate affairs, it is unclear whether the SEC has acquired the authority to regulate executive compensation. Roberta S. Karmel is a professor of law and codirector of the Center for the Study of International Business Law at Brooklyn Law School. She also is a former commissioner of the SEC. ::::FOOTNOTES:::: FN1 See Susan J. Stabile, “One for A, Two for B, and Four Hundred for C: The Widening Gap in Pay Between Executives and Rank and File Employees,” 36 U. MICH. J. L. REF. 115, 115-16 (2002). FN2 Id. at 117, 134. FN3 See generally Lucian Arye Bebchuk et al., “Managerial Power and Rent Extraction in the Design of Executive Compensation,” 69 U. CHI. L. REV. 751 (2002). FN4 In re Oracle Corp. Derivative Litigation, 824 A2d 917 (Del. Ch. 2003). Generally, where there is a self-dealing transaction, the transaction will be voidable unless it is disclosed to and approved by disinterested directors; it is disclosed to and approved by disinterested shareholders; or it is fair to the corporation. See, e.g., 8 Del. C. � 144; N.Y. Bus. Corp. L. � 713(a). However, state statutes permit directors to fix their own compensation, see, e.g., 8 Del. C. � 141(h); N.Y. Bus. Corp. L. � 713(e), and the test for the upholding management remuneration if that it only needs to be reasonable, rather than fair. FN5 IRC � 162(m) (2003). FN6 Michael H. Moskow, “Breaking Down the Breakdown of Corporate Governance: Incentives, Information, and a Rational Course for Policy,” Speech at Loyola University (April 2, 2003), at http://www.chicagofed.org/newsandevents/speeches/2003/apr022003.cfm. FN7 Sarbanes-Oxley Act 2002, Pub. L. No. 107-204, 116 Stat. 745 (2002). FN8 See JOHN T. BOSTELMAN, THE SARBANES-OXLEY DESKBOOK �� 13:2.1-2.6 (2003). FN9 REPORT OF THE NEW YORK STOCK EXCHANGE CORPORATE ACCOUNTABILITY AND LISTING STANDARDS COMMITTEE (June 6, 2002). FN10 See “Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change and Amendment No. 1 Thereto by the New York Stock Exchange, Inc. Relating to Corporate Governance,” Exchange Act Release No. 47,672, 68 Fed. Reg. 19,051 (April 2003). FN11 See “Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change and Amend. 1 Thereto, The National Assoc. of Securities Dealers, Inc. Relating to Proposed Amendments to NASD Rules 4200 and 4350 Regarding Board Independence and Independent Committees,” Exchange Act Release No. 47, 516, 68 Fed. Reg. 14,451 (March 2003). FN12 Self-Regulatory Organizations; New York Stock Exchange, Inc. and National Association of Securities Dealers, Inc.; Order Approving NYSE and Nasdaq Proposed Rule Changes and Nasdaq Amendment No. 1 and Notice of Filing and Order Granting Accelerated Approval to NYSE Amendments No. 1 and 2 and Nasdaq Amendments No. 2 and 3 Thereto Relating to Equity Compensation Plans, Securities Exchange Act Release No. 48,108, 68 Fed. Reg. 39,995 (July 2003). FN13 See Susan J. Stabile, “One for A, Two for B, and Four Hundred for C: The Widening Gap in Pay Between Executives and Rank and File Employees,” 36 U. MICH. J. L. REF. 115, 115-16 (2002). FN14 Id. at 117, 134. FN15 See generally Lucian Arye Bebchuk et al., “Managerial Power and Rent Extraction in the Design of Executive Compensation,” 69 U. CHI. L. REV. 751 (2002). FN16 In re Oracle Corp. Derivative Litigation, 824 A2d 917 (Del. Ch. 2003). Generally, where there is a self-dealing transaction, the transaction will be voidable unless it is disclosed to and approved by disinterested directors; it is disclosed to and approved by disinterested shareholders; or it is fair to the corporation. See, e.g., 8 Del. C. � 144; N.Y. Bus. Corp. L. � 713(a). However, state statutes permit directors to fix their own compensation, see, e.g., 8 Del. C. � 141(h); N.Y. Bus. Corp. L. � 713(e), and the test for the upholding management remuneration if that it only needs to be reasonable, rather than fair. 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