ON Securities : Securities Lawyer & Attorney for Corporate Governance & Executive Compensation Matters

I attended a compelling legal education program this week, taught by Egil "Bud" Krogh. Political junkies know that Krogh was a young assistant White House counsel in the Nixon years. As a leader of the "Plumbers" unit, he authorized the 1971 break-in of the offices of Daniel Ellsberg's psychiatrist after the leak of the Pentagon Papers. After the break-in came to light in the Watergate hearings, Krogh pleaded guilty, served time in prison, was disbarred and later reinstated.

Bud now lectures on the topic of legal ethics, based on his recent book, Integrity: Good People, Bad Choices, and Life Lessons from the White House. His premise: in a pressure-filled environment such as the White House, intense loyalty to individuals can blind you to your higher principles. This is compounded by fear, inexperience, pride and other factors.

Krogh's description of an environment that can put pressure on decision-making is familiar to anyone called on to say yes or no to any proposal by a corporate officer. Whether the proponent is the client of an outside attorney or the boss of an in-house attorney, there is a lot of pressure just to nod approval, as Bud Krogh nodded to Howard Hunt when the Plumbers break-in was discussed. I think the situation is especially acute for in-house attorneys. Of course, most proposed actions are legal, and the advice is often about the level of risk involved in two alternatives. And most in-house attorneys do a great job of balancing the competing pressures of giving sound advice while also being part of the team. But how do some decisions, even decisions by good people, go astray?

A great example can be found in the options backdating scandals. An article in the Financial Times in November 2006 reported that the backdating scandals had resulted in at least twelve major US companies replacing their general counsel, and a March 2008 speech by the SEC's Director of Enforcement reported that at least seven former general counsel had been charged by the SEC in connection with the scandals. Backdating, even though not necessarily illegal in itself, in these cases represented falsification of documents and involved misleading accounting and tax fraud. I know many attorneys said "no" to the practice, but these counsel simply nodded as backdating was pushed by other corporate officers. It might not have seemed like such a big deal at the time.

I asked Krogh how to advise an attorney (maybe a younger in-house attorney) how to avoid the pitfalls of losing perspective in a pressure-filled situation. He steered me toward a Top Ten List provided by Hank Shea, a former Assistant U.S. Attorney in Minnesota who teaches ethical leadership at the University of St. Thomas Law School, including the following two lessons learned from the misconduct of others:

When faced with a right versus a wrong decision, guard against that first intentional misstep.

When faced with an ethical dilemma, seek advice and counsel from others.

After an interesting program, Bud entertained us with a great Nixon impression, including, at the request of one of my colleagues, the famous phrase "I am not a crook". Bud proved that we can all learn lessons about how to be able to make that statement, and mean it.

It's Just An IP Thriller - One More Comment

Bud Krogh also told a great story about Elvis, the King of Rock and Roll, who came to visit President Nixon in a meeting engineered by Bud. I just saw a great film about another King - the King of Pop. "This Is It" chronicles the rehearsals for Michael Jackson's planned comeback concert tour. I recommend it to anyone who wants to see the combination of pure genius and meticulous attention to detail shown by MJ. If you didn't see it before, it's worth reading my previous post, reporting that Jackson was actually one of the named inventors in an issued patent.

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Mark Borges, the well known compensation consultant with Compensia, gave a very interesting talk this week at a joint meeting of the Society of Corporate Secretaries and Governance Professionals and the Twin Cities Compensation Network. Mark was gracious enough to give me permission to post his presentation, which is full of useful updates on governance and compensation reform and tips on how to get ready. One of the interesting features is a time line showing the dates of adoption and introduction of various legislative and regulatory initiatives, as well as a preview of what's to come. As I've said before, watching the progress of these initiatives through Congress and the SEC reminds me of the arcade game where you can watch the little mechanical horses race around and around the track, with the lead constantly changing - as in this great video.

Mark made these points, among many others:

Given the amount of attention Congress is giving to health care reform, it is very possible that governance and compensation reform will be pushed to 2010 - unless there is some unforeseen crisis before then, which is always possible.

Mark, like me, had thought the Shareholder Bill of Rights Act (the Schumer Bill) introduced in the Senate had probably been swept aside or at least delayed by the passage by the House of the Corporate and Financial Institution Compensation Fairness Act (the Frank Bill). Now, he believes that the Schumer Bill may be getting new traction. The Schumer Bill is heavier on governance reform than the Frank Bill, and some of these provisions may be grafted onto a financial institutions reform bill.

Even though a shareholder advisory vote (Say-on-Pay) requirement likely will be part of any reform bill, it almost certainly will not be effective for the 2010 proxy season. Meanwhile, some major companies have voluntarily adopted other advisory vote models - in September, Microsoft adopted a triennial advisory vote, and in October, Prudential adopted a biennial advisory vote. If one of these approaches gains support, Congress may mandate one of these approaches rather than an annual vote on compensation.

I will mention some of Mark's other observations in a future post.

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Wall Street Wealth

Just as lawmakers and regulators are preparing to consider compensation reform once again, a new report has surfaced that's likely to turn up the heat on the debate. The Wall Street Journal reported that the major financial institutions are on pace to pay their employees around $140 billion this year - a record level. The Journal's study is based on compensation amounts these firms have accrued to date this year. Therefore, the amounts might be inflated. However, it's clear that the amounts will be back to pre-crash levels.

For example, the Journal projects that Goldman Sachs will pay $20 billion in compensation and benefits ($743,000 per employee) this year. Of course, Goldman is having a great year so far. But, as reported in the New York Times DealBlog, there is still a lot of debate over how much Goldman's results were helped by the government's bailout of AIG, which resulted in significant payouts to Goldman on AIG-insured contracts.

As reported by the Journal, its findings come at a time when the Obama administration's pay czar is preparing to issue his findings on pay packages at many of the financial firms that received TARP money. More generally, Congress will be considering reforms such as Say-on-Pay for all publicly held companies. One way or another, numbers like we're seeing from Wall Street are sure to affect the debate.

Are the banks paying the best and the brightest what they deserve, or do you think Wall Street greed is being rewarded by paying out bonuses fueled by taxpayer bailouts? Comment below or send me an e-mail.

Change (to the Cheat Sheet) You Can Believe In

It's been easy to keep the ON Securities Cheat Sheet up-to-date since early August - nothing really changed. All of the various legislative and regulatory reforms were dormant for a couple of months. (Probably waiting for the Olympic Committee to select a host city for 2016 and the Nobel Committee to select a Peace Prize winner.)

At long last, this month there has been a new development worthy of changing the Cheat Sheet. As reported in Bloomberg and elsewhere, the SEC has decided not to take any action on the proposed shareholder access rules this year, as it evaluates the many public comments on the proposal. The Cheat Sheet has been updated to reflect this decision, and as always, the updated version is available on the Resources section of this Blog.

The changes should start coming more quickly in the next few weeks. Stay tuned.

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More Risky Business - A Case Study in the Risk Aspects of Compensation

There was a fascinating article in the New York Times on Thursday about Merrill Lynch's 2006 bonus program, which resulted in large payouts to top management even as the company was sold to Bank of America in a distressed sale. The author of the article provides more in-depth analysis in a post in the Times' DealBook Blog. Of course, these pieces probably attracted my attention because the DealBook post starts with "Calling all compensation nerds".

The Times article lays out the ways in which the Merrill plan was supposed to align top management pay with long-term performance, but concludes that the plan "did not keep workers from taking risks that nearly sank the brokerage giant. And some of its senior executives still stand to collect millions of dollars in stock under the plan." The Blog post discusses the features of the plan that put a portion of the employees' bonuses at risk, provided for a partial clawback if return on equity was not adequate, and invested the bonus amounts in stock that was locked up for a year past the three-year term of the plan.

While the article itself focuses attention on the failings of the Merrill plan, the Blog post provides a more nuanced view of the effort put into structuring the program, and the reasons it may not have been fully effective:

The Bottom Line: Talk to people who were in the plan, and they will tell you it worked because Merrill executives lost money in the clawback in 2007 and also because of the sunken stock price. However, the executives all did better than regular investors who put in money at the same three points but did not have the firm's leverage to help. Of course, the executives work at the company, and the plan was meant to compensate them in part for that work.

Why did the plan fail to save Merrill? Some compensation experts suggested it should have been applied to far more people. Others said a single year's return on equity might not be the right metric. And others said risk management and capital rules also contributed to Merrill's problems.

I think the Merrill plan had many worthy features that should command the attention of compensation professionals, especially in the financial services industry where risk management will become the Holy Grail of compensation programs. The Blog analysis above points out that some adjustments in the Merrill program could have made it much more effective - for example, the plan should have applied to far more people. In the financial services industry, bonuses to employees at all levels fueled excessively risky practices. But just because the program didn't perfectly match investor losses with executive losses, that doesn't mean the Merrill program wasn't a worthy effort.

In-House Lawyer Bloggers - What's Next?

Here's a new one - The Corporate Counsel Blog reports that in-house corporate attorneys have joined the blogging world. For example, Doug Chia, Senior Counsel at Johnson & Johnson, is posting on J&J's corporate blog. Chia reports that he is encouraging other in-house attorneys to blog. One of his goals is to get relevant information to retail shareholders, in preparation for the next proxy season when brokers will not be able to vote without instructions from these shareholders.

What's next? I haven't seen any GC's tweeting - yet.

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Compensation consultant Frederic W. Cook & Co. just published a study of recent changes in change in control agreements. The study focuses on the practices of the 125 largest public companies. Frederic Cook found that, of the companies that use change in control agreements, 57% made changes in the past three years, including a number of changes that make the agreements less "executive-friendly". The changes included the following:

Many of the companies modified their excise tax gross-ups - the commitment to reimburse the executive for excise taxes payable as a result of excessive change in control payments. Eleven percent of the companies eliminated the gross-ups entirely. Another eight percent modified their gross-ups, moving to a modified gross-up formula instead of a full gross-up.

Nine percent moved from single-trigger vesting of equity awards upon a change in control to double-trigger vesting.

Nine percent modified their severance multiples. In many cases, the multiples for top officers were changed from 3X to 2X.

The Cook study also describes numerous other changes.

The Cook study points out that the first two provisions described above (tax gross-ups and single-trigger vesting) are considered "poor pay practices" under the standards of RiskMetrics Group. If these provisions are contained in new or materially amended agreements, RiskMetrics may recommend to shareholders that they vote against compensation committee members at the next annual meeting. This factor may have resulted in pressure on compensation committees to change these provisions in their change in control agreements.

The Cook study points out that some of the legislation being considered in Congress would not only require "say on pay" but would also require "say on severance" - an annual non-binding shareholder vote to approve golden parachutes. The study predicts continuing changes in change in control agreements.

What do you think? Will change in control agreement practices continue to change? Comment below or send me an e-mail.

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