Remuneration committees - “in the line of fire”

The courtroom battles between shareholders and directors are seldom the stuff of “Vanity Fair” magazine. However, if the subject matter is the Disney company, the directors include Sydney Poitier and the matter revolves around the tale of two Hollywood titans, then expect the unusual.
Shareholders of Disney are claiming against the Disney directors and the compensation committee in particular for their role in the employment and severance agreements of former president Michael Ovitz. The compensation committee approved the dismissal of the president and the payment of a US$140 million severance package after Mr Ovitz was less than 15 months in the job.
The recently concluded trial, and the SEC orders (settling inadequate "related party transaction" disclosure issues), are part of a continuum for the Walt Disney Company that included a very difficult shareholder meeting in 2004 that resulted in the board separating the positions of chairman and chief executive. Last year, nearly 45% of shareholders voted against CEO Michael Eisner's re-election to the board. In response, the board stripped Eisner of his role as chair and elevated former U.S. Senator George Mitchell to that post. Eisner later announced that he would retire by September 2006.
This case is interesting because it examines a claim around excessive compensation for people other than interested directors in question and because the case explores the duty of directors and directors on the remuneration committee in particular, to act in good faith.
The US and Australian formulations of the business judgment rule provide that directors have the right and duty to decide where the company's interests lie. Directors are entitled to have regard to a wide range of practical considerations and their judgment is not open to review in the courts.
It is a prerequisite of the business judgment rule that directors have acted in good faith and for a proper purpose. The elements of the rule are good faith, disinterest, exercise of judgment, proper information and reasonable belief. Thus, although the board of directors is entitled to a presumption that it exercised proper business judgment, the board will need to be able to demonstrate:
 the decision was made in good faith and for a proper purpose (ie in the best interests of the corporation as a whole);
 they had no material personal interest in the matter;
 they informed themselves of available material information by, for example:
 considering an appropriately selected expert’s opinion;
 providing all board members with adequate and timely notice of the matter , of its purpose and all relevant information for the purpose of considering the transaction; and
 inquiring adequately into the reasons for, or terms of, the transaction.
The duty of good faith requires that directors must: exercise their powers in the interests of the company, not misuse or abuse their power, avoid conflict between their personal interests and those of the company, not take advantage of their position to make secret profits, account to the company for business opportunities which come to them by reason of or in the course of holding office as a director and exercise an independent judgment in relation to proposals put before the board.
Executive compensation (as opposed to that of directors) is a matter of business judgment. Good corporate governance requires that boards take responsibility for the remuneration of the business’ key executives. In the US it has been suggested that if directors say that they base compensation decisions on some performance measure and then don't do so, or if they are disingenuous or dishonest about it, this could amount a breach of the directors duty of good faith.
The question is what type of conduct must a director engage in to be found to have not acted in good faith and thereby allow a court to review the board (or the committee’s) business judgment? Courts have traditionally had some difficulty in divining the subjective motivation (good faith or bad faith) of officers from objective facts; generally conduct must be fairly egregious in order to rise to the level of "bad faith".
The standard of behaviour required is not complied with by subjective good faith or by a mere belief by a director that his or her purpose was proper, rather it involves a determination of whether a reasonable director could have reached that conclusion.
In the first Disney case the Court refused to dismiss a complaint seeking to hold the directors of The Walt Disney Company personally liable for damages arising out of the hiring and termination of Michael Ovitz as Disney's President. The complaint suggested complete abdication of authority by the directors. It was alleged that, when Ovitz was hired, the compensation committee and the directors paid little attention to the terms of his employment, leaving the arrangements to be negotiated by Mr. Ovitz and his "close friend," Michael Eisner, Disney's Chief Executive Officer.
The board's alleged neglect will be key to the Court's decision. While the business judgment rule might have applied if "the board had taken the time or effort to review [its] options, perhaps with the assistance of expert legal advisors," the allegations, if found made out, "imply that the defendant directors knew that they were making material decisions without adequate information and without adequate deliberation, and that they simply did not care if the decisions caused the corporation and its stockholders to suffer injury or loss."
The duty of good faith requires that a director act in the best interests of the corporation. While the Court's review requires it to examine the board's subjective motivation, the Court will utilise objective facts to infer such motivation. The analysis will focus on the process by which the board reached the decision under review. That said however, Australian courts are likely to remain extremely reluctant to impose liability on disinterested directors who make genuine efforts to fulfil their duty to make informed decisions regarding matters of importance like executive compensation.
The good faith obligation includes an obligation to penetrate beyond the superficial whilst this is a more onerous obligation than that held by a director generally because a specific responsibility has been assigned to the committee it is consistent with the obligation to exercise a level of care and diligence having regard to the circumstances of the director the office held.
In the Australian context the good faith test will probably cross similar ground to the statutory requirement of the business judgment rule that the committee members have informed “themselves about the subject matter of the judgment to the extent they reasonably believe appropriate”, that is, the committee came to an informed decision.
In this context committee members need to be able to establish they conducted themselves in a manner that enabled them to reach an informed business judgement about the remuneration/compensation issue. The committee needs initiative, diligence and independent thought. Unfortunately this might mean a proliferation of external advice designed to protect the members of the committee from liability.
For Disney it will be interesting to see whether without the harsh glare of shareholder criticism the company will maintain its interest in shareholder rights and whether the Delaware court is willing to open the board room door and analysis the appropriateness of the Ovitz termination and employment arrangements.
Remuneration/ compensation committee
Remuneration/compensation committees used to be considered relatively innocuous, but the rules of the game are about to change, if they haven’t already, the Corporations Act now includes specific references to the work of the remuneration committee, if not committee itself. The ASX corporate governance principles recommend the establishment of a remuneration committee the majority of whom should be independent and who should be lead by an independent chair.

The committee will usually be responsible for remuneration policies and practices, it will to take control of the disclosure obligations relating to executive remuneration and the adoption of the remuneration report.
Takeaway – satisfying the business judgment ‘defence
To rely on the business judgment rule members of the remuneration committee need to be able to demonstrate five things:
1. That a decision was taken.
2. No personal interest in the matter that could be seen to have a capacity to influence the individual’s vote.
3. The decision was made for a proper purpose (in the best interests of the company) without misuse or abuse of power and exercising independent judgment.
4. That members reasonably informed themself of all material information concerning the matter by, for example:
 considering an expert’s opinion;
 adequate and timely notice of the to allow proper consideration of the matter; and
 demonstrate inquiry.
5. That members rationally believe the decision is in the best interests of the company.
In general a systematic approach to the transaction will help committee members substantiate that they took reasonable steps to inform themselves and that their belief that the transaction was in the best interests of the company was reasonable.