I was recently introduced as a “leading” advocate of an “expertise” board. I guess I am pleased to be described as “leading,” because “lagging” probably would connote that I am deceased!

I am delighted that the concept of an expertise board is becoming known: A board composed of persons each having particular competencies (i.e., knowledge, skills, experience, and expertise) needed for the board to have as a whole all of the competencies necessary to achieve its future objectives. This is in contrast to a “constituency” board which is composed of persons who represent the view of a particular constituency (such as the US Congress or a state legislature).

In this month's issue of Acredula, we advocate “The Case for the ‘Expertise’ Board: Selecting Board Members on the Basis of ‘Competencies’ rather than ‘Constituencies.’”

Although “words are my business” now, many do not know I have a background in mathematics and statistical analysis. I conducted public opinion polls and focus groups before practicing law, and I have continued to review and extrapolate the empirical data from such polls and groups to the present day. I believe that both existing law and changes in law should be supported by empirical data.

So “The Case for . . .” article begins with empirical data supporting the expertise board. It then discusses basic tenants of corporation law also in its support.

I passionately believe that governing boards are not only the first line of defense against mismanagement and fraud, but also the best line of offense for good governance. Recent failures over the last dozen years show that all organizations can do a better job selecting their board members. Doing so, upon the basis of the collective expertise and competencies of the board as a whole, may reinvigorate confidence in corporate America.

Read past issues of Acredula.

The role of a director is to oversee that direction is provided, but it is not to execute that direction or manage the organization unless the board member believes that the CEO and management are not reliable and competent to do so. A director does this by asking sufficient questions, so the director has a reasonable belief that the CEO and management are reliable and competent in what they are authorized or directed to do.

Questions should not generally be "how are you going to do this." Management should have the authority to determine "how." A director’s questions are to verify or confirm management’s reliability and competence in making the "how" determination: "How does this benefit the best interests of the business?" "Is it consistent with our business model and strategy for the future?" "What financial, legal, ethical, strategic and reputational issues have been considered?"

Directors should take into account the premise of Nassim Nicholas Taleb’s book, "Black Swan, The Impact of the Highly Improbable," that policy makers such as directors must consider all of the possibilities, especially those that could have a high impact, albeit remotely probable, and not just the normal. The current "Great Recession" is the likely result of a failure to take into account the highly improbable, but high impact, occurrence of real estate and investment prices falling significantly at the same time.

Accordingly, the most important questions that a director should ask are "what if," most importantly, "What happens if things don’t go as expected?"

Read February's issue of Acredula which continues our series on making better boards: "Questions Directors Should Consider Asking." Other articles of our series include: "Caveat Director!" and "Questions to Ask Before Joining a Non-Profit Board (November 2009); "Ten Strategies to Make Your Board More Effective (December 2009); and "Ten Considerations for Making You a Better Board Member" (January 2010).

Also in February's issue is an article by Kevin Kinross on the duties of a constituency director, "Don’t Forget which Hat You’re Wearing."

“The thoroughness of the board’s understanding of the company” is viewed by directors as one of the misfeasances by board that contributed to the current Great Recession, according to a paper written by Jay Lorsch that was based upon a survey of directors conducted in 2009 by the Harvard Business School as part of its Corporate Governance Initiative.  

One director is quoted as saying, “I don’t think independence is anywhere near as important as we thought it was.”  

Congress reacted to the dot.com burst by enacting Sarbanes-Oxley and requiring greater independence of members of audit committees. Quasi-government organizations such as the New York Stock Exchange and Nasdaq expanded the independence requirements from audit committees to other oversight committees, such as compensation and nominating, and to the board itself. Regulators such as the SEC, IRS and the Treasury, as well as banking and insurance regulators, expanded the independence requirements from publicly-held companies to tax-exempt organizations and financial institutions.  

The result has been that management members of the board who understood the business model and strategic direction of their organizations are being replaced with independent members not having such understanding. This loss of understanding is now being realized by the independent directors.

The trend toward independence probably should not be reversed. Independent directors, especially those who are selected on the basis of the expertise, experience and knowledge they contribute to the board as a whole, add value to the board and the organization.

However, if the loss cited by the directors surveyed by Harvard is true, then this loss should be mitigated by inviting key management in addition to the CEO to serve as resources to the board at board meetings.

In any event, a good practice is for boards and their oversight committees to meet regularly with key management. Benefits of regular meetings with key management are that:

• It opens communication channels between the board and key management;
• Doing so regularly usually does not offend CEO;
• It facilitates the board’s federal and state obligations not to impede whistle blowing by encouraging communication both from employees to the board, hopefully without anonymity, and
• Board and management will each learn from the other.

Generally, familiarity of management with the board and vice versa will not breed contempt, but will foster trust and eliminate contempt.

Read January's issue of Acredula which contains an article on Ten Considerations for Making You a Better Board Member. Also included is an article by Kevin Kinross on the governance checklist recently released by the IRS for its agents audits of tax-exempt entities entitled IRS Continues Focus on Corporate Governance.

Internal Revenue Service (IRS) Commissioner Douglas H. Shulman addressed the 2009 National Association of Corporate Directors Conference on October 19, 2009. In his remarks, Commissioner Shulman discussed the importance of involving boards of directors in overseeing corporate tax risks and strategies. His emphasis was to offer attendees a number of suggestions for managing task risks and FIN 48 compliance. (FIN 48 establishes the financial statement accounting for uncertain tax positions, including recognizing and measuring their effect on financial statements).

Shulman suggests, as part of board members’ ongoing corporate responsibilities, that boards of directors implement a mechanism to oversee tax risks. According to Shulman, boards should consider the following actions:

• Set a threshold confidence level for taking a tax position and review major tax positions.
• Discourage or eliminate opinion shopping by tax departments by engaging an independent tax firm, which has some direct dialogue with the board of directors.
• Specifically address transfer pricing and the relative profit allocated to low-tax jurisdictions, and make sure they reflect real economic contributions made in those jurisdictions.

In his speech, Shulman also discussed FIN 48 compliance as a, “very significant window into tax risk, liability and management in your company.” He recommended that boards consider asking their tax director and external auditors the following questions relating to FIN 48 compliance:

• What was the process for identifying uncertain tax positions and how do you know all material issues have been identified?
• How did you go about determining the maximum tax exposure relating to each uncertain tax position? What makes you comfortable that it accurately reflects your maximum exposure?
• How did you go about quantifying the likelihood of winning or losing uncertain tax positions? Do you plan to litigate the issue if the IRS challenges the position? Does the external auditor or tax advisor agree with the tax director’s assessment?
• Could the company be subject to potential penalties, such as for underpayment of tax, negligence or worse? If so, are they appropriately recorded, and perhaps more important, what does this say about how aggressive the company’s position is regarding those issues?

Shulman emphasized that taxes are no different than any other large expense in that responsible management should try to control it, he stated. However, Shulman reminded the audience that, “In the case of taxes, controlling it can expose the company to challenge, which can result in reputational damage and perhaps large, unexpected expenses.” 

His recommendation is that boards need to have a close understanding of how their management has chosen to control the tax expense, and how aggressive they have decided to be. In addition, reporting must be effective. Shulman concludes by stating that as with any expense, “ Manage it (taxes) too loosely and you give up profit. Manage it too aggressively and there are bad consequences.”

In a troubled economy where businesses are struggling to survive, it is no surprise that many organizations find themselves insolvent or nearly insolvent. Directors of insolvent or nearly insolvent organizations are facing the question of to whom they owe their duty of loyalty, and whose best interest must they consider when making decisions. When in the zone of insolvency, directors still owe a duty to stakeholders to act in their best interests. Judicial decisions in some jurisdictions, however, have suggested that when an organization is insolvent or in the “zone of insolvency,” the directors’ fiduciary duties extend to the organization’s creditors as well.

Ohio courts have not decided whether directors of an insolvent or nearly insolvent corporation owe a fiduciary duty to the corporation’s creditors. Federal courts applying Ohio law, however, have held that directors owe no such duty to creditors. The cases, discussed below, rely on Ohio Rev. Code § 1701.59 to reach their conclusions. Rev. Code § 1701.59(B) imposes a duty on a director to act in good faith and in a manner that he believes is in or not opposed to the best interests of the corporation. Section 1701.59(E) explains the factors a director may take into consideration when performing his duty:

(E) For purposes of this section, a director, in determining what the director reasonably believes to be in the best interests of the corporation, shall consider the interests of the corporation’s shareholders and, in the director’s discretion, may consider any of the following:

(1) The interests of the corporation’s employees, suppliers, creditors, and customers . . . .

Ohio Rev. Code § 1701.59(E) (emphasis added). The most significant language is the distinction between the mandatory consideration (the interests of the shareholders) and the permissive considerations (which include the interests of the corporation’s creditors). 

In Official Committee of Unsecured Creditors of PHD, Inc. v. Bank One, the District Court for the Northern District of Ohio granted a director’s motion to dismiss and found that the director of an insolvent corporation owed no fiduciary duty to the corporation’s creditors. The Committee argued that upon PHD’s insolvency, the director owed a duty of care to PHD’s unsecured creditors. The Committee further argued that he breached this duty by failing to fulfill his responsibilities as a director, failing to prevent others from making misrepresentations to PHD’s creditors, and failing to mitigate the effect of others’ misrepresentations to the creditors. 

The court disagreed. It focused on the word “may” § 1701.59(E) and determined that there was no indication that the legislature intended that consideration of creditors’ interests was anything other than permissive. The court denied the motion for reconsideration as to the dismissal of the Committee’s claims for breach of fiduciary duty owed to the creditors. The court explained, “because Ohio statutory law explicitly defines the duties of directors of a corporation, and because that explicit definition does not require directors to consider the interests of creditors, there is no fiduciary duty owed by directors to creditors, regardless of the financial state of the corporation.” 

The court granted the motion for reconsideration as to dismissal of the Committee’s claims that the directors breached their fiduciary duties to the corporation because none of the parties had moved to dismiss those claims, so the court’s dismissal of those claims was clear error. This distinction clarifies the court’s belief that under Ohio law, even during insolvency, directors do not owe fiduciary duties to a corporation’s creditors. However, the creditors of an insolvent corporation may bring a claim for breach of fiduciary duty to the corporation itself.

In In re Amcast Industrial Corp., the bankruptcy court took a similar approach and reached the same conclusion, that officers and directors do not owe a fiduciary duty to a corporation’s creditors even if the corporation is insolvent or in the zone of insolvency. There, the court concluded:

The plain language of Ohio Rev. Code § 1701.59(E) clarifies that a director has discretion to consider many constituencies of the corporate enterprise, including creditors, when making corporate decisions. However, a director has no distinct legal obligation directly to creditors, separate from the corporate entity as a whole, even when a corporation has reached the point of insolvency. 

Thus, the court found that Ohio law does not impose a fiduciary duty on directors to a corporation’s creditors when the corporation is insolvent or nearly insolvent.

While not controlling on Ohio courts, Bank One and Amcast may be influential on the issue because they reflect reasonable applications of Rev. Code § 1701.59(E).

Ohio state courts have not determined the issue, but the Supreme Court of Delaware recently analyzed it in detail in National American Catholic Educational Programming Foundation, Inc. v. Gheewalla. Because Ohio case law is silent on the subject, an Ohio court might consider a Delaware business law case as persuasive authority. In Gheewalla, the plaintiff was a creditor of Clearwire Holdings, Inc. The defendants were directors of Clearwire while it was either insolvent or in the zone of insolvency. The plaintiff alleged that the defendants breached the fiduciary duties they owed to the plaintiff as a creditor. 

The Supreme Court affirmed the Chancery Court’s decision to dismiss the complaint. It first held, “no direct claim for breach of fiduciary duties may be asserted by the creditors of a solvent corporation that is operating in the zone of insolvency.” The court reasoned that creditors, unlike shareholders, have contractual agreements, fraud and fraudulent conveyance law, implied covenants of good faith and fair dealing, bankruptcy law, commercial law, and other sources of creditor rights to protect them. It concluded that a corporation in the zone of insolvency is most in need of effective and proactive leadership and the ability to negotiate with creditors; a direct fiduciary duty cause of action for creditors likely would undermine these goals. Finally, when in the zone of insolvency, the court stated that the focus for directors does not change; they must continue to exercise their business judgment in the best interests of the corporation for the benefit of the shareholders. For all of these reasons, the court refused to allow creditors to bring direct claims for breach of fiduciary duty.

Second, the Supreme Court held, “individual creditors of an insolvent corporation have no right to assert direct claims for breach of fiduciary duty against corporate directors.” (emphasis by court). The court noted that when a corporation is insolvent, creditors take the place of shareholders as beneficiaries of an increase in value, so creditors of an insolvent corporation have standing to maintain derivative claims on behalf of the corporation for breaches of fiduciary duties. However, to find that directors owe fiduciary duties directly to creditors “would create uncertainty for directors who have a fiduciary duty to exercise their business judgment in the best interest of the insolvent corporation.” It also would conflict with the directors’ duty to maximize the value of the insolvent corporation for the benefit of all those with an interest in it. Therefore, while creditors of an insolvent corporation may bring a derivative action against the directors for breach of fiduciary duty, they cannot bring a direct action because the directors owe no fiduciary duty to the creditors.

Given the vast experience of Delaware courts with business and corporate law matters, Ohio state courts may well see Gheewalla as persuasive on the issue. Furthermore, as the federal courts explained in Amcast and Bank One, the plain language of Rev. Code § 1701.59(E) supports a finding that directors do not owe a fiduciary duty to the corporation’s creditors regardless of the corporation’s financial state. This is especially true given that the statute expressly makes the consideration of shareholders’ interests mandatory but makes consideration of creditors’ interests permissive. Thus, we can say that Ohio law probably does not impose on corporate directors a fiduciary duty to the corporation’s creditors when the corporation is insolvent or nearly insolvent. Still, with no Ohio case on point, it is impossible to conclude with certainty.

NOTE: A glossary of the terms used in this and future posts on executive compensation are contained in the July 2009 issue of Acredula and are also available at http://www.bricker.com/legalservices/practice/deferredcomp/glossary.aspx.

A supplemental executive retirement plan or supplemental executive retention plan (SERP) is an arrangement providing retirement or retention benefits to supplement the basic retirement benefits or regular compensation to which the employee is otherwise entitled. The arrangement is typically a non-qualified deferred compensation plan that is limited to a select group of management or highly compensated employees (i.e., a “top-hat employee”).

SERPs exist in a variety of forms for a variety of purposes. The purpose of this article is to facilitate consideration of the relevant factors for the design of an appropriate SERP.

Retirement or Retention. They may be for purposes of retirement or retention for a period of time.

• A retirement SERP supplements a top-hat employee’s qualified retirement benefits if the employee remains in service until retirement (or another defined “triggering” severance such as normal retirement, death or disability). A “restorative” SERP is a common form of retirement SERP that provides non-qualified deferred compensation to a top-hat employee to restore qualified plan benefits to which the employee is not entitled because of the limitations on contributions and benefits imposed by Internal Revenue Code on highly-compensation employees under qualified plans. Retirement SERPs may be a defined-benefit, defined-contribution, cash-balance or target-benefit arrangement as discussed below.
    
• A retention SERP provides a cash award, typically in the form of a bonus, to a top-hat employee for remaining in service for a number of years that is not based upon retirement. Most retention SERPs are a defined contribution arrangement (discussed below).

Defined-Benefit, Defined-Contribution, Cash-Balance or Target-Benefit Arrangement. SERPs may be a defined benefit, defined contribution, cash balance, or target benefit arrangement. 

• A defined benefit SERP defines the benefit, occasionally a fixed dollar amount or more frequently, an amount based upon an employee’s compensation or a combination of compensation and years of service and for which the employer bears the investment risk. A common form of defined benefit SERP provides a benefit upon retirement in the form of an annuity that, when added to the employee’s projected qualified plan retirement and Social Security benefits, will equal a percentage, such as 60 percent, of the employee’s final average compensation. 
    
• A defined contribution SERP provides for (i) an individual account for the employee and (ii) benefits based solely on the amount contributed to the employee’s account and any income, expenses, gains and losses for which the employee bears the investment risk. A common form of a defined contribution retention SERP provides a contribution of a fixed dollar amount to an individual account that is invested until the employee completes a period of service, at which time the employee receives the account in lump sum. A common form of a defined contribution retirement SERP provides a contribution of periodic contributions, typically annually, to an individual account that is invested until the employee has a triggering severance (typically, normal retirement, death or disability), at which time the employee receives the account in lump sum.
     
• A cash balance SERP has characteristics of a defined contribution plan that is intended to constitute a defined benefit plan. Typically, the employee is credited with a pay credit, such as a percent of his or her compensation over the years of participation or other period, and an interest credit based upon a fixed or variable rate (often an index rate such as the 1-year Treasury bill rate) on the pay credits over the same period. There is a hypothetical accounting of the credits, and the benefit to the employee is the accounted value of the credits at the date of payment. As with other defined benefit plans, the employer bears the investment risk.
     
• A target benefit SERP has characteristics of a defined benefit plan that is intended to constitute a defined contribution plan. Typically, the plan defines a target benefit upon reaching retirement age and then defines a contribution that, using actuarial assumptions (such as interest rates, mortality and employee turnover) determined pursuant to the plan, is projected to result in that target benefit at the payment date. The contributions are credited to an individual account for the employee, and the account also is credited or debited with the actual (not the assumed) income, expenses, gains and losses from the investment of the account. As with other defined contribution plans, the employee’s benefit is the account value at the date of payment, and the employee bears the investment risk.

Reserved assets, Rabbi Trust, or not. Assets may or may not be reserved on the employer’s books for the SERP, and any reserved assets may be held by a Rabbi trust:

• Subject to the no-constructive receipt limitation common to all SERPs discussed below, the employer may reserve assets on the employer’s books to satisfy the employer’s obligation to pay the SERP’s benefit in the future. Any reserved assets may be transferred and held in a Rabbi trust discussed below.
    
• In absence of an asset reserve, SERP benefits will be paid from what assets exist on the books of the employer as SERP payments become due.
    
• A Rabbi trust is a grantor trust used to receive and hold assets reserved to satisfy an employer’s obligation in connection with deferred compensation arrangements and comply with no-constructive receipt limitation discussed below. The assets of the Rabbi trust are held for the exclusive purpose of satisfying the employer’s obligation to make payments to the employees or their beneficiaries except in the case of insolvency of the employer. In the case of insolvency, the assets of the trust will become subject to the claims of employer’s general creditors under federal and state law. If the trustee becomes aware of the employer’s insolvency, the trustee is required to discontinue payments to employees or their beneficiaries and is required to hold the assets of the trust for the benefit of the employer’s general creditors. Because the Rabbi trust is a grantor trust, all income of the trust and items of deduction against that income or credit against any taxes on that income are passed through to the employer pursuant to the grantor trust rules.

Limitations common to all SERPs. The following are limitations generally common to all SERPs:

• Top-hat limitation. A SERP must generally be limited to a select group of management or highly compensated employees.
   
• No constructive receipt. An employee cannot be in constructive receipt of any SERP benefit or any of the assets securing its payment. The rules of constructive receipt require that (i) an employee’s rights to payment of any SERP amount may be no greater than those of general unsecured creditors of the employer; (ii) the obligation of the employer to pay the SERP may constitute no more than a mere promise to the payments in the future; and (iii) the employee’s rights to payment may not be subject, in any manner, to anticipation, alienation, sale, transfer, assignment, pledge, encumbrance, attachment or garnishment by creditors of the employee or his or her beneficiary.
   
• Time and form of payment determined upon commencement of participation. The events triggering payment, and the time and form of payment, of the SERP’s benefits must be determined before the employee has a legally binding right under the SERP, which is generally at the time the employee commences participation or, in some circumstances, by the 30th day after the employee first becomes eligible to participate. The time and form of payment generally is irrevocable and cannot be accelerated and may only be postponed in limited circumstances.
   
• Inclusion in gross income or wages for employment taxes. The value of non-qualified deferred compensation such as a SERP benefits must be included in the gross income and reported as wages of an employee for purposes of federal employment taxes, including Social Security and Medicare taxes, as of the later of when the underlying service is performed or when there is no substantial risk of forfeiture. Some SERPs are designed to require an advanced payment of an employee’s SERP benefit equal to the employment taxes required to be withheld, and if so, the employee’s SERP benefit is reduced by the amount of the advanced payment.

Additional limitation applicable to SERPs of tax-exempt and government organizations. Unlike employees of taxable organizations whose non-qualified deferred compensation such as SERP benefits is not included in gross income for federal income taxes, the value of non-qualified deferred compensation of employees of tax-exempt and government organizations is includible for federal income taxes for the first taxable year in which the compensation is not subject to a substantial risk of forfeiture. A SERP for an employee of a tax-exempt or government organization is typically designed to require the employee’s service through the last day of the service period, for a retention SERP, or until retirement (or another triggering severance such as death or disability) for a retirement SERP. If the employee’s service is terminated before the last day of such period or other than by a triggering severance, the employee typically forfeits his or her entire SERP benefit.

Limitation desired by some governance commentators. Some governance commentators dislike SERPs other than restorative arrangements designed to restore qualified plan benefits to which the employee is not entitled because of the limitations on contributions and benefits imposed by Internal Revenue Code on highly-compensated employees under qualified plans. For example, a policy of the Council for Institutional Investors is that a SERP should only be an extension of the retirement program covering other employees or, in other words, a restorative arrangement. Compensation committees should not be so limited as long as they are confident the value of the potential benefit to the employee is taken into account in determining total compensation and nothing excessive is hidden.

Limitation announced by Treasury and the Special Executive Compensation Master. On October 22, 2009, Treasury and the Special Executive Compensation Master for companies receive TARP funds issues rulings requiring governing boards to (i) “ascertain the full amount of pay an executive will receive upon retirement,” including specifically from SERPs, and (ii) base SERP benefits upon the employee’s or the organization’s performance to the extent that it provides more than a restoration of qualified plan benefits to which the employee is not entitled because of the limitations on contributions and benefits imposed on highly-compensation employees.

A properly designed SERP can not only attract and retain a highly-compensated employee important to the organization but also can facilitate a transition by the employee after a period of service or upon retirement.

On October 22, 2009, the US Department of Treasury’s Office of Special Master for executive compensation of companies receiving TARP funds made public letters issued to seven companies (AIG, Citigroup, Bank of America, Chrysler, General Motors, GMAC, and Chrysler Financial), and the Board of Governance of the Federal Reserve issued proposed guidance on incentive compensation policies. The Special Master’s focus is to determine executive compensation by formulaic rule while the Federal Reserve’s focus is that incentive compensation should be determined by director oversight guided by the three principles.

For example, the Special Master’s letter to AIG states that “2009 compensation for AIG’s senior executive officers and most highly compensated employees generally must comport with the following important standards:

• Base salary paid in cash should not exceed $500,000 per year, except in appropriate cases for good cause show . . .
   
• Rather than cash, the majority of each individual’s based salary will be paid in the form of stock units reflecting the value of a “basket” of four AIG insurance subsidiaries . . .
   
• Total compensation for each individual must be appropriate when compared with total compensation provided to persons in similar positions or roles at similar entities. Overall, total compensation must be significantly reduced from the amounts paid in 2008. In AIG’s case, total compensation for these employees will decrease 58% from 2008 levels.
   
• If – and only if – the employee achieves objective performance metrics developed and reviewed in consultation with the Office of the Special Master, the employee may be eligible for long-term incentive awards. These awards, however, must be payable in the form of restricted stock that will be forfeited unless the employee stays with AIG for at least three years following grant, and may only be redeemed in 25% installments for each 25% of AIG’s TARP obligations that are repaid. . . 
   
• Any and all incentive compensation will be subject to recovery or clawback if the payments are based on materially inaccurate financial statements, any other materially inaccurate performance metrics, or if the employee is terminated due to misconduct that occurred during the period in which the incentive was earned.
    
• Any and all ‘other’ compensation and perquisites will not exceed $25,000 for each employee . . .
    
• No severance benefit to which an employee becomes entitled in the future may take into account a cash salary increase, or any payment of stock salary, that the Special Master has approved for 2009.  
    
• No additional amounts in 2009 may be accrued under supplemental executive retirement plans or credited by the company to other ‘non-qualified deferred compensation’ plans…”

The Federal Reserve’s guidance reflects none of these formulaic rules. Instead, states that “arrangement at one firm may not be suitable for use at another firm because of differences in the risks, controls, structure, and management among firms,” and provides as guidance three key principles:

1. Provide employees incentives that do not encourage excessive risk-taking beyond the organization’s ability to effectively identify and manage risk;
2. Be compatible with effective controls and risk management; and 
3. Be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.

Even though a majority of the directors of AIG’s board were appointed at the direction of the Treasury, the Special Master’s letter dictates to AIG’s board that it “must take certain additional corporate governance steps,” including granting long-term incentive awards only “as measured against objective performance criteria that the [Board’s Compensation] Committee has developed and reviewed in consultation with the Office of the Special Master.” On the other hand, the Federal Reserve’s guidance recognizes that governing boards are the highest authority in American corporate governance by stating that “the board retains responsibility for ensuring that the organization’s incentive compensation arrangements are consistent with safety and soundness.”

Nevertheless, there are similarities between the Special Master’s letter and the Federal Reserve’s guidance that boards of any organization and their compensation committees should be aware:

• Avoidance of excessive risks. Boards should delegate to a senior officer or group evaluating and managing risks to the enterprise, and these risk-management personnel should have input into the organization’s processes for designing incentive compensation and assessing their effectiveness in restraining excessive risk taking. The board and its compensation committee should receive on an annual or more frequent basis an assessment by management with appropriate input from risk-management personnel of the effectiveness of the design and operation of the organization’s incentive compensation system in providing risk-taking incentives that are consistent with the organization’s safety and soundness. In addition, at least the compensation committee should work closely with any board-level risk and audit committees.
    
• Use of enterprise-wide measures. Both the Special Master’s letters and the Federal Reserve’s guidance favor enterprise-wide measures “that are only distantly linked to the employee’s activities” for avoiding excessive risk taking. The Special Master’s letter to AIG focuses on increases in enterprise net work, capital or surplus through “stock units” or appreciation rights reflecting the adjusted book value of a “basket” of four AIG insurance subsidiary, excluding extraordinary events. The Federal Reserve guidance gives “firm-wide profit” as an example of a measure.
    
• Longer term performance periods. Both the Special Master’s letters and the Federal Reserve guidance focus on longer-term plans than annual bonus plans. The Special Master’s letters states that the period should be three years with cliff vesting unless the employee remains employed until the third anniversary of the date granted.
    
• Deferred payouts. Both the Special Master’s letters and the Federal Reserve guidance focus on deferred payouts. The Special Master’s letters state the payouts should be in 25% installments for each 25% of TARP obligations that are repaid. The Federal Reserve guidance states that the payout should be delayed significantly beyond the end of the performance period to allow for adjustment based upon actual losses or liabilities that are realized after the period.
    
• Not granting exponentially increasing awards. The Federal Reserve Guidance discourages awards having exponentially increasing increments for performance about target because this may motivate employees to take excessive risk in order to reach those targets. The Special Master’s letters approaches this more formulaically by correlating the amount of the award with specified, objective performance criteria that do not diminish long-term value creation.
    
• Forward-looking and backward looking clawbacks. Both the Special Master’s letters and the Federal Reserve guidance include clawbacks, or recovery by the organization of compensation, for risks recognized currently as possibly resulting in future losses or liabilities as well as for currently recognized losses or liabilities that result from risks incurred during past performance periods. The Special Master’s letters require clawback for any award based upon materially inaccurate financial statements or other materially inaccurate performance metric criteria as well as to reduce the amount of any incentive award on the basis of the overall evaluation of the employee’s or the organization’s performance (notwithstanding full or partial satisfaction of the performance criteria).
    
• Disfavor of entitlements. The Special Master’s letters prohibit paying for executives’ personal expenses in excess of an aggregate of $25,000 annually; employer-funded supplemental executive retirement plans and non-qualified deferred compensation unless based upon the executive’s or the organization’s (or a business unit’s) performance; and additional accruals to severance plans after 2009. The Federal Reserve’s guidelines discourage “golden parachutes” or arrangements awarding an employee for departing, or upon a change control of, the organization.

Despite these similarities, a striking difference exists between the Special Master’s approach of formulaic rule and the Federal Reserve’s approach of director oversight guides by some key principles.