Cross-Examining Executive Comp Experts Under New, Evolving Rules - 16 Dec 2008

Cross-Examining Executive Comp Experts Under New, Evolving Rules

Steven A. Beckelman and Daniel P. D'Alessandro
New York Law Journal
December 16, 2008

Recent events, such as the financial crisis and the enactment of
provisions of the Troubled Asset Relief Program (TARP) limiting certain
executive compensation will likely lead to an increase in the number of
disputes over executive compensation. Litigation involving challenges
to executive and director compensation will generally feature reports
and testimony by expert witnesses in the field of executive
compensation.



This article will outline some of the issues to be considered by
counsel in preparing to cross-examine an expert at deposition or at
trial on the basis for the expert's opinion on the amount of
compensation and benefits awarded.



Compensation experts have been utilized, and the flaws in their
opinions have been exposed by the courts, in the context of derivative
actions or other corporate governance disputes, see In re Walt Disney Co. Derivative Litig., 906 A.2d 27, 58 (Del. 2006), in claims of terminated executives, see Bensen v. American Ultramar Ltd., 1996
WL 422262 (S.D.N.Y. 1996), and in disputes with the Internal Revenue
Service (IRS) over reasonable compensation expense under §§162 and
280(G) of the Internal Revenue Code (IRC), see Labelgraphics Inc. v. Commissioner, 1998 WL 668645 (Tax Ct. 1998) and Square D Co. v. Commissioner, 121 T.C. 168 (Tax Ct. 2003).



EVOLVING LEGAL RULES



The field of executive and director compensation implicates complex and
rapidly evolving legal requirements, accounting rules, standards
promulgated by SROs and "best practices" advocated by investor
organizations. Many of the legal rules relating to the process of
decision making and disclosure requirements may be relevant to
attacking or defending compensation decisions. For example IRC §162(m)
requires prior approval by outside directors of performance-based
compensation of certain "covered employees" in order for the expense to
be fully deductible. The SROs, such as the NYSE and NASDAQ, have
additional process-related and disclosure requirements affecting public
companies, such as the requirement of a compensation committee charter.



Litigation over executive compensation will generally involve questions
of process, as the failure of the compensation committee and the board
to act consistently with the duty of due care may rebut the business
judgment rule presumption that the board acted on an informed basis and
in the honest belief that the action was taken in the best interests of
the company and its shareholders, and require the defendants to
demonstrate the entire fairness of the compensation. In re Walt Disney Co. Derivative Litig., 907 A.2d. 693, 747 (Del. Ch. 2005). While the duty of due care is not synonymous with compliance with best practices, In re Walt Disney Company Derivative Litig.,
supra, 906 A.2d at 58, courts may admit evidence regarding standards
and best practices. It is therefore likely that compensation experts
will seek to give an opinion on process-related issues as well as the
reasonableness of the resulting decisions, so familiarity with all
process requirements and the state of the art on best practices is
essential.



The evolution of laws, rules and standards requires that counsel
consider the state of the art and applicable rules at the time of the
compensation committee or board decision as to compensation process and
amounts in question.



As an example, prior to 2006, accounting standard FAS 123 did not make
performance-conditioned vesting of stock benefits practical because it
subjected companies to variable accounting for the cost of stock
awards. The process of acceptance of evolving standards is also
gradual, commencing with the largest organizations.



"As has typically been the pattern, the top 200 companies are leading
the way by introducing new directions in the structure and level of
director compensation with changes gradually extending to other revenue
groups," according to the National Association of Corporate Directors
2006-'07 Directors Compensation Report.



'BEST PRACTICES'



It is also important to review multiple sources of pronouncements on
"best practices" in compensation, such as the National Association of
Corporate Directors, Council of Institutional Investors, Business
Roundtable, Conference Board Commission on Public Trust and Private
Enterprise and TIAA-CREF, as their positions are not uniform on all
issues and it may be possible to demonstrate that an expert is taking a
position in reliance on one source that is contradicted by other
sources of best practices. Some of the recommended best practices
relate to the data to be used in connection with compensation decisions
discussed below.



As with all experts, their prior opinions, experience and
qualifications must be explored in general and with reference to the
scope of their opinion. For experts affiliated with consulting firms,
review of materials published by their firms may yield positions at
odds with those taken by the expert on specific issues.



An expert may seek to give an opinion on position qualifications,
relative economic performance of the entity against its peers or
individual performance, but may lack the qualifications to opine on
such issues. Compensation practices vary substantially among industries
and an expert's lack of industry specific knowledge and experience may
devalue the opinion. See Anderson v. Sotheby's Inc. (No.
4 CIV. 8180-June 13, 2005) (expert not qualified to give opinion on job
responsibilities). Federal courts have applied the principles of Daubert v. Merrill Dow Pharm., 509 U.S. 579 (1993) and Kumho Tire Co., Ltd. v. Carmichael,
526 U.S. 137 (1999), to decisions on the admissibility of executive
compensation expert testimony and limited the scope of opinions based
on qualifications. United Co. v. Keenan, 2007 WL 4260930,
*15, 19 (W.D. Va. 2007). Even if the scope of the opinion is not
limited, demonstrating the lack of qualifications or industry knowledge
may reduce the weight and credibility of all of the expert's testimony.



DETERMINING COMPENSATION



The basic tools for determining executive compensation utilized by
compensation committees as well as experts include industry surveys and
a customized comparison study created by assembling a list of peer
companies to create a model. If the expert refers to surveys, the
underlying data relating to the surveyed companies should be obtained
and reviewed. In creating a model, peers should be selected based on
similarity of industry, using the Standard Industrial Classifications,
revenue, market capitalization, financial performance or other factors.
See Pereira v. Cogan, 294 B.R. 449, 479-84 (S.D.N.Y. 2003) (concluding that experts did not utilize proper peer groups), rev'd e.g., Pereira v. Farace, 413 F.3d 330 (2d Cir. 2005); In re Adelphia Commc'n Corp., 2003 WL 22316543, *26-28 (Bankr. S.D.N.Y. March 4, 2000); Eckelkamp v. Beste, 201
F. Supp.2d 1012, 1024-28 (E.D. Mo. 2002). Ignoring relevant criteria in
selecting peers may indicate an attempt to obtain a result. Counsel
should compare the peer group used by the compensation committee or the
expert to peer groups used for other purposes by the corporation as
reflected in 10Ks or other filings.



Preparation of cross-examination should include independent data
gathering and review that may expose the inappropriateness of the peers
selected based on their business, performance or other factors such as
regulatory actions.



Facts specific to the compensation of executives at each peer may also expose reasons why they are inappropriate benchmarks.



The peer group may also contain components that are inappropriate or
data that should be adjusted due to differences in cost of living at
the location of the peer's

more....http://www.law.com/jsp/ihc/PubArticleIHC.jsp?id=1202426713305

factors relating to
individual performance can be taken into account can serve to devalue
an opinion based solely on quantitative data.



EDUCATE THE FACT-FINDER



Cross-examination of the expert can also be used to educate the finder
of fact about compensation philosophy through the testimony of the
adverse expert. The best practices pronouncements contain statements
that can be utilized in the defense of compensation decisions, such as
the importance of aligning director and executive interests with
shareholders through equity stakes and considering long-term
performance goals, not just short-term results.



The best practices pronouncements also contain statements that can be
used in aid of making compensation and benefits appear unreasonable,
including statements regarding limits on the ratio of the value of
stock rights awarded by way of options or restricted stock to base
compensation.



Steven A. Beckelman is a partner at McCarter & English and
practices in the areas of securities litigation and commercial
litigation matters in federal and state courts. Daniel P. D'Alessandro
is an associate at the firm who concentrates his practice in securities
litigation.