Key 1: Committee Composition

Composition of the board Compensation Committee is the first step toward achieving an effective Committee. Below are some tips to keep in mind when determining which Board members should be on the Compensation Committee:

  • Compensation Committees are typically composed
    of 3 – 5 board members with different, yet complementary backgrounds and skills
  • The Committee should have representation from an active senior executive, an academic, an industry expert, etc., as appropriate. If the Compensation Committee is composed of members with different backgrounds it will allow for more comprehensive and fully vetted discussions
  • The Chair of the Committee should be a strong facilitator who pushes forth open discussion and is willing to hear opposing viewpoints, while being an effective communicator and consensus builder
  • The Chair works to bring meetings to resolution and to conduct efficient meetings

Key 2: Planning

A second important factor for having an effective Compensation Committee is proper planning. Providing Committee members with a road map of what is going to happen at each meeting and throughout the year allows for a more thoughtful approach to topics. Some planning tips include:

  • Annually review the Compensation Committee charter to ensure that the Committee complies with their responsibilities and to see if any changes are required based on regulatory and legislative changes, or evolving practices
  • Review the annual calendar at the beginning of each fiscal/calendar year and highlight any key priorities for the year (e.g., long-term incentive plan re-design)
  • Provide Committee member education on key and emerging topics on an ongoing basis so they can make informed decisions. Recent emerging topics include the risk assessment process, SEC disclosure rules, shareholder red flags, and the voting policies of the two main proxy advisory firms – Institutional Shareholder Services (“ISS”) and Glass Lewis
  • Obtain views of shareholders on an ongoing basis; listen closely to shareholders to get ahead of any potential issues on an annual basis
  • Educate new members to provide them with a background on the company’s historical pay practices and performance

Key 3: Establish Processes

Finally, another important factor for having an effective Compensation Committee is having proper and systematic processes for each Committee meeting. Effective Committee processes include:

  • Set meeting dates with plenty of lead time to allow for well attended meetings by Committee members, management and external advisors
  • Preview each meeting agenda with Committee Chair; establish time limits for topics
  • Preview meeting materials well in advance of meetings to address all issues that may potentially arise
  • Allow major decision points to be covered at two meetings to give the Committee time to preview and fully vet prior to final approval
  • Ensure open and ongoing communication with management to have context for decision making
  • Involve the Audit Committee and company Finance during the goal setting process for absolute performance plan goals in the annual incentive and long-term incentive plans
  • Involve Legal in CD&A and proxy disclosure, potential filings related to any pay decisions and other technical issues
  • Annually test effectiveness of pay plans relative to actual company and stock price performance as well as pre-established goals
  • Monitor evolving regulatory, legislative and corporate governance practices by including the topic as an annual or biannual agenda item
  • Conduct an executive session at each Committee meeting to ensure any concerns are addressed
  • Schedule calls after each Committee meeting with Committee Chair, management and external advisors to debrief and confirm next steps
  • Annually assess the performance of the Compensation Committee and its external advisors during the self-assessment process

In our experience, Compensation Committees that incorporate these three keys have more efficient meetings and are more effective in bringing tough decisions to resolution. While not all approaches will be the same, using a framework with similar characteristics often leads to more engaged Committee members and more organized meetings. In today’s environment, with Say on Pay and increased shareholder concerns, it is increasingly important to have a best-in-class Compensation Committee.

  • In addition to the five factors (listed later) that must be considered when assessing a compensation adviser’s independence originally included in the Dodd-Frank legislation and the proposed rules, the committee must also consider any relationships the adviser may have with an executive officer (proposed rules only required assessment of relationships with committee members)
  • The proposed rules only addressed the independence of the members of the Compensation Committee; however, the final rules also specify that the requirements apply to all Board members who are acting in a fashion similar to the Compensation Committee
  • This may be of particular relevance when significant compensation decisions are made by the full board. Companies will need to be cognizant of what Directors may or may not vote on specific compensation issues.

Timing for Implementation

The new rules and amendments will take effect 30 days after publication in the Federal Register. The stock exchanges have 90 days from the date the rules are effective to propose listing standards and one year from the date of effectiveness to have final rules in place. In addition, companies must be in compliance with the new required disclosure regarding the use of a compensation consultant (including whether the work of the compensation consultant has raised any conflicts of interest and if so, how the conflict is being addressed) for the proxy material for any annual meeting at which directors are elected on or after January 1, 2013.

In the section below, we provide a brief summary of highlights of the adopted rules.

Committee Independence

The listing standards must require that each member of a company’s compensation committee be independent. The definition of independent is left to each of the exchanges to define, but needs to consider relevant factors, including:

  • A director’s source of income, including any compensatory arrangement with the company
  • Whether a director is affiliated with the company or any related entity

The rules do provide the exchanges flexibility to exempt particular relationships from the independence requirement, as deemed appropriate by the exchanges, if warranted by relevant factors (e.g., size of company).

Compensation Advisers

The final regulations also direct the exchanges to establish listing standards related to compensation advisers (e.g., consultants, legal counsel, etc.), they specify the following:

  • Each compensation committee must have the authority, in its sole discretion, to obtain the advice of compensation advisers
  • Before selecting any compensation adviser, the compensation committee must take into consideration specific factors identified by the Commission that affect the independence of compensation advisers, though there are no specific thresholds or tests specified. The six factors are:
    1. Does the adviser’s firm provide any other services to the company
    2. The fees received by the adviser as a percent of the adviser’s total revenue
    3. The policies and procedures the adviser firm has in place to prevent conflicts of interest
    4. Any business or personal relationship between an advisor and the compensation committee
    5. Whether the adviser owns stock in the company
    6. Any business or personal relationship between the adviser and executive officers
  • The compensation committee must be directly responsible for the appointment, compensation and oversight of the work of the advisers
  • Sufficient funding must be provided to pay the adviser

Note the rules do not limit the exchanges from adding additional criteria to the assessment of adviser independence. It is also worth pointing out that the adopted rules do not require Committee’s to use an independent adviser, but only to assess the independence of the adviser. The adopted rules also clarify that in using the advice of in-house legal counsel, the Committee does not have to consider the independence factors.

Disclosure of Consultant Independence and Conflicts of Interest

As mentioned earlier, for any consultant that played a role in determining or recommending the amount or form of executive and director compensation and whose work has raised any conflict of interest, the companies will be required to disclose the nature of the conflict of interest and what the company did to address the conflict. This disclosure does not eliminate any of the currently required disclosure regarding executive compensation consultants (e.g., identify consultant, state whether consultant was engaged directly by the compensation committee, describe the nature and scope of the engagement and instructions given to the consultant, and fee disclosure if the consultant provided additional fees greater than $120,000)

Conclusion

The adopted rules adhere closely to the original language of the Dodd-Frank legislation and to the proposed rules. The next step in the process of implementation will be in the exchanges’ development of the listing standards. The adopted rules provide the exchanges with a good degree of flexibility in how they will define independence and the factors to consider in assessing independence. It will be interesting to see if they do much beyond what is laid out in the adopted rules to clarify the rules.

The proposed rules are generally consistent with expectations and reflect a straight-forward application of Dodd-Frank. Much of the implementation of this aspect of Dodd-Frank will actually be accomplished through the listing standards adopted by the national securities exchanges, subject to approval by the SEC. For the most part, where there was ambiguity in how to interpret Dodd-Frank’s language, the SEC has passed the responsibility for interpretation on to the national securities exchanges or has let the Dodd-Frank language stand, but solicited comments on whether further clarification is necessary.

The SEC is soliciting comments on a number of aspects of the proposed rules, with a deadline for any comments of April 29, 2011. Below is a summary of the key provisions of the proposed rules based on a review of the full text and accompanying press release. We also provide our own comments on some of the key areas where the SEC is seeking input.

Listing Standards and Compensation Committee Independence

One of the objectives of Dodd-Frank was to ensure the independence of the Compensation Committee. To promote this objective, Dodd-Frank requires that national securities exchanges adopt listing standards to address the following issues:

  • Require that Compensation Committee members be independent. Factors that need to be considered in assessing independence include:
    • Sources of compensation of a director, including any consulting, advisory or compensatory fee paid by the company to such member of the board of directors
    • Whether a member of the board of directors of a company is affiliated with the company, a subsidiary of the company, or an affiliate of a subsidiary of the company
    • CAP Comment: The SEC is seeking comments on aspects of this rule including whether they should require minimum independence standards for all exchanges beyond consideration of the two factors above and whether the standards should be based on current relationships only or have a “look back” period. It will be interesting to see if the listing standards converge to a consistent standard or if slight differences remain
  • Authority and Funding of the Compensation Committee – Listing standards need to indicate that the Compensation Committee has the authority to obtain a compensation adviser, is directly responsible for the adviser and must be appropriately funded to pay for the adviser
    • CAP Comment: This aspect of the rule is more straightforward, but the SEC is seeking comments on technical aspects related to use of legal advisers including the definition of an “independent legal counsel” and the potential need for clarification around the use of in-house legal counsel or the company’s outside counsel. In addition, they are seeking comments on what the typical administrative expenses for Compensation Committees are and whether a provision requiring funding of such expenses would be helpful
  • Compensation Adviser Selection: Listing standards must state that the Compensation Committee may select a compensation consultant, legal counsel or other adviser only after considering the following five factors:
    • Other services provided to the company by the adviser
    • Compensation adviser fees from company as a % of total fees
    • Compensation consulting firm’s conflict of interest policies and procedures
    • Business or personal relationships between compensation adviser and members of the Compensation Committee
    • Compensation adviser’s ownership of company stock
    • CAP Comment: In the proposed rules, the SEC did not choose to expand the number of factors to be considered beyond the original five specified in Dodd-Frank. The SEC is soliciting comment on the competitive neutrality of the five factors, potential additions to the factors to consider, and multiple issues for potential clarification (e.g., does adviser refer to the firm or individual providing services?, should there be specific tests/thresholds applied to the five factors?)
  • Exemptions: The proposed rules require the exchanges to exempt the following five categories of companies from the Compensation Committee independence requirements:
    • Controlled companies
    • Limited partnerships
    • Companies in bankruptcy proceedings
    • Open-end management investment companies
    • Foreign private issuers that disclose in annual report why they do not have an independent Compensation Committee
    • Note: The proposed rules would authorize exchanges to exempt certain types of relationships or classes of companies from the independence requirements, subject to SEC approval
    • CAP Comment: The SEC is soliciting comments on whether certain types of companies (e.g., smaller reporting companies, recent IPOs) should be exempt from the rules or provided with additional time to comply

Compensation Conflicts of Interest Disclosure

The proposed rules will build on the existing disclosure requirements but also require additional disclosure about whether:

  • The Compensation Committee has retained or obtained the advice of a Compensation Consultant
  • The work of the compensation consultant has raised any conflict of interest, and, if so, the nature of the conflict and how the conflict is being addressed
  • The proposed rules would eliminate the current disclosure exception for services that are limited to consulting on broad-based plans and the provision of non-customized benchmark data, but retain the current fee disclosure requirements, including the exemptions from those requirements
  • CAP Comment: The SEC is soliciting comments on key aspects of this issue, including whether or not they should attempt to clarify what a “conflict of interest” that must be disclosed is. Another area where they are seeking input is on whether any information related to the five factors under consideration needs to be disclosed

Conclusion

For most of these rules, the impact will be through the new listing standards for the national securities exchanges rather than directly through the SEC’s regulations. For larger companies, Compensation Committee member independence will likely be a non-issue as most already have Compensation Committees made up of all independent directors and it is unlikely that the new listing standards will make the independence requirements significantly more stringent.

On adviser independence, we expect that the outcome will be that companies will likely operate within the general guidance provided by the five factors. Companies will need to develop a process to conduct a review of the five factors and come to their own conclusions about whether or not there is a conflict of interest. Companies may choose to say they evaluated the principles and determined the adviser to be independent. Other may go into more elaborate detail about the process and determination similar to the way companies have addressed the disclosure of risk assessment in compensation.

Each pay consulting relationship is unique. Once the consultant is selected, the committee should define in advance its objectives and expectations.

Board compensation committees must not only deal with the competing demands of regulators and shareholders, but must now operate in an environment where their actions and decisions are highly visible and often criticized. For many boards, hiring an out-side compensation consultant to help them navigate this highly complex environment is a worthwhile and prudent business decision. A consultant can help the committee fulfill its oversight and governance responsibilities while maintaining competitive, compliant, and responsible executive pay.

In this article, we discuss how the compensation committee and the compensation consultant can have an effective relationship. The process begins with the compensation committee defining its objectives and expectations and hiring the consultant. We then discuss procedures that emphasize communication and facilitate productivity.

A mutually beneficial consulting relationship will require considerable dialogue. When the relationship is built on a solid foundation, differing points of view can be addressed without detriment to the ongoing consulting relationship.

An effective consulting relationship begins with the selection process. The human resources department or procurement may begin the process with a “request for proposal.” However, the process should be driven by the compensation committee itself. Selection criteria should be identified as well as any required skills, knowledge, or experience. Often, experience in a particular industry, or experience with a specific transaction, such as an IPO or merger is important. If the company is expanding internationally, global resources and data may be needed.

The full compensation committee should be involved in interviewing the consultant or team, and they should assure that those they are interviewing will be the ones involved in the engagement. The committee must be comfortable with the consultant’s experience on similar issues facing the company, with the consultant’s technical acumen, access to available resources, and ability to present a coherent and well thought-out point of view. The consultant’s references should also be checked.

Where the committee is not experienced in working with outside advisors, the consultant can help structure objectives and processes that work.

Each consulting relationship is unique. A start-up company, an IPO, or a newly merged or acquired company may need help with virtually every aspect of employee pay design. Other companies may need an overall review of management’s pay recommendations and expert opinion to the committee at each meeting. Others may need specific technical expertise (a company in Chapter 11; one that has received TARP monies, etc.)

Once the consultant is selected, the committee should define in advance its objectives for the year and its expectations of the consultant. This need not be an involved or lengthy process, but in any working relationship, purpose and context need to be provided.

For example, if the compensation committee needs education and training on executive pay issues and practices, it should inform the consultant. If the committee is not comfortable with the design of the incentive plans that have provided lucrative payouts while stock price remained flat, the consultant should know about it. If there is disagreement over Ike CEO’s pay or the pay and performance linkage, the consultant should be alerted.

Certainly, if the prior consultant did not meet the expectations of the committee, the new consultant should be told why. Where the compensation committee is not experienced in working with outside advisors, the consultant is in an excellent position to help structure objectives and processes that work.

Most of all, the committee relies on the consultant for experience and expertise, to help ensure that the company is not exposed in terms of inappropriate pay practices. Ultimately, the overall goals of the compensation committee and consultant are the same: to help the board perform its governance and oversight role in an informed manner.

It is surprising how often committee chair/ consultant dialogue does not happen or comes too late to avoid a problem.

Throughout the year, the compensation committee and consultant should adhere to certain practices that will lead to a successful working relationship. There will still be challenges and tough issues to work through together, but these processes will help materially in achieving committee objectives.

  • At the beginning of every year, the consultant should develop a “statement of work” that defines the scope of their consulting activities for the coming year, including deliverables, fees, timing, and reporting relationships to the committee. If there is an annual calendar of meeting dates and activities, the statement of work is straightforward. Since the human resource function is typically responsible for the annual calendar, this planning helps to ensure that all parties have a common understanding for the year ahead.
  • If the committee has not done so already, its goals and objectives should be articulated to the consultant. This should include objectives for the consultant, but might also include objectives for the committee itself. The committee chairperson should also alert the consultant to any critical issues facing the committee.
  • In a new relationship, the committee will often request that the consultant provide a high-level review of the company’s executive pay program, highlighting any atypical or uncompetitive pay practices or plan features that should be reviewed in detail. It is incumbent on the consultant to uncover potential problem areas that need to be addressed.
  • The committee chairperson and consultant should review meeting materials in advance of each meeting, preferably before the materials are mailed, which allows for revisions. This allows both parties to understand each other’s point of view and pose questions that will help in meeting preparation.
  • The consultant should assure that the chair under-stands the key messages to be delivered on a particular topic. The chair, in turn, can use the opportunity to bring the consultant up to speed on any strong committee views or business issues that may be relevant to the subject matter at hand. This could include plan design, competitive analysis, the CEO’s contract or pay recommendations. It is surprising how often this dialogue does not happen, or comes at the last minute when it is often too late to resolve an issue or avoid a problem during the meeting.
  • In today’s environment, the compensation committee cannot be passively waiting for problems to occur. It relies on the consultant to uncover relevant and timely pay issues.
  • The consultant should be available for every meeting and executive session, as requested by the chairperson. Time should be scheduled for debriefing, particularly when follow-up activities are required. When the meeting agenda is full, or when many decisions have been made, follow-up ensures that everyone has similar takeaways.
  • The committee’s annual calendar typically includes a review of compensation strategy, annual pay benchmarking, assessment of the pay and performance relationship, and risk assessment. At the most basic level, both parties should work to avoid controversial pay practices, ensure that pay programs support company strategy, and establish appropriate performance linkages for incentive plans. These are joint responsibilities. Any review of CEO pay (with recommendations) should go to the chairperson first, without prior review by the CEO.
  • The performance of outside advisors should be evaluated as part of the committee’s annual self -evaluation. Even if the consultant assists the committee with the evaluation, it is important that the members review the overall relationship each year to determine if the consultant is meeting expectations. Feedback should be provided to the consultant.
  • At the end of each year, management (usually human resources) should provide the committee with documentation on the consultant’s fees and deliverables for the year. A summary of all services and fees provided by the consultant’s firm to the company overall should also be provided.
  • As part of the committee’s review of the proxy Compensation Discussion and Analysis (CD&A), the required language describing the consultant’s involvement in pay decisions should be reviewed, as well as other needed disclosure.
  • There should be a clear process for requesting and approving additional work for the consultant during the year. If management has a need for additional work, the committee should approve it. If the amount of work the consultant’s company does overall is significant, the committee may want to know about such work in advance.

The processes described above will contribute to a productive relationship between the compensation committee and its consultant. The following success factors can strengthen the relationship even more.

The consultant should not play both sides of an issue, and has a responsibility to express an opinion even if it is not one shared with the chair, the committee or the CEO.
  • The chairperson and consultant must have access to one another during the year. They should communicate before and after each meeting, and whenever necessary.
  • Both parties must have realistic expectations about the relationship. They may not always agree on every issue, but this is not a signal of failure or dysfunctional relationship. The committee must be open to views and opinions different from its own, and consultants must understand that their responsibility is to voice opinions to the committee, even if it is not what the board (or CEO) wants to hear.
  • The committee and consultant should proactively review company pay programs and practices, while anticipating potential issues or necessary changes. In today’s environment, the compensation committee cannot be reactive and wait for problems to occur. The consultant must uncover relevant and timely issues.

For example, if the company intends to seek shareholder approval of a new long-term incentive plan share reserve, the committee should research the voting policies of their largest institutional investors before making the request. When advisory groups introduce new policies, companies should review their programs to anticipate any problem areas that could arise. The committee should also involve the board’s audit or risk committee in an annual evaluation of pay programs as it relates to risk.

  • Understand that the ultimate decision-making is the responsibility of the compensation committee, not the consultant. The committee needs to exercise its own judgment after getting the best information and advice possible.

In the past year, consultant independence has come to the forefront. Since 2006, if a consultant played a role in determining or recommending executive or director pay, the consultant had to be identified in the company’s proxy and the scope of services and reporting relationship had to be noted. SEC rules approved in December 2009 expanded the requirement to include the fee disclosure if a consultant provides additional services to the company beyond $120,000 in the aggregate. Also in 2009 draft legislation delivered from the Treasury Department to Congress included a provision that any compensation consultant or legal counsel hired by the compensation committee must be “independent” from management.

Most full-service consulting firms have independence standards to manage any potential conflicts, while a boutique firm specializing only in executive compensation is generally structured to reduce the potential for conflict.

Treasury Department Fact Sheet

Providing Compensation Committees With New Independence

Draft legislation was delivered by the Treasury Department to Congress in 2009 to promote the independence of compensation committees. Key elements would include:

  • Compensation committee members will be required to meet stronger standards for independence that are to be issued by the SEC.
  • To ensure that compensation committees receive objective advice, any compensation consultants and legal counsel hired by the committee must be independent from management.
  • Committees must be given the authority and funding to hire independent consultants, outside counsel, and other advisors who can help ensure that the committee bargains for pay packages in the best interests of shareholders.

The compensation committee should also have procedures in place regarding the consultant relationship (hiring and firing authority, direct access to the committee, performance evaluation, executive sessions, etc.) that help ensure objective advice, as well as a protocol on mitigating conflicts. Absent a mandated definition of consultant independence, what is important is that the committee be satisfied with the relationship and that there are procedures to avoid conflict.

A related issue which has attracted increased attention is the use of more than one compensation consultant. If two consultants are used (one reporting to the compensation committee, the other to management) the roles should be clearly defined and agreed to in advance. The predominant view is that one consultant reporting to the committee is a more effective arrangement, but the dual consultant model is certainly workable.

To have an effective working relationship, both the compensation committee and the consultant have specific roles to play.

Outside compensation consultant. It is expected that the consultant know the company and industry and stay current on all regulatory issues, as well as best practices in plan design, performance measurement, and pay practices. The consultant should not play both sides of an issue, and has a responsibility to express an opinion even if it is not one shared with the chairperson, the committee, or the CEO. Above all else, the consultant needs to be a “trusted advisor” helping the committee think strategically, raising questions and issues the committee should be thinking about.

Compensation committee. Many committee activities are dictated by various regulatory bodies (stock exchanges, the SEC. FASB, etc.), or specific legislation, such as Sarbanes-Oxley. At a tactical level, each committee must follow its charter to ensure members are fulfilling their responsibilities.

The committee also needs to work with other committees of the board (audit, nominating/governance, risk, etc.) and keep the full board informed of decisions, particularly on CEO compensation. The compensation committee chairperson should develop a healthy working relationship with the CEO.

The committee itself should maintain adequate skills among its members. Diverse areas of expertise and complementary skills are a plus, and basic financial acumen a necessity. Most importantly, the committee must represent the shareholders.

While the formal reporting relationship of the consultant must be to the committee, a good working relationship between the consultant and management can have an extremely positive impact. Management provides necessary compensation data and financial or legal information. Management can also confirm data accuracy and timeliness, and provide a historical perspective or rationale for unusual pay practices. It can explain how certain programs are implemented (such as company specific definitions for metrics used in incentive plans.)

A good relationship with management can also help provide information on the various viewpoints held on pertinent issues, and offer insights on culture and business strategy. In many cases, pre-committee meeting conference calls and preparation may involve the consultant, the compensation committee chair, and human resources. When all three parties are involved, productivity in the committee meetings can be greatly enhanced. Open communication, where appropriate, contributes to better working relationships overall.

A good working relationship between the consultant and management is a positive. Management provides necessary pay and financial information, plus insights on culture and business strategy.

Executive compensation is a sensitive area. Such factors as company performance, personal views on pay, or a shareholder vote against committee members can temporarily change committee dynamics. Additionally, problem areas can arise: a mistake may be made as a result of not having current data; meeting participants may not be fully prepared when a specific issue arises that was not on the agenda; a committee member may question a methodology used by the consultant; or the consultant may be caught in the middle of two disparate views. Most issues can be worked out. The important thing is for the chairperson and consultant to acknowledge a problem when it occurs, accept responsibility for their role in the misunderstanding, and focus on action to correct the problem.

In the future, the need for compensation committees to work effectively with consultants will increase as new regulations take effect and companies work their way out of the current recession. The committee’s role and potential impact – as well as its exposure to public scrutiny – will not diminish.

Nonetheless, along with greater demands and challenges comes the opportunity to make meaningful decisions in shaping pay programs. In many companies, this will ultimately result in pay strategies and programs that are tightly aligned with the competitive market and meaningful returns to shareholders

Please contact us at (212) 921-9350 if you have any questions about the issues discussed above or would like to discuss your own executive compensation issues. You can access our website at www.capartners.com for more information on executive compensation.

Reprinted by THE CORPORATE BOARD
4400 Hagadorn Rd, Okemos, MI 48864-2414, (517) 336-1700
www.corporateboard.com @ 2010 by Vanguard Publications, Inc.

We found that 20 out of 25 companies (80%) retained the services of an executive compensation advisory firm in 2008. The large multi-service human resource consulting firms dominated, with either Towers Perrin, Mercer or Watson Wyatt providing services to 12 of the 20 companies (60%). The remaining eight companies (40%) retained smaller boutique firms that are unlikely to provide other services, including Pearl Meyer & Partners, Frederick W. Cook, Total Reward Strategies LLC, Compensation Strategies LL, ExeQuity and icca .

Two of the 20 companies (10%) reported changing advisors, but a trend toward the boutique firms was not apparent. Chevron replaced Hewitt, a multi-service firm, with ExeQuity, but Unitedhealth Group moved in the other direction, replacing Semler-Brossy, a boutique, with Towers Perrin, a multi-service firm.

Seventeen of the 20 companies (85%) indicated that their executive compensation advisory firm was independent. Three companies (15%) did not address this issue in their disclosures.

Nine of the 20 companies (45%) defined an independent compensation consultant as a firm that did not do any other work for the company. One company (5%) applied this standard to the individual adviser, rather than the firm, noting that the individual consultant did no other work for the company. Seven of the 20 companies (35%) maintained that their compensation consultant was independent, while allowing the consulting firm to provide other services. Several noted that the extent of these services were modest or immaterial. In some cases, the Compensation Committee required advance approval of other services. In other cases, Committee approval was not required specifically.

Several companies added their own unique provisions to their definition of independence. Some examples include:

  • Requiring that the consulting firm annually attest to compliance with the stipulation to do no other work;
  • Rotating the consultant after five years, and prohibiting the Company from hiring any consulting firm staff involved with the account for one year;
  • Requiring that the individual consultant not be involved in other work, prohibiting sharing of information on compensation with other staff of the consulting firm, and requiring that the consultant’s compensation not depend on cross-selling other services;
  • Limiting payments to affiliates of the consulting firm to two percent of aggregate gross revenues of the consulting firm and its affiliates;
  • Prohibiting the consulting firm from providing services directly to senior officers of the Company.

Two companies embraced the concept of enhanced disclosure. Home Depot disclosed fees paid to both its consulting firm and to an affiliate of its consulting firm that provides other services related to the retirement plan. Another company committed to disclose aggregate fees by category of service if it determined that its consultant was not independent. In this case, the consulting firm would not be deemed independent if it or its affiliates provide other services that exceed two percent of gross revenues; or if individuals serving the Compensation Committee provide other services not at direction and under supervision of the Committee. A third approach we have seen used outside of the Fortune 25 population is to publish the ratio of executive compensation consulting fees to fees for other services, with the consulting firm deemed independent provided fees for other services are less than compensation consulting fees.

In summary, the majority of companies are now defining independence strictly to prohibit the firm and the individual consultant from doing other work for the company. A minority of Compensation Committees allow their consultants to perform other work, but require Committee approval and/or a materiality threshold.

Assuming the SEC is ultimately called to develop standards for consultant independence, what approach will they take? If the SEC requires consulting firms to do no other work, the SEC will limit the ability of the large multi-service consulting firms to compete in the marketplace. On the other hand, if the SEC imposes less rigorous standards, it may be in the awkward position of espousing a set of standards that are less comprehensive than in place currently at the majority of large companies.

Please contact us at ((212) 921-9350 or info@capartners.com) if you have any questions about the independence issues discussed above or would like to discuss your own executive compensation issues.

Below we review the recent legislative and regulatory activity, culminating in passage of the Corporate and Financial Institution Compensation Fairness Act of 2009 by the House on July 30, 2009.

Shareholder Empowerment Act

Representative Gary Peters proposed an amendment to the Securities and Exchange Act of 1934 that would require a number of reforms, including enhanced proxy access, independent chairman for corporate boards and say on pay.  The Act would require boards retaining advisors in connection with negotiating employment contracts or compensation agreements with executives to retain only independent advisors that report solely to the board of directors or the committee responsible for executive compensation. The Act also requires that companies not agree to indemnify or limit the liability of compensation advisers or advisory firms.

Examples of criteria Boards should consider in determining whether an adviser is independent suggested by Peters include:

The extent (as measured by annual fees and other relevant metrics) to which the individual adviser or advisory firm provides other services to the Company or its executives;

Whether individual advisers are permitted to hold equity and do hold equity in the  Company; and

Whether an advisory firm’s incentive compensation plan links the compensation of individual advisers to the advisory firm’s provision of other services to the issuer.

Corporate and Financial Institution Compensation Fairness Act of 2009

Representative Barney Frank, Chairman of the House Financial Services Committee, submitted H.R. 3269 a few weeks later.  The primary purpose of this Act is to amend the Securities Exchange Act of 1934 to provide shareholders with an advisory vote on executive compensation and to prevent perverse incentives in the compensation practices of financial institutions.  But independence standards for both Compensation.

Committee members and outside compensation consultants are also addressed.  H. R. 3269 was passed by the House on July 30, 2009.

H.R. 3269 requires that Compensation Committee advisers for all public companies – including compensation consultants, legal counsel, or other advisers — meet new standards for independence to be established by the SEC within nine months of the Act’s enactment.  While the bill will not become law unless the Senate acts, many feel that independence will almost certainly become an absolute requirement for Compensation Committees.

The bill was amended to provide that the SEC’s regulations for independence and disclosure are competitively neutral among categories of consultants.   The intent here is to preserve the ability of Compensation Committees to retain either boutique consulting firms that only provide compensation consulting advice or multi-service consulting firms that provide other services, such as actuarial services or outsourcing.  Nevertheless, we predict that it will be difficult for multi-service firms to compete effectively if they provide substantial other services to corporate clients.

The Compensation Committee would have the authority, in its sole discretion, to retain an independent compensation consultant and would be directly responsible for the appointment, compensation, and oversight of the work of the consultant. Committees would not be required to follow the adviser’s recommendations and would continue to be expected to exercise its own judgment, but they would own the process.

Frank’s Act also requires disclosure in the proxy whether or not the adviser met the standards for independence that the SEC will establish.  Finally, appropriate funding of payments to independent advisers, as determined by the Compensation Committee, will be required, assuring Committees’ access to appropriate advisers.

Treasury’s Proposed Investor Protection Act of 2009

On July 16, 2009, Treasury submitted draft legislation to congress that would ensure the independence of Compensation Committees.  Treasury noted that Compensation Committees without access to independent compensation consultants may be at a significant disadvantage when negotiating pay plans with management. Treasury sought to level the playing field by providing Committees with access to compensation consultants, legal counsel, and other advisers.

Treasury noted that conflicts of compensation consultants are pervasive since advisory firms often provide other, non-compensation related services to companies.  In addition the fees earned for other services often dwarf the fees earned from compensation consulting.

Treasury outlined several new requirements applicable to all public companies within nine months of the bill’s enactment.  First, the SEC would be empowered to set standards for consultant independence. Each Compensation Committee would be authorized to retain an independent compensation consultant and would be directly responsible for the appointment, compensation, and oversight of the work of the independent consultant.

The Committee’s choices would be subject to proxy disclosure.  The company would be required to disclose whether or not the Compensation Committee retained an independent compensation consultant.  If the Committee did not retain an independent consultant, the rationale not to do so would need to be explained.

SEC Proposed Rules on Proxy Disclosure and Solicitation Enhancements

The SEC also weighed in on the compensation consultant independence issues.  Currently companies are required to disclose the role of compensation consultants in determining executive and director compensation, including whether they are engaged directly by the Compensation Committee. The SEC noted that many compensation consultants provide a broad range of additional services to companies, and fees for other services may be larger than fees earned by consultants for executive compensation. The SEC noted that “ provision of such additional service by compensation consultants or their affiliates may create the appearance, or risk, or a conflict of interest that may call into question the objectivity of the consultants’ executive pay recommendations.”

Under the SEC’s proposed rules, if a consultant played a role in determining or recommending the amount or form of executive or director compensation and also provided additional services, the Company would be required to disclose:

A description of all additional services provided during the prior fiscal year;

Aggregate fees for all additional services, as well as aggregate fees related to executive and director compensation consulting;

Management’s role in the decision to engage the consultant for additional services;

Whether the Board or Compensation Committee approved all of these additional services.

We expect the SEC to modify these disclosure rules to respond to the requirement for “competitively neutral” regulations embedded in H.R. 3269. The SEC’s proposed rules are not competitively neutral since fee disclosure would apply only if additional services were provided.  This confers a major advantage on boutique firms that do not provide additional services, since they would be exempt from the disclosure requirements.  The  attention of regulatory and legislative bodies on this issue will certainly continue. As we point out below (“How Companies Handle Independence Issues”) some companies are already initiating their own independence standards for compensation consultants.

Please contact us at ((212) 921-9350 or info@capartners.com) if you have any questions about the independence issues discussed above or would like to discuss your own executive compensation issues. Compensation Advisory Partners LLC