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Unfortunately, too many disclosures reveal the opposite—a philosophical muddle that underlies overly complicated compensation plans hidden behind nearly impenetrable disclosures. Such disclosures make investors uncomfortable, as if the board is hiding something, even when directors have no such intent.

First Principles
A good philosopher begins from first principles. In executive compensation, as with most governance matters, the overarching objective is (or should be) compensation plans that enhance shareholder value. The specific goals that satisfy this basic objective are essentially the same for every company:

• To attract and retain the talent needed by the company to create value;
• To reward, and thereby motivate, that talent for sustainable value creation; and
• To meet the company’s attraction and alignment objectives at the lowest reasonable cost to the shareholders.

This list satisfies another philosophical touchstone: that any set of objectives or goals be mutually distinct and collectively complete. Attraction, alignment and cost comprise all of the relevant points that a board ought to consider in the design, implementation and disclosure of compensation plans.

Compare this list to an actual 2010 disclosure:

• To attract and retain the highest possible caliber management team;
• To reward the achievement of predetermined company objectives;
• To reward superior performance;
• To provide management with incentives to build value; and
• To align the interests of management with those of our shareholders.

The last four items all describe alignment. What about the cost to shareholders? When you repeat two, three or four times the reasons that you would reward managers, and leave out any consideration of cost, your investors are bound to wonder what you really care about.

Schering-Plough’s list (from its 2009 proxy) shows a slightly subtler redundancy:

• To attract and retain a management team that will continue to deliver excellent performance;
• To motivate the management team to provide superior performance that would build long-term shareholder value; and
• To compensate the management team based on the level of corporate and individual performance, providing pay at or above the 75th percentile of the peer group if performance is superior and with compensation decreasing for lesser performance.

Stripped to its essence, one can see that the last objective is largely redundant, essentially saying that the company will reward its managers for superior performance (presumably motivating it) by paying them superior compensation for that performance (presumably enough to retain them). While pay for performance may hint at cost control, you can’t blame investors for wondering if cost was, in fact, a specific consideration.

No Principles
The opposite of reasoning from first principles is copying what everyone else seems to be doing. Too many compensation committees are stuck in a benchmarking mentality that inadvertently overrides their basic desire for shareholder value creation. A recent review of how a company’s statement of objectives had evolved over time showed that the list grew from five to eight objectives in 2009. The company said that it had hired a consultant to review its compensation philosophy, and had accepted their recommendations to revise them. The eight objectives included, as one might expect, six repetitive or irrelevant items, and was missing one relevant item—cost control. It was clear from looking at the disclosures of their peers that the consultant had benchmarked their peers’ objectives, making sure that they left nothing out.

A general review of CD&As reveals that nearly every company lists attraction or alignment in some fashion (often in multiple fashions) in their objectives. Many companies list other objectives that, under a good philosopher’s glare, would never really be traded off against attraction or alignment. Less than half include cost control.

From my experience, I know that very few directors are oblivious to cost. In fact, boards are highly conscious of compensation costs, and are wary of being perceived as overpaying their CEOs. Instead, I think the reason that cost control is missing is the same reason that relevant objectives get repeated, and irrelevant objectives slip in, i.e., many boards have not thought about their philosophy as a philosopher would, and instead benchmark their philosophy, creating something akin to everyone copying everyone else’s C paper.

The Mysterious Fourth Objective
Many directors have suggested to me that they could think of a fourth objective that should be added to my list of three. However, after discussing their suggestion, we almost invariably agree that (a) their proposed fourth objective is subsumed by one of the other three, or (b) that it is not directly relevant to shareholder value and therefore must be subordinated to the other three, or (c) that we disagree about shareholder value being the governing principle. (I understand that there are directors out there who believe that companies should focus on certain things that may run counter to shareholder value, but I don’t recall ever having seen such a sentiment expressed in a disclosure to investors.)

Multiple, distinct objectives invariably imply trade-offs. In other words, you can’t get more of everything— attraction, alignment and cost control—at the same time. Indeed, a critical role of the board is balancing those objectives, making those trade-offs against the ultimate standard of shareholder value. For example, the board must decide whether reducing the cost of compensation to the shareholders may be worth the risk of failing to retain key managers, or whether the higher cost of incentive payments is likely to result in the better performance that those incentives are designed to motivate. Given the importance of these trade-offs, it is surprising that this “balancing” role is not more widely mentioned in the CD&A, or the board actually addresses those trade-offs. Of course, you cannot make trade-offs if you are missing a key objective, like cost control.

The Cost of Poor Philosophy
Larry Ellison gets about $70 million per year, almost all of it in equity grants. This extraordinary sum is justified by an unbridled desire to align the interests of management and shareholders. It conforms pretty well to Oracle’s compensation objectives:

• To attract and retain highly talented and productive executives;
• To provide incentives for superior performance; and
• To align the interests of our executive officers with those of our stockholders.

The last two objectives are, of course, redundant; incentives for performance are the means of aligning interests. However, the real problem is the lack of a cost-control objective. The effects of that omission are particularly apparent in Ellison’s compensation plan. It’s a good bet that paying Ellison $70 million enables Oracle to retain his services as CEO. But what if the board asked themselves how much less than $70 million they could pay Ellison without risk of losing him? If they insisted on paying him $1, where would Ellison go? Would he say adios, and worry about how some other CEO might manage his $30 billion stake in the company?

Similarly, what if the board asked themselves how offering less than seven million options would affect Ellison’s incentive for performance or the alignment of his interests with the other shareholders? Given that Ellison already owns one billion shares, any number less than seven million additional shares would—my guess—probably not materially reduce his focus on shareholder value.

But Oracle doesn’t have cost control as an objective. The dominant shareholder—Larry Ellison—does not mind, so the board can act as if it has no constraint on what it pays to retain or motivate him. In Oracle’s case, the lack of a cost-control objective is quite visible, as it is for other firms whose CEO pay seems unmoored from the rest of Corporate America.

While the lack of a cost-control objective can be harmful for shareholders, inclusion of objectives that are irrelevant to shareholder value can be just as frustrating in other ways. Executive compensation is already complicated by the many elements available in meeting just those three basic objectives: fixed versus variable comp, cash versus equity comp, guaranteed versus contingent, in-service versus post-employment, and many more.

All of these trade-offs create an exponential number of permutations in how pay packages can be designed. This complexity can be more easily managed if the underlying philosophy guiding the trade-offs is clear and straightforward.

Investors are beginning to demand clarity. They crave simpler, clearer disclosures about executive compensation, especially now that they will have to vote on it every first, second or third year.

Marc Hodak is managing director of Hodak Value Advisors and teaches corporate governance at New York University’s Leonard N. Stern School of Business.

The Chairman said that for the first time, SEC rules require boards to explain in the proxy what a director adds to a particular board. Further, now a company’s proxy simply cannot state “risk is overseen by the board” and leave it at that; it must explain the board’s and C-suite’s risk functions, and illustrate that the board understands the compensation issues affecting risk.

Chairman Schapiro encouraged director engagement with the SEC and has instructed her staff to accept all “face-to-face meeting” requests. In addition, the SEC continues to post on the SEC website all written comment letters on SEC proposed rules and concept releases. Chairman Schapiro encouraged NACD to continue to be active and engaged in robust dialogue with the SEC and invited individual directors to join the conversation.

Highlights of the SEC Guidance
The SEC guidance highlights four ways in which climate change may trigger disclosure obligations:

1. Impact of international climate change accords; Indirect consequences of climate change regulation or resulting business trends, such as (a) decreased demand for carbon-intensive goods and services related to carbon-based energy sources and a corresponding increased demand for goods and services with a low carbon footprint, (b) increased competition to develop innovative products, and (c) increased demand for alternative energy sources;
2. Physical impacts of climate change, such as (a) property damage and disruption to operations on coastlines as a result of rising sea levels or severe weather, (b) indirect financial and operational impacts from disruptions to operations of major customers or suppliers from severe weather, (c) decreased agricultural production in areas affected by weather-related changes, and (d) increased insurance claims, premiums and deductibles for public companies with facilities in areas subject to severe weather.

If material to a registrant’s business, disclosure of the foregoing potential impacts of climate change may be required under Regulation S-K, specifically Item 101 (description of business), Item 103 (legal proceedings), Item 303 (management discussion and analysis) or Item 503(c) (risk factors).

Implications of the SEC Guidance
Public companies should keep the following issues in mind in preparing their annual reports to shareholders, Form 10-Ks and other public filings.

• Consider both the risks and opportunities of climate change: Companies should not focus solely upon the risks of climate change, but also on the opportunities of climate change (such as sales of allowances in a cap and trade system or increased demand for products with a low carbon footprint).
• Consider both indirect and direct risks and opportunities of climate change: The SEC Guidance provides examples of direct climate change risks (such as potential physical impacts or costs to improve facilities) as well as indirect risks and opportunities (such as changing demand for certain goods and services or reputational harm).
• Resolve doubts concerning the materiality of climate change in favor of disclosure: Although the SEC Guidance does not alter the traditional standard of “materiality” — which requires disclosure if a reasonable investor would view the information as important in making an investment decision — doubts whether information is material should be resolved in favor of disclosure.
• Ensure that adequate disclosure controls and procedures are in place to evaluate the materiality of climate change issues: The SEC Guidance does not require public companies to disclose their carbon footprint, but management needs sufficient information concerning greenhouse gas emissions and related operational matters to evaluate the likelihood of a material effect. Therefore, companies must have adequate controls and procedures to process information potentially subject to disclosure. Such controls and procedures should already be in place for management to make required certifications under Sarbanes-Oxley, but disclosure committees should now add an assessment of the materiality of climate change issues to the company’s business.
• Reconcile voluntary and mandatory disclosure of climate change issues: Many public companies voluntarily disclose information regarding their greenhouse gas emissions and climate change risk in corporate sustainability reports and various greenhouse gas reporting programs, such as the Climate Registry, the Carbon Disclosure Project and the Global Reporting Initiative. Companies should ensure that any mandatory SEC disclosure is consistent with prior voluntary disclosure or be prepared to explain any differences.

Richard M. Schwartz is a litigation partner and head of the environmental practice group in the New York office of Fried, Frank, Harris, Shriver & Jacobson LLP. Donna Mussio is a senior associate in the environmental practice group. Coleman Kennedy, an associate in the environmental practice group, also contributed to the preparation of this article.

1. Truth
This is a powerful principle. It has been stated simply as, “Say what you do, and do what you say.”

Michael Ross

When searching for solutions to problems, there are often several alternatives. Directors and senior management often engage in cost-benefit or risk-reward analysis, and sometimes obtain expert opinions. This is certainly appropriate, but in some instances, decisions can be reached, or at least some alternatives eliminated, by simply sticking to the facts. When an alternative has the “benefit of being true,” it is likely to be a viable one.

Decisions based on the assumption, or hope, that “no one will know” are very likely to turn out badly. This is probably truer now than historically was the case because there are so many parties interested in finding the truth for their own purposes. It is not just the press, the various levels of Federal, state and local government and the class action bar. There are also shareholder activists, special interest groups, whistle-blowers and bloggers. They are all out to “scoop” the company with some evidence of the truth that has not been told by the company.

Illustrations of the importance of truth come from many of the investigations of wrongdoing by corporate executives. These investigations often turn from the underlying allegations of substantive violations of law to allegations of obstruction of justice, commonly making false statements to government officials or destruction of documents. How different might the result have been if Martha Stewart had been motivated by truth as a guiding principle during the investigation of her alleged insider-trading.

Truth promotes long-term credibility and inspires confidence among the company’s constituencies. A company’s reputation for truthfulness can facilitate dealings with regulators, help manage investigations into alleged wrongdoing and get the company’s story effectively communicated to the public. We know how we feel about companies whose explanations do not make sense or contradict prior explanations, and it is not good.

2. Disclosure
A general inclination toward disclosure can be a sign of a healthy corporate culture. If the issue is whether or not to disclose material unfavorable facts, stretching to rationalize non-disclosure can be dangerous. A good general indicator of integrity is management’s willingness to disclose material adverse facts. Disappointing financial results or other adverse developments are bad enough, but the failure to make required disclosures compounds the problems. Material misstatements and omissions will cause the company to bear the costs of investigations and litigation, and possibly fines, damages and the loss of credibility with investors and the public.

The disclosure question arises in many contexts, e.g., public company reports and releases to investors, regulatory filings, certifications to creditors, advertisements and promotions and product labeling. Senior management’s propensity to engage in effective disclosure and resist burying salient facts in fine print or behind puffery is an indication of integrity.

There are, however, exceptions to the benefits of disclosure. Competition requires keeping secrets. Strategies for reducing the pressures from Wall Street for short-term profits may include limiting or eliminating disclosure of projections and “guidance.” Shareholder activists tout “transparency” as a bell-weather of good corporate governance, but there are limits. For example, when pressures for disclosure become a de-facto requirement that a company post its code of business conduct on its web site, the benefits of “transparency” may be outweighed by the costs. The incentives to create and take competitive advantage of a confidential, superior code are lost; many companies merely look to see what is prevalent in the industry, and there is a tendency for the substance of the codes to sink to the “lowest common denominator.”

3. Clarity of Communications
The business world is full of important communications. Companies constantly communicate with numerous audiences by a variety of means. Clarity in these communications is a sign of a well-run business and a healthy corporate culture. Fuzzy language is often a pretty indicator of fuzzy thinking.

For the board of directors to discharge its responsibilities, management must give directors clear information about the company’s strategy and its plans for execution. When (not if) problems arise, communications often break down, and what communication there is becomes unclear. The board must insist, in good times and bad, that management give the board concise, understandable information on a timely basis.

For its part, the board must be direct with management about what information it wants, and how and when it wants it. In setting policy, the board must be certain that management understands the policy, the rationale for it and how the board expects to see the policy implemented and its effectiveness measured.

Management should be clear with analysts and investors in describing the company’s strategy, plans and results. Confusion in the marketplace will generally lead to lack of confidence, and that will usually adversely affect shareholder value.

Clarity is also important in communications to customers. In advertising, marketing, promotions, labeling, warranties, disclaimers and customer relations, management should be sure customers know what they are buying and what they are not buying. Putting the bad news in the “fine print” is not likely to be a sensible long-term tactic. Bold print might do a better job.

Employees cannot be expected to perform unless they understand what is expected of them, and the consequences for them and the company of success and failure. To avoid misunderstanding, multiple communications, by various means may be necessary. When it comes to codes of conduct and compliance, effective communications should include the reasons for the rules and illustrative examples.

If management’s communications with regulators are straightforward, the company should gain a reputation for integrity that will pay off in the long run. Regulators will be around forever, and the regulatory, institutional memory is long. Regulators will discover and seize upon inconsistent company communications to various constituencies, e.g., investors, customers and employees.

4. Consent
Consent goes hand in hand with disclosure. It is often the next logical step. Consent is relevant with many constituencies, not just shareholders, but also employees, customers and suppliers.

Consent is not always required, as a matter of law, contract or otherwise. In many circumstances, it is not advisable or practicable to obtain consent. Consent may be implied in some situations, such as, when a customer has full and fair disclosure about the company’s products or services, and makes a purchase. In more sensitive contexts, such as, the confidentiality of personal medical or financial information, advance written consent may be more appropriate.

This is not to say that public companies should seek shareholder consent for actions that do not require shareholder consent as a matter of law. It also does not mean that companies should give counter-parties more consent rights than are customarily negotiated in commercial contracts or corporate transactions. The principle of consent may, however, be instructive in making decisions about the treatment of stakeholders. We know from our personal experience when we think that our consent is required, and how we feel when our consent is obtained and when is it not.

The NACD’s SEC comment letter takes the following positions on the SEC proposal:

• NACD supports improved disclosure on the board’s role in risk oversight, including compensation matters as they relate to risk, on a limited basis: NACD disagrees with the SEC’s proposal to expand the scope of the CD&A to require disclosure concerning a company’s overall compensation program as it relates to risk management and or risk-taking incentives. NACD supports the idea that compensation information is an important feature of the risk discussion. Companies should be encouraged to provide this information in the most appropriate format, including narrative explanation.
• Whether freshman or long-serving director, we believe that experience and education should be reported so that those shareholders making judgments on a director candidate’s capability to serve are adequately informed.
• NACD supports the principle of an independent board leader.
• NACD supports the disclosure of all additional services provided by the compensation consultant to the company or its affiliates during the last fiscal year, along with an explanation of why these services were sought. However, NACD does not support disclosure of aggregate fees paid for executive pay consulting vs. all additional services.
• NACD does not believe boards need to disclose whether management recommended or screened the engagement of the compensation consultant. NACD does agree that, when the board (or a compensation committee) approves additional services, they should disclosure the nature of these services.
• NACD believes that there should be a separate undertaking by the SEC to review all the current requirements in the proxy statement, item by item, so they all get proper consideration.