Caveat Emptor Updated

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Expert Perspective by Grahall’s OmniMedia Editorial Board

Julie Connelly’s February 09, 2010 article in Corporate Board Member “Transparency Time for Compensation Consultants’ Own Compensation” really got our Editorial Board talking. 

Connelly says: “[The] Fury over excessive executive compensation is beating up on the pay consultants too.”  We agree, and found our conversation ranging from the criteria to select an executive comp consultant to whether comp consultants or their firms might find themselves as defendants in shareholder lawsuits over excessively risky behavior that might be seen to be encouraged by executive compensation programs.

The SEC’s new rules around disclosure have driven many public companies to avoid any suggestion of conflict by finding an independent compensation consultant, despite the fact that, as the article points out: “Doing other business for the company when you consult on executive compensation hasn’t been outlawed…  It just has to be disclosed.”

Most public companies do not want to raise any suspicion of conflict, and most multi-service firms do not want to have the fees their clients pay for services disclosed. (According to the Hewitt letter to the SEC  the argument against fee disclosure is something about it being “Proprietary pricing data [which] represents critical market intelligence [that] … competitors could use to potentially underbid us for existing and potential projects.” And, gosh, we guess Hewitt wouldn’t want to give their clients that kind of an advantage!)

At one time, hiring a multi-service firm for compensation advice was about the safest choice a Board could make.  It didn’t matter that the consultant often delivered the same cookie-cutter advice to every client. The mere presence of the multi-line was essentially considered a “seal of approval”, and the company could turn to shareholders and say: “We are doing it right”. 

Now a new age has dawned and companies across the spectrum of size, industry and circumstance are seeking out tailored advice from their consultants as they gear up to meet the increasing demands of shareholders and regulatory agencies (read: the SEC) who will no longer tolerate the mundane, “one size fits all” boilerplate approach to compensation program design and disclosure which was propagated quite profitably by these former standard bearers.

Selection Criteria

So what should companies consider when they look to create an independent relationship for executive compensation?

First of all, it is important to for companies to realize that their decision should not be just “firm” related but “consultant” related as well. The first step is to meet the threshold requirement of identifying non-conflicted compensation firms, because visible and important decisions such those regarding CEO compensation schemes cannot be ignored.  However, selecting an independent firm with an unqualified consultant who doesn’t tailor the program to the company’s specific needs won’t do a company any good either. 

In Grahall’s view, there are four critical factors upon which we have built our practice and approach to executive compensation, and which we believe companies must consider when selecting a consultant:
 
1) Compensation Knowledge: Does the consultant have the requisite knowledge about executive pay?  This may seem obvious, but many consultants focus on broad based pay, which is actually quite different than executive pay.

2) Industry Knowledge:  Does the consultant know your industry?  This is important because of performance characteristics, and being able to accurately gauge the market’s demand for talent.

3) Growth Phase: Does the consultant have experience working with companies in your company’s stage of maturity in its growth cycle?  Ultimately, executive compensation strategies are distinctly different for mature vs. start-up companies, and the failure to adequately consider those differences by focusing solely on best practices can have enormous negative consequences for an organization.

4) Future Planning: Does your company have any potential future events such as IPO, M&A, LBO, etc and does the consultant have experience working in those situations?

Many multi-line firms assign a primary consultant to a company once the relationship is established and the company has little influence in this decision.  Often, new client assignments go to the least busy consultants (who may be the least effective) without regard to specific industry experience or any other attempt to “match” the best consultant with the company’s needs.   That unilateral decision can be a calamity for a company who needs a consultant with certain experience in industry, organizational stage or who expects organizational events to occur.

So let’s review. When looking for a new compensation consultant, companies must:
 
1) Meet threshold requirements: for example, only consider independent firms that are non-conflicted.
2) Identify the minimum requirements for the individual consultant using the four considerations above (Compensation Knowledge, Industry Knowledge, Growth Phase and Future Planning).
3) Look for additional traits or qualities, including the consultant’s integrity, overall experience, and ability to manage research.

Another important consideration is that taking a thoughtful approach to selecting your compensation consultant and using these criteria as a starting point can help identify a consultant who will provide assistance that will limit a company’s risk of poor compensation decisions which can could lead to exposure, embarrassment and shareholder ire.

I doubt that you will be surprised to learn that Grahall is organized so that clients can interview and select the appropriate consultant to meet its needs.  Grahall prides itself as being a client centric that offers tailored advice addressing the distinct aspects of each of our clients.   

Influencers

Another important consideration in the selection of an executive compensation consultant is how will the powerful RiskMetrics Group rate your decision?   RiskMetrics Group, the self proclaimed “leading provider of risk management and corporate governance products and services to participants in the global financial markets”. Helps shareholders make decisions on proxy votes based on assessments of governance.  Poor governance scores = “no” votes. 

At this point, with regard to the new proxy disclosure requirements pertaining to fees paid to companies who advise boards on executive compensation, RiskMetrics indicates that it “… will not apply formulas or any specific policy with regard to compensation consultant fees. As this data is brand new, we will be analyzing it after proxy season and will then develop, in consultation with clients, any policy guidelines that are warranted.

So likely before the 2011 proxy season we will see what consultant decisions are favored by RiskMetrics and which are not. 

Choices

Clients who were worried that all this transparency would leave them with few choices for non-conflicted and qualified executive compensation consultants can relax.  All of these transparency changes have made many executive compensation consultant realize that they are frankly better off outside of the large multi-service firms than inside.  There has been a wholesale migration of some of the most prominent individuals from multi-service to boutique firms leaving many options for companies.

Consultants At Risk?

With the downfall and near collapse of many companies over the past few years and with public outrage still running high, there is a growing demand that the leaders of these companies be brought to justice, and regulators are taking notice.   Most recently we have seen the US District court refuse to dismiss SEC fraud charges against Countrywide’s former CEO Angelo Mozilo, former COO David Sambol and former CFO Eric Sieracki.

According to a November 2009 Reuters article: “The SEC sued the defendants in June, accusing them of misleading investors about the quality of Countrywide’s loans, including tens of billions of dollars of risky subprime and adjustable-rate mortgages.” 

As this case and possibly others move forward, we wonder how long it might be before the defense attorneys start to look for other places to lay blame other than at the feet of their clients.  Perhaps those lawyers will turn their sights on the compensation consultants who designed the pay packages for these now dethroned executives.

An even bigger question involves the role of the consultant: Could Towers Perrin, who advised Countrywide on its executive pay program, ultimately be seen as contributing to the circumstances that resulted in the alleged fraud perpetrated against shareholders? Could the pay package Towers designed be seen as driving the executives to take excessive risks? 

It might be a tough sledding for these CEOs – not far removed from “masters of the universe” status – to argue “I am just a puppet who was victimized by my compensation program”.  That is to try and use the “my consultants made me do it” defense.

Further, if the disclosures are properly written, a lawyer might find little to latch onto when trying to make that connection. However, certain cases in the past might make us think it is not so far-fetched:  in 2003 E&Y and KPMG were sued over tax shelters they were setting up “after the Internal Revenue Service denied the tax savings that [clients] had been promised… plaintiffs in the suits [said] that the accounting firms should have known that the tax shelters would be disallowed and that the firms put their own financial interests ahead of those of their clients.”

Final Thoughts

One final thought on Connelly’s article: Connelly includes a comment about the research that has been used to support multi-service firms’ position of denying any conflict.  She says of published studies: “a paper written by Kevin Murphy and Tatiana Sandino, professors at the University of Southern California Marshall School of Business, turned up the interesting tidbit that CEOs are paid more if a consultant works exclusively for the board than if it works for management.”  Since we are in support of transparency we thought it important to advice our readers that Kevin Murphy was at one time a paid advisor to Towers Perrin.  We wonder whether this relationship with Towers might in some way have influenced Murphy’s findings.     

Companies might be wise to remember the adage “caveat emptor” (let the buyer beware) when looking to replace a conflicted compensation consultant.  Better yet, we encourage companies shopping for a new compensation consultant to consider a newer adage “Let the buyer be AWARE”.

Contact Grahall’s OmniMedia Editorial Board at edie.kingston@grahall.com


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