The incoherency of American corporate governance and the need for federal standards.

• Author: De Lizza, Timothy

INTRODUCTION

On January 17, 2006, Chairman Christopher Cox of the Securities Exchange Commission ("SEC") announced that the SEC would propose extensive revisions to its current rules relating to executive compensation. (1) These rules are now enacted. (2)

"Over the last decade and half," Cox said in his speech, "the compensation packages awarded to directors and top executives have changed substantially. Our disclosure rules haven't kept pace with changes in the marketplace, and in some cases disclosure obfuscates rather than illuminates the true picture of compensation." (3) He added that the rules were "about wage clarity, not wage controls ... [because] the SEC lacks statutory authority to impose salary caps on corporate executives and we'd be out of bounds to attempt that through indirection." (4)

The problem of executive compensation, however, far exceeds disclosure. It involves substantive unfairness of the wages that executives receive, the process used to set their wages, and the inconsistent regulation of corporate governance. (5) Cox's suggestion that the SEC's mandate will not allow it to set wage controls explains his silence on these matters. (6) The SEC, however, already sets wage controls, both directly and indirectly. (7)

Less clear is whether these controls go beyond the SEC's mandate and to what extent new rules could regulate executive compensation. This may mean that the SEC's new rules are an overcautious attempt to stay within its mandate, and will lead to ineffective rulemaking.

This Comment suggests that the U.S. Congress should expand the SEC's mandate so that it has clear authority to implement corporate governance standards. Part I provides an overview of problems regarding how much executive pay is given, how pay is set, and how it is disclosed. (8) It then highlights regulatory responses to those problems, including how they provide contradictory incentives and result in unpredictability and over-regulation. (9) Part II considers the current scope of the SEC's mandate, including courts' and commentators' difficulty in defining its boundaries. (10) Part II concludes that this difficulty sometimes makes the SEC's regulatory actions either ineffective or beyond its mandate. (11) Part III looks at the SEC's recently enacted executive compensation rules and concludes that as a result of the SEC's mandate, the rules will not fix the problems set out in Part I. (12) Last, Part IV argues that the U.S. Congress must expand the SEC's mandate to enable the SEC to set federal corporate governance standards, and to allow it to effectively regulate executive compensation. (13)

1. AN OVERVIEW OF THE EXECUTIVE COMPENSATION DEBATE

   Critics of current executive compensation standards have made three broad complaints relating to executive compensation: the pay is too high, the process currently in place for setting compensation is flawed, and executive compensation is poorly disclosed. (14) Regulatory responses to these problems have created mixed results, and in some cases, arguably worsened the problem. (15) Additionally, the many official and unofficial regulatory bodies sometimes provide contradictory incentives that result in unpredictability and over-regulation. (16)

   Pay is Too High

   Adjusted for inflation, the pay of the average worker remained almost flat at $27,000 from 1990 to 2004, while average Chief Executive Officer ("CEO") pay rose from $2.82 million to $11.8 million. (17) Thus, CEOs now receive about four hundred times the salary of low-ranking employees. (18) This problem affects small to mid-sized companies, as well as larger ones. (19)

   Compensation of CEOs at two thousand of the biggest U.S. companies increased thirty percent in 2004, compared with fifteen percent in 2003 and nine and a half percent in 2002. (20) This increase occurred even as company and portfolio values dropped. (21) Corporate assets used to compensate the top five executives at companies grew from less than five percent to more than ten percent of aggregate corporate earnings from 1993 to 2003. (22) Again, many companies have seen CEO pay rise as shareholder returns have gone down. (23)

   These figures suggest that, as a percentage of aggregate corporate earnings, pay for U.S. executives is too high compared to the compensation of the average worker, and it is "delinked" to company performance. (24)

   Similar studies suggest that pay is too high when compared to executive compensation of foreign counterparts, (25) and when compared to other highly sought after employees, such as sports figures, entertainers, and professionals including attorneys and investment bankers. (26)

   There are two counterarguments to the claim that pay is too high. One argument is that even if executives are overpaid, it is not a problem. (27) Many people are not shareholders. (28) Even for those who are shareholders, the amount of value dilution that results from over-compensation is negligible on a per share basis. (29) This suggests that the problem gets disproportionate attention. (30) As a response to this first common counterargument, critics of executive compensation generally argue that excessive compensation indicates broader governance problems, affects company morale, and is used by rating agencies as a factor in debt and credit ratings. (31)

   The other argument countering the claim that executive compensation is too high is that market forces serve to limit executive compensation and that executives are worth what they earn. (32) Commentators who hold this view suggest that the executive compensation problem is overstated and that major tinkering with corporate governance should be avoided, especially insofar as it suggests giving more power to shareholders. (33) These commentators point to the large pool of potential executives and the companies that bid for their services, and they conclude that the free market fixes compensation. (34) They note the wealth of information available about compensation and the qualifications of the executives who receive that compensation. (35) Furthermore, they argue that studies suggesting that pay is delinked to stock performance ignore the fact that CEOs may have little ability to influence stock prices because many factors, including general economic conditions and politics, affect prices. (36) These commentators conclude that competition for CEOs is fierce and considerable, which leads to efficient and appropriate levels of executive pay. (37)

   The Process of Setting Pay Is Flawed

   There are three central figures in the internal corporate structure: shareholders, the board of directors, and management. (38) Shareholders are the owners of the company. Through an agency relationship, they directly "elect" a board of directors at an annual meeting. The board of directors then selects management, who in turn runs the company.

   While shareholders are theoretically the most powerful stakeholder, problems of rational apathy significantly diminish their power. (39)

   Most shareholders are rationally apathetic; since their investments are small, they will not research companies or make sophisticated voting decisions. (40) Large institutional investors are the exception since they are more sophisticated and have more influence, but even they face the hurdle of the expenses involved in bringing shareholder actions. (41)

   The board of directors has the ultimate authority to set executive compensation. (42) Although Delaware law is silent on methods of setting compensation, including whether a compensation committee is necessary, compensation cannot breach the directors' fiduciary duties. (43) Permissible indemnity rights, however, take the potency of these duties away. (44) Where shareholder actions successfully challenge executive compensation, there is often a taint of self-dealing. (45)

   In many public corporations the task of setting pay is delegated to a compensation committee (46) since such a committee is required to qualify for certain tax deductions (47) and for a New York Stock Exchange ("NYSE") listing. (48) The committees are typically composed of "disinterested" and independent outside directors who determine executive compensation, (49) but the actual extent of these directors' independence is debatable.

   The CEO and management typically nominate directors, which might create a sense of loyalty or concern for continuing nomination in future elections. (50) There is also an "old boys club" element to the nominations in that personal friends of the CEO or CEOs from other companies are often selected, which might create motive for tacit or even subconscious inflation of salaries. (51) For example, in 1996, almost ninety percent of companies had at least one CEO or Chief Operating Officer ("COO") on its board. (52)

   Compensation consultants who owe no fiduciary duties to shareholders may also advise the committees. (53) Management typically hires these consultants. (54) Thus, the consultants will often have an incentive to push compensation upward to guarantee future consulting contracts. (55) For example, the New York Times recently reported that Verizon's compensation consultant received $500 million in consulting fees from Verizon between 1997 and 2005. (56) Directors often rely heavily on consultant's figures because the directors themselves are typically not experts in compensation, typically have separate full time jobs, and might meet as infrequently as four times a year. (57)

   An illustrative example is the Disney Board in the period prior to the hiring of the CEO's friend as the company president. (58) A Delaware court described the Compensation Committee as "stacked" with the CEO's personal friends and acquaintances, who although "not necessarily beholden to him in a legal sense, were certainly more willing to accede to his wishes and support him unconditionally than truly independent directors." (59) The director that mainly negotiated the contract also served as the CEO's...