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It seems the reformers are not quite finished with thecorporate boardroom. This time the issue is executive compensation, propelled tothe front lines by the scandal over former New York Stock Exchange ChairmanRichard Grasso’s $188 million compensation package. The debacle has already caused heads to roll in the NYSEboardroom. Sept. 26, H. Carl McCall, the board’s lead director since Grasso left, announced he was stepping down. On Sunday, Daimler-Chrysler CEOJuergen Schrempp, a critic of Grasso’s compensation arrangement, said hetoo was leaving the NYSE board. More resignations are expected, as directors bow topressure from institutional investors and investor advocacy groups. InterimNYSE Chairman John S. Reed has said publicly that the 27-member board should bereduced to no more than 12. There is talk, too, that a lawsuit is in the making.Earlier this month, the Financial Times reported that a group of NYSEseatholders, backed by about 400 of the exchange’s 1,366 members, were planningto sue to force a renegotiation of Grasso’s pay. Yet corporate governance experts say the Grasso pay flap isonly the latest in a series of recent events causing corporate directors towonder if they too could be blamed for how they go about paying companyexecutives. “It’s a combination of public concern about whatappear to be extremely generous compensation packages with the courts sayingthat directors in some cases have fallen down on the job,” said John F.Olson, a partner in the Washington, D.C., office of Gibson Dunn & Crutcherand chairman of the American Bar Association’s corporate governance committee. Olson said the first shoe to drop was probably thescandal at Tyco International, whose former CEO L. Dennis Kozlawski andfinancial chief Mark Swartz are on trial for allegedly looting the conglomerateof more than $100 million. Tyco’s directors are facing a shareholder suit fortheir alleged acquiescence in the plunder of the company. Public outrage over the lavish compensation packages ofHealthSouth Corp.’s former CEO Richard Scrushy and former chief executiveof WorldCom Inc. Bernard Ebbers also had directors sitting up and payingattention, Olson said. And just last week, Henry de Ruiter, chairman of thetroubled Dutch food retailer Royal Ahold, resigned following a consumer revoltover the pay package offered to Ahold’s new chief executive. DIRECTOR’S DUTIES Even more worrisome, two recent court rulings suggest thatit is not just the posts of directors that are at stake but their pocketbooksas well. In In re Walt Disney Co. Derivative Litigation, 825A.2d 275, the Delaware Chancery Court — known as the “mother court”of corporate law — refused to dismiss a shareholder suit alleging thatDisney’s directors breached their fiduciary duty by giving chief executiveMichael D. Eisner carte blanche to negotiate Michael Ovitz’s deal as presidentof Disney in the late 1990s. Ovitz lasted just over a year at Disney — andallegedly did a substandard job to boot — but scored more than $140 million inseverance on his way out the door. Infuriated shareholders sued. The directors moved todismiss, arguing that they were protected from liability by the businessjudgment rule, which shields good faith actions by corporate directors andofficers. In a May 2003 decision, Judge William Chandler III sidedwith the shareholders, finding that the allegations, if proven, would place thedirectors outside the ambit of the rule. The court cited the board’s alleged “ostrich-likeapproach” to Ovitz’s pay package in support of sending the case to ajury. The directors allegedly spent less than an hour each reviewing Ovitz’s hiring, it noted, and did not even bother to review the employmentagreement or the details of Ovitz’s salary and severance packagethemselves, or bring in a compensation expert to do so. The court found the directors were likewise”invisible” when it came time to terminate Ovitz, making noeffort to consider whether he could be fired for fault, entitling him to a muchsmaller severance. Instead, the court found, they blithely let Eisner stuffhis good friend’s pockets with more than $38 million in cash and three millionstock options. Equally disquieting for corporate board members was thecourt’s finding that the Disney directors could be held personally liable fortheir inaction, unprotected by the liability waiver in Disney’s charter. “Where a director consciously ignores his or herduties to the corporation, thereby causing economic injury to its stockholders,the director’s actions are either ‘not in good faith’ or involve ‘intentionalmisconduct,’ the court said. The ruling sent shock waves through the corporategovernance bar. It was particularly surprising, said Robert Profusek, a partnerin the New York office of Jones Day, because the same court had summarilydismissed an identical case against Disney a few years before. He said the ruling was particularly worrisome because itcame up with a new theory to justify its decision — “the so-called dutyof good faith.” Courts traditionally have held directors liable only ifthey derived personal benefit from a transaction. “The court did a 180 degree turn,” Profuseksaid. “It’s a manifestation of the fact that the Delaware courts haveturned against boards and management, at least for now.” May was a nerve-wracking month for corporate directors.That same month, a New York federal court found directors of TraceInternational Holdings, a now-bankrupt privately held company, liable forallowing chief executive Marshall Cogan to raise his salary unilaterally andtake out loans to the tune of $40 million. In Pereira v. Cogan, 294 B.R.449, Southern District Judge Robert Sweet found after a bench trial that boardmembers had “clearly abdicated their duties” of loyalty and care inrubber-stamping Cogan’s self-imposed pay increases and eventually, allowingCogan to liquidate the company. “The mere fact that [the CEO] had successfullyspearheaded extremely lucrative deals” is not necessarily enough tojustify a blind vote in favor of Cogan’s outsized compensation package, thecourt said. Neither would the company’s exculpatory charter provisionrescue the directors, Sweet found. The self-interest of the CEO and hisclose relationships with the board, and the board’s utter lack of diligence inperforming its duties, “vitiated” any argument that the clauseshielded them from liability. BUSINESS JUDGMENT By throwing into question the inviolability of the businessjudgment rule, these rulings suggest that board members can no longer takecomfort that the courts will grant them the benefit of the doubt, experts said. “All boards have gotten a wake-up call,” saidLouis Bevilacqua, a partner at Cadwalader, Wickersham & Taft. He added thatmany directors had gotten complacent during the 1990s, when the stock marketwas booming and shareholder complaints were few. Public and judicial indignation over executive compensationmay not necessarily cause boards to slash the pay of their chief executives.But, experts said, it could force them to take steps to safeguard against aGrasso-like debacle. Such steps should include creating an effective process forsetting compensation levels, including the use of a truly independentcompensation advisor and negotiations with management from the viewpoint of theowner, not a management retainee, said Charles Elson, director of the Centerfor Corporate Governance at the University of Delaware. Compensation committee members also need to have along-term equity ownership stake in the company, and be truly independent, Elson said. Public companies also need to become much more forthcomingwith the terms of the deals reached with company executives, experts said. “You want compensation arrangements to be verytransparent and clearly disclosed,” Gibson Dunn’s Olson said, “sopeople cannot say, ‘I had no idea.’” He said he anticipated that we will see more detail inproxy statements on executive pay packages. But at least one company — GeneralElectric Co. — has already taken disclosure a step further, issuing a pressrelease earlier this month detailing CEO Jeffrey R. Immelt’s pay package. Olson said he expected other companies will followsuit. “You don’t want to become the next poster child forexcess and nondisclosure,” he said.

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