Safe passage in approving pay plans: executive pay decisions are ending up in court. Here are processes for a compensation committee to implement to make appropriate decisions and help shield itself from liability.

• Author: Cole, Thomas A.
• Position: COMPENSATION COMMITTEE

EXECUTIVE COMPENSATION has been a lightning-rod issue since at least the early 1990s, the beginning of the current "modern era" of interest in corporate governance. Directors are now, in a wide range of contexts, being forced to defend themselves for actions taken (or not taken) with respect to executive compensation.

The risks to directors of becoming embroiled in compensation controversies are now greater than ever. The risk of adverse publicity is heightened by the possibility that the director will become the target of a "withhold" vote campaign that could, as a result of proposed new Securities and Exchange Commission proxy rules, trigger the right of shareholders to place a nominee or nominees on the management proxy card. The risk of litigation is heightened by recent judicial decisions that question the applicability of director-protecting "exculpatory" charter provisions in situations in which directors are found to have been insufficiently vigilant.

While these risks are real, they are, with the implementation of thoughtful processes, eminently manageable. In nearly all of the compensation-related scandals that have erupted in recent years, the central criticism that has been levied against directors is that they used a flawed process to arrive at their decisions. At the New York Stock Exchange, press reports and Eliot Spitzer's complaint suggest that the compensation committee agreed to a compensation package the substance of which its members did not fully understand. The plaintiffs in the Walt Disney Co. shareholder derivative litigation have contended that the compensation committee approved Michael Ovitz's contract to become president of the company on the basis solely of a "rough summary" of its terms and was not involved at all in the decision to grant him a "non-fault" termination. In its Disney decision, the Delaware Court of Chancery concluded that, if true, this could support a claim that the directors failed to "act in good faith and meet minimal proceduralist standards of attention."

What sort of processes should a compensation committee implement to increase the likelihood that it will make appropriate decisions and shield itself from liability? Specific suggestions follow:

1. Treat senior executive hirings as material transactions

   One of the subtexts of the Disney decision is that the Delaware courts will expect boards to treat decisions regarding senior executive hirings and severance arrangements, even if not...