In Whom Do We Trust?

Author: By James T. Berger, Contributing Editor

In the wake of the malfeasance era, a new buzzword has emerged in the corporate vocabulary—transparency.

Transparency is based on the concept that information disclosed about corporate activities in a timely manner is a “best practice” for corporations. Typical examples of transparency include:

Ø     Expanding financial information guidelines and standards.

Ø     Prohibiting certain types of compensation.

Ø     Setting up independent boards to monitor ethical compliance.

Ø     Full disclosures of executive compensation and ownership of shares and stock options.

Ø     Penalties for false and misleading reporting.

“The current climate on Capitol Hill and in boardrooms is to try to achieve as much transparency as possible particularly to try to address the requirements of the SEC (Securities and Exchange Commission).  People have had their eye on the ball for a while,” says corporate attorney Alan L. Dye, a partner in the Washington, D.C., firm of Hogan and Hartson, and a former special counsel to the chairman of the SEC.

Seemingly endless groups scrutinize the executive compensation system. Proactive institutional investors and other shareholders, the media, the government, employee organizations, customers, and even vendors are all asking increasingly tough questions about how much senior executives are paid, according to Yale Tauber, program director for the Conference Board’s Executive Compensation Conferences and the principal of Independent Compensation Committee Adviser, LLC, based in.

Meanwhile, tax, accounting, and regulatory requirements have proliferated and grown more complex.

“The issue is not simply about rational executive pay, but encompasses the broader issues of competitive, vibrant, and accountable corporate management. Today, an organization's executive compensation has become a litmus test regarding corporate governance and accountability,” Tauber says.

“Two things have occurred that make the atmosphere for disclosure and transparency different than in the past,” comments University of Chicago Professor Steven Kaplan. “Boards are far more aggressive than they have been in the past on compliance and fraud-type issues and the audit committee hires the auditor and not the CFO.”

“Most responsible companies are trying to and are going to comply,” says Professor Jay W. Lorsch of Harvard University. “Clearly, we have put safeguards in place.” 

Two Major Building Blocks

The key reasons for the rise in corporate honesty are the two building blocks that form its foundation—the Sarbanes-Oxley Act (SOA) of 2002 and the amendments to the disclosure requirements for executive and director compensation adopted by the SEC in 2006.

Sarbanes-Oxley established new or enhanced standards for all U.S. public companies, boards, management and public accounting firms.  It contains 11 sections ranging from board responsibilities to criminal penalties.  It established a quasi-public agency, the Public Company Accounting Oversight Board, which is in charge of overseeing, regulating, inspecting and disciplining accountings firms in their roles as auditors of public companies. SarBox also addresses auditor independence, internal controls, corporate governance and financial disclosure.

The SEC amendment to its disclosure requirements: Provide investors with the total compensation of the corporation’s top five most highly compensated executives; provides for a narrative Compensation Disclosure and Analysis (CD&A) to be filed with the SEC; adds a description of payments made to executives upon termination or change in management and guards against backdating and “spring-loading” of stock options. This applies to all companies that file with the SEC.

The End of Abuses?

While the safeguards are in place, Dye points out, “I think it’s impossible to totally eliminate fraud. With SOA reforms and the related SEC requirements, I believe corporate directors feel much more empowered to do a better job.”

Kaplan adds: “There will probably be fraud in the future but today the scrutiny and incentives are much stronger on the side of ferreting out fraud than allowing it to go on.”  He adds that the regulations might have gone too far. “I think section 404 of SOA has gone too far by adding more bureaucracy than is probably desirable.”

Lorsch says, “I think we have the safeguards in place, but people are always capable of finding new ways to do things outside the rules,” he says. “We’ve covered everything we can think of for the time being until people devise new ways to cheat.”

Is Executive Compensation Too High?

In tandem with the disclosures of corporate fraud were the revelations about the excessive levels of executive compensation especially for executives managing poorly performing firms. 

While SOA and the SEC regulations address “obscene” levels of compensation, the key question that frequently arises: Is executive compensation today too high?

Kaplan thinks not. “If anything I think it’s too low,” he says. “CEO pay is lower today than it was in 2000 in real dollars. While an S&P (Standard & Poor’s) 500 CEO’s package is still around $10 million a year, if you run a company of that size you generally have more than 25,000 employees. There are plenty of investment bankers and hedge fund managers who make that kind of money and have much easier jobs.”

Dye adds, “Everybody would agree that in some cases, compensation might not seem to be merited by the performance of the company. There is no consensus whether you can blame non-performance on the company or the executive,” he says. “But the compensation process is becoming more rational.  There are some institutional shareholders that are rigorously seeking to discipline that whole process.  If you have a compensation committee that believes that the CEO and other high-level officers are entitled to a nice payday even though the company has not been performing well, you will find shareholder groups that are going to apply some discipline to that process.”