Spitzer V. Grasso: Compensation-Related Governance Issues For Not-For-Profits

The complaint filed on May 24, 2004, by the New York attorney general against the New York Stock Exchange (a New York not-for-profit corporation), its former CEO and the former chair of its Compensation Committee, has important corporate governance, executive compensation and tax law implications for not-for-profit corporations nationwide.

Essentially an action to rescind compensation payments made to the former CEO, the complaint raises important issues with respect to the exercise by a not-for-profit board of its fiduciary duties-particularly the process by which the board makes critical decisions in areas such as executive compensation. Furthermore, the scope of the complaint, the nature of the requested relief and the settlements (reached immediately prior to filing) with a former NYSE executive and the compensation consultant to the NYSE underscore the authority and leverage attorneys general may bring to bear over not-for-profit corporations.

The New York attorney general is proceeding under statutory provisions common in the not-for-profit and/or charitable trust laws of most states. These include: (a) "reasonableness" limitations on compensation arrangements; and (b) the ability of the attorney general to: (i) seek an accounting from officers and directors for improper actions involving corporate assets; (ii) set aside unlawful corporate asset transfers; (iii) seek recovery from officers and directors who approve unlawful compensation arrangements; and (iv) bring an action to prevent the not-for-profit corporation from conducting unauthorized activities.

The renewed focus of state regulators on the amount and process of awarding executive compensation by not-for-profit corporations mirrors the recent Internal Revenue Service initiative to apply the standards of the Intermediate Sanctions rules and regulations in examining executive compensation arrangements of tax-exempt organizations. The IRS intends to selectively examine compensation data from the Form 990 returns of tax-exempt organizations and "request" of certain organizations that they provide more detail on the types and amounts of compensation provided and the justification for the compensation.

These regulatory initiatives, as well as the dollar amounts involved in the NYSE case, can cause observers to believe that the risk in this case is solely a function of the compensation amounts. While these compensation amounts are enormous by any standards, the case is equally about the failure to wield independent and effective board oversight. The essence of the complaint is that everything that could go wrong in not-for-profit executive compensation did go wrong, and the employer, the employed CEO and the head of the approval body all should be held personally accountable.

These situations should not be viewed as novel or isolated. We have witnessed many recent examples of high-profile scrutiny of not-for-profit executive compensation arrangements. For example, the Minnesota attorney general’s 2002 "business compliance review" of HealthPartners closely resembles the NYSE situation in the focus on allegedly flawed methodology and alleged disengagement of the board.

Moreover, in what should serve as a wake-up call for executives, these regulatory actions are more frequently involving repayment of compensation. In partial settlement of the litigation (involving the attorneys general of both Kansas and Missouri) arising out of the then-proposed sale of HealthMidwest’s Kansas City area hospital system to HCA, the CEO was required to pay $500,000 of his prior compensation to a community foundation. Similarly, earlier this year the New Hampshire attorney general required the restructuring of the executive compensation of the senior leadership at the prestigious St. Paul’s School.

This trend should lead every not-for-profit corporation to ask itself, "If the attorney general of our state, or the IRS, were to investigate our executive compensation arrangements, would we have in place a strong process and supportable, well-documented record- to insulate us from regulatory challenge to our executive compensation payments (past, present and future)?"

The suit revolves around the decision of the NYSE Board’s Compensation Committee to approve a compensation package for the CEO of $187.5 million ($139.5 million of which would be paid immediately, and the remaining $48 million of which would be paid over four years of employment). This amount represented only the value of pension supplements and deferred compensation; other forms of compensation would be paid on an ongoing basis. In challenging these payouts, the principal allegations of the New York AG include the following:

The suit alleges that Grasso had the authority to hand-pick all NYSE board members (including those who served on the Compensation Committee), and that Grasso had authority over the manner in which NYSE would regulate the exchange members at which the board members were executives. This, according to the suit, permitted Grasso to wield improper influence over the compensation awarded to him and over the directors who were required to approve the compensation in essence using the NYSE regulatory process to influence directors who might be inclined to pay him less or to reward directors who might be inclined to pay him more.

The complaint alleges that total compensation was objectively unreasonable because compensation from 1999 through 2002 was more than four times the compensation paid from 1995 through 1998. The complaint supports this finding of unreasonable total compensation by noting that Grasso’s compensation equaled nearly all the net income of the NYSE over that four-year period. In alleging how the compensation package grew to an unreasonable size, the complaint cites many factors, including:

• Sharp increases in base salary, incentive compensation and other forms of compensation led to an exponential increase in the value of pension supplements.

• Companies with which the NYSE was compared for compensation purposes were not comparable in size, revenue or complexity, but were selected as companies with which NYSE might compete for executive talent.

• The compensation provided was roughly double the amount of the "benchmark" set by the compensation consultant after analyzing the data of organizations that were specified by the consultant as comparable.

The board allegedly was not told about certain forms of compensation provided to the CEO over a four-year period, nor about the true nature of certain pension supplements transferred to the CEO’s control. Part of the factual basis for this allegation came from consultants’ notes that were not protected from discovery by the attorney-client privilege. The suit seeks to have the board approval of the compensation package rescinded because the approval was based on "materially incomplete, inaccurate and misleading information." In other words, the board simply did not know precisely what it was approving.

Reactions to the NYSE suit have centered around two poles. One reaction is that very high compensation is, by its nature, unreasonable. Some dollar amounts are so high that they must be unreasonable. The other reaction is that any compensation amount approved by the governing board, or that is simply carrying out a compensation approach written into an employment agreement approved by the governing board, is inherently reasonable and must be given deference. Underlying this reaction is the belief that boards are in the best position to determine the "value" of senior management’s performance to the organization.

In our view, neither of these extremes is true. Extraordinarily high compensation is not necessarily unreasonable, and board-approved compensation may be considered by regulators to be unreasonable. The reality is that determining reasonableness is a process that, properly conducted, relies on independent and statistically reliable comparability studies, the exercise of due care and the consideration of all relevant facts and circumstances. The IRS makes it clear that reasonableness must take into consideration all the factors that are relevant in assessing the value of an employee’s services. It is only after a thorough analysis of all relevant factors that the reasonableness of executive pay and benefits can be assessed. This may well lead to support for a very high level of compensation where the executive has provided commensurate value.

It would be a mistake to view the NYSE case as an "outlier," in other words, an example of outrageous compensation that provides little guidance to "real world" not-for-profits. The alleged failures in this case lead to important procedural lessons that can be gleaned from its unique facts. We suggest the following procedural protections be instituted by not-for-profits as risk minimization techniques in the executive compensation process:

Every organization should designate an individual who is disinterested in the compensation process and who is responsible to ensure that the organization establishes and implements a defensible executive compensation process. This person may be an outside director, the general counsel, or outside counsel. The important thing is to have someone who makes sure that the organization is ready for the proverbial "knock on the door."

Regulators will focus on the reliability of the board’s decision-making process. It may be useful to re-examine the adequacy of board practices designed to elicit informed decision-making, such as advance distribution of meeting/briefing materials in "plain English"; limited use of "consent agendas"; access to board/corporate advisors; absence of last-minute material additions to the agenda; and distribution of relevant written professional opinions with all supporting materials.

Concentration of exclusive authority in a combined chairman /CEO position is becoming increasingly disfavored in this era of corporate responsibility. The concern is for an appropriate balance between the powers of the chief executive and those of the independent directors in their oversight role. Where the two positions cannot be separated for whatever reason, consider the appointment of a "lead independent director" with sufficient authority to assure an appropriate balance of governance power.

This board-level policy should name the board-level body responsible for oversight and approval of executive compensation and benefits and should contain other safeguards such as the following:

• Monitor the ongoing independence of the committee members (such as with a questionnaire that discloses the types of relationships that may undermine the necessary level of independence).

• Ensure that all committee members are aware of every type of compensation or benefit that is or might be provided to each executive.

• Ensure that the committee understands the benefit of reviewing and approving (in advance) every form of executive compensation and benefit in a manner that qualifies for the "rebuttable presumption of reasonableness" under the intermediate sanctions rules.

• Include in committee minutes a description of how the particular element of executive compensation and benefits is in the best interests of the organization and would further its exempt purposes.

• Require committee approval of each new form of, or each change to, executive compensation and benefits.

Too often a compensation arrangement is presented for board or compensation committee approval without a complete description of the circumstances in which the greatest amount could be paid for the least amount of service to the organization. Recent enforcement actions focus greater attention on whether the board understood the financial magnitude of the compensation arrangements. The board or committee should carefully study the proposed arrangement and use professional advice to gain a complete understanding of the likely value, and maximum value, of the proposed compensation arrangement. The consultant should certify the numbers provided to the board or committee under "best case" and "worst case" scenarios.

The board will gain maximum legal protection against "Monday morning quarterbacking" if it takes the steps necessary to qualify for the rebuttable presumption of reasonableness under the intermediate sanctions rules. This presumption will apply if total compensation is reviewed and approved in advance by independent members of the board, if those board members rely on appropriate comparability data from similarly situated organizations and if a contemporaneous and thorough written record of the deliberations is prepared. This presumption is so important that even the IRS refers to it as a "safe harbor."

The IRS has great difficulty in determining what constitutes "reasonable" compensation and will try to avoid having to do this. Instead, the IRS strategy will be to attack the rebuttable presumption of reasonableness. If the IRS can show that the rebuttable presumption does not apply and consequently pin on the employer the burden of proving that compensation is reasonable, the IRS can force the parties to specify a pay level that the IRS agrees is reasonable. If an exempt organization wants to be sure that the presumption is in place, it should ask counsel to provide a "wrap-up" advice letter at the end of the process describing the support for the application of the rebuttable presumption.

The Spitzer v. Grasso lawsuit offers valuable lessons on not-for-profit board practices and compensation-related procedures considered problematic by state regulators. When viewed together with the recently announced Senate Finance Committee hearings on nonprofit board governance practices, as well as the IRS’s imminent investigation of compensation at large exempt organizations, this litigation suggests that board oversight of executive compensation will remain a front-burner issue for the foreseeable future.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.