Proper Compensation Governance Meets Business Objectives and Keeps Directors Out of Trouble
Now, more than ever, directors and executives are under pressure to ensure that their business practices and processes meet new disclosure and governance standards. Recent corporate scandals in the United States and Canada have eroded shareholder confidence. As a result, corporate decision making is under the microscope, and directors and executives are more accountable than ever for corporate decisions.
Directors are charged with a growing list of governance responsibilities, including decisions regarding remuneration. Companies are under pressure to strike a balance between rewarding and retaining talent by offering competitive and attractive compensation packages, on one hand, and providing incentives that meet standards established under the Canadian compensation governance regime, on the other hand. As a result, boards are taking compensation issues more seriously. Compensation committees are being staffed with capable directors who are spending more time at the job and who are retaining experts to provide advice.
Directors making compensation decisions must be wary of attracting personal liability and should take steps to avoid reputational harm. To meet the requisite standard of conduct, directors should consider both statutory and fiduciary requirements, and ensure that the decision making process is properly undertaken. This article includes a brief survey of the regulatory framework that applies to compensation governance and a practical guide to "getting it right" that sets out the steps that directors can take to avoid problems.
Regulation of Compensation Decisions in Canada
The Ontario Business Corporations Act provides that in making decisions, directors must act honestly and in good faith and with a view to the best interests of the corporation.1 Canadian case law adds that the courts will defer to the business judgment of directors where the decision is within a range of reasonableness.2 A director who fails to meet his or her duty of care to the corporation and has not acted reasonably, honestly and in good faith may be personally liable. Further, any indemnity provided by the corporation may not apply to a director who has failed to meet this standard of conduct.3
In Canada, new governance practices give existing sources of liability, such as those set out in the Ontario Business Corporations Act, specific and tangible standards that should be met to avoid liability. In particular, the TSX, securities regulators and institutional investors provide specific standards that directors and executives must meet and disclose publicly.
The TSX and the Ontario Securities Commission have recently increased required disclosure and documentation of decision-making processes. For example, more information about directors must be provided, including attendance records and the names of other public company boards on which a director sits. Companies are required to disclose whether they have adopted the recommended regulatory approach; identify where their practices depart from that approach; and describe the procedures implemented to meet the governance objective.
With respect to compensation in particular, the board of directors is required to appoint a compensation committee that is composed entirely of independent directors. The responsibilities, powers and operation of the compensation committee must be set out in all proxy circulars.
The compensation committee is required to
- Adopt a written charter.
- Make recommendations to the board regarding the compensation of officers and directors.
- Make recommendations to the board regarding incentive-compensation plans and equity-based plans.
- Review executive compensation disclosure in proxy circulars and in offering documents before public release.
- Disclose the identity of compensation consultants or advisers retained to determine compensation practices and processes of the corporation, as well as a summary of the work done.
Institutional Investor Influence
The governance role of institutional investors has grown in recent years as pension funds, mutual funds and independent money managers in Canada have acquired significant ownership positions in publicly traded corporations. Currently, as much as one-third of major Canadian corporations are owned by institutions that manage the savings of Canadians. In achieving long-term growth goals, institutional investors evaluate company practices and their effect on corporate performance. Canadian institutional investors have formulated both minimum governance requirements and best practices standards.
For example, the Canadian Coalition for Good Governance has developed the following minimum standards for executive compensation.
- The management compensation program should be linked to meaningful and measurable performance targets.
- The overall compensation philosophy for senior executives should be disclosed in all appropriate public documents, explaining the rationale for salary levels, incentive payments, stock grants (real or phantom), stock options, pensions (including supplemental pensions) and all other components of executive compensation.
- The compensation committee should be empowered to seek independent compensation advice as required.
- Stock options should be strictly limited in number and those that are granted should be focused on long-term remuneration and subject to vesting periods.
- All equity-based compensation plans should be subject to shareholder approval.
The Canadian Coalition for Good Governance has also established the following best practices:
- At least one director experienced in compensation should be included on the compensation committee.
- The chair of the compensation committee should answer questions relating to executive compensation at the annual general meeting.
- Senior executives should own shares throughout their tenure with the company.
- Options should have performance hurdles so that time alone does not determine their vesting.
- Post-exercise holding conditions should be considered for shares under option to ensure that stock ownership targets are met and exceeded.4
Six Steps to a Proper Process
Each director should consider taking the six steps set out below when making compensation decisions.
Deal with issues in a timely fashion.
Disclosure must be timely to be effective. Directors should raise issues at the first possible meeting. Failure to act in a timely fashion may result in a failure of directors to meet their duty to the corporation.5
- Understand the issue.
Directors must fully understand the issues before approving a compensation proposal. Directors should seek disclosure of all information necessary to understand the full context of the compensation decisions they make. Having a diverse board with directors with different skill sets and having at least one committee member with compensation expertise will help directors to meet this requirement.
Make proper use of experts.
The compensation committee or board of directors should directly retain experts and direct the type and scope of expertise required. Experts can advise compensation committees on the relevant legal background, proper process, tax and securities issues and current market trends. Experts can assist directors to implement compensation arrangements that meet the company’s business needs in an effective and efficient manner, and suggest potential compensation programs.
Consider the relevant factors.
The directors engaged in making compensation decisions should have and consider all information relevant to the compensation program they are considering.
Specifically, directors should ensure that they understand the business implications of the compensation program; the executive behaviour it will motivate; the potential payout in various scenarios (both good and bad); the tax, securities, accounting and employment law implications of their decisions; and where their programs rank in relation to the business’s competitors. Directors should seek detailed answers to all questions asked so they thoroughly address and understand all aspects of the issue in context.
Document the process.
Throughout the decision-making process, directors should ensure that their decisions and meetings are accurately recorded. Courts look to these records as evidence of a sound decision making process. Good records will assist directors to establish that they acted reasonably and properly.
All compensation committee members should maintain up-to-date records of meetings and all communications outside meetings; details and research respecting all issues currently before the committee; detailed information on compensation plans; all employment and related agreements subject to the committee’s scrutiny; detailed current and projected company financial data; information on current market standards and practices; and expert reports on compensation issues.
Understand the economics.
Directors must always consider remuneration decisions in the context of the company’s financial position. They should understand the tax and accounting treatment of the proposed compensation and payment levels in different business scenarios. Where compensation decisions are not made in the context of the financial status of the company or are disproportionate to the issues being addressed, the decision may be found to be unreasonable.
Change of Control
Compensation decisions should be considered in the context of the affairs of the company as a whole. Potential changes of control are particularly treacherous terrain for making compensation decisions. A new board or shareholder may closely scrutinize these decisions from a very different perspective. There must be sound business reasons and a welldocumented process to defend against a finding that, for example, generous severance payments are an indirect way of injuring the corporation financially in retaliation for a change of control. If a court makes such a finding, the decision to award an overly generous severance payment may be reversed.6 Where executive employment agreements are implemented immediately prior to a change of control, directors approving amendments to existing employment arrangements must proceed carefully.
Change of control or "golden parachute" agreements require particularly careful consideration. Two features of these agreements that were common five or more years ago have more recently drawn shareholder fire: (i) enhanced severance on termination following change of control; and (ii) the right to receive severance on a change of control without actual or constructive termination ("Single Trigger").
Executive agreements that provide for greater severance if the employee’s employment is terminated following a change of control are difficult to justify as being in the best interests of the company. Severance provisions should provide fair and reasonable compensation on termination of employment. It is difficult to support the proposition that the financial effect of termination on an executive is different if the executive is terminated following a change of control.
Single Trigger change of control agreements permit the executive to resign for no reason following a change of control and to receive severance. Single Trigger agreements may be justified for the CEO where the CEO’s termination is "inevitable" following a change of control. This may arise where the acquiror has a full executive team in place, the acquisition process is unusually hostile, or there is a hostile or very competitive history between the acquiror and the target. However, Single Trigger agreements are generally viewed as not being in the company’s interest. These agreements increase severance costs to the company, allow executives to resign even in circumstances where the acquiror considers them to be part of the value of the business and often require expensive additional retention programs to retain executives after a change of control.
1. Ontario Business Corporations Act, R.S.O. 1990, c. B.16, s. 134 [OBCA].
2. Peoples Department Stores Inc. (Trustee of) v. Wise,  S.C.J. No 64.
3. OBCA ss. 124(1) and (3).
4. Canadian Coalition for Good Governance.Online: The Canadian Coalition for Good Governance: www.ccgg.ca/web/ccgg.nsf/web/ccggguidelines.
5. UPM-Kymmene Corp. v. UPM-Kymmene Miramichi Inc. (2002), 214 D.L.R. (4th) 496, aff’d  O.J. No.636 (Ont. C.A.)
6. On December 22, 2000 Luscar Ltd.announced a settlement deal for CDN$10.9 million with nine former executives of a predecessor entity. "Settlement with Former Manalta Executives" (March 1, 2001), online: http://lexpert.ca/deal. php?id=1084.
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.