Medical Device Link.

Originally Published MX July/August 2005

FINANCE

Medical device company boards of directors are improving governance in this area, but more work needs to be done.

Ted Ginsburg

Acting in response to the Sarbanes-Oxley Act of 2002, stock exchange rule changes, and investor concerns about passive boards of directors who rubber-stamped executive pay requests, medical device company boards of directors have begun to change the way they look at the executive compensation process.¹ This is among the key findings of a recent survey looking at how the boards of directors of selected publicly traded medical device manufacturing companies have modified their governance of executive compensation.

Now that Sarbanes-Oxley has been in force for another year and a half, it is worth investigating whether medical device companies have further embraced the corporate governance changes that the act—not to mention deeply interested investors and regulators—envisioned. Another study was conducted along the same lines as before. Its results indicate that compensation committees at medical device companies have made progress toward effective governance of executive compensation programs, but also that more work toward the ultimate objective is necessary.

This article looks briefly at the reasons behind the demand for increased corporate governance of executive compensation, then discusses the changes that have been made within the medical device community and outlines what still needs to be done.

Corporate Governance Initiatives

The Sarbanes-Oxley Act was an answer to years of corporate misdeeds that centered on executives manipulating company financial records in order to support stock prices or their annual bonuses deceptively. One of the act's key initiatives was to impose greater corporate governance responsibilities on executives and board members. Studies have shown that companies with stronger corporate governance perform better than companies with weaker corporate governance.² Nevertheless, most corporate complaints about Sarbanes-Oxley have focused on its impact on a company's internal accounting control systems.

The changes in corporate governance of executive compensation introduced by the legislation garnered publicity initially, but they have disappeared from the public eye somewhat. This is surprising, as executive pay scandals continue to receive attention from the press.

A clear accomplishment of Sarbanes-Oxley was its generation of a wave of corporate governance reforms relating to executive compensation at publicly traded companies. Some of the governance changes were made mandatory by the national securities exchanges—the New York Stock Exchange (NYSE), the American Stock Exchange (Amex), and the National Association of Securities Dealers Automated Quotations (NASDAQ)—while others were proposed by various interest groups (such as The Conference Board and Institutional Shareholder Services) and investors (for example, CalPERS, the California Public Employees’ Retirement System).

Several changes sought by the corporate governance movement were key. Central to these was the creation of a board of directors' compensation committee composed of independent—that is, outside—directors. At a minimum, this committee was to have oversight over the chief executive officer's pay package, though it was thought preferable that it have oversight over any compen-sation-related program affecting any executive, including base pay, short- and long-term incentives, and equity programs. Independent compensation committees now are required by the securities exchanges.³

The compensation committee would have to be provided with the resources it needed to be able to make informed decisions. The company was to give the committee the funds necessary for it to hire independent compensation consultants and to obtain training for committee members in the area of executive compensation.

In addition, the compensation committee was to be made responsible for its actions. The committee should create a charter outlining its duties, hold regular meetings during the year, perform an annual self-evaluation of its actions, and bear individual legal liability for any rewarding of executives in a manner not reflecting shareholder interests.

The last significant change expected was increased disclosure of executive compensation. Compensation committees now must prepare a separate report for proxy inclusion that details the key elements of the executive compensation program. Also, the Securities and Exchange Commission is now requiring expanded executive compensation program information to be included with Form 8-K.⁴

Progress Report

For the update study, the most recently filed proxy statements for 20 medical device companies were reviewed (see sidebar). Half of the companies reported 2004 revenues in excess of $1 billion (see Table I). The study focused on five key areas that demonstrate the commitment of a company and its compensation committee to effective corporate governance of executive compensation. The following results lead to the overall conclusion that, while there has been improvement over the past year and more, the boards' job is incomplete.

Membership. Continuity in membership is important to good governance. Committee membership decreased during the 2004 fiscal year, with the average number of committee members for large companies falling to 3.6 (from 4.4 in the prior study) and to 3.1 (from 3.6) for the smaller companies below $1 billion in revenues. The number of compensation committee members changed for 40% of the companies in the study, with all but one of those changes being a reduction in committee size. All of the committee members were independent under securities exchange guidelines.

The decreasing size of the committees is troubling. Perhaps it can be attributed to a greater focus on audit committees as a result of Sarbanes-Oxley's internal accounting control initiative. One positive trend is that, with this edition of the survey, no committee had fewer than three members, which corporate governance experts generally feel is the minimum acceptable size for such a committee.

Meetings. Although many companies call regular quarterly meetings of the entire board, good governance policy would suggest simply that the compensation committee meet on a regular basis, not necessarily quarterly, and whenever specific issues arise that warrant a meeting. The study found that the number of compensation committee meetings held during the 2004 fiscal year increased substantially. The average number of meetings for the entire sample increased to 4.6 from 3.55 in the earlier study. Half of the companies in the study held more compensation committee meetings in 2004 than in 2003, while only 10% had fewer meetings. Seventy-five percent of the companies conducted at least four meetings in fiscal year 2004, as compared with 40% in the prior study. Two companies had only one meeting in 2004. By contrast, that had been the case with 5 of 20 companies in the survey of 18 months before.

The increase in the number of meetings is a positive sign. It indicates that compensation committees are considering more issues or going into greater detail in their consideration of them. Many compensation committees now are discussing the changes to be made to their company's equity programs in light of the current expensing of stock options that is resulting from the creation of Financial Accounting Standard 123R. That standard becomes effective January 1, 2006, for employers with a calendar year-end.⁵ Committees may have been having those discussions during 2004.

Charters. Mandatory for NYSE-listed companies, a compensation committee charter informs investors about the areas of executive compensation for which the committee assumes responsibility. It should delineate the extent of the committee's role in each area, specifically detailing whether the committee will create, review, advise, or administer each function. Fifteen percent of the companies surveyed did not have charters for their compensation committee; these were all companies listed on NASDAQ. During fiscal year 2004, 45% of companies in the group added charters. Most of the companies with charters disclosed them in the proxy statement, while several referred the reader of the proxy to the company Web site, where the charter was posted.

Compensation Philosophy. It is imperative that company business objectives be related to executive compensation programs. This philosophy, which should include supporting strategies and results, demonstrates that executives are being compensated for meeting their business objectives. As in the prior study, 95% of the companies surveyed disclosed their compensation philosophy in their proxies.

Information Sources. To be truly independent of management, the committee should have access to information that will assist it in evaluating currently offered programs and pay levels and also the company's competitive standing in terms of both levels of compensation and programs offered. This information should not be provided by management. A compensation committee that relies on reports generated by management or management's compensation consultant will not convey to investors a sense of committee independence. That raises the question of whether management is asking the consultant all of the questions that the committee would have asked. Also, if the compensation committee does not have direct access to the consultant, there will likely be concerns about how its questions are answered.

The recent survey found that 80% of the companies in the study used an independent consultant to advise them on executive pay levels and programs, compared with 60% in the prior survey. Use of independent consultants was less at the smaller companies, though the figure rose to 40% from 20% in the earlier survey. Twenty-five percent of the compensation committees used publicly available compensation surveys for guidance in this area.

It was interesting that none of the companies relied upon management for their information in 2004 and only 20% of them did not disclose the source of their compensation information. In the 2003 survey, 40% of the participating companies either appeared to rely entirely on management-supplied information or else did not disclose their information sources.

Room for Improvement

Compensation committees should continue increasing their involvement in the executive compensation function in order to reassure the shareholders that those directors serving on the committee are fulfilling their duty to the company. That duty consists of three principal charges: to make sure that executive pay programs attract and retain desired executive talent, to pay executives in a manner that is consistent with a well-reasoned compensation philosophy, and to incite executives to act in the company’s best interests.

The companies surveyed for the study have taken the steps necessary to remain in compliance with the provision of the Sarbanes-Oxley Act and the requirements of the securities exchange upon which their shares are traded. The further steps that now need to be taken to improve corporate governance of executive compensation are not typically publicized; they are implemented as part of the normal operation of the compensation committee. These actions will improve the committee's effectiveness and deliver a better result to shareholders and to the executives.

Relationship with Management. The committee should evaluate whether it could be viewed by investors, analysts, and employees as a rubber stamp for management. It should consider whether sufficient questions are being asked about proposed programs, and whether committee members can talk to anyone besides the chief executive officer. The absence of a budget for outside education and technical support in the fulfillment of its duty should be a concern. If the committee is not receiving sufficient information about company financials and marketplace performance, it should demand necessary changes.

Continuing Education. Most corporate directors are not experts in executive compensation. Their experience in that area is usually limited to what occurs at their own companies and at the other companies upon whose boards they sit. But this is a period of dramatic flux in executive compensation, due in part to equity plan changes necessitated by FAS 123R and in part to deferred-compensation program changes pursuant to the American Jobs Creation Act of 2004.⁶ The compensation committee needs to educate itself in the altered universe of executive compensation programs and has to understand what programs are offered by successful companies both within and outside its own industry.

Committee Calendar. At the beginning of each year, effective compensation committees schedule meetings with specific agenda items to occur with at least quarterly frequency. This calendar should be shared with appropriate company officers to ensure that necessary information is provided to the committee on a timely basis.

Self-Evaluation. As corporate governance proponents have suggested, the committee should annually compare what it has accomplished with the duties specified in its charter and the tasks set out in its calendar.⁷ The committee should then determine what changes need to be made in its charter, calendar, or method of operation to enable it to be more effective in the following year.

Finally, the compensation committee should present to the full board of directors its recommendations and its reasons for bringing certain actions before the entire board. The board should approve those actions as a whole after review of the recommendations and discussion.

References

1. T Ginsburg, "Corporate Governance: Determining Executive Compensation," MX 4, no. 2 (2004): 36–41.
2. LD Brown and ML Caylor, "Corporate Gov- ernance Study: The Correlation between Corporate Governance and Firm Performance," (Rockville, MD: Institutional Shareholder Services, 2004); available from Internet: www.issproxy.com/pdf/Corporate%20Governance%20Study%201.04.pdf.
3. New York Stock Exchange Final Corporate Governance Listing Standards (New York: NYSE, November 4, 2003); available from Internet: www.nyse.com/pdfs/finalcorpgovrules.pdf.
4. Securities and Exchange Commission, Division of Corporation Finance, “Current Report on Form 8-K, Frequently Asked Questions (November 23, 2004); available from Internet: http://sec.gov/divisions/corpfin/form8kfaq. htm.
5. Financial Accounting Standards Board of the Financial Accounting Foundation, Statement of Financial Accounting Standards No. 123, Financial Accounting Series no. 263-C (Norwalk, cT: FASB, 2004).
6. American Jobs Creation Act of 2004, P.L. 108-357 (October 22, 2004), sect. 671.
7. Conference Board Commission on Public Trust and Private Enterprise, "Findings and Recommendations—Part 1: Executive Compensation," (New York: The Conference Board, September 17, 2002), 21; available from Internet: www.conference-board.org/knowledge/governCommission.cfm.

Ted Ginsburg, JD, is a consulting principal with Top Five Data Services Inc. (Fremont, CA).

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