August 7, 2008 | Read Time: 6 minutes
Richard A. Grasso, former head of the New York Stock Exchange, won a major victory when two New York courts ruled this summer in his favor — allowing him to keep the $139.5-million he was paid during his tenure.
Because Mr. Grasso and the stock exchange were sued for violating laws governing nonprofit groups, the case represented the most consequential legal challenge that has been pursued over executive-compensation practices at nonprofit organizations.
The case began in 2004 when Eliot Spitzer, who was then serving as state attorney general, took legal action to recoup what he believed to be excessive compensation payments to Mr. Grasso. (The stock exchange was a nonprofit organization at the time of the compensation payments; during the course of the lawsuit it converted to for-profit status as part of a merger with another organization.)
Mr. Spitzer charged in part that Mr. Grasso, and Kenneth Langone, the Home Depot co-founder who served as chairman of the exchange’s compensation committee during the years challenged by Mr. Spitzer, violated their fiduciary duties under New York’s nonprofit law by authorizing and accepting excessive pay.
The controversy ended last month when Mr. Spitzer’s successor, Andrew Cuomo, announced soon after the state lost two key court challenges that the government would not appeal the rulings.
But the implications for nonprofit groups continue. Among the key matters nonprofit leaders must keep in mind:
- The court rulings did not resolve key legal issues. The court rulings dismissed certain allegations, saying they were not sustainable under state law, and also ruled that the state couldn’t seek repayment of excessive compensation because of the stock exchange’s conversion to for-profit status during the time of the lawsuit.
As a result, it didn’t rule on many of the key issues that would come up the next time a state regulator takes a nonprofit group to court over excessive-compensation issues. Among the unresolved questions in the lawsuit pursued by Mr. Spitzer: What does the law mean by its standard that nonprofit groups must make sure compensation is “reasonable,” how can nonprofit groups prove that they have gathered data to show what other executives with similar jobs are paid, and what standards do the board members who serve on compensation committees have to follow? Those are exactly the kinds of questions nonprofit groups can expect to face from regulators in states beyond New York.
- The lawsuit matters to all kinds of nonprofit groups. Leaders of charitable organizations had two dangerous misperceptions about this case. First, they believed that because the compensation Mr. Grasso received was so much higher than any leader in the nonprofit world received, the case did not set any meaningful standards. Second, they saw the case as simply a byproduct of a rogue attorney general who has since been discredited on multiple fronts.
But the importance of the case was not about the dollars; it was the fact that an attorney general was using nonprofit laws similar to those in other states to challenge compensation practices that are common in the nonprofit world.
What’s more, it would be a serious miscalculation for nonprofit leaders to dismiss the case as a “prosecutorial whim.” State charity officials have bona fide reasons for pursuing improper executive-compensation practices at nonprofit groups, and it is clear they have jurisdiction to do so.
Nonprofit leaders should recognize that the resolution of this case by no means limits the fundamental authority and interest of government officials in challenging instances of allegedly excessive compensation.
Indeed, the interest of government officials is likely to remain high, as the Internal Revenue Service continues to examine pay at colleges and universities and in the fall is expected to release a report on the pay of executives at nonprofit hospitals.
In addition, the new provisions that have been added to the informational tax return charities must file are designed to place even more attention on nonprofit pay levels.
- Chairmen of the compensation committees appointed by nonprofit boards need to be careful. Mr. Spitzer charged that Mr. Langone violated the “prudent man” standard of conduct in his role overseeing compensation decisions. Information provided to the compensation committee and to the board members regarding Mr. Grasso’s compensation was “inaccurate, incomplete, and misleading,” according to the allegations. The lawsuit suggested that Mr. Langone withheld certain potentially damaging information at the request of Mr. Grasso.
In his defense, Mr. Langone argued that the records of the compensation-committee meetings made clear that he had fully and faithfully advised his colleagues concerning the relevant details of Mr. Grasso’s compensation.
This case should remind chairmen of compensation committees that they must provide adequate information to committee members, and that they must make sure all members comprehend the information provided so they can make informed decisions.
Keeping full and complete minutes is essential. Well-kept minutes will set forth with clarity the information made available to and relied upon by the committee. They will also help show whether committee members involved in reviewing and approving compensation levels were aware of and understood both the information and the underlying issues involved in setting compensation.
- Think about decisions over the long haul. When a lower court ruled on the case, it said that Mr. Grasso breached his fiduciary duty by failing to advise the compensation committee on the impact each pay raise approved would have on the amount of retirement benefits he received.
While that ruling was overturned on appeal, its basic theme should offer a key lesson — that compensation decisions are more supportable when the board members are made aware of all actual and potential costs. Going forward, chief executives should make certain that the compensation committee has all information necessary for it to understand and evaluate all forms of executive compensation and benefits.
- Avoid conflicts of interest. In his lawsuit, Mr. Spitzer charged that the exchange’s compensation practice reflected a “fundamental breakdown of corporate governance” — beginning with the composition of the compensation committee. He charged that Mr. Grasso was inappropriately involved in the selection of both board and compensation-committee members. Conflicts of interest and independence of charity boards are issues of increasing importance to charity regulators. To avoid real or perceived problems, nonprofit chief executives should not play a serious role in selecting board members or in choosing who serves on the compensation committee.
- “Playing cowboy” has a high cost. An overarching message for nonprofit groups is that there are significant costs — both intangible and tangible — associated with defending aggressive compensation decisions that capture the attention of state charity officials.
For example, the New York Stock Exchange case lasted almost four years. The defendants were able to sustain their defense in large part because they had strong resolve and were very wealthy people who could afford large legal fees.
But the reputations of many individuals — including members of the exchange’s compensation committee — and of the stock exchange itself suffered. And the dollar costs were huge: Total legal fees in the case tallied at least $70-million by some estimates.
The risk of large legal bills, as well as the potential to damage reputations and take time away from other projects, is not a reason for organizations to abandon generous compensation packages that were fashioned in good faith. But given the demands on nonprofit groups, and their mission to serve the public good, it is questionable whether it is wise to keep fighting when state regulators challenge arrangements about pay that could fairly be viewed by the public as excessive.
Ralph E. DeJong and Michael W. Peregrine are lawyers at McDermott, Will, & Emery, in Chicago. They both specialize in legal issues related to nonprofit groups.
