Medical Device Link.

Originally Published MX March/April 2004

FINANCE

Medical device company boards of directors can strengthen investor confidence by setting standards and adhering to best practices.

Ted Ginsburg

The wave of scandals at publicly traded corporations continues today. Beginning with the collapse of energy giant Enron Corp. after the company's fraudulent accounting practices were revealed in 2001, news of corporate transgressions persists. Such improper business dealings led Congress to enact the statutory changes embodied in the Sarbanes-Oxley Act of 2002, and have also led to the creation of new exchange registration rules for publicly traded companies. Nevertheless, it seems that another company is charged with some type of financial misdeed on a monthly, if not daily, basis.

The investing public, members of Congress, influential business groups, and the media blame greedy corporate executives and inattentive boards of directors for this problem. These groups argue that today's corporate misdeeds are rooted in the following problem areas.

• Executives will do anything to maximize their employer's stock price because they have been heavily compensated with company stock.
• Executives are paid inequitably, as they receive pay raises and bonuses while company performance lags and share prices drop.
• Boards of directors act as a rubber stamp for executive pay programs that are suggested by management.

Although no companies that exclusively manufacture medical devices have been named in any of these recent scandals, the corporate parents of certain medical device manufacturers have been connected with adverse publicity, litigation, and government enforcement actions.

These scandals have dramatically reduced investor confidence in the securities markets and have spotlighted corporate director liability. The board of directors of every corporation must be concerned about investor perception of its role in determining executive compensation. The Conference Board (New York City), a nonprofit organization dedicated to management and marketplace issues, reported in September 2002 through its commission on public trust and private enterprise that "investors entrust their assets to management while boards of directors oversee management so that the potential for conflict of interest between owners and managers is policed."¹

Additionally, individual board members can face shareholder wrath and legal liability for not acting carefully in monitoring and directing management's activities. The Sarbanes-Oxley Act, for instance, expanded directors' responsibilities and liability. According to Institutional Shareholder Services Inc. (Rockville, MD), shareholder proposals relating to executive compensation increased by 400% between 2002 and 2003.² Shareholders need to see that executives are working to benefit their companies (and therefore the shareholders) in the long term; boards need to set standards that will lead to this result. Angry shareholders place much of the blame for excessive executive compensation on inattentive or compliant boards.

This article focuses on the proper role of the board in the area of executive pay, and what the boards of publicly traded medical device manufacturers are currently doing. Although it may be early for some companies to take action in this area, a survey of medical device manufacturers indicates that medical device company boards could do more to show investors that they are not simply rubber stamping management's pay requests (see sidebar).

The Board of Directors

Directors can be employees (called inside directors) or nonemployees (called independent directors or outside directors). One of the major changes to board membership that has arisen from the recent corporate scandals is that a majority of the boards of publicly traded companies must now be comprised of independent directors. These directors are often current or retired corporate executives, attorneys, bankers, academics, or substantial nonemployee shareholders.

Last November, the New York Stock Exchange (NYSE) adopted corporate governance standards for companies that wish to list their shares on the exchange.³ The standards contained, among other things, detailed board member independence requirements, which basically provide that the director, the director's immediate family, and the director's employer have limited (or no, in some circumstances) relationships with the company.

The NYSE also requires that listing companies maintain a board-level compensation committee to deal with executive compensation issues. The compensation committee, which is to consist entirely of independent directors, has the following minimum duties.

• Review and approve goals and objectives relative to the CEO's compensation, evaluate the CEO's performance, and approve the CEO's compensation based on performance.
• Recommend compensation programs, incentive compensation programs, and equity-based plans for non-CEO employees to the board.
• Prepare a report of the committee's activities to be included in the proxy or Securities and Exchange Commission's (SEC) 10-K form.

Those are minimum standards; many companies have charters dealing with executive compensation that are much more detailed. Other exchanges have different standards, but the NYSE is generally representative of regulatory change in this area.

Compensation Committee Best Practices

Compensation committees can implement certain procedures to ensure that they function effectively. While every item on the following list may not be applicable to all companies or discussed in a filing with the SEC, they do serve as a guide to some of the best practices in this evolving area.

Compensation Committee Charter. Mandatory for NYSE companies, a charter informs investors about the areas of executive compensation in which the committee assumes responsibility. It also 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.

Executive Compensation Philosophy. It is imperative to relate company business objectives to executive compensation programs. This philosophy, including its supporting strategies and results (for both company and pay programs), shows shareholders that executives are being compensated for meeting their business objectives. Philosophies may contain phrases such as "pay for performance" and "maximize long-term shareholder value."

Committee Education. The vast majority of corporate directors are not experts in executive compensation. The compensation committee needs to understand not only what the employer is offering, but also the universe of executive compensation programs and what programs are offered by successful companies within and outside its industry.

Outside Consultants. To be truly independent of management, the committee should have access to expert advisors to assist in evaluating currently offered programs and pay levels, management proposals, and the company's competitive standing (both in levels of compensation and programs offered).

Human Resources (HR) Confidentiality. Many committees obtain all of their information through the CEO. The ability to contact the HR department for information should allow the committee to function more efficiently and may remove a source of information filtering.

Committee Calendar. Many committees meet infrequently and for short periods of time; as a result, full discussion of necessary programs cannot occur. Effective committees schedule (at a minimum) quarterly meetings and set out specific agenda items at the beginning of each year. The calendar should be shared with the CEO and HR department, so that each knows when specific information will be needed by the committee.

Board Advisory. The committee should present to the entire board its recommendations and reasons for taking certain actions. The board should approve those actions as a whole after reviewing and discussing the recommendations.

Self-Evaluation. At the end of each year, the committee should compare what it actually accomplished to the duties specified in the charter and the goals contained in its annual calendar. The committee should analyze whether it has acted in the interests of shareholders. Finally, the committee should determine what changes need to be made in its charter, calendar, or method of operation, so that it can be more effective in the following year.

Corporate Governance

Unfortunately, several of the best practices that are described here are not being employed by publicly traded medical device companies. A recent survey found that larger companies tended to follow more of these practices than smaller companies (see sidebar). Consider the following results.

Meetings. Slightly more than one-third of the entire survey had fewer compensation committee meetings in 2002 than in 2001. Of the companies surveyed, 60% had fewer than four compensation committee meetings during 2002. Five companies' compensation committees had one meeting or fewer during that year. The larger companies met almost twice as frequently as the smaller companies.

Information Sources. Of the surveyed boards, 40% appeared to rely entirely on management-supplied information or did not disclose their information sources. Of the compensation committees of larger companies, 60% used an independent consultant to advise them on executive pay levels and programs.

Charters. None of the smaller companies had a proxy statement that would likely serve as a compensation committee charter for the purposes of the NYSE. On the other hand, 60% of the larger companies had such a charter (which isn't surprising because 80% of those companies trade on that exchange). Only one NYSE-listed company lacked a charter, and another did not disclose its charter.

Self-Evaluation. None of the companies discussed a compensation committee self-evaluation process in their proxies.

On the other hand, there were some indications of good corporate governance disclosed in the study.

Membership. Continuity in membership is important to good governance. Committee membership was stable during the two-year study, with 20% changing the number or identities of committee members. All but one committee had three members or more, and more than half of the committees had at least four members. The larger companies had larger committees (averaging 4.4 members) than the committees of the smaller companies (averaging 3.6 members), but both groups are within recognized levels of acceptability.

Independence. All members of the committees were independent of management, although it is unclear that they would meet the independence tests created by the NYSE or other exchanges.

Compensation Philosophies. Of all the surveyed companies, 95% disclosed their compensation philosophy in their proxies.

In general, the boards of the surveyed companies appeared to make few changes to their methods of monitoring executive compensation during the 2002 fiscal year. This is surprising in light of the negative publicity and regulatory changes in this area. However, the survey was based on proxy data that could have been filed with the SEC as early as March 2003. The surveyed companies may have been waiting for additional regulatory guidance, which agrees with the perception that these heavily regulated companies are very cautious in their approach to change.

Conclusion

The furor over executive compensation will not go away in the near future. Boards of directors will continue to come under scrutiny for their actions and perceived inactions. Companies that do not, at the very least, show investors that they are making conscious improvements in corporate governance will be severely judged by the investment community. Individual directors should be concerned about potential liability if the board is viewed as having a lower level of involvement when compared with other boards.

What initial steps should boards take to bring their corporate governance in line with best practices in this area? First, the board should ensure that it complies with all requirements of the exchange upon which the company's stock is listed (e.g., board member independence) as well as the requirements of the Sarbanes-Oxley Act (e.g., board expertise on the audit committee).

Second, the compensation committee should evaluate its relationship with management, and ask itself whether it could be viewed by outsiders as a rubber stamp. The committee should find out if it is receiving sufficient information about the executive compensation marketplace and about company performance so that it can properly judge the appropriateness of executive pay programs—and demand necessary changes.

A further step would have the committee retain outside compensation counsel to assist in determining what other steps are necessary to perform its assigned tasks properly and to serve as a resource for evaluating performance standards, management pay and program proposals, and executive pay levels.

References

1. The Conference Board Commission on Public Trust and Private Enterprise, "Findings and Recommendations—Part 1: Executive Compensation" (September 17, 2002): page 5; available from Internet: www.conferenceboard.org/knowledge/governCommission.cfm.

2. M Bruno, "Shareholder Proposals on Executive Compensation Rise in 2003," Institutional Shareholder Services (November 7, 2003); available from Internet: www.issproxy.com/articles/archived/archived61.asp.

3. New York Stock Exchange Final Corporate Governance Listing Standards (2003); available from Internet: www.nyse.com/pdfs/finalcorpgovrules.pdf.

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

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