May 5, 2003
Ms. Janice O'Neill
Re: Amendment No. 1 to the NYSE Corporate Governance Rule Proposals
Dear Ms. O'Neill:
I write to express my strong concerns regarding the proposed changes to compensation committee responsibilities specified in Amendment No. 1 to the NYSE's Corporate Governance Rule Proposals ("Amendment No. 1"). As a member of the Harvard Business School faculty, I have studied corporate boards for almost two decades, and have also consulted to numerous boards of NYSE listed companies. I have also served on several corporate boards and their compensation committees, including three NYSE listed companies. Let me begin by stating that I strongly support the general tenor, and most of the specifics, of the corporate governance reforms that have been proposed to date by the NYSE.
In my view, however, it would be a serious mistake to assign to the compensation committee the sole authority for evaluating the CEO and determining his or her compensation as the proposed amendment to subsection 5 of new section 303A of the Listed Company Manual mandates. Specifically it is proposed that the board's compensation committee "review and approve corporate goals and objectives relevant to CEO compensation, evaluate the CEO's performance in light of those goals and objectives, and have sole authority to determine the CEO's compensation level based on this evaluation" (italics added). As amended, this subsection would inappropriately delegate to a board committee a responsibility-the evaluation of the CEO-that could hardly be more central to what it means to be a director. Similarly it mandates that the compensation committee have the sole responsibility for determining CEO compensation, a decision in my view that also should remain with all the independent directors. I should add that I have very similar concerns with the provisions of the Sarbanes-Oxley Act which gives authority to the audit committee to oversee the auditors and the process. However, I assume that since the matter is already enacted into a Federal law, there is nothing that can be done to change it, at least in the short run.
I shall elaborate on my reasoning below, therefore, with regard to the compensation committee. But you can assume my concerns about board fragmentation also apply to the audit committee.
The Risk of Board Fragmentation. The amended subsection mirrors the approach of Section 301 of the Sarbanes-Oxley Act of 2002, which assigned unilateral authority to audit committees to oversee company auditors and audits. While well intended, these two sets of rules would create a grave risk of "balkanizing" corporate boards, by empowering a single committee to make critically important decisions and effectively disenfranchising independent directors not on the committee. This, I believe, will be divisive to boards, threatening their unity and adversely affecting their power to govern.
Further, the proposed regime is difficult to reconcile with the well-established (and, I believe, salutary) doctrine that a board's directors are equally and jointly responsible for the board's actions. It would make no sense to hold a director accountable for a board action from which he or she was excluded by virtue of not being on the relevant committee.
Moreover, the setting of executive compensation has broad implications for the board, the company, and the shareholders to whom all directors owe fiduciary duties. Therefore this is a decision that all independent directors must approve. This is so for three reasons. First, as the amended subsection acknowledges, CEO compensation should be tied to the board's evaluation of the CEO's performance. Second, compensation arrangements provide the CEO with powerful incentives to do either the right or wrong things. Third, executive compensation and its relationship to company performance affects the investors support for, and belief in, the legitimacy of individual companies and their willingness to invest in them.
I wrote about these concerns because of the fact that the most important developments in American corporate governance, over the past decade, have been the recognition that the CEO works for the board, and serves at its pleasure. Today's directors believe that the single most important contribution they can make to a company's well-being is to hire a high-quality CEO, monitor his or her performance, determine the appropriate rewards and replace that CEO if performance is inadequate. To accomplish all this, boards increasingly undertake formal evaluations of the CEO. This CEO evaluation is absolutely central to the independent directors' role, and simply cannot be delegated in its entirety to a single committee. To do so will impair the other independent directors' capacity to fulfill their fiduciary obligations. In fact, an important by-product of involving all independent directors in these evaluations is that this allows them to share their assessments, exchange ideas and develop a clear assessment of how well their company and its CEO are performing.
The evidence of the past few years suggests that the damage done by poorly designed executive compensation schemes went far beyond the waste of corporate resources. Even more significantly, CEOs were given powerful financial incentives to make decisions intended to raise the stock price in the short term, even to the company's detriment in the longer term. Given this fact, it is hard to see how determining the CEO's incentives should be delegated to a committee without all the independent directors retaining oversight authority.
American business has collectively paid a heavy price for the rampant excesses in CEO compensation in these past few years. This price has been paid in an erosion of public support for business, and confidence that companies are governed and managed in the interests of shareholders and the corporation itself. Because the reputation of business, and indeed its very legitimacy, are implicated in the issue of executive compensation, it is difficult to see how boards could be required to fully delegate responsibilities in this area to a committee, without retaining at least the right to approve the committee's recommendations.
If the board of directors as a whole, and each of its members, are ultimately responsible as fiduciaries to the company and its shareholders, all the independent directors ought not to be deprived of a role in evaluating the CEO, structuring his or her incentives, and helping to safeguard the legitimacy of business in the public's mind. While the logic of some specialization to assure efficiency on boards is compelling, the best way to reconcile the need for specialization with oversight by the full board is to require the compensation committee to present its recommendations about CEO compensation to all the independent directors for their approval.
Of course, the management members of the board would be excluded from these deliberations, given their conflict of interest. But the compensation committee should not usurp from the other independent directors what are properly viewed as the most critical board responsibilities of all.
I very much appreciate this opportunity to comment on Amendment No. 1. I would be pleased to discuss this further with you at your convenience.