The 2007 proxy season is the first in which most companies will have to comply with the SEC’s new rules on the disclosure of executive compensation. These rules require companies to disclose a variety of information about executive pay and benefits, including a “total compensation” figure. Although these rules are intended to improve transparency for the benefit of shareholders, an unwelcome side effect may be increased litigation challenging executive compensation and naming corporate directors as defendants. Fortunately, the best defense to such claims remains what it has always been: a fully informed board of directors acting in good faith after following a documented process designed to bring all pertinent information to the board’s attention.

The first litigation risk to consider in connection with the new rules is a claim that the board’s approval of an executive compensation package was a breach of fiduciary duty. In the past, the plaintiffs’ bar has not been very successful in asserting these claims. The best example of this is the decision in In re Walt Disney Co. Deriv. Litig., 906 A.2d 27 (Del. 2006), in which the Delaware Supreme Court held that the directors of Disney did not breach their fiduciary duties by awarding Michael Ovitz a severance package valued at $130 million, after he spent only fourteen months on the job.

The Disney court, however, did state clearly that Disney’s compensation committee did not come close to adhering to “best practices” in approving Ovitz’s severance package. The chancery court even hinted that the result in the case could have been different had the alleged misconduct occurred in today’s climate of evolving governance norms rather than in 1997. In addition, at least two cases alleging breach of fiduciary duty in connection with executive compensation have settled for nontrivial amounts in the past few years (albeit before the Disney decision). In 2005, Abercrombie & Fitch settled shareholder claims alleging waste of corporate assets by slashing its CEO’s $12 million bonus in half and denying him new stock options for two years. In the same year, Fairchild Corporation settled similar claims on similar terms.

The best way to limit the risk of such claims is to ensure that the board acts in an informed manner following an appropriate deliberative process. Courts are more inclined to credit such a process when the following steps, among others, are followed. The compensation committee should take the lead in compensation decisions, and it should retain and rely on an outside expert in executive compensation. This expert should make formal presentations at appropriate times to the compensation committee. The committee should meet as many times as necessary to make a fully informed decision. The length of those meetings should be commensurate with the materiality of the compensation issues being discussed, as courts have found relatively short meetings indicative of a lack of informed discussion. Directors should receive notice of the meeting and the agenda sufficiently in advance to allow them to familiarize themselves with the topics.

Directors should also receive a full draft of any proposed compensation agreement, a summary of its key provisions, and, perhaps most importantly, an analysis of the aggregate cost to the company. Surprisingly, a recent survey by PricewaterhouseCoopers and the Corporate Board Member magazine found that less than half of the directors surveyed said their boards use tally sheets to add up an executive’s total compensation.

Directors should also ensure that they understand the legal standard that will be applied to their decisions. While compensation decisions are normally subject to review under the deferential business judgment standard, if a compensation arrangement is deemed to be a defensive measure intended to ward off a takeover the court may apply the more stringent standard of review articulated in Unocal Corp. v Mesa Petroleum Co., 493 A.2d 946 (Del. 1985).

The second litigation risk to consider in connection with the new rules is a claim alleging that the company’s new disclosures are false and misleading in violation of the Securities Exchange Act. In addition to alleging that companies failed to comply with the new rules, plaintiffs taking this route could argue that what is being disclosed for the first time in 2007 was a material omission from earlier public filings.

Claims of this nature are not typically leveled against directors. Rather, they are filed as class actions against the company and its executives. Given the requirement that plaintiffs in such actions plead and prove loss causation, companies are unlikely to see many of these claims unless their new compensation disclosure triggers a dramatic decline in their share price.

The biggest risk to companies under the new disclosure rules may not be shareholder litigation, but shareholder activism and negative press coverage. With names like Richard Grasso (the former CEO of the New York Stock Exchange) and Robert Nardelli (the former CEO of Home Depot) on the front pages of the nation’s newspapers, combined with continuing fallout from allegations of options backdating, the focus of shareholders and the press on executive compensation has perhaps never been higher. Even President Bush, in his “State of the Economy” speech on January 31, 2007, called on corporate boards to pay more attention to executive compensation, stating that “salaries and bonuses of CEOs should be based on their success at improving their companies and bringing value to their shareholders.”

The SEC’s new disclosure regime may provide more grist for this mill by giving shareholder activists, labor unions and political leaders more easily understood data on executive compensation. Although the new disclosures will allow companies to explain the reasoning behind their compensation decisions, it is doubtful that these explanations, however compelling, will satisfy all of these constituents. Companies will likely feel increased shareholder pressure to align executive compensation more closely with total shareholder return. Companies will also likely see an increased number of shareholder proposals for shareholder approval of decisions related to executive compensation.